In the current situation, the assumption that the credit crisis is behind us is completely out of line with what possibly could result from the marriage of deep employment losses and an onerous reset schedule on mortgages that have extremely high loan-to-value ratios. A major second wave of mortgage losses isn’t a question of whether the economy will post a positive GDP print this quarter or next. Rather, it is a structural feature of the debt market that is baked into the cake because of how the mortgages were designed and issued in the first place.
If one wishes to monitor the markets for emerging signs of risk, several areas are worth watching. First, the FDIC should release its most current Quarterly Banking Profile later this week. That report will be an interesting gauge of emerging credit stress. Yet even here, a lot of the pressure to properly account for losses on off-balance sheet entities and so forth won’t start until next year. In the meantime, credit spreads in general, and credit-default swaps on individual companies may bear closer attention in the weeks ahead. Finally, given the enormous pressure there may be to put a good face on increasingly bad assets, the departure of the chief financial officer of at least one major banking institution, which would not surprise me early next year, might be a sign that all hell could break loose.
The past decade has been largely the experience of watching tanks rolling over a hilltop to attack the villagers celebrating below. Repeatedly, one could observe these huge objects rolling over the horizon, with an ominous knowledge that things would not work out well. But repeatedly, nobody cared as long as it looked like there might be a little punch left in the bowl. As a result, long-term investors in the S&P 500 have achieved negative total returns over a full decade. These negative returns, of course, were also predictable at the time, based on our standard methodology of applying a range of terminal multiples to an S&P 500 earnings profile that has – aside from the recent collapse – maintained a well-behaved growth channel for the better part of a century.
From my perspective, we are again at the point where we should be alert for tanks. We already know that stocks are priced to deliver a 10-year total return in the area of 6.1% annually – among the lowest levels observed in history except for the period since the late-1990’s (which despite periodic advances has ultimately not worked out well for investors). We are already observing evidence of weak sponsorship from a volume perspective and growing non-confirmations of recent highs from the standpoint of market internals. The cumulative tally of surprises in economic reports (a metric we credit to Bridgewater, which Bill Hester adapted here), has also turned down decidedly. Though the historical correlation is not always as strong as it has been during the recent downturn, shifts in economic surprises have tended to lead market turns in recent years.