Time Horizon Compression

Before I start for the evening, I would like to point to another Stable Value is in trouble piece from a reputable source.  I never knew that AIG was 10% of the wrapper business.  Well, as I often say, “Seemingly free money brings out the worst in people.”

This piece will have echoes from my recent piece The Bane of Broken Balance Sheets, where I tried to point out why many assets are trading below equilibrium levels, but also why it is rational for them to be so valued, because of the lack of long-term financing capacity.  This piece will talk about shrinking time horizons, or equivalently, a rise in discount rates for distant and risky cash flows.

During recessions, people become more short term in their thinking.  It is even worse in depression conditions, as we are in now.  Average people become concerned for their jobs, and begin saving as a pad against the future.  Spending is not so free.  Things that are broken can be fixed or done without.  We can live with a dent here or a scratch there. Coffee?  I can make that myself.  Homemade bread tastes a lot better.

Given the implicit downward pressure on wages, people begin producing more at home, and more in informal areas of society, where the ability of the taxman to reach in is reduced or non-existent.  Now when average people are so concerned about their current expenses, do you think they are in a mood to take investment risks?  Not at all.  Money is needed with near certainty.  Even tax-advantaged vehicles like 401(k)s and IRAs are targets for raiding.  The concept of retirement becomes quaint, fueled by the large birth cohort attempting to do it, versus the smaller prior birth cohorts that society could easily handle.

Sorry, but someone has to do the work, and to have too many aiming to retire in a nation that does not save is not possible.  So there are many with inadequate savings that are pulling back, and realizing that they will have to work until they die, or are incapacited.  Social Security won’t swing it, and in another 10-15 years, benefits will begin to be reduced in real terms, because the economy will not be able to bear it.

Now, someone might (tactlessly) say, “Okay, so poor working schmoes will have to work until they die.  Big deal for the capital markets, because they are marginal players there.”  For one with more delicate sensibilities, I would point them to the subprime mortgage market in 2006, of which I wrote a timely piece.  Who cared about subprime?  It was less than 1% of the mortgage market.  Well, true, but it would have an impact on housing prices as resets happened, and would be the straw that broke the camel’s back, leading to a self-reinforcing decline in housing prices.  The poor working schmoes are the first to get hurt when the cycle turns, but they certainly aren’t the last to be hurt.

Corporations shepherd their liquidity as well in such a crisis, and think less of long term projects with less certain rewards, but instead look at things that can affect the bottom line now.  Cutting projects, workers, etc., will aid the bottom line.  Small acquisitions of technologies and marketing channels that can be grown organically may work.  Dividends and buybacks may not work.  Cash might have to be conserved.

Private equity faces a situation where debts need to be serviced, but business is slow, and contributions from limited partners are not forthcoming.  Even the private equity players become more short-term in their orientation.

Equity managers hold onto more cash.  Prime brokers extend less leverage.  Banks become more particular with underwriting standards.  In everything there is more of a desire to preserve the present than to build the future.

This is what we get for years of mindless monetary policy where everyone trusted in the “Greenspan Put.”  After years where liquidity would be thrown at every small problem, now we are in a situation where there is little liquidity to throw at big problems.  We overleveraged the system — of course there is no liquidity until the system is delevered.  Liquidity only exists when leverage is stable or being built up.  When leverage declines, there is no liquidity.

In such a situation as this, we should expect compression of P/E, P/B, and other ratios.  We should expect high yields on corporate and high-yield bonds.  Are stocks cheap?  Yes, but they will probably get cheaper, because we don’t have a lot of liquidity to bid for them.

This cycle will turn when the cash flow yield of assets reaches levels people can make money on in the worst environments; where equity funds new projects with no debt, and the profit is obvious.  We’re not there yet by any means.  Perhaps 20% or so lower, we will find a bottom.