I enjoyed the opinion piece in yesterday’s WSJ, From Bubble to Depression? I want to clear up a few of their misconceptions.? Key quote:
Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.
How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?
They almost get it in their later paragraphs, but the answer is simple.? In the first “crash,” the losses were mainly equity-based, so there were no knock-on effects on other entities.? No additional dominoes fell.? With housing in the late 2000s, a loss of $3 billion happened on assets that were usually levered with debt at 5x to 30x, probably averaging 10x.? And, these mortgages were held by leveraged banks that had borrowed in many other places in the overall financial system, and sometimes by even more leveraged speculators using CDOs.
Let me say it again — Bubbles are financing phenomena; depressions are financing phenomena.? They are opposite sides of the same coin.? The severity of bubbles differs with the amount of debt employed and the pervasiveness of the sectors of the economy affected.? The tech bubble did not have much debt, and it was contained.? The real estate bubble was the opposite.
The thing is, the amount of debt we have racked up as a fraction of GDP exceeds that of the Great Depression.? My view is that many debts will have to be liquidated before the US economy grows robustly again, whether through payoff, compromise or inflation.
Now, we had Michael Mayo today offering his opinions on the banks, (two, three) which are not all that much different than mine.? In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation.? Better not to try at all.? An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.
This last bubble has led to a depression, because of the debts incurred.? We must liquidate debts, but in the process, the economy will suffer.? I’m sorry, I like prosperity too, but there is no way out of this period of debt liquidation.? Just as the period of debt growth pushed asset prices up, so the period of debt deflation will push asset prices down.
My advice?? Avoid almost all banks, and other financial companies sensitive to the stock market or real estate, in terms of both equity and bond investments.
I agree with everything you said in comparing the two bubble/collapses. I would add that the negative effects of the tech crash were mitigated by the fed slashing interest rates and moving the bubble from tech to real estate. People with tech losses suddenly found that their home value had gone up by as much or more than they lost in tech. And while debt-to-GDP was high in 2000, it had not yet reached the no-going-back level of 2007, a level at which the fed can slash rates all they want, but there is no one left who can borrow.
By the way, one question: what does debt deflation mean for gold?
“In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation. Better not to try at all. An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.”
Richard Russell (Dow Theory) said this exact thing the other day. He said he was asked “what he would do” if he controlled the government, and he replied “not a d*mn thing”, just let the bear market in stocks and the economy run its course.
But should or should not and will are two different things, and in our modern society government must be seen as “doing something”, right? Doing nothing is not a politically viable option.
Given government’s probable course of action, and the likely impact on the dollar, does it make sense to tilt a portfolio towards hedging dollar weakness, and what do you think are the top choices to hedge the dollar (gold, commodities, foreign currencies, etc?)
“An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.”
You say that like it’s a bad thing. Why would, for example, inflationary stimulus spending be so bad as to be dismissed out of hand? We know that our comparatively strong dollar is destroying domestic industries, and we can use the infrastructure investment and employment that comes with stimulus.
Logan, I’m not ruling it out. I’m saying there would be a cost attached. Some problems with collateral values could be solved through inflation, passing the costs to those who cannot hedge fully, which is most of us, but especially the elderly and foreign creditors.
I’ve been asked about the effect on gold and other hedges — I do think that inflation will be one of the tools that the government/Fed uses to get out of this crisis, and it will have a positive effect on all inflation hedges. In the short run, though, Ben Bernanke is determined not to let any the liquidity that he is monopolizing leak out into the broader economy; I think he is trying to fight a depression without creating any inflation, which I think is an unusual intellectual conceit. I’m just not sure how long the condition will last.
Oh, and regarding bonds — since someone else asked: I like TIPS, foreign short-to-intermediate bonds, conforming RMBS, Short-to-intermediate corporates BBB and lower but not of financials (except a few stray insurers).
If you believe that we are heading into a period of asset deflation, wouldn’t TIPs be a poor investment?
Also, what do you think about short-term, investment grade financials?
I’m in agreement with you David on inflation, or to be as specific as possible: currency debauchment. I just don’t see how it can end any other way. There’s too much debt to service and our ability to earn more is severely constrained.
As a thought exercise for myself I think, pretend it’s seven years from now and we are looking back at 2009. What could 2016 look like and what would we be wishing we had done back then. (It’s like boy didn’t people in 1990 wish they’d bought zeros in 1982. Or boy in 2000 didn’t people wish they’d bought tech stocks in 1992.)
I also think it works best when it’s things that are scary to buy, zeros and tech were scary in 82 and 92. Today, for a lot of people TIPS are scary. The real yield on them is so low, and their other asset losses are so high that it is scary to decide what you have right now is all you’re gonna have, that you’re going to give up on capital appreciation going forward.
Gold I think is another one with potential. It also a little bit scary. It’s come so far, it feels like a crowded trade from all the media attention, who can forget that $800 top from the early 80’s. Yet, when you look at the actions of the various central banks, it seems they all want to competitively devalue. In that regard, is it really a crowded trade? It seems to me on a world-wide basis we have an order of magnitude more people wishing to protect their wealth than we did in ’80. How many Chinese, Indians, Russians, and Indonesians today had absolutely no wealth to protect in ’80?
Similar can be said for oil. How many more cars world-wide today than ’79? And after last summer who wants to double-down on oil stocks? There’s no telling when global demand will recover. Right now it feels like never, but if it does where is the new supply going to come from? Tar sand? Boy wouldn’t you wish you had an old fashioned, Okie crude oil well when everyone is paying the marginal rate for tar sand.
So there you go: TIPS, gold, and oil. When I say it all in a row like that it sounds trite. When I think of actually putting money down on ’em, it gets scary. Maybe that they sound so trite is part of why they are scary?
You suggest that people avoid financials, but what about insurance companies?
Avoid equity and credit-sensitive insurers. Those with little risk on the asset side are fine. My short term performance model favors brokers and reinsurers.
I totally agree with this post. Problem is that most do not believe the inefficacy of government actions against a debt mountain. It is like transferring a pocket full of marbles from one pocket to the other. Someone pays for it – either the orginal borrower pays or the government pays (with the taxpayers’s money) which effectively means that the employed bears it (whether the taxpayer borrowed or not)