Tuesday, August 9, 2011


Let's hope it happens this time - Leadership almost always emerges out of crisis in our country.

The reaction of our policymakers will influence the long-term health of the U.S. economy and our capital markets.

World leaders face a choice of truly historic proportions. They can follow one of two paths. The first path would require them to finally admit their prior policy errors and embark upon comprehensive reform of all of the fiscal policies that affect the economy -- energy, education, tax, business regulation, technology and science policy and industrial policy -- in order to give their economies a chance to grow through productive investments. (By the way, these investments and policies would also have the side benefit of improving the quality of human life.) This path would also require central bank discipline on the long-lost Paul Volcker model. Or they can stay on their current path and continue to monetize their debts in the hope that future generations will be able to repay them with deflated currencies and the markets won't abandon them. The choice is clear. The question is whether leaders will have the courage to make the right one, and their citizens the fortitude to stand behind them.

-- Michael Lewitt, El Mundo (Aug. 8, 2011)

There is nothing revelatory in the Standard & Poor's downgrade, which puts us in a tie with Belgium, as it is largely symbolic. The downgrade reflects known facts. There is plenty to be critical of, however, in the manner and composition of S&P's decision, and I suspect that will be the subject of a lot of commentary in the week ahead.

The optimistic view is that we will see renewed leadership under the current period of crisis. Rather than being seen as a continuing political football of partisanship, the S&P downgrade (when coupled with the stock market swoon) could become a catalyst for change -- a clarion and wake-up call for both parties to address our country's fiscal imbalances. (This subject was a prime topic on The Edge last week.) Indeed, investors could grow more constructive that a November select committee meeting of Republicans and Democrats will now be galvanized into finding another $1.5 trillion in new deficit reductions, providing the opportunity for a "grand bargain" by finally addressing tax reform, Medicare, Medicade and Social Security (importantly in an up-or-down vote.)

There are other reasons why there may not be a sustained risk-off reaction:

1. S&P's downgrade move was previously telegraphed. Most market participants expected the move in light of earlier warnings by S&P and the disappointingly modest size of the deficit reduction that was the outgrowth of last Monday's budget compromise.

2. Other ratings agencies are staying put. Moody's and Fitch have maintained their AAA rating for the U.S.

3. Risk weightings are unchanged. The move will not affect the risk-weighting of Treasury assets held by banks.

4. Banks have ample liquidity. Our financial institutions can readily absorb any short-term funding disruptions.

5. Sentiment is already poor. Investor expectations are already low.

6. Investors are on the defensive. Hedge funds are sitting on their hands, and, as I have observed, so are individual investors -- and both classes of market participants have de-risked, so margin calls are not really coming into play.

7. A precedent had been set. History shows (e.g., Japan) that an S&P downgrade has a negligible impact on the economy and markets.

8. S&P has lost some of its influence and much of its credibility. A $2 trillion mathematical miscue , the political spin associated with the downgrade and the change in the assumption regarding the Bush-era tax cuts further strain and undermine the ratings agency's move.

9. S&P's move was discounted. Just as the debt ceiling compromise last Monday was obviously already priced into the US stock market (as the market failed to rally) - so is it possible that much of the US debt downgrade has already been incorporated in share prices (and might not decline much further).

The rating agencies -- Moody's Investors Service, Standard & Poor's and Fitch Ratings -- all originally served bond investors, who paid for their research. But that model changed in the 1990s to one that was funded by the syndicators and underwriter of structured financial products such as mortgage-backed securities. Essentially, bankers "purchased" the rating they desired. As a result, the performance of the ratings agencies decayed, as they were no longer judged on the quality of their analytical reviews. Second, the underwriting quality of syndicators fell, as they (not a neutral third party) were, in effect, picking their own credit ratings. The real question for the financial markets is why we even require ratings agencies to evaluate complex financial products anymore.

-- Barry Ritholtz, The Big Picture

Let me start on a critical note regarding S&P's rating credibility. Historically, the agency has tended to be backward-looking, and its questionable ratings played an important role in the last credit crisis.

I tend to side with Warren Buffett's comments -- remember this is the same agency that downgraded Berkshire Hathaway's (BRK.A/BRK.B) debt and maintained AAA ratings on U.S. mortgage-backed securities and other structured products (to the bitter end).

For years, the ratings agencies have not acted as "arm's length" and independent entities; they have acted as financial pimps to those institutions that distribute fixed income and structured products.

S&P's credibility was further strained on Friday by a $2 trillion mathematical error in the deficit calculation, leading the Obama Administration to challenge the S&P's decision.

Morgan Stanley's David Greenlaw pointedly summarizes the criticism that will likely be levied on S&P:

I have a very hard time seeing how the S&P action will have a significant impact on markets. The only thing that has changed in the U.S. is that a bunch of Keystone Kops at S&P have issued a ratings change using bad data, questionable assumptions and political spin. To be sure, the U.S. has plenty of long-term fiscal problems that need to be addressed, but the justification for a ratings change (using the criteria that S&P itself outlined in prior reports) is severely lacking. While I suspect that markets will come to the same conclusion as I do regarding S&P's credibility, the major issue for me, is whether word of the downgrade further damages confidence on Main Street. Here are my specific concerns.

1. The political spin is obvious in S&P's public position. According to The Wall Street Journal: S&P's conclusion "was pretty much motivated by all of the debate about raising of the debt ceiling," John Chambers, chairman of S&P' sovereign ratings committee, said in an interview, "It involved a level of brinksmanship greater than what we had expected earlier in the year." Admittedly, the process got very ugly -- but no one in a leadership position in Congress or the Administration was advocating default at any point along the way.

2. The Treasury Department has issued an official explanation of S&P's error involving the wrong baseline. See "Just the Facts: S&P's $2 Trillion Mistake" available here.

3. Perhaps the most outrageous aspect of the downgrade in my opinion involves the change in assumption regarding the Bush-era tax cuts. This is a massive adjustment (worth nearly $4 trillion over the next 10 years) that appeared to be slipped in at the last second to make up for the baseline error discovered by the Treasury Department.

I wrote two columns that have a direct "bearing" to the S&P rating decision on U.S. debt and to how policymakers react -- and, in turn, influence the long-term health of the U.S. economy and our capital markets.

A week ago, I suggested that structural unemployment, government spending cuts and future rate rises would serve to weigh on the markets:

"The four most dangerous words in investing are 'this time it's different.'"

-- Sir John Templeton

With apologies to Sir John Templeton, it is different this time after a decade of goings-on (though Rogoff and Reinhart would say that we have experienced eight centuries of financial folly!).

"The biggest threat to advanced economies is that debt will accumulate until the overhang weighs on growth."

-- Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly

The one singular and consistent argument communicated by bullish investors is that stocks are cheap as measured against consensus 2011-2012 S&P 500 profits.

While corporate profits are up substantially from recession lows and back to impressive and near-record levels, to a large degree, the factors that contributed to that growth could create headwinds to growth in the future.

Below are three such headwinds (jobs, the deficit, interest rates) that have importantly contributed to growth over the past decade but, perversely, lie on the horizon over the next decade as headwinds. These three factors create a fallacy of composition in the way the bullish cabal look at today's economy.

The modo hoc (or "just this") fallacy is the error of assessing meaning to an existent based on the constituent properties of its material makeup while omitting the matter's arrangement. In today's economy the fallacy of composition is that the very source of past profits and growth becomes a headwind to future profits and growth.

1. The drag of structural unemployment: Since companies couldn't control the costs of raw materials, they have opted to improve productivity and cut costs primarily by reducing jobs or by making their current workforce work longer and harder. As economic growth decelerates, the drag of elevated and structural unemployment will serve as a constant headwind ahead.

2. The drag of government spending cuts: Corporate profits are also up in part because of the ballooning deficit, as the government has overspent. So it follows that the necessary spending cuts (aimed at reducing the size of the deficit) will adversely impact prospective economic growth and, in turn, corporate sales and profits.

3. The drag of future rate rises: Finally, corporate profit growth has been spurred on and elevated by the most aggressive monetary policy moves in history (quantitative easing and zero interest rate policy). The generational lows in interest rates have enabled corporations to roll over debt cheaply, have allowed consumers to borrow (on installment and mortgage debt) at unprecedented low interest rates and have kept government borrowing costs low relative to the size of a ballooning deficit. While all three borrowers have become addicted to low rates, it is not likely a permanent condition. Though it is clear that rates will be pegged low for at least the next year, it is unreasonable to expect interest rates to be low forever. The withdrawal from artificially low interest rates could be growth- and profit-deflating painful in the fullness of time.

The above factors are important secular/structural headwinds that will weigh on profit growth and will likely limit stock market upside appreciation. They represent fundamental reasons why I believe that one shouldn't overly rely upon good corporate earnings (and an estimated 13x P/E multiple on 2011 S&P profits) in assessing the outlook for the stock market.

Importantly, structural headwinds that adversely impact economic activity and corporate profitability have not been addressed by policymakers and, until recently, have been ignored by market participants. Instead, legislators (and investment managers) have seemed more interested in "illusionomics" (e.g., setting asset prices).

Over the past 12 months, the comfort of rising stock prices has hidden a lot of sins. Unfortunately, this past week's GDP revisions and other economic releases have exposed a domestic economy that is more challenged than many had believed.

The growth-deflating, nontraditional headwinds that have been born out of a decade of lending abuses, overproduction of new homes, excessive government spending, refusal to address our jobs deficit, and ill-timed, unfocused and misdirected monetary and fiscal policy are about to come to the fore.

As a result of these factors (and others), an uneven and inconsistent growth path, not a smooth and self-sustaining growth path, seems the most likely base case for 2011-2012.

This future profile of lumpy economic and profit growth doesn't preclude market gains in the months and year ahead. Contained current inflation (and tame inflation expectations), a market-friendly Fed, low real and nominal interest rates, healthy corporate balance sheets, stable bank swap and credit spreads, negative investor sentiment (as reflected in low invested positions of individual investors and the hedge fund community) and excellent profit and dividend growth (even in the face of sluggish GDP growth) are all constructive factors that support stock prices and likely diminish the case for material market risk from current levels.

According to SenitmenTrader.com, the only two other times we were as oversold as today (on a 10-day basis) was the crash of October 1987 and when Germany invaded France in 1940.

Anything owned by John Paulson is getting obliterated.

French credit default swaps are widening dramatically today and now stand at about three times as wide as the U.S.

I believe this move is contributing to market instability, as France's AAA rating is among the important factors that support the AAA rating of the ESFS.

The interesting thing is that U.S. credit default swaps have not widened despite Friday night's downgrade.

Full-fledged panic; The selling has become "forced."

As Jim Cramer notes, automated and highly-leveraged trading renders our market models useless.

"It's a slow-motion "flash crash." You have to believe that it is related to the machines, because it is in total lockstep. It's not acknowledging that gasoline prices are coming down and raw energy declines are good for many stocks. It is not even acknowledging that the positives for gold stocks and gold are off the charts."

-- Jim Cramer

Stated simply, with the dominant role of high-frequency trading and the proliferation of "super" (double/triple) bearish ETFs, old operating trading models have been rendered useless.

I am convinced of the above - and I am also convinced that the SEC will react by the time it's too late.