We Hold These Truths No Longer Self-Evident
In the long run, the equity market is a weighing market. I keep trying to remind myself as the short-term “voters” push stocks higher because Goldman’s quarterly profits are more exciting than their long-term prospects. Stocks rallied 0.8%, erasing on Monday and Tuesday almost all of Friday’s (mild) decline. That response is positively bubble-like. The Nasdaq Financials Index (NDF) is currently back at early October 2008 levels, but trading at 63x trailing earnings. Now, maybe with the volatility in those earnings – currently improving rapidly – perhaps the dividend yield, 1.6%, is a more-fair representation of the valuation level. Whoops. That is the lowest dividend yield of the NDF in this millennium. In December 2007, the dividend yield for the capitalization-weighted index was around 3% (Source: Bloomberg).
Now, return on equity is turnover x margin x leverage (the DuPont model). Tell me again why I would want to own financials? Looking forward, there is pressure on all three components of return: distrust of Wall Street and increased scrutiny of hedge funds will decrease turnover, margins may well collapse as a function of a combination of the Volcker Rule and the drive to put derivatives on exchanges (more on profit pressures here), and of course we know there is tremendous regulator pressure to put all leverage on-balance-sheet, and then to reduce it. Every place that financials make money will be suspect and, while the populist anger holds, subject to being eliminated by legislative fiat.
When financials start pricing half of the current leverage, half of the current margins, and half of the current turnover, I will be interested. Seems to me that if that happens, and they trade at the same multiple of ROE, then I need to see an 88% fall in price (of course, safer leverage would be worthy of a higher multiple, so maybe I’ll dip my toe in after only a 75% decline). And that, friends, is assuming that the current multiple is fair.
While stocks were interesting, and it’s fun to watch the market figure out what to do with Apple (I don’t own it) when it blows out revenues and guides next quarter earnings sharply lower (if you need to look at your screen, you have forgotten that the market is trading like a bubble. It’s up 7% right now), the bond market was boring. June 10y Note futures fell 1/32nd, with the 10y yield still at 3.8%.
Can We Survive Without Credit?
Recently, former St. Louis Fed President William Poole wrote a piece in the Financial Analysts Journal about moral hazard and his proposal to fix the “Too Big To Fail” problem. It wasn’t a bad start, I thought, although impractical on some levels, but one reader took him to task in a letter to the editor published in the March/April 2010 edition. The reader, Eric Boughton of Deschutes Investment Advisers, argued in part that “All who took risk and miscalculated it must bear the consequences of their miscalculation; that is how capitalism works. Capitalism need not be sacrificed on the altar of crisis!”
In response, Dr. Poole fell back on the usual defense: systemic risk.
So, here is the image to keep in mind: What would you do if your acces to cash were totally cut off, as happened in March 1933? How long could you function by using only the cash in your wallet and whatever inventory of food you had at home? For most of us, the answer is only a few days. Could you borrow from neighbors, all of whom are in the same situation? Could you lend to neighbors? The economy cannot function on currency alone when it has adjusted to operating on a large base of deposits and other credit markets.
Dogs and cats living together! Mass hysteria!
I guess what all policymakers have in common is that they believe that policymakers are indispensable. It irks me to read breathless accounts of what might have happened, if nature had run its course. I wonder if these are the same sorts of people who can’t stand to camp out of doors without running water, or if they just believe paternally that everyone else is unable to cope without running water.
Whatever would we do without a credit card? What would we do without currency? Let me ask: how did people survive the aftermath of Hurricane Katrina? The banks were closed, and currency wasn’t worth very much as a consequence (unless you had an awful lot of it). If you needed help from the electrician, you offered to help him out in return or you offered something of value. Barter, in other words.
If banks vanished completely, or even for several months, then of course it would be a horrible hardship and devastating for the economy. But what are the farmers who have fields full of grain going to do? The farmer must sell the produce for currency, scrip, or other goods and services, or let it rot. My guess is that he will take an IOU from someone he knows has the money or means to get it in the future, or in a real pinch would trade you a hog if you fixed his truck. Hey, California recently had to pay for services with IOUs, and they didn’t even have any money in the bank! We would find a way to get by. We would probably have to spend less than we produced for a short time…horror of horrors!
The ones who would really be hurt would be the ones who are used to receiving checks from the government for doing nothing, who would have to sell their labor for a little while. Again, horror of horrors. The truly helpless, of course, would still find private charity to help.
I know, this doesn’t sound like the life you had planned. But whether the government wants to preserve the system or not, it isn’t entirely up to them. I can think of lots of things that could put us in the same situation for a time, no matter what the government wants: terrorist acts; acts of God like a tsunami, earthquake, or asteroid strike; UFOs (just kidding); acts of war involving cyber-attacks; or just another crisis like 2008’s, but larger. Not all of these have vanishingly small probabilities, and taken collectively I think it warrants keeping a reserve – of food, water, tools, fuel, etcetera. I suspect we would survive.
But maybe the bigger point is that if there is anything in the system that threatens our extermination if it fails, then the solution isn’t to keep propping up the system but to eliminate those dependencies. If the town is built in the shadow of a giant rock that could topple at any moment, two solutions when the rock starts to wobble are to (1) keep building more-elaborate support structures, or (2) move the town. The current system is set up for (1). We should adapt.
Another quote, this time from the afterword of my book:
…But in all of this, as with his entire tenure, [Greenspan] missed the bigger point about how the system works, when it works well, and about the usual suspect, when things go awry. There are, at the root, two competing theories about what saves the system and preserves our way of life, both in times like these and well as in calmer times. It boils down to a fundamental question our society wrestles with in this context and in others, and has for a long time: who is responsible for my well-being?
One camp would point to the government as the institution ultimately responsible for taking care of us. As Congress prepares, even as I write this, another kajillion-dollar “stimulus” package, it is clear on which side it stands in that debate. By protecting the economy and preventing recessions, bailing out failed institutions such as Long-Term Capital Management, and so on in ways I have detailed in this book, the Greenspan Fed staked out the same intellectual ground. It is the State which must care for us all.
The opposing view is that personal responsibility is paramount. Greenspan was tantalizingly close to an epiphany when he expressed shock at the failure of counterparties to properly examine the risks they were taking relative to each other and to the system. But he missed the crucial point, and that is this: if it is true that the system and its institutions are preserved by a margin of safety that they wrap around themselves, it is also true that what triggers that response is the occasional necessity of having such a margin of safety.
Economic actors, in short, evolve their responses based on the environment. And, under Greenspan, it was clear that the environment was designed to always be sunny, safe, and warm. There was scant need for a margin of safety when nothing bad had ever happened and was never permitted to happen. Economic actors relaxed, because it was in their interest to do so: why evolve a hardened shell, with all of the energy that requires, if you never need a hardened shell?
But there always comes a time when the levees erected to keep us dry are breached. It is a fact of economic nature that there are (in Dr. Greenspan’s terms that October day) “once-in-a-century credit tsunamis.” It is at those times that the heavy lifting of economic evolution occurs. The soundest entities survive. The risk is that if all of these entities have been evolving unsafe strategies, the resulting economic carnage can change the system forever.
This is not a new thought! The United States was founded to reclaim and secure for the future rights that were enumerated simply as “life, liberty, and the pursuit of happiness.” Nowhere did the Framers express a desire to guarantee wealth, happiness itself, or success in any way. You shall be free, and the State will protect you from physical harm. You may accumulate property that will belong to you and not to the State. That is all.
And, since that time, in the long list of failed states are many socialist and totalitarian regimes – state-dominated nations, that is. The flexible ones, the ones that rely on individuals to adapt, survive…
Is this lengthy thought relevant to the market today, meaning Tuesday, April 20th? Not any more so than on any other day. But occasionally, we need to revisit these truths, because they are no longer considered self-evident.
Wednesday sees a third day with no significant economic data, although Chairman Bernanke, also known as Ben, speaks at the unveiling of another Benjamin, the $100 note redesign. I am crossing my fingers that he breaks into rap.