An immediate note on market conditions. Last week's market advance cleared out the "predictable" expectation for constructive returns that briefly emerged from the recent market selloff. That doesn't mean that the market can't advance further, but given that the expected return/risk profile of stocks has now shifted hard negative again, any such advance would be a random fluctuation rather than a predictable one. Strategic Growth and Strategic International Equity have shifted from a briefly constructive position back to a full hedge. Our principal investment position in Strategic Total Return remains a 20% allocation to precious metals shares, where the ensemble of conditions remains very favorable on our measures, despite what we view as a welcome correction in the spot price of physical gold. The Fund has a duration of only about 1.5 years in Treasury securities, mostly driven by a modest exposure in 3-5 year maturities.
It is now urgent for investors to recognize that the set of economic evidence we observe reflects a unique signature of recessions comprising deterioration in financial and economic measures that isalways and only observed during or immediately prior to U.S. recessions. These include a widening of credit spreads on corporate debt versus 6 months prior, the S&P 500 below its level of 6 months prior, the Treasury yield curve flatter than 2.5% (10-year minus 3-month), year-over-year GDP growth below 2%, ISM Purchasing Managers Index below 54, year-over-year growth in total nonfarm payrolls below 1%, as well as important corroborating indicators such as plunging consumer confidence. There are certainly a great number of opinions about the prospect of recession, but theevidence we observe at present has 100% sensitivity (these conditions have always been observed during or just prior to each U.S. recession) and 100% specificity (the only time we observe the full setof these conditions is during or just prior to U.S. recessions). This doesn't mean that the U.S. economy cannot possibly avoid a recession, but to expect that outcome relies on the hope that "this time is different."
While the reduced set of options for monetary policy action may seem unfortunate, it is important to observe that each time the Fed has attempted to "backstop" the financial markets by distorting the set of investment opportunities that are available, the Fed has bought a temporary reprieve only at the cost of amplifying the later fallout.
Recall how the housing bubble started. Back in 2002-2003, Alan Greenspan held short term interest rates at such low levels that investors felt forced to "reach for yield" - and they found that extra yield in mortgage securities, which up until then had never experienced major credit difficulties. Wall Street quickly got a whiff of that, and realized that it could earn enormous fees by cranking out more "product" to satisfy investor demand. Soon, a flood of mortgage securities was created featuring increasingly complex structures (in order to maintain "AAA" status) while the proceeds from issuing these securities were offered to borrowers who were less and less creditworthy. As long as a willing borrower could be found - however unable to actually pay off the mortgage, and as long as a willing lender could be found - pressed to reach for yield by the Fed's distortive low interest rate policies, Wall Street and the banking system got them together, and obscured the gaping chasm between actual and perceived credit risk through "financial engineering" that created slice-and-dice securities with mind-numbing complexity.
Once the housing bubble collapsed, the Fed again responded with policies aimed primarily at distorting the set of investment opportunities through zero interest rates, preserving the misallocation of capital toward speculative investments (on Bernanke's misguided and empirically unsupported belief that consumers spend out of speculative gains). Yet the underlying debt burdens have not been restructured, so consumers - particularly homeowners - continue to pare back spending in order to reduce those debt burdens. As a result, there is little expectation of significant growth in demand, and companies therefore have little reason to hire new employees - all of which reinforces a "low level equilibrium" in the economy.
The way to get out of this is to abandon the misguided belief that economic prosperity can be obtained by encouraging speculation and distorting the set of investment opportunities. Rather, we will eventually find, as was eventually also discovered in the post-Depression stagnation of the 1930's, that the way to get the economy moving again is to restructure hopelessly burdensome debt obligations.
Of course, this same story is playing out on a global scale. It is worth noting that the yield on 1-year Greek government debt surged to 55% last week. At present, the global bond market is expressing a 100% expectation that this debt will default. The only question now is what the recovery rate will be.
Over the past three years, Wall Street and the banking system have enjoyed enormous fiscal and monetary concessions on the self-serving assertion that the global financial system will "implode" if anyone who made a bad loan might actually experience a loss. Because reversing this mantra is so difficult, policy makers are likely to continue fitful efforts to "rescue" this debt for the sake of bondholders, through mechanisms that are increasingly distasteful to the broader population. The justification for those policies will therefore have to be coupled with rhetoric that institutions holding these securities are too "systemically important" to suffer losses.
On this note, it is critical to remember that nearly all financial institutions have enough capital and obligations to their own bondholders to completely absorb restructuring losses without customers or counterparties bearing any loss at all. So keep in mind that the debate here is not about protecting customers or counterparties - it is really about whether the stockholders and bondholders of banks and other financial institutions should bear a loss. The "failure" of a bank only means that existing stockholders and bondholders are disenfranchised - the company simply takes on a new life under new ownership. Existing stockholders lose everything, unsecured bondholders typically lose something, and senior bondholders get any residual obtained as a result of the sale or transfer of the company. If the global economy is fortunate, the financial system two or three years from now will look much the same as it does today, but the ownership and capital structure will have changed almost entirely. A major restructuring of debt is the clearest path to long-term economic recovery, and the accompanying losses to those who recklessly made bad loans would be the highest realization of Schumpeter's idea of "creative destruction."
From that perspective, Warren Buffett's $5 billion investment in Bank of America preferred stock last week was essentially a defense of the old guard. Buffet observed, "It's a vote of confidence, not only in Bank of America, but also in the country."
Yes - to be specific, it's a vote of confidence that the country will bail out Bank of America in any future crisis. We should all hope that Buffett's investment is successful - provided there is no future crisis - and we should equally hope that Buffett loses the entire investment otherwise.
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