Money Sage (archive)

It becomes increasingly clear, with the passage of every day, that the dire forecasts (samples here and here) about the banking system and a forthcoming credit contraction which we made last summer and have reiterated periodically was only too accurate. We are NOT happy about this; we would rather that we had been wrong.

Looking at stock market prospects for 2008, we believe that it is not too useful to attend closely to the prognostications of Wall Street seers. Our skepticism here results from far more than a contemplation of the erroneous forecasts of this company over the years, and the sad fact that an investor would probably have done better by flipping a coin.

No. The crucial question each investor needs to answer for himself is the question: are we heading into (or already in) a "normal" mild recession, or is it going to be something different.

The bulk of the forecasts we have seen are based upon the "historical" record of the past relationships between stock index values and recessions. These forecasts seek to measure and generalize upon the lags that have marked the end of a market downturn and the beginning, trough, and/or end of a recession. In truth, the data is so "noisy" that one could derive almost any conclusion. Throw in assertions, speculation, guesses about forthcoming earnings and, consequently, equity valuations and you have a lot of copy and talking head material, but precious little guidance of even minimal utility. Indeed, we find ourselves yet again in the land of statistics, statistical inference, statistically-based prognostication -- and we recall, yet again, the brilliant perception of the American philosopher, George Santayana, who so aptly noted: "There are three kinds of liars. There are liars, there are damned liars, and there are statistics."

Thus we are back to familiar, and familiarly useless, terrain.
So, what to make of it all?

Actually, there are, we think, two considerations.
One is that propunded by the greatest investor in American history, Mr. Warren Buffett. Mr. Buffett, if we understand correctly, is not particularly interested in trying to forecast the market. It is our impression that he regards such an effort as fruitless, a waste of time and energy which could otherwise be employed productively elsewhere.
Where? In analyzing INDIVIDUAL BUSINESSES AND INDIVIDUAL EQUITIES. This approach is a profoundly wise one we think. Mr. Buffett invests when the valuation of an attractive enterprise is low, as he judges it. His decision-making requires great skill, great wisdom, and great psychological and emotional strength -- the ability to ignore the endless outpouring of verbal and written garbage from Wall Street, the financial media, gurus of all stripes, and politicians. Unfortunately for the generality of investors, few indeed possess anything even remotely akin to Mr. Buffett's remarkable analytical skills and his tensile psychological strength.

We, in this post, wish to focus on an issue which we presuppose is of interest to our readers, and which does indeed have a profound significance. This issue is: are we looking at a familiar, shallow recession and a contained deflation of one asset class, or are we looking at something more serious by orders of magnitude. If the former is the case, then extracting some reasonable inferences from past experience in the post-World War II era would provide some general guidance, with broad indications of where to invest, where not to invest, and what very general time-frame we are looking at.

If, however, we are moving toward a different, more serious type of financial system/economic experience, then the utility of the post-World War II investment "wisdom" would be less than negligible.

We will say, quite frankly, that WE DO NOT KNOW. All we can note is certain disturbing trends. These trends, we think, are still containable within roughly "normal" parameters. However, we would also note that the risk of a real puncturing of the debt bubble with profound consequences for consumer spending, economic functioning, and investing direction is quite a bit higher than at any time since the 1920s. We have said in earlier posts that we believe the debt overhang is manageable, but will take some doing. Our main concern is not so much the cascading downturn in the banking system, but the reliabiity of our central bank. In short, the question is: is the current FED policymaking echelon capable of acting with sufficient speed and decisiveness to contain the credit contraction BEFORE IT PUNCTURES THE DEBT BUBBLE?

It is here, as the Bard would say: "Aye, there's the rub."

We have, as our readers know, been optimistic on this absolutely critical issue. Now, while we are not changing our position, we must acknowledge that our doubts are growing.

Those who deny the decisive importance of the FED at critical moments demonstrate a profound ignorance of economic history. Despite the firebreaks against another depression created by the New Deal and enhanced by the widespread acceptance of Keynesian economic doctrine by politicians, the attentive public, and the generality of the economics profession, it would be a very serious error to assume that a depression of sorts is impossible. Indeed, some of the distinguishing elements of the current financial situation are more characteristic of a forthcoming "depression" than recession. Most important, of course, is the paralysis of credit, the acute contraction of the lendable capital of the banking system in consequence of gross speculation turned bad, and a panic mentality in the credit markets. In recent days, this has been joined by a serious sell-off in the equity market.

The "depression" that we think possible -- though still deem unlikely -- is NOT a classic depression. Rather, it is something analogous to what the Japanese economy and Japanese households have suffered through for the past twenty years.

The "Japanese disease" has rendered equity investment a catastrophe. Real estate has similarly proven to be a financially ruinous speculation. The one major investment beneficiary of the Japanese "depression"/cum deflation has, of course been long-dated Japanese government bonds. The bonds issued before the deflation really took hold yield 4 or 5% in nominal terms. In considering the actual annual DROP IN PRICES, the REAL ("inflation-adjusted") yield ranges upwards of 5 or 6 points. This is a tremendous yield. In REAL terms, long-dated US government obligations have yielded 1 or 2 points. Japanese stocks, by contrast, moved from 39,000 in the autumn of 1989 to 8,000 at the trough of what has been a 15 year PLUS BEAR MARKET. Today the Nikkei is in the 13,000 area. Real estate prices in the major cities are down UPWARDS of 80% in some areas, 90% or more in others, after 19 years of a continuing real estate deflation.

In plain English -- or Japanese, if you prefer -- while a "normal" recession in this country suggests the viability of carefully selected equity investment once a stock downturn bottoms and before, or in the early stages of a new upturn attending an envisionable economic recovery, an "abnormal" economic downturn would suggest consideration of the Japanese model.

The decisive role will be played by our central bank. While we think they will perform with minimal competence, and thus avert an abnormal economic configuration, our confidence is declining in the face of their persisting obtuseness.

We are not embarrassed in the slightest to say: we DO NOT KNOW, WE CANNOT PREDICT, how things will ultimately unfold. We would note here that the ancient Greeks, the most intelligent, creative, and intellectually sophisticated people in history were not ashamed to admit they could not predict the future: they therefore consulted the Oracle of Delphi. The priestesses, being astute individuals, invariably communicated a message riddled with ambiguity.

The Romans, perhaps not the smartest people in history, but surely the most successful empire-builders, consulted the entrails of oxen to get a read on the future.