Mish's Global Economic Trend Analysis

Trichet's Exit Strategy Trapped by PIIGS; Currency Tensions Continue to Build; China Tells EU to Stuff It
Real Time Probabilities of Recession Above 20% Second Consecutive Month
Hussman calls for 10-Year S&P 500 Total Return in the Low 5% Area; Thoughts on Risk Management

Trichet's Exit Strategy Trapped by PIIGS; Currency Tensions Continue to Build; China Tells EU to Stuff It

Posted: 06 Oct 2010 06:04 PM PDT

In the midst of the crisis with sovereign debt of Greece, Spain, and Portugal, Trichet and the ECB acted by offering as much cash as the countries needed. This stabilized things for a while and Trichet was supposed to drop this support.

However, yield spreads between Germany and the PIIGS is once again soaring, and if unlimited lending is withdrawn now, it is a near-certainty that spreads will widen further.

Thus Trichet is 'Trapped' by Banks' Addiction to ECB Cash.

Near-record borrowing costs for nations across the euro region's periphery are making it harder for the ECB to wean commercial banks off the lifeline it introduced two years. The extra yield that investors demand to hold Irish and Portuguese debt over Germany's rose last week to 454 basis points and 441 basis points respectively. Spain's spread hit a two-month high.

The risk for the ECB is that it gets pulled deeper into helping the banking systems of the most indebted nations in the 16-member euro bloc. Governing Council member Ewald Nowotny said Sept. 6 that addiction to ECB liquidity is "a problem" that "needs to be tackled." Complicating the ECB's task is that interbank lending rates have risen, tightening credit conditions and making access to market funding more expensive for banks.

"The ECB is trapped and the exit door is blocked," said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London. "The state of credit markets is going to force them to stay in crisis mode for longer than some of them would like."

Irish 10-year bond yields soared to a record on Sept. 29 on concern the bailouts of Anglo Irish Bank Corp. and Allied Irish Banks Plc. would overwhelm government finances. The Portuguese- German 10-year yield spread, which hit a record on Sept. 28, was at 398 basis points yesterday, up from 88 basis points on March 10.

While it has phased out its 12- and 6-month loans, the central bank still lends unlimited amounts in its weekly, monthly and three-month tenders. In May, it was forced to reintroduce the unlimited three-month loans and start buying government bonds as Europe's deepening debt crisis started to threaten the survival of the euro.

With the ECB unlikely to match other nations' "expansive monetary policy measures," the euro may continue to strengthen, crimping the region's exports and economic expansion, economists at WestLB AG economists said in a research note. The single currency has gained 16 percent against the dollar in the past four months and touched $1.3941 yesterday, the highest since February.

Currency Tensions Build

With the rise in the Euro vs. the US dollar, the Euro is also rising vs the Yuan given the Yuan's peg to the dollar.

Trichet and the EU are pissed that the Euro, and not the Yuan is at the center of global currency trends. Japan is also upset to the point of currency intervention.

China Tells EU to Stuff It

In the midst of global currency debasement wars, China Hardens Opposition Over Yuan Gains, Tells EU to Back Off

China stiffened its opposition to a rapid appreciation of the yuan, setting the stage for a confrontation over exchange rates at this week's international monetary meetings in Washington.

Premier Wen Jiabao said China will stick to its policy of gradually increasing the currency's flexibility and lashed out at European Union leaders for teaming with the U.S. to pressure the Chinese government.

"Europe shouldn't join the choir" clamoring for a higher yuan, Wen told a business conference yesterday before an EU- China summit in Brussels. "If the yuan isn't stable, it will bring disaster to China and the world. If we increase the yuan by 20-40 percent as some people are calling for, many of our factories will shut down and society will be in turmoil."

International exchange-rate diplomacy shifts into high gear at the Oct. 8 Group of Seven meeting in Washington after China rebuffed EU and U.S. pleas, the Bank of Japan sought to drive down the yen by unexpectedly easing monetary policy, and Brazilian Finance Minister Guido Mantega warned of a global "currency war."

"There's a game of brinksmanship being played," David Cohen, an economist at Action Economics in Singapore, said in a Bloomberg Television interview. "I suspect at the end of the day the Chinese will agree to return to gradual appreciation of their currency."

Mistake To Assume Anything

While it's crystal clear a game is underway, it's debatable whether that game is better called "brinksmanship" or "currency wars". Furthermore, it's a mistake to assume China will agree to anything.

Every country wants a weaker currency to stimulate exports, but that is physically impossible, except of course against gold. The irony is rising gold prices will not stimulate anything that central banks want, but global competitive currency debasement sure has stimulated the price of gold and silver.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Real Time Probabilities of Recession Above 20% Second Consecutive Month

Posted: 06 Oct 2010 10:31 AM PDT

Seeking to eliminate the enormous lag of NBER in declaring the beginning and end of recessions, economist Marcelle Chauvet computes real-time recession probabilities in a manner consistent with the long after the fact findings of the NBER.

The probability is down from last month, nonetheless Real Time Probabilities of Recession are above 20% for the second consecutive month.

Real-time means a one quarter delay, but that is still faster than the NBER is likely to make proclamations.

click on chart for sharper image

Month/Year	Probability of Recession%
January 2009	100.0%
February 2009	99.7%
March 2009	98.9%
April 2009	94.3%
May 2009	92.6%
June 2009	69.4%
July 2009	41.0%
August 2009	39.3%
September 2009	27.1%
October 2009	18.9%
November 2009	7.9%
December 2009	6.5%
January 2010	4.1%
February 2010	2.4%
March 2010	2.1%
April 2010	1.1%
May 2010	2.8%
June 2010	27.0%
July 2010	20.6%

Note the drop from 69.4% to 41.0% in June/July 2009 accurately timing the end of the recession well in advance of the NBER. Also note the huge leap from 2.8% in April to over 20% in June and July.

For a description of the methodology, please see the Center for Research on Economic and Financial Cycles post CREFC Real Time Probabilities of Recession.

Also see Real Time Analysis of the U.S. Business Cycle

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Hussman calls for 10-Year S&P 500 Total Return in the Low 5% Area; Thoughts on Risk Management

Posted: 06 Oct 2010 06:57 AM PDT

John Hussman is bearish on the economy and stocks. He backs up his beliefs with good commentary and a series of charts in Economic Measures Continue to Slow .

Please see the article for some excellent economic charts. Here are a few snips regarding equity returns.

With the S&P 500 at a Shiller P/E over 21, and our own measures indicating an estimated 10-year total return for the S&P 500 in the low 5% area, it is clear that investors have priced in a much more robust recovery than we are likely to observe. Our long-term total return estimates are consistent the historical norms based on Shiller P/Es - since 1940, Shiller P/E values above 21 have been associated with annual total returns for the S&P 500 averaging 5.3% over the following 7 years and 4.9% annually over the following decade.

Dividend payout ratios and operating earnings growth

A note on valuation. A number of observers have suggested that the low level of dividend payouts as a fraction of operating earnings is indicative of strong prospects for reinvestment, which is then extrapolated into assumptions for high rates of future earnings growth. Unfortunately, this argument is problematic on two counts.

First, forward operating earnings are not realized cash flows. As I've noted frequently over the years, forward operating earnings represent analyst estimates of the next year's earnings excluding a whole range of chargeoffs and "extraordinary expenses" as if they do not exist. While operating earnings provide a smoother measure of business performance, they don't provide a good measure of the cash flows that are actually deliverable to shareholders.

Losses that are booked as "extraordinary" are still losses, and represent the results of bad investments and a consumption of amounts that were previously reported as earnings. Similarly, the portion of earnings used for share buybacks is often expended simply to offset dilution from grants of stock to employees and corporate insiders, and again do not reflect cash that is deliverable to shareholders. In recent years, based on the widening gap between reported operating earnings on one hand, and the sum of dividends and increments to book value on the other, a great deal of what is reported as earnings ends up evaporating as extraordinary losses and share compensation.

The second problem with the low level of dividend payouts, relative to forward operating earnings, is that there is no historical evidence whatsoever that low payouts are accompanied by higher growth in future operating earnings. To the contrary, when dividends are low relative to forward operating earnings, it is a signal that operating earnings are temporarily elevated - typically because of transitory profit margins. As a result, subsequent growth in forward earnings is actually slower than normal over the following decade.

On the latitude for a constructive investment stance

Based on the data that we've observed in recent months, my view remains that a fresh downturn in the economy remains a not only a possibility but a likelihood. Little of the economic improvement we've observed since 2009 appears intrinsic, but instead appears driven by enormous government interventions that are now trailing off. Still, while I believe that there is a second shoe that has not dropped, I recognize that the full force of government policy is to obscure, stimulate, intervene and borrow in every effort to kick that can down the road. I believe that the unaddressed and unresolved problems relating to debt service, employment conditions and housing are too large for this to be successful, but as we move through the remainder of this year - as I've said throughout 2010 - we are gradually assigning greater probability to the "post-1940" dataset. Accordingly, there are developments that could potentially move us to a more constructive position. We don't observe those at present, but an improvement in economic evidence and a clearing of overbought conditions, leaving market internals intact, would be one configuration that might warrant less defensiveness.

To some extent, I view current market conditions as something of a "Ponzi game" in that valuations appear neither sustainable nor likely to produce acceptably high long-term returns, and speculators increasingly rely on finding a greater fool. As the mathematician John Allen Paulos has observed, "people generally worry only about what happens one or two steps ahead and anticipate being able to get out before a collapse... In countless situations people prepare exclusively for near-term outcomes and don't look very far ahead. They myopically discount the future at an absurdly steep rate." Undoubtedly, we have periodically missed returns due to our aversion to risks that rely on the ability to find a "greater fool" in order to get out safely. But it is important to recognize that speculative risks are not a source of durable long-term returns. At a Shiller P/E of 21 and a historical peak-to-peak S&P 500 earnings growth rate of 6%, a simple reversion to the historical (non-bubble) Shiller norm of 14 would require seven years of earnings growth and yet zero growth in prices. Stocks are not cheap here.

Stocks Not Cheap

I wholeheartedly endorse Hussman's analysis that suggests stocks are not cheap. I have said the same thing repeatedly all year long, most recently in Analysts Cut S&P 500 Profits Forecast; Earnings Estimates Still Overly Optimistic; Stocks Not Cheap

Earnings Estimates A Mirage

It's important to understand why earnings have gone up: Trillions of dollars of stimulus worldwide that is not sustainable. Bank earnings estimates have been inflated by massive extend-and-pretend games encouraged by the Fed with a blind eye from the FASB.

Moreover, the FASB has delayed mark-to-market accounting rules and has still not forced banks to bring SIVs and off-balance-sheet assets back on the books. Those assets are held at inflated values.

Equities only look cheap if you use absurd forward earnings estimates, and ignore future writeoffs and other "one-time" items that seem to have a way of recurring with remarkable regularity.

No Sure Things

Although most are plowing hand-over-fist into the "QE-Trade", it is a mistake to assume that quantitative easing is a guaranteed play for equities. It's not. Please see Sure Thing?! for a discussion.

Moreover, QE is not a guaranteed play for the economy either, as noted in Bernanke says Lawmakers Should Consider Rules on Fiscal Limits; Expect Hissy Fit from Krugman; Bernanke Pisses in the Wind

Yet everyday I get emails calling me a "chicken little" or other unprintable names for not recommending everyone plow into equities. I heard the exact same thing in 2006-2007.

However, I have recommended gold continuously since it was $300. I have also recommended treasuries with many attempting to short the things and getting their heads blown off.

Superior Returns Come From Reducing Risk

I see no reason to like equities here, but that does not mean they won't go up. Indeed they did. However, investors need to understand why equities are rising, the likelihood it continues, and what the risks are, even if short-term traders don't.

When this rally ends, it is as likely as not to be a steep descent with dip buyers fully conditioned to "buy the dip" all the way down.

Day traders and swing traders seem to think that everyone ought to be hopping in and out of stocks every hour or every week. However, not everyone wants to, or can - for many reasons, trade that way. Money managers in particular are unlikely to trade that way.

It is important to honor your timeframe and trading style, not someone else's.

Most of those fully invested here were also fully invested in 2008, with disastrous consequences.

In the long haul, superior returns are made by reducing risk, patiently waiting for favorable opportunities to invest. In the meantime, (and although this opinion can change at any time without warning) I am comfortable owning gold and treasuries, and being hedged in equities.

It is far easier to make up for lost opportunities than it is to make up for losses, especially losses that happen while chasing the latest sure thing.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

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Wednesday, October 6, 2010

Mish's Global Economic Trend Analysis

Mish's Global Economic Trend Analysis

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