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Forex Blog - The Rise of A New Asset ClassThe Rise of A New Asset Class
August 1, 2008
This week I am in Maine on vacation with my son, and next week is my
daughter Tiffani's wedding, so for the next two weeks I am going to
send an updated version of a speech I have been giving the past few
months on what I think is the likely potential for the rise of a brand
new asset class. It is too long to be sent as one letter, so we will
start with the first part today and finish with the second part next
week. This first part can be read as a standalone letter.
The Rise of A New Asset Class
think we're at a watershed moment, what Peter Bernstein defines as an
"epochal event," with the very order of the investment world changing
as it did in 1929, in '50, in 1981, where a number of things came
together - it wasn't just one thing but a number of events happening
that conspired to change the nature of what worked in the investment
world for the next period of time. It took most people a decade after
1981-2 to recognize that we were in a different period, because we make
our future expectations out of past experience. It's very hard for us
to recognize a watershed moment in the process. We're going to look
back in five or ten years and go, "Wow, things changed." As we will
see, it's going to be a change that's going to cost people in their
portfolios and in their retirement habits.
We're going to look
at a number of different concepts and separate ideas that in and of
themselves don't make that much difference. But I think their
confluence in the present moment is going to change things.
some of this is new, some of it is old. The old stuff we're going to
fly through. Most of you have been reading me for a while now, and
you've got the concepts down. So let's start.
The first thing to
note is that we're in a Muddle Through Economy. We're in a recession
that's fueled by the bursting of two bubbles: the housing bubble and
the credit crisis. The real question is: when do we come out of the
recession? At what time do we come back to trend growth, which is 3 to
3.5 percent a year?
I believe that over the next 20 years the US
economy will grow at roughly a rate of 3 percent compounded, in real
terms. But I believe that we have some headwinds for the next year or
two. So I think the real bottom of this economic cycle will be later
this year, during the fourth quarter and possibly into the first
quarter of next year. But it will take two years, for some reasons we
are going to get into, to get back to long-term trend growth. It will
take much longer than normal because the things that created the
problem - the housing bubble and the credit crisis - aren't things that
can respond to Fed policy, and they aren't things that can respond to
the normal cycles. It's going to take a long time to work through these.
we had an investor-driven transaction bubble in housing. There were 48%
more houses built since 2005 than should have been built, if you were
simply looking at trends.
that means is there are 3.5 million homes we have to work through. Now,
that means that the 8 or 9 hundred thousand homes that we're now down
to building a year, is going to end up going down to 400,000. It's
going to take some time to work through those excess homes - for the
prices to drop enough that people can go in and buy them or rent them.
We are probably talking 2011 before we finally work through this
housing crisis and get back to a normal market where housing
contributes significantly to GDP growth.
activity is probably going to correct another 30 percent. That's not
fun. By the middle to the end of this year, sales are going to be
really low. As a side issue, those of you who like to invest in real
estate and actually want to own a home to rent are going to have some
look at the credit crisis very quickly. We vaporized 60 percent to the
shadow banking system, the SIVs and CDOs, the people who actually
bought US mortgages, who bought student loans, who bought credit cards,
who bought car loans. That's gone and it's never coming back. As we'll
see, it's going to take well into the next decade for us to create a
completely new infrastructure to replace the broken one. It took
decades to get to where we were last year. I don't think it will take
decades to recover, but it's going to take five, six, seven years. That
means things are going to be difficult if you want to borrow money.
Credit spreads are going to be wider; it's going to affect you more. By
the way, if you're in business, if you're paying more, it's going to
put pressure on your profits.
Let's look at GDP growth for the last ten years, with and without mortgage equity withdrawal.
MEW, we would have had two years, in 2001 and 2002, with negative GDP
growth. We're not going to go get those levels of mortgage equity
withdrawals today, not in this environment. We're still seeing some
cash-out borrowing, but it's getting more and more difficult; and as
home values drop, there are going to be fewer and fewer people pulling
less and less money out of the "home ATMs." As Paul McCulley says, your
home ATM is starting to spit out negative twenty-dollar bills.
means consumer spending is going to continue to slow. We haven't had a
consumer recession since 1990-91. There are a lot of people today who
have kind of forgotten that consumer spending can actually slow down.
That's going to happen from lower mortgage equity withdrawals, and it's
going to happen because of higher gas and energy costs that are
displacing normal spending. You've got to fill up your Ford F-150 to be
able to get to work. I saw $4 a gallon gasoline when we arrived in La
Jolla. I mean, I guess around here people don't really pay attention,
but that means it would cost a hundred bucks to fill up my big SUV.
That's just a lot of money. That's a hundred bucks I can't spend on
something else - on clothes or kids or education. It means I'm going to
be consuming less.
We're in a recession. Recessions by definition
mean that we're going to be seeing rising unemployment. We're already
up past 5.5 percent. We'll probably see 6 percent and maybe higher.
We're not going to see the 9 and 10 percents like we did in the '70s or
'80s, because we're not as subject to the manufacturing cycle as we
were back then. That's both good and bad. We don't have that boom-bust
in the manufacturing world. We're seeing a bust in the construction
world and we're starting to see commercial lending and commercial
building go down. But I don't think we're going to see the large 8 and
9 percent unemployment rates that we typically see in a recession. But
still, if you see rising unemployment - and unemployment rises by 20
percent, from 5 to 6 - that means those people are going to have less
money and they're not going to be spending it.
inflation in an environment of low real-income growth. Inflation is
running over 4 percent now. And real-income growth is running a little
bit less. While we may see some nominal growth in consumer spending,
real spending is going to be dropping over the next year. That has some
consequences that we'll talk about later. Also, consumer spending is
going to drop because we have less availability of easy credit. Now, it
probably hasn't hit this room. But there is a wave of letters going out
from credit card companies, cutting people's credit lines, cutting
people's home mortgage lines. There are a lot of people actually
hitting their home equity credit lines and putting it in a savings
account because they're afraid that it's going away. They're afraid
that they may not be able to get the cash when they need it. "What
happens if I lose my job? I better get the cash, and I'll pay the
difference in interest costs just to make sure that I'm OK." That's
happening a lot.
In summary, lower mortgage equity withdrawals,
higher gas and energy costs, rising unemployment, inflation in an
environment of low real-income growth, and less availability of cheap
and easy credit are all contributing factors to slowing consumer
This has three major effects. First, lower corporate
earnings. We're in a period where earnings disappointments are going to
be the rule and not the exception. We're going to go into this in
detail in just a little bit. But GE wasn't a one-off announcement. Yes,
it was their financial system. But we're going to see a lot of earnings
disappointments from all sorts of retailers, from all sorts of
companies, for a variety of reasons. We're going to look at the
documentation for a minute to demonstrate that. Second, lower corporate
profits put pressure on the stock market. There's a relationship
between earnings, valuations, and stock prices. And third, that also
means we're going to see lower than expected long-term returns. That's
going to be a problem for people who are looking for traditional assets
to be the bulk of the growth for their retirement portfolios.
I think we're still in a bear market. Remember that in 2000 and 2001,
we had three corrections of over plus 20% percent and one in the plus
30% range. It's not unusual to see large corrections inside an overall
Why do I think we're in a bear market? Long-term
markets - and we're going to talk long term for a second and then come
to the shorter term - long-term markets in bear cycles have several
characteristics. Number one, they all start with high P/E ratios. Now,
Vitaliy Katsenelson, who wrote my e-letter this week so that I could be
here, lays out what he calls "cowardly lion markets," as distinct from
bear markets, because stocks tend to go sideways for a long period of
time. We'll talk about why that is in a minute, but I think he's right
You are told that you should invest for the long run.
Twenty years for a lot of people is the long run. However, what they do
not tell you is that you can see negative real stock market returns
over 20 years. It's happened four or five times. So when you're reading
in somebody's book that says, "Hey stocks are going to compound at 11
percent a year" or whatever la-la number can be seduced from the data,
secular bear markets, you can have returns for long periods of time
from zero to 3 percent, every 15 to 30 years. We're kind of starting
one here again. If you went to Standard and Poor's website in March of
2007 and you asked what the earnings were going to be for 2008, their
analysts said that earnings would be $92 for 2008. Two months later, at
the end of the year in December 2007 - this is four months ago - they
were projecting $84. In February, it was $71.20. Today Merrill Lynch
estimates that earnings could drop to as low as $45 next year. Notice a
When you go into a recession, analysts begin to
project lower earnings. They keep ratcheting them down. What do they
use to project future earnings? Past performance. There are very few
analysts who actually go out and say, "OK, how is this company going to
perform in a recession?" They all say, "The company that I cover is an
exception." This is how they're going to cover it, because they're
talking to management.
And when's the last time management
said, "Oh man, we're really going to get clobbered; there's a recession
coming." Not if they want to keep their jobs. John Chambers will be
telling us that Cisco's going to be doing wonderfully, just like he did
all of '99, all of 2000 and all of 2001.
Now, what does this
mean for P/E ratios? About 30 days ago, it was estimated, based on
prices, that the P/E ratio for the end of the last quarter would be
20.5. Today, as companies mark their earnings down, the P/E ratio is
22.5. For the end of September, third quarter, a month ago, they were
saying the P/E ratio would be 21. Today they're projecting that if the
market stayed at the same price, it would be 28. Now, does anyone think
we're going to see a P/E ratio of 28 at the end of the third quarter?
People are going to be projecting positive earnings forward - and we're
going to see one earnings surprise after another.
takes three to four really good earnings disappointments to reach a
point where investors really begin to understand that things are
different, because we project future performance from past performance.
When past performance disappoints us three or four times, then we begin
to project negative performance, and that's when the stock market
drops. It's not that the stock market is telling us that things are
going to be better. It's that we have expectations of things getting
better because that's what our past experience has been - so we need
This is from Vitaliy Katsenelson's book:
If you take 10-year trailing P/Es - you average them together so you
don't have the effect of just one year - you find that valuations go
from high to low from where bull markets start, in what he calls a
range-bound market or what I would call a secular bear.
go from high valuations to low valuations and back. Around 2000 we were
at 48. It's down to 30 today on those long, ten-year runs, and it
always corrects below the mean. Valuations are mean-reverting machines.
you just look at one year, you get the same effect. You have a P/E
average of 15 - remember they're projecting 28. You don't have a
projection of 28 in a recession and not have the stock market feel
Maine, Maryland, and Weddings
It takes a full day to get from Texas to Leen's Lodge (http://www.leenslodge.com/)
in Grand Lake Stream, Maine. Trey and I make the last part of the trip
by float plane. This is the third time I've gone with Trey, and I
really look forward to the trip. It's just a great bunch of guys. As I
have noted, we do make predictions about the markets. Last year a
number of readers sent in their predictions, and we have tabulated
those. I will report back on how well we all did, and some of you will
win a book for being the best predictors.
It looks like I am
going to Maryland for a day in a few weeks, and New York is looming on
the horizon again, as well as another trip to Baltimore to be with my
really good friend Bill Bonner (of Daily Reckoning fame) for his 60th
birthday party. Now that should be a blast.
It is amazing how
many details have to be worked out for a wedding. And it is just a few
days away. Tiffani will be gone on her honeymoon for almost an entire
month, so a lot of business details have to be worked out for the
interim. She and Ryan will be in South Africa and Ireland, and I really
do want to leave her alone. She deserves some time away. When she comes
back, we will really start to work on our book.
Have a great week. Enjoy the summer with friends and family.
Your ready for some fishing analyst,
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