Increased Recession Risks!

As we acquire more knowledge, things do not become more comprehensible, but more mysterious.
— Albert Schweitzer

According to Stephen Roach, “April was a critical turning point on the global rebalancing watch. After years of denial, the stewards of globalization – namely, the G-7 finance ministers and the IMF – finally sounded the alarm over the threat of mounting imbalances. The rebalancing fix that was endorsed has three key ingredients: the adoption of a multilateral global architecture of surveillance and consultation, general agreement on dollar depreciation, and a global tightening of monetary policies.” And after having warned for the last few years that the growing global imbalances would lead to some sort of crisis, Roach expressed optimism that “the good news is that none of this speaks of a terribly disruptive endgame for global rebalancing. Had global policy makers ignored the problem, a dollar crisis at some point in the not-so-distant future was a distinctive possibility. But now the combination of architectural reform, currency adjustments, and monetary tightening points toward a more orderly and hopefully benign strain of global rebalancing.” Still, Roach also warns: “It is important to stress that an orderly adjustment in the real economy is no guarantee of an orderly adjustment in liquidity-driven markets, especially those risky assets that have gone to excess.”

I have to confess that I am far less optimistic about the prospects of the G-7 governments and, in particular, finance ministers, central bankers, and the IMF being able to achieve “orderly” and “benign strains” of the rebalancing act. In fact, my principal concern centres on the negative impact of a disorderly adjustment in liquidity-driven markets leading to severe adjustments in the global economy. In fact, the innovative solution advanced by Dario Perkins of the ABN-AMRO research team in London seems to make far more sense. In a very humorous piece, also critical of the governments’ interventions, Dario writes:

During my time in the government, I heard many novel solutions to the UK’s economic problems. For example, perhaps giving unemployed workers their own cars would eliminate joblessness. If they had their own transportation, they would be able to visit the jobcentre more easily (perhaps we should also give them new shoes, so they make a good impression, watches to make sure they aren’t late for interviews, and umbrellas, just in case it rains). And surely, if the government is having trouble meeting its fiscal rules, the best solution is just to use a thicker line when publishing a chart of the deficit in the budget book (it’s best to be vague here – let’s not forget I signed the Official Secrets Act). Anyway, Gordon Brown has recently adopted a more global approach to policy. He wants to end world poverty, eliminate Third World debt, rebalance the global economy and discover his own cure for cancer. I don’t work for Gordon anymore, but I have a suggestion to help him solve global imbalances – population swapping (if successful it would also make a great reality TV show).

Consider this – the average European saves 11.5% of their income. But the average
American saves nothing. So, if we replaced 106 million Europeans with Americans, the US household saving rate would rise to 4%. And the European saving rate would drop to 7.5%. Suddenly, we have a European consumer boom, a sustainable US saving rate and a significant reduction in global imbalances (Gordon, I’ve still got it!). But I doubt that even Mr. Brown would take this suggestion seriously – to start, where are we going to find 106 million Americans who have their own passports? So, to get a European consumer recovery and a better balance to global growth, we might have to rely on more conventional means. Fortunately, recent data suggests we might be seeing such a recovery, despite European policymakers’ best attempt to prevent it.

I am writing this report in the apartment of a friend of mine in Pfäffikon, overlooking Lake of Zurich, the island of Ufenau, and the picturesque town of Rapperswil, before travelling on with my family to Africa. Pfäffikon is a small but thriving (thanks to its low taxes) business and residential town situated on the shores of the lake just 20 minutes from Zurich. (People with incomes above US$100,000 pay about half as much in taxes here as in the city of Zurich.) Before arriving here, where I find the atmosphere very conducive to reading and writing (my friend’s beautiful apartment is located next to one of Pfäffikon’s last remaining farms – a bio-farm – from where cowbells can be heard), I spent the weekend in Zurich. It was the weekend just prior to the end of the month, when salaries are usually paid. On Saturday night I bumped into a Hong Kong card-playing friend of mine who now lives in Pattaya, as well as my philosopher friend, Gery Hauck, who frequently helps me to refresh my memory of historical facts. We all met by chance in a rather colourful place (but one of ill repute) called Sonne, which is located on Hohlstrasse in the red-light district near Langstrasse. From there we went on to several other nightlife venues. In one of them we met an interesting character who works for Credit Suisse in a job he hates. This fellow has been studying Old Greek for the last few years, and can read and write it and seems to understand the old texts perfectly. I was very pleased that there are still Swiss people who value culture and find time to pursue an interest that has nothing to do with an economic or financial goal, since Old Greek is no longer spoken. I also felt some pride at finding such an educated population in Switzerland. But how disappointed I was today!

My friend’s cleaning lady took it upon herself to tune into a music station on the radio while she was working, commenting that it would also be good for me to enjoy some music while writing. During the hourly news, I heard that a recent survey by the Swiss Statistical Office had revealed that 800,000 Swiss – 16% of the adult population – “cannot even read and understand a simple text”. So, my American friends can relax. It’s not only in their country that educational standards are poor; the problem exists everywhere!

While the Langstrasse area was reasonably busy on Saturday night, it was almost empty on Sunday night and one of the barmen at the Sonne, who is from Bangladesh and a friend of mine, commented that he had never seen it “this quiet”. Granted it is holiday time, when lots of people are vacationing in the mountains or along the shores of the Mediterranean, but I am sure it is also a reflection of the standard of living of the average Swiss having stagnated over the last 10 to 20 years, and of the cost of life’s necessities having risen substantially over the last two years, leaving far less money in the consumer’s pocket for discretionary spending. Zurich is ranked by a Mercer survey as the world’s most pleasant city for expatriates. (The survey assesses more than 350 cities on 39 criteria, including traffic congestion and crime. It assigned Baghdad the lowest rating, while Singapore enjoys the highest rating in Asia.) However, it is also one of the world’s most expensive places to live (but not for well-to-do immigrants who can avoid paying estate taxes and can conclude favourable tax deals in the city’s surrounding cantons such as Zug and Schwyz). The problem is that for the local population, salaries have mostly stagnated, while taxes are high and the cost of items such as insurance, transportation, healthcare, and services has risen substantially. This seems also to have happened in the United States, where the cost of food, energy, interest payments, and medical expenses has risen substantially and led to a slowdown of discretionary consumption (see Figure 1). That consumer spending isn’t doing well is also evident from retail stocks rolling over and from consumer discretionary stocks’ poor performance. The Consumer Discretionary Select Sector SPDR (XLY) is an exchange-traded fund that includes companies in the auto, consumer durable, apparel, media, hotel, and leisure industries.

Confirming my observation about how casual dining places in Switzerland are “quiet”, USA Today reported on July 18 that, in the United States, “the $70 billion casual dining industry – sit down eateries that generally serve alcohol and sell entrees from $10 to $20 – is taking a hit”. According to the article, some of the industry’s big names – such as Applebee’s (APPB), Cheesecake Factory (CAKE), and Outback Steakhouse (OSI) – recently reported slides in sales at stores that have been open for at least a year. In June, Red Lobster’s same-store sales were down 5%, Ruby Tuesday (RI) was down 2.3%, and P.F. Chang’s (PFCB) was down 1.1%. In May, the last month reported, Applebee’s same-store sales were down 1.9%, and Outback was down 2.6%. High-flying and fast-growing P.F. Chang’s, whose stock had risen more than six-fold from 2000 until last summer, has now tumbled by over 50% (see Figure 4). At the same time, Cheesecake Factory reported a 1.3% same-store sales decline in the first quarter and has warned that the second quarter will be flat to slightly negative. According to Cheesecake’s chief financial officer, the chain has never had two negative quarters in a row. USA Today also reported that, according to Lynne Collier, restaurant analyst at Stephens Inc., in the 12 years she has covered this industry she has never seen a “downturn of this magnitude”. Nine out of the ten casual restaurant chains she follows have seen traffic decline in the past three months. And even at Panera Bread (PNRA), which until recently had stellar same-store sales growth based on a fast, casual spot concept, sales have recently shown a remarkable slowdown and led to some disappointments and heavy short selling among investors (see Figure 5). Given the stock’s lofty valuation (P/E of more than 30) and its huge price gain since 2000 (from less than US$4 to a recent high of US$76), some significant further downside risk exists! What seems to have happened is that diminishing available incomes for discretionary spending due to higher energy prices and higher interest costs have forced consumers to scale down to fast-food stores such as McDonald’s (MCD), where second-quarter same-store sales were up 4.2%.

The other day, I read Raymond DeVoe’s DeVoe Report, which is always entertaining and loaded with personal anecdotes. His April 26 issue immediately caught my attention, as I am on my way to Uganda to see the gorillas and from where communication is difficult.

(For information regarding the DeVoe Report , call: 1-800-457 8459.) DeVoe writes:

The late Bernard Baruch, one of the great speculators of all time, had a strategy that he followed whenever he became bored with his stock holdings. Not only bored, but when he was confused about the stock market’s action – or lack of it. If the stock market appeared to be drifting, not reacting to generally favorable fundamentals and his stocks were going nowhere he closed out all positions, long and short and went away for a month – two months when he sailed to Europe.

Invariably the stock market was down when he returned, and his former long positions frequently down more than the market averages. He had sensed a subtle change in market patterns, and followed his instincts. Similarly Polynesian seamen navigated by wave action, and could detect when approaching land by changes in the shape or amplitude of waves. This could also warn them of some distant change in the weather. Long before the tsunami hit Asia in December 2004, the elephants and other non-human earth dwellers moved to high ground – there were practically no animal fatalities when the wave struck. They are much better attuned than humans to detect changes in natural phenomenon, [sic] since their survival depends on that ability. For some time I followed Mr. Baruch’s strategy whenever I planned a vacation – not that I was bored with my stocks, but for another reason.

DeVoe then recounts how in March 1962 he had to sell his six promising stocks to pay for a Mercedes he had bought in Europe and was to drive there for a while on a holiday. The Dow was then around 723, just below the high of the year. In April 1962, US Steel raised its prices, which led to a nasty confrontation between the Kennedy administration and US Steel, and was perceived by investors as anti-business. From that 723 level in March the market slumped to 535 at the end of June, whereby technology stocks were devastated. DeVoe writes that:

…after several weeks driving back-country roads in Europe during June, without newspapers, I saw the price for IBM of $300 posted in the lobby of the Hotel de Paris in Monaco. “It must have split 2-for-one” was my natural assumption. No split – IBM stock was down 47.8% from where I sold it and the other five stocks sold in March were off about 80% each. I could not have paid for a Volkswagen if I had sold the same stocks at the end of June. Lucky – of course, but for many vacations after that I would sell all my non-core holding stocks before leaving. Returning from vacation I discovered something Mr. Baruch had also learned decades earlier. Since there was no emotional attachment to the stocks that had previously been sold, they could be evaluated rationally in relation to many other stocks. As Mr. Baruch found out they did not look nearly as attractive – and were very rarely bought back. Financial behaviorists have a term for this but I consider it to be “liberation from the prison of past decisions”. It is one of the reasons newly formed mutual funds tend to have above average performance in their first year – the new funds are allocated for what the money managers consider to be their best opportunities. Subsequently when some of those ideas don’t work out there is always the difficulty in admitting that a mistake was made, and selling the stock. In my opinion, that is making a second mistake, and frequently the situation gets worse, not better….

If Mr. Baruch was confused about the stock market’s action before he went on vacation, I confess I am just as confused after my vacation. The widespread complacency is not just about stocks but about virtually all markets, almost everywhere. The only significant exception would be in the housing market, where homeowners are either in denial, or dismissive about apparently changing fundamentals. The results of the Gallup Organization’s poll of U.S. consumers were released on April 19th and “71% of the adults surveyed believe a bubble exists (in the housing market) and could burst within the next 12 months.” However, 56% of them believe that the bubble is unlikely to pop in their residential area. Or, “bubbles all around but my bubble is not going to pop”…. Perhaps the realtor’s fallback fantasy, “The rolling boom” is operating to some extent, but I think that something more significant is taking place. I cited my luck in the vicious bear market of March-June 1962 to illustrate how quickly conditions can change in any speculative market. Following Pres. Kennedy’s election in November 1960, his campaign themes of “Getting the country moving again”, “Closing the missile gap”, and “Putting a man on the moon” had propelled many science, technology and space stocks into heady valuations – and led into a highly speculative stock market in questionable issues. At the time many stock market analysts contended that it was “a combustible market – all that is needed is some spark to set it off.” That “spark” was U.S. Steel raising prices, and the violent reaction to it by the Kennedy Administration…. A recent book, Malcolm Gladwell’sThe Tipping Point might be more appropriate than “Combustible market.” He goes into what starts major trends and epidemics, and what causes them to reverse. At some “tipping point” the trend takes off, and at others, it reverses. Before Mr. Gladwell’s book and his “tipping point” concept I used “The Sun Also Rises Syndrome”, named after Ernest Hemingway’s classic novel about post-World War I “lost generation.” In the novel the central character Jake Barnes asks his friend Bill Gorton how he went bankrupt. Gorton answers, “Slowly at first, then very, very quickly.” That’s what happened in the 1962 bear market, and what followed after “The Crazy Day” March 10, 2000 when the NASDAQ Composite peaked at 5,048. In both cases the bear market started slowly at first, and then picked up momentum very quickly.

I think Raymond DeVoe makes some very important points. It has also been my experience that investors tend to become attached to equities that are showing large losses in their portfolios in the hope of a recovery. Stocks such as Cisco (CSCO), Intel (INTC), Dell (DELL), Sun (SUNW), Oracle (ORCL), Yahoo (YHOO), Amazon (AMZN), and eBay (EBAY) are still widely held by the public, although a recovery to their previous highs is almost impossible. (The Nasdaq, despite its recovery since October 2002, is still down by more than 50%.) Had investors sold these shares in 2000 with moderate losses or still with some gains (depending on when they were bought during the late 1990s’ boom), it is likely that with a fresh mind or, as DeVoe points out, liberated “from the prison of past decisions”, they would have reinvested in the last five years in different and more promising equities. This is especially likely if they had taken into account my contention – expressed repeatedly during the last few years in these comments – that following the bursting of a bubble the leadership always changes.

So, selling one’s stocks occasionally (or taking one’s losses on short positions, which have moved up against one’s expectations) seems to be an excellent concept. In the world of investments, there will never be a shortage of opportunities for the patient, persistent, and disciplined investor.

The complacency DeVoe refers to concerning the housing market also exists – despite all the talk of widespread bearishness – for equities. It is true that sentiment readings have turned more bearish, but also consider the following. Barron’s reported in mid-July (after the market’s May-June sell-off) that “The State Street Investor Confidence Index” – a unique gauge that measures real-money investment flows among various asset classes and which is distilled to represent institutions’ relative risk-taking activity – showed, as of mid-June, a steep increase since February in institutions’ “confidence” or willingness to take on risk – specifically, equity risk. Because State Street is a huge asset custodian for global institutions, its clients’ behaviour is a representative snapshot of what traditional, longonly institutions are doing. Moreover, Barron’s reported that while the index had settled into a somewhat lower range since early 2004, “the latest reading was exceeded only once in the past two years, in March 2005, and then only slightly…”

Barron’s also referred to Robert Shiller, the author of Irrational Exuberance, whose work focuses on behavioural finance, and who compiles a monthly institutional investor confidence measure. It is quite a simple measure, which tallies the percentage of respondents who think the Dow will be higher in a year. The latest result, for May, showed that 92.6% of respondents believed the Dow would be up in a year – the highest level since Shiller started the survey in 1989! Finally, the COT [Consensus of Traders] Report shows that large speculators are holding their largest DJIA futures positions since the Bush re-election rally and that small speculators are holding a record number of Dow Jones Average futures by a multiple number.

That institutional investors have great “confidence” in the market rising soon is also evident from the Equity Mutual Funds cash to assets ratio. As Robert Prechter points out, it will take time to break fund managers’ complacency and to bring the cash to assets ratio to above 10%, which usually occurs at major market lows (1974, 1982, and 1991). Still, it is true that Investors’ Intelligence Sentiment Index readings have improved (less bullishness). As Ed Yardeni has pointed out, the bulls to bears ratio recently dropped to 1, which was the lowest reading since October 2002. However, because the stock market slide in May-June caught so many investors by surprise, resulting in not insignificant losses, unlike in 2002, this low sentiment reading may be more a reflection of “disappointed expectations” than of widespread bearishness. Also, I should like to emphasise that if the bulls to bears ratio could register continuous high readings from 2002 to May 2006, why couldn’t it stay at low readings for an extended period of time? Finally, I follow the NYSE Uptick-Downtick indicator (Tick index). From June 26 to July 24, this index rose to above 1000 (short-term buying panics) on more than 60 occasions. But how many times did it show a reading of minus 1000, which indicates some kind of short-term selling panic? On just six occasions. The Tick indicator would therefore, at present, indicate enormous latent bullishness rather than any strong desire to liquidate stock positions and to “get out at any cost”!

Lastly, the “tipping point” DeVoe refers to might come from a side that was totally overlooked until just very recently, but which was beginning to be reflected in the poor stock market action of many individual companies whose stocks no longer rose even on very positive earnings reports. So, whereas investors’ attention is still focused on the Fed increasing, maintaining, or lowering the Fed fund rate over the next few months, the market may start to focus more on the outlook for corporate profits.

Marc Faber
August 23, 2006