Thursday, August 16, 2007

Economic Recap

Back in March, I said the following:

"One can't underestimate the effects this could have. If many of these subprime loans prove unsustainable without the hope of refinancing, this could increase defaults, which could decrease home prices, which could spread the default risk up the credit quality ladder. Meanwhile, mortgage insurers will be affected, along with banks, which pretty much spreads out to everywhere. Consumer demand, which has been so reliant on asset monetization, can drop. That branches out to affect the whole economy."

Well, so far we are beginning to see the beginning of the effects on banks and mortgage insurers. (I should of included hedge funds). But it's important to remember that subprime is just one example of the overall credit bubble. If I had to make a case for overvaluation in the markets, I would focus on three things:

1. Historical P/E's

2. Historical Return on Equity
Average earnings for the the Dow Jones Industrial Average are 11% of the company's book value in any 20-year period between 1920 and 1986 (1920-39, 1921-40, 1922-41, etc.). "Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external factor." Warren Buffett said something similar, although I think he said 12%. Over the last decade, the DJIA Return on Equity has averaged 18%, with it currently running at 23%.

3. Leverage in the Economy

When things turn the other way, debt can get very messy. As the new Economist says, "because this crisis taps so deeply into the newly devised structures of finance, anyone who says the worst is definitely over is either a fool or someone with a position to protect. As risk has become bewilderingly dispersed, so too has information. ...Nobody knows how messy the inevitable bankruptcies will turn out to be. What markets need now is time to piece that information back together. Time before the next wave strikes." Similarly, many people have been claiming that high quality names have gone on sale during this recent market drop. I think it is way too early to tell.

"I place economy among the first and most important of republican virtues, and debt as the greatest of the dangers to be feared." -Thomas Jefferson, 1816



Nick said...

Isn't the net debt at least partially relevant?

Nnejad said...

Yes it is, and that number is just as discouraging. I've attached a chart so you can see that as well on the bottom. The only reason our net debt as a percent of GDP isnt increasing as fast as the current account deficit is due to currency depriciation and price changes(We earn more yield than foreigners on our investments). Still, we are in unchartered territory.

The reason I showed total debt, however, is because net debt doesn't take into account inter-country balances. Overall, we can see from this that there is a much higher leverage ratio within our own economic system, the consequences of which are tough to be certain, but certainly won't be good.