Thursday, February 07, 2008

Predictions '08

Let me begin this with a quote from Robert Reich's Work of Nations:
The predictable failure of all prediction notwithstanding, the public continues to pay attention to stock analysts, trend spotters, futurologists, weather forecasters, astrologers, and economists. Presumably such respect is due less to the accuracy of their prophecies than to the certainty with which they are delivered. The reader of these pages is duly warned...
That being said, I think we can observe certain facts to get a feel for where things stand in our economy today. Let me begin by introducing you a concept I picked up from the economist Hyman Minsky. Minsky came up with three classifications for debt relationships.

The first and safest class was hedge financing; In these arrangements, the borrower's income could cover both the interest payments and the principal balance.
The second stage was speculative finance, in which the borrower could afford the interest payments, but for principal the borrower needed to either sell assets or refinance.
Finally, the riskiest stage was Ponzi finance, defined as the borrower's income being insufficient for even the interest payments.

The reason this is relevant is that this concept can be applied to all sorts of investing relationships. Take stock investing for an example. The goal in stock picking is to buy an enterprise for less than the discounted future cash flow of the business. Stated another way, it is equivalent to buying a security where its income stream can cover both our interest(discounting) and our principal payments. Ponzi units, which deal with the other extreme, can be seen during a stock market bubble. For example, during the tech bubble many companies were trading at P/E ratios of over 30. That meant that the earnings yield on a stock investment was likely much lower than the prevailing risk-free interest rates. What this meant was that stocks were in Ponzi territory- the only way these investments could be justified were if you could assume significant earnings growth. When that did not materialize, the prices of stocks plummeted.

So that brings us to where we are at today. The most obvious source of economic uncertainty today is from residential housing. Here was another example of a Ponzi. Since 2004, many loans were made to borrower's who could not even afford their interest payments. There are many reasons for why things got out of hand, but the idea of an adjustable-rate mortgage was certainly one factor in promoting the excesses. I mentioned earlier in the stock example that the only way a Ponzi situation could be justified was if income was expected to grow rapidly. But with residential housing, our "earnings" is simply nationwide household incomes. To make the assumption that national income would rise significantly seems foolish and calls into question the worth of many of these loans. It is clear that residential investment became very imbalanced, and going into this year we will probably see things continue to languish.

Now without being an expert in commercial real estate, I have to gauge from information like this that things got out of hand here, too.
Mr. Macklowe and his son Billy paid $6.8 billion to buy seven New York buildings from Equity Office Properties Trust. ... Macklowe Properties put in only $50 million of equity and borrowed $7.6 billion, according to the documents. (Mr. Macklowe borrowed more than the purchase price to cover closing costs and other fees.) The deal also had "negative debt service," meaning that the rents from the buildings weren't expected to cover the debt payments for five years..
Again, here we see another example of a Ponzi relationship in the commercial real estate market, characterized by extreme leverage and an inability to service the interest on the deal. As the post goes on to say:
Troubled New York real estate titan Harry Macklowe has reached a tentative agreement with his lender to turn over effective control of seven Manhattan office buildings he triumphantly acquired less than a year ago for $7.2 billion ...
So there is likely to be additional losses in wealth and economic headwinds from the decline in the commercial real estate market. We are beginning to see signs of this here.

Moving on to the corporate world, we have the issue of corporate profits as a percent of GDP. Here's what Warren Buffett had to say on the issue:
You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.

Currently, the figure stands at a relatively high 8.24%. (The chart isn't fully updated) With the nation coming off a period of excess consumption, profits are likely to come down. This means two things. One, stock wealth will disappear as valuations are discovered to be expensive. Two, corporate debt from last year's M&A surge will run into trouble. We've already begun to see signs of this here.

This is a lot of wealth disappearance and this has secondary effects on spending and employment- the exact extent of which is difficult to tell. I personally feel the consequences might be more painful than most are imagining. And if I had to make a few more bold predictions, I would say:

-International wealth and profits will not be spared.
-there will be more derivative losses and more counter-party problems.

The nation as an average needs to expel the expectation of double-digit investment returns over the next few years- Profits are at cyclical highs, valuations are rich, and the 10-year treasury is at 3.77%. But in the end I yield to the idea that 10 years from now we will all be better off than we are today, and that individual opportunities do exist. So it is with a cautious mindset that I proceed with investing this year.


David said...

Your points on profit margins at all time highs are well taken. It seems like everyone today is calling the market "ridiculously cheap" because of forward PE ratios in the 13-15 range and ttm levels in the 15-16 range. No one wants to talk about the elephant in the room - corporate profit margins, and if you do - as have Jeremy Grantham, Julian Robertson, and John Hussman - then you're labeled a "perma-bear" or "Short-sighted." Bravo for actually talking about the big fat elephant no one wants a prt of...

Nnejad said...

I am glad you mentioned Grantham because there is a great interview with him at the link below.

This is what he had to say on corporate profits and housing:

Profit margins, the great prop to the market, surprisingly defied the laws of gravity for three years in the developed world and, particularly, in the emerging world and even in Japan. That was because the global economy was stronger than any corporation counted on and, in the U.S., consumption was always higher and our savings rate was always lower than any corporate economist would have suggested, going into negative territory. But there are a few near certainties in this business -- not many, but a few -- and one of them is that abnormally high profit margins will go back to normal. The timing is unfortunately shrouded in fog. The other near certainty is that house prices will go back to a normal multiple of family income. In the end, we, the people, have to be able to afford the houses and they are affordable at something around 2.8 times family income. When they peak in Boston at 6 times and nationally at 3.9 times, you know you are in for tough times.