Here is my latest article in the October issue of Institutional Investor
By Vitaliy N. Katsenelson
During the ’80s and ’90s, ignorance was bliss. The global economy was growing nicely, and analyzing it (or even paying attention to market cycles) seemed like a waste of time, as the economy came in only three flavors: good, great and awesome. Even if you misread the flavor, the downside was that you’d just make a little less money. Value investors prided themselves on being bottom-up-only analysts, focused on scrutinizing individual stocks, while top-down analysis — making investment decisions by looking only at the macro picture — became unfashionable, viewed as market timing. (I know the above statement may sound a bit over the top, but over the years I have read and listened to dozens of interviews with famous and successful investors who declared that they do bottom-up-only analysis and don’t pay attention to the economy.)
Prolonged and virtually uninterrupted growth brought complacency, excesses, and debt. Bottom-up-only analysis worked until it stopped working, as investors discovered during the recent crisis that the global economy can come in additional flavors: bad, horrible, and downright nasty. Today the cost of misreading the economy is much higher.
Two years ago the Great Recession waltzed in — to the great surprise of homeowners, the Fed, and the banks — and everyone discovered that house prices don’t always go up. The financial sector, the lifeblood of our economy, started to drown in the sea of bad debt. As the troubles in that sector began to spill into the real economy, the government felt it had no choice but to step in, and the bailouts and stimuli began.
Today it is hard to take a walk through our economy and not meet a friendly Uncle Sam; he is everywhere. He’s buying long-term bonds and thereby keeping long-term interest rates artificially low. Since he took over the defunct (for all practical purposes) Fannie Mae and Freddie Mac, he is the U.S. mortgage market, because those organizations account for the bulk of mortgages originated. Of course, he is also on the hook for their losses.
Our dear Uncle Sam rolls in style; he doesn’t know how to bail out or stimulate on the cheap. U.S. government debt (at least, the debt that is on the balance sheet) leapt from about 60 percent of GDP before the Great Recession to more than 100 percent in 2010. The party of overleveraged consumers has been crashed by an overleveraged government.
To understand the consequences of the Great Recession, consider this analogy: The U.S. economy is like a marathon runner who runs too hard and pulls a hamstring, but finds himself with another race to run. So he’s injected with some industrial-strength steroids, and away he goes. As the steroids kick in, his pace accelerates as if the injury never happened. He’s up and running, so he must be okay — this is the impression we get, judging from his speed and his progress. What we don’t see is what is behind this athlete’s terrific performance: the steroids, or, in the case of our economy, the stimulus.
Obviously, we can keep our fingers crossed and hope the runner has recovered from his injury, but there are problems with this thinking. Let’s address them one by one:
• Serious steroid intake exaggerates true performance. Economic stimulus creates an appearance of stability and growth, but a lot of it is teetering on a very weak foundation of government intervention.
• Steroids are addictive; once we get used to their effects, it is hard to give them up. When the first home-buyer tax credit expired, it was extended for anyone with the patriotic ambition to buy a house. It is hard to give up stimulus, because the immediate consequences are painful, but long-term gain has to be purchased by short-term discomfort.
• The longer we use steroids, the less effective they are. Take Japan, which was on the stimulus bandwagon for more than a decade. With the exception of tripled government debt, Japan has nothing to show for its efforts; the economy is mired in the same rut it was in when the stimulus started.
• Steroids damage the body and come with significant side effects. In the case of the economy, the side effects are higher future taxes and increased government debt, which brings on higher interest rates and thus below-average economic growth. The hopes that we’ll transition from government steroid injections back to an economy running on its own are overly optimistic.
So what does this mean for investors? When we purchase a stock, we are buying a stream of future cash flows. By doing only bottom-up analysis, investors implicitly assume that external factors (the winds and hurricanes of the global economy) have no impact on these cash flows. That is a brave and careless assumption, especially in a poststeroid world. Instead, investors should take a more holistic approach, mixing bottom-up insights with top-down analysis.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing” (Wiley, 2007) and the upcoming The Little Book of Sideways Markets (Wiley, December 2010). To receive my future articles by email, click here
P.S. I want to bring to your attention two articles from the NY Times. The first one takes a deep look at Ordos, the infamous Chinese ghost town built for 1.5 million residents (here is a slideshow from Time magazine). A few excerpts:
Kangbashi was projected to have 300,000 residents by now. And the government claims that 28,000 people live in the new area. But during a recent visit, a reporter driving around for hours with two real estate brokers saw only a handful of residents in the housing developments.
Analysts estimate there could be as many as a dozen other Chinese cities just like Ordos, with sprawling ghost town annexes. In the southern city of Kunming, for example, a nearly 40-square-mile area called Chenggong has raised alarms because of similarly deserted roads, high-rises and government offices. And in Tianjin, in the northeast, the city spent lavishly on a huge district festooned with golf courses, hot springs and thousands of villas that are still empty five years after completion.
If excesses in the Chinese economy were limited to Ordos, it would just be a little multi-billion-dollar pimple on the pinkie of a $5-trillion economy. But unfortunately Ordos is symptomatic of much greater excesses all over China.
“I bought two places in Kangbashi, one for my own use and one as an investment,” said Mr. Zhang, who paid about $125,000 for his 2,000-square-foot investment apartment. “I bought it because housing prices will definitely go up in such a new town. There is no reason to doubt it. The government has already moved in.” Asked whether he worried about the lack of other residents, Mr. Zhang shrugged off the question. “I know people say it’s an empty city, but I don’t find any inconveniences living by myself,” said Mr. Zhang, who borrowed to finance his purchases. “It’s a new town, let’s give it some time.”
The second article in the Times tells the very depresseing story of what is taking place in Japan. A few excerpts:
In 1991, economists were predicting that Japan would overtake the United States as the world’s largest economy by 2010. In fact, Japan’s economy remains the same size it was then: a gross domestic product of $5.7 trillion at current exchange rates. During the same period, the United States economy doubled in size to $14.7 trillion, and this year China overtook Japan to become the world’s No. 2 economy.
This has a such a familiar ring to it; in fact it sounds exactly like the prediction we often hear that the GDP of the Chinese economy will overtake that of the US by 20xx. Though it may happen, I would not make this prediction solely on the basis of drawing straight lines to extend the growth of the last two decades into the future. This type of analysis is too simplistic, and dangerous. It is important to understand the roots of past success, and often past success is the precursor of a less-than-bright future — Japan is a great example of that!
The decline has been painful for the Japanese, with companies and individuals like Masato having lost the equivalent of trillions of dollars in the stock market, which is now just a quarter of its value in 1989, and in real estate, where the average price of a home is the same as it was in 1983. And the future looks even bleaker, as Japan faces the world’s largest government debt — around 200 percent of gross domestic product — a shrinking population and rising rates of poverty and suicide.
… the small-business owner, who sold his four-bedroom condo to a relative for about $185,000, 15 years after buying it for a bit more than $500,000. He said he was still deliberating about whether to expunge the $110,000 he still owed his bank by declaring personal bankruptcy.
I am a value investor and rarely have a view on currencies; I don’t know how to value them. But the yen hitting a fifteen-year high against the dollar makes no sense whatsoever. The US has plenty of problems but it is not Japan, at least not yet. In fact the strong yen in itself will likely lead to a substantial decline in the yen, as it is crippling Japan’s export-driven economy.
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