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« Interpreting Government Data: Is a Conspiracy Afoot? | Main | JOLTS from the BLS »

April 08, 2009

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Mike C

“The wrong-headed public policy about distressed assets ***and the decision to allow Lehman to fail both helped to make these predictions come true.***

The key question is whether those who correctly predicted this are lucky or good.
Some of them are now contending that any opinion they ever had on any subject has been proved correct. Does this make any sense?

***Just wondering....***”

Since you are wondering... :)

Just an opinion, but I’m skeptical of the view/thesis that what we’ve seen unfold in both the global and U.S. economies and stock markets the last 12 months is *mostly* a result of wrong-headed public policy about distressed assets and the Lehman decision (although that may have exacerbated the situation). I think it was inevitable, although getting the timing right was tricky and many looked like stupid “permabears” for a long time (where is the line between being early and being wrong, I do not know).

http://oldprof.typepad.com/a_dash_of_insight/2007/10/results-matter-.html

“and the "very poor track record" of Jeremy Grantham.”

http://oldprof.typepad.com/a_dash_of_insight/2007/10/media-competiti.html

http://oldprof.typepad.com/a_dash_of_insight/2007/10/process-versus-.html

http://oldprof.typepad.com/a_dash_of_insight/2007/10/new-market-high.html

I think the Hyman Minsky view that “stability is unstable” captures the reality of what has happened more accurately. What did we have? Unsustainable debt levels across the board (consumer credit, mortgage credit). Too much leverage (IBs at 40:1 leverage). Corporate profits at an unsustainably high percentage of GDP (and some had repeatedly pointed out that profit margins are the most reliably mean reverting item in capitalist economies). Stagnant wage growth with consumers going into debt and relying on MEW to make up the difference in their living standards and consumption. Residential housing prices at bubble levels. Substantial imbalances in exports/imports.

I think it was just a matter of *when* not if the entire artifice came crumbling down, and if it wasn’t Lehman that set the ball in motion, it would have been something else on a slightly different timeline. The unsustainable cannot be sustained indefinitely.

In 1998-2000, we had a *stock valuation* bubble. With the S&P 500 at 25-35x earnings, anyone with a brain and a smidgen of knowledge of history recognized that. In my view 2005-2007 was *much trickier*. We had a *credit bubble” where the second derivative effects were a *global economic activity/corporate profits* bubble and thus gave the illusion of cheap stock valuations. Few recognized this and those that did generally were ridiculed and derided.

I think we are in transition mode now to something that hopefully is more sustainable in the long-term (the next decade+, lower debt levels, lower consumer spending, more saving, affordable housing relative to wages, etc.), and hopefully public policy decisions ease that transition so that we do not overshoot and have GD2. I don’t think anyone wants that except uber-bears who want to see the world implode and cash in, but I think there are very legitimate arguments/points that concern me that we are going in the wrong direction on public policy, and this is way too important to get wrong.
****************************************************
http://www.safehaven.com/article-13076.htm

“But I can live with $50 trough earnings, say many. And at historical multiple of 14-16 times trough earnings, the S&P should stop its downside in the 700-800 range. But the point is, they're not trough earnings, ****they are the "new normal." ***And in the current "slow" (zero or worse) growth environment, a trough P/E of 6-8 times earnings is more likely. Put another way, we are about to get the worst of all worlds; below trend earnings, below trend growth from a depressed base, and below trend P/E, after having gotten the best of all worlds, astronomical P/Es on above-trend and rapidly growing earnings, about a decade ago. Warren Buffett now agrees, saying that we will get "almost the worst of all possible worlds..."
The bears-turned-bulls have taken the latter stance because the market now reflects at least a severe recession. One such commentator likened the recent market to 1938-1939, and feels that the latter represents a bottom. But the 1930s bottom was 1932, not 1939, which is to say that the market probably has further to fall. Having correctly dodged the "overvaluation" bullet earlier, the new bulls pin their hopes on the prospect that the current market represents everything bad short of the 1930s Depression. Unlike us, they aren't willing to grasp the nettle that the current crisis will likely be as bad as anything including the Great Depression.”

******************************************************

To your other points, I absolutely agree that just because someone might have gotten certain aspects of what has unfolded correct, that certainly doesn’t mean they are omniscient on everything else. I think your “happy zone” idea is applicable.

As to the key question of lucky versus good, I don’t think one can generalize across everyone. No doubt, some were lucky. Others like Grantham clearly outlined well in advance in archived writings what the issues were (home prices, credit bubble) and how it all would end, although obviously they were early by a few years (lesson to self is NEVER underestimate how far an unsustainable trend can go before it finally ends). I’m not sure how any unbiased lookback could conclude anything but good/solid analysis that got it right but with poor timing.

At this point, all that is history, and my primary concern is forward analysis (although I think revisiting the past is useful just like sports teams watching game film to see where mistakes were made), and it seems to me the million dollar questions are “what is normal”, “what is sustainable”. What are sustainable debt levels? How much deleveraging must occur? What are sustainable corporate profits to get a handle on whether the market is actually CHEAP or just fairly valued?

FWIW, I want to close with reiterating that I find your commentary useful and valuable which is why I am a regular reader. One of the reasons I leave lengthy comments like this is that writing forces one to think about and sharpen one’s own views and it is the dialogue and pushback that creates further sharpening. An echo chamber where everyone agrees 100% is not useful at all, especially if “everyone” is holding on to the wrong view.

oldprof

Mike C -- I agree about the regulatory capital issue. Frankly, anything that allowed normal and sensible lending would be a big help, as I have often written.

As to the academic experts who have been so right -- Some of them advocated pumping money into banks or nationalizing instead of dealing with distressed assets. This was a stop-gap and a source of delay. The wrong-headed public policy about distressed assets and the decision to allow Lehman to fail both helped to make these predictions come true.

The key question is whether those who correctly predicted this are lucky or good.

Some of them are now contending that any opinion they ever had on any subject has been proved correct. Does this make any sense?

Just wondering....

Jeff

oldprof

You are correct in spotting the pattern. No attention to a potential problem, a crisis or big event, over-reaction. It is not just political. It is human nature.

Thanks for taking time to comment.

Jeff

Mike C

Excellent food for thought, and from a perspective I wouldn't have normally considered. That's why I read regularly, even though we often disagree.

Your point is well taken that those from different backgrounds all of whom are intelligent and knowledgeable can have different opinions and "solutions". Still, I would think there are "more right" and "more wrong" solutions that "are what they are" rather then the result of interplay of political negotiations.

A blogger you and I both read recently posted that accounting rules don't affect cash flows, and investors are not stupid. They will apply a substantial haircut to the book value of companies where the financial assets are being valued in a less then accurate and transparent manner.

I really don't have a strong opinion on this issue because it is definitely outside my "happy zone". However, there are a few "pundits" (some of who have strong academic credentials) who unlike most have generally been dead on accurate with respect to the economy and stock market the past 18-24 months who lay out specifics of what they think should and should not be done.

It would seem to me that from a broader economy/public policy perspective the regulatory capital issue could be addressed separately from the marking of the "toxic" assets. Still, a spade is a spade, and if institutions are essentially insolvent, then covering our eyes and pretending otherwise just probably delays and stretches out the inevitable.

Some would suggest we are just playing "hot potato" here, and that many of these issues are just playing games on the periphery, and that the real fundamental issue is that debt which is essentially not able to be repaid at current levels must be restructured in a way that allows realistic levels of cash flows (such as incomes for wage earners) to actually be able to service that debt on an ongoing basis. Everything else is just a bunch of heat not producing useful work.

Russ Wood

Prof wrote:
"The implementation of this rule led many accountants to take the most conservative view of assets held by financial institutions. While the rule provided some flexibility in implementation, most accounting firms in the post-Enron era chose a conservative course. Many had the government-dictated death of Arthur Andersen and the loss of accumulated partnership interests at the forefront of their thinking. Why take such a risk?"

I continue to believe that Sarbanes Oxley, which made over-optimistic estimates a criminal offense, regardless of intent, is the main reason for the overly conservative implementation of accounting rules. No amount of tweaking of FAS 157 can remove this risk to corporate executives.

However, the Prof is correct that it is in the public interest to improve the FASB rules. At a time of unprecedented intervention by Congress into the daily decision-making processes at public corportations, it seems silly for critics to say FASB bowed to pressure from Congress to relax rules on corporations. Congress is tightening their grip on corporations, not relaxing it.

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