Sunday, October 25, 2009

9 years and counting

I’ve been saying for many years now that we have been and still are stuck in a secular bear market since March of 2000. I know there are quite a few people who consider that the new highs made by the Dow, and nominal new highs in the S&P, constitute a continuation of the secular bull market that began in 1974 (some would argue `82).

However if you price stocks in a stable currency or inflation adjusted it’s readily apparent that the secular bull topped in 2000.

We saw a similar occurrence during the `66-`82 bear when the Dow made a nominal new high in `73. That still didn’t change the fact that the bear started in `66 in inflation adjusted terms.

This bear is now 9 years old. History has shown that a secular bear market tends to last about 1/3 the duration of the preceding bull market. Using that criteria and the valuations at the March `09 bottom we should see at least one more leg down before this secular bear expires, possibly as the market drops into the 2012 four year cycle low. Actually if the market runs the full four year duration we should bottom in 2013. However since the last cycle ran very long it wouldn’t be unusual to see the next cycle contract a bit. However this bear may be an exception as the powers that be are doing everything in their power to prolong this, similar to how Japan prolonged their secular bear, which is now in its 19th year.

Usually secular bear markets tend to unfold in three phases. Now whether this bear is going to bottom with the third phase down or not is again going to be determined by whether or not our elected officials come to their senses and put an end to the destructive policies we’ve been following for the last 9 years.

If not then we may very well follow the Japanese model of multiple bear legs drawn out over a couple of decades.

Either way at a true secular bear market bottom we should see the P/E and dividend yield at roughly the same level and P/E’s will be in the single digits. So far neither the low in Oct. `02 or March `09 have approached anything even remotely resembling a true secular bear market bottom.

The catalyst for the first phase of the secular bear was the implosion of the tech bubble. That collapse set the stage for the Fed to take over and lay the groundwork for the next phase of the bear. Their response to the bursting of tech was to slash interest rates to multidecade lows and flood the world with paper money. Truly we bought one hell of a party with all that liquidity but I’m sure we all know that the harder you party the bigger the hangover.

The catalyst for the second phase of the bear originated in the credit markets with the collapse of the housing and credit bubbles the Fed had created. The hangover began in `07 with the implosion of subprime which we now know only started the snowball rolling down the hill. This hangover was destined to be infinitely worse than the hangover from the tech bubble bursting.

The herculean efforts by the Fed to halt the secular bear market not only didn’t halt the bear, they angered him. The bear retaliated with the worst recession since the Great Depression.

I suspect the catalyst for the third phase of the bear is going to originate in the currency markets. Every central bank in the world is now swept up in the fantasy that they can get something for nothing by simply running the printing presses. By creating trillions and trillions of bank notes and forcing this liquidity into asset markets central banks have created the illusion that all is well again. However all is not well. Conditions in the real economy are not improving. On the contrary they are getting worse. All the liquidity the Fed has been creating is causing inflation to heat up in the commodity markets and most specifically in the energy markets again. The one thing we don’t need in a high unemployment/depressed economic environment is spiking energy costs. But that is exactly what the Fed is doing.

This liquidity the Fed is forcing into the banking system has two potential outlets. First, banks could take the liquidity and make loans. However, as we are in a global recession, one has to wonder how many people actually want to borrow in this environment? How many borrowers are even credit worthy? How many businesses need to expand? The answer to all of those questions is… not many. So I think it’s safe to say most banks are a bit nervous when it comes to expanding credit. It's probably a safe bet that credit will continue to contract.

But the banks still need to earn something from all this free money so what’s the next logical thing to do? Why pump that money into asset markets of course. Obviously that’s exactly what they’ve been doing as evidenced by the explosive rally in the stock and commodity markets.

There seems to be quite the contingent of voices out there that believe there is no way to achieve inflation during a deflationary credit contraction. I would argue quite the opposite. In an environment where all currencies are fiat and not backed by gold, any determined government can create asset inflation. Well any government can create inflation as long as they don't care about future consequences and lack even a modicum of common sense. Of course when have politicians ever had any common sense. In general politicians have a keen understanding of how to push the problem down the road just long enough to get re-elected. Genenerally speaking that's usually not good for the long term health of the country though.

We don’t need borrowing or credit expansion for inflation to heat up. Taken to extreme, governments could simply drop money from helicopters as the saying goes. I would point out that’s exactly what the US did last year with the tax rebates. This money had nothing to do with credit expansion and it certainly did spike the price of gasoline. In my book that was a clear example of government creating inflation without having to expand credit.

Despite the severe deflationary environment of the post bubble collapse, Japan was able to create asset inflation in certain markets. Specifically they managed to create multiple explosive rallies in the Nikkei. Each one ultimately failed because they weren’t driven by true economic expansion. They were driven by liquidity. We are now embarking on the same path. The Fed is trying to create the illusion of prosperity through nothing more than liquidity driven asset inflation. It’s going to look impressive in the short term but it’s destined to failure. As a matter of fact, if the Fed doesn’t come to its senses soon we are likely to open Pandora’s box and unleash a currency crisis on the world. I don’t think I have to tell you that would be much much worse than the credit market implosion we just went through. A credit market collapse could be temporarily halted with liquidity. You can’t stop a currency collapse by printing more dollars. There simply is no way out of a currency crisis that doesn’t involve tremendous pain. Unfortunately the Fed’s attempt to “fix” the credit markets is forcing us down the path that leads to currency problems.