27 May 2010

Try and try again until Lions become lambs

In the best Hallmark traditions, today’s DU is part one of a gripping mini series:-

Economic historians know all about the tragic year. Back in 1932 everyone believed that the measures taken by Hoover’s administration had beaten the recession. Stock markets and optimism soared. Jeremy Grantham describes a similar situation in his latest newsletter;

 “The market has had a near record rally, sprinting far past our estimated fair value of 875 for the S&P 500. Bernanke is, in fact, begging us to speculate, and is being mean only to conservative investors like pensioners who cannot make a penny on their cash.”

Just like in the early days after the Wall St Crash of 1929 the masters of the universe have taken change as the massive bailout program prevented the meltdown of the financial system and engineered at least a temporary economic recovery. The obvious cost of this bailout has been the unprecedented deterioration of the Federal balance sheet. Grantham recently focused on the less obvious costs incurred by taking away the rewards of caution by saving the reckless and incompetent:

“Weak enterprises, financial and other, were not gobbled up by the stronger, more prudent, and more competent natural survivors, and there is a long-term cost in that. So now, Bernanke begs us to speculate, and we are obedient. Despite being hammered down twice in 10 years and getting punished for speculating, we again pick ourselves up off of the canvas and get back into the good fight. Such persistence is unprecedented – 20 years for each really painful experience has been the normal recovery time – but Uncles Ben and Alan have treated us so well in these two disasters that, with hindsight, they don’t feel so bad after all. Yes, the market is still down a lot in over 10 years and on our data is likely to have a second consecutive very poor decade, but we have had two wonderful recoveries in which the more speculative you were, the more money you made. So why not break the historical rules and try a third time? Perhaps this time it will be lucky.”

He talks of the Fed helping us up and then leading us off the cliff again:

“To do it twice seems like sadism. And for us to play the game once more seems like lining up behind hot stoves and begging, “Please, can I burn my hand a third time?” Investors used to be more pain averse. It used to be “once bitten, twice shy.” This time, surely it should be “twice bitten, once bloody shy!” The key shift seems to be the confidence we now have in Bernanke’s soldiering on with low rates and moral hazard to the bitter end, if necessary, cliff or no cliff. The concept of moral hazard has changed. It used to be a vague expression of intent: ‘if anything goes wrong, I will help you if I can.’ It seems to have been transmuted into a cast-iron commitment. The Fed seems to be pledging that it will bail us out after every flood. All that is lacking is a rainbow…..This time, the recovery for the total market was 80% in one year, second only to 1932, and the really speculative stocks are almost double the market, as they also were in 1932.”
 
Grantham believes that conditions almost 80 years ago were more conducive to such a rally. It’s taken different conditions this time. “I’m convinced that this excessive market response has occurred because stocks are far more sensitive to both low rates and the Fed’s promises than is the economy. The economy is limping back into action, but faces some tough long-term headwinds that I collectively call “seven lean years.” Mortgage defaults in housing, steady repayments of consumer debt, and refinancings in commercial real estate and private equity, are all problems that linger, as do many others, on what is becoming a long, boring list. We may get very lucky and have a strong broad-based economic recovery. The economy’s durability and flexibility is usually undersold by the bears, and I have generally been leery of underestimating its potential. But we can probably agree that the economy is plagued by unusual problems this time. It is therefore perhaps more likely that the economy will recover in fits and starts, and that over several years it will underperform its historical record.”