From the Desk of David Gratke

Interesting market observations in today’s marketplace.

March 8 (Bloomberg) — Equity mutual funds are burning through cash at the fastest rate in 18 years, leaving them with the smallest reserves since 2007 in a sign that gains for the Standard & Poor’s 500 Index may slow.

Cash dropped to 3.6 percent of assets from 5.7 percent in January 2009, leaving managers with $172 billion in the quickest decrease since 1991, Investment Company Institute data show. The last time stock managers held such a small proportion was September 2007, a month before the S&P 500 began a 57 percent drop, according to data compiled by Bloomberg.

Click link for full article:
http://www.bloomberg.com/apps/news?pid=20603037&sid=aPidmY6Nga30

And…….

The Rubber Hits the Road

John P. Hussman, Ph.D.

“Despite the high level of bullishness here, the market has gained only a few percent beyond its September highs. Most of what we are seeing now is a tendency to make marginal new highs, back off slightly, and then recover that ground enough to register another marginal new high. As I’ve noted frequently, when market conditions are characterized by unfavorable valuations, overbought conditions, overbullish sentiment, and upward yield pressures, the market’s tendency is exactly that – to make continued marginal new highs for some period of time, followed by abrupt and often steep losses virtually out of nowhere. Being defensive in that situation can make each slight new high feel excruciating, even if the market is not making much net progress. I remember that my own patience with this process was tested in mid-2007, when I quoted Wallace Stevens – “Does ripe fruit never fall? Or do the boughs hang always heavy in that perfect sky?”

What then?

The simple answer is that we will respond in line with historical precedent. A deleveraging cycle is much like a secular bear market in that the market experiences a great deal of volatility, but tends to establish a sequence of troughs, each at lower levels of valuation (even if not at lower absolute prices). In that environment, there is significant risk of abrupt spikes in risk aversion (which implies abrupt price spikes to the downside), so you can’t trade with “hot” valuation or market action criteria. It should be no surprise that Graham and Dodd wrote Security Analysis following the post-credit crisis period of the 1920’s and 1930’s. If there’s one lesson from those environments, it is that valuations and the idea of a “margin of safety” takes precedence over all other considerations.

It’s unlikely, given the seriousness I place in being a fiduciary to shareholders (in some cases to their life savings), that I’ll ever completely submit to the idea of relying on the speculative impulses of investors, but I do recognize that we can probably accept a greater level of speculative risk going forward than we were willing to adopt coming off of a valuation bubble and a credit crisis with a latent second-leg still looming. I expect that clarity about the underlying economic conditions here will be helpful in striking that balance.

Click link for full article:
http://www.hussmanfunds.com/wmc/wmc100308.htm

The title is from my second most favorite New Yorker magazine cartoon. The cartoon was first published in August 1983 and created by Lee Lorenz.

Ok, so we all know debt levels around the world are becoming increasingly problematic. The purpose of this posting is to bring together a few key elements and comments regarding the growing worldwide debt and to monitor this trend.

Liz Ann Sonders, CIO of Charles Schwab and Co, Inc puts it succulently in her posting of February 1, 2010, titled, Debt: What Is and What Should Never Be

• Strong economy and stock market, but debt remains the No. 1 concern.
• Rising public-sector debt is threatening to long-term economic stability.
• Investors have grave concerns about inflation; but deflation may be the bigger threat.

and allow me to quote her further:

“Throughout the past year, although I’ve been very optimistic about both the economy and the stock market, when asked what concerns me most, my answer has been consistent: debt.

As you can see in the table below, which is broken out by decade, it took $1.36 of debt to create $1 of economic growth during the 1950s. The acceleration began in the 1960s and 1970s with the Vietnam War and the “Space Race,” and continued in the 1980s and 1990s with the leveraged buyout boom and the Internet bubble.

Fast-forward to the most recent decade (through September of last year) and it’s taken nearly $6 of debt to create $1 of economic growth. This is clearly not sustainable, and is a threat to the long-term stability of the US economy.”

I find her last statement chilling at best..

Sonders again,

“I’m a big fan of the work of economists Carmen M. Reinhart, of the University of Maryland, and Kenneth S. Rogoff, of Harvard University. They’re the authors of a new book, “This Time Is Different: Eight Centuries of Financial Folly” (Princeton, 2009), which I’ve just begun to read.

It highlights what happened in more than 250 historical crises in 66 countries, and it’s a fascinating read. They also recently published a paper titled, “Growth in a Time of Debt,” which looks at the relationship between debt and growth/inflation among 44 countries during the past 200 years.

90% … the tipping point “Growth in a Time of Debt” main findings:

• The relationship between government debt and real gross domestic product (GDP) growth has been weak for debt/GDP ratios below a threshold of 90% of GDP. Above 90%, median growth rates fell by one percentage point and average growth fell considerably more. The threshold for public debt was similar in advanced and emerging economies.

As you can see, there is plenty of work available to us in the field of how much debt governments can successfully take on before the weight of the debt causes unintended consequences.

Well how much debt is out there?

Again, Sonders on the matter,

“Public debt high … total debt stratospheric

The United States’ public debt-to-GDP number is high (84%) and rising (set to jump to more than 90% this year). We’re not the worst though; there are a couple of countries with even higher figures: Japan (182%) and Greece (119%). If you look at total credit-market debt (not just government), the numbers are really glaring.

According to a recent McKinsey Global Institute report, US total debt doubled from 2000 to 2008, from $26 trillion to $53 trillion, and rose again in 2009. This represents more than 370% of US GDP—the highest since the Great Depression, when it reached 260%.”

“But on this metric, we’re in “good” company: The United Kingdom’s total debt-to-GDP is a whopping 470%, Japan’s is 460%, Spain’s and South Korea’s are 340%, Switzerland’s is 315%, France’s and Italy’s are about 300%, Germany’s is 275% and Canada’s is 245%. These are all records.

The “BRIC” countries (Brazil, Russia, India and China) all have total debt-to-GDP under 160%. However, since this study ended in 2008, we have to add in China’s stimulus package, which was three times the size of the US package, not to mention China’s banks lending out $1.3 trillion during 2009. Some believe China could now be more leveraged than the United States.”

The Ring of Fire

Bill Gross of PIMCO wrote his February 2010 newsletter, titled The Ring of Fire..

Gross, too, quotes the authors Carmen Reinhart and Kenneth Rogoff of the book, This Time is Different.

“The Reinhart/Rogoff book speaks primarily to public debt that balloons in response to financial crises. It is a voluminous, somewhat academic production but it has numerous critical conclusions gleaned from an analysis of centuries of creditor/sovereign debt cycles. It states:

1. The true legacy of banking crises is greater public indebtedness, far beyond the direct headline costs of bailout packages. On average a country’s outstanding debt nearly doubles within three years following the crisis.
2. The aftermath of banking crises is associated with an average increase of seven percentage points in the unemployment rate, which remains elevated for five years.
3. Once a country’s public debt exceeds 90% of GDP, its economic growth rate slows by 1%.

Their conclusions are eerily parallel to events of the past 12 months and suggest that PIMCO’s New Normal may as well be described as the “time-tested historical reliable.” These examples tend to confirm that banking crises are followed by a deleveraging of the private sector accompanied by a substitution and escalation of government debt, which in turn slows economic growth and (PIMCO’s thesis) lowers returns on investment and financial assets. The most vulnerable countries in 2010 are shown in PIMCO’s chart “The Ring of Fire.” These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth.”

Conclusion

One
Wage earners will continue to be challenged for some time as discussed in my blog posting: Nearly one in five Americans is either unemployed or underemployed

Two
Deleveraging will continue for some time

Three
What will be GDP growth rates of major economies going forward? Do Wall Street forecasters have this in their sights,  and ‘dialed in’?

Four
Have world financial markets ‘priced in’ the plausible decline in economic and corporate growth as a result of high debt levels?

I say no to the above questions. I believe market participates have yet to re-price the finanical markets for these above concerns.  What do you think?

Contact me and let me know what you think.

Thanks for reading.

The links below reflect a handful of blogs that do an excellent job of aggregating data for a quick read on a particular subject.

Business/Economy/Finance

The Big Picture: http://www.ritholtz.com/blog/
A daily read for me.

Real Clear Markets: http://www.realclearmarkets.com/
Time compressed, want to scan dozens of news articles at once? here you go..

Political

Real Clear Politics: http://www.realclearpolitics.com/
This aggregator does a good job of roaming both sides of the aisle for content.

Global Views

Real Clear World: http://www.realclearworld.com/
The world outside of our US borders.

The commonality of these blogs is that they aggregate scores of articles from around the world within their area of focus. These blogs can provide you,  the reader, a quick snapshot of news in our fast paced world.

Enjoy the reading.

Dave Gratke