Well Happy Thanksgiving - now that the holiday in the US is over and we're getting back to realities it's time to consider what little surprises were brought to us. One of course is the downward revision of US GDP numbers from 3.5% to 2.8% a whopper of a surprise though in our preferred YoY approach it was a drop from -2.3% to -2.5% "growth". Among other real surprises was the announcement from Dubai that the government was going to seek to re-structure the debt on some very grandiose real estate projects. There's a great deal of confusion and x-connections making things harder to de-cipher not least of which is because Dubai is one of the UAE members and not the major one. So what debt gets supported or not by which government is up in the air. Nonetheless the threat of sovereign defaults shook up markets around the world.

We think people should be paying careful attention to Dubai and related tremors but not for the reasons you think or are being commonly discussed. It being the tailend of the holiday we're going to throw out one chart on the Markets that we've looked at over the last couple of weeks in some form but not all the others we typically wrap around it to cover more ground.

Part of the reason is that the fundamental finding remains exactly the sames as it has (we almost ought to let the readers draw it out) but a) we're still in the downtrend b) the bear rally hasn't touched the upper bounds and in fact keeps failing there and c) we're right at the 50% resistance line on the Fib limits.

What we think is really important is the re-iteration and re-confirmation of the logic chain from the last posting the notion of fragile markets exposed to surprises and a policy-driven recovery. It's also critically important that you take all those points together as a set - as most investors haven't been. What Dubai was was a wake-up call about the fragile underpinnings that they were getting over-complacent about and the major risks and flaws that still have to be carefully worked thru to keep the wheels on the wagon and keep them turning. Back in Mar07 when the Shanghai Exchange dropped 8% with no warning we talked about the Shanghai Surprise in this post -Tender is the Market. And tried to argue that based on economic fundamentals the market was tender i.e. fragile and tipsy and therefore prone to surprises and upsets. Now the next show to really drop was Bear-Stearns almost a year later but... surely you take the point? :)!

Speaking of which what 'bout those GDP numbers eh? The top part of this chart is the YoY changes in GDP and Consumption running back to 1950. We won't go back into our previous discussions where we took it apart in some detail. We will stand by our argument that we won Stalingrad but are now facing the bigger battle for Kursk i.e. we arrested the downturn but have yet to start creating jobs. And have a lot of downside risks.

Which leads us to the second chart - call it the before and after picture comparing the Initial and Revised Q309 GDP estimates. Judging from the bar chart it'd be hard to see what the big differences had been but the red line highlights the differences by major element. The only two areas where the revised estimates are higher than the initial is in Gov't spending for both Federal and State & Local. Other than that there was a pretty across the board revision across Consumption Capex and Housing. The relatively nasty surprise was in Net Exports - we didn't sell as much as we thought we would and we bought more than anticipated. Oops.

Perhaps the two biggest dangers floating around which we see on a very widespread basis in the news and among the talking heads as well as in our network is complacency about the strength and reliability of the recovery. That combines with a perverse lack of awareness of how fragile and policy-dependent the so-called recovery is. But the real myths that need to be debunked are with regard to debt and deficits. Please don't get us wrong - excess and unfunded spending is in the long run a poor ideas. In the short-run in our circumstances is a vital and critically important lifesaver.

Yet for partisan political reasons and/or ideological ones everybody from the politicians in Washington to the CNBC guest opinonators is wringing their hands. It might help you to remember that we were pulling out of the Great Depression until similar handwringing pulled the plug on government spending and sent us back into Depression.

It may also help to take a careful look at this composite chart drawn from several NYT pieces and re-combined into a new set. Despite all the hand-wringing what we're really talking about is returning to the debt levels of the '80 and '90s and the interest services charges and rates of the same period. In fact it's fair to say after the worst economic crisis in living memory how scary to find we're returning to the destructiveness of Bush I deficit and payment rates! The bottom chart highlights another key aspect of this - which is all the borrowers who drove up total US debt during the last three decades have all been driven from the credit markets. Put that another way - we have a major demand shortfall in which business and consumer's are unable to pick up  the slack and will be hurting for some time. What's picking up the spending slack is the government and what's replacing private debt or some of it is government borrowing.

BUT the most important two pieces for you to put together is nobody's acknowledging these circumstances and the economic weakness. In fact just the opposite. Which means a fragile market and recovery is very exposed to mythology and delusions. But then what else is new.

A rally that needs more “E” Though conventional wisdom assumes that P/E ratios continue to grow throughout a bull market that’s not always the case. In fact it’s rarely the case. On average the market’s P/E tends to peak a little more than a year into a bull market according to analysis by Ned Davis Research an investment consulting firm in Venice Fla. “And the lion’s share of that P/E expansion takes place in the first six months” said Ed Clissold senior global analyst at Ned Davis.  Indeed Ned Davis researchers found that price-to-earnings ratios shot up 28 percent on average in the first 15 months of bull markets since 1929. But four-fifths of that expansion took place within the first six months. Sam Stovall chief investment strategist at S.& P. analyzed bull markets back to 1942 and found that in 9 of the last 11 the S.& P. 500’s P/E ratio grew within the first year by an average of 29 percent. In the second year of those run-ups though the market’s P/E ratio actually fell — by 6 percent on average. What’s more in bull markets that survived into a third year the P/E continued to slip. In many cases that’s because corporate profits expand so fast that their growth outpaces rising share prices. In other words as the “E” in the P/E ratio grows faster than the “P” the multiple contracts even as stocks gain ground. As for the current decline in corporate profits the best that can be said is that the rate of contraction has slowed. At the start of October Wall Street analysts were bracing for a 24.8 percent decline in S.& P. 500 profits in the third quarter versus the same period a year ago. Today the consensus estimate is for a much more modest fall of 13.7 percent. WHEN will the earnings outlook turn around? For a while now analysts have been predicting that corporate profits will start growing in 2010.

The next bubble? Here’s a logical and surprising place to look Everyone is warning about bubbles. These warnings have all been unconvincing to me because they imagine that the next bubble will look like the last one. Until today. Gillian Tett in the November 23 Financial Times has come up with the first description of a bubble that I’ve seen that is both convincing to me in its mechanism and in its unexpectedness. The bubble she describes is still inflating and isn’t about to break tomorrow but it is worth taking very seriously if you’re building a portfolio with a time frame of five years or longer. Warnings are a dime a dozen these days. The weakness in all these warnings about a new bubble is that when they get around to describing the next bubble it sounds an awful lot like the last bubble. We’ll see an unsustainable increase in real estate prices for instance or commodity stocks will rocket and then burn or banks will use cheap money to rebuild risky derivative portfolios. But if past bubbles should have taught investors anything it is that the next disaster never duplicates the last disaster. That’s because we put rules—official and ad hoc—in place after each disaster to prevent a replay. This is where Tett’s piece comes in. First she posits a completely unanticipated location for the bubble: In the markets for what’s called sovereign debt. Sovereign debt is made up of the bonds and such that countries sell to finance their budget deficits. And second Tett posits a mechanism for the bubble to keep inflating and then bursting. No one wants to say Hey these sovereign bonds really aren’t risk free. The banks certainly don’t want to say it because recognition of the risk in these bonds would drive down their prices.

The Dubai Collection

Everyone agrees that the dollar will keep falling; the dispute is over how long Unemployment. Consumer spending. New home sales. End of the year profit-taking. End of the year portfolio window dressing. All those drive the stock market day to day. But none pack the wallop that the rising and falling (mostly falling recently) price of the U.S. dollar does. When the dollar falls these days usually stocks rise. When the dollar climbs usually stocks fall. Until we can see clear evidence that the U.S. economy is in a sustained economic recovery—or not—I don’t see anything as important to investors as the direction of the dollar. So what’s the most likely trend on the dollar? Down say most of the dollar forecasters recently surveyed by Bloomberg. Although they disagree on how far into 2010 that downward trend will stretch. By the end of 2010 the Bloomberg survey projects the European Central Bank will have increased its benchmark overnight lending rate to 1.5% while the Federal Reserve will be at 1%. If that’s correct the dollar will stay weak against the euro into 2011 if I follow Henderson’s logic correctly.

Our steroidally challenged economy The global economy reminds me of a marathon runner who runs too hard and hurts himself. But now he has another race to run.  So he’s injected with some serious industrial-quality 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 ok; 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.  Our economy suffered severe injuries last year and to keep it going massive amounts of steroids were and are being injected – they’re what economists call stimulus (or government intervention). Let me demonstrate what is priced into cyclical stocks by looking at Caterpillar (CAT) – your typical American blue chip industrial cyclical stock – one that in theory should prosper during global economic recovery.   Third-quarter sales were down 44% from last year. China was its brightest spot as sales there dropped (only) 26%.  The stock is around $60 more than double its low in March and not far from $85 its all-time high reached in 2008 when global growth was its oyster.  The company expects to earn around $2 this year (excluding recurring nonrecurring charges) and expects sales to grow in teens next year from this year’s base.  But even if CAT were to earn $3 next year investors are not paying for next year’s earnings as they’d paying 20 times next year’s earnings. This cyclical stock is not worth that; investors are paying for what happens beyond 2010.  If I owned CAT the question I’d want to know the answer to is what’s next after 2010?  Stimulus creates an appearance of stability and growth but a lot of it is teetering on a very weak foundation of government intervention.  Investors must distinguish between what is real and what is not; in this environment investment success will not only depend on what stocks you own but also on the ones you don’t – stock selection is important.

Investors are finally seeing the nonsense in the efficient market theory inancial Analyst Institute which has been teaching efficient markets theory for decades has admitted that most of its members have lost the faith. Two thirds say they no longer believe market prices reflect all available information and three quarters disagree that investors as a whole behave "rationally". What's amazing is that it has taken so long for the penny to drop. It has seemingly required investors to lose their collective senses twice in a decade (dotcom bubble housing boom) for people to realise that the crowd is mad as often as it is wise. Markets have always been prone to bouts of "irrational exuberance". The price of tulips in 17th century Amsterdam that of South Sea Company stock in 18th century London and of Florida real estate in the 1920s are just highlights of the procession of booms and busts down the ages that has taught every subsequent generation that markets often get it wrong. They do so for two reasons. They get it wrong because they reflect human behaviour in all its fearful greedy irrationality. And they get it wrong because they reflect a world that is inherently unpredictable. So increasingly few people still believe that markets are wholly efficient and that is a good thing. It means fewer people will believe as governments and regulators did that the prices of loss-making internet stocks in 1999 and Miami condominiums in 2006 were in any way not a disaster waiting to happen. It might mean that fewer people are tempted by passive investments which promise an answer to the awkward fact that most active fund managers do not beat the market but can only do so by guaranteeing that you will hold all the market's very worst stocks as well as its good ones. However there is one problem with dismissing out of hand the efficient markets theory. It is that markets are not so inefficient that anyone can safely bet against them. Assuming that you know more than the market is a dangerous game to play when most of the time most of the information is accurately factored in. The answer is not to give up trying to beat the market but it argues for finding someone who because of their skill knowledge or intuition is good at spotting the £20 notes on the pavement – and sticking with them. 

How to escape the next lost decade A lost decade. 1999 to 2009 sure qualifies for many investors in stocks. A lost decade to come? I can’t tell you what stocks or stock markets will perform best over the next ten years. But I can tell you that many U.S. investors are still sitting in portfolios that increase the odds that the next ten years will be as unrewarding as the last ten. The last ten years have been really really painful for investors in U.S. stocks. It you had invested in the U.S. Standard & Poor’s 500 stock index in October 1999 by October 31 2009 you would be looking at an average annual compounded return of a negative 0.95%. Lock your money up in stocks for 10 years and lose 1% a year. It’s not supposed to work that way. And of course it didn’t have to. Investors can’t go back in time and re-do the their under-exposure to overseas stocks in general and emerging markets stocks in particular but sure can try not to make the same mistake in the next ten years that they made in the last ten. All the evidence though is that U.S. investors are about to do it to themselves again. The U.S. share of the global stock market is falling as other countries built larger economies and deeper capital markets. In 2004 U.S. capital markets accounted for 53% of the value of all shares in the world that were free to trade according to Standard & Poor’s. (Many shares in markets such as China and India are locked up under government control and aren’t free to trade.) By 2007 that percentage was down to 44% and by 2008 it had fallen to 41%. Asset allocation by U.S. investors hasn’t kept pace with that change. Depending on what group of investors you measure U.S. investors have somewhere between 2% and 20% of their equity portfolios in overseas stocks. Among 401(K) investors about 12% of their stock portfolios are in foreign stocks. If you simply look at the makeup of world equity markets U.S. investors are massively over-weighted U.S. stocks and massively underweighted foreign stocks. That might not be so devastating to the portfolios of U.S. investors if the U.S. economy was projected to outperform the economies of the rest of the world. But it’s not. The Organization for Economic Cooperation and Development (OECD) projects that the U.S. economy will grow by 2.5% in 2010 and 2.8% in 2011. China in comparison will grow by a projected 10.2% in 2010 and 9.3% in 2011. For India forecasts read 7.3% growth in 2010 and 7.6% growth in 2011. Brazil 4.8% growth in 2010 and 4.5% growth in 2011.

The world still can learn from Keynesian economics Great crises have a way of reminding us that acting as though we know perfectly well what the future holds almost always leads to disaster. That's especially true in economics which tends to underscore the murkiness of the real world by dealing out surprises one after another -- booms crashes bubbles you name it. It's fitting therefore that the recent economic meltdown has begun to restore that great apostle of uncertainty John Maynard Keynes to his rightful position of influence in economic thought. "Keynes asked why financial markets are inherently unstable" Robert Skidelsky told me the other day. "His answer was that we don't know what the future will bring. He talked about the inherent precariousness of knowledge that when we estimate the future we're only disguising our ignorance." If that sounds obvious keep in mind that the financial disaster of recent times was born in the hubris that the financial markets are nearly flawless machines for assessing risk and that government regulation would make them inefficient. The hallmark of Keynes' thought was the recognition that the efficient-market theory -- the notion that the market synthesizes all that is known and that needs to be known about current conditions and that it therefore can be left to regulate itself -- is flawed. "If you have a self-regulating market" Skidelsky explains "you don't have crashes like this. You don't have great contractions."
Keynesian economics and its implicit warning that the free market has inherent limitations and therefore demands regulation remained in vogue from World War II until the mid-1970s followed by its nearly complete abandonment by British Prime Minister Margaret Thatcher and President Ronald Reagan in the 1980s. Many of the problems that developed since then derived from the assumption that risk can be predicted measured and accurately priced.

Seeing the Glass as Mostly Empty THE American economy is in its worst shape in a quarter-century. At least that appears to be the belief of the consumers questioned by the Conference Board for its consumer confidence survey for which preliminary November results were announced this week. Over all the index shows that confidence is significantly better than it was early this year when stock markets had crumbled and the credit crisis was at its worst. That increase comes from a rise in consumer expectations. But as can be seen in the accompanying charts the present-conditions index fell in November to 20 the lowest level for that index since early 1983. The index is based on a scale in which the average opinions of 1985 are equal to 100. Why the glum opinion at a time when many economists say they think the recession that began in December 2007 ended sometime last summer or fall? The primary reason is unemployment. The index of present conditions is based on answers to two questions one on jobs and one on business conditions. Business conditions are considered poor; only 8.1 percent of respondents deemed them good and 45.7 percent said they were bad. The rest said business conditions were normal. But those figures are not quite as bad as they were last winter. On jobs however the relentless rise in the unemployment rate to 10.2 percent in October has left nearly half the population 49.8 percent saying jobs are hard to get while only 3.2 percent say they think jobs are plentiful. Not since late 1982 have people been that negative on jobs. Consumer Confidence Graphic

The illusion of improving global imbalances They are blamed for the global crisis directly (Paulson 2008) or indirectly (Calvo 2009) G20 leaders are committed to ending them and commentators have generated an ocean of html painting them as one of the world’s greatest banes. “They” are global imbalances – large trade surpluses and large trade deficits. Good news then – global imbalances have been shrinking at a fabulous rate (Figure 1). The figure – which includes China Germany the US and all the other usual suspects in the global-imbalances saga – shows that trade gaps have closed remarkably quickly since late 2008. The IMF and World Bank both forecast substantial improvements for 2009 and into 2010 (IMF 2009 and World Bank 2009a). The World Bank for instance predicts that China’s surplus in 2010 will be half its 2008 value. This rapid improvement seems odd given how little reform has occurred. The renminbi has not appreciated against the dollar and Chinese consumption has not boomed; the dollar has depreciated modestly against European currencies and the US savings rate has risen gently but neither seems large enough to account for the massive shifts already observed to say nothing of the World Bank predictions for future improvements. We argue here that these global imbalance improvements are mostly illusory – the transitory side effect of the greatest trade collapse the world has ever seen. Before making the argument we lay out the basic facts.

The Dogbert theory of the debt When I was on This Week yesterday George Will tried his hand at the debt scare thing saying that we’re in terrible shape because by 2019 the interest on the debt will be SEVEN HUNDRED BILLION DOLLARS. (That should be read in the voice of Dr. Evil). I get that a lot — people who talk about the big numbers which are supposed to imply that things are terrible impossible we’re doomed etc. The point of course is that everything about the United States is big. So you have to interpret numbers accordingly. As the graphic above shows — it’s taken from an article that managed to maintain a grim tone while reporting numbers that actually weren’t all that grim — what we’re talking about is a debt-service burden roughly comparable to that under the first President Bush. How many of the people now warning about the impossible burden of currently projected debt were issuing similar warnings back in 1992? Not many I’d guess. And bear in mind my point about causes of deficits: the deficits of the Reagan-Bush years were essentially gratuitous the result of a desire to cut taxes while increasing military spending rather than a response to a temporary emergency. So that debt burden should have been more worrying than what we’re facing now. But people still seem to think that repeating those big numbers is enough to make their point.

Fed Officials Watch Asset Prices for Signs of ‘Excessive Risk’  Federal Reserve policy makers said for the first time that their decision to cut interest rates to zero may be fueling undue financial-market speculation even as they called the dollar’s decline “orderly.”  The Federal Open Market Committee said its policy of keeping rates low might cause “excessive risk-taking” or an “unanchoring of inflation expectations” according to minutes of its Nov. 3-4 meeting released yesterday. Central bankers also said further dollar depreciation that might “put significant upward pressure on inflation would bear close watching.” The dollar weakened as investors wagered the central bank will tolerate further declines in a currency that has slid more than 6 percent against the yen in three months. Policy makers are wary of fueling a third asset-price bubble in about a decade as they hold the benchmark interest rate near a record low to revive growth economists said. “Financial markets have been doing much better than people might have expected” said Marvin Goodfriend a former policy adviser at the Richmond Fed who is now a professor at Carnegie Mellon University in Pittsburgh. “The Fed is saying to markets ‘Don’t overdo it.’”

Repairing China’s financial system The stock market had a bad day today with the SSE Composite down 3.62% mainly on rumors that banks will be seeking to raise equity capital next year in response to their loan surge this year.  On Tuesday Bloomberg reported that the five largest banks were supposed to have submitted plans to regulators for raising money after unprecedented lending eroded their capital. I would argue that a more compelling reason to raise capital is the almost-certain surge in NPLs over the next three or four years.  In fact I am pretty surprised that these rumors caught the market by surprise.  Every time that banks have engineered a policy-induced surge in lending they have followed up with a surge in NPLs and it would be pretty extraordinary if this time were any different.  A refusal to raise capital levels would have been very imprudent and it is pretty clear that the PBoC and the CBRC are already worried about the impacts of the credit expansion on the banking system.

Wall Street’s Spin Game A few years ago Wall Street would have cared less for such artifice — it was enough that the Masters of the Universe were wildly successful; their success spoke for itself. But politics and the bottom line have energized the relationship between these New York institutions of money and spin as banks see the need to calm the rage directed toward them and confront a public relations problem that has seemed in recent weeks to be spiraling out of control. Just last week Goldman announced that it would spend $500 million to help thousands of small businesses recover from the recession. At the same time Mr. Blankfein acknowledged that Goldman had made mistakes. “We participated in things that were clearly wrong and we have reasons to regret and apologize for” he said. But is that enough? And if it isn’t what will be? Examples of the public’s anger at Wall Street are legion. Last month a couple of thousand protesters marched on the American Bankers Association’s annual conference in Chicago brandishing cut-outs of bank C.E.O.s. As the Chicago demonstration made clear the image problems aren’t confined to Goldman and could have a cost. Wall Street banks are under regulatory pressure and come election time if unemployment is still above 10 percent and Wall Street is still paying itself big bonuses lawmakers’ wrath might force broader pay curbs tougher restrictions on what banks can do or even a break up of the biggest banks. They are already losing business because of their toxic reputations. One recent Goldman deal for instance to buy cheap assets from Fannie Mae the hobbled mortgage lender was blocked by the Treasury because it couldn’t be seen to be helping Wall Street benefit once again from the crisis. Critics say the negative media chatter is dragging on their share price.

`Screaming Hot' TVs $5 Toys Abound as Walmart Kohl's Push for ShoppersWal-Mart Stores Inc. Kohl’s Corp. and Toys ‘R’ Us Inc. are competing for customers with discounts and extended Black Friday hours as cost-conscious shoppers say they plan to spend less on gifts than they did last year. Kohl’s the fourth-largest U.S. department-store chain will open at 4 a.m. on Nov. 27 and offer more than 300 early- bird specials including $34.99 cashmere sweaters. Toys ‘R’ Us is offering almost 50 percent more of such deals than last year. Walmart is staying open all of tonight so shoppers can grab $3 pajamas and $15 Miley Cyrus jeans when they go on sale at 5 a.m. Chains are also contending for home-electronics shoppers. Walmart’s Web site is offering home delivery of flat-panel televisions and other electronics for 97 cents. Best Buy Co. the world’s largest electronics chain is discounting flat-panel TVs cameras and laptops. “We have been more aggressive than ever before in our marketing and in our pricing” Toys ‘R’ Us Inc. Chairman and Chief Executive Officer Jerry Storch said in a telephone interview yesterday. The Wayne New Jersey-based chain is opening at midnight tonight five hours earlier than last year offering 220 doorbusters compared with 150 in 2008 and has distributed a 28- page national Black Friday circular. It promised to have thousands of the Zhu Zhu Pets robot hamsters that sold out in recent months and will be handing out 64-crayon Crayola boxes as gifts with purchases.