Research & Insights

Posts published in June 2010

Midweek Market Comment: The Market's Exquisite Philosophical Dilemma

June 29, 2010

By Katrina Lamb, CFA

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For the last month or so the market has exhibited two qualities: volatility and aimlessness.  After another drop of more than 2.5% today the Dow and the S&P 500 were back to roughly their lows of May, when they first entered technical correction territory from the cyclical highs reached in April.  Based on the trading patterns we’ve seen during this period it is clear that anything could happen tomorrow - daily gains or losses of more than 2% seem to be a fixed piece of the firmament.  We always tell our clients to put little stock in the vagaries of the short-term and all the more so when the wild ways of the 3:30 Club hold sway.  But there is also, we think, something of a deeper nature going on here - something, dare we sound so French? - philosophical.  A philosophical dilemma, actually, with two diametrically opposed schools of thought about how we get out of our economic predicament.

Call these opposed schools of thought Team Krugman and Team Merkel.  Reader’s of Princeton economist Paul Krugman’s New York Times columns know what he thinks needs to be done: increase spending via stimulus programs to ward off the dreaded Return of 1937.  1937 was the year when - in Krugman’s telling - a four year run of growth from the depths of the Depression was choked off by a premature return to austerity measures targeting deficit reduction.  Because the austerity measures directly hit the incomes and jobs of working Americans they killed off the incipient seeds of organic growth and sent the country back into a deflationary spiral that only ended with the onset of wartime spending.  Krugman’s point - and it is a compelling one supported by history - is that choking off a recovery is ultimately not going to help lower deficits - it will not only increase deficits but also increase the misery of unemployed, barely employed or hanging-on-by-a-thread employed Americans (or, for that matter, the good citizens of the battered Eurozone).

Despite the intellectual rigor of Team Krugman’s arguments it is the other side, Team Merkel, that is winning the war of words in the estuaries of public discourse.  German Chancellor Angela Merkel has fast become the global face of the deficit hawks, whose main argument is that, figuratively, you don’t cure the drunkard by pumping more booze into his system.  In this metaphor the bond market plays the role of the drunkard’s wife: for awhile she goes with the flow and supports him because there seems to be no better alternative (read: 10-year Treasury yields below 3% and the 2-year at historic lows below 0.6%).  But eventually she’s going to reach her limit of tolerance, get up and slam the door on her way out - Treasury yields soar through the roof because nobody thinks of Uncle Sam as a risk-free investment any more.  Catastrophically high interest rates in turn make a deficit crisis a deficit Armageddon, and so it goes.

The problem - and thus the “exquisite philosophical dilemma” of our title to this posting - is that there is a reasonable case to make that the road to meltdown could lead through either of these scenarios - the premature hijacking of a recovery or the toxic effects of adding flames to the fires of insolvency.  Very few people in the world share the absolute certainty of conviction that both Paul Krugman and Angela Merkel display in the correctness of their respective positions.  That makes all of us nervous and uncertain, which is the time-honored recipe for extreme market volatility.

Here at MVCM we generally think of ourselves as unbeholden to rigid ideology.  After all the essence of our investment philosophy is the “chaos of wisdoms” - no one answer is right and we try to distill clarity from the complex ecosystem that is the global investment world.  Much more is at stake here than who wins the battle of words and arguments - and we hope that prudent discourse will lead to prudent policy actions and calmer markets.  But that calm is hard to discern today.

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The Week Ahead: The Friday Flop Continues and Japan Feels the Pain

June 7, 2010

By Katrina Lamb, CFA

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The week began on a sour note, adding to last Friday’s 324-point selloff on the Dow as the 3:30 Club knocked another 115 points off the index today.  The return of volatility has been a generally negative story for global risk assets, most of which are considerably down from where they were at the beginning of spring.  The world’s safe havens are playing their time-honored roles in the investor pantomime, with gold prices at 12-month highs and U.S. Treasury yields at 12-month lows.  Both the dollar and the yen are sharply higher versus the euro - in roughly equivalent amounts, in fact, as the current dollar/yen rate of 91 is roughly what it was at the beginning of the year.

The yen’s relative strength is not helping Japan’s fragile economic recovery to gain traction: capital expenditures are coming in lower than expected as businesses contemplate the effects of lower exports to Europe (currency and demand weakness) and China (where financial tightening is having a broader effect on spending activity).  As the annual rainy season gets underway in Tokyo investor moods were likewise gray and dour with the Nikkei 225 registering a 3.8% drop to close at 9520.

The overarching narrative in financial markets has not really been focused on Japan, as other stories of more immediacy have crowded out precious front-page media real estate.  Subprime mortgages in 2007, Wall Street’s fallen masters of the universe in ‘08, the recovery of ‘09 and now the EU debt crisis have been the successive stories of the day.  THat may change, and in my own opinion there is a better-than-average probability that the $5 trillion economy with a debt/GDP ratio of 197%, chronic deflation and the worst demographic outlook of the developed world is going to have its day on center stage.

If nothing else Japan offers a sobering case study for equities market analysis.  On December 31 1989 the Nikkei index reached its all-time high of just under 40,000.  That was 21 years ago.  Today the same Nikkei is valued at less than 25% of that high-water mark.  That is an astounding data point.  In the wake of the Great Depression and Second World War it took the U.S. stock market about 25 years to recover its high-point value of 1929, but by 1937 it had recovered about 50% of that value and survived the most turbulent crises of the 20th century before resuming its long-term upward climb.  There is simply no precedent in modern securities markets for an economically mature country’s stock market to sustain as bleak a long-term picture as Japan’s does.  “Stocks for the long term” is the investor’s mantra, but that mantra has one large glaring elephant in the room that cannot be ignored.

The curious case of Japan’s stock market is going to be the subject of an upcoming in-depth research piece.  As for the remainder of this week, keep an eye on the bond market data points in Europe.  Belgium had a rather flaccid auction of 10-year bonds that generated some market chatter about the “Greece of the north” - an unwelcome moniker to be sure.  We’ve been talking about Hungary for some time now in our commentaries, and this week has Budapest back in the news.  No rest for the weary indeed.

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