Today's Market Observation  10.15.2009  Mon  Tue  Wed  Thu  Fri  Eckert Archive

IPO Nos

Part 1

by Richard A. Eckert, cfa | OCTOBER 15, 2009

The Great Disconnect

I continue to marvel at what appears to be a fundamental disconnect between the U.S. capital markets, particularly the equity markets, and the economy they putatively reflect.  Since bottoming in early March, the major stock market indices have advanced by 50% or more; the Nasdaq composite is up over 70% from its March 9 close of 1268.64.  To be certain, the furious rally in the U.S. capital markets isn’t an equity-only—or even U.S.-only—affair.  The DJ Global (stock) Index has jumped 70%¹ since that fateful day in March; the DJ Global ex U.S. has leapfrogged even that lofty return, soaring 78%² over the same period.  YTD, high-yield corporate bonds have generated a total return of 48%, nearly tripling the 18% earned on investment-grade corporates³ .  Long-term (22+ years) munis have returned 27%, all-in, to their investors through the end of last week⁴ , while emerging market government bonds have generated a total return of 28% over the same timeframe⁵ .  The spot price on crude oil has risen 56% since March 9 and 58% YTD.   

All of these returns seem to fly in the face of the persistent weakness I feel will come to characterize America’s consumer sector, upon which the world’s largest economy—as well as many smaller export-oriented economies—has come to rely very heavily.  And this sector, in order to provide 2/3 or more of the propellant needed to fuel increases in U.S. output, has come to rely very heavily on credit.  As the national savings rate plummeted from 10.9% in 1982 to 1.4% in 2005 (recovering just slightly to 2.7% in 2008)⁶ and real wages stagnated (average weekly wages in the private sector advanced at a rate that compounded at only 0.2% annually over those 26 years)⁷ , household debt mushroomed by a factor of nearly 9x from $1.6 trillion at the end of 1982 to $13.8 trillion at the end of 2008 (increased by 4.4x by the end of the last millennium and then nearly doubled again in the first 8 years of this millennium)⁸ . 

So a rather flat real wage base will have to support higher levels of debt service—which will become even more onerous if the deflationary environment I foresee in the near term materializes (real wages may remain flat even if nominal income decreases, but debt is denominated and serviced in current dollars)—higher levels of saving (boomers nearing retirement age, sobering effects of 401k and home value declines, necessity of putting something away for a “rainy” day as job losses mount), and higher costs of food and energy (as well as increases in those items that never seem fully captured in CPI).  Reinforcing the downward pressures of deleveraging, thrift and caution on consumer spending is widespread un- and underemployment.  Nearly 1 in 10 Americans who want a job and are actively looking cannot find work⁹ .  If the definition of joblessness is expanded to include part-timers looking for full-time work, those marginally attached to the labor force and discouraged workers, over 1 in 6 Americans is unemployed (the U-6 definition, under which the total unemployed amounted to 17.0% at the end of September)¹⁰ .  One can’t spend what one does not have—and cannot borrow because credit is still tight (especially if one has no visible income).  So where is consumer spending going to come from?  And if it falls back to the 64.5% of GDP (63% in nominal dollars) reported for 1980¹¹ —before the nearly 3 decade-long borrowing and spending binge began—from over 70% (both real and nominal) in the second quarter of this year¹² , where will increases in U.S. output come from?

In an earlier piece posted to this forum, Risky Business? (posted in two parts, 8/26/09 and 9/1/09), we demonstrated that American business was either unable or unwilling to step up its spending and investment even under the most propitious of circumstances during the 1980s,

Exhibit I

1990s and early 2000s (see Exhibit I above).  These included declining tax rates, the dismantling of personal income tax brackets, deregulation, declining interest rates, declining inflation rates, declining costs of capital goods and declining capital intensity.  Plus surging consumer demand powered by a veritable tsunami of ever cheaper credit obtained on ever easier terms.  Notwithstanding these most favorable of conditions, gross private domestic investment flattened out at roughly 15% of GDP (both real and nominal).  The only deviation from this pattern was uptick in capital spending required of Y2K preparations in the late 1990s.  And if one excludes single-family residential (SFR) construction, business investment actually fell as a percent of GDP from 1980 to 2008 (at least in nominal dollars).  Even in real dollars, gross private domestic investment in 2008 was flat with that reported for 2000.  The stagnation in gross private domestic investment becomes even more demonstrable when quarterly figures for the current decade are used are used (see Exhibit II).

Exhibit II

Although we concede the role of cheaper capital goods and the lower capital intensity associated with a service economy in restraining increases in business investment, but I believe there are other, larger forces at work here.  They are outside of the scope of this article, but I did address some of these in Risky Business?  The bottom line here is that, if American businesses can’t boost their investment (as a percent of GDP) in the most benevolent of environments, what would lead one to believe they can in a slow-growing economy where the consumer is in retreat, credit tight, regulation more rigorous, tax increases likely, and—at some point, given massive stimulus and even more massive deficits—higher interest rates even more likely.

So that leaves government, which has already made many—legislators, economists, policymakers, small business owners, corporate executives and taxpayers—uneasy with its growing role in the economy.  As well as the cost of that intervention.  The $700 billion Trouble Asset Repurchase Program (TARP) approved last fall.  The $787 fiscal stimulus package passed into law early this year.  Trillion dollar shortfalls in the federal budget.  And that’s just what’s on center stage.  Behind the scenes, the Fed’s balance sheet has ballooned to over $2 trillion from several hundred billion at the onset of the financial crisis. 

What’s more, the trillion shortfalls in the federal budget extend a decade out according to the CBO—$872 billion per year from 2009 – 2019, to be precise—according to its latest Budget and Economic Outlook¹³ .  It should be noted here that these projections assume a 2.8% increase in 2010, a 3.8% increase in 2011, an average annual increase of 4.5% in 2012 – 2013, and 2.4% thereafter (thru 2019).  The forecast also assumes that, after peaking at 10.2% in 2010, the unemployment rate will drop to 9.1% in 2011, 6.4%, on average, in 2012 and 2013, and then settle in at 6.4%, on average, over the last five years of the 10-yr projection.  And none of these estimates appears to take into account the likely snowballing of claims on the Social Security and Medicare systems as large cohorts of the baby boom generation become eligible for benefits.  If this is the case, trillion dollar deficits could give way to multi-trillion dollar deficits by 2025, 2030 at the latest if serious reforms of those systems are not undertaken before the end of the next decade.

In the near term, the significant intervention of the U.S. government and Federal Reserve in the economy has left it between a rock and a hard place.  It is apparent—to this observer, at least—that the economy has become very dependent on the stimulus provided.  I fear that if any of it is withdrawn, or withdrawn too soon, the resultant shock would push the economy back into serious recession.  But if the government and the Fed continue to print money, sooner or later, inflationary expectations—if not actual inflationary pressures—will begin to embed themselves in intermediate and long-term interest rates, over which the Fed has no real control (and I expect that Middle and Far Eastern fixed-income investors and central bankers will not be loath to remind Ben Bernanke, painfully if necessary, of this), sending borrowing rates higher and crushing any nascent recovery or tepid growth in the economy. 

Longer-term, the prospect of gargantuan increases in the U.S. deficit, as well as Fed borrowings—not to mention the likely increases in the borrowings of other industrialized nations struggling to fulfill the same social promises amid much slower growing economies and the rather finite number of resources that can be tapped to finance this growing mountain of debt—is truly frightening.  Many promises, upon which large segments of the U.S. population have now seemed to come to depend, may be unfulfillable or unfinanceable. 

Layer on to these concerns the large shortfalls in most state government budgets--as well as those of many large municipalities—peaking resets in option ARM and Alt-A mortgages as the largest vintages of loans in these categories, those originated in 2005 and 2006, reach their first repricing date or “negative amortization” cap (which are likely to coincide with peaking unemployment rates in the localities in which those loans were made like California), a huge shadow inventory of homes held off the market by banks and mortgage servicers hoping for housing markets to recover before they reach the point they can no longer tie up capital unnecessarily (this author estimates this shadow inventory at 500,000 homes), the expiration of unemployment benefits for the large number of workers laid off or displaced in the wake of last fall’s meltdown in the financial markets, and the balloon payments due on $100s of billions of commercial real estate loans between now and 2012 in an era of skyrocketing vacancy and tenant delinquency rates, free falling lease rates, and sharp increases in cap rates just as underwriting standards tighten considerably (notably, LTVs and DSCRs) and I see little reason for the optimism displayed in the capital markets.  Particularly the markets for “risk” assets.

Repeat offenders

That these conditions, concerns, considerations, and day-to-day realities (very few of this author’s friends are fully employed and I do not believe our circle is unrepresentative of the broader economy) are not embedded in the prices of a broad array of marketable securities suggests to me that the capital markets are becoming increasingly detached from the real economy they purportedly serve and reflect.  Indeed, I would go so far as to argue that the capital markets have not only divorced themselves from the real economy where value added goods and services are produced, but, in fact, compete with the real economy for financial and human resources (once again, I refer readers to Risky Business?, 8/26/09 and 9/1/09).  And that the run-up in market values across a variety of financial asset classes (to which, thanks to the advent of structured finance, globalization, and advances in information technology, I would add residential and commercial real estate) merely represents the capital, the liquidity being siphoned out of the real economy and into the capital markets. 

The money fleeing the real economy in this manner only serves two purposes, neither of them a positive: 1) it inflates the value of paper assets; and 2) deprives the real economy of the vital capital it needs to innovate and expand.  This hypothesis would explain not only the “irrational exuberance” to which we now bear witness in the capital markets, but also the absence of true innovation in the American economy discussed in Risky Business?, as well as a decaying infrastructure the U.S. has allowed to languish (see photo below).

Historically, in a capitalistic, free market economy, financial intermediaries were just that, intermediaries, facilitating the transfer—via any number of lending or investment mechanisms—from economic units with surplus capital to economic units with deficit capital, retaining a small slice of the transaction for their services (illustrated below).

Economic unit (surplus capital)----->Financial intermediary----->Economic unit (deficit capital)

However, it appears that the capital so raised in today’s markets is trapped in the middle link of this chain.  Increasingly, it seems to be used only for investment in the instruments created by financial intermediaries, leaving economic units (particularly in the real economy) with deficit capital bereft of capital.  There are nuances and twists to this thesis, which will be explored in greater detail below, in the section on IPOs.  Some of the individual components of the entity with deficit capital benefit along with the financial intermediaries at the expense of the entity with surplus capital and the broader economy.

Exhibit III

Source: Wikipedia, NY Times, January 27, 2009 edition.  At approximately 6:05 CDT on Wednesday, August 1, 2007, the central span of I-35W Mississippi River Bridge (officially known as Bridge 9340) suddenly collapsed, followed almost immediately by adjoining spans.  A “report card” issued by the American Society of Civil Engineers on January 28, 2009 found that over ¼ of America’s bridges are structurally deficient or functionally obsolete.  The ASCE also found that leaky pipes lose an estimated 7 billion gallons of clean drinking water every day and the aging sewer systems send billions of untreated wastewater into U.S. waterways and the oceans off its coasts every year.  The ASCE issued an overall grade of “D” to U.S. infrastructure and recommended spending $2.2 billion over the following five years to bring it into a state of good repair.

The upshot of the foregoing three paragraphs is that, among capital market participants, capital-raising has become an end in itself, not a means of investing in a merit worthy endeavor in the real economy of goods and services.  Nowhere is this clearer to me than in the equity markets, where stocks trade back and forth at seemingly ever higher prices and new shares issued (both primary and secondary) with precious little trickling down to the real economy.  And in no other financial asset class is the separation between “church and state” (capital economy and real economy) more visible than in the equity markets (see Exhibits IV & V below).

Exhibit IV

Exhibit V

From the end of 1990 to the end of 2000, for instance, U.S. equity market capitalization nearly quintupled while nominal GDP advanced 72%, real GDP 40% and corporate profits 89%¹⁴ .  On a compounded annual basis, equity market capitalization in the U.S. expanded at a rate of 17.2%, 3.1x, 5.1x and 2.6x the rates at which nominal GDP, real GDP and corporate profits grew, respectively.  Similarly, after recovering from a 27% downdraft from the end of 2000 to the end of 2002 in the wake of 9/11 and the 2001 recession, U.S. equity market capitalization, climbed 80% over the next five years, or at a compounded annual rate of 12.5%, or 2.2x and 4.5x the rates at which nominal GDP and real GDP increased, respectively.  And while the compounded annual rate of increase in market capitalization was in line with that of corporate profits, which also advanced at a CAGR of just over 12%, it must be remembered that corporate profits were during this period were probably distorted by both the quantity and quality of earnings reported by the financial services sector. 

If one excludes the hyperinflationary 1970s, the financial services industry accounted for 12.5% of domestic corporate profits before tax, on average, between the end of WWII and 1985 (this varied between 8.1% in 1946 to 16.2% in 1960)¹⁵ . In the late 1980s, the mean contribution of financial services businesses to corporate profits expanded to 20.1%.  In the 1990s, the mean contribution to corporate profits grew again to 25.9%.  In the first years of this decade, the role of the financial services sector in total domestic corporate profits ballooned to 34.7%, on average, and on two occasions—2002 and 2003—eclipsed 40%.  When considering the outsized role of the financial services sector in corporate profits—and, indeed, the entire domestic (and, most probably, global) economy—it must also be remembered that much of the revenue reported by the largest of industry participants consisted of capitalized mortgage servicing rights and residual income—or the mark-up of lower-rated ABS tranches companies couldn’t sell and had to retain—mark-to-model calculations, interest accruing on loans that were never repaid (and never reserved for or properly marked to market or impaired).

How real were those revenue items and the resultant earnings reported by many financial services corporations?  Many amounted to nothing more than a mere calculation. The results of those calculations were heavily influenced—if nothing largely determined—by several key assumptions, which were often formulated with the goal of simplifying the models using them or creating normal or log-normal distributions of outcomes, instead of properly characterizing underlying relationships between the raw data (see Beware of Geeks Bearing Stats, Market Observation, Wednesday, September 23, 2009).  In many respects, the losses reported by financial institutions, both large and small, over the past two years may—and should—be construed as a restatement, a correction, a true-up of the unrealistic assumptions and erroneous calculations to which they led in the first five or six years of this decade. 

To the Pollyanna-ish equity investors who argue that those losses are only temporary—the result of a momentary withdrawal of liquidity in the markets for certain assets—and noncash, I would respond that the 2001 – 2005 revenue and earnings reported by financial corporations were just as surreal.  And that the losses are not noncash.  At some point, cash was borrowed—and is still owed—to acquire assets that are today, for all intents and purposes, worthless.  Finally, I make the observation that, if the revenue and profits reported earlier this decade were real, why did financial services executives insist on cash bonuses, instead of, say, NIM certificates and IO strips?

I digress.  The point being here is that, if I am interpreting Exhibit IV and the statistics cited in the opening paragraphs of this dissertation correctly, equity investors have blown three bubbles now (including the current one) in the last two decades, inflating the paper value of their assets to the point where the paper wealth created bears no relationship to the wealth-generating power/capability/ability of the underlying economy or individual businesses populating it.  They appear to be serial offenders when it comes to printing bogus currency.

Resources:

¹ Wall Street Journal (online edition), Dow Jones Global Index, as of mid-morning, Oct. 13, 2009.

² Ibid, Dow Jones Global Index, ex U.S., as of mid-morning, Oct. 13, 2009.

³ Merrill Lynch, High Yield and Corporate Master, as of Friday, Oct. 9, 2009, as reproduced in the online edition of the Wall Street Journal, Tuesday, Oct. 13, 2009.

⁴ Ibid.  Tax-Exempt 22-plus years, as of Friday, Oct. 9, 2009, as reproduced in the online edition of the Wall Street Journal, Tuesday, Oct. 13, 2009.

⁵ J.P. Morgan Emerging Markets Bond Index (EMBI), as of Friday, Oct. 9, 2009, as reproduced in the online edition of the Wall Street Journal, Tuesday, Oct. 13, 2009.

⁶ US Dept of Commerce, Bureau of Economic Analysis, NIPA tables, as of 9/30/2009.

⁷ US Dept of Labor, Bureau of Labor Statistics, Current Employment Statistics survey (National), as of 10/2/2009.

⁸ Federal Reserve Bank of the U.S., Flow of Funds Accounts of the United States, Second Quarter 2009, September 17, 2009.

⁹ US Dept of Labor, Bureau of Labor Statistics, The Employment Situation – September 2009, 10/2/2009.

¹⁰ Ibid.

¹¹ US Dept of Commerce, Bureau of Economic Analysis, NIPA tables, as of 9/30/2009.

¹² Ibid.

¹³ Congressional Budget Office, The Budget and Economic Outlook: An Update, August 2009.

¹⁴ Expressed in current dollars (nominal) and includes the BEA’s inventory valuation and capital consumption adjustments.

¹⁵ Once again, these figures include the BEA’s inventory valuation and capital consumption adjustments.

Rich Eckert

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Richard A. Eckert, CFA | (415) 674-4996 | San Francisco, CA
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