Four More Years?
by Brian Pretti CFA, Contrary Investor. January 19, 2007
It's often amazing that many a technician will strongly eschew fundamental analysis as if it were of zero value. It's also amazing that many a fundamentalist will scoff at those trying to make investment decisions strictly by looking at "pictures" of the rhythm of asset price movements over time. Extremism in any form is incredibly detrimental to long-term investment success. Very often the answers to apparent fundamental conundrums can be found in the forewarning of technical analysis, and vice versa. So why not use all of the tools at our disposal as opposed to limiting ourselves or favoring only one side of the technical and fundamental investment tool box? Of course the investment art in all of this is finding the right tool for the right job at the right time, whether that be technical, fundamental, or both. When I figure out how to do that consistently correctly with each and every investment decision, I'll be sure to let you know. But in the meantime, do yourself a favor. Don't hold your breath, Okay?
In trying to put into practice the preaching above, here are a few thoughts regarding the four-year cycle for equities. As you know, we've seen relatively important lows in the major equity averages about every four years for some time now. The following is a very shortened graphical version of this phenomenon.
At least since the early 1980's, we've experienced interim lows in the S&P (as a proxy for equities broadly) roughly every four years with more than a fair amount of regularity. As opposed to this being some type of magic technical Holy Grail, this phenomenon is necessarily intertwined with what has been the ongoing rhythm of the US business cycle, the reality of the four-year Presidential cycle, etc. In other words, there is a fundamental backdrop for the four-year equity cycle phenomenon. As you most likely know, and is apparent in the chart above, the regularity of the four year equity cycle suggests to us that the equity market as a whole was set to put in some type of meaningful bottom somewhere around the middle to latter part of last year. But the key question at the time was, bottom from what? Although we experienced what turned out to be a relatively minor and temporary correction between May and mid-summer, we'd be hard pressed to call that some type of meaningful bottom within the context of the ongoing macro equity market rally begun in late 2002/early 2003. It was much more a speed bump, if anything.
So we have a technical problem. Where's the four-year cycle low we've been expecting? At this point a number of technicians continue to call for the proverbial four-year cycle low in the months ahead. But is it really still to come? Or has something changed relative to past cycles? Trying to use all of the tools at our disposal, coincident with technical cycles we need to perhaps take a quick check in on fundamental cycles. Without sounding melodramatic, one of the keys to maneuvering in the current environment is proper identification of the fundamental backdrop. To cut directly to the bottom line, here's perhaps the key question to be answered. Is the US economy running on a business cycle or a credit cycle? Which one is it? And if we're not running on a traditional business cycle, can we really expect the equity market to follow a traditional four-year technical cycle low pattern? Is this the reason the anticipated four-year cycle low for equities seems to have simply passed us by? If nothing else, I think this is a big part of the reason.
My personal outlook is that the US economy has been for some time and continues to run on a credit cycle, not a traditional business cycle. If that indeed is the case, how can we expect financial markets to mirror prior price pattern experience when the current credit cycle is really of generational proportion at this point? Simple answer: We can't. As the systemic US credit cycle has continued to accelerate, the influence of this fundamental cycle on both real economic and financial market outcomes has only become more pronounced. Shall we look at a few anecdotes of this change in terms of financial assets?
Although the thought has been bantered about the Street for a while now that corporate capital spending would compensate for any type of consumer slowdown, the evidence is anything but wildly convincing. In simple terms, the bulk of US corporate capital spending is reasonably strong, it’s just not happening in the US. But there is one domestic area in which corporate chieftains have spent corporate cash quite profusely – stock buybacks. Have a look:
The year 2006 was simply a record year for net equity retirement in the US. It's not only stock buybacks, but also M&A activity as well as ever larger private equity deals that are putting a certain and important bid under US equity prices. So just how is this related to the credit cycle? Although net equity reduction in the chart above looks incredible, it just so happens that over the period shown, corporate debt issuance has exceeded equity reduction. Although not all corporate borrowing was initially earmarked for stock buybacks, the cash used in buyback activity could have been used for debt reduction, but it wasn't. Certainly a big driver in this activity has been to negate the dilutive influence of stock options issuance. But point-to-point in the period above, credit markets have been very accommodative in financing corporate capital needs at ever lower costs.
Does private equity need an accommodative and perhaps hyper credit cycle to have attracted as much investment as it has? If nothing else, the credit cycle has been a huge support mechanism in that we see bond buyers and lenders lining up to finance the corporate re-leveraging taking place in the world of private equity at the moment. Yields on some of this ever-riskier newly created debt seem almost devoid of any type of meaningful risk premium. A very accommodative credit cycle in action, ultimately supporting equity prices via private equity takeout activities? It sure looks that way.
FOREIGN FLOWS OF CAPITAL
The global capital flow imbalances of the moment are more than self-evident and have been a point of controversy on the Street for years now. The timing of ultimate resolution is anyone's guess. The feedback loop here is quite simple. The nature of the US credit cycle is clearly responsible for US households being able to spend more than they have earned for years now. And a very good portion of this spending has been directed to consumer goods produced offshore. As growth in US credit market debt has accelerated, the US trade deficit has mushroomed in coincident fashion. As dollars have become one of the largest US exports in trade for foreign wares, many of these dollars have found their way back into US financial markets as foreign central banks have accommodated this process with unique credit cycles of their own in the build up of dollar denominated foreign reserves. What you see below is the twelve-month moving average of foreign purchases of US financial assets and the nominal US trade deficit.
Foreign investment in US financial assets is well above and beyond the simple recycling of trade related US capital flows outward. Again, without question, a very important bid under US financial markets. For now, the spread between these two numbers is approximately one quarter of a trillion dollars. Very meaningful indeed. And a very big piece of this global capital flow circumstance finds its origin in the US credit cycle (as well as simultaneous credit expansion being sponsored by the Bank Of Japan and the People's Bank Of China). Although a bit circuitous, the US credit cycle is influencing the ongoing rhythm of US financial asset prices via a massive global capital flow feedback loop. Clear enough?
WALL STREET/SPECULATIVE INVESTMENT COMMUNITY
It absolutely goes without saying that the US credit cycle has found its way to Wall Street. Incredibly insightful comment, right? In fact, isn't levered speculation one of the attractions of hedge investing? And don't the large broker prop desks imbibe on a regular basis to "enhance" returns? You already know that two key pieces of earnings growth for the big brokers these days is proprietary trading (using leverage), as well as the act of lending itself (subprime mortgages in packaging MBS securities, hedge lending, etc.). In the recent Fed Flow of Funds statement for 3Q 2006, it is clear that the rate of change in household leverage growth is slowing. But for the leveraged and speculative investment community it is growing strongly. In other words, at least as of late, the US credit cycle is alive in well on Wall Street as well as in such locales as Greenwich. Non-seasonally adjusted growth in broker/dealer liabilities through 3Q of last year saw an increase of 18.6%. In the following chart this number is annualized to give you a sense of longer term perspective.
For now, this is a decade high. As long as the return on leveraged investment capital exceeds the cost of borrowing, expansion of the credit cycle for speculative investment purposes will continue. And in many ways in this modern world of ours, the Street can create it’s own liquidity. A big conduit for this is the broker/dealer community as is clear above.
In addition to currently strong broker/dealer liability expansion being an anecdote of the macro credit cycle influencing financial market prices, growth in the Fed Funds and repo market is at a level unseen in a decade and one half at least as of 3Q 2006. Again, there's one heck of a lot of current borrowing supporting levered financial speculation/investment. The Fed Funds and repo markets are a key source of liquidity/credit for this type of activity. The macro US credit cycle in action.
So having looked at these manifestations of the greater current credit cycle and their implied positive influence on US financial assets prices, once again pondering the question seems appropriate, is it really so strange that the four-year equity cycle seems to have passed us by recently? It sure seems very hard to debate that the US credit cycle of the moment has not been extremely important in shaping the character of both the real economy and financial markets. A force quite different and currently more powerful than has been the case in prior economic and financial market cycles. And as per the latest fundamental data, the influence of credit market expansion on financial asset prices may indeed be more meaningful than any experience in recent memory. If it’s "different this time" in terms of what's driving the real world economic cycle, should we not expect historical repetition in the rhythm of financial asset prices to also appear out of character set against past precedent? For now, that sure seems to be the message when we use all of the fundamental and technical tools at our disposal. I simply cannot stress enough just how important the macro US and global credit cycle has become to both the real economy and financial asset price movements in the here and now. In my mind, ongoing analysis of the character and ultimate change in this cycle is mandatory all investors. As per the lack of a current four-year equity cycle low, does this help explain the apparent vanishing act?
© 2007 Brian Pretti