Monday, February 4, 2008 9 comments ++[ CLICK TO COMMENT ]++

Economy and Asset Prices May Diverge

I have been of the opinion that the US economy may not suffer terribly, but the equity markets may. A lot of people are expecting the stock market to hold up if we have a mild slowdown or recession. I am not sure. My thinking is similar to John Hussman. In his latest commentary, he speculates on the possibility of relatively major asset price correction while the economy does OK.

So in terms of GDP, I would expect to observe some slowing in all categories of expenditure, with the worst showing in residential investment. Still, I doubt that the losses in GDP (the “real” production of goods and services) will be particularly striking or deep.

Rather, the current economic downturn is likely to focus its damage on asset prices – the U.S. dollar, home values, low and mid-quality debt, and equity prices (largely through the combination of narrowing profit margins and lower valuations). In short, I expect that we are in the process of what might be called a “writeoff recession,” where significant amounts of asset value and perceived wealth will ultimately be written off. There will undoubtedly be some “wealth effects” on the real economy, but I would expect these to be only moderate.

I also think that a reasonable correction is possible even if the economy only has a mild slowdown. A lot of people don't realize that the correlation between stocks and the economy is not very high (I alluded to it in one of my earlier posts).

Similarly, in stocks, analyst estimates reflect a quick return to record profit margins about 50% above their historical norms. If those assumptions disappoint and it becomes clear that profit margins will not be forever sustained at record highs, it doesn't only imply near-term earnings disappointments – it implies that the whole stream of future earnings impounded into stock prices is wrong. After all, a moderate price/earnings multiple on elevated earnings does not imply moderate valuation...

What matters most is the long-term stream of cash that companies can actually deliver into the hands of shareholders, and whether that stream of cash would provide an acceptable long-term return if you paid the existing share prices. We're certainly willing to assume higher growth rates for well-managed companies with defensible product lines, which is why we don't simply define value as “low P/E” or “low price-to-book.” But at a market-wide level, valuations remain far too high to provide investors with tenable long-term returns.

Corporate profits are very high relative to the GDP and I just don't see them going up much, if at all. Even the super-hot oil&gas sector, which has contributed enormously to S&P 500 profits, is likely to cool down (ExxonMobil posted the largest corporate profit in history last year ($40.6 billion--size of Microsoft's price for Yahoo!) and I just don't see how that can increase meaningfully in the future). If you strip out materials and energy sectors from S&P500, corporate profits haven't been that great.

Again, I don't believe we are likely to observe major declines in consumption, or capital spending such as information technology – even assuming the U.S. has entered a recession. Indeed, nominal consumption has never declined year-over-year. Though consumption represents the largest share of the economy, it is also the most stable (Friedman and Modigliani were right). Yes, growth rates will probably slow for these classes of spending in a recession, but the bulk of the downward pressure is likely to fall on housing and fixed investment. Meanwhile, an already lean level of inventories should help to prevent much further decline in inventories, which should offer some support to industrial production. Since negative inventory investment or “inventory runoffs” represent a good portion of the output losses in a recession, it follows that losses in real economic output (and by extension, employment), though not insignificant, are unlikely to be dire.

So, things are going to get interesting. We may not see big job losses like in past slowdowns (that's good for lower income people like me) but asset markdowns will likely be sizeable. Already, many financial assets related to real estate have been marked down significantly.

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9 Response to Economy and Asset Prices May Diverge

February 5, 2008 at 3:06 PM

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February 6, 2008 at 4:34 PM

Slippery slope.


February 6, 2008 at 8:09 PM

Hi Cak,

Hope things are well. We are having a snow storm in Toronto so it's all white everywhere :)

How is the rest of your portfolio holding up? With the way the markets are selling off, it'll be interesting to see which one results in a greater loss.

As for the monolines, well, there is the good, the bad, and the ugly.

The ugly news of late is the fact that some rating agencies, like Fitch, expect to see materially higher losses in subprime assets. It's difficult to say what any of this means given that everything depends on the specifics of the insured asset. Fitch also basically implied that almost no amount of capital is enough to keep an AAA rating with subprime exposure. For what it's worth, the rating agencies have even less credibility than the monolines right now.

The bad news is that the US economy is slowing materially, and may go into a recession. The subprime problems materialized before an actual economic slowdown so it remains to be seen what happens with a real slowdown. Economic slowdown may adversely impact non-mortgage assets like insured credit card debt, insured auto loans, and the like.

The good news is that the stock prices have been flat, moving up and down within 10% range, for a while now. This doesn't mean that they won't collapse any minute now, but it does mean that the market is waiting to see what unfolds with the ratings, capital funding, and other issues.

I get the feeling that the panic over the monolines is kind of dying down. It'll come down to what the monolines can actually do and what the economic losses turn out to be...

February 6, 2008 at 9:01 PM

It's definitely been a tough market, although the Fed cut inducing rally helped out a bit - so its a lot of zig-zagging going nowhere.

Check this out -


February 6, 2008 at 9:19 PM

As for the ratings agencies, I thought it was humorous that S+P put China Aluminum on negative credit watch after the company bought a 14 billion dollar stake in miner Rio Tinto. It was as if they did'nt get the memo that Beijing has allocated Chalco 120 billion, just in case they wanted to buy the whole enchilada. Amazing.

February 7, 2008 at 7:05 PM

MBI sold an additional 80 million shares to raise another 1 billion, on top of the 750 mill pfd. Shares were sold at 12.15. Don;t know who the buyers are yet.

The ratings agencies put a gun to MBI's head threatening the AAA, and for better or worse - essentially diluting the shares all to hell - the co. has decided to go all in to maintain it. And still no guarantee!

I wonder if Whitman bought some more? But he loathes these dilution scenarios. I wonder what his input was in all this?

February 7, 2008 at 7:46 PM

It's interesting how this is all playing out. As you said, MBIA is going all in. It is literally betting everything to keep its rating. It may have had no other choice because it already diluted shareholders so raising another billion is simply continuation of that strategy.

Ambac, on the other hand, is in a really tough situation and I am not sure what they will do.

I personally think this was a huge positive for MBIA. It diluted shareholders heavily but it gives a huge signal to the market that some parties are willing to invest at these price levels. Although MBIA is a rival to Ambac and this doesn├Ęt really mean anything good is happening to Ambac, I think positive news from a fellow monoline is good...

February 7, 2008 at 7:59 PM

I have to correct. The early news was not very clear. Originally Pincus was buying a conv pfd but it looks like that has changed.

Brief WSJ note -


February 7, 2008 at 8:02 PM

February 7, 2008 7:52 p.m.

Bond-insurer MBIA Inc. said it boosted the size of a share offering to $1 billion from $750 million after it was oversubscribed by investors.

The Armonk, N.Y.-based company said it priced 82,304,527 shares of common stock at $12.15 a share to raise $1 billion. The offering is larger than its previously announced $750 million share issue and is likely to be greeted positively by analysts and investors who have been worried that the company will lose its coveted AAA credit rating.

Together with a previously announced $500 million share-purchase by private-equity fund Warburg Pincus LLC and a $1 billion debt issue in January, the share offering brings the total amount of capital raised by MBIA to $2.5 billion.

It will likely use the proceeds to buttress its capital levels and preserve its rating, which has been placed on watch for possible downgrade by Fitch Ratings, Moody's Investors Service and Standard & Poor's.

"The company intends to contribute most of the net proceeds of the offering to the surplus of its subsidiary, MBIA Insurance Corporation," MBIA said in a news release

In another vote of confidence, Warburg Pincus will also buy $300 million in common stock as part of the offering, according to the MBIA news release. MBIA said it doesn't intend to tap a "backstop" by Warburg to buy $300 million in convertible participating preferred stock. A backstop is an agreement to buy a certain amount of shares if an offering isn't fully subscribed.

Two Warburg managing directors, David Coulter and Kewsong Lee, have joined the MBIA board of directors.

MBIA said it has granted the underwriters J.P. Morgan Chase & Co. and Lehman Brothers Inc. a 30-day option to buy up to an additional 12,345,679 shares of common stock to meet orders for more shares than currently exist in the offering.

MBIA and its rivals, including Ambac Financial Group Inc., insure about $2.4 trillion in debt, guaranteeing the principal and interest in the event of default. Most of it is municipal debt, but bond insurers have about $100 billion exposure to complex debt securities backed by mortgages, which have been deteriorating and increasing the likelihood that the bond insurers will need to pay out substantial claims.

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