Author: Sizemore Capital
Covestor model: Tactical ETF
Though the timing took many by surprise, the S&P downgrade of America’s debt rating was a long time coming. The cited proximate cause of the downgrade was “policy uncertainty” stemming from the inability of the White House and Congress to negotiate with one another, but the issues go much deeper. The fiscal indiscipline of the Bush Administration has actually been surpassed by that of the Obama Administration in its short tenure–a remarkable feat, of sorts. The grandstanding by many House Republicans is hypocritical, of course. Some of those screaming the loudest about the debt and deficit didn’t seem to mind too much when their own party held the White House. Many who vow to dismantle ObamaCare, supported George W. Bush’s Medicare Part D, which created enormous unfunded liabilities that this country can ill afford.
On cue, both political parties used S&P’s ratings announcement as propaganda to bash the other party–essentially proving S&P’s case.
So here we are again, staring into the great unknown. It is highly likely that global stock markets will fall sharply, as nothing causes a market to crash harder than uncertainty. Perversely, Treasury yields will almost certainly fall, even though yields should rise to reflect their lower credit rating. Herein lies the irony; when confronted by a financial crisis that is largely political, investors run to the relative safety of government bonds for lack of anywhere else to go.
Because markets are driven by human emotions, it is impossible to know ahead of time how this will play out. Our best estimate will be that stocks will initially fall, but we do not necessarily see this turning into a multi-month bear market. Once investors see that the world as they know it has not ended after all, the market is likely to rally.
Worry Top Down and Invest Bottom Up
There is a statement by legendary value investor Seth Klarman that I’d like to repeat. Klarman, the founder and manager of the Baupost Group, says regarding his firm – and I paraphrase – that “We worry top down and invest bottom up.”
What Klarman means by “bottom up” is that he chooses his investments one-by-one based on their price and investment merits. But at the same time, he worries “top down,” meaning that he keeps an eye on the big picture.
This is sage advice. Even good investments can get slammed in a panic. Many investors—myself included—failed to fully appreciate the systemic risk facing the market in the fall of 2007. While I fully believed that there would be fallout from the mortgage excesses of the 2000s, I didn’t see the entire financial system failing. I also believed that choosing highquality companies at reasonable prices would protect investors from the carnage. Needless to say, it didn’t. In the forced selling of 2008, the baby was thrown out with the bathwater and virtually everything fell together.
The trauma of 2008 left investors shellshocked. Now, big-picture macro worries are all anyone can think about. To give an idea of how timid investors are, the Bank of New York Mellon said it would start charging its large institutional investors to hold their cash because they are selling so much of their stock and depositing so much in cash that BNY Mellon doesn’t know what to do with it. That a bank is considering paying negative interest rates on cash is testament to the times we live in.
To be sure, there is no shortage of macro concerns to worry about. The debt ceiling fiasco took us a lot closer than it should have to national default. The sovereign debt crisis continues to fester in Europe with no end in sight. And most critically in the recent selloff, it now appears that the economy is markedly slowing down and that a new recession is a real possibility.
I take these issues seriously, of course. But let’s look at them a little deeper. The debt ceiling incident was an embarrassment, but at no point did anyone seriously doubt the country’s ability to pay its debts. The issue was its willingness to do so.
In Europe, Spain and Italy are widely feared to be the next dominos to fall. I remain skeptical of this fear. We’ll start with Spain. While Spain had (and still has) some of the most inflated home prices and at-risk banks, the country’s national debt is surprisingly low. It is adding to that debt at an alarming rate due to its yawning budget deficits, high unemployment, and decimated housing market, but the country is (belatedly) taking the crisis seriously and is reining in its public spending. With an election scheduled for November, there is some amount of political risk. But overall Spain’s situation would appear to be manageable, though not particularly enviable. Spain is not Greece.
Italy is a different story. It is one of the most indebted countries in the world. Among major economic powers, only Japan owes more money. Italy largely escaped the bank runs of 2008, but its economy has barely grown in the past decade, its political system is dysfunctional, and its population is aging at an alarming rate. Still, Japan has proven that an aging, politically-dysfunctional country can limp along with high levels of debt for years without incident. I sincerely hope that Italians get their fiscal house in order before their situation gets as hopeless as that of Japan, but my point is that a country’s ability to limp along should never be underestimated.
I fully expect both Japan and Italy to eventually “blow up,” and this is something I worry about. But I don’t see the blow-up happening this year. The bond market is punishing Italy for its wayward ways, sending yields to highs not seen since the adoption of the euro.
As for the risk of recession, the preoccupation with this is something I have never understood. By the time a recession is officially declared, it is usually close to being over. Its damage has
already been done, and its effects long ago already factored into stock prices. Granted, we live in extraordinary times. That the Great Recession was not even worse was due to unprecedented fiscal and monetary stimulus from Washington—stimulus that is now politically unpopular.
Still, with all of this in mind, it would appear to me that, at current prices, something fairly close to the worst-case scenario is already baked in. I agree on the need to worry “top down,” but when everyone else is already worried to the point of paralysis, it might make sense to bet the other way.