2011: Fingers of Instability

This is Our Man’s way of (exceptionally broadly, see here for an explanation of the thinking behind Fingers of Instability & Glimmers of Hope) applying the concepts of Bak-Tang-Wisenfeld’s sandpile model to how he thinks about investing

- Fraudclosure & the Housing Market
Residential construction has been an important driver in post-WW2 recoveries.  Unfortunately, there have been recent signs of a double dip in house prices and the underlying problem of too much supply/too many homes on the market has not been solved.   One of the ancillary factors that has been in the background is the “fraudclosure” scandal.  While the long-term impacts are unclear, what is clear is that there is greater doubt surrounding the ownership of homes (both foreclosed and not) in the US, which adds yet more uncertainty to the housing market. In all probability there’s unlikely to be any Federal moratorium on foreclosures, though a State-level moratorium (like we saw in the 30’s) is eminently possible. An interesting, but less talked about issue, remains that most of the Mortgage-Backed Securities vehicles (to whom the mortgages were sold) were enacted under NYS Law, where the dealer has to deliver to the mortgage notes to the trustee.   If the trustee doesn’t have notes, then the contract isn’t alive and is potentially uncollateralized which I’m certain will lead to all manner of legal arguments. 

- Property Taxes, and State & Local Government Finances
The unwritten story of foreclosures is the impact on property taxes, which will hamper state and local governments.  This is just another problem for cash-strapped states and local governments with a number of analysts predicting potential defaults in 2011 and the municipal bond market reacting negatively.  What does seem likely is that we’ll see some belt-tightening at the state level.

- European debt problems
During 2010 we saw bailouts for Greece and Ireland, what does 2011 hold for Portugal, Spain and Italy?  The Europeans have largely been resistant to burden-sharing (i.e. making bondholders take a haircut), instead preferring bailouts of troubled members, as this would force European banks to take losses and potentially raise fears concerning their stability.  It will be worth watching to see if there's any impact from the Irish election in March, where the opposition currently lead by double digits and are threatening to press for debt reduction.

-The make-up of the Fed and Politics
Ron Paul, author of “End the Fed”, is now the chairman of the sub-committee charged with overseeing the Fed which should prove for closer Congressional scrutiny and livelier hearings.  However, a more important change is in the voting make-up of the Federal Reserve; 2 of the new voting Federal Reserve Bank presidents (Charles Plosser, Philly Fed, and Richard Fisher, Dallas Fed) oppose QE and a third (Narayana Kocherlakota, Minneapolis Fed), is skeptical that it will work.   They replace three of the “doves” (Rosengren (Boston Fed), Pianalto (Cleveland Fed) and Bullard (St. Louis Fed), which may not make QE3 as inevitable as it currently seems.

-Inflation (in China)
Our Man has talked about inflation in China before, in large part because it presents great difficulties for the economic planners there.  The two biggest ways that the Chinese have been trying to control it is through raising rates and controlling credit expansion (directly, or indirectly via the banks’ reserve ratios).  However, both of these have the potential impact of slowing down their economy growth which has been a driver of Global growth (and especially commodity prices) and is expected to grow at 10% (ad infinitum!).  Furthermore, given the possibility of a credit-driven bubble in Chinese property are the Chinese about to discover (like their Western peers) that it’s not easy to engineer a soft-landing from a credit boom?

- Global Trade, Protectionism & Emerging Asian Economies
For those who are historically minded, the steady decline of Global Trade and the rise of Protectionism, was one of the noticeable features of the 1930's depression in the US.  With many seeing Quantitative Easing (QE) as an attempt to weaken the dollar, others accusing China of currency manipulation and most countries still hoping to drive GDP gains through increases in exports, it is little surprise that rhetoric surrounding trade wars continues to increase.  Let’s hope we don’t see an equivalent of the Kindleberger spiral for 2010’s!

- Valuation
Though market participants always seem to manage to call the market ‘cheap’, from Our Man’s perspective the market does not appear cheap based on long-term measures.  Both the Shiller CAPE ratio (currently 22x vs. a historical average of 16.5x), and the Tobin’s Q (Q3-end 1.05x vs. a historical average of 0.70x) suggest that markets are over-valued.  While these long-term measures have not helped investors time the markets, they have served as good long-term guides to valuation and are worth noting.