The Economic Roots Of Beta Climates

May 30, 2009


It is best to source researchers who are paid to be contrarians. There are those who often get it right. Last week's Barron's featured "The Incomparable Stephanie Pomboy." Here are direct quotes:

Under the elegant title "Burping Out Loud," Stephanie stands the conventional wisdom on its head on corporate profits and the stock market. We should warn you that recovery isn't currently a prominent part of her lexicon.

Absent the powerful stimulus provided by the unprecedented boom in housing, she sees a huge hit still in the offing for nonfinancial corporate profits. A worst-case analysis is that such profits would sink to 2003 levels, a further decline of $450 billion, or 54%. Under a less exacting (and frightening) estimate, using their relationship to GDP, they would return to their pre-bubble percentage of 3.5%, which translates into a drop from here of $340 billion, or 41%.

Ms. Pomboy often gets it right because she searches for new and old factors that link prices (the micro) to economic fundamentals (the macro). She also believes that the current cycle of recovery, credit, profits and stocks are dependent upon home values and confidence in the financial sector.

Getting it right is dependent upon the identification of primary drivers that move secondary factors. Home values peaked in June 2006 when they were 60% above trend and near a peak in a wider credit bubble. Extreme readings for home values, debt levels and credit spreads (risk premium) in April 2006 were my primary motivators for seeking a leading indicator of housing sentiment, which leads me to builder's sentiment (HMI). Sentiment always leads price. Our hypothesis was confirmed. Housing and credit were bubbles.

Do you recall Federal Reserve Board Chairman Ben Bernanke's estimate of bank loan losses stemming from home mortgage defaults in August 2007? He estimated they would be "up to $100 billion." Back then, he was still living in Normalville. In November 2007, during the New York Economic Club Dinner, he was asked by the renowned economist Henry Kaufman: "If you had a crystal ball, what question would you ask it in an effort to help you with the credit crisis?" His response was: "How the hell do you price these things?" At that moment, I knew we were in very deep trouble. The entire Street was there too. What did they hear? They were deaf.

Building More Alternative Indicators

Our April InPerspective showed how we employ economic scenario frequencies to build all-weather portfolios. Asset diversification has economic roots dominated by inflationary and deflationary boom and bust climates. Asset allocation is aided by economic and asset price indicators. Since consumer spending has represented 65% to 72% of RGDP since the late 1960s, it is an important determinant of our economic view.


Figure 9. Consumer Confidence (Conference Board)



Figure 9 tracks the Conference Board's future (F) and present (P) economic outlooks of U.S. consumers and the National Bureau of Economic Research (NBER) recession periods. Represented here are the monthly ratios of F and P (F:P) and the 36-month moving average of F:P readings since 1997. In 2009 Q1, the short-term (F:P) and long-term (F:P 36m) indictors troughed and then turned higher, which is supportive of a stronger economy. This is one view and below is another.



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