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End of days, or just a major recession?

By Justin Fox

Ezra said I'd be writing about "all things money." So I just wasted 15 minutes watching "Swingers" clips on YouTube, then thought: Maybe I should write about actual money. Such as the $33.12 billion that U.S. investors withdrew from domestic stock mutual funds in the first seven months of the year.

The NYT, which put this news on the front page of Sunday's paper, quoted Brian K. Reid, chief economist of the Investment Company Institute (the compiler of the mutual fund flows data), as he scratched his head:

At this stage in the economic cycle, $10 to $20 billion would normally be flowing into domestic equity funds. This is very unusual.

Well, depends what kind of economic cycle you're talking about. For a run-of-the-mill recession and recovery, yeah, this is unusual. For a big-time, era-shifting financial market bust, like in the 1930s and 1970s, this is just what happens. Small investors, lured into the market by a decade or more of good times (the 1920s, the 1950s and early 1960s, the 1980s and 1990s), sour on stocks during the ugly time that follows. Their departure eventually brings prices down to more-than-reasonable levels, paving the way for a long rise in stock prices, the early stages of which will entirely bypass all those small investors who bailed out.

At least, that's what happened in the past. There's no absolute guarantee that it will happen again in the future: This could be the beginning of the end of civilization, in which case gold, canned goods and archery supplies (and maybe enriched plutonium) are the only safe investments. Or, some other risky investment vehicle could supplant stocks and funds that hold stocks as the small investor's favorite way to share in the economy's growth.

I'm going to count both of those outcomes as unlikely. Meaning that we should expect a long bull market in stocks. It will, among other things, richly reward the minority who were pouring money into equities as everyone else was pulling out. It will result in upward revisions to the gloomiest current assessments of future federal deficits and state pension shortfalls. It will mean that, someday, Dow 36,000 will be a reality.

Ah, but when? Sorry, I haven't the faintest.

Justin Fox is editorial director of the Harvard Business Review Group and author of "The Myth of the Rational Market."

By Justin Fox  |  August 23, 2010; 11:00 AM ET
 
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Comments

People are pulling out because the rate hike is expected to come in a few months. It's time to expose your capital gains to the tax man; this should reverse in January, unless the Dems **** it up.

In addition, boomers hitting retirement will start liquifying 401K stock assets, and some will transition stocks to bonds 5-10 years before hitting retirement. This should continue to put a downward pressure on the market for the next decade.

I really don't see how (A) anyone can possibly be suprised to see this market pullout, which you could have set your watch to 7 years ago when the temporary cap gains rate cut passed or (B) why anyone would try to make a broader market interpretation with both of these massive market distorting effects in play.

Posted by: eggnogfool | August 23, 2010 11:49 AM | Report abuse

Could it be that people are simply withdrawing this money to pay current expenses?

Posted by: paul314 | August 23, 2010 12:00 PM | Report abuse

We've had 6 comparable recessions since 1950, though the latest may be the worst of those. The recovery from this recession, though, has been miserably weak for the U.S. and many countries of the world, but not all.

Some countries, notably Canada and Germany, are having a much stronger recovery than other countries, such as Greece and the U.S.A.

So, what could the problem be? Just weeks after Obama took office, by March 15,2009, the Obama Administration reported seeing the "green shoots" of an economic recovery. That was before the first dollar of Obama's stimulus had been spent. Indeed by June positive GDP growth had returned. Again before the 'stimulus' funds reached the economy.

Posted by: mgsorens | August 23, 2010 12:00 PM | Report abuse

@mgsorens:
The stimulus passed in late February, and the stock market immediately began a sustained recovery. Take home pay increased due to "Making Work Pay" starting in April.

Traditionally, residential construction has led us out of recessions. That's not available this time around, so a slow recovery was to be expected (and was projected by the Obama administration from the outset).

Posted by: eggnogfool | August 23, 2010 12:23 PM | Report abuse

The capital gains tax is really overdone as a factor. The current rate is 15% on long-term gains (held > 1 year), and if the Bush tax cuts expire it will go to 20%, what it was under Bill Clinton. That is an increase in 5% of the gain, not 5% of the total sales price. Plus, many people lost money in the past couple of years, which can be used to offset gains.

IMHO this is a non-issue except for a very small (less than 1%) segment of the population, and I'd hazard a guess none of them post here.

What has soured people on stocks is simply the perception that the stock market is a casino operated by hedge funds, machines and flippers and that as an investment vehicle stocks are really pretty risky. The problem is that with interest rates so low, there aren't good savings vehicles for average people.

Posted by: Mimikatz | August 23, 2010 12:40 PM | Report abuse

@eggnogfool,
Yes, I agree that consumer confidence did spike upward when 'stimulus' was passed.

It seems that GDP growth had actually turned around at the beginning of January, though it took some months to arrive at positive growth.

I'm not one of those who claims the 'stimulus' did nothing at all, though it has performed much worse than even most detractors thought it would.

My point is that, the consensus among economists that the debt and deficit are presently the most critical problems we have to deal with. Countries that have dealt with their deficits are currently enjoying robust recoveries.

Posted by: mgsorens | August 23, 2010 12:41 PM | Report abuse

Indeed. Tulips, tech stocks, housing. Where's the next bubble? Apparently U.S. gov't bonds (which is where the equity money is flowing to). Yields going lower and lower each week.

Are the odds better that yields continue to fall? Or that they increase to more reasonable levels? Seems to me the odds favor the later overwhelmingly. Which means significant losses for today's bond investor. Ooops, did it again!

Best place right now to invest would seem to be dividend paying stocks. Again, which has better odds: we're being too optimistic about the economy and should be investing in fishing poles and sod houses? Or we herd animals are just as wrong now as pre-crash and the economy is more resilient than common wisdom?

I'd say the later. I can't recall the last recovery from recession that didn't have headlines asking: where are the jobs?

(Note: this isn't an argument that government shouldn't be working on further stimulus and accommodation projects. I for one would have the gov't extending much more aid to the states, undertaking a large infrastructure remediation project, and directly hiring long-term unemployed rather than just continuing sending them checks for nothing. And I would make it a priority in the next Congress to pass spending controls and tax reform to take effect within a few years.)

Posted by: Jamesaust | August 23, 2010 1:05 PM | Report abuse

@Mimikatz: "IMHO this is a non-issue except for a very small (less than 1%) segment of the population, and I'd hazard a guess none of them post here."

Depends on what you mean by 'non-issue'. it's a non-issue for our broad economic outlook, but your "1%" represents around 35% of American wealth, and a much greater % of investment wealth. When they behave a certain way, the market is affected. The CBO projects capital gains realizations to spike up about 25% this year relative to 2009 and 2011; in a year with stagnant home prices and a stagant stock market, that's fairly significant.

@mgsorens: "performed much worse than its detractors thought it would"

Which is to say, the economy is worse today than many stimulus opponents expected. The same people who told us about "the myth of the so-called 'housing bubble'" and "DOW 36,000" and "the fundamentals of the economy are strong." There is a reason the American people sent them packing; they were and are morons.

In practice, the economy is performing very close to the initial projections that came with the stimulus package; those models suggested it would be much worse without the stimulus. Some pointed out at the time that the with-stimulus recovery projection was a pretty depressing forecast. Some weren't paying much attention.

Posted by: eggnogfool | August 23, 2010 1:43 PM | Report abuse

Archery supplies? What kind of self respecting survivalist would hoard archery supplies? Guns and ammo, gold, and canned goods.

Sheesh

Posted by: bgmma50 | August 23, 2010 1:55 PM | Report abuse

"Indeed. Tulips, tech stocks, housing. Where's the next bubble? Apparently U.S. gov't bonds (which is where the equity money is flowing to). Yields going lower and lower each week."

Jamesaust,
The bubble call depends on fundamentals. Are low yields always indicative of a bubble?

The U.S. 10 year bond is yielding 2.6%, and the Japanese 10 year bond is yielding 0.93%. Given that Japan has a long run trend of stable prices going back to the early nineties, the 10 year yield here is consistent with 1.7% inflation expectations over the next decade if you assume investors in U.S. and Japanese bonds require a similar real return. The Japanese 10 year yield has been consistently below present U.S. levels since 1997.

In addition, the probability of a double dip in the U.S. is high (David Rosenberg is calling it 'single scoop', in that the 2009 recovery was an inventory cycle mirage). Q2 growth looks likely to be revised down to near 1%, and Rosenberg in particular expects Q3 to be -0.5% to -1.0%. If the economy does resume contraction, long duration govvies will continue to rally, short duration govvies already yield nothing and stocks of all stripes will tank. Even low growth of 1% for the next year or two would be good for bonds.

If the economy returns to what we would perceive as normal, then you are correct - bond holders will be smoked. But I don't think that implies a bubble per se. A bubble requires valuations to be completely out of touch with fundamentals. Given the downside risks to the economy, and the experience of Japan after its own credit bubble burst, I don't think we can call bond valuations bubbly just yet.

Posted by: justin84 | August 23, 2010 2:05 PM | Report abuse

"I'm not one of those who claims the 'stimulus' did nothing at all, though it has performed much worse than even most detractors thought it would."

There are many problems with fiscal stimulus:

1) The effect on the economy cannot be measured. As an example, a good model should include a central bank reaction funtion, meaning that the central bank will change the amount of monetary stimulus based on the amount of fiscal stimulus. This reaction function is unknowable in practice, and to the extent the Fed targets inflation it should be a very close offset.

2) Let's assume the stimulus was not offset by the Fed intentionally. At this point, the question becomes did the stimulus reduce the demand for money, and by doing so boost demand? This cannot be known with any certainty either, but let's assume that it did.

3) Does the stimulus create sustainable patterns of specialization and trade? Or does it generate a burst of short-term activity which melts away as the stimulus is withdrawn? By it's very nature as a short term infusion (or more appropriately a transfer) of cash, most of the activity generated by the stimulus is temporary. A frenzy of repaving roads is not sustainable - the roads will not need repaving afterwards. Even filling in state and local deficits isn't sustainable unless it lasts for many years - effectively becoming more a new source of financing rather than stimulus per se.

As a cost, it is easy to see why the alternative source of funds had stimulus not occurred would have been directed, on balance, to more sustainable uses. Investments of little marginal value are also less likely to be made in the private sector (e.g. repaving perfectly fine roads).

While GDP might not have bounced as quickly, the eventual bounce would have been far more durable.

After the GDP bounce fades, you are left with a huge pile of debt.

Posted by: justin84 | August 23, 2010 2:56 PM | Report abuse

Some level of equity fund withdrawal is perfectly understandable and even laudable in light of the fact that stocks had a fantastically good year in 2009. Anyone who sets reasonable equity allocations and rebalances when things get out of alignment sold stocks this year. And good for us!

Posted by: ckbryant | August 23, 2010 3:21 PM | Report abuse

"If the economy returns to what we would perceive as normal, then you are correct - bond holders will be smoked."

If?

I would think that the odds of a return to normal for a 10 year bond holder would be exceedingly high. As such, these bond holders are (as you put it) "smoked." The Fed I believe will amaze all at the speed they rush to withdraw liquidity from the markets at the first firm sign of lasting growth. Bond holders will be lucky if yields are not double a year later.

Likewise, the likihood of a double-dip. There's no shortage of economists who put the odds at "high" but it's important to remember that "high" odds are still very low odds. That is, is "high" a relative or absolute measure? I don't know of anyone who has tried to average these guesses but I'd say the mean guess is about 25% -- low in likihood but very high compared to what we'd typically expect.

(If I told you the odds of an airplane crash today was 25%, I'd also say that was "high" as I would normally anticipate a figure far short of 1%. But I still wouldn't faint from fear even if I was flying.)

For what it may be worth, the Treasury spread, which has a near perfect predictive record, gives no chance to a double dip. We're at 2003-2005 levels of lows. (Granted, this figure has been unusually manipulated by Fed actions and with real interest rates near zero might not be as predictive as previously. Still...if it happened there'd be a generation of Ph.D.s writing their thesis on 'how the hell that happened'.)

So, I stand by my claim: the most likely course of events is that the economy staggers into growth leading to a rally in equities and a lot of bondholders learning that buying bonds isn't any more of a sure thing than any other "bubble."

Posted by: Jamesaust | August 23, 2010 7:44 PM | Report abuse

@Jamesaust--

Well, I guess that's the nature of the beast, no? You pays your money and you takes your choice. Do I read you correctly in predicting a doubling of the yield on the 10-year Treasury a year from now? Or only a year from some unspecified point at which the Fed elects to start removing liquidity? If the former, I'll shake your hand on a gentlemen's wager. Let's bookmark and check back August 23, 2011. Bragging rights to the victor.

My guess is that the economy will still be perfectly lousy--we will have avoided, technically, a double-dip, but rates will be bouncing along the floor and equities will be more likely down than up--possibly by a great deal. Government is paralyzed (possibly with a Republican House), the Fed remains reluctant to move, and inflation is 1% or less per annum. For what it's worth, I remain about 60% in equities, because I'm bullish on the next 40 years and no one knows when the next rally is coming. But I tell ya--I could be out 30% of that money a year from now, and I don't think I'd be too shocked. I guess my dividend yield will look just GREAT then.

Posted by: ckbryant | August 23, 2010 10:13 PM | Report abuse

"I would think that the odds of a return to normal for a 10 year bond holder would be exceedingly high. As such, these bond holders are (as you put it) "smoked."

The economy has so far suggested little confidence in the typical recovery scenario. During the so-called recovery, final sales (GDP - inventory) has grown at an anemic 1% annual pace, even with all of the fiscal and monetary stimulus. Unemployment is only below 10% because the labor force has shrunk in the wake of recession.

But suppose that the recovery does strengthen and I am completely wrong. I admit I cannot predict the future. While bond holders take capital losses today, they are (more or less) guaranteed a 2.6% annual return over the next 10 years.

What of the meantime? Well, a return to 4.5% yields would mean for an investor in a Aug 2020 2.6% bond to take a capital loss of 15% if it occurred instantaneously. Smoked from a trader's perspective, but hardly bubbly in the sense of a dot.com stock or a property in Vegas circa 2006.

It is hard to think of many bubbles in which a buyer at the top could not only expect, but expect with a federal guarantee, a positive nominal return over a 10 year period (and in all probability the return to a profitable position would be much less than 10 years).

http://www.smartmoney.com/investing/bonds/bond-calculator-7917/

"If I told you the odds of an airplane crash today was 25%, I'd also say that was "high" as I would normally anticipate a figure far short of 1%. But I still wouldn't faint from fear even if I was flying."

I commend your bravery. I would faint.

"For what it may be worth, the Treasury spread, which has a near perfect predictive record, gives no chance to a double dip. We're at 2003-2005 levels of lows."

This raises the question of what we'd expect Treasuries to do if recession risks were high and rising. The short bond is already trading at little yield. The answer is that we'd expect the Treasury curve to flatten with long yields screaming in, which is what we see now.

I'm not sure the Fed's treasury purchases were the driving force in the market over the past several months either:

http://www.clevelandfed.org/research/data/credit_easing/index.cfm

The Fed's yield curve model is useful to predict recessions when the Fed pushes short rates above long rates, but it breaks down when short rates are low. We have do have some experience of what happens when short rates are stuck near zero. In 1937 we had a particularly awful recession which extended the Great Depression for several years.

In August 1936, the 3mo tbill was at 0.20%, and the average long bond was yielding 2.64%.

These are quite close to the August 2010 yields. Contraction later this year or in 2011 is not something we can rule out via the yield curve.

http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/

http://research.stlouisfed.org/fred2/data/LTGOVTBD.txt

http://research.stlouisfed.org/fred2/data/TB3MS.txt

Posted by: justin84 | August 24, 2010 12:25 AM | Report abuse

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