“Kee” Points with Jim Kee, Ph.D.

Markets sold off last week amidst generally positive economic data. US factory activity, according to the ISM’s manufacturing index, is at a 3-year high, and Chinese manufacturing activity rose to a 27-month high (according to official Chinese government measures as well as HSBC’s survey). European and Japanese measures remain flat to challenging near-term. The S&P 500 is down a little over 3% from its recent July 24th peak of 1987.98. Stock market pullbacks are to be expected, and this one is being chalked up to, among other things, the “good news is bad news” thesis, meaning that good economic data in the United States is reacted to poorly by the market because it hastens the date at which the Fed will start raising short-term interest rates (from basically zero). I’m not really fond of that analysis, and I’ll share a few thoughts on that as well as other reasons for the market selloff below.

 

Good news is bad news: Perhaps that explains transient ups and downs in the market short-term, but longer-term good news is definitely good news. The error in some of the reasoning, in my opinion, stems from a simplistic view of Fed actions since the crash and the remarkable stock market rebound that has occurred since then. During the bleak 2007-2009 period the world, literally, was on the brink of a global financial meltdown. The situation was actually worse, according to several Nobel Laureates who specialize in macroeconomics, than during the Great Depression of the 1930s. But the policy response on the part of the central bank - acting as a lender of last resort and rushing to get liquidity in the market - was the exact opposite of what occurred in the 1930s, and that made all of the difference. The market rebound was a reversal of the prior crash as confidence returned.

 

So has Fed policy been “goosing the market”? If that were true, stock market valuation levels would be totally disconnected from fundamentals (i.e. earnings and cash flow), but that’s not what we see. Current valuation levels are not stretched (or really cheap!) by any reasonable historic measures, including price-to-earnings ratios and price-to-book ratios, as well as more elaborate discounted cash flow estimates of equity risk premiums. The money, really excess reserves in the banking system that the Fed has created, is still sitting at the Fed, not “goosing the market.” Inflation measures reflect that, and those measures aren’t seriously or deliberately understating inflation: recall that in the decade prior to the crash the story was that government statistics were overstating inflation(!). Back in 2008, the BLS (Bureau of Labor Statistics) published a great research piece, “Addressing misconceptions about the Consumer Price Index,” which I’d love to walk through in Kee Points if we ever get a slow news week. Among other things, the piece points out that most criticisms of the CPI come from “bloggers, magazine writers, and others in the popular press,” not from academic journal articles and panel reports. These criticisms have not been aimed at the BLS, which calculates the measure, but at the public at large, sowing much misunderstanding. And remember, private sector initiatives to measure inflation (e.g. Google’s “Google Price Index” and M.I.T’s “Billion Prices Project”) are fairly close to the official CPI measures.

 

Global debt problems: Portugal unveiled a rescue plan late Sunday evening to rescue the country’s second largest lender, Banco Espirito Santa. I think the swiftness and size (6.6 billion euros) of the rescue plan is the important lesson here. And Argentina has defaulted on $29 billion in debt by missing a 30-day grace period on $539 million worth of interest payments. Talks are underway between Argentina’s government and creditors, including J.P. Morgan Chase, to help Argentina pay off portions of its debt and resume payments to bondholders (WSJ). I think the lesson here is that Argentina’s debt problems reflect the rather sad and ongoing state of Argentine politics. Fed Chairman Janet Yellen spoke of pockets of seemingly overvalued debt instruments, like high yield or junk bonds, and I would put a lot of emerging market debt in that category. These are some of the reasons why we at STMM staunchly avoid going too far down the fixed income risk continuum (taking on more risk) for incrementally higher yields. Bad risk/reward tradeoff! Holding high quality individual securities in your portfolio is the antidote to these sorts of worries. That’s what we do.

 

Ongoing Russian/Ukraine and Israel/Hamas turmoil: The Wall Street Journal recently published an article, “Bill Gates’ Favorite Business Book,” about Business Adventures, first published in 1969 and given to Gates as a gift from Warren Buffett. I took interest in the article because the focus of the book’s first chapter is the “flash crash” that occurred on May 29, 1962, the year of my birth. But that chapter was also a great account of how market analysts struggle for explanations of temporary panics, often never reaching consensus even decades afterward. That specific episode was part of the brief bear market of December 1961 to October 1962, no doubt attributable to the Cold War nuclear panic that occurred amidst the Bay of Pigs Invasion (April 1961) and Cuban Missile Crisis ( October 1962). I don’t put the current situation in that category, but I do think of wars and confrontations - from an investment perspective - as being on a continuum between localized or regional conflicts, which are ongoing, and threats (like in 1962) of global wars (WWI and II) and/or nuclear annihilation. Within that framework, I place the current conflicts closer to the former rather than the latter.