Merrill Lynch just privately published to their clients a very scary report entitled, “The emperors’s new clothes in a post bubble society.” It picks up on some of the economic themes I talked about in “The Cost of Empire”, most specifically,
Regrettably, we have become a bubble society, always in search of the quick-fix strategy to build wealth – Tech, real estate, and now commodities (although though the latest action points to a break in corn and crude prices; corn is down 25% since the end of June!).
They then go on to make two predictions that are decidedly contrarian. The first, contrary to the belief of Morgan and some of our other hawks, is that market for bonds of good quality is going to skyrocket. There will be more demand than supply. Interest rates are not the problem.
Indeed, if there is another bubble around the corner, it is likely to be in bonds, and this will be particularly apparent once the commodity explosion reverses course. We are talking about fixed-income instruments that have an adequate level of credit quality and call protection to provide the type of income characteristics and capital preservation that will satisfy the needs of our society’s actuarial liabilities embedded in retirement portfolios, which represent the largest concentration of investment assets in the financial system ($17 trillion).
In other word’s retirees and pension planners appetite for risk has disappeared. “Give me a 4% coupon and a government guarantee.” The Obama administration will have no problem funding the Keynesian stimulus needed to bring us out of Bush’s near depression.
The second theme is that the equity market cannot start an upward leg until the economy “returns to the mean” in key economic statistics. Three of the charts really jump out at you at which they show (the red line) where the “mean” is, and how far we have traveled in the latest bubble from the mean in corporate profits, consumer spending and real estate.
So corporate profit margins were “off the charts” since about 2004. They have a long way (maybe 50%) to fall to return to the mean. This means current multiples of the S & P 500 will be lower. We are not close to a bottom.
Next up is Consumer Spending. Holy Cow!
This chart backs up my contention that since Ronald Reagan was elected the average middle class consumer has gone crazy in the mall. We are so off the “mean” that Merrill Lynch thinks it’s going to be wrenching for the retail business, the car business, etc.
In the meantime, the economy is over the hill at this point, and the laws of physics dictate that once you are over the hill, you pick up speed. The $120 billion tax rebate is nothing more than a Band-Aid because this economy is not one iPod short of prosperity. In our view, it is too overstocked with monster homes, shopping centers and SUVs. Using temporary tax rebates only cushions the impact from the “need to get small”, as Japan found out in the early 1990s when the government attempted to fiscally reflate into a credit crunch. Using the Japan post-bubble experience of the 1990s as a benchmark for comparison purposes may not be such a stretch as many people think it is because this is increasingly looking like a very similar secular bear market in equities. We say this because there is no other way to characterize a backdrop, as aptly described by Rich Bernstein, in which the S&P 500 has generated a negative total return in real terms over the past ten years. Over that time period, cash has outperformed equities by 1,000 basis points and long bonds have outperformed by 6,000 basis points. If Rich believed these patterns were about to reverse course, he wouldn’t have boosted the bond weighting in his asset mix recommendation by 15 percentage points last month.
I promise you, this report was only released this morning, but it repeats my opening paragraph in Cost of Empire.
Finally, the killer–The Housing Market.
You get the point. Once again we are way off the mean, and will have to return there. This is going to be more painful than anyone realizes.