The Bloodless Verdict of the Marketplace.

October 3, 2011

[Today's missive is best accompanied by the Russian State Symphony Orchestra's rendition of O Fortuna. Neither this review, nor its musical accompaniment, are for the faint of heart.]
. . .
The third quarter ended last week. These last three months saw the S&P 500 lose 14 percent of its value. Increasingly, it appears that the supposed "soft patch" oft mentioned by optimistic economists may be the harbinger of something worse.
Prognosticators have told us these markets are undervalued. Warren Buffett has extolled on the vice of betting against the U.S. economy. Dr. Bernanke has used every weapon in his arsenal to prime the pump. And yet, here we are.
Employment data? Bad. Manufacturing activity? Bad. Productivity? Bad. The global economic outlook? You've got it.
What exactly did the markets say these last three months? Simply that, regardless of any amount of cajoling, stimulus or manipulation, the economy may be beyond help.
Risk assets appear to be headed lower. How much lower? Much. As I write this I'm watching the S&P 500 dip beneath the 1100 line.
The markets are telling us that recession may already he upon us.
We hope that the market, and our translation of it, is wrong. We hope that the tea leaves are incorrect. But the ugly evidence grows daily.
At some point, one of three things will occur:
1) Recession fears and Europe's problems will prove overblown, and third-quarter earnings will be the catalyst to send markets higher.
2) A recession is a forgone conclusion, in which case you should be selling risk assets and buying those that stand a chance to ride the oncoming waves.
3) The status quo will continue, keeping stocks in a trading range and offering the opportunity to selectively dip your toes while also accumulating attractive fixed yields and low-correlation assets.
Three choices. Pick one. Do something. Because in this type of market, indecision can get you hurt.
The late Senator John Spooner, while reading The Wall Street Journal one morning, marveled at the merciless accuracy of the market in predicting economic trends, patterns and outcomes.
"Listen to the bloodless verdict of the marketplace," pontificated Senator Spooner.
Now, pontification from the elected class is hardly surprising. But the senator's assessment of the market's cold calculus in forecasting the unknown was insightful.
The stock market is a capital allocation mechanism. It takes the opinions of millions of investors each and every day, allowing them to vote on how and where their hard-earned dollars will be best spent. Their motivation? Profit. Their objective? Mitigating risk.
The market is not a beauty contest, a Hollywood script or even a political election. For the marketplace leaves no room for politics. If you prove an ability to wisely expend capital and provide a return to investors, you are given more. If you cannot, you receive nothing. A meritocracy. Do your job? Get rewarded. Do a poor job? Get cut off.
There are no special interest groups. No elections. No stump speeches. There is return on invested capital. And that does not lie.
As of now, the market is telling us to watch out below. The trajectory of our slowing economy and that of events in Europe are on a crash course that has few happy outcomes.
No less an authority than Doubleline's Jeff Gundlach has recently portended that a recession is baked into the pie. According to him, there is little to be done about it. We can only prepare.
Further, the Economic Cycle Research Institute (ECRI), of which we have written before, recently assessed that the U.S. economy is already in a recession. Significantly, the ECRI's Weekly Leading Index tool has been one of the most astute forecasting mechanisms when it comes to recessions and recoveries.
Moreover, last week saw Dr. Ben Bernanke deliver a blasé speech on the "lessons from emerging market economies." Yawn.
But, his post-speech remarks? Compelling.
Bernanke bemoaned the current labor market, calling it a "national crisis." He explained that "we've had close to 10-percent unemployment now for a number of years, and of the people who are unemployed, about 45% have been unemployed for six months or more... This is unheard of."
He called on D.C. to create policies that could help them find work. Training. And he mentioned that, if inflation falls too far, the Fed would have to respond in order to prevent deflation.
The Fed Chairman is in full retreat. He is handing the ball back to the politicians. Signaling that he has played his hand. "It's your problem now," Bernanke is essentially telling our elected officials.
[Increase the volume of O Fortuna.]
This time? It's not different. This recovery has unfolded like every other credit-driven crisis recovery the nation has experienced. What was different was the weak, politically oriented, unfocused response.
Last week I attended a lunch at which the heads of three regional private equity firms spoke. They opined on the state of investment, private equity, and growth. Their opinions varied. But, they each appeared to be perfectly correlated in their belief that, until the politicians in D.C. clear up this foggy, inhospitable environment, companies will be hard pressed to invest in themselves and this economy.
Like ships in the night, corporations need to be able to discern what lay ahead in order to chart a course. And the environment perpetuated by our elected officials these last few years has clarified nothing. Healthcare expenditures? Nobody knows. Financial reporting obligations? Nobody knows. The taxation of revenue, dividends and investment capital? Nobody knows. The regulatory picture? Nobody knows.
There is a reason that D.C. is one of a couple of areas in the country that has seen rising home prices, more jobs and economic growth these last few years. Because in the nation's capital, politics is a growth industry. Everywhere else, where the bloodless verdict of the marketplace determines the success of every decision, tactic and strategy, uncertainty rules the day.
Ships do not sail into storms. Planes fly around them. Why should businesses, who have shareholders to whom they must answer, spend their capital when the risk-to-reward ratio is indiscernible?
In economics, supply and demand has the same affect that the law of gravity exerts upon our physical world. It determines everything. It may be manipulated for brief periods, but eventually the dynamic wins out.
In politics, there are no omnipotent laws of the universe to which everything can be applied. There are special interest groups. Focus groups. Electoral votes. And idealistic voters with nothing at stake--so a promise goes a long way. At least until its proven otherwise. Usually long after the election.
In the marketplace, an unfulfilled promise gets you fired. It is a meritocracy. Good work is rewarded. Every coup is bloodless.
Yet, enough editorializing.
Bottom line? It appears that the frying pan is behind us. Fire ahead.

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