Saturday, December 20, 2008

IR WARNING/the Japanese Experience with Deflation/Debasement of the U.S. Currency

Late last week, Ingersoll Rand (IR) slashed its guidance for the 4th quarter to .20- .30 from its prior guidance in October of $.55 to $.75.  The October guidance was itself a lowered forecast.  This indicates again a steepening of the economic downturn as the 4th quarter has progressed, far exceeding the anticipated slowdown forecasted by most industrial companies in October.  Similarly, Pentair (PNR) also cut its forecast for the 4th quarter and for 2009, and further announced 1600 job cuts.  I started a small position in IR a few weeks ago but I have placed further adds on hold as the information flow continues to indicate an ever deepening worldwide recession. | Reuters 
A lot of bad news is already baked in Ingersoll's share price and the last warning ended up having little impact on the stock by the end of last week.  IR is hovering at 1997 price having lost more than a decade of price appreciation which is not unusual.  

The technical analyst who writes for Barron's reads the markets tea leaves as setting the stage for a rally.
If one occurs from the current levels, I would agree with his assessment that it would not be the start of a bull market rally.  I would just characterize any rally now as a bear market rally off oversold conditions.  

Since some of the parallels between the experience of Japan after 1989 and our current predicament become more apparent by the day, including the response to the current economic cycle by the U.S. government and the Fed, more prognosticators are predicting an even greater fall in the long bond treasury rates, predicting the possibility of a 1% yield for the long bond and 3 to 4% mortgage rates.
The prediction of a continued fall in treasury rates is predicated on the deflationary cycle continuing for some time as leverage is unwound in the financial system.  The above referenced article, appearing in  the online edition of Barrons  written by Randall Forsyth,  points out that there was recently $3.5 in debt for every dollar in GDP which is an unprecedented level .  A continued flight to U.S. treasuries is certainly a possibility, and it may very well be the most reasonable prediction for the next six months.  We are already close to the rates suggested in this article.  I still believe that the massive federal stimulus that Obama and the new Congress will soon enact, along with the new money creation and the quantitative easing by the Federal Reserve Reuters, will ultimately cause a weakening of the dollar, a rise in inflation and an acceleration of growth starting sometime in the later part of 2009.  If that scenario pans out, which is my current prediction, then a play on the long treasury going to 2 to 1% will have to be a very nimble trade at this point, which I am not willing to even try.   In that regard, I share the sentiment expressed by Rob Arnott in his interview in this week's Barrons.
I do not agree with Arnott's suggestion of increasing the allocation to emerging market debt.  A reading of my posts over the past two months would reveal my agreement with his opinion about investment grade corporate debt since I drastically increased my allocation during the recent market meltdown, with many but not all of the buys mentioned in these posts.  The months of September through November were historic opportunities to add to investment grade bond positions. 

 A good summary of Japan's efforts at fiscal stimulus can be found in this opinion article from the
For more discussion about quantitative easing, see:

My view, which should only have importance to me, is that the Federal Reserve is currently embarked on a massive and unprecedented debasement of the U.S. currency by flooding the market with paper money backed  only by the full faith and credit of a debt-ladened country.   I can not understand why anyone is lending this beast money for thirty years at 2%.  That is one reason why I intend to hedge my long corporate bond portfolio with a double short ETF for the long Treasury bond.   I may be wrong about the future but I have to invest my money based on what I believe to be the likely outcome to the extreme measures now being undertaken to break the fall from an ill-advised credit expansion in the private sector. 

For those who slavishly look at the Japanese experience to justify recommendations now, it is apparent to me that the bubble in Japanese real estate was far more severe than anything that has happened in the U.S. over the past few years.  In 1991, the price of Japanese real estate was about four times greater than all of the property in the U.S. at the time.  New York Times
Their stock market was likewise inflated to extreme levels in 1989.  P/E ratios were in the 80s and 90s with most companies paying no or minuscule dividends.  Seeking Alpha 
The bubble in the U.S. for real estate  did not reach such epic proportions and was largely confined to a few states that experienced parabolic rises in residential housing.  The U.S. stock market began the current decline from levels nowhere near the Japanese froth in 1989.  The closest that the U.S. market came to the silly valuations prevalent in Japan in 1989 was the Nasdaq madness in 1999 to 2000.  It has also been difficult for the domestic Japanese economy to grow due to the Japanese being savers rather than reckless spenders.  The U.S. is chock full of tens of millions of reckless spenders whose forward looking time span is about one day in the remote control nation,  and those people in desperate need of a spendthrift trust will eventually resort to their old habits, thereby helping to pull the U.S. and most of the world out of its current slump.  The U.S. also has  a more entrepreneurial and risk taking culture.   The Japanese central bank and government were very slow to respond to the deflationary popping of their bubbles.  So there are only so many parallels that can be drawn between the Japanese experience and the current downturn in the U.S.  

The Japanese experience does however highlight the problem of static asset allocation percentages for a major asset class like stocks. Japanese Market
The Nikkii average had a major bull run, along with Japanese real estate prices, in the 1980s peaking at around 39,000 in 1989.  It closed Friday, 12/19/2008,  at 8588.  This would constitute an obvious failure of a major asset class for anyone in Japan attempting to allocate a fixed percentage to the total Japanese stock market, something similar to Bogle's recommendation for the U.S. investor in the U.S. stock market.  Before you say that was Japan, not the U.S.,  I would hasten to add the S & P 500 is now at 888 which is where it was in April 1997.   The proponent of static allocation percentages will just say wait it out, but that poor Japanese investor from the late 1980s is still waiting.  Similar periods have happened in the U.S., as in the period between 1965 to 1982. (the S & P 500 hit 102 in August 1982 and it was at 92 in 1965)  That is a long time for a major asset class to deliver no return, with the purchasing power of money falling significantly during that period due to inflation which hit double digits for part of that period.  Historical Inflation data from 1914 to the present
While my dynamic allocation approach saved me a great deal during the current downturn, with a large shift out of stocks in 2007 and out of certain stock sectors like small caps and emerging markets,  I was not aggressive enough in lowering my allocations to stocks since I failed to anticipate the magnitude and duration of the current bear.  

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