Can spending hold up?

Overview of the the current state of the US economy

The American economy is contracting at its steepest pace in 50 years, the government reported on Wednesday, but an unanticipated rise in consumer spending since January suggested to many economists that the worst of the recession might have passed

Output fell at a 6.1 percent annual rate in the January-through-March quarter after falling at a rate of 6.3 percent in last year’s fourth quar
Analysts are expecting that as tax breaks and government stimulus spending kick in, the decline in the gross domestic product could be cut in half by summer by federal spending and on various small windfalls for consumers

The looming question remains the severity of job losses. More than five million jobs have disappeared since the recession began in December 2007. As their wages disappear, households spend less, and business, in response, reduces the output of goods and services, cutting more jobs in the process.

Eric Tan

Thoughts on being "cautiously optimistic" on the economy.

Key question to ask: Can an inventory-driven recovery in output, alongside aggressively expansionary monetary and fiscal policy, generate enough optimism among consumers, producers, and lenders to make the recovery sustainable for more than a few months?

any thoughts ?

PPIP: A Stampede on Thin Ice. Markets for the week ending 27-Mar

The S&P 500 Index rose more than 6% this week as hope mounted that the worst might be over for the banking system and a turn of the broader global economy is on the way.

As US released more details of its Public Private Investment Plan (PPIP), the US stock market surged 7% overnight but fears on the viability of the plan and likelihood of participation from banks were the main concerns.

My take on the new release is that the US is taking on a "do-everything-it-takes" attitude to rescue the economy and that should set the right tone for investors and stabilise the markets but ultimately it is not the pricing of the legacy assets and loans that will turn around the lack of confidence, but the greater transparency that is attached to this move that will allow the big banks to raise sufficient capital from private markets (in the range of hundreds of billions more) that will call an end to the crisis.

A couple of issues need also to be addressed to stop the economy from spiralling down further:

a) Distressed home sales: Without a clear sign of the bottom of falling house prices, risk appetite will not return. Hence, finance for viable borrowers with sound leverage need to be earmarked to help establish a floor for home valuations

b) Deleveraging of consumer : UK household savings rate jumped from 1.7% in the third quarter of 08 to 4.8% in the fourth quarter. Although rebuilding and repairs of the household balance sheet will bring balance back to the debt-fueled decades of 90's and early 2000's, the governments also need to ensure consumer credit is freed up to improve liquidty for the people. This is not to fuel another debt spending spree, but to inject consumption back into the economy and pull it out of a longer than expected recession.

Final words, Stabilisation is still not equal to Recovery.

Eric Tan, London

How is Gold a play on quantitative easing and debasing of currencies ?

Gold in itself is a relatively smaller market, and say if the market starts to have doubts that Obama will not be able to halve the US deficit by the end of his first term, investors may start to shift their reserves into gold. So let's expand this exponetially to say China or the Middle Eastern states start to do the same with their reserves, we will certainly see new levels of gold prices.

Hence a bet on gold is essentially a bet against all paper currencies and against all central banks, and that seems to be a bet put on by several hedge funds including Paulson's now.

If the Fed is forced to debase the USD because of increasing prospects of deflation or inflation, UBS's forecast of $2500 per ounce gold prices, may not look impossible..

Eric Tan, London

Are we witnessing a possible turn? Markets for the week ending 13-Mar

So it's true. After I commented last week about equities appearing to look cheap, the market has gained several more percentage points. The thought on most investors mind is whether this is another bear market rally or does it signal the possible turn of the bull market.

Anthony Bolton, President of Investments at Fidelity, has called for a bottom in stock, although he did make the same call late last year. My personal opinion is that the economy is not out of the woods yets and this is highly probable to be a bear market rally that may fade in investor memory in time to come.

Bear market rallies are often short and explosive in nature and it's not uncommon to see bounces in excess of 10 percentage points on the stock market indices. I believe that last month's low will mark a temporary floor for global benchmarks and indices may trade sideways, hence it might not be a bad idea to start making some investments in the Equity market although it is most likely moving too early.

Some analysts are still reiterating that the CAPE (cyclically adjusted P/Es) ratios of companies, are still expensive and markets may fall further, but it is very dangerous to time the market and if you are planning to invest for the long term, current valuations appear relatively cheap.

My take as I've mentioned in previous posts is that if you agree property values have stabilised, i.e. levels of personal wealth no longer falling, we should start to see a return of risk appetite in the equity markets and that should initiate the turn of the bear to bull market.

Eric Tan, London

Grantham of GMO urges

If you are a fan of Jeremy Grantham's quarterly letter to his investors, you might be interested to know that he is now urging investors to shift cash into the stock markets.

Grantham dubbed a "perma-bear" for having a negative view of the stock market for 10 years, and correctly predicting the end of the dot-com era and foreseeing in 2007 that the credit bubble would lead to collapse of banks and hedge funds. He reversed his decade long bearish stance on stocks and expects it to return 10-13% in the next 7 years. Grantham recommended investing in a few large steps instead of all at once as it would be impossible to catch the bottom of the market. His fair value estimate of the S&P500 index is 900.

My take is that, the S&P500 currently projects 2009 earnings at $48.10. Given the long term (last 20 years) average earnings of 19.4 it traded at, the current fair value can be estimated at 933. However, in the last 20 years, we've been in a bubble for more than half the time, hence maybe an average earning of 15 would be more conservative, and that would estimate fair value of S&p500 index at 721.

As I am writing this, the S&P500 has already risen more than 6% today to 719, but I would still support Jeremy Grantham's urge to start shifting cash to stock in stages and this is definitely a attractive level on valuation grounds to put your money into the stock markets.

Eric Tan, London

Why Go Long Equities? Week ending 6-Mar

It's true, hedge fund redemptions are still going on. A total of $73bn was redeemed from hedge fund managers in Jan 2009. Given the need to meet client redemptions, highly liquid asset classes such as index futures seem to be the obvious choice for hedge fund managers.

But having witnessed the sharp falls in world equity indices in the last 2 weeks, we wonder what the impact would be on hedge fund performance. HFRX reported dismal Feb-09 results for equity strategies.

I believe this can be partially attributed to the high cost of hedging. Put option interest has been declining since Nov 08 due to higher costs - it costs approximately 25% to purchase a 12 month at-the-money put on SX5E. So implicitly it costs the same amount to buy a put as the estimated downside of the position, and if historically bear market rallies provide a 50% upside, the cost of hedging would have consumed 1/2 of the potential profits.

It would be interesting to find out the average level of protection put on by equity-based hedge funds...

Eric Tan, London