Demographic Blues

The Federal Reserve Bank of San Francisco published a fascinating piece of research on Monday relating U.S. stock market performance to demographic trends. The results are not encouraging for long-term 'Buy and Hold' type investors.

Boomer Retirement: Headwinds for U.S. Equity Markets?

By Zheng Liu and Mark M. Spiegel

Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.

Historical data suggests a strong relationship exists between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, Boomers are likely to shift from a bias toward saving and buying stocks, to selling their equity holdings to finance retirement. Statistical models suggest that this shift could substantially depress equity valuations over the next 15 years or more.

Without belaboring the mechanics of the study, the researchers analyzed trends in the proportion of middle-aged workers in the U.S. economy relative to the proportion of retired workers to forecast future stock market valuations. This research follows other studies which found that the booming markets of the 1980s and 1990s were largely attributable to the bulge bracket of baby boomers who were entering their prime saving and investing years during those decades.

In contrast, the current Federal Reserve study finds that, as the ratio of middle aged workers to retired persons is forecast to fall persistently through 2025 as the bulk of baby boomers retire, these same boomers will be withdrawing savings from stock and bond markets, thereby exerting slow but steady downward pressure on prices of financial assets, including stocks, for the foreseeable future.

The specific demographic ratio analyzed in the study is the M/O ratio, which is the population ratio of those aged 40 - 49 to those aged 60 - 69. This ratio broadly captures the number of people in prime saving and investing years relative to the number of people who are beginning to withdraw from savings to fund retirement. From 1981 to 2000 this ratio increased from 0.18 to 0.74 at the same time stock valuations rose from roughly 8 times earnings to almost 30, and the main U.S. stock market index exploded from 150 to almost 1500.

Source: Stockcharts.com

Sadly, the U.S. Census Bureau is forecasting exactly the opposite dynamic to play out over the next 15 years as boomers retire. As this demographic scenario unfolds, the Federal Reserve Bank's model suggests that stock prices will enter a persistent decline until 2021. Further, stocks are not expected to exceed their 2010 levels until 2027, after adjusting for inflation.

Key findings:

• The M/O ratio explains about 61% of the movements in the P/E ratio during the sample period. In other words, the M/O ratio predicts long-run trends in the P/E ratio well.
• Given the projected path for P/E* and the estimated convergence process, we find that the actual P/E ratio should decline from about 15 in 2010 to about 8.3 in 2025 before recovering to about 9 in 2030.
• The model-generated path for real stock prices implied by demographic trends is quite bearish. Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. 
• Inflation adjusted stock prices are not expected to return to their 2010 level until 2027.
• On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.

Source: Federal Reserve Bank of San Francisco

Interestingly, the conclusions from the Federal Reserve paper mirror the conclusions from our own proprietary 'Estimating Future Returns' models, which suggest investors should expect near zero returns after inflation for at least the next 15 years.

Source: Shiller (2011), DShort.com (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)

While this outcome may appear inconceivable to many, I would urge you to examine the path of Japanese stocks from their peak in 1989 at almost 40,000 to their current price under 10,000. Japan suffered from too much debt and an unhealthy property sector, but these headwinds were amplified by another challenge which we in the West share (though not quite as badly): a declining share of working persons relative to retired persons.

Source: Stockcharts.com

Perhaps not surprisingly, U.S. stock markets have been tracking the performance of Japanese stocks since U.S. stocks peaked in 2000. When we overlay the two stock market indices and align their respective peaks, the resemblance is uncanny (and not a little bit shocking for 'Buy and Hold' investors). If we continue to track the Japanese experience, we may be setting up for another major drop, perhaps to new lows.
Source: Bloomberg, Ritholtz.com

You probably aren't hearing this message from pundits on TV or in the papers, or economists at the major banks or investment firms. However, I urge you to keep three thoughts in mind when you hear these experts speak:

1. If a person's job depends on them not knowing something, then they won't know it.

2. Investment firms make much higher margins from clients who hold or trade stocks or stock mutual funds than from clients who hold bonds or cash instruments like GICs or money market funds. As such, they have a strong incentive to keep clients invested in stocks and stock mutual funds at all times, per the 'Buy and Hold' approach.

So what is a person to do when long-term Canadian bonds are yielding 0.64% after inflation, and developed market stocks are likely to yield no returns (but probably typically high volatility) for the next 15 years or more?

At Butler|Philbrick & Associates, we have a plan. At its core, our approach embraces two major areas of differentiation:

1. Broaden the investment opportunity set for portfolios to include international and emerging market stocks, real estate, commodities,etc. Cash is an asset class!
2. Apply a proven process to decide which asset classes to own (including cash when markets are risky), and when to own them.

As a proof of the effectiveness of our approach in difficult markets, we published a study on how to profitably trade the Japanese bear market back in February (see here for full study). We have suspected for some time that the Japanese template was the most likely trajectory for developed stock markets over the next several years.

In the study, we applied our trend following approach to the Japanese stock market to see how it would have performed over its 21 year downhill roller coaster ride.

 

Source: Butler|Philbrick & Associates 

You can see in the chart that by taking advantage of both positive and negative trends using a simple timing system over this period, our technique delivered over 16% annualized investment performance, while never dropping more than 22.9% from any peak to trough (see "CAGR%" and "Max Total Equity DD" respectively in the table above the chart).

Pretty good results generally, but especially when they're compared with the 75% cumulative loss that most Japanese investors experienced by holding stocks over the past 20 years.

We are following a proven trend following model like the one above to deliver prospective returns for clients no matter what happens in markets. What are you (or your Advisor) doing to prepare for this potential investment outcome?

Market Update: July 23rd, 2010

This is a quick update on markets and models.

As you know, markets swooned in April, May and June, culminating in a nearly 12% loss for average Canadian investors in global stocks at the deepest stage of the decline. Market risk doubled between April and June as measured by standard volatility measures.

The three primary risk management layers in our models were extremely effective during this period:

1. Put options bought in late April as insurance paid off as markets fell from their April peak
2. Many positions were sold on the first wave down in early May as stop losses were hit
3. The small number of remaining positions, ex gold, were sold for cash at the end of May

Models, and hence client portfolios, are essentially flat from their peak in April. We are currently over 90% cash and bonds, and awaiting fresh signals.

Whither Markets?

That said, we are on the verge of something meaningful happening. We are currently managing three scenarios:

1. Global stocks turn lower immediately and we proceed into a deeper plunge
2. We break higher, with commodities leading, but we fail between S&P 1130 and 1160 and then reverse into a deeper plunge
3. We break higher for a sustainable multi-month trend

Models are currently positioned for scenario 1, but we will know if the next day or so whether we need to position short-term for Scenario 2. Our long-term trend indicators will then provide direction at the end of July so that we can position for a possible Scenario 3.

It is important to remember that it is not enough for the economy, or the companies that operate within it, to deliver strong results. If the participants in the market are already expecting strong results, then the economy must do even better than expected to drive markets higher. John Maynard Keynes draws a worthwhile comparison with a beauty contest:

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).

We are thus awaiting signals based on actual capital flows to determine whether average market participants are more impressed, or less impressed than they expected to be. In investing, the large drives the small, so we focus on the biggest, most liquid, most important markets around to judge major changes in trend. It has been the case since 2003 that Asian markets have driven global growth, and this is no less so today. Given the amount of debt (leverage) in the system, Asian growth trends are even more important today than ever. Thus, we are focused on the strength of a basket of Asian currencies (excluding the Japanese Yen), as an indicator of broad Asian growth. The chart for this index is below (Chart 1.)

Chart 1. Asian Dollar Index

Source: Bloomberg, Butler|Philbrick & Associates

Note that this index of Asian currencies has been moving sideways since late April. Should the index break through the upper trend-line near 111.50, this would trigger Scenario 2 by sending a meaningful signal that markets are prepared to allocate capital to growing Asian countries, and this would be a positive signal for markets. We would layer into model positions for Aggressive clients on a break of this line. A break of the 112 line would signal Scenario 3 represent a higher intermediate term high for the index, and send a strong signal of a sustainable up-trend, and would lend confidence to a decision to reinvest cash in all client portfolios.

The exchange rate between the Australian dollar and the Japanese Yen has been an excellent indicator of investor confidence in global growth, as Australia is a major provider of commodities to the Asian growth countries, while Japan is a net importer of nearly every commodity. This indicator has also been consolidating since late April. A break of the upper trendline (Chart 2.) would signal Scenario 2, confirming renewed optimism in global growth, and would lend further confidence to our decision to reinvest client cash. A close above 78.60 would confirm this new up-trend defined by Scenario 3.

Chart 2. Australia Dollar / Japanese Yen Cross

Source: Stockcharts, Butler|Philbrick & Associates

Last, but certainly not least, the U.S. Treasury market has indicated a high degree of skepticism regarding the very recent optimism as reflected in rising stock prices. The debt markets swamp the equity markets in terms of size and sophistication, so we watch Treasury yields closely for confirmation of stock and commodity price moves. So far, Treasuries have NOT confirmed the recent stock price rally, so we would like to see Treasury yields break the upper trendline (Chart 3.). A break of this upper trendline would signal Scenario 2. If U.S. Treasury Yields trade above 3.10% (31 on the chart below), we would interpret that as a final trigger for Scenario 3.

Chart 3. U.S. 10-Year Treasury Yields

Source: Stockcharts, Butler|Philbrick & Associates

Quantifying the Debt Drag

Most economists and analysts do a poor job of capturing the juxtaposition between normal cyclical recovery expectations and long-term headwinds from structural consumer over-indebtedness. Those who argue for a perpetuation of the consumer credit cycle that began post WWII and accelerated exponentially starting in 1982, with a steepening in 1994, must implicitly believe that household debt can grow to the sky.

If instead we acknowledge that households have accumulated new debt equal to 50% of rolling GDP since 1980 (chart below), thereby doubling aggregate household debt outstanding to ~102%, this implies a 2.4% p.a. boost to aggregate consumer spending over that time period. Assuming average consumer spending as a proportion of GDP was 65% over this horizon, this amounted to a boost of ~1.6% p.a. to U.S. GDP.

This analysis is upwardly biased by mortgage debt, which only flows through to GDP in the form of rents, new home construction and sales, and consumption funded by 2^nd mortgages or home equity lines of credit. If we just take the increase in consumer credit (revolving and non-revolving) since 1980 (chart below), which has increased from 12.93% of GDP to 17.988% of GDP, our analysis yields a boost of 1.15% p.a. as a result of this new consumer debt. With consumer spending at 65% of GDP this would have resulted in a boost of 0.75% p.a. from unsecured lines of credit, credit card debt, and car loans alone.

It is difficult to know to what degree mortgages to purchase existing homes biased the first analysis higher, or to what degree not accounting for home equity lines of credit and second mortgages biased the second analysis lower. I think it is safe to say, however, that the annual boost to U.S. GDP from the expansion in consumer debt is between 1% and 1.25% per annum between 1980 and 2009.

Importantly, if consumer debt somehow remains constant at current nosebleed levels going forward, U.S. GDP will grow at a rate 1% - 1.25% below average growth rates since 1980. If however consumers pay-down debt at the same pace that they accumulated it from 1980 - 2008, GDP growth will drop by a further 1% - 1.25%. This would then shave a total of 2% - 2.5% from GDP growth potential, which puts likely growth rates for U.S. GDP between 1% and 2% p.a. for the foreseeable future, barring the creation of another consumer credit cycle.

Interestingly, Japanese GDP growth averaged 1.9% during its 'Lost Decade' from 1990 - 2000 after posting 10+ years of 3 - 4% growth leading up to the Nikkei's 1989 peak. Despite aggressive policies by the BOJ to bring rates to zero and a massive buildup in Japanese government debt to offset corporate and household balance sheet rebuilding, Japanese GDP was exceedingly volatile through the 1990s and share prices dropped by 65% over the decade. Of course, they are almost 75% below their 1989 peak today.

Given this anemic consumption scenario, and the Japanese template for a debt deflation scenario, investors should be asking to what degree the market is discounting a long period of slower economic growth. With consumers retrenching, boomers retiring, and government indebtedness likely to necessitate higher corporate and personal taxes in the future, is it likely that stock market valuations will continue to hold at 1980 - 2008 levels relative to the size of the economy? Or is it possible that they may revert to levels that dominated for most of the last century.

Chart: Ratio of U.S. Stock Market Capitalization to U.S. GDP

Source: Ned Davis Research

Hussman: We face two possible states of the world.

John Hussman manages the eponymous Hussman Funds. Hussman was among the few who both forecast the 2008/2009 credit crisis, and also had the fortitude to position his clients' defensively in advance. Returns this year have lagged global stocks, but Hussman is largely unrepentant. Like us, he lacks faith in the sustainability of the current rally, and rails against the unconstitutional actions of the Fed in supporting the bondholders of egregiously mismanaged banks.

Dr. Hussman writes a weekly column at his web site, which I strongly encourage everyone to read. This is his latest piece.

November 30, 2009

Reckless Myopia

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

I was wrong.

Not about the implosion of the credit markets, which I urgently warned about in 2007 and early 2008. Not about the recession, which we shifted to anticipating in November 2007. Not about the plunge in the stock market, which erased the entire 2002-2007 market gain, which was no surprise. Not about the “ebb and flow” of short-term data, which I frequently noted could produce a powerful (though perhaps abruptly terminated) market advance even in the face of dangerous longer-term cross-currents. I expect not even about the “surprising” second wave of credit distress that we can expect as we move into 2010.

From a long-term perspective, my record is very comfortable. But clearly, I was wrong about the extent to which Wall Street would respond to the ebb-and-flow in the economic data – particularly the obvious and temporary lull in the mortgage reset schedule between March and November 2009 – and drive stocks to the point where they are not only overvalued again, but strikingly dependent on a sustained economic recovery and the achievement and maintenance of record profit margins in the years ahead.

I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble.

And here we are again.

We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.

Taking the weighted average outcome for the two states of the world still produces a poor average return/risk tradeoff. Taking the weighted average investment position for the two states of the world is somewhat more constructive. As I noted several weeks ago, I have adapted our weightings accordingly. As a result, we have been trading around a modest positive net exposure, increasing it slightly on market weakness, and clipping it on strength, as is our discipline. Currently, the Strategic Growth Fund has a net exposure to market fluctuations of less than 10%, but enough “curvature” (through index options) that our exposure to market risk will automatically become more muted on market weakness and more positive on market advances, allowing us to buy weakness and sell strength without material concern about the (increasing) risk of a market collapse.

There is no chance, even in hindsight (“could have, would have, should have” stuff) that I would have responded to the existing evidence in recent months with more than a moderate exposure to market risk during some portion of the advance since March. But our year-to-date returns might now be into a second digit had I recognized that investors have learned utterly nothing from the bubbles and collapses of the past decade. That recognition might have encouraged a greater weight on trend-following measures versus fundamentals, valuations, price-volume sponsorship, and other factors.

Still, our stock selections continue to perform well relative to the market, our risks remain well-managed through a substantial (though not full) hedge, and our investment approach has nicely outperformed the S&P 500 over complete market cycles, with substantially less downside risk than a passive investment approach. We have implemented some modest changes to improve our potential to benefit from (even ill-advised) speculative runs, but we've done fine nonetheless, and we can sleep nights.

Whether or not I have focused too much on probable “second-wave” credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a “miss” on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster.

Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them.

This is utterly different from true discounting – which does not rely on multiples, but instead carefully traces out the likely path of future revenues, profit margins, cash flows and earnings over time, and explicitly discounts expected payouts and probable terminal values back at an appropriate rate of return. That's what we actually do here. Talking in terms of multiples can make the process easier to explain, and can be a reasonable approach to the market as a whole if earnings are normalized properly, but ultimately, an investment security is a claim to a long-term stream of cash flows. It is not simply a blind multiple to the latest analyst estimate.

Fortunately, the evidence suggests that the long-term returns to a careful discounting approach tend to be strong even if investors repeatedly behave in speculative and short-sighted ways. This is because long-term returns are fully determined by the stream of cash flows actually received by investors over time, and because inappropriate valuations ultimately tend to mean-revert. In the face of speculative noise, the long-term returns from a proper discounting approach may not capture as much speculative return as might be possible, but over time, many of those speculative swings tend to wash out anyway.

In part, the market's increasing propensity toward speculation reflects the increasing lack of fiscal and monetary discipline from our leaders. Policy makers who seek quick fixes and could care less about long-term consequences undoubtedly encourage investors to embrace the same value system. Paul Volcker was the last Fed Chairman to have any sense that discipline and the acceptance of temporary discomfort was good for the nation.

Our current Fed Chairman's voice literally quivers in response to the phrase “bank failure,” even though in the present context, a bank failure implies none of the disorganized outcomes that characterized the Great Depression. It simply means that the bondholders take a loss and the remaining part of the institution survives intact as a “whole bank” entity (and can be sold or re-issued back to public ownership, less the debt to bondholders, as such). The same outcome would have been possible with Lehman had the FDIC been granted authority from Congress to take conservatorship of a non-bank financial entity.

In my estimation, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we've observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle. Meanwhile, valuations are clearly unfavorable here, and even under the “typical post-war recovery” scenario, we are observing an increasing number of internal divergences and non-confirmations in market action.

As Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.

“This is why people didn't figure out that it was the Great Depression until two years after the worst point in the crisis in the 1930s; and why it took decades, not months, quarters or even years, for the complete transition to the next sustainable economic expansion and bull market.

“Mortgage applications for new home purchases hit a 12-year low in the middle of November (down 22% in the past month!), fully two weeks after the Administration said it was going to not only extend but expand the program to include higher-income trade-up buyers. Once again, there is minimal demand for autos and housing, and that is partly because the market is still saturated with both of these credit-sensitive big-ticket items after an unprecedented credit and consumer bubble that went absolutely parabolic in the seven years prior to the collapse in the financial markets an asset values. We are probably not even one-third of the way through this deleveraging cycle. Tread carefully.”

Andrew Smithers, one of the few other analysts who foresaw the credit implosion and remains a credible voice now, concurred last week in an interview with my friend Kate Welling (a former Barrons' editor now at Weeden & Company): “The good news so far is that the stock market got down to pretty much fair value or even, possibly, a tickle below it, at its March bottom. But now it has gone up… we probably have a market which is, roughly, 40% overpriced. In order to assess value, it is necessary either to calculate the level at which the EPS would be if profits were neither depressed nor elevated, or to use a metric of value which does not depend on profits. The cyclically adjusted P/E (CAPE) normalizes EPS by averaging them over 10 years. It thus follows the first of those two possible methods. Using even longer time periods has advantages, particularly as EPS have been exceptionally volatile in recent years - and using longer time periods raises the current measured degree of overvaluation. The other methodology we use measures stock market value without reference to profits: the q ratio. It compares the market capitalization of companies with their net worth, also adjusted to current prices. The validity of both of these approaches can be tested and is robust under testing - and they produce results that agree. Currently, both q and CAPE are saying that the U.S. stock market is about 40% overvalued.”

In the chart below, the current data point would be about 0.4, not as extreme as we observed in 1929, 2000, or 2007 of course, but equal to or beyond what we've observed at virtually every other market peak in history. This aligns well with our own analysis, where as I've noted in recent weeks, the S&P 500 is priced to deliver one of the weakest 10-year total returns in history except for the (ultimately disappointing) period since the mid-1990's.



One of the fascinating aspects of the past few months is the lack of equilibrium thinking with respect to what happened to the trillions of dollars in government money that has been spent to defend the bondholders of mismanaged financial companies. Almost by definition, money given to corporations will show up most quickly as improvements in corporate earnings, and then slightly later, as executive compensation. A few pieces came across my desk last week, hailing the ability of the corporate sector to bounce back from the recent economic downturn even though revenues have continued to suffer and employment has been steeply cut. Why is this a surprise? Where else could the money have gone? Labor compensation? It is truly mind-numbing that a moment after a temporary surge of trillions of dollars, borrowed and tossed out of a helicopter (though to specific corporations and private beneficiaries), analysts would hail a subsequent improvement in corporate results as evidence of “resilience.”

What matters is sustainability, and unfortunately, it is clear that credit continues to collapse. Banks are contracting their loan portfolios at a record rate, according to the latest FDIC Quarterly Banking Profile. Even so, new delinquencies continue to accelerate faster than loan loss reserves. Tier 1 capital looked quite good last quarter, as one would expect from the combination of a large new issuance of bank securities, combined with an easing of accounting rules to allow “substantial discretion” with respect to credit losses. The list of problem institutions is still rising exponentially. Overall, earnings and capital ratios have enjoyed a reprieve in the past couple of quarters, but delinquencies have not, and all evidence points to an acceleration as we move into 2010.

Urgent Policy Implications

From a policy standpoint, it is effectively too late to forestall further foreclosures absent explicit losses to creditors. The best policy option now is to make sure that the second wave does not result in a debasement of the U.S. dollar. The way to do that is to require three things:

First, the FDIC should be given regulatory authority to take non-bank financials into conservatorship the way they should have been able to do with Bear Stearns and Lehman. If this authority had existed in 2008, Bear's bondholders would not now stand to get 100% of their money back, with interest, as they presently do, and Lehman's disorganized liquidation would have been completely unnecessary. As I've noted before, the problem with Lehman was not that it went bankrupt, but that it went bankrupt in a disorganized way. If the FDIC had authority over insolvent non-bank financials and bank holding companies, it could wipe out equity and an appropriate amount of bondholder capital, and sell the fully-functioning residual to an acquirer, as is typically done with failing banks, without any loss to depositors or customers.

Second, bank capital requirements should be altered to require a substantial portion of bank debt to be of a form that automatically converts to equity in the event of capital inadequacy. This would force losses onto bondholders, rather than onto taxpayers. This policy adjustment is urgent – we have perhaps a few months to get this right.

Finally, Congress should be clear that government funds will be available only to protect the interests of depositors, not bondholders. Specifically, any funds provided by the government should be contingent on the ability to exert a senior claim to bondholders in the event of subsequent bankruptcy, even if a category is created to allow those funds to be counted as “capital” for purposes of satisfying capital requirements prior to such bankruptcy. Government-provided capital should be subordinate only to depositor claims, if equity and bondholder capital ultimately proves insufficient to meet those obligations.

Since early 2008, beginning with the provision of non-recourse funding in the Bear Stearns debacle, the Federal Reserve and the Treasury have repeatedly allocated or implicitly obligated public funds to defend the bondholders of mismanaged financial companies. This has included the outright and non-recourse purchase of nearly a trillion dollars in mortgage securities that have no explicit guarantee by the U.S. government. By purchasing these securities outright (rather than through a well-defined repurchase agreement), the Fed is effectively obligating the U.S. government to either guarantee them or to absorb any future losses.

Aside from the fraction of bailout funding that was specifically allocated by Congress through legislation, these actions represent an unconstitutional breach into enumerated spending powers that are the domain of the elected members of Congress alone. The issue here is not whether the Fed should be independent from political influence. The issue is the constitutionality of the Fed's actions. The discretion that it has exerted over the past two years crosses the line into prerogatives reserved for Congress. That line needs to be clarified sooner rather than later.

Emphatically, the trillions of dollars spent over the past year were not in the interest of protecting bank depositors or the general public. They went to protect bank bondholders. Instead of taking appropriate losses on those bonds (which financed reckless mortgage lending), those bonds are happily priced near their face value, for the benefit of private individuals, thanks to an equivalent issuance of U.S. Treasury debt. But that's not enough. Outside of a very narrow set of institutions that are subject to compensation limits, just watch how much of the public's money – which benefitted several major investment banks following a very direct route – gets allocated to Wall Street bonuses in the next few weeks.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and mixed market action. The market remains significantly overbought on an intermediate-term basis, and we've seen increasing divergences from breadth, small and mid-cap stocks, trading volume, and other internals, which have lagged the most recent advance in the S&P 500 and other cap-weighted indices.

The prospect of a debt-repayment “standstill” from Dubai prompted some weakness in foreign markets that spilled over to the U.S. on Friday. This was interesting given that David Faber reported the issue on CNBC on Wednesday, to no reaction. Importantly, the payment difficulties do not stem from oil revenues, but largely from tourism and financial activity, as those are Dubai's chief industries (Dubai is home to the tallest building and the largest man-made islands in the world, for example). From that standpoint, it is difficult to imagine much in the way of contagion as a result of Dubai's difficulties.

Whatever shock the market will get from left field is likely to come from larger financial or geopolitical risks. The market for credit default swaps bears watching, but thus far we haven't observed spikes to indicate that something major is imminent. Unfortunately, as I noted earlier, investors have earned an “F” for vigilance in recent years, so our lead time on new difficulties may be shorter than we might like.

In any event, I'm pleased with the overall behavior of our stock holdings, and I expect that we'll have plenty of opportunity to increase our exposure to market fluctuations at more appropriate valuations. Presently, we've got a small amount of exposure to market fluctuations, but not enough to cause any material difficulties if the market experiences some trouble. The largest source of day-to-day fluctuations remains the difference in performance between the stocks we hold long and the indices we use to hedge. That source of risk has also been the primary contributor to returns over the life of the Fund.

In bonds, the Market Climate was characterized last week by moderately unfavorable yield levels and generally favorable yield pressures. We saw a good example of how the market is inclined to respond to fresh credit concerns last week, with upward pressure on the U.S. dollar and U.S. Treasuries, and downward pressure on foreign currencies and commodities. While I continue to believe that the dollar faces substantial risk of further erosion in its exchange value, as well as a near doubling of the CPI over the coming decade or so (both reflecting the massive increase in U.S. government liabilities in recent years), those prospects are not likely to emerge until risk-aversion about credit default materially abates. Credit concerns typically create a spike in demand for default-free assets such as U.S. government liabilities, so even though there is a much larger float than is likely to be sustained over time without inflation as the ultimate outcome, credit concerns tend to support the value of these liabilities and hence mutes immediate inflation pressures (essentially, monetary velocity declines as these liabilities are sought as a default-free store of value).

The Strategic Total Return Fund currently has an overall duration slightly over 3 years, primarily in straight Treasuries, with a small 1% exposure to precious metals shares and about 4% of assets in utility shares.

Links: Hussman Funds 

1930's Redux

David Rosenberg quoted from a September 1930 Wall Street Journal editorial in this morning's 'Breakfast with Dave'. With Spiritus Animus bubbling to the surface today, wise investors would be well served to keep things in perspective. The following piece should put even the most bullish data and comments in context:

August 28, 1930:

"There’s a large amount of money on the sidelines waiting for investment opportunities; this should be felt in market when “cheerful sentiment is more firmly entrenched.” Economists point out that banks and insurance companies “never before had so much money lying idle.”

September 3, 1930:

"Market has now reached [the] resistance level where it ran out of steam on July 18 (240.57) and July 28 (240.81). Breaking through this level would be considered a highly bullish signal. General confidence that this will happen based on recent market action; many leading stocks have already surpassed July highs. Further positive technicals seen in recent volume pattern (higher on rallies and lower on pullbacks), and in continued large short interest.

Some wariness based on recent good rally recovering all of drought-related break; some observers advise taking profits on at least part of long positions, to be in position to rebuy on good pullbacks.

Most economists agree business upturn is close; peak in business was reached July 1929, so depression has lasted about 14 months. “Those who have faith and confidence in the country and its ability to come back will profit by their foresight. This has also been the case over the past half century.”

Harvard Economic Society points to steady rise in bond prices as favorable for stocks. Says there is “every prospect that the [business] recovery ... will not long be delayed,” although fall period may not be strong as expected. Notes worldwide decline in business, but 1922 recovery demonstrates U.S. due to “great size, natural advantages, and diversity of conditions ... can lift itself out of depression without the stimulus of improved foreign demand.”

Rosenberg concludes with the ominous, "We only know now with perfect hindsight what these pundits did not know back then — that there was another 80% of downside left in the bear market."

Macro Indicator Summary

I am impressed with markets' resilience in the face of China's 6.7% sell-off overnight. Aside from Hong-Kong, global equity markets have shrugged-off the new Chinese bear market with a disinterested grunt. Here in Canada, banks are mostly higher on the day despite a 1.5% drop in the index, while the U.S. banking sector continues to consolidate sideways, off just 0.75% today.

4:30pm update: Volume was lower across the board, so institutions are sitting on their hands.

9:30pm update: After-hours volume pushed end-of-day numbers well above yesterday's levels, registering a 'distribution day'.

Note: Please click on any and all charts for a larger image.

The clear losers from the China sell-off are commodities, with oil down $3 to below $70, and copper off 12 cents at 2.83. Oil is at critical support from a trend-line going back to late April (see chart of DBO below), while copper has reversed off important resistance at the 61.8% Fibonacci retracement level of $3.00 (See copper Fibs below).

DBO Oil Fund ETF

Source: Stockcharts.com

Copper Market with Fibonacci Levels

Source: Stockcharts.com

Commodity currencies, like the CAD and AUD sold off substantially earlier in the day but have since rebounded, especially against the Yen. The CAD/USD found support from its 50 day moving average slightly below 90 in the morning, and is likely to test its multi-week trend-line (currently at ~89) before finding further direction.

Canadian Dollar ETF

Source: Stockcharts.com

Canadian Dollar ETF / Japanese Yen ETF Ratio

Souce: Stockcharts.com

We monitor the Asian Dollar Index for macroeconomic strength in that region. The index has been consolidating for several weeks in a pennant formation which is likely to break up or down in the next few days. Given the ADXY's strength in the face of China's panic sell-off overnight, an upside breakout is more likely. On an upward break-out, there is resistance at the previous high (~109) which, if broken, would signal further emerging market strength, led by Asia.

Asian Dollar Index

Source: Bloomberg

Bonds are confirming the bearish story in commodities, with long-term Treasuries rallying to resistance for the second time in 2 days.

20+ Year US Treasury Bond ETF

Source: Stockcharts.com

The 10-year TIPS breakeven rate, a measure of bond traders' future inflation expectations, is testing key support today, suggesting that traders are skeptical of current commodity strength.

10-Year TIPS Breakeven Rate

Source: Bloomberg

10-year yields have also been consolidating in a pennant formation; a break of 3.25% would indicate a major change in the trend of 10-year rates, at which point equity bulls would necessarily be put on the defensive.

10-Year US Bond Yield

Source: Bloomberg

Gold continues to consolidate in its intermediate-term pennant structure forming the right shoulder of what looks like a huge inverse head and shoulders formation. This structure suggests higher prices lie ahead. However, there are two clear resistance levels that must be breached before we can celebrate gold's new up-trend. Using the GLD ETF chart, the first resistance line sits at ~$94.25, with the longer-term line at ~$95.50. These are important levels to watch. A breach of the upper resistance line would suggest a re-test of the previous highs near $99, with potential for a test of it's all-time high of $100.44.

GLD US Gold ETF

Source: Stockcharts

Meanwhile, credit spreads seem impervious to the macro fragility implied by the charts above. CDS spreads in Europe and the U.S. continue to consolidate near their intermediate-term lows.

In conclusion, several important macro indicators are testing important resistance and support levels, but the pennant-shaped consolidation patterns suggest trend-continuation at this time. As such, stock markets are likely to move sideways in the short-term, with the potential for a short-term correction driven by commodity weakness. The most likely intermediate-term direction for stocks is up, with the potential for the S&P to move as high as 1200 before we begin wave 3 down. Should 980 be taken out on the S&P, we would look for a more immediate, steeper decline to ensue.

For longer-term context, I leave you with Doug Short's most recent chart of the Three Mega Bear Markets.


Source: Dshort.com

The Fallacy of Cash on the Sidelines

Merrill Lynch posted the results of its most recent Survey of Fund Managers for August this morning. The survey covered 204 fund managers in 80 countries who control $554 billion in assets, and the data dispels the myth of excess cash on the sidelines.

Barry Ritholtz at ritholtz.com summarized the findings. Note that U.S. markets peaked in September 2007:

• Cash balances plunge to 3.5%, lowest since July'07;

• Highest equity allocation (34% from 7%) since Oct'07;

• Bond allocation (-28% from -12%) lowest since April'07;

• Tech (28%) is the most favored sector everywhere.

Barry concluded, 'While I keep hearing about cash on the sidelines, the professionals seem to be "All In."'

As an addendum to the Merrill Lynch survey (full release pasted below), please see the attached chart of US commercial paper and Money Market assets. The chart was originally posted by WallStreetExaminer.com using US Federal Reserve data. Annotations in red are my own.


Source: WallStreetExaminer.com
Click image for larger version

Conclusion: Investable Money Market fund assets are no higher than at the peak of markets in September 2007. Retail holdings of MM funds have now retraced to the levels of Sept 2007. The spike in Institutional MM assets from Sept 2007 is exactly equivalent to the drop in CP assets over the same time period, offering compelling evidence that companies have simply moved treasury working capital out of CP and into IMM funds. This is NOT parked investment capital, and is unlikely to find its way into stocks.

Investors appear to be exactly as fully invested as they were in September 2007, at the peak of the bull market. This dovetails nicely with the Merrill survey.

That said, the Primary Dealers are swimming in reserves. Liquidity parked in Securities Open Market Accounts at Primary Dealers is also back at September 2007 levels (See PD Liquidity Chart). If the money-centre banks decided to leverage these reserves into the system, they could single-handedly push stocks, commodities and corporate bonds higher. It remains to be seen whether banks will hold these as reserves against 'Level III' assets on their balance sheets or put it to work speculating.


Source: WallStreetExaminer.com
Click image for larger version

*************************************************************************
http://news.prnewswire.com/DisplayReleaseContent.aspx?ACCT=104&STORY=/www/story/08-19-2009/0005079889&EDATE=

NEW YORK, NY UNITED STATES

Questions over Imbalances in Early Stages of Recovery

NEW YORK and LONDON, Aug. 19 /PRNewswire/ -- Investor optimism about the global economy has soared to its highest level in nearly six years, with portfolio managers putting their cash back into equity markets, according to the Merrill Lynch Survey of Fund Managers for August.

A net 75 percent of survey respondents believe the world economy will strengthen in the coming 12 months, the highest reading since November 2003 and up from 63 percent in July. Confidence about corporate health is at its highest since January 2004. A net 70 percent of the panel respondents expect global corporate profits to rise in the coming year, up from 51 percent last month.

August's survey shows that investors are matching their sentiment with action, by putting cash to work. Average cash balances have fallen to 3.5 percent from 4.7 percent in July, their lowest level since July 2007. Equity allocations have risen sharply month-over-month with a net 34 percent of respondents overweight the asset class, up from a net 7 percent in July. Merrill Lynch's Risk and Liquidity Indicator, a measure of risk appetite, has risen to 41, the highest in two years.

"Strong optimism in August represents a big turnaround from the apocalyptic bearishness of March. And yet with four out of five investors predicting below trend growth for the year ahead, a nagging lack of conviction about the durability of the recovery remains," said Michael Hartnett, chief global equities strategist at Banc of America Securities-Merrill Lynch Research. "The equity rally has been narrowly led by China and tech stocks. We have yet to see investors fully embrace cyclical regions such as Japan or Europe, or Western bank stocks."

Lasting recovery requires greater balance

Global emerging markets, led by China, and technology stocks are the strongest engines behind the early recovery. Investors would rather be overweight emerging markets than any other region, and by some distance. A net 33 percent of the panel prefers to overweight emerging markets while investor consensus is to remain underweight the U.S., the eurozone, the U.K. and Japan.

Technology remains the number one sector, with 28 percent of the global panel overweight the industry. Industrials and Materials lag with global fund managers holding 11 percent and 12 percent overweight positions respectively.

Further behind are Banks. Global fund managers remain concerned about the sector, holding a 10 percent underweight position. In contrast, investors within emerging markets are positive about Banks with a net 17 percent of fund managers in the regional survey overweight bank stocks.

Some of these sectoral and regional imbalances are starting to erode, however. Global fund managers have scaled back their underweight positions in bank stocks from 20 percent in July. Industrials and Materials have recovered from underweight positions one month ago. Emerging markets are less popular than in July when 48 percent of the panel most wanted to overweight the region. And Europe is a lot less unpopular. In July, a net 30 percent of respondents wanted to underweight the eurozone. That figure has dropped to just 2 percent in August.

Improved outlook for Europe, but investors drag their feet

Within Europe, fund managers appear as excited about the outlook as their global colleagues. A net 66 percent of respondents to the regional survey expect the European economy to improve in the coming year, up from a net 34 percent in July.

The net percentage expecting earnings per share to rise nearly trebled, reaching 62 compared with a net 23 percent a month ago. Investors in the region took an overweight position in Basic Resources, a cyclical sector, and radically scaled back their overweight position in Pharmaceuticals, a defensive sector.

In contrast to global respondents, those in Europe have failed to inject new money. "European growth optimism has finally caught up with other regions, but fund managers have yet to fully act on this and cash levels have actually increased and overall sector conviction is near record lows," said Patrik Schowitz, European equity strategist at Banc of America Securities-Merrill Lynch Research.

Survey of Fund Managers

A total of 204 fund managers, managing a total of US$554 billion, participated in the global survey from 7 August to 12 August. A total of 177 managers, managing US$370 billion, participated in the regional surveys. The survey was conducted by Banc of America Securities - Merrill Lynch Research with the help of market research company TNS. Through its international network in more than 50 countries, TNS provides market information services in over 80 countries to national and multi-national organizations. It is ranked as the fourth-largest market information group in the world.

----------------------------------------------------

Prudent Capitalism - China Style

China is behaving in truly Keynesian fashion by cleaning up bad debts on bank balance sheets and demanding prudence and risk management during boom times while forcing banks to expand their balance sheets aggressively during more challenging times in order to move funds into the economy.

Though the author of the article below takes the view that China’s actions within the banking system are inappropriate, I would assert that it is exactly this mechanism for moving funds into the economy that European and North American economies are lacking.

It is also why China is likely to lead us out of this global slump. Chinese shares have been demonstrating consistent relative strength since 
mid-October. Shares in Shanghai and equivalent H-Shares in Hong Kong are making higher highs and higher lows, and they are holding above both short- and longer-term moving averages.

Singapore, Hong Kong and Taiwan appear poised to break out to the upside on the back of the strength in Chinese shares. Brazil and South Africa also look strong and, with both the reais and the rand looking to join the Euro in a surge against the dollar, you may receive a double whammy on the ETFs.

Please see the following story from Dow Jones News.
---------------------------------------------------------------------

Chinese Banks' Great Leap Backward

Around the world, the banks we see today are very different from their former selves of just a few months ago. The transformation has been most pronounced in the U.S. and Europe, where a combination of mergers and government involvement have reshaped the financial sector. But change is afoot elsewhere as well, and it isn't always positive. In particular, Chinese banks are currently under enormous pressure to change their business practices in ways that represent a serious step backward.

A year ago, many of us were ready to be impressed with China's banking system. To be sure, banks were still mainly state-owned, and the Chinese Communist Party continued to be omnipresent. However, the average bank managers were extremely risk conscious, and regulators from the China Banking Regulatory Commission (CBRC) swooped down on bank branches conducting surprise inspections every so often. Bankers were extremely hesitant to make uncollateralized loans to any firm except for the largest corporations.

This was an enormous change from just 10 years ago, when bankers doled out large sums at the slightest urging of the local governments and when banks were considered the "second treasury" by central policy makers. At that time, the nonperforming loan ratio was estimated to be nearly half of all loans outstanding. By January 2008, the official NPL ratio was less than 6%. This transformation wasn't cheap or easy -- it required hundreds of billions of dollars from the government to buy bad loans off bank balance sheets and recapitalize the institutions, and also the participation of Western "strategic partners" brought in to lend their expertise in best practices.

However, risk-prevention institutions built up over the past decade are now under enormous pressure to forgo prudence in the interest of maintaining economic growth. There have been two triggers for this. First, the global recession caused a plunge in demand for Chinese goods -- in November, Chinese exports fell for the first time in nearly a decade. At the same time, the property market continues to shrink in many major Chinese cities.

Anticipating a declining economy, in November the central government announced a four trillion yuan ($586 billion) stimulus package to be carried out in the next two years. At the same time, the National Development and Reform Commission was ordered to approve fixed asset investment worth 100 billion yuan before the end of the year. As of mid-December, much of the money has been doled out. This forceful injection of funds into the economy will be the dominant method of generating growth in the next two years.
---
Banks are trapped in the middle, because they will finance much of the stimulus package. Of the four trillion yuan stimulus, only about a quarter will be financed by the government's central budget. At a time when local governments are strapped for cash due to falling land prices (land sales are a common form of municipal cash-raising), banks are expected to finance much of the remaining three trillion yuan in the package. This isn't a matter of choice. Most banks must follow the government's lead because senior bankers are appointed by the Party.

It gets worse. Local governments have announced a further 20 trillion yuan in investment to "supplement" the central package. Assuming both Beijing and the local governments stick to these spending targets, banks will be under enormous pressure to finance trillions in state-sponsored projects in the next two years. With so much money to push out the door, risk management will almost inevitably take a back seat. Banks that had made enormous strides toward global best practices were compelled by central pressure to greatly boost credit in the last two months of this year.
Prudence is not completely out the window yet because of continuation of CBRC monitoring, but risk management is increasingly a second priority. The CBRC has sent subtle signals to banks to not worry about profit too much and to exclude more risky loans to small- and medium enterprises from their main balance sheets.

Partly as a result, banks are increasingly compromising between risk prevention and political pressure by boosting lending through bill financing instead of writing outright loans. In theory this limits risks because bill financing tends to be short-term and can be easily transferred to another bank. Of the 477 billion yuan of new loans made in November, half were in bill financing. The rise of bill financing may increase systemic risks in the future because banks tend to be less careful when they discount these bills due to their transferability. Loans, on the other hand, are stuck on banks' balance sheets.

Meanwhile, if the economy worsens in the first quarter the government may be tempted to abandon prudent regulation altogether. Beijing could order the CBRC to disregard risk targets or even abolish the CBRC. This would plunge China back into the old days when the only risks that bankers faced were political ones.

Without a global financial crisis, the global financial community might have criticized such a giant step back toward the planned economy. The criticism might have at least triggered some debate in China. However, with the rest of the world suffering a severe credit crunch that has seen free-market governments bailing out their own financial institutions, there are few people left who can credibly criticize China's actions.
Western central banks have conducted operations that once were monopolized by the Chinese central bank and drew scoffs and snorts from the global banking community. For example, the People's Bank of China, the central bank, used to conduct "relending" operations to inject funds into distressed banks to pay creditors or to write off distressed assets. Now, the Federal Reserve is doing the same by buying or accepting as collateral questionable assets from banks.

In any event, everyone is too preoccupied with their own losses to comment on Chinese policies. Which is a problem, not least for China itself. With enormous political pressure from the central government to pump money into the economy and silence from the rest of the world, much of the work in the past decade is being undone.

Prudent Capitalism - China Style

Source: Stockcharts.com

China is behaving in truly Keynesian fashion by cleaning up bad debts on bank balance sheets and demanding prudence and risk management during boom times while forcing banks to expand their balance sheets aggressively during more challenging times in order to move funds into the economy.

Though the author of the article below takes the view that China’s actions within the banking system are inappropriate, I would assert that it is exactly this mechanism for moving funds into the economy that European and North American economies are lacking.

It is also why China is likely to lead us out of this global slump. Chinese shares have been demonstrating consistent relative strength since mid-October. Shares in Shanghai and equivalent H-Shares in Hong Kong are making higher highs and higher lows, and they are holding above both short- and longer-term moving averages.

 Source: Stockcharts.com

Singapore, Hong Kong and Taiwan appear poised to break out to the upside on the back of the strength in Chinese shares. Brazil and South Africa also look strong and, with both the reais and the rand looking to join the Euro in a surge against the dollar, you may receive a double whammy on the ETFs.

Please see the following story from Dow Jones News.

---------------------------------------------------------------------

Chinese Banks' Great Leap Backward

Around the world, the banks we see today are very different from their former selves of just a few months ago. The transformation has been most pronounced in the U.S. and Europe, where a combination of mergers and government involvement have reshaped the financial sector. But change is afoot elsewhere as well, and it isn't always positive. In particular, Chinese banks are currently under enormous pressure to change their business practices in ways that represent a serious step backward.


A year ago, many of us were ready to be impressed with China's banking system. To be sure, banks were still mainly state-owned, and the Chinese Communist Party continued to be omnipresent. However, the average bank managers were extremely risk conscious, and regulators from the China Banking Regulatory Commission (CBRC) swooped down on bank branches conducting surprise inspections every so often. Bankers were extremely hesitant to make uncollateralized loans to any firm except for the largest corporations.

This was an enormous change from just 10 years ago, when bankers doled out large sums at the slightest urging of the local governments and when banks were considered the "second treasury" by central policy makers. At that time, the nonperforming loan ratio was estimated to be nearly half of all loans outstanding. By January 2008, the official NPL ratio was less than 6%. This transformation wasn't cheap or easy -- it required hundreds of billions of dollars from the government to buy bad loans off bank balance sheets and recapitalize the institutions, and also the participation of Western "strategic partners" brought in to lend their expertise in best practices.

However, risk-prevention institutions built up over the past decade are now under enormous pressure to forgo prudence in the interest of maintaining economic growth. There have been two triggers for this. First, the global recession caused a plunge in demand for Chinese goods -- in November, Chinese exports fell for the first time in nearly a decade. At the same time, the property market continues to shrink in many major Chinese cities.

Anticipating a declining economy, in November the central government announced a four trillion yuan ($586 billion) stimulus package to be carried out in the next two years. At the same time, the National Development and Reform Commission was ordered to approve fixed asset investment worth 100 billion yuan before the end of the year. As of mid-December, much of the money has been doled out. This forceful injection of funds into the economy will be the dominant method of generating growth in the next two years.
---
Banks are trapped in the middle, because they will finance much of the stimulus package. Of the four trillion yuan stimulus, only about a quarter will be financed by the government's central budget. At a time when local governments are strapped for cash due to falling land prices (land sales are a common form of municipal cash-raising), banks are expected to finance much of the remaining three trillion yuan in the package. This isn't a matter of choice. Most banks must follow the government's lead because senior bankers are appointed by the Party.

It gets worse. Local governments have announced a further 20 trillion yuan in investment to "supplement" the central package. Assuming both Beijing and the local governments stick to these spending targets, banks will be under enormous pressure to finance trillions in state-sponsored projects in the next two years. With so much money to push out the door, risk management will almost inevitably take a back seat. Banks that had made enormous strides toward global best practices were compelled by central pressure to greatly boost credit in the last two months of this year.
Prudence is not completely out the window yet because of continuation of CBRC monitoring, but risk management is increasingly a second priority. The CBRC has sent subtle signals to banks to not worry about profit too much and to exclude more risky loans to small- and medium enterprises from their main balance sheets.

Partly as a result, banks are increasingly compromising between risk prevention and political pressure by boosting lending through bill financing instead of writing outright loans. In theory this limits risks because bill financing tends to be short-term and can be easily transferred to another bank. Of the 477 billion yuan of new loans made in November, half were in bill financing. The rise of bill financing may increase systemic risks in the future because banks tend to be less careful when they discount these bills due to their transferability. Loans, on the other hand, are stuck on banks' balance sheets.

Meanwhile, if the economy worsens in the first quarter the government may be tempted to abandon prudent regulation altogether. Beijing could order the CBRC to disregard risk targets or even abolish the CBRC. This would plunge China back into the old days when the only risks that bankers faced were political ones.

Without a global financial crisis, the global financial community might have criticized such a giant step back toward the planned economy. The criticism might have at least triggered some debate in China. However, with the rest of the world suffering a severe credit crunch that has seen free-market governments bailing out their own financial institutions, there are few people left who can credibly criticize China's actions.
Western central banks have conducted operations that once were monopolized by the Chinese central bank and drew scoffs and snorts from the global banking community. For example, the People's Bank of China, the central bank, used to conduct "relending" operations to inject funds into distressed banks to pay creditors or to write off distressed assets. Now, the Federal Reserve is doing the same by buying or accepting as collateral questionable assets from banks.

In any event, everyone is too preoccupied with their own losses to comment on Chinese policies. Which is a problem, not least for China itself. With enormous political pressure from the central government to pump money into the economy and silence from the rest of the world, much of the work in the past decade is being undone.