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Monday, April 15, 2013

Wine Country Conference Presentations

I spent the first weekend in April at the inaugural Wine Country Conference in Sonoma, which was organized by economics blogger Mish Shedlock to raise money for the Les Turner ALS Foundation; Mish had lost his wife to ALS a couple of years ago.

Interesting presentations on a variety of economic and financial topics were delivered by Mish and by John Hussman of the Hussman funds, John Mauldin whose newsletters are widely distributed, and Chris Martenson of the Peak Prosperity blog.  The presentations are supposed to be posted online sometime, but as of now, I haven't seen them available, so I will write up some of my notes.  Yahoo! Finance covered the conference and has posted 5-minute video interviews with each of the speakers.  

Hussman's presentation, well reviewed by Yahoo! here, has generated a lot of secondary attention on sites like Advisor Perspectives and Business Insider for his thesis that corporate profits in the US have risen to a historically anomalous 11% share of US GDP and should be expected to revert to the mean of about 6%.  He contends that there are basically three sectors in any economy - the individual consumer, government and the corporate sector - and their respective deficits and surpluses must balance out; thus, when consumers and government increase their deficits, the corporate sector's profits will increase and conversely. 

I have a lot of issues with his thesis which I will briefly touch on: first, GDP is not a static or zero-sum measure, such that the growth of one component must come at the expense of another. GDP is a periodic measure that is analogous to an income statement for a corporation.  Just as all the y/y growth in a corporation's revenues can in some cases fall to the bottom line, so too all the y/y growth in GDP can go into one sector. But because total GDP has grown, the one sector's doesn't necessarily come at the expense of another sector.  Second, there are aspects of how GDP and corporate profits are defined by the agency that keeps them that, in my opinion, make them not wholly reflective of the economy.  Mainly, they are defined to exclude much of the financial activity in the economy and do not, for example, capture directly changes in balance sheets or wealth, people can draw down on savings, or borrow, and the changes in their net worth don't show up in GDP or corporate profits, although the spending that is thereby funded will increase GDP.  So  profits can go up without a corresponding offset occurring in the individual or government sector - that increase comes out of the incremental GDP.  Thirdly, the experience of Japan shows that corporate profits can stay well above 6% of GDP for an extended period of time; as this chart from Credit Suisse shows (in Exhibit 5), the mean share of that economy's GDP attributed to corporate profits has risen steadily over the past 40 years and now stands about 9% (faint red line rising from left to right). So short-term mean reversion is not a given. 

Hussman made an excellent point about QE's failure to impact economic activity with this chart:



Simply put, the chart shows that, as the monetary base has increased, the turnover of that money -- its velocity -- has been declining.  In other words, much more money is being created but economic activity is not going up commensurately, so the stock of money just moves around more slowly.  It's not doing much of anything for economic activity; by creating more money than the economy is really going to use, it drives up financial asset prices. In the case of financial assets in the form of debt, it drives down yield, as this chart shows: 


In the case of financial asset prices, they have maintained or increased yield despite price appreciation due to the rise in corporate profits.   One way to describe what's been going on is the interest income being lost annually by savers due to QE's financial repression has just found its way into corporate profits instead, increasing equity returns but just moving money from one form of savings to another. You can read a good summary of Hussman's presentation at Advisor Perspectives.

John Mauldin made some very good points about Japan's pursuit of inflation to stimulate its economy.  In addition to endorsing a strategy of long Japanese stocks (due to increased exports) / short the Japanese yen (which can be implemented through the ETF symbol DXY, which is up about 50% the past 6 months), he also observed, as did Mish, that industrial sectors in other countries will experience deflationary pressures when they have to compete with companies whose costs are paid in a depreciated yen.  They advised focusing on Japanese high-tech stocks that are not much affected by commodity prices, which will rise in yen if the central bank achieves the anticipated inflation. He also pointed out that Japan's export growth would probably make things harder for South Korean competitors.

Chris Martensen presentation substantially tracked this blog post of his, which lays out many of his concerns about natural resources and central bank policy.  In his Yahoo! interview, he predicts a 40% or worse fall in the S&P 500.

Additionally, Michael Pettis and Jim Chanos delivered very bearish presentations on China's economy. It was made clear by other speakers that Pettis, who teaches in Beijing, could not speak with full candor on the record because negative views could impact his status in China.  The implication was that he was soft-pedaling how bad things are ( to the extent that was true, Chanos cleaned up for it later).  Pettis doesn't believe the country can sustain another decade of investment-driven growth. One interesting point he made was that the annual cost of pollution in China is estimated at roughly 3.5% of GDP.  He also said the economic gap between Beijing / Shanghai and the interior of the country is enormous and growing; no one seeking economic success wants to "go west".  is massive.  His Yahoo! interview is here.

Chanos's short thesis was impressive.  As he says in his interview here,China's GDP has quadrupled this century but its stock market has not budged.  There is an ongoing credit bubble and their economy is increasingly dependent on credit creation, but the marginal impact of new credit is declining and quality is poor. Capital flows out of the country are enormous.  He had some remarkable tales of how party, business and military elite circumvent capital controls in Macau and HK. He pointed out that GDP measure reported by China does not account for depreciation (capital consumption), so if a building is thrown up, it adds to GDP, but if it falls down, it doesn't reduce GDP. 

Mish Shedlock spoke a little less than some of the other speakers.  He covered a number of topics.  The one  point he made that stayed with me the most was when he showed that, contrary to popular thinking, the corporate sector is not really awash in cash; as this chart shows, if you take into account corporate debt, the corporate sector is in fact a net debtor as you would expect it to be.  

So basically everyone was quite bearish on financial conditions.

Afterwards, a number of attendees went to Nicholson Ranch, a magnificent winery in Sonoma with a number of 90+ rated wines, where owner Deepak Gulrajani gave us a tour of his caves - yes, real caves underground where he stores wines  - and fed us a terrific dinner.  I definitely recommend including it on a tour of the Sonoma wine country.