Friday, October 24, 2008

What about the stock bubble?

I am having a hard time no opening this post with an obscenity, as they keep talking about the housing bubble. We have a stock bubble, which I define as any market where the dividend yield is under 3%. We have left that area recently, but for 13 years we sat in the below 3% range on the SPX and Dow and the Nasdaq doesn't have a dividend save a few large stocks. The stock bubble has been so ridiculous that they quote long term statistics now that only encompass the bubble that began somewhere between 1993 and 1995.
Long term the top of the SPX was defined as a 3% dividend. That is the top, not the bottom. Also, a downturn wasn't conducive to 3% dividends, but more like 5% dividends, the return necessary to hold stocks while the economy wasn't growing. This has happened for long periods of time in the past when the system could not produce its own inflation, a period we may be headed into now. Being that stocks use inflation to appreciate, running in place isn't conducive and you can get 3.6% or so on a 10 year treasury, so why hold stocks. But, we have a generation X that knows stocks always go up and a boomer generation that has to have stocks work or they are poor geezers who have bills that will consume their entire savings.
Another measure has been the percentage of GDP the market equates. The closing value of the SPX yesterday was 908 for a cap value of $7.949 trillion. This indicates the entire US market is worth about $11 trillion which is 80% of $13.75 trillion. I don't believe the US economy is any larger than that, but the point of this contention is that 1929 was capped at 80% of GDP and no prior market had ever traded higher, yet this one is [B]DOWN TO A BOTTOM IF YOU LISTEN TO THESE IDIOTS. [/B] We are at bubble valuations no matter how you slice the history of the market. The housing market could remedy a bubble by a 50% decline, but the stock market is still roughly in a bubble even 50% down. In fact we are as high today as we were in 1929 when dividends were headed upward.
The only difference between the stock bubble and the housing bubble is the housing bubble provided the cash for both and for the bubbles in automobiles. The market would have gone to 400 in 2002 had we not had AAA rated and evidently government backed FRE and FNM pumping triliions into the markets, spilling money all over the world to launch a boom in China and a huge jump in demand for commodities around the world. What the housing bubble floated were bubbles themselves, but I believe the stock market bubble actually got the whole poison punch party going.

Wednesday, October 22, 2008

The inflation side is missing it

Santelli has to sell something and now it is the idea that there is actually money going somewhere. The Fed stuff is replacing missing cash from the system to hide the insolvency of the big banks. The government bailout is going to be a swap of marketable securities for unmarketable securities and for interest bearing equity positions. The banks are taking on liabilities in this situation and really not getting interest bearing assets in return. Banks don't have a cash account and one of the reasons t-bill are so low in yield is that all this money is circling the drain back into t-bills, which are in short supply.

The other thing they are missing is that the economy hasn't slowed to the point we are going to see it slow. The government hasn't admitted to a recession, yet the public has been screaming for a year now. I read in Bloomberg that SPX earnings have declined 27% from last year on the 147 companies that have reported so far, but the CNBC crew was advertising -10%. Wait until we see 8% to 10% unemployment. The Fed is pushing on a string.

They are now saying the Fed started agressive action in early October. Which October? The Fed has been agressive for a year, letting commodity inflation rage. There is revisionist history going on over and over again. The Fed has really not had to wage a fight against inflation for 20 years now, only the rise of China creating inflation through excessive flow of dollars to lower production cost areas. One could say the dollar and the US inflation rate has benefitted from this action, but it was the dollars that put the jobs and demand in place in Asia.

There is an absurdity being revealed, whether you listen to one of the CNBC idiots or Warren Buffet. Buffet has been waiting on a time like this, except he buys into the Socialist idea that the central bank can do anything. Well, I don't see anyone cancelling debts because they can't make their own books balance if they cancel them and if that becomes the norm, then there isn't any use being in business because all money becomes an IOU nothing because no one is going to pay.

The CNBC crew, the idiot Dennis Kneale, brought up the revised 110-age (used to be 100-age) model for being in the market. I don't know too many people rich enough to have half their assets in an asset class at age 60 that goes nowhere but sideways down for 10 years and promises to do the same for the next 10 years. People don't live to 110 except on rare occasions, so rare that hardly anyone on this board has ever personally known a person that did. Second, the price idea, which is where Buffet is piling in doesn't support a long term market return. Stocks are cheap when the dividend for the market is around 5%, not 2.8% or 3.7%, which is the stated returns on the SPX and Dow, inflated by a credit bubble.

Going forward, lets see who is stupid enough to plunge into debt, which is about the only way all this smoke (replacing lost funds with IOU's to the Central bank and government isn't printing money) or how willing the banks are to lend more money to those that couldn't pay the interest on it for 3 weeks? I believe we are going to see an amazing backwards roll in the emerging markets. I have been making this argument for a long time, but they try to spin it out as a disconnect. It is clear there isn't a disconnect, that the debt bubble isn't a US subprime problem, but a global speculative credit bubble. The losses on US subprime were minimal in light of the total debt structure in the world and is a CNBC coined excuse for the entire worldwide investment banking scheme. We are going to find the corporate takeover bubble is going to dwarf the subprime mess.

Now they are talking about the gasoline decline boost. If the price of gasoline had the effect Dennis and company pretended it did, the economy would have collapsed in 2005 when we first saw $3 gasoline. My contention is that gasoline was going on the credit card and we are now in need of more borrowing to keep the credit bubble inflated. Also, every penny of decline comes out of GDP, as it is measured as production at some point. Every $1 is $82 million per day, which means $10 is $820 million. It isn't necessarily money that is going to be spent and it will have devastating consequences in countries that depend on oil production. I expect a massive downturn here in the DFW area if this phenomenon continues as the largest oil field in the country is being developed here by XTO, Devon, Chesepeak and others. I believe these companies could very well go broke in a deep recession, as the cost of producing this gas is only marginally below current prices.

The price of gasoline is actually below the price of oil when you do the 42 times gas price. The energy argument is one the bulls can't win because a rebound means we move back to $144 or higher and if we don't, we are probably going to get cheaper gas prices, it will be because we have a depression.

The deflation argument is centered around what is going on. Oil is declining because of a drop in demand, not because to dollar got more valuable. But, the dollar got more valuable because the market can't supply the cheap extra dollars it was providing in the past. Forget the Fed funds rate, as that is either income or expense for a bank and a wash for the banking system. The impact is going to be if the economy demands more or less money to operate. There is a difference between that idea and what is going on with the banking system, which is central bank and government injections, not for lending but to stop total collapse. The gasoline example is one comparison. For the consumer that doesn't have a credit card, the spendable income is going to go up, but the guy who is living around credit will merely not put extra cost on his card. All people are going to attempt to lay in some kind of cash cushion, something many wouldn't have thought about a few years ago.

Now Dennis is calling a bottom of the California housing crisis. He has no clue how long this will take to reconstruct. Neither do the stock bulls, who look at the credit bubble reflated 2002 market and how it got even in 5 years. The bubble that made the 1990's market and picked up the 2002 market has burst. A couple of people on this housing nonsense are telling the truth after 2 years of studying this mess. More than anything in the US, the amount of home equity left is as deflationary an indicator as anything.

The other inflationary power in the world is the emerging markets, the BRIC countries. They are the canaries in the coalmine, as most of them have been on spending binges. China has been literally built into a modern economy in 20 years, most of it happening in the past 10 years. Almost half the people in the world live in China and India and a slight move upward or downward in per capita demand for anything in these 2 countries has a massive world effect. Consumer demand for automobiles in these 2 countries has been the demand push for oil, as much as anything. But there is another demand push, capital expansion. If the demand for goods shrinks in a recession, I am afraid the capital goods industry rolls so far backwards (read Von Mises business cycle) that major chunks of the economy just goes idle.

Look at how strong the battle has been against something they say isn't likely, deflation. It isn't likely, but we watched it occur in the second largest economy in the world while the rest of the world was actually pumping up a bubble. How could Japan go in the tank while the rest of the world was pushing the game upward? This happened in Japan while the rest of the world was having an inflation party. What happens now that the demand for the world, the US, undergoes a massive economic restructuring and financial re-organization?

What is true for the US is also going on for Europe and will be going on in the emerging markets as well. I believe Brazil and China are massive bubbles and Russia and India really have such poor and socialist supported economic models that they have huge black holes to fall into. China claims to be growing at a significant pace, but I suspect it is expansion that will not be utilized. When it runs its course, the demand for commodities worldwide are going to fall into collapse and the resulting hit on world demand for everything is going to be mindboggling.

The CNBC guys are again talking about the bottom being in based on the speed of the decline. One guy says wait and the other guy says plunge, but neither is really arguing we go lower. Erin Burnett brings up the decline and they all measure this market against 1974 and 2002. I don't believe any of them can honestly compare this market with those 2 markets, though 2002 has a few simularities. The market in 1973 was paying a 3% dividend on the SPX and by the bottom, the market was paying enough yield to make a bottom. Also, the financial system hadn't collapsed. The financial system has collapsed across the board and what is left that hasn't collapsed is going to collapse, mainly in the discussed emerging markets. What is actually a series of props, is being sold as stimulous and printing money. Deleveraging is being done with no recogition that leverage isn't coming back and that deleveraging means destruction of credit.

We are off about 45%, give or take a few percentage points. This looks like a buying opportunity, but in real markets, the SPX would pay 3% at peak. It pays about 2.8% after this decline, so we are above peak, not below it. The financial situation supports the idea of dividend cut instead of dividend increases, with declines of 50% before this bear is done, not out of the question. It hasn't occurred to most companies and consumers yet that they are going to need to conserve capital and cash, as has been shown by the busted industries. It amazes me that banks are still paying dividends while panhandling money under smoke screens from the government and Warren Buffett at high rates. They won't be paying anything by this time next year and bank dividends are a huge part of what is paid on the market. Also, the stock buybacks are going to end, as they find out it is harder to raise capital than it is to spend it.

The point I am moving to is that the market is probably going to fall 80% or more before we find a tradable bottom. This market isn't a 1974 or a 2002 market, but a Japan market or a 1930 market. This is the difference between a slowdown and a bursted bubble and this is a worldwide bursted bubble. Remember, the disconnect story was still playing 3 months ago and some of it is still playing for China now. The downturn in Europe and the burst bubble is worse than the US and the bubble permeates all areas. My point is that the investor that has ridden this market down and gets out now is going to lose the 45% or so. The guy that takes the plunge here could lose 60% to 70% based on other bubble models, namely Japan and the great depression.

I believe Wall Street has been trained to depend on the allmighty Fed. It amazes me that they threw rocks at Japan, but in reality we aren't doing anything different other than the pre-emptive bank bailout. One problem is the traders are too young to have lived through a real bear market in everything. Remember, though the 2000-2002 market was hard on tech, housing and commodities actually did pretty well during that period of time and there were carry trades to be had that were like stealing money. Today all this stuff is unwinding and the Fed can't cut to zero.

The idea of how the banking system works has been confused. The Fed is a liquidity provider and a lender of last resort, not a loan maker. In theory, the Fed could buy treasuries and leave the money in the system, but it is more likely in a tough market that the banks would take the money and buy treasuries, thus putting it back into the Fed. Fed liabilities don't make for lending and we are about to find this out. They keep the banking system liquid, but not necessarily solvent.

The banking system has literally been allowed to operate in a position of insolvency. The Treasury smoke screen that has allowed so many insolvent banks to get capital injections in the form of government 5% preferred stocks is almost criminal. Injections from the Fed and capital injections hardly make for a lending boom. Especially when the limits of the last boom have been permanently pulled in, no subprime and soon no high risk credit cards. What is also missing is the previously mentioned home equity, which will threaten the credit card, mortgage, real estate and other consumer related industries. Its effects will be felt from mainstreet to Bejing.

Friday, October 17, 2008

Is it safe to get back in the water?

In late 2002, I was going to write a book I was going to cal, Is it Safe to Get Back in the Water? In it, I used all kinds of market data to show that stocks were extremely overvalued, even near the bottom price of 2002 and that the buy and holder who got out or the guy looking for a once in a lifetime buy was making a mistake. For one, the PE on the S&P at that time was near 50, most companies having taken losses they were holding during the make the number or crash boom and financing being tough for the junk portion of the market. My reasoning was that the valuations were extremely rich, the dividend yields lower than at any time in history prior to this bull market and this was even true on the exact bottom tick, where there was about a 4 day opportunity to get in. Even so, the market presented a good opportunity to get in at prices not seen since 1997 and 1998, which is one of the reasons I expected the market to go down after a rally, not up. Generally, it has been my experience that if a prior bottom of significance doesn't hold, we go to the next significant bottom. There wasn't a significant bottom in the market until you got back to 1996, when the Dow was in the 5000 range and the SPX in the 500 range.

Being that the S&P internals over recent time had valuations over the long term that presented a value under 500 in 2002, I built a case that the market wasn't going anywhere long term for quite awhile. I didn't count on the extraction of several billion in home equity, the circular lending of credit back to the US for close to a decade from China and other countries and the advent of financial tools that could create marketable debt out of water. The financial bubble was going to get bigger.

What never changed was that stocks remained in ridiculous territory. At the peak, the dividends on the S&P were under 2%. It is true that there were companies in the S&P that spent huge amounts of money buying back their own stock, namely Exxon-Mobil (XOM), the big banks and a few staples like PG and MSFT. These 4 or 5 banks, 2 or 3 oil companies and 4 or 5 consumer companies amounted to over $100 billion a year in buybacks. XOM was buying back huge amounts of stock despite the protests that it wasn't putting its money back into oil exploration. The big banks, Citi, Bank of America and Chase were buying back $30 to $40 billion a year between them. Few would realize they would be going around the world shortly with hat in hand begging capital infusions, finally being part of a big government bailout.

The point of all these buybacks is that they could be used to pay dividends and adding them to dividends would give the market a pretty decent number. But, in my education, this isn't growth, but instead liquidation. In the case of the banks, we are now finding out that paying out all this capital in liquidation was a terrible mistake, as the ownership interest in these entities has been irreverisbly damaged and in fact, I suspect most would have gone broke without government and central bank assistance. In the case of XOM, it was clearly a liquidation of assets and likely vision that prices wouldn't hold at current levels and it would be better to use the money in liquidation than in exploration at that time. In XOM's case, investing in its own stock may have been the best use for the funds. I doubt their cash flow is going to zero any time soon.

Throwing out these entities, the negative and the positive, what do we have. The 3 Dow banks, at the peak, had earnings above $50 billion as a group. XOM has had historic earnings, so large that they have incited class warfare talk in Congress. Combined these 4 entities had close to 1/8 of the earnings in corporate America. Do they continue to generate this kind of income once the credit bubble deflates and quite possibly oil profits decline? I am going to say no for the time being and probably $50 billion or more of the temporary, bubble peak earning capacity of the Dow is gone having been a beneficiary of the biggest financial bubble in history. The other big earners in the Dow, are INTC, MSFT, MRK, PFE and a few others. In fact, all the Dow companies, save GM are high earning companies and between them, probably comprise close to 40% of all corporate profits. They claim MSFT is trading around a PE of 12, meaning their profits are around $20 billion. INTC is around $10 billion and the 2 drugs are probably a combined $20 billion minimum. Throw in another $25 billion for the telecoms (at least this amount, but I am making a mental estimate and not an informed guess). Then we are left with GE, JNJ, PG, WMT, AXP, BA, CVT and IBM. There is easily another $140 billion earnings out of this group. This gives the Dow 30 a top earning capacity of around $350 billion, easily 40% of all corporate earnings in the US at the peak. A bull could easily justify a market cap of $5 trillion for this group that should be able to pay $175 billion in dividends for a 3.5% yield.

This would be a reasonable valuation if we were talking about reasonable times, but I suspect we are on the way down. My past argument was based on SPX earnings and dividends, not the economy, though I knew at the time there was a threat to the economy. I had only an inkling of what the threat was, having digested only a small bit of what actually causes deflation. I did know it had something to do with asset bubbles, but what was supposed to crumble first? It is pretty apparent today what that is.

There are 2 reasons I don't like stocks. One is the low dividends, which I believe is a reflection of the judgement of corporate directors that these companies cannot sustain higher dividends and run the corporate environment they have evolved into, namely paying huge salaries and stock options to management. Another could be contained in the prior sentance, that management and Wall Street are taking advantage of shareholders in fashions that shareholders are only going to be aware of in years to come. Stock buybacks only give money to those that sell the stock, not those that own it, though it serves to concentrate earnings. What do you do for an encore if you need cashflow out of stocks? You don't live off dividends at valuations bulls would have you believe, unless you are very rich. Imagine being a millionaire and drawing less than $20,000 a year income out of your portfolio. I believe that the S&P ETF would pay you about $23,000 net out of todays SPX, roughly 940. $23,000 hardly pays the utilities and rent on a cheap apartment and gasoline and depreciation on a nice car these days. Thus, the holder is caught in a strangle of living below their means or liquidating their principal, neither attractive. The real point is that few are situated with million dollar portfolios and more than likely with less than $250,000. Holding an index fund provides very little in living expenses on this level and holding your portfolio heavily in one stock that pays well or in marginal bonds exposes the holder to market risk, though one could hold a portfolio of several stocks paying in the 5% range now. But, the capacity for this stock to be widely held is not there. Which of the banks do you want to hold now? I figure that 50% of the dividends are paid by 20% of the market capitalization on the SPX, which leaves room for about an $1.6 trillion investment in these stocks. Being that so much of the holdings are held by trusts, this doesn't leave much public float in these companies for the public to concentrate their wealth. The annual outlay for Social Security and Medicare are not much below half this range and I doubt half this stock is available to the public. This really isn't a solution to people looking for retirement savings.

The second reason is the bubble itself. I have looked at dividends and PE's from 1925 to 1930. There was an amazing growth in dividends and earnings between 1925 and 1930, as the financial bubble financed everything. I believe the Dow paid roughly a 3% dividend on the top in 1929 and an 8% dividend on the bottom. It quadrupled between 1925 and 1929 in price. The dividend rate fell from 4.8% to 3%, meaning payments went from roughly $4.80 on the Dow to about $11. If you look at the past 4 years, you will see growth in earnings that are way beyond reasonable and a level of corporate earnings that are the highest against GDP since, you guessed it, 1929. The momentum on these earnings went right into 1930, despite the crash.

It is hard to say how much of the earnings in the market came out of the bubble, but it is a good bet that most of them are going away. The government might be able to save the banks, but are we going to have a return to subprime lending, huge piles of money being borrowed by the financial industry to spin into leverage against a myriad of products, credit cards to homeless people and money for leveraged buyouts to anyone that can show the banks a plan? Remember, all this credit circulates and creates marginal demand. Marginal units are much more profitable than the average unit sold for about all industries other than units that cannot be produced without extensive extra resources. For example, how much do you think MSFT earns off an additional set of Windows or Office? My best guess is the box, disk and instruction book probably costs them $2 in the quantities they manufacture them for. The costs were already paid for the development and the product support is going to be the same whether they sell 20 million copies or 200 million copies. Being the real money is in business licenses, figure that business formation and growth goes down the drain in a burst bubble and they lose 10% of 100 million copies they would otherwise sell. My guess is that a license sells for $100 annually, so we are talking about 10% of MSFT's profits on this one item. Throw in the license of Office, probably 50% of Windows and there goes another 5% of their business. Throw in the fact that consumers aren't buying new PC's to roughly a 30% sales decline and the 200 million copies becomes 140 million copies at $50 each. There goes another $7 billion or 35% of their profits. In these 3 centers alone, there is 50% of MSFT's profits and we aren't even talking about growth.

We have already seen the auto industry implode. Housing is still being peddled at pre bubble records, so it hasn't come apart as it should before we are done. AAPL has some new fangled computers and cellphones, but I find it doubtful that the market for $500 cellphone gadgets is going to hold up and we are going to see a price war between the competitors for a shrinking market. The market may not shrink as much because the prices may fall to the point that the cheap alternatives are no longer attractive. Then throw in the shrinkage in cellphone demand, the shrinkage in business demand for telephones and you see the marginal profits of the telephone companies disappear. You also see a battle to utilize capacity in this field, which could very well erupt in a price war for subscribers. I venture telecom is nearly as big as oil in the US economy.

What is the alternative? Bulls are now claiming that the Dow is priced along historical grounds. Of course, they are looking at a Dow of 8800 and not 14,000. They were bulling the Dow at 14,000 too, but the outlook when it was at 14,000 was much better to the general public than it is now. If they are correct and we get the financial collapse solved, you then own an index that pays about a 3.4% dividend and will grow at inflation plus maybe 1%. This gives an inflation plus 4.4% return, some 1.4% greater than the long term return out of treasuries, but far from the 10% they tell you that stocks return. 7.5% looks good when compared to t-bills and CD's right now, but the CD's and t-bills aren't going to be this low forever and will return inflation plus 3% over the long term.

In taking this alternative, one must realize that if stocks are roughly at long term normal values, using 2.5% inflation, you get a double in 20 year and maybe as long as 24 years. They are telling young people they should stay in the market and old people to get out, why? Is it just risk now? In any case, if you get the double, you are looking at a Dow of 17,600 in 20 to 24 years, which would be a disaster for those that got in near the top. Not exactly a repeat of the last 24 years is it? If the Dow price is higher, it will be due to higher inflation, not better performance, as we are using bubble economics to stand where we are, not a depression. The view on stocks if we go into a deep recession or depression will be entirely different, but look on this perspective as well. If you do get in and this is the result, which it will be the most likely best bull result, remember that capital gains is going to take 20% of your gain, so deduct 2200 from the 17,600 and you will find out that inflation and capital gains has taken part of your principal. I believe we can see this result looking at the price history between 1929 and 1954 and between 1966 and about 1982. In both cases the S&P started out with much higher dividend yields than this S&P peaked or for that matter pays now.

What are the hazards? Look at the Great Depression market. It was a disaster and even the 50% point held the price action for 20 years. If you don't believe the depression will repeat itself, try Japan. This past week, Japan got really close to 8000 on the Nikkei. It has been as low as 7600 and change over the past 10 years, but it started at 39,000 at the end of 1989. We are approaching the end of 2008, meaning that after close to 19 years, the Nikkei is trading near 20% of its peak and has been lower. Money has devalued 30% or more, meaning the current price is closer to 5600 against the peak of 39,000. From what I can tell, business in Japan has been as good as it has in the US, so it isn't like they fell off the face of the earth and they had the worldwide benefit of the US financial bubble to prop them. Imagine what would happen if the bubble hadn't been present?

So where are we? If you believe my figures, we are hung between after tax break even on one side long term and potentially at roughly the same level we are now with devalued money in 20 years or even worse, a Japan situation in 20 years. What happens in the meantime is even more important, as Japan has had some great bull markets over the past 20 years, 50% moves in a year several times. But, what happens if you stay in and have to sell and never have your capital again, something that is more common than you think? Markets bottom when the players give up, not when they get too cheap. We are far from being too cheap or the players giving up right now. They talk about capitulation, but there isn't enough money in the world for the accumulation of players and stock to capitulate in a month, a quarter, a year or maybe even a decade. The smart money will wait for values to appear that cannot even be imagined now and for the edge of the world to appear so they know they won't fall off. Though it appears there are nice values in some stocks, it all depends on financing returning to abnormal, which I don't believe is going to happen. We are going to see a different earnings and dividend picture appear over the next year as financial deflation and capital conservation take hold. It isn't out of the realm of possibility that earnings in retailers implode, that banks all suspend their dividends, that XOM no longer has fuel to buy back stock and that the tech industry has a collapse in high margin business. Being we are only 1 year after the peak, it is highly unlikely the real buys are going to show up for at least another 18 months.

Tuesday, October 14, 2008

How they are going to do it

First of all, I would like to point out the lying, deception and lack of fairness in this finacial crisis. The government, namely the Treasury department and probably the Congress have failed to come clean on who was and wasn't solvent in this matter. There has been this nonsense that the banks wouldn't lend to each other, when in reality, they have allowed huge NY entities to operation insolvent while trying to mask the problem. I have a hard time believing that either of the huge NY banks or any of the brokers, including Goldman Sachs have been solvent and most likely none of them are less than $25 billion below even. Thus they have all been engaging in business with either a negative net worth or below statutory capital. The whole matter has been masked under the topic of subprime mortgages, when in fact, subprime is just the tip of the iceberg and most likely not even the primary cause of this crisis.

It wouldn't take a rocket scientist to recognize that Citi was in trouble even 1 or 2 years ago. Their financials from mid 2007 revealed they were deficit $400 billion in fed funds. Any banker would quickly pick up on that idea and thus anything they might come out with in losses short of $400 billion was probably suspect. JPM is quite likely in the same boat, though they have been fed everything under the sun. I highly doubt Citi really gave in on acquiring WB, but that to attempt to fight that battle would open a can of worms that came out of something dead. WFC, which I don't believe is exactly on top of the world would make Citi prove their net worth and I doubt Citi was in as good of shape as WB and thus would be commiting fraud in the merger, but then again, I don't believe these guys recognize fraud.

The guarantees made to prop up the banks are not only unconstitutional, but criminal. The government should seize every one of them rather than make such promises. I would be for the government chartering a $700 billion capital reserve bank and getting matching capital and go into business against these bastards rather than agree to take the hit for what is likely to be trillions. I still say that they have spent a year trying to create enough smoke to get Citi, Goldman, JPM and a few other NY firms in out of the rain. For now, it appears they have succeeded.

How are they going to do this? I listened to Maria Bartaroma Tuesday and she had the opionion they were going to buy stock. I even saw it on the Prudent Bear board, but there won't be any stock buying. Buying the stock over the counter of banks wouldn't do anything to solve the problem. In fact, they might as well print up the money and throw it in the street as to buy stock in this fashion. It appears they are going the preferred stock way and in order to create the smokescreen I mentioned, they are going to act like all the big banks are required to give in and take this money. For 5% interest, they are going to get treasury bonds that yield probably around 4%, thus the net cost is going to be 1% or so. Beats hell out of Buffets deal for 10% to be used to buy securities that yield 4%.

The idea here is that there isn't going to be any money. The delusion is the Fed is going to print money and give it to the banks is just way out there. In fact, the government is going to make 1% out of this game of make believe. Though it is highly unlikely, they are also going to sustain a gain out of the stock of the banks, should they go up. If the banks go bust, the government gets their bonds back because they are in essense the guarantor.

What else this is going to do is open the door for all this Fed financing to be reversed. All the TAF's can be ended for the time being. If they continue, you can bet the liquidity crisis is on going and nothing has been solved. But, if we see the TAF cease and the interest rates go back to normal we probably have something the bulls would like. For one, I don't believe anything that keeps this bubble intact is going to be anything more than a bandaid. I don't care if they put in a trillion dollars. (amazingly they probably have and it is amazing we are talking about trillions around the world when such a number is so phenomenal that I would have never thought I would see it anywhere involving money but the Federal Debt).

What I see is more deflation coming out of this. The gold bugs, the action counters can't see this, but the interbank lending will do away with the double Fed action and remove bank money from the money markets. The money supply will shrink, not grow. Second, they will replace lost bank capital with treasury bonds, not cash. The banks can lend the money back in the overnight market if they like and the customers of the banks don't use a lot of cash unless there is a panic. I am not sure the banks are going to go out and lend a lot of money out of this because of what I wrote to start here, that they were massively insolvent. Some banks had a lot of money to lend because they had so much deposited from the overleveraged banks.

The idea that you can blow another bubble to replace the bubble that bust might work as long as there is another bubble. There isn't a bubble to replace the world real estate bubble. I have heard about Hong Kong real estate prices forever. I wonder how they can pay those prices or is it just something that sits there, as the US stock market has for years to draw money on as collateral with no recognition of the carrying costs or the rental market. I don't know many people that can pay $1000 a square foot or more for a place to live. $1 million for 1000 feet blows my mind, as that is $7000 or $8000 a month when you throw in maintenance and debt service. I didn't know Chinese made that much money. Ditto California and NY and Florida and now New England. The market is going to now show the bubble in the mentioned areas where the bubble hadn't burst yet.

I don't believe the government can go to market with an extraordinary number of bonds. The t-bill rates we are seeing now have more to do with the overflow of funds the Fed is pushing into the accounts of weak banks and financials than interest rates in general, as the suplus funds are coming back through the back door. It is amazing to watch an insolvent system operate.

Friday, October 10, 2008


sorry about the rambling nature of this post, as I started it somewhere else

I tell you that this indicator isn't even an accurate read here. This isn't a sell off, it is a liquidation. We could get a strong rally. They keep talking about bottoms. They keep talking about bottoms. They keep talking about bottoms. No one is talking about what could happen, what is going on, only about bottoms.

My bean counter friend called me a few weeks back and brought up the VIX. I think the Dow was about 10,800 or even higher. He said that was supposed to make a bottom. Now we are down 3000 points. The VIX is supposed to make a bottom.

The reason there aren't any buyers is they have already bought. The guys that say they would buy have already for the biggest extent, already bought. The shorts are going to have to put a bottom in this market as they have the money.

Lets see if the brokers still have the short money to cover the trades? This will be the next mess, what have the brokers done in a decline like this? We are well into the 1987 mess and we were already down 3500 points when this downdraft started.

They are talking about confidence. The public doesn't have a clue about confidence. They still think confidence is the problem. This a broken bubble and there is continued confidence there will be a tradable bottom that will make the trader rich. There is little recognition this is the start of a deflationary market, not a buying opportunity. The market keeps going down because the bulls are buying every bounce as the bottom. Today is no different but the rally actually happened at the right time, right after the open.

The lost idea is that what the Fed has put out is owed back to the Fed. Thus these are liabilities in the system, not gifts. The CDS's are nothing more than money changing hands. The bulls think all this money has come out of the market. Nothing came out of the market that didn't go in. The whole idea there is cash in the market is nonsense.

Right now I am in front of the TV watching experts, all under 40 years old and some under 30 years old and some that look like they might be 25 or less telling us what is going on. The people that have seen a game like this are all dead. The market isn't cheap, it is high. It is high in relation to every generational top over history. It might be cheap compared to the top, compared to the Mississippi, South Seas and Tulipmania bubbles, but it isn't cheap.

This is not a capitulation market, it is not a crash yet, though it is a crash. It is a liquidation of tens of trillions of excess credit, excess speculation and overvalued assets. We are in a generational deflation. Everything about the stock market requires the re-establishment of the credit machine we have seen constructed and implode over the past 20 years for it to resume its trend to make anything. The money out there is all owed to something and it isn't sitting on the sidelines waiting to pounce on stock market deals. The money on the sidelines got there from money on the sidelines, not from heaven. The money on the sidelines, sans Federal reserve hocus pocus has no support behind it.

Tuesday, October 7, 2008


We are in a bear market, yet no one wants to recognize that. We are in a recession, yet we keep hearing about how we might avoid a recession. We have reached the level of maximum credit, yet the Fed pushes on a string, refusing to allow the markets to correct. Every bounce in the market brings in the debate between the talking heads that a bottom is in.

2006 was the year home prices peaked and trouble appeared on the horizon. The top wasn't in for 3 months before speculation started as to if the bottom had been hit or not. The year 2007 had more bottoms, despite the research and history being provided by Robert Shiller, whose name is now on the index he created, that housing was way out of the bounds of American pricing history. The appreciation was real, the subprime buyers were real buyers and the stall was nothing but a hiccup.

2007 saw the top of the stock market. A top in the early part of 2007 was followed by a break that many bears thought was the top. The bulls piled in and the market went higher. CDO's were still selling and hedge funds were still leveraging up on everything, providing massive cash. We had a mild panic in July 2007, followed by another bottom and bulls piled in and created a new high in October. The bulls had been buying for 2 years based on the idea that the Fed would cut rates and everything would be okay, even while the Fed was raising rates. Speculation was rampant and thinking was wishful.

What has 2008 provided us? In housing we have witnessed lower and lower prices and sales of existing homes has fallen to 4.9 million units. How many truly qualified new home buyers are out there? My guess is maybe enough to absorb 1.5 million to 2.5 million units annually, putting speculative purchases in the range of at least 50% of the market. They call these guys investors. I call them speculators and I think over the history of investing, these buyers would be called speculators and not investors.

Why would a housing market, where existing sales had fallen about 30% be speculative? I say it is speculative because there is a long history of statistics in housing sales and existing home sales had never exceeded 4 million units prior to 1997. That was the long term top. We are 125% of the long term top in home purchases. Some of this could be related to excessive inventories, but what we are looking at is excessive inventories being even more excessive if sales actually reflected the bust that prices are reflecting. What we are seeing is price declines in the midst of historically high home sales in a period where the claim is that credit is being restrictive. Normal busts would have home sales at or below 3 million units, not 5 million. If you look at this link, you will see where downturns have taken home sales and under any definition, housing is still in a speculative bubble. It is one that if it actually succeeds in turning a profit over the next couple of years will actually lead to an even larger bubble, more speculative lending and an even bigger bust. The NAR has carefully hidden long term statistics to hide the fact that home sales are still at boom levels on a nationwide basis and not in a bust, hoping of course to get more government aid and more speculative interest.

The stock market may be even more speculative. I can hear over and over again these guys talking about the bottom being in, how stocks are cheap and how earnings are going higher and higher. The 20 somethings and 30 somethings have never seen a market that wiped out a decade of gains, as the 1966 to 1976 market did, taking the Dow down to mid 1950's levels on a non-inflation adjusted basis in 1975. A return to prices last seen 20 years ago would take us down 80% from current levels, which is in the territory of where most bursted bubbles end up. The last trip down has created the idea that anything under the 2000 top is a bargain and anything under Dow 10,000 or Nasdaq 2000 has to be a steal, throwing out economics and financial principals that have prevailed up until this bubble.

It takes buyers to make the market go down because the market ceases to exist without buyers. The insiders have to become buyers or face ruin quite often as their inventories of stock have to be marked to market and thus they have to stop declines. But, they also get to sell out in general terms once the rallies happen. This time it might different as so much of the capacity to short stocks has been forbidden, thus denying the market of one of its key braking and rallying mechanisms, forced short covering.

I believe that there are literally millions of speculators out there on the long side that recent years have convinced that making money in stocks is simple business, just buy dips. The bigger the dip, the bigger the bargain. This time is different is what they say, and this time is different. I believe that the collapse after the House vote on the $700 billion fund to buy mortgages and other paper was due to the fact that the entire world had already front ran the news. What the bailout did was give the smart money time to sell out. Give the illiquid time to raise liquidity. Once the vote happened, the reason to buy was gone and the selling took over. The speculators were all in before, but they were there none the less. When the whole world is afraid of missing a rally on a vote, speculation is excessive.

There are prime indicators this is a speculative market. For one, there is the idea that prices are cheap. The Shiller index shows that prices are high, not cheap. Dividends are lower on the SPX now than they were at the peak in 1929, 1966 and 1987, yet stocks are being called cheap. The PE is based on the peak of a credit bubble, thus on inflated earnings and at the same point, historically high, not low, but being considered at bargain levels. There is buying on anticipation of the end of an economic downturn that hasn't even been admitted to exist. Supreme faith is being put in the Fed recreating the mess that got us in this mess in the first place.

This market is going to ruin about all that play it. Bears will get ripped to shreds and once bears gain faith to stay on their shorts, the bottom will be in, as there will be a rally that totally wipes out short margin. But, in the meantime, bulls will continue to relate to the highs on stocks and the shortness of prior recessions. The 2001 recession literally didn't happen if you believe statistics, though the market didn't finish declining for a year after the recession supposedly ended. The bulls say the market will see the end of the recession 6 months early, while it took a year last time for the market to see the end of the recession. Such are bubbles, as opposed to normal markets.

I lived through a housing bust in DFW back in the 1980's. The bust started in 1983 to the best of my estimate and wasn't over until about 1992 or 1993. DFW was a rapidly growing metro area during that time, not a ghost town. One problem DFW had and I believe a problem California and Florida are going to have is that housing and commercial real estate were such huge parts of the local economies, long term growth having been established much earlier that the industry itself put a hole in demand.

There were some amazing deals on the DFW real estate market in 1992. Guys with deep pockets picked up deals that broke guys with deep pockets several years earlier. Trammel Crow, who was one of the biggest developers in the world was on the ropes by 1992 and couldn't buy anything. My guess is Buffett will be on the ropes by the end of this one and won't be buying much. There won't be much dry powder by the time this bear is done.

This is why I am a deflationist. I will cover in another writing what I think is going on, why the Fed, despite its current wrecklessness, won't be able to produce the expected inflation until we don't need it. I think the basic problem is the bulk of debt that can be covered is in the financial, business and corporate management areas and stocks will be sold to cover debt. Instead of the cash changing accounts as it has over the past several decades, this cash is going to pay credit. Irving Fisher, in his deflation thesis (Bernanke is clearly a follower of Fisher, who was a Wall Street delusional socialist), said the more debt was paid down, the greater the actual value of what was owed. What the bulls think is the solution is nothing more than keeping the door open for this process to occur. Until everyone that wants to buy to make a quick buck is broke, this market will keep going down.

Monday, October 6, 2008

Is this what is going on?

The story is the banks won't lend to each other. The truth is probably that loan quality across the board has been deteriorating and banks realize they need more reserves themselves. It is clear that this is more than a subprime problem and it is also clear that many in the business probably looked at this as an opportunity to pick up some good customers until probably May. Bear was really at that time only an exceptional casualty and Citi had gotten plenty of money as had the brokers.

I don't believe many realize how much income Citi has been claiming over the past few years. They have done this in a climate where they haven't even begun to cover their lending with retail and commercial deposits, making them beholden to the system for massive funds. Citi had $400 billion in fed funds liabilities in summer of 2007 and the entire Fed balance sheet at that time was less than $900 billion, so massive amounts of money had to go in that direction. Then we get into the brokers, who were carrying massive leverage, probably in the trillions between them and all this needs to be unwound. But, I doubt it can.

I don't think it takes a genius to realize that credit has to shrink. That is what deleveraging means, selling enough assets to move your debt/capital ratio downward. Being that the leverage is in the financial and real estate markets, this means selling assets in these areas. I believe the financial mess is worse than the real estate mess, as it permeates the entire economy. LEH going bust set off a massive liquidation of assets. Some think this is a derivatives play, but I suspect the derivatives model was more of something that allowed all this credit structure to be built and not so much what is taking it down. The truth is the derivative market is capital neutral for the system, only punative on the players on the losing side. Clearly there were operations that were heavily on the wrong side of these trades, the brokers, monolines and AIG to name some majors, but the banks are also on the wrong side of the trade.

The fashion that the banks are on the wrong side of the trade is that financial growth was supported and encouraged by the derivative structures. Credit has to expand or there becomes a shortage of liquidity. There isn't anything out there to replace the leverage created by the derivatives market, which has gone from a structured market to a pure and simple casino with the CDS's over the past year. I can see where mark to market has wrecked havoc in this market, as traders have driven up premiums on everything, including a swap on the credit of the US. Absent the efficient use of these instruments, I highly doubt we could have carried the world economy past 2000 had these instruments not been there to allow for much lending.
I know I am going to have charges that I don't have a clue, but I am not sure anyone can put into words what is going on. I don't view this as a derivatives situation so much as a situation where the world debtor group has run out of the capacity to pay. Banks aren't lending because there is a hole in their cash machine, not because they have good loans to be made out there. Most banks are conservative, lend locally and attempt to make good loans. But, most money in the system has been loaned by wild west financiers and banks geared to attempt to maximize size and profit growth, mainly concentrated in NYC and comprising the largest players in the game. The banks that have expanded their balance sheets with little local knowledge, using market insurance are the ones that are insolvent.

So many are watching the VIX, but the VIX doesn't really matter now. It might matter at some point, but there are 900 stocks you can't short, which means that put options now have to be naked or hedged through the SPX, which creates a complex derivative model. The real situation is we are in a liquidation, a deleveraging event where the economy, the financial system and consumer balance sheets have reached maximum leverage potential. I don't know where you can move the housing market beyond 100% or even 125% LTV(remember the Ditech commercials), the broker balance sheets beyond 30 to 1. Or for that matter, the forward use of derivatives to create immediate capital for banks out of future income on debt they create.
The use of derivatives has allowed the finacial industry to paint a wishful picture, the reality that the massive piles of credit could be paid or insured. Of course, this is what is defined as a delusion. I have wondered how much totally synthetic stuff was created out there to allow for locking in and swapping these instruments of mass destruction that are now coming unwound. But, I propose the real damage was done on the way up and showing up now in a burst bubble.
One might note that these aren't the little banks going under here, but the largest. I feel that the ones that are giving the appearance of having avoided this mess, JPM, GS, WFC and a few others just haven't owned up to what they have lost. LEH had about $700 billion in liabilities and I don't know of that includes the deficit in their CDS accounts. FNM and FRE were trillion dollar outfits. I would venture that Bear was about the same size as LEH. I don't know how big WB is, but I venture it is pretty large. Some idiot said it was worth $60 billion right now, which goes to the point of how much speculation is still in the system.

What happens when large institutions deleverage? Clearly the money supply is destroyed. The Fed is trying to prop this mess by replacing the funds removed from the system with interbank credit. But, now the real picture is coming into view and there can't be any real lift to the banking system by changing the nature of its liabilities. It is very clear that every dollar of deleveraging most likely comes from the same over extended banks originated the debt. If bank A lends Hedge Fund B $1 billion and hedge fund B sells stock to get the $1 billion back, it has to come from somewhere, or some account. It likely comes from the bank that finances the buyer of the instuments, but in retirement of debt it goes into the black hole on the other end.
I am sure there are plenty of bankers that know how this thing works, thus the NY banks are financing the brokers who are, through the Fed, financing the liquidations. Of course these guys have to find someone with cash to off load this stuff. Unless this offloading is financed, the result will be a decline in account balances.

The end result is we have run out of people to take out credit to pass the bags to. Bags include housing in hot areas, bags in stock, bags in financial instruments, bags in derivatives. Deleveraging doesn't mean taking out more loans, but instead liquidating assets. Any fool in the banking business knows this and I think they also know that there isn't much in lending that doesn't carry extreme risks. Why would a bank risk their money to another bank at some kind of minimal rate when they can buy other junk yielding 10%? I will leave the derivative figuring to guys like Ras and stick to my idea that the lead horse in this game is credit generation and quality and not the lube on the axle.