Saturday, December 27, 2008

The most misguided analysis in history

The more I read and study the current economic situation, the more amazed I am that the people with the platforms to speak haven't a clue what happened and what is going to happen in the world economy. In the news media, there is too much talk about the level of consumer spending and too much begging for consumer spending to pick up. This is going to be the great shock of so many, as we have seen the real peak per capita in consumer spending for the forseeable future, maybe 20 to 50 years forward. The banking industry, the consumer goods industry and the capital goods industry are going into a long flat spell worldwide. First the growth will turn negative, then it will flatten out to zero and there will be no growth along with sizable cuts in dividends, as companies struggle to survive. Without growth, the dividend rate has to reflect either the deflationary loss in future income or the real risk of holding stock. In either case, we are looking at dividends in the 6% to 8% range for most stocks and figuring the market in general is about half that, we have another 50% decline in the market at a minimum. This will combine with a 50%decline in dividends, meaning we probably have a 75% decline at a minimum, taking the SPX into the 200 range and the Dow to the 2000 level.

There is a tendency to credit groups and blame groups. I am writing this in response to the blaming of Greenspan and Bernanke in a article I just read. I think Paul Volker has as much to do with this mess as either of these 2, with his death grip monetary policy in the 1980's, but the role of all these 3 guys in all areas of their field is much less than thought. I know this idea will generate an argument 1000 miles long in print.

I have also been reading nonsense about the Chinese and their lending back to the US helping to perpetuate this mess. The money machine was in the US and when combined with the Chinese central bank, only the skids were greased a little more. The nature of a reserve currency is it runs deficits and ends right back in the country of origin, as other countries use it for monetary collateral and long term income. If the Chinese created this money cycle, how did they get the dollars in the first place?

If I were to point a finger at anyone, it would be Robert Rubin. But, much of this ball was rolling when Rubin took office in 1994. Rubin taught Greenie about the non-existance of bubbles, if Greenspans book is to be believed. The 2000 Nasdaq peak was by a factor of 2 or 3, the biggest major market bubble in history. That market alone was 100% of GDP at the peak and I believe the 1929 market peak was only 80%. The then valuations of CSCO, INTC, MSFT, ORCL and WCOM was near the valuation of the entire Nasdaq at the present. Those 5 stocks combined wouldn't buy CSCO at its peak at the present and they were nowhere near being the overvalued portion of the Nasdaq. I believe the Shiller housing index would have had to reach a level double or triple where it peaked in order to mirror such excess. The Nasdaq bottomed at 1300 on October 8, 1998 and peaked in March (I believe the 10th) in the neighborhood of 5200 for a 300% gain in 17 months. Though Greenie helped in this matter, it was the enabling acts of Rubin (collateralizing the issuance of money is what is important in money, not the interest rate, the gold or how much money the Fed says you can have) that produced this bubble. The Clinton administration put more slugs in the fusebox once this market bubble got started than Greenie could have ever managed. There was no 10% margin in this market, aka 1929 and was more a factor of continued support of cash flow through government activity. Rubin, the US treasury secretary, had at least some power over the activities of the IMF. Even so, I can only point a broken finger at Rubin.

Getting back to blame, I mentioned Volker. Volker did the US a favor by shocking it into the idea that borrowed money could get expensive, but he didn't stop inflation. Ronald Reagan stopped inflation. I know the Democrats out there are going to have a fit over this one, especially since Volker is one of your darlings today, but this in fact true. Inflation had become institutionalized and like it or not, Reagan put an end to it, either intentionally or by accident. The biggest factor in inflation was income tax bracket creep. People that are making $30,000 a year today weren't intended to have a tax bracket when the brackets were drawn out or if they were, it was to be 10% or so, maybe 14%. But, if Reagan hadn't have done what he did to taxes, the $30,000 a year guy would be paying taxes like he was a $200,000 year guy. In fact, I don't think the $200,000 a year guy pays taxes like the $30,000 a year guy did in that code. Those of us old enough to remember, recall that $30,000 a year was a magic income around 1970, the dividing line between whether you were doing okay or had arrived. Today, it is a secretarys salary in corporate America. Cutting the taxes and forcing government to cut its rate of growth of expenditures changed the institutional makeup of the US.

In short, what Volker did with interest rates, probably doubled the Reagan deficits after 1984 and created the sudden asset appreciation that produced the trend of the early 1990's that created the bubble mania. Even so, the link I propose here could be weakened by argument and I am not prepared to go at length to crucify or defend Volker. I think the ease out of the interest rate squeeze was 5 years too late at least and should have been done by 1985. Instead of easing in 1984, Volker tightened and that in itself produced a financial crisis of its own. In any case, the move from Volker to normal was an extreme shift in financial valuation and the fuel that created the real ogre of the 1990's to 2007 bubble, home finance.

I was selling real estate when I graduated from college in 1978. At the time, interest rates were a high 9% and the Iranian revolution threw a real bomb into the gearing of the US economy. As I pointed out, the structural composition of the US was such that in order to stay even with inflation, you had to outrun inflation, which produced a spiral. Higher income produced higher taxes which produced a decline in living standards which produced a need for higher prices and the spiral was on. What else this procedure did was produce an automatic tax increase for the government through the progressive income tax, which wasn't indexed to inflation in those days (Reagan could have done nothing more than reverse taxes to inflation adjusted 1976 levels and inflation adjusted the tax rates to 1976 and left them unchanged and done the same thing but left more upper income in the future for the government), so government spending went out of control in the 1970's. The spending and income trends of the 1970's projected on trend from 1960 to 1975 would have produced deficits in the $900 billion range by 1990. I have generated these figures out of actual numbers on spread sheets, so I am not making this one up. In any case, what I am trying to propose here is the shock that interest rates on mortgages going from the 8% to 9% range to almost permanently for 11 years to above 10% and many years above 13%. After moving to mortgage lending, I recall the first refinance boom was a move to under 12% on 30 year fixed money.

There was another psychology created out of this rate structure, the psychology of the CD holder. Conservative people that had cash were able to put their cash in CD's and earn significant income. My father accumulated cash through his own endeavors, inheritance and through a lawsuit for extensive injuries he sustained in a fall and during the 1980's was able to earn more money retired out of CD interest than he made working some years. Of course I am leaving out inflation, but I am also leaving out his travel expenses. It was a shock to a lot of these older people when their income out of their $200,000, $300,000 or $500,000 in cash dropped from $30,000, $45,000 or $75,000 to something like $6000 or $9000 or $15,000 in the first Greenspan thaw around 1991. These people had adapted their lifestyles to high interest rates giving them income and they needed to speculate to support their lifestyles. The stock market had already benefitted for several years from the marginal declines in interest rates along with the gradual restoration of value lost in the 1970's to inflation and the trend drew interest. Remember, the Dow in the early 1980's was in the 800's and despite the 1987 crash, the market was well into the 2000's and rising come 1990. The passing of 3000 together with the decline in the Fed funds rate to 3% from some amazingly high number was a combination that made a mass move into stocks a no brainer. Since very few Americans, including many on Wall Street, had no clue as to financial valuation of stocks, the sky was the limit. (More and more is coming out about the education of those on Wall Street quite often being something besides financial and more connected to what school they went to or who their daddy is than what they know about valuations).

The other side of this coin was real estate. My complaints about Volker are massive and for much of his early term, Greenspan continued Volkers actions. I believe these actions created one of the worst financial recessions in history, the 1990-1992 mess that cost Bush I his office. There were housing crashes around the US and the affordability of homes had been pushed down to lower levels. When the built up decade of high interest rate mortgages suddenly were refinanciable at single digit levels, the gates opened for a housing boom. FNMA and FHLMC became major players in the financial world and the paper machine of the US. Complicit in this matter were the efforts of HUD and the congressional panels that oversaw housing matters. Stemming from an act in the mid 1970's designed to encourage lending to low income people, a 1995 act dictated to these GSE's they find a way to lend more money to these lower income buyers. But, I don't believe this was the real impact behind the housing boom or the stock boom. I do believe that the shift in rates and rising activity in equity extraction created the 1990's stock bubble. It doesn't take a lot of fire to clear a crowded arena, nor does it take much additional money to push a crowded stock market into a mania.

My contention is that the securitization of mortgages and the effects of lower rates going into the early 1990's and beyond unleashed an amount of equity and spending power out of housing that was totally financed under the guise of government guarantees and Wall Street hype that created this entire world economy. The Chinese buying mortgages and government bonds only explains a part of this mess. Something had to generate the extreme levels of cash in the first place to have moved that much money to China and I believe the above described mechanism was it. China itself is part of this bubble and thus will not escape its effects, not because they are going to lose their money they put back in the US, but because their business model is built on being financed by this Wall Street/GSE machine. So are the earning of the US corporations as well as the European and Asian ones as well, as we are seeing at the present. Toyota has fallen on hard times along with Ford and GM.

Michael Koo, of the Japanese Central bank, is the closest I have seen in coming to grips with what is going on. The populace is spent out and the corporations of which they are customers is over capacity and overleveraged. In some ways, Koo says that the current direction of stimulous packages is the right path to avoiding depression, but that it won't get us back to where we were on the peak or anywhere near it. That will take time. Some speak of the great shape the balance sheets of corporate America are in, but I beg to differ. If they were so cash rich, there wouldn't be a credit crunch would there? Also, some speak of cash on the balance sheet, but I doubt a lot of it is real cash. By this I mean there are current liabilities and current assets and in a lot of cases, I doubt the reliability of the current assets, which exposes the cash to the current liabilities and the company to bankruptcy. Instead of being highly solvent, many of these companies are going to be liable to the full extent of their cash balances.

I have seen some mention brokerage firms as having $X of cash per share and I highly doubt that money actually belongs in whole to the firms involved. In fact, I would be highly watchful of the solvency of any Wall Street firm or its ability to meet withdrawals. I see a lot of cash in the minerals and oil and gas business, but I know enough people that were in the oil business before to have doubts about their receivables. Few people realize the deflationary pull that has set in and how fast cash can evaporate.

My point in all of this is that the roots of this mess go way back. I am not sure that Greenspan, then Rubin, then Bernanke weren't all doing all they could to forstall a collapse that was caused by the interest rate and generational structure of the US in the 1970's and 1980's. I believe from my own experience that Volker kept rates too high for a lot longer than Greenspan and Bernanke kept them too low. I also believe the perceived government guarantees of the GSE's contributed to excessive securitized debt and thus the monetization of consumption in the US and therefore the world. The size of this bubble doesn't meet a a border,nor was it caused by a single asset class like subprime mortgages. It was caused by a series of bubbles that were caused by a shift of perception by a group of people worldwide without the experience and knowledge to intelligently invest in such assets.

Now, the last bubble is bonds. Bonds aren't a bubble, but an asset class. The financial bubble has broken and it isn't possible for there to be another bubble. I think people are going to be surprised, unless the entire mess collapses, how long treasuries stay below 3%. I believe the minimum will be 2020 before we see a sustained rise of treasury bonds above 3%. Aren't we all shocked that Japanese 10 years have spent more than a decade below 2%? Remember, the dollar is the reserve currency.

So many people keep thinking this is a housing problem, but it isn't a housing problem, but a problem with financing and raising more cash. The source of new cash for the US for 2 decades or longer was home equity and to some extent, commercial real estate equity and stock equity. This became the source of cash for the world. The entire world will need to deleverage out of this mess and any attempt to become the US by another country will lead to its immediate collapse. I believe that most mortgages will be under water before this mess is done and that all markets will be affected. I am in the housing business at this time and due to the current condition of the local market, DFW, I have to resist the temptation to buy more all the time. It would be a good idea to see what summer looks like.