A Horrible Mess, and How We Got There

If last week was bad for the markets, it looks like this week is going to be even worse. Yesterday, after the House rejected the bailout bill, the Dow suffered its worst point loss of all time. While most are shocked by the calamity in the markets, Casey Research’s Oliver Garret points out that the warning signs have been around for years.

No one will deny that last week was one of the most tumultuous in history. The streets red with blood…the bodies of the dead and dying strewn about where they fell.

You already know the names: Lehman, Merrill, AIG. Fannie and Freddie.

But none of this happened by accident.

The warning signs have been all around us for years.

Bud Conrad, chief economist at Casey Research, wrote about the beginnings of our current problems back in March of 2007…before most people were even aware of the storms brewing just over the horizon.

"Faced with historic levels of debt, falling housing prices, and weaker economy, the pressure on housing would gain momentum as desperate homeowners either hand their keys back to the banks, or simply hit the bid on the best (low) offer they can get. A vicious cycle would set in, threatening to shove the economy into uncharted and unpredictable waters.

"The impending calamity – mass housing foreclosures, failing banks, Fannie Mae and Freddie Mac in ashes, millions of personal bankruptcies – is so dire…most people can’t even conceive of it. And indeed, it may not hit us this year, or next, but the market always corrects itself, and this time will be no exception – sooner or later… That’s why the coming crisis is so predictable: there’s no way to avoid it."

I actually wish that his analysis had been flawed.

I also wish that the government officials had been right who have consistently claimed since then that the subprime crisis was contained and the markets would rebound in the second half of the year.

Unfortunately, this is not the case.

The Fed’s recent attempts at quick fixes have not worked, and current events are reinforcing what Bud Conrad prognosticated almost two years ag that this is much more than a normal cyclical correction. This is a disaster of biblical proportions.

As the Fed and the Treasury continue to intervene in the market, they continue to lose ground and credibility, caught between a sharp recession and strong inflationary pressures. In an effort to bail out the financial sector, they have no choice but to start injecting hundreds of billions in liquidity into a contracting market place.

This will contribute to the creation of a stagflation period that will make the ’70s look like a tea party.

The Fed’s never-ending injection of liquidity into the market has, and will continue to, devalue the dollar.

Ordinarily, a country threatened with currency collapse would lean toward tight money, perhaps contracting its domestic money supply. That would push interest rates upward and compensate foreigners for holding on to the currency despite the depreciation risk. And it would soften that risk.

But this time, things aren’t ordinary…there is a difference that has turned what might otherwise be a disturbance into a disaster: the U.S. economy’s inability to endure high interest rates.

Because of the corrections taking place now in the grossly distorted U.S. housing, commercial real estate, and personal credit markets, raising interest rates to protect the dollar would prove as calamitous as not raising interest rates.

The housing bubble fueled a blockbuster business in first mortgages, and then home equity loans. Homeowners drew down their equity to splurge on consumer goods, including shiploads of imports.

The relative attractiveness of U.S. financial instruments kept the game going into overtime. The foreigners who received all those U.S. dollars put them back into U.S. Treasury bills and other dollar-denominated instruments, thereby underwriting low interest rates for all U.S. borrowers.

The net result? Foreigners funded our housing boom. The amount of mortgage growth annually matched the amount of trade deficit, which foreigners dutifully invested back into the U.S.

And subprime lending was no mere sideshow. It was big business. In 2005, it accounted for 25% of all new mortgages – about $600 billion of high-risk paper, most of it with adjustable interest rates.

The collapse of the subprime market soon spread into other mortgage sectors…and the derivatives created on top of all those subprime mortgages made everything much worse. Given that the annual GDP of the U.S. economy is just $13 trillion, the $250 trillion in derivatives should have been seen as an accident waiting to happen.

Foreign reinvestment is part of the system of U.S. debt, and we are already seeing a significant impact.

As foreign investors watched the collapse of the U.S. housing markets, and the relative values of their debts began to sink, they quickly moved out of U.S. debt, particularly Fannie/Freddie obligations.

This massive exodus of foreign cash out of the debt of Fannie/Freddie prompted the biggest stock market fall since the days just after 9/11. On September 15, 2008, Treasury Secretary Paulson injected the biggest amount of daily liquidity since 2001, a whopping $70 billion in just one day.

And now the government is proposing an additional infusion of approximately $1 trillion. More than the total cost of the Iraq War.

To put this amount into perspective: if you had spent $1,000,000 a day, from the birth of Christ until today, you would have only spent about 732 billion dollars.

It’s going to be interesting to see what happens to our markets if that proposal goes through.

Regards,

Oliver Garret
for The Daily Reckoning
September 30, 2008

P.S. If you had known all this was happening, what would you have done differently?

If you had seen this coming, you could have moved to protect yourself and your portfolio. You could have shorted financials and bond insurers, like MBIA. You could have played more in the gold fields.

But how could you know all this was going to happen?

We at Casey Research have long foreseen what is unfolding right now…and those investors who followed our recommendations made three- and four-digit returns. We believe in making the trend your friend…otherwise it can be a fearsome enemy.

Which is what The Casey Report is all about – giving you the pertinent and well-researched information on big economic trends unfolding at this moment, and how best to invest to make them work for you, instead of against you.

Is our "Crash Alert" flag still on the mast? Yes it is…

"Stocks dive on bail-out rejection," says the headline on today’s Financial Times.

"Panic grips world’s markets," says The Guardian.

"Staring into the abyss," shouts the Daily Telegraph.

"Sell! Sell! Sell!" was the advice from the Independent.

Writers had an easy time of it this morning as world stock markets had their worst day since Morgan Stanley began following them 38 years ago. The headlines practically wrote themselves. The MSCI was down 6%.

The House voted down the $700 billion bailout. Investors were downcast. They had hoped for an easy, quick rescue. The Dow fell 777 points – its worse day ever. For the S&P, it was the worse day since ’87. The Fed, however, didn’t want to leave investors disappointed.

"Fed pumps further $630 billion into financial system," is the headline story from Bloomberg.

Let’s see, $630 billion is not much less than $700 billion. And here, the Fed acted on its own authority, needing no permission from the foot-draggers in Congress.

The Fed is "flooding banks with cash to alleviate the worst banking crisis since the Great Depression," continued the story.

In the United States, the feds seized Washington Mutual last week. This week, Wachovia is the latest victim – selling itself in a hurry to Citigroup.

"Wachovia…we are here," said its ad campaign. Bye bye…

Regional banks are falling hard, too – shares of National City, based in Cleveland, dropped 45%.

In England, Bradford and Bingley…and in Belgium, Fortis… were on the rescue list on Monday. Today, Hypo Real Estate, a large property lender in Germany, was thrown a lifeline by the government after its shares fell 71%. Iceland took control of one of its largest lenders too – Glitnir. And Dexia, in Brussels, is said to be getting desperate.

And the poor Irish! Their luck seemed to run out yesterday. The Dublin market sold off…as banking shares suffered their biggest one-day sell-off in 20 years. Anglo Irish Bank, a major property lender, dropped 45%. Regulators gathered round…wondering how to keep Ireland’s banks in business.

"Banks saved…" says the FT. All over the world, the rescue teams are at work. Bailing out the banks…forcing mergers and takeovers…nationalizing…

Meanwhile, oil slid 9%. Investors see the world slowing down – meaning, there will be less demand for oil. Last week, the Baltic Dry Index fell 25% – 10% on Friday alone. The index measures shipping costs…and roughly correlates with globalization, commodity prices and Chinese output. Typically, ships pick up iron ore or copper or wheat from, say, Brazil and deliver it to Asia. When orders fall, so does the index. Now, it’s almost in free-fall…down a full 70% from its May peak.

What this is telling us is that there has been no post-Olympic resurgence in China…at least not yet. Remember, in preparation for the games, the Chinese ordered their heavy industries to shut down. They were trying to give the athletes some air. Once the Olympics were over, these industries were supposed to rev up again – putting in huge new orders for raw materials.

So far…the boats are still riding high in the water. In fact, ships leaving Brazil are putting to sea empty – partly because Asian buyers are balking at Vale’s mid-contract price increase. Vale is the largest iron ore producer in the world. Sales must be falling…

What really is going on?

You will remember our dictum, dear reader: a correction is equal and opposite to the deception that preceded it. You can quote us, if you like.

The deception of the Late Bubble Period was mammoth. People deceived themselves in such extravagant and absurd ways, it took our breath away. That has been our beat, here at The Daily Reckoning, for the last 9 years – describing the delusions and hallucinations of the bubble era.

Now, it’s the correction that is taking our breath away. And if you feel like you’re having trouble breathing as well, check out our Strategic Financial Survival Library. It’ll keep you in know on what to expect around the bend…and how to profit in the face of disaster. 

*** European central banks are selling less gold. They used to keep the price down – perhaps not intentionally – by selling tons of the stuff every year. It was mad, of course. The British government – under then-chancellor of the exchequer, now Prime Minister Gordon Brown – actually sold a huge quantity of gold in 1998/99 at the lowest price in two decades. This was the famous "Brown Bottom" to the gold market. Soon after, we came out with our Trade of the Decade – selling stocks on rallies, buy gold on dips.

Since then, the price of gold has risen from $260 to over $1,000…and recently pulled back to the low 900s. Stocks, at least in nominal terms, fell heavily in ’01-’02…then rallied back to about where they had been at the end of the ’90s.

Our guess was that the stock market peaked out in January 2000. Since then, we’ve taken the to-and-fro of stock prices as market noise…misleading investors into thinking there is another great bull trend underway…and making it hard to hear what the market is really saying. In real terms…that is, adjusted for inflation…there is no doubt about it. The Dow is down about 30% in terms of consumer prices…and down 75% in terms of gold and oil.

Now, after all this time…the nominal trend of stock prices seems to be going down too.

It’s easier to follow the real trend in stocks by looking at price-to-earnings ratios than actual prices. You will see that the stock market follows long, broad trends – roughly coinciding with movements in the credit cycle. When people are feeling confident…they lend at lower rates…and they buy stocks at higher prices. More or less. At the top of the cycle, they’ll pay 20…30…50 times annual earnings for a stock. At the bottom, they want a more immediate and more sure pay off; stocks typically sell for only 5 times earnings.

Where are we now?

We are between 15 and 20. Not terribly high…but a long way to go before the market bottoms out.

As to the other side of the trade, European central banks have finally realized that selling their most important asset into a rising market was not such a good idea after all. They’re now curtailing gold sales.

And from the United States, we hear that dealers are running out of bullion coins. No wonder; these coins are the cheapest and easiest way to protect yourself from the risks of inflation (and, under certain conditions, deflation too).

One of the nice things about bullion coins is that once you buy them and put them away, they tend to stay put. You see the gold price going down and you may be tempted to call your broker and say: ‘let’s sell out that gold ETF.’ But you are less likely to get out your coins and lug them to the dealer. Not only is it more trouble, but coins are regarded as a kind of insurance…a kind of patrimony…that you sell only as a last resort. In a long bull market, coins are the perfect way to hold gold; you’re less tempted to get rid of them when the price dips. So, you end up riding the long wave all the way to its end.

Then, of course, you’re also likely to forget to sell. But that’s a story for another day.

And, judging by the current market climate, it’s likely that more and more investors will be turning to gold as a safe haven for their portfolio. Yesterday, the price hit above $900…and if things keep going the way they have been, $900 an ounce for gold will seem like a bargain.

But if the current price of gold still seems like a lot of cash to dish out, fear not. There is a way for you to get gold… for just a penny per ounce.

*** How about that Warren Buffett! He bought $5 billion worth of Goldman preferred. The stock gives him a 10% annual dividend. Plus, he got warrants good for another 5 big bills worth. These come with a strike price of $115 a share – a discount of more than 15% from Friday’s closing price. That alone has a value – probably about $2 billion…which puts Buffett’s effective yield at 17% (according to a calculation in Barron’s). The Oracle of Omaha is showing those New York slicks a trick or two.

Until tomorrow,

Bill Bonner
The Daily Reckoning