Here Come the Modern 1930s
The modern 1930s are the logical consequence of the "New Economy" of the past decade, just as the original was a logical consequence of the "Roaring Twenties." In each case, technology and leverage combined to create a potent but ultimately poisonous brew of wildly inflated asset prices. Tom Au explores…
Former Fed Chairman Alan Greenspan, one of the major architects of the current crisis finally "fessed up" the other day when he referred to the current crisis as the "most wrenching since the end of the Second World War." But the end of the Second World War marked the start of the boom times in America (at least for those who lived to tell the tale) so he must really be referring to the crisis since the beginning of the Second World War, which would be the late 1930s. And this decade is basically where we are now.
The modern 1930s are the logical consequence of the "New Economy" of the past decade, just as the original was a logical consequence of the "Roaring Twenties." In each case, technology and leverage combined to create a potent but ultimately poisonous brew of wildly inflated asset prices. In essence, greedy CEOs (and investment managers) said, "we brought you the new economy, please cash us out now." And a gullible American public affirmed this by bidding up prices to insane levels, expecting to share, rather than subsidize, the wealth of the selling shareholders. First the tech companies, then the financial intermediaries were then caught in traps of their own making, and escaped as sorely crippled entities, if they survived at all. But by this time, the more privileged players had "taken their money and run."
Probably without meaning to, the Los Angeles Times aptly summed things up with an article headlined "A New Great Depression? It’s Different This Time." The aptness is if you interpret the headline as "The Depression is Different This Time" as opposed to "Things Are Different This Time." The details will naturally differ from those of the 1930s, but the substance will remain the same. But the paper dismisses the popping of asset bubbles in housing and stocks as merely "disturbing parallels." Working together, the Fed (and the modern J.P. Morgan) "saved" Bear Stearns, the modern Bank of the United States, thereby preventing a collapse of the banking system. International trade remains robust, at least for now. So things don’t seem to bad, at least to the Times.
But are things really that different almost 80 years later? For instance, the popping of major asset bubbles almost defines a recession by itself. And one can argue that the 1930s collapse of the banking system is the consequence, or reflection of the real economy, rather than its cause. So saving one insolvent institution isn’t going to prevent the unraveling of the rest of the system early in the new century. And yes, the international situation is okay, but that’s just because America is the cause, rather than the recipient, of global economic problems this time around; falling stock prices abroad are saying that foreign GDP growth will soon collapse as a result of America’s troubles.
In deciding whether or not we are headed toward depression, one needs to look at the substance of economic events, as opposed to the form. Some examples of the substance: 1) A post-war record level of home foreclosures headed to 1930s levels fueled by a similarly record collapse of home prices. 2) Several major "runs on banks" as investors begin to wake up to the fact that a lot of what passes for collateral is in fact worth very little. 3) A panicked Fed trying to head off a financial panic by simultaneously lowering interest rates and injecting money into the system.
And what’s worse, we are only in the early stages of the crisis. Last year, 2007, was the year that the mortgage market unwound. This year, 2008, will feature the collapse of major financial institutions, starting, but not ending, with Bear Stearns. Next year, 2009, will be the year when the problems make their way to the rest of the U.S. economy, including the still-buoyant industrial sector. By 2010, the recession (or worse) will be global.
Some take comfort in the fact that we haven’t yet seen soup lines, or 25% unemployment. But soup lines are merely an unnecessary (and hopefully unrepeated) appendage of the above. And anecdotal evidence suggests that many welfare agencies are now stretched to the absolute limit, meaning that new soup lines will appear if the system is tested just a bit more. And unemployment hasn’t risen because companies have so far chosen to cut health care and pension contributions rather than lay off workers. One can easily get to the 1930s 25% unemployment with a 0% headline unemployment rate – by assuming that half the work force will be "temps" working half time without fringe benefits.
But perhaps one of the better definitions of the modern 1930s was given in a previous article on this site – a two decade pullback in the American standard of living to the 1980s (the original took American consumption back to the 1910s). Such a pullback seems inevitable from the deleveraging and loss of wealth that is now taking place. Moreover, such a retreat would last for an extended period of time. That’s because we had the best of all possible worlds (relative to the true state of the global economy) for most of the past decade and half. The next decade and half will probably see the worst of all such worlds.
for The Daily Reckoning
March 26, 2008
Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Mr. Au is the author of A Modern Approach to Graham and Dodd Investing.
The price of gold bounced up $16 yesterday, to close at $935. Have we seen the bottom of this correction? Is this the moment to buy? Is this the last opportunity we will have to buy gold under $1,000 in our lifetimes?
We don’t know the answer.
But when we think back on this bull market we remember all those times we tried to ‘buy the dips’ – for no good reason. When gold was $500…we waited to buy until it dipped down to $450. And when it was $700…we wanted it to go back to $600 before we bought more. Often, it didn’t dip at all…or didn’t dip enough.
We would have been better off taking a massive position at the beginning – when gold was under $300 – instead of chasing it all the way up to $1,000.
And now, here we are again…trying to get a good price. Is this the bottom? Or is this just a narrow ledge, from which gold will drop down another $100…or more? Will we feel like geniuses if we buy now…or idiots?
Alas, it is not given to man to know his fate.
But we have to make a decision. Buy? Sell? Do nothing?
Usually, doing nothing is the right choice. But, over the last eight years, doing nothing in the gold market has been the wrong choice. So, let us pull back the camera and try to look at the big picture again. Maybe we will see which direction gold is going.
"The trouble is gold stocks can fall a lot during even a typical correction," opines colleague, Ed Bugos.
"Most everyone already knows that markets do not go straight up. If every dip led to higher and higher highs nobody would ever lose sleep over it. Trouble is, the company could always screw up, or one of those dips could turn into a bear market. I have seen the conviction behind many buy/hold strategies melt at the tail end of a normal correction, just because it is invariably worse than expected.
"However, there are ways to improve your long-term returns and reduce the impact of market volatility on your portfolio without ever having to trade in and out of your shares, and risk getting bucked off the bull too early. Options! Options allow investors to take advantage of leverage and limit their risk.
"They represent a way to benefit from most of the change in the value of the underlying property, or shares, without ever having to buy it. Due to this leverage they can sometimes increase hundreds and thousands of percent in the space of a week, or even a day, as in the case of Bear Stearns put options when the stock halved that fateful Friday before last. Consequently, they don’t only draw speculators; they draw gamblers ready to stake the farm on getting rich quick, by abusing the available leverage."
Gold investors are getting nervous because of the recent run up in prices. They started to sell, sending bullion prices down. But with Ed’s new service, Gold & Options Trader, you could have been making money as it fell – using easy-to-use gold options.
And until tomorrow at 5 PM we are offering Gold & Options Trader for 34% off its regular price…so act now.
But we digress. The news yesterday was as mixed as ever. There is record short interest on Wall Street. Speculators have sold short so many shares – anticipating falling prices – that they have practically guaranteed a rally.
Yesterday, the Dow rose only slightly. But as soon as prices rise – even a little bit – the short sellers take losses. They have no way of knowing how much the market will rise and how much they will eventually lose, so they have to cover their positions by buying back the shares they have shorted. This buying pressure drives up prices even more…forcing more short-sellers to cover…and turning a mild rally into an explosive move to the upside.
There is also a very high level of bearish sentiment among stock market professionals too – usually, a contrarian indicator of rising prices.
But the underlying news is still discouraging.
Jobless benefit payouts have just reached a three-year high, after a loss of 63,000 jobs in February – the most in five years.
House prices fell heavily in January…down about 11% from a year before. They’ve gone down every month – according to the Case/Shiller numbers – for the last 13 months. Foreclosures are still going up. And subprime defaults are still increasing.
With his house going down in price, and his job in jeopardy, the poor householder is feeling under pressure. "Consumer confidence crumbling," says the Chicago Tribune. Polls show the consumer less optimistic than at any time since the Nixon administration. No wonder, really. Regular gas costs an average of $3.28. Food prices are soaring all over the world. In several foreign countries people have been killed in food riots; in America, family budgets are getting stomped.
Naturally and predictably, Americans can no longer spend money so freely. Retail sales fell 0.6% in February and are projected to grow at their weakest pace in 17 years – if they grow at all. And what’s a consumer economy to do if consumers stop consuming? How will it expand when the consumers’ pockets are empty?
Meanwhile, over on Wall Street, things aren’t looking much better. The wizards, it turned out, did the same dumb things that ordinary householders did – just with more leverage and champagne. Now, their high yield bonds are in trouble. Their private equity deals are in trouble. Their municipal clients are in trouble. Their MBS, SIVs and CDS are all in trouble. And because no one quite knows who is most in trouble lenders are reluctant to hire out their money. They keep it in their vaults – fearful that a borrower may not be able to pay it back…and that they may need it themselves.
Goldman (NYSE:GS) is in the news today – with an estimate of total Wall Street losses from bad subprime lending of $460 billion. That’s about three times what has been disclosed so far. Which means, there are more disclosures coming…and no one is sure where the losses will turn up…nor what effect it will have on capital values when it does. So, while the money flows out of the central banks like Kool-Aid…when it reaches the banks it is more like molasses, sticking to the bankers’ fingers and clogging up the whole financial system.
Big mergers and acquisitions can’t be done. Today’s news tells us that the Clear Channel deal has been gummed up – banks are reluctant to finance it. Little deals, too, are getting stuck. "Small firms find credit is tightening," reports the New York Times.
On Wall Street, as on Main Street, the situation is the same – "the game is over," as the Economist put it.
*** Stepping back…we try to bring the world economy into focus.
Yes, the economies of the West have overdone it. They are burdened by high costs…an aging workforce…and enormous debt. After a big run up in debt (the U.S. government has added $20 trillion to its ‘financial gap’ in the two terms of George W. Bush alone)…it is normal that you would have a period of debt liquidation. That is what is happening. And that’s what is so troubling Wall Street. No one knows exactly which debt will be liquidated most abruptly…nor who, exactly, holds it.
Of course, the feds are trying to stop this process. They fear a Japan-like slump – long, slow and impossible to reverse – or even a Great Depression-like crash…with even greater suffering for even more people.
What can they do about it? They can make money and credit more available to the banks. That is what they have done – with mixed results so far. While the Fed has pushed down on short rates, for example, most borrowers’ cost of money has actually gone up.
The feds can also try other tricks – such as tax rebates. Or, they could actually step in and buy mortgages. These measures do not really prevent losses. The losses are already there. All they do is take them away from the people who deserve them and distribute them among the public, often in ways that are hard for the voters to understand.
None of these things are likely to set off another boom on Wall Street or in the economy. Any way you look at it, consumers are squeezed…and the financial industry (which was to blame for the bubble of the last few years) is now in decline. It is very rare for a bubble to re-inflate. Usually (in fact, in every case we can think of) when a bubble deflates in one sector…the next bubble will occur somewhere else, normally in a rising market. The bubble in Japan of the ’80s was followed by the bubble in the United States of the ’90s. Japan still has not recovered. And the bubble in the United States of the ’90s was centered in the tech area…on the NASDAQ. That sector crashed and has never recovered. The next bubbles were in residential property and the financial sector, notably in private equity, hedge funds, and derivatives. Those bubbles have popped too…and are losing air fast. They will probably not reflate in our lifetimes.
So, a logical question: where’s the next bubble?
"It’s in emerging markets," says colleague Manraaj Singh.
"Haven’t they already had a bubble?" we ask in response.
No, was his answer. They’ve only had the beginnings of a bubble. They are rising markets…but not crazy markets. What we’re seeing now is a correction in many emerging markets, but not a change of the underlying trend.
Manraaj argues that the same mechanics that puffed up a bubble in residential housing and financial services is now at work in emerging markets. The financial authorities of the West are making more money and credit available to aid their aging, debt-burdened economies. Many foreign nations – China and the major Gulf oil exporters, for example – tie their own currencies to the dollar and their economies to that of their biggest customer – the U.S.A. When the Fed cuts rates, as it did to try to save the tech sector and cure the recession of 2001-2002, the credit goes somewhere…but not necessarily where it was intended to go. In 2002-2007, it went into housing and finance, not into the deflating bubbles. Now that the Fed is cutting again, the emerging markets will be the ones to reap the benefits of the easier credit…so you can look new bubbles there.
Latin America was the best performing region over the last three years – with annual returns of 47%. And the best single market over the last three years was Brazil – with annual returns of 56%.
Are these spectacular returns the peak of a trend…or just the prelude to the next bubble? Perhaps Manraaj is right: the next bubble will be in these hot emerging markets.
Another possible focus for the next bubble: gold. More to come…
The Daily Reckoning
March 26, 2008