The Battle on Wall Street
The big guns came out on Monday. Mr. Market shot down almost every stock in the entire world.
He would have caused U.S. stocks to crash and burn too…but it was a holiday behind the American lines. U.S. shares never raised their heads.
And then, at dawn on Tuesday, the other side opened up with its big guns. The Fed made a “once in a generation” rate cut – taking it two key rates down 75 basis points each. Now, it’s official. Favored borrowers can get money for substantially less than the rate of consumer price inflation.
After this volley, it was still early morning in the Eastern Standard Time zone. We sat on the edge of our chair waiting to see how Mr. Market would react. Would the rate cuts be enough to stop him? Or would he still do to U.S. stocks what he had already done to those in Japan, India and France – that is to say, roughly what Sherman did to Atlanta?
In the event, the fireworks from the Fed slowed Mr. Market’s advance…but did not stop it completely. The Dow retreated down as much as 400 points…staged a counterattack…and ended up with a 128-point loss.
Which was enough for most commentators to pronounce the Fed’s counteroffensive as a success. We’d call it a draw.
The bigger news is that the forces of deflation – led by Mr. Market – are on the move. They’ve wiped out $5 trillion of value from equity markets all over the world in just the last three weeks.
This is the “biggest finance crisis since WWII,” says George Soros.
“Wall Street is in deep trouble,” says TheStreet.com.
The trouble now comes in waves – like a Soviet army assault. There are the ARMs…then the SIVs…then the SWAPS…then the credit cards…then the home equity loans…then corporate debt… One problem after another…one loss after another.
Each assault takes its toll on the defenders. Fannie (NYSE:FNM) and Freddie (NYSE:FRE) – two of the largest mortgage lenders in the nation – could see losses of $16 billion, says Credit Suisse. Wachovia has seen its earnings “vaporize,” says TheStreet.com. Bank of America’s net has been cut by 95%.
Mortgage defaults in California are running 114% ahead of last year. They’re at a 15-year high.
And dispatches from the front lines suggest that pockets of real estate holdouts are being overwhelmed and wiped out. The national figures show declines of only about 10% so far. But in some areas, the damage is said to be catastrophic. Houses go up for auction…and no one bids. Banks are taking back thousands of them. And when a house sells…it goes for only half of what it costs to build.
Against these crushing attacks…the authorities seem to be both out-gunned…and out-maneuvered. Mr. Bush’s rebate package is only $145 billion. U.S. stocks lost more than twice that much in the first few seconds of trading yesterday. And the whole idea of providing more cash and credit is the wrong strategy anyway. These efforts at Keynesian stimulus were designed to overcome a different kind of enemy…a case where consumer demand was low…or where consumers saved too much money. Keynes worried that people had a “propensity to save,” which needed to be corrected by reducing the returns to savers. But the real rate on savings now is less than zero. And the savings rate is down to minus 0.5% of disposable income.
No, dear reader, the problem is not that consumers spend too little, but that they spend too much they don’t have. Nor is the problem that consumers save too much, but that they don’t save enough. And while the feds might slow down Mr. Market’s deflationary campaign with more cash and credit…they will not be able to stop it.
In the meantime…the battle rages on…
*** What happened to gold, oil and commodities yesterday?
If our theory is right, when Mr. Market was knocking the stuffing out of stocks…gold and oil would get beaten down too, but not as much. What happened was that gold fell $25…and then bounced back. At the end of the day, it was ahead $8.60 cents…closing at $890. Oil held at $89.
So far, so good.
*** But what will be the effect of the feds’ attempt to stop a recession and reverse the bear market?
We expect the bear market on Wall Street to continue, almost no matter what. But the recession is another matter. Surely consumers could be encouraged to spend more? And surely, enough consumer spending would stop a recession. Currently, the U.S. Congress is considering the alternatives. At the top of the list – at least among Democrats – is the curious idea of giving tax “rebates” to people who never paid taxes in the first place. The nation already has plenty of circuses, say the deep thinkers in the imperial capitol; what is needed is more bread. And the people most likely to consume their bread are those who have the least of it. Barely half the people in the United States pay any taxes anyway…so it is not hard to find non-taxpayers. And it’s not hard to encourage them to consume. Most live hand to mouth; just put something in their hands. And if you put enough bread in their hands, would not a recession be averted?
That’s what most people think.
But where does the manna come from? Ah, there’s the rub, isn’t it? Yes, a recession could theoretically be sidestepped. But it would be like dodging a bicycle…and stepping in front of a bus.
Colleague Dan Amoss sent these words of advice yesterday:
“Emotion – not rational decision-making – is driving the selling this morning, so don’t panic with the crowd and sell quality stocks when they are cheap. This is not 1987. Thirty-year Treasury bond yields are not spiking toward 9%, as they were in the months leading up to the 1987 crash. Instead, they have been plummeting toward 4%:
“The Fed’s emergency 75 basis point cut sparked a late morning recovery, but it’s more of a psychological move than anything. Investment banks must still take losses on toxic mortgage-related securities that they had assumed were covered by bond insurers MBIA and Ambac. It remains to be seen whether these companies will be able to pay claims as they arise.
“But those banks with access to the discount window now have access to Fed credit that’s nearly a percentage point cheaper this morning and will get even cheaper in the coming weeks. The yield curve is still flat after this rate cut, but it will eventually become positive. Inflation is coming down the pike, but right now, the market is fearful of unknown financial sector write-offs.
“I do recommend, as I have for the past year, that you avoid stocks with overstretched valuations and stocks in the financial and consumer sectors. The puts I recommended in the beta issues of the Strategic Short Report have performed well, and I expect to find several similar ideas in 2008.”
Until next Tuesday, January 29, we are offering Dan’s newest service, the Strategic Short Report at a special price…for less than half of what people will be spending after next Tuesday evening.
*** And Byron King sends us this:
“‘I’m just a broken down old disc jockey,’ said Jim Quinn this morning on his Pittsburgh-based radio talk show. ‘I’ve been spinning records and running my mouth on the radio for 45 years, so what the hell do I know?’ he asked.
“‘But even I can tell you that cutting interest rates is the exact last thing that the U.S. economy needs right now.’
“Quinn was reporting the news that Fed Chairman Ben Bernanke had just announced a cut in interest rates of 75 basis points. ‘Most of the problems of the U.S. economy have been caused by too much easy credit,’ said disc-jockey Quinn. ‘And the solution to the problem is not to pump out even more easy credit. The Fed ought to just let whatever is going to happen, happen. Let things run their course and clean the rot out of the whole system. If people are going to get foreclosed and lose their houses, then that kind of stuff happens. It is what happens when you take on too much debt, and bet the wrong way in life. But no, the Fed and the Washington politicians are just going to drag this whole thing out. Instead of a sharp correction over a period of months, they will drag this thing out so that it lasts for years.’
“Not bad analysis for a broken down old disc jockey,” says Byron.
*** On the home front, everyone is hard at school. Elizabeth is at the Sorbonne, taking exams for the equivalent of a master’s degree in history. Sophia is studying nutrition here in London. Henry is studying hard to pass his exams for his final year of the French equivalent of high school. And Edward is studying off and on, too, in order to move on to the 10th grade next year.
But here at The Daily Reckoning headquarters we are doubters. We do not share the public’s great appreciation of formal schooling – at least, not in the usual sense. It is true that certain subjects lend themselves to formal, disciplined study. Building a bridge involves knowable formulae, measurable quantities, forces and distances, proven components, reliable circumstances and precise numbers. You can learn to build bridges by studying these things in a structured way.
Most of life, on the other hand, does not fit to an engineer’s discipline. And trying to learn about it in an artificially bounded and organized way could lead to misconceptions and false precision. Economics, sociology, psychology, literature, poetry, film, politics, finance, and business…in fact, most of what people study…are better learned as they are lived, in our opinion. The ground shifts…perceptions are twisted…rules are broken…and people always come to believe what they want to believe when they want to believe it. No use in dressing them up as though they had the stiff discipline of a marine lieutenant. They are all unruly misfits…disorganized personalities…and social deviants. Better to observe them up close…in the hurly burly of real life. You’ll have a much more realistic picture of what they are really like.
The Daily Reckoning
Wednesday, January 23, 2008
The Daily Reckoning PRESENTS: Do you know what the Western Canadian Sedimentary Basin is? No? Neither did we…that is, until we read what Byron King had to say about it, below…
CANADA IS A VERY BIG PLACE, EH?
by Byron King
Canada is a very big place. In fact, Canada is the second largest country in the world, after Russia. Canada is quite a bit larger than the U.S. lower 48 states, but many people in the U.S. do not realize that because of the way most maps distort scales at higher latitudes. Even just half of Canada is larger than all of Western Europe. And due to the often harsh climate, about 90% of Canada’s population of 33 million lives within 150 miles of the U.S. border.
When you leave the major Canadian population centers, particularly “back east” in the likes of Ontario, you enter some vast open spaces. West of about Sudbury, Ontario, or so, you start to measure distances in terms of hundreds of miles. For as cosmopolitan and sophisticated as many of the big cities are – Vancouver, Toronto and Montreal – the wide-open ranges in Canada are far away from everything. Most of Canada is just plain rugged and undeveloped.
In May 2007, I traveled to Alaska to see the Alaska Pipeline and tour the Prudhoe Bay oil field. The route of flight to Anchorage took me over central and western Canada. I was fortunate to be flying on a clear day. As I looked down from the aircraft, I could see many dozens of oil and natural gas fields. The layout of the rig roads and drilling pads was apparent, at least to my eye. There was oil patch after oil patch for almost as far as I could see – which was pretty far from my perch at 38,000 feet. From the air, some parts of the ground were drilled up like a pincushion. But other stretches of this endless vista had almost no sign of human or industrial development whatsoever. What was I seeing? From my background in geology, I knew that I was traveling over a geologic feature called the Western Canadian Sedimentary Basin (WCSB).
The WCSB is a large area of the Earth’s crust that has filled with sediments over a very long geologic time. There are sandstones, shale and limestone, and numerous related kinds of sedimentary rocks. In short, there is everything that Mother Nature would ever need to form hydrocarbon deposits. Toward the west of the WCSB, in the Alberta region, the total thickness of the sediments is well over 2 miles.
So these kinds of sediments in the WCSB, coupled with the structural history of the region, hold immense resources of hydrocarbons. There are conventional resources of oil and natural gas hidden in structural and stratigraphic traps. There are thick seams of coal, filled with coalbed methane gas. And there are the famous tar sands of Alberta. Thus is the WCSB one of the major oil and natural gas producing areas of North America. That is why I saw so many oil and gas fields as I flew from Minnesota to Alaska.
Today, when many people think of Alberta, they probably think of the tar sand plays that have received so much attention in recent years. In the quest for oil from the tar sands, literally hundreds of billions of dollars worth of capital investment has poured into this region from every corner of the world. There is no question about it, but Alberta is home to one of the most significant hydrocarbon resources on the face of the planet.
Yet Alberta is also an old oil- and gas-producing area in its own right. The first significant oil discovery in the WCSB was in 1948, in Alberta. And the WCSB has been a lucrative oil province ever since. For many years, the WCSB has been one of the most active onshore drilling locales for conventional oil and natural gas in North America. The WCSB yields 98% of the natural gas that Canada produces. And 15% of the U.S. gas supply comes from the WCSB. So the WCSB is really a critical part of the North American gas supply chain.
One big problem in the WCSB, however, is depletion. The really large gas fields have been discovered and drilled. Now the drilling is focusing on the smaller, more dispersed fields. Sure, the resource is there, but it takes more work to locate the gas and be able to drill it up and book it as reserves. And then the well operators have to extract that natural gas and get it to market. And each year, the gas output rates are falling in the WCSB, even from new fields. That is, it takes more and more drilling just for output to stay essentially even, year over year. An acquaintance of mine, David Hughes, who works for the Geological Survey of Canada, gave some pretty impressive – kind of scary, really – briefings on this at the past couple of meetings of the Association for the Study of Peak Oil & Gas (ASPO). It takes more and more drilling overall just to keep output steady. That’s ominous.
Another problem for the WCSB has been the relatively low price for natural gas in North America in the past couple of years. When gas was selling at $12-15 per mcf about two years ago, those were the salad days for drillers. But now the North American gas price is in about half that range. And the drilling industry in the WCSB has slowed down quite a bit. Still, there is a lot of continuing and ongoing drilling activity in western Canada. The industry does not just turn on and off like a light switch. But we are not seeing drilling at the level of what we would call a “gas boom” (no pun intended). Still, that could change quickly if the price for natural gas begins to rise comparable with the recent price increases for oil.
Until next we meet,
for The Daily Reckoning
P.S. We are seeing immense investment pouring into Alberta and its environs. And all of these development efforts require large amounts of earth moving, road building, pipe laying and other general construction. There are ways to play this.
Editor’s Note: Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. Byron is also co-editor of Outstanding Investments, and editor of Energy & Scarcity Investor.