The Dumb and the Restless

As we move forward in these volatile markets, it seems that the sand in the hour glass is getting closer and closer to running out. The prices of gold and oil are signaling that we may be experiencing the calm before the storm.

The price of our favorite yellow metal, although it’s surely a telling commodity, isn’t the most compelling thing that I have been noticing over the past couple of weeks.

I am exposed to many different mediums of information. I read several economic journals. I keep myself aware to what the talking heads are saying on Bloomberg and CNBC. I also listen to what people are saying in order to keep a feel of what Joe Sixpack’s mentality is towards the markets.

These mediums all have one thing that has been very consistent, and very worrisome.  They are telling me that the markets are once again feeling invincible, and with that we have seen a reemergence of an appetite for risk.

It’s amazing how short some people’s memories really are. The mentality surrounding the markets today is eerily similar to what it was in July before the 10% correction in August. The rhetoric I have been hearing these past couple of weeks is also far too similar to that of 1929.

So how does something like this happen? How can so many irrational investors drive markets in the wrong direction? Is that the case, or is it that we’re in the midst of an equities bull market and I’m just missing out on all of the profits?

The Credit Market’s Effect on Equities

I’m sure you are aware of the recent record highs set by the DOW and S&P. I happen to be under the opinion that the credit market is driving equities. It is definitely the culprit of the August sell off. With that belief, I have to look forward to both housing and credit to decide on the direction of equities.

I don’t need a crystal ball to tell you that we have only seen the tip of the iceberg when it comes to turmoil in the credit markets.

This recent period of time has been a telling one for the investment bankers. Both Merrill Lynch and Zurich-based UBS, the largest U.S. brokerage house and largest European bank, respectively, posted losses for the third quarter. For UBS, this was their first quarterly loss in four and a half years. 

Bear Stearns reported its biggest earning decline in the last 10 years and Citigroup posted a 60% decline in earnings. Recently, Morgan Stanley reported that it would have an estimated third quarter loss of $.50 per share, after an initial estimate of having positive earnings of $1.25 per share.

Let’s not forget about the bank run that occurred at England based Northern Rock.  Citigroup is in the process of organizing a bailout, but this all comes after the Bank of England supplied all the liquidity needed and guaranteed all bank deposits.

How about the fire sale by Lennar Homes? They unloaded a huge amount of inventory as discounts of up to $100,000. The editors here at Agora Financial warned that more of these fire sales would occur. That is exactly what has happened.

As I write on this fall day in Minnesota, St. Joe Co., Florida’s largest private landowner, has announced that they will also have a fire sale of sorts. They plan to fire 75% of their employees and sell 190 homes and approximately 1,200 sites planned for development. They threw their dividend out the window and will report a 41% decline in sales. That hurts…and you can expect more of the same to keep on coming.

The culprit of all these credit losses was tens of billions of dollars in write downs of mortgage-backed securities and other fixed income assets. In short, the reason for the write downs were bad loans made to people who couldn’t pay for them, and increased foreclosures resulting in a glut of homes on the market. It’s easy to see how this carries a snowball effect. 

More Credit Concerns Could Be on the Way

If you ask both Wall Street and Main Street, they will tell you that we have put the worst of the credit concerns behind us. In fact, there’s no need to ask, just look at how the homebuilder and financial stocks have rallied up to 20%. This seems encouraging, but I couldn’t disagree more.

There are two very important statistics I have been watching. First and foremost, we must understand that there are still $300 billion dollars of interest rates reset by the end of 2009, with a large chunk of those coming in the next six months. The implications of this cannot be denied. Remember it was the marked-to-market mortgage-backed securities that made up the majority of losses for the investment banks I just mentioned.

Those mortgage-backed securities are just sliced up mortgages packaged into bonds, and given investment grade ratings by Moody’s. Whether or not these bonds pay out is directly dependent on whether or not these mortgages get paid for by the homeowner. That is the risk in these bonds, which has been grossly under priced. 

Pimco’s Bill Gross referred to theses subprime mortgage-backed securities as “toxic waste.” There are a lot more skeletons on these investment bankers’ balance sheets. I expect there to be many more “earnings reductions” and “unforeseen circumstances” that result in some large losses. Don’t look for one of the big investment brokerage houses to go bust, but I wouldn’t be surprised to see one of these guys get bought out.

The other worrisome statistic is the $12 billion increase in credit card debt and non-mortgage loans that American consumers hold. This brings the running total to $2.47 trillion dollars. The private sector debt as a share of private sector GDP is now an astounding 340%. This is a scary thought, but the trend is even scarier.

We have seen a frightening trend that shows how truly stretched out American consumers are. There has been an exponential increase in Americans paying their mortgages with their credit cards. Homeowners do this to prevent themselves from defaulting on their mortgage payments, but in the process build up an unnerving amount of high interest debt. Even with Halloween right around the corner, what could be more terrifying?

This is exactly what Alan Greenspan has taught Americans. Bill Bonner of the Daily Reckoning had this to say on the topic: “Thanks largely to ‘Easy’ Al Greenspan down at the Fed, they could always stretch one end of their budget — the spending end. ‘Just put it on the credit card, honey…we’ll extend the equity line if we need to.’ But now the equity line is snapping back and hitting them in the face.”

So Americans are using their credit cards to postpone the inevitable foreclosures a little big longer. The amount of loans to reset at a higher interest rate is going to increase dramatically, resulting in more homes on the market, more losses on mortgage-backed securities and more losses on bank sheets.

I almost pity the dumb money that has bid up the financials and homebuilders. In fact, I almost pity the dumb money that has been purchasing any of the industrials at or near this record high…almost.

The fact of the matter is that while dumb money is at a historical record in size, it is also at a historical record in stupidity. As a result of the shear quantity of money in the wrong hands, we have seen equities boosted while the smart money notices that transports have trailed behind. We have seen dumb money buy treasury notes in huge numbers while receiving nearly a -10% real return on investment.

So have I missed out on the run to DOW 15k? Maybe. But I do understand the fundamentals of this market. So while the dumb money may have been king for the past couple of weeks, it will soon be dethroned. Ignorance can only rule for so long.

Nick Jones

October 17, 2007

The Daily Reckoning