Twenty-Five Standard Deviations in a Blue Moon
“We recall looking out our window. Outside, we saw a summer day much like any other. And inside, what we saw in the news was also rather typical – a credit crunch. No, credit crunches don’t come along every day…but nor do 100,000 years separate one from another. In the United States, recently, we have had the crash of the dotcoms, the crash of Long Term Capital in ’98 and the crash of ’87; outside of the United States, there have been a number of credit crunches, in Japan, Russia, Mexico and various Asian countries.
“When you make loans to people who can’t pay the money back, trouble is only a couple standard deviations away. So far, during the first eight months of 2007, some 1.7 million houses have been caught up in foreclosure proceedings in the United States. That is just the beginning. According to Congressional estimates, up to 2 million families are expected to lose their homes over the next two years.
“The individual amounts of money weren’t very large, not by Wall Street standards. But when the money didn’t show up, it had an alarming effect. Last week’s press brought estimates of total losses of over $13 billion at Citi. Morgan Stanley is said to be facing $8 billion in losses. Merrill Lynch set records with estimated losses of $18 billion. The cat still has Goldman Sachs’ tongue. But when the losses are toted up, they will probably be spectacular. Altogether, there is more than $1 trillion in subprime debt outstanding; much of it will go bad.”
November 12, 2007
Now, back to Bill for a few more noteworthy items…
As we commented last week, despite the habitual confusion and misinformation in the financial press, there are probably a few things you can count on.
First, housing prices are going down. In theory, they have to go down – because the average family can’t afford the average house. That’s not a situation that can last for long. If the average family doesn’t buy the average house, who will? No one. So, it will go down in price until the average family can buy it. Pretty simple, huh?
Of course, that doesn’t mean it will go down in nominal terms. Prices could remain the same, while inflation raises other prices and family incomes too. But in real terms, the effect is the same: the real price of housing must go down.
Second, corporate profits are going down. They are going down because they always go down after they go up. That’s the way the world works. Whenever you can make an exceptional amount of money there arise an exceptional number of people who want to take it from you. Competition narrows profit margins. Some companies are making exceptional profits because they have been able to outsource labor to Asia…but Asian labor rates are rising, too. Other companies have made an exceptional amount of money because they have gotten into the finance business – like General Motors (NYSE:GM). But, suddenly, finance ain’t the business it was a couple of years ago. One way or another, profit margins will contract.
Third, stock prices will go down. Here, too, they could go down in nominal terms…or they could be taken down by inflation. One way or another, stocks will go down. Why? Because profit margins are going down. Because risk premiums are going up. And because the tide of money that held up asset prices is ebbing away.
Fourth, the middle class in America and Britain will have to make do with less money. Standards of living will fall for average people in both countries. Their major assets – houses – are going down. They are already deeply in debt, while the price of debt is rising. The only way they can hope to make financial progress is to earn more. But, faced with two billion willing wage earners in Asia, rising wages in the two leading Anglo-Saxon countries seem unlikely. At the very least, it would require huge new investments in capital equipment and training – money that is now being squandered on consumption and war.
What about gold? The yellow metal seems ready for a correction. It has gone up so fast, it probably needs to take a breather.
But gold, too, is almost sure to rise over the long run. It is the anti-dollar…the anti-dote to financial engineering, debt, derivatives, and paper currencies generally. It is what people buy when they begin to doubt that their financial authorities know what they are doing. Our guess: gold is a cinch to rise.
But wait, dear reader. We are also facing a possible financial meltdown of monumental size. As stocks, houses, and sophisticated financial instruments lose their value…”wealth” disappears. People have fewer dollars to spend…and they grow less eager to part with them. In dollar terms, the price of gold could stabilize…or even fall. Still, given the scarcity of gold…and its record of protecting people in times of crisis, we guess that the real price of gold will go up…even in a generalized, Japan-like deflation.
But, we’re a long way from there. As far as most of the world is concerned, we’re still in a boom…prices are rising…and gold looks like a good hedge against inflation. Just a guess: Look for a correction in the short-term…and then, another run-up which will take the price over $1,000.
The Daily Reckoning
The tide has turned, dear reader.
On Friday, the Dow lost another 224 points.
The Wilshire index, meanwhile, is helpfully quoted in dollars. So you can see immediately how much money people are losing. From the top around 15,900 to last week – when the index bounced around 14,600 – is a loss of $1.3 trillion.
That’s in U.S. dollars. But the U.S. dollar has lost about 10% of its value this year. So, the real world loss to investors is more than twice that amount…or around $3 trillion.
(John Connelly, treasury secretary under Richard Nixon, once famously remarked to a group of European visitors: “It’s our dollar, but it’s your problem.” That was back in the days when America still had an almost-positive trade balance. Now, when the United States needs nearly $3 billion in foreign money every day, the dollar has become OUR problem too.)
Add to that the loss in housing values – probably about another $1 trillion, so far.
And then, there are the losses, both announced and still hidden, in subprime debt and derivatives, which could tote up to another $0.5 trillion or so.
Hey…we’re starting to talk about some real money here – a combined loss of wealth equal to $4.5 trillion…or nearly 10% of the entire net worth of the United States of America.
Could that be?
We’re very suspicious of numbers. They’re twisted. They’re bent. They’re shifty. Still, our guess is that these big numbers are telling us something. They’re telling us that the tide has turned…that there won’t be another big bull market in stocks or property any time soon…and the feds’ efforts to goose up the economy with more monetary inflation are probably not working…
…at least, that’s what it looks like this morning.
You’ll recall the basic plot, dear reader: central banks encourage consumption by artificially increasing the supply of money and credit. This flood tide of extra money boosted asset prices worldwide, leaving the impression of a booming economy. But wages in the United States are not rising – so the only way ordinary people could participate in the boom was by borrowing. As they borrowed more and more, credit quality decreased. Finally, holders of subprime debt realized that their credits weren’t as solid as they thought they were.
Early this year, housing prices were already falling…and housing owners were having a hard time making their payments. Then, in August, credit crunched.
And now people are asking questions…borrowers are reluctant to borrow; lenders are wary about lending…
“Gloom envelops world markets,” says the Financial Times.
“Wall Street Braces for More Trouble,” says another headline.
The wash of credit – which lifted spirits and asset prices all over the planet – is ebbing. And once begun, it is probably impossible to reverse it.