| The Big Bubble Bust |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Sunday, 09 November 2008 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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The Big Bubble BustJust how smart are attempts to stop it?By Matt Blackman Adding up the damageValue DilemmaShort-Circuiting the Correction Most Daunting Economic Environment in 76 YearsNow that the election is over, reality is sinking in. Other than a different party in charge and a new family in the White House, what has really changed? Economic challenges, which briefly gave way to pre-election excitement, loom larger than ever. Markets rallied to their biggest one-day Election Day rally ever on the expectation that Obama would win. Then in a clear ‘be careful what you wish for’ demonstration, stocks then suffered their biggest two-day post election drop in history as the S&P500 shed 10%. It was a double-whammy post-election hangover as euphoric Democratic supporters realized that the serious challenges now face the new president-elect and investors were hit with the reality of what an Obama presidency means for their portfolios. In his first press conference since the election, Senator Obama backed by his cadre of advisors, reiterated his promise of tax cuts for the middle class paid for by tax increases on the so-called rich in spite of abysmal record of this action in response to prior economic malaises. He also stressed that his first task as President would be to pass another bailout package if President Bush failed do so before January 20 and institute a raft of new financial regulation. Was it any surprise that the Dow dropped 100 points in the first five minutes of his 12-minute speech? This introduction and market reaction was a juxtaposition of the hopes in having a new president against the obstacles facing the nation he now leads. During the campaign, Democrats focused their fusillade at the Bush Administration for the economic woes we now face. But while the bubbles now breaking formed on Bush’s watch and are partly attributable to the actions or inaction of government, Treasury and Fed, they were not of Mr. Bush’s making. Notwithstanding the spate of government stimulus programs and recent socialization of Wall Street, we still live in a free market society after all, and it is not the government’s job to make it work. But that hasn’t stopped the government from trying every trick in the book as well as a bunch of new ones to stop the rapid devaluation now being felt around the globe. Adding Up the DamageGovernment action in the wake of our economic woes by both the Republicans and Democrats maybe likened to closing the barn door after the horse has escaped. Can these actions repair the substantial damage after the fact? Valuations in U.S. markets have been hammered. Since peaking in late October 2007, the chart below shows the impact on stocks. Total market capitalization for the Wilshire 5000 Index, the broadest measure of North American stocks, peaked at $18.73 trillion at the end of October last year. By the end of October 2008, the index had lost nearly 40% carving a whopping $7.2 trillion off equity valuations in the U.S. But this pales in comparison to global market losses.
Figure 1 – Chart of the Wilshire 5000 Index, the broadest index of U.S. stocks showing the 38.3% drop over the last year which translates to loss of more than $7 trillion in U.S. stock values. The Wilshire 5000 dropped back to lows not seen since May 2003 before putting in the recent bounce. Chart by Metastock.com As we see from the next table, the damage on this side of the Atlantic and Pacific seems modest in comparison with other markets and as we see, there is no part of the globe that has been spared. Worst hit are Chinese stocks down a breath-taking 71% in the last year. But also note that the stock prices for small cap markets such as the Canadian TSX Venture and U.K. FTSE AIM Index have also been decimated. More than a dozen indexes have lost in excess of 50% (red). Next we see the markets that have lost between 30 and 50% (orange) including the Value Line Geometric, the S&P500, Dow Jones Industrial Average and Mexican IPC (highlighted in blue). The Toronto TSX Composite has fared better, thanks mostly to the fact that it is a rich in commodity stocks, but now that commodities are falling, it could see losses accelerate. Another plus for U.S. stocks is the fact that the US Dollar has rallied this year, in part offsetting stock price declines. But profligate government spending on bailouts and other programs could see this trend quickly reverse.
Table 1 – List of 50 global indexes showing annual returns with North American indexes highlighted in blue. On average, losses were 43.13%. The next chart of the Bloomberg World Exchange of market capitalization for global stocks shows the extent of the losses around the world. After peaking on October 30, 2007 at $62 trillion, stock values plummeted nearly $30 trillion over the following year, more than four times the equities losses in U.S. markets.
Figure 2 – Chart of the World Exchange Market Index showing the market capitalization of global stock markets. Bad as it seems, equity values dropped to where they were in May 2004 as global equities markets lost $29.72 trillion in value. Chart by Bloomberg Residential real estate prices in the U.S. have fallen more than 20% from their 2006 to August according to the Case-Shiller home price index. Considering that the total value of residential real estate was $21 trillion at its peak means that U.S. homeowners have seen another $4.2 trillion disappear. According to Kyle Bass of Hayman Advisors, “in the U.S. alone, with Lehman, AIG, Bear Stearns, Fannie, Freddie, WaMu, IndyMac, CountryWide, and the rest of the companies that have failed to date (October 14), there are [another] $8 TRILLION of assets already in receivership, conservatorship, liquidation, or “parked” with big brother” and backed by the taxpayer. By mid-October, financial firms had reported $637 billion in losses according to Bloomberg while economist Nouriel Roubini estimates that losses stemming from the subprime mortgage market will now be “closer to $3 trillion.” Kyle Bass expects to see at least $1 trillion of corporate debt default over the next two years. It is important to point out that these losses are limited to equities and residential real estate markets as well as corporate bankruptcies but do not include losses in commodities (like metals, grains, softs and energy), bonds, commercial real estate, currencies or the biggest of them all, the derivatives markets (which we discussed in our last Special Report: The Mother of All Bubbles that Ate Wall Street.) Value Dilemma"Overpriced assets are like poison mushrooms. You eat them, you get sick, you learn to avoid them. A credit bubble is different. Credit is the air that financial markets breathe, and when the air is poisoned, there's no place to hide." Charles R. Morris. There has been much ado about how crazy the real estate market got and how easy it was for just about anyone with a heartbeat who could sign his or her name to get a mortgage. But mortgage mayhem occurred elsewhere as well. In Australia, banks were lending based on nine times median income. The historic average in most developed countries was 3.5 times. The world got caught up in a crazy real estate party never before experienced. So how crazy did it get? Most are by now aware that home sales have fallen off a cliff and prices have also been falling rapidly. But there is much debate about how far. As of September, median prices reported by the National Association of Realtors have fallen 17% from their peak. According to the more precise Case-Shiller home price index that tracks paired sales data in 20 metropolitan areas around the country average prices have fallen more than 20% since their 2006 peak. But less well-known is the fact that C-S Index co-founder Dr. Robert Shiller has collected inflation-adjusted home prices across the country for more than 100 years and the results are revealing. Since 1890 through their highs and lows, home prices have basically kept up with inflation, rising above their historic average during good economic times and dropping below during the bad times. But then something very interesting happened in 2000. After hitting 128 which was the prior inflation-adjusted high reached, prices kept moving up over the next six years until they had risen above 202, nearly 60% above their previous all-time high. In other words, even though prices in the U.S. have fallen over 20%, home prices still have to fall more than 32% just to get back to highs reached in previous peaks and more than 60% to return to their historic average price!
Figure 3 –Annual inflation-adjusted U.S. home price index showing the incredible bubble that has just begun to burst. After peaking at 202.89 in 2006, the index has fallen to 170.76 so far in 2008. The long-term average is 106.4. Over the last 120 years, housing prices have fluctuated above and below 100 roughly just keep up with inflation until 2000 when prices moved beyond their previous inflation-adjusted high of 128. After peaking above 200 in 2006, home prices now have a long way to fall before getting back to anywhere near their history norm. Data – R. Shiller This contention is supported by other historic real estate metrics. As we see from the next chart, home prices still have a long way to fall in relation to rents. To return to the average home price to rent ratio, either home prices still have to fall at least 12% further nationwide or rents would have to increase roughly 15% - the former being much more likely than the latter in a recession.
Figure 4 – Quarterly chart showing changes in the price-to-rent ratio over the last two decades. The bubble beginning in 2002 and ending in 2005 is clearly visible on the right-hand side. It also shows that we have a long way to go to get back to the historic norm in mean (average) prices to average incomes over different periods. Chart – Northern Trust Next, we see a chart of the ratio of the value of the family home as a percentage of household income. Prices still have a long way to fall to return to normal compared to median incomes as well.
Figure 5 – Value of the family home as a percentage of median income showing that the correction still has a long way to go. Chart – Northern Trust It is clear that residential property prices are still high – too high to be sustainable. Short-Circuiting the Correction and the Election PumpCorporate assets are more difficult to measure. Lehman Brothers, now extinct is a good example. In a press release on March 18, 2008, the company announced net income of $489 million for the first quarter with net assets totaling $395.9 billion. But by the third quarter, the company had gone bankrupt. How can that be? How can a company with $400 billion in assets disappear? In retrospect and in light of their credit derivative swap auction, it became clear that these assets weren’t worth anything near their stated value. As we learned from the auction, the Lehman assets weren’t worth $200 billion. They weren’t even worth $40 billion – they were worth exactly 8.625 cents on the dollar. But far more importantly, how many other financial companies, banks, lenders and corporations are in similar financial straits but just haven’t told us yet? The problem according to Bass is that many corporations were simply making values on their assets up. Now that the Democrats control the Senate, Congress and White House, they have made it clear that they will use their new found powers to try to fix our broken economy no matter what the cost. The latest $500 billion mortgage bailout proposal brings the total of stimulus packages and bailouts to $2.7 trillion by my calculation. This doesn’t include any new plans the Mr. Obama has in mind. History tells us that the two years leading up to an election is the most important time for any government. If the economy is robust as voters head to the polls, there is a good chance that the incumbent party will be elected or re-elected. If not, their chances of winning are poor. And these stimulus programs during pre-election periods have had a powerful effect on markets. A strategy to buy the 30 companies of the Dow Jones Industrial Average at the mid-term low 26 months before the election and selling after the election captured 93% of all Dow gains between 1902 and 2006 compared to just 7% in the 22 months after the election. And our study showed that this election effect is getting more powerful. But every stimulus program has a price. Since World War II, with the exception of the relatively brief 1987 correction, every single serious bear market and recession has occurred in the two-year post-election period as the government worked to right the excesses built up during the pre-election party. Put another way, after nearly every election, it has taken two years of pain just to get the economy back on track again. Actions during the final two years of the Bush Administration, especially in the final months leading up to the election are a case in point. Unfortunately, even though the government outdid itself compared to previous pre-elections in an attempt to fix our broken economy, the trillions of dollars have so far achieved little of the desired effect.
Figure 6 – The weekly chart of money supply shows the rapid jump in cash in the system thanks to Fed actions. Between end of August and November 5, 2008 the Fed increased the money in circulation by an incredible 44.4% and dropped the effective overnight lending rate to nearly zero. If this doesn't devalue the dollar, I don’t know what will, except that every other major industrized nation and a number of emerging ones are doing the same thing! So far more than $2 trillion have been thrown into the economy to try to stop the massive asset re-pricing now underway. But even this incredible amount pales compared to the losses at home and abroad so far. As we see from the above chart, in the weeks leading up to the election, the Fed cranked the money presses into high gear adding nearly 45% to our monetary base to try and fix the problem. The Fed funds rate is now at historic lows again of 1%. Now the government is trying to force banks to spread the money around (see article below “Treasury…”). In other words, the government and Fed are getting near the end of their resources to stimulate the economy. So far such tactics haven’t worked but somehow, geniuses in government think more of a bad thing will actually be good. What is that old saying about the definition of insanity? Now that the government is running out of options and money, it has been estimated that the budget deficit will jump from $400 billion to over $1 trillion in 2009. Where will the government (and the Fed) get it? Not at home because even during the good times before the recent meltdown, our national savings rate was negative. In other words, we have become dependent on the generosity of foreigners to finance our standard of living and keeping interest rates low. But this free ride may be coming to an end sooner rather than later and has the potential to drive interest rates into the stratosphere. But even with interest rates (the effective Fed funds rate) near zero, people are losing their jobs in increasing numbers. Unemployment hit 6.5% in October a level not seen since 1994. At the current rate of jobs losses, it may not be very long before we reach the 9.5% peak in 1982 during the last severe recession. If anything consumers who are the main drivers of our economy will need to spend whatever savings they have to pay mortgages or rent and buy necessities. Will the Chinese and Japanese, who have been the major buyers of U.S. Treasuries, continue to support our economy even though their own economies are now suffering slowdowns? Except now, instead of buying $33 billion of our Treasuries every month, we will need to sell them over $80 billion monthly given current budget deficit projections of over $1 trillion. However, the Chinese are now getting into the bailout act. They recently announced a $586 billion plan of their own. Every dollar spent at home means a dollar less to lend to the U.S. And other emerging nations are joining in the bailout game (see articles “Emerging...” and “Zero…”). It is looking more and more like our government will have to learn this painful truth the hard way. It is financial folly to try to stop the massive re-pricing when an asset bubble breaks. It’s like trying to stop a runaway freight train. But perhaps more importantly, bailouts transfer the losses from those in the private sector who made bad investments to the taxpayer, many of whom were responsible and did not take on unmanageable levels of debt. As they learned in Japan, which is still suffering through a two decade-long economic malaise, trying to fix the problem through government bailouts and creative accounting to hide or bury losses versus letting financial gravity take its course only prolongs the pain. To sum up, the underlying premise of these bailouts is to stimulate a rapid reversal and return to the days of high prices and bloated valuations. But this will come at a cost – a fiat currency that has no real relationship to true value and rapidly rising inflation accompanied by a staggering loss in purchasing power. We will be left with unprofitable companies and homes that no one can afford. As a best-case scenario, we risk years of anemic economic performance, a rapidly declining dollar combined with stagflation and eventual spike in interest rates as foreigners avoid dollar-denominated assets like the plague in search of those assets that are realistically priced. If these bailouts fail, and they will if history is any guide, we can expect a continuation of extreme levels of volatility as markets swing between periods of euphoria as new stimulative plans are announced and then depression as prices plummet and the realization hits home that the latest plan has failed. SUGGESTED READING:Fed Balance Sheet Swells Above $2 Trillion http://www.reuters.com/article/marketsNews/idUSN0640103620081106Democrats Set to Take On Stimulus Bill as Price Rises http://www.bloomberg.com/apps/news?pid=20601110&sid=aXUnWNKW7P5I Treasury, Congressional Democrats Clash on Policing Bank Loans http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNRUoQDt.aLY China Unveils 4 Trillion Yuan Spending as World Faces Recession http://www.bloomberg.com/apps/news?pid=newsarchive&sid=augL9_cumtA4 Emerging Economies Pledge Stimulus to Fight Slump http://www.bloomberg.com/apps/news?pid=20601110&sid=aVGp.cu7Yhvs Zero Rate World May Lie Ahead as King, Trichet Cut http://www.bloomberg.com/apps/news?pid=20601109&sid=ayE0YPzpdD38&refer=exclusive Democrat Emanuel Says Auto Industry Essential to U.S. Economy http://www.bloomberg.com/apps/news?pid=20601110&sid=aSy5ga58yIJg Wilshire 5000 Index Characteristics http://www.wilshire.com/Indexes/Broad/Wilshire5000/Characteristics.html --------------------------------------------------------------------------------------------------------------------- If you find this newsletter insightful, please feel free to forward this report and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be have it sent to them each week). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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