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Generational Dynamics Web Log for 25-Jul-07
Deals are collapsing as financial managers can no longer "make money"

Web Log - July, 2007

Deals are collapsing as financial managers can no longer "make money"

New York stocks fell 1.5-2% on Tuesday, as "Mean Reversion" stunts earnings growth.

As second quarter earnings come in, it's becoming apparent that the Law of Mean Reversion is finally beginning to apply to earnings growth.

As I wrote in a 2005 article called "The 11% Solution," over the long term, corporate earnings grow at the rate of 11% per year. But since the mid-1990s, earnings growth has averaged about 18%. By the Law of Mean Reversion, that means that we have to have an equal number of years of near-zero earnings growth, to maintain the long-term average.

That was in 2005, but earnings growth averages have stayed in double-digits -- until this year. For the first quarter, earnings grew around 7%. We're now getting second quarter earnings announcements, and it appears that they're going to be averaging around 3%.

Leading the way in bad news was Countrywide Financial Corp., whose second-quarter profits were down 33%, because of surging mortgage foreclosures.

It's the double-digit earnings growth that investors used to buy more stocks, even though price/earnings indexes have been way above average since 1995.

But that wasn't the only thing to spook investors on Tuesday.

We have discussed currencies much lately, but it's worth pointing out that that the dollar has been falling rapidly on international markets. It's at its lowest level ever against the euro, and at a 26-year low against the British pound.

Let me just pause for a moment to discuss the two meanings of the word "inflation." If you read the papers, all that anyone seems to worry about is whether there's too much inflation, since too much inflation means that the Fed will have to raise interest rates, and that will make it harder to borrow money.

Actually, inflation is that big a problem. My prediction in 2003, based on long-term forecasting techniques, was that the Consumer Price Index (CPI) was at a secular high and that prices would fall by 30% by the 2010 time frame. That's still my prediction today, based on the scenario that an inevitable stock market crash and financial crisis will cause massive deflation.

This should hardly be a surprise, especially if you look at Japan. When their secular financial crisis and stock market crash began in 1990, prices started falling, and they experienced deflation for many years.

People only started seriously worrying about inflation during the so-called "Great Inflation of the 1970s." Even this phrase is something of a joke, because it parallels the "Great Depression of the 1930s." In the 1940s-70s, mainstream economists and pundits used to worry about a repeat of the Great Depression. Now they've decided that that can't ever happen any more, and they worry about inflation, and a repeat of the 1970s.

But it's easy to see that that concern is misplaced. Look at our experience since 2001. The Fed kept interest rates close to zero for several years. Mainstream macroeconomic theory, based on the 1970s experience, predicts that near-zero interest rates should have caused high inflation and a burst of new employment for several years. Instead, inflation has been extremely low, and unemployment has remained stubbornly high.

However, there are two different kinds of "inflation": Domestic inflation is measured by the CPI, and the international inflation is the value of the dollar against other currencies.

Mainstream macroeconomic theory says that these two measures of inflation should remain roughly synchronized. But they haven't.

The domestic inflation rate, as measured by core CPI, has been very low, almost deflationary. Internationally, the value of the dollar has been falling, which is an inflationary measure. The fact that these two measures have been going in different directions is another example of the failure of mainstream macroeconomics to predict or explain anything since 1995, and why it's necessary to integrate classical System Dynamics into macroeconomic models.

So the falling value of the dollar in international currency markets is another reason why investors are getting spooked.

But the third reason is at least equally worrying: The continued collapse of the market for credit derivatives -- especially "collateralized debt obligations," or CDOs.

You may recall that last year I told you how hedge fund managers "make money" -- and I mean that literally -- they actually create new money. Briefly, they start up a new hedge fund, based on underlying assets of any kind whatsoever, and then bid up the price of the hedge fund shares so that they're worth many times more than the value of the underlying assets. In essence, the hedge fund manager is "making money" -- literally, as if he had a printing press. The hedge fund shares can now be traded at their inflated values, so in some circles they're as good as money.

At least that's how I explained it last year. But now we can put things into a little better perspective.

The "underlying assets" that I mentioned above have turned out to be mostly these CDOs. The CDOs themselves had "underlying assets," namely the payments due from mortgages.

As foreclosures have surged, the CDOs have lost value, and the hedge funds based on them have collapsed, as happened last week when Bear Stearns announced that its hedge funds are almost worthless.

The collapse of the CDO market means that hedge fund managers are no longer able to "make money." They can't just issue some new hedge funds, get buyers, and use the assets to fund some other deal.

The result is that within the last month, it costs about 2% per year more to get financing for a deal. If the deal involves a few billion dollars, then 2% makes a huge difference.

That's why a huge deal involving General Motors collapsed on Tuesday. GM had agreed in June to sell their Allison Transmission unit to private equity firms for $5.6 billion. The deal would have required a $3.5 billion bank loan. A month ago, it would have been easy. Tuesday, it was impossible.

The GM deal is not unique. A Reuters article lists 24 such deals that have had to be postponed in July alone.

The deals involved a French insurer, a German truck parts supplier, an Austrian machine maker, the Russian state-owned oil firm Rosneft, a Dutch retailer, and many other firms around the world.

Why is this important?

It means that everything in the world is slowing down economically. If credit isn't available, then deals can't be made, products can't be purchases, and services can't be provided. Big firms and little firms, rich people and poor people, are finding it harder and harder to get money for the things they need, and this creates a domino effect.

When I predicted in 2002 that we were entering a new 1930s-style Great Depression, it was based on very general macroeconomic and generational considerations. I showed that the stock market was way overpriced, using long range financial forecasting techniques, and I showed that we were overdue for a generational financial crisis.

The last point is worth reviewing briefly again.

From the point of view of Generational Dynamics, a generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash. We're now overdue for the next one. It could happen next week, next month or next year, but it will come with absolutely certainty, and will come sooner rather than later.

The 2002 prediction was really a "big picture" prediction, a macroeconomic prediction, a systems dynamics prediction, because it told you where we were going, but not what path we would take to get there.

Now, as the time approaches, we're looking more and more at the minute details. In 2002 I couldn't have told you that the CDO market would collapse, because 2002 was before the housing bubble, before the credit bubble, before the liquidity bubble, and before there was any real market for CDOs.

Today, the "big picture" prediction is exactly the same, but now we can be pretty certain of some of the details. We can see now that CDOs will play a big role. We can see that the Shanghai stock market bubble and the Chinese economy bubble will play a big role. And it's beginning to look like the falling US dollar value will play a role.

When historians look back at this time, they'll say, "It was all the fault of those darn CDOs and the Chinese. If it hadn't been for them, there wouldn't have been a crash."

But that's wrong. It's like saying that there wouldn't have been a World War II if there'd been no Hitler. Hitler didn't cause WW II; he was merely the actor that brought it about. But without Hitler, someone else would have done the same kind of thing.

The same is true of CDOs and the Chinese today. They aren't the cause of the financial crash, only the actors.

The financial crash is coming because all the people who survived the last crash (in 1929), and who survived the Great Depression of the 1930s, are gone. They've been replaced by new, younger generations of people with no fear of abusive credit practices and debauched economic practices. The new 1930s style Great Depression has to come -- not because of CDOs but because of Boomers and Generation-Xers. (25-Jul-07) Permanent Link
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Generational Dynamics Web Log for 25-Jul-07 Deals are collapsing as financial managers can no longer "make money"

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Generational Dynamics Web Log for 25-Jul-07
Deals are collapsing as financial managers can no longer "make money"