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Generational Dynamics Web Log for 23-Sep-07
Stock markets again are approaching a new all time-high

Web Log - September, 2007

Stock markets again are approaching a new all time-high

I've received some criticism for being a bit too negative.

Several readers and correspondents have expressed some scorn, now that the market seems to be "back on track" (as one person put it), headed for new highs.

Let's start by quoting web site reader Bob:

"You are a funny guy since 2006 you predict a crash, it will never happen. After all this mess, the Dow still close to 14 000 nothing can kill this market. It seems obvious...Even the bursting of the housing bubfle and the mortgage mess don't kill that market... What it will take... Why don't you explain that, genius?"

Well actually I've been predicting a crash since 2002, based on the fact that the market is way overpriced by historical standards, and that hasn't changed at all. In 2002 I said it would probably happen in the 2006-2007 time frame, and that's still a pretty good prediction.

One of the standards is price/earnings ratios, and here's the current graph, from my recent article "How to compute the 'real value' of the stock market":

S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

Now, the thing that I don't understand, and have never understood, is how anyone can look at the above graph and not realize instantly that the stock market is going to crash. This graph isn't rocket science; it simply depicts a standard way of measuring the "real" value of the stock market.

The graph doesn't tell you on which day this will occur; it might happen next week, next month or next year. But it does tell you that it will happen soon.

There are a lot of people who used to call me nuts but don't anymore, as the economy has continued to worsen. But one thing I've noticed over the years is that people who do so never address things like the above graph. Does anyone seriously believe that P/E ratios are going to stay well above average forever? No one, including people who call me nuts, has ever made that argument, because it can't be made. The above graph alone is actually very close to a mathematical proof that a crash is coming.

So let's step back now, and see where things stand today.

The Fed / Bank of England reversal

Related Articles

Macroeconomics
Understanding deflation: Why there's less money in the world today than a month ago.: As the markets continue to fall, the Fed is increasingly in a big bind.... (10-Sep-07)

Alan Greenspan predicts the panic and crash of 2007: He's said this kind of thing before, but this time it's resonating.... (08-Sep-07)

Bernanke's historic experiment takes center stage: An assessment of where we are and where we're going.... (27-Aug-07)
How to compute the "real value" of the stock market. : And some additional speculations about stock market crashes. (20-Aug-2007)

Ben Bernanke's Great Historic Experiment: Bernanke doesn't believe that bubbles exist. His Fed policy will now test his core beliefs.... (18-Aug-07)

Redemptions of money market funds now fully in doubt: Wednesday is the deadline for 3Q redemption of many hedge fund shares.... (15-Aug-07)

Alan Greenspan defends his Fed policies, as people blame him for the subprime crisis: Greenspan never ceases to amaze, and he did so again on Monday.... (8-Aug-07)

Nouriel Roubini says: "Worry about systemic risk." Whoo hoo!: His arguments show what's wrong with mainstream macroeconomics.... (6-Aug-07)

Robert Shiller compares stock market to 1929: He says the recent fall was caused by "market psychology," but is puzzled why.... (20-Mar-07)

A conundrum: How increases in 'risk aversion' lead to higher stock prices: Maybe because the global financial markets are increasingly "accident-prone."... (12-Mar-07)

Pundits are suddenly talking about (gasp!) "risk aversion": Fearing full-scale panic in the mortgage loan marketplace,... (6-Mar-07)

Alan Greenspan blames the housing bubble on the fall of the Berlin Wall: Meanwhile, the stock market keeps skyrocketing and appears unstoppable to many investors.... (25-Oct-06)
System Dynamics and the Failure of Macroeconomics Theory : Mainstream macroeconomic theory, invented by Maynard Keynes in the 1930s, has failed to predict or explain anything that's happened since the bubble started, including the bubble itself. We need a new "Dynamic Macroeconomics" theory. (25-Oct-2006)

Alan Greenspan gives another harsh doom and gloom speech: Saying that "the consequences for the U.S. economy of doing nothing could be severe,"... (4-Dec-05)
Ben S. Bernanke: The man without agony : Bernanke and Greenspan are as different as night and day, despite what the pundits say. (29-Oct-2005)

Fed Chairman Alan Greenspan says that the deficit is out of control: France's Finance Minister Thierry Breton quoted Greenspan... (25-Sep-05)

Fed Governor Ben Bernanke blames America's sky-high public debt on other nations: I'm normally wary of applying specific generational archetypes to individuals, but Bernanke is acting like a Baby Boomer.... (14-Mar-05)

Greenspan's testimony further repudiates his earlier stock bubble reasoning: The Fed Chairman has now completely reversed his previous position on the stock market bubble... (17-Feb-05)
Alan Greenspan warns that global economic dangers are without historical precedent : In a speech on Friday, Greenspan buried a major change of position in a speech admitting that his assumptions about the economy for the last decade were wrong. (6-Feb-2005)

It's hard to overestimate the impact of this week's monetary loosening by the Fed and Bank of England.

Before Tuesday, the public debate was whether the interest rate cut would be none or 25 basis points (Ľ%). The 50 basis point (˝%) interest rate reduction was much larger than was expected, and represented a sudden and substantial loosening of Fed policy.

The same was true when the UK government agreed to guarantee all Northern Rock bank deposits. The Bank of England then followed up by substantially and unexpectedly loosening the standards for borrowing money from the Bank of England.

Among investors, the euphoria was instantaneous, and lasted through the end of the week. The commercial paper market, which had become frozen, unfroze, partially relieving the credit crunch.

The 50 bp interest rate cut did inject some liquidity into the market and make some additional lending possible, but no one that I've read seriously believes that the 50 bp interest rate reduction is large enough to substantially change the underlying fundamentals that caused the credit crunch, and made other things worse, as we'll discuss in the following paragraphs.

What's going to happen when there's another bout of bad news? There'll be demands for a further Fed rate cut, and this time, any cut, even a 50 bp cut, will not have anything like the same psychological effect.

Fall in the value of the dollar

Just as stock market investors received a psychological boost to push the stock market up higher, currency traders received a psychological boost to push the value of the dollar down.

Here's how one news article described the situation:

"The dollar fell sharply Friday, reaching a record low against the euro and capping a dramatic week for global financial markets that was marked by interest rate cuts, bank bailouts and skyrocketing oil prices.

The level of the dollar - often regarded as a barometer of the U.S. economy's health - dropped to $1.4120 against the euro during business hours in Asia, reaching an all-time low for a second consecutive day.

It also slipped against a number of other major currencies on speculation that the U.S. Federal Reserve would keep cutting interest rates as the world's largest economy weakens.

Sentiment soured for the dollar after Ben Bernanke, chairman of the Federal Reserve, stoked speculation that he might continue to lower rates following this week's aggressive trim of half a percentage point. Bernanke said Thursday that the sell-off in credit markets could make the housing recession more severe."

This makes several things clear: The dollar was weakened by the Fed move, and the world now expects further weakening.

Here's how another news article describes the Saudi view:

"Fears of dollar collapse as Saudis take fright

Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East.

Ben Bernanke has placed the dollar in a dangerous situation, say analysts. "This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

"Saudi Arabia has $800bn (Ł400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg."

Finally, it's worth noting that Canadians are brimming with pride this week because, for the first time in decades, a Canadian dollar is worth just as much as an American dollar.

Europeans suffer "worst jolt" since 9/11

That's the headline in a Financial Times news story about the effects of American's financial turmoil on Europe.

The eurozone "purchasing managers' index," which measures economic activity among both manufacturers and service provides, fell steeply in September, the biggest drop since October 2001.

These problems are being exacerbated now by the fall of the dollar against the euro, which means rise in value of the euro against the dollar, following the Fed's interest rate reduction.

If the "super euro" remains high against the dollar, it means that European exports become a lot more expensive to Americans. This is bad for business in Europe, and there are now concerns that Europe will fall into recession because of the Fed rate cut.

CDOs and other Credit Derivatives

If you've been reading this web site for the last six months, then you know that you know that the economic turmoil has been caused by "collateralized debt obligations" (CDOs) and other credit derivatives.

Without attempting to repeat previous detailed explanations, CDOs and other credit derivatives allow you to make various "bets" related to credit, especially whether certain classes of debt will be repaid or go into default. These got into particular trouble because many CDOs are based on sub-prime mortgage loans.

If you're a very "sophisticated" investor, you might have purchased a CDO that will pay you a regular income provided that the underlying mortgages are not foreclosed. You may have thought it was a "sure bet," because the major ratings agencies told you that these CDOs were AAA investments. But with foreclosures surging in the last few months, these investments have performed badly.

For months, we were told that the "subprime mortgage problem" was completely "contained." But in fact, it's now turning out that CDOs are in the portfolios of all kinds of financial institutions around the world, including banks, pension funds, and so forth.

Here's what Fed Chairman Ben Bernanke said to Congress, just last week:

"Most recently, as I am sure Committee members are well aware, subprime mortgage losses that triggered uncertainty about structured products more generally have reverberated in broader financial markets, raising concern about the consequences for economic activity. As I noted in a speech last month at the economic symposium hosted by the Federal Reserve Bank of Kansas City, the turbulence originated in concerns about subprime mortgages, but the resulting global financial losses have far exceeded even the most pessimistic estimates of the credit losses on these loans. These wider losses reflect, in part, a significant increase in investor uncertainty centered on the difficulty of evaluating the risks for a wide range of structured securities products, which can be opaque or have complex payoffs. Investors also may have become less willing to assume risk. Some increase in premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. However, in this episode, the shift in risk attitudes combined with greater credit risk and uncertainty about how to value those risks has created significant market stress. On the positive side of the ledger, past efforts to strengthen capital positions and financial market infrastructure places the global financial system in a relatively strong position to work through this process."

Notice the phrase: "the resulting global financial losses have far exceeded even the most pessimistic estimates of the credit losses on these loans."

Now you may wonder if perhaps the crisis is over. In fact, it's only just beginning.

Many mortgage loan foreclosures are from ARMs (adjustable rate mortgages), where the homeowner signs up for the mortgage with a low monthly payment, based on a low "teaser" interest rate. That teaser rate expires after 1, 2 or 3 years, depending on the terms, and then the interest rate "resets" to a much higher value, and the homeowner's monthly payment can double or even quadruple.

Here's a chart showing ARM reset schedules from the Calculated Risk blog:

Monthly ARM reset schedules, 2007-2009 <font face=Arial size=-2>(Source: Calculated Risk)</font>

Monthly ARM reset schedules, 2007-2009 (Source: Calculated Risk)

As you can see, the great bulk of ARM resets occurs in the next 10 months. So the worst is yet to come.

How bad can it be?

First, you have to remember what's really going on here. There have been global financial crises at regular intervals throughout history. The details have been different each time, but they always have one thing in common: A debauched and perverted use of credit, occurring at exactly the time that the survivors of the previous financial crisis have all died or retired.

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.

I've quoted this paragraph a couple of times before, but it such a powerful paragraph that I want to repeat it. It describes the the last days of the Tulipomania bubble of the 1630s, as described in Edward Chancellor's 1999 book, Devil Take the Hindmost, a history of financial speculation:

"No actual delivery of tulips took place during the height of the boom in late 1636 and early 1637 as the bulbs remained snug in the ground. A market in tulip futures appeared, known as the windhandel (the wind trade): sellers promised to deliver a bulb of a certain type and weight the following spring, buyers took the right to delivery -- in the meantime, cash settlement could be made for any difference in market price. Most transactions were expedited with personal credit notes which also fell due in the spring when the bulbs would be dug up and delivered. Gaergoedt boasts of having made 60,000 guilders from his tulip speculations but admits that he has only received "other people's writing." By the later stages of the mania the fusion of the windhandel with paper credit created a perfect symmetry of insubstantiality: most transactions were for tulip bulbs that could never be delivered because they didn't exist and were paid for with credit notes that could never be honoured because the money wasn't there." (pp. 16-18)

This last sentence tells you exactly what CDOs and other credit derivatives have become. They're based on leveraged mortgage-based investments that no longer exist in viable form, and were paid for with other credit derivatives that could never be honored because they too were worthless.

So how bad can it be?

Nobody knows for sure, because large financial institutions are now doing everything in their power to cover up the size of their exposure. But here are some figures you should be aware of:

The nominal value of all credit derivatives in the world is now around $750 trillion.

The total world GDP is around $45 trillion. That is, if you add together all the products and services produced by all the countries and firms in the world, it adds up to $45 trillion.

Now, in the case of Bear Stears and other financial institutions, we've seen that some of the credit derivative instruments lost something like 90% of their value when an attempt was made to actually sell them, and they were "marked to market."

But let's suppose that, on the average, when all those credit derivatives are finally "marked to market," the average loss is only 10%. That's an optimistic assumption, but 10% of $750 trillion is $75 trillion!

In other words, even in this optimistic scenario, the amount of money to be pulled out of the world's economies is 1˝ times the GDP of the entire world!

Now, for those of you who think that can't happen, remember what Bernanke himself said this week:"the resulting global financial losses have far exceeded even the most pessimistic estimates of the credit losses on these loans."

There is absolutely no evidence to support the belief that the worst has past. In fact, the trends are clearly pointing in the direction that the worst is yet to come.

What happens next?

Let me return to an analogy that I've used before.

Imagine the world economy as a huge mansion, blown up into a huge bubble. For several months now, pieces of that huge mansion have been breaking off and falling into the ravine. Examples of "implosions" are: Bear Stearns' hedge funds, Countrywide Bank, Sentinel Management, and Northern Rock bank in the UK. According to the mortgage lender Implode-o-Meter, the count of major U.S. lending operations that have "imploded" since December is now up to 159.

Maybe the stock market crash would have occurred by now, as it had at this point in the 1929 cycle, but there's something very different today that wasn't true in 1929.

The Fed and other central banks are running around the mansion with hammer and nails, patching things up as fast as they can, trying to keep ahead of things -- and they're being pretty successful at that. Last week's interest rate reduction by the Fed was a particularly big wad of glue and nails.

But it can't work for much longer. The price/earnings graphic near the beginning of this article tells you so. The stock market is overpriced by a factor of 250% or so. Wads of glue can't fix that.

This is the Principle of Maximum Ruin that I've discussed many times in the past. The longer the crash is delayed, the worse it will be. In time, the world's financial officials will see to it that the maximum number of people are ruined to the maximum extent possible.

All the advances in economics and macroeconomics that we've learned since 1929 really haven't done anything useful except provide for new and clever ways of applying glue and nails. But sooner or later, the entire mansion has to collapse and fall into the ravine.

So, to Bob and others, I say to you, take another look at that price/earnings graphic at the beginning of this article, and think about what it's telling you. Is it telling you that "nothing can kill this market," as you claim? Is it telling you that "it's different this time"? If so, then just keep pouring your money into the bubble.

But if it's telling you, as it's telling me, that the P/E index is soon going to start plummeting down below 10, as it has several times in the last century, most recently in 1982, then you'd better take your money and run for the hills.

From the point of view of Generational Dynamics, there's no doubt whatsoever: We're headed for a generational stock market panic and crash. Really, we have different names for things today, but the underlying basics today are no different than they were in 1929. (23-Sep-07) Permanent Link
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