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Generational Dynamics Web Log for 10-Jul-2008
Pundits and analysts are baffled by the market's performance

Web Log - July, 2008

Pundits and analysts are baffled by the market's performance

They have some interesting fantasies, as well.

Market summary, 9-July-2008

Market summary, 9-July-2008

The Dow Industrials fell another 2.08% on Wednesday. The index is now at 78% of its October high.

These dreary plunges aren't going to continue long, according to some analysts.

In fact, the analysts at Deutsche Bank AG, Lehman Brothers Holdings Inc. and UBS AG say that things will really take off in the second half of 2008. They say that the market indexes will gain the most in 26 years! Pop the champagne! The party is on again!

Ashwani Kaul, Thomson Reuters director of research <font face=Arial size=-2>(Source: CNBC)</font>

Ashwani Kaul, Thomson Reuters director of research (Source: CNBC)

How can these analysts possible believe that kind of fantasy? Well, it turns out that it depends on another fantasy that they believe in.

On Tuesday morning, Ashwani Kaul, director of research at Thomson Reuters, was on CNBC talking about corporate earnings. He said that they're now estimating that S&P 500 earnings for the second quarter have fallen 13% from the second quarter of last year.

As regular readers know, I frequently post the estimated corporate earnings for the most recent quarter, and show how the estimates keep falling, week after week. Well, Mr. Kaul was kind enough to provide one more data point.

With that, here's the latest table for second quarter earnings:

  Date    2Q Earnings estimate as of that date
  ------- ------------------------------------
  Jan  1:              +4.7%
  Feb  6:              +3.5%
  Apr  1:              -2.0%
  Jun  6:              -7.3%
  Jun 13:              -8.1%
  Jun 20:              -9.0%
  Jun 27:             -11.3%
  Jul  3:             -12.4%
  Jul  8:             -13.0%

As usual, the earnings estimates have fallen again in the 5 days since the last estimates was posted on CNBC Earnings Central. Lower earnings estimates mean high price/earnings ratios (valuations), motivating investors to sell off their stock holdings. That's why the market has been falling.

Well, Mr. Kaul was kind enough to go and give us his estimates for the third and fourth quarters:

Quarter              Earnings growth estimate
--------------       ------------------------
Third quarter        +13%
Fourth quarter       +59%

Wow! No wonder the pundits believe that the stock market is going to take off like a rocket.

How do they justify this fantasy? Well, third quarter earnings last year were pretty bad, and fourth quarter earnings were VERY bad. And so, this year's quarterly earnings will grow 13% and 59% respectively, because the growth results will be computed based on last year's lowered earnings.

Now this is really interesting reasoning. I always talk about the Law of Mean Reversion, meaning that earnings have been well above average for many years, and so they'll have to be equally below average for approximately the same number of years, so that the historic average will be the same.

But these pundits have invented an entirely new law: The Law of Bubble Reversion. According to their reasoning, the recent fall in earnings growth was just a blip, and earnings will recover just as if that blip hadn't happened. So earnings will be back in full bubble mode.

The Law of Bubble Reversion. I like it! And the "Bubble Reversion" concept goes so well with the hopes and dreams that the days of the champagne parties will return again.

And why do they think that Bubble Reversion will occur, and push earnings growth up to 59%? Well, that depends on yet a third fantasy.

Kaul said it during his CNBC interview -- that the 13% and 59% figures are computed under the assumption that the asset writedowns are over.

Well, we've heard that before, haven't we. Do you remember, Dear Reader, what I wrote on October 25 of last year, just after Merrill Lynch had shocked Wall Street with a massive $8.4 billion writedown?

Here's an excerpt from that article:

"At any rate, bubbly investors now have one less hook on which to hang their hats.

In the "bad news is good news" frame of mind, investors have been treating previous writedowns as a good thing. The phrase we've been hearing was that the third quarter was a "kitchen sink" quarter, meaning that financial institutions would get all their writedowns out of the way in the third quarter, so that they could go back to inflating the bubble in the fourth quarter.

This concept is no longer viable. It's now clear that, at best, financial institutions have no idea how big their exposure is and, at worst, they do know, but are fraudulently hiding it from the public.

Either way, bubbly investors are now beginning to realize that the "kitchen sink" concept doesn't work, and that there will be a lot more writedowns in the quarters to come.

And with foreclosures surging and real estate prices falling, it's increasingly clear that much worse is yet to come."

Remember that great phrase, "kitchen sink quarter?" Last year's third quarter would be a kitchen sink quarter, when all the writedowns would be taken, and the bubble could grow again.

Well, Dear Reader, we heard the same thing at the end of the fourth quarter, at the end of the first quarter, and now again at the end of the second quarter.

It's impossible on its face. Residential housing prices are still falling, and foreclosures are still increasing, and are expected to continue increasing into 2010. The asset writedowns are directly linked to the increasing foreclosure rate, and so obviously the writedowns are going to continue and increase.

I just have to take a breath here, before we go on to the next step. You know, I've been writing for this web site for six years now, and I've discussed so many unbelievably stupid things said and done by analysts and reporters and politicians and government officials, and yet each new example astonishes me just as much as the previous ones.

But of course it's much worse than stupidity. As I've outlined in detail many times, these same analysts, reporters, politicians and government officials have committed fraud or have been complicit in fraud. Even today, certain government officials are encouraging and helping banks to hide the true values of their assets, thus defrauding investors who continue to buy stock shares in the banks. The stench of corruption and fraud continues to be sickening, as it's occurred throughout the finance industry, the real estate industry, the IT industry, and probably every other industry as well. An online correspondent has told me that she's seen massive fraud and loss of ethics among lawyers and judges as well.

Anyway, back to our story.

We were saying that it's ridiculous on its face to assume that the asset writedowns are over, but the ridiculousness has been confirmed by a confidential study from hedge-fund firm Bridgewater Associates Inc. The study was leaked to a German language newspaper, and their article was translated by the Infectious Greed blog by Paul Kedrosky:

"Explosive Study: The banking crisis will be much worse

Westport (USA) - The expected losses from the financial crisis will reach $1600 billion [$1.6 trillion]. To-date financial institutions have so far announced only $400 billion. The pessimistic forecast comes from a confidential study by Bridgewater Associates, the second largest hedge fund in the world.

"We are facing an avalanche of bad assets," says the study. The biggest losses were the U.S. credit banks before. "We have big doubts that the financial institutions will be able to have enough new capital in order to cover the losses," the authors write.

Bridgewater Associates in financial circles enjoy a first-class reputation, several central banks are among its customers. "Bridgewater are on the pessimistic side," says George Magnus, Senior Economic Adviser at UBS in London, "but they are absolutely right."

Well, let's see. The credit crisis began last August, just after the Bear Stearns writedowns began. That's 11 months. According to this report, only 1/4 ($400 billion) of the total writedowns ($1.6 trillion) have yet occurred. That would seem to indicate that the writedowns will go on for another 33 months, if the writedowns continue at the same rate.

Actually, that's not what's going to happen. At some point there's going to be total panic. That's the scenario that Oppenheimer analyst Meredith Whitney predicted, as she laid out the template for the coming financial crisis.

Anyway, anyone who's betting that those 13% and 59% growth figures are going to come to pass are going to lose a lot of money.

The capitulation fantasy - a logical paradox

There's one more fantasy to mention. It's something that I wrote about a few months ago.

According to what the pundits keep saying, capitulation occurs when investors lose all hope, and when they do, the market will go up again. They talk about capitulation on CNBC every day. "Do you think this is capitulation?" the anchor will ask the guest. The guest usually answers, "No, I don't think it's capitulation yet."

Carter Worth, Oppenheimer chief market technician <font face=Arial size=-2>(Source: CNBC)</font>

Carter Worth, Oppenheimer chief market technician (Source: CNBC)

After the Wall Street markets closed on Wednesday, Oppenheimer's chief market technician, Carter Worth, described why capitulation hasn't yet occurred. He noted that the market had just gone down 236 points, but went UP 152 points for a big rally on Tuesday:

"The problem is not today. The problem is yesterday. That's exactly what we don't need. We can't have those kinds of rallies. It needs to go down 300 for the market, next day down 300, next day up 20, then down 300. Then we'll get this done. But the hope is alive. As long as the hope's alive, the bear market's very much intact."

In other words, when the market goes down another 1200 points or so, to approximately the Dow 10,000 level, then everyone will lose hope, and the market will go up again.

This is insanity at so many levels, it's hard to know where to begin.

First of all, why would anyone lose hope? All the brokers, analysts and investors watch CNBC, where they talk about capitulation all the time. If the market suddenly went down to 10,000, all the girls on CNBC would be squealing, "It's capitulation!!! It's capitulation!!! That means the market is going up again!!!" Instead of losing hope, everyone's going to believe that the worst is over, and the champagne party will begin again.

Thus, we have a logical paradox. If capitulation occurs, then everyone on CNBC will tell the world that it's occurred, and everyone will assume that the market will start going up again, so capitulation hasn't occurred. So capitulation can't possibly occur.

For some reason, this logical paradox doesn't occur to all these anchors and guests and CNBC. I guess it's just another one of those things that's so complex and abstract that only readers of this web site are capable of understanding it.

If you look at my Dow Jones historical page, you can see how all this worked out after the 1929 crash. The market kept falling until summer, 1932, when it reached 10% of it's peak value in 1929.

But it didn't go straight down. The market rallied frequently during those three years, sometimes a great deal or for a very long time. Whenever one of those rallies occurred, President Hoover would say, "The worst is over!" But somehow it never was. They didn't use the word "capitulation," but it was the same thing.

As gruesome as it is for me to follow what's happening today, and write about it almost every day, it's also incredibly fascinating to see how the things that are happening today explain the mysteries of what really happened in 1929.

I've quoted the following paragraph from John Kenneth Galbraith's 1954 book The Great Crash - 1929, where he contrasted the 1929 with previous panics, but I never really had a feel for what was really going on. Now I do:

"A common feature of all these earlier troubles [previous panics] was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune." (p. 108)

This is the capitulation concept in a nutshell. The same logical paradox occurring today also occurred in 1929-1933. Maybe they didn't use the word "capitulation," but they were expecting the same thing: A few sharp market plunges, everyone would lose hope, and the market would go up again. But everyone knew that the market was supposed to go up again, so they never really lost hope. So the market kept falling. I would guess that by summer 1933, when the market had fallen 90% from its peak, people really DID lost hope.

We've discussed so many hopes, dreams and fantasies in this article, that it's good to remember how we know that a crash is coming.

As I've been saying hundreds of times since 2002, the stock market is overpriced by a factor of more than 200%, as I described in "How to compute the 'real value' of the stock market," indicating that we're entering a new 1930s style Great Depression. In 2002 I had no idea what scenario we would follow to reach that point, but the end result has always been certain with 100% probability.

Here's the first graph that I used in that article:

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

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

The historic average of the P/E1 (price divided by one-year trailing earnings) is about 14. From 1995 to the present, it's averaged around 25, creating a huge bubble. By the Law of Mean Reversion, the price/earnings ratio will fall well below 10 for a dozen years or so. You can see that it's poised to fall quickly in the near future, leading to a stock market crash.

Forget the CNBC fantasies. Forget the imaginary Law of Bubble Reversion. Here's the reality.

Over the next couple of weeks, actual second quarter earnings for financial services firms will be announced. These will probably determine the short-range direction of the market.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (10-Jul-2008) Permanent Link
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Generational Dynamics Web Log for 10-Jul-2008 Pundits and analysts are baffled by the market's performance

The capitulation fantasy - a logical paradox

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Generational Dynamics Web Log for 10-Jul-2008
Pundits and analysts are baffled by the market's performance