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Generational Dynamics Web Log for 24-Aug-2009
Stock markets reflect increasingly delusional Wall Street

Web Log - August, 2009

Stock markets reflect increasingly delusional Wall Street

The Dow Industrials reached a 2009 high on Friday, but most analysts believe that a major correction is coming.

Speaking Friday on PBS's Marketplace, Reuters financial blogger Felix Salmon said the following:

"The markets haven't capitulated yet. They still seem to be in this weird delusional state they've been in for the past few months. And so long as there isn't something absolutely gruesome out there, there's no reason why they shouldn't stay delusional for the foreseeable future. Eventually something is going to set them off. It's going to cause something of a panic, and the panic will snowball, and you're going to see a bunch of selling again."

This quote explains what's going on in the markets today, and what's likely to be coming in the near future. But first, we need to explain the sources of the delusions.

The view that the stock market is due for a correction is actually fairly widespread among analysts. Analysts differ on the amount of the expected correction -- 10%, 20% or 30%, the last one returning us to the March 15 lows.

This is exactly the same thing that Generational Dynamics predicts. The difference is the predicted aftermath. The analysts say that after the 10% or 20% or 30% correction, the markets will return to a longer period of rallies. This is the "capitulation" concept that Salmon refers to in the quote above.

But the Generational Dynamics prediction is quite different. We're in the midst of a "generational market crash." These generational crashes occur every 70-80 years, just as the generation of survivors of the previous one have all disappeared (retired or died), and the younger generations have resumed the same dangerous credit securitization practices that led to the previous generational crash. 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.

Thus, the Generational Dynamics prediction is that the market will indeed experience a 10% or 20% or 30% correction, but that instead of rallying after that, it will keep falling, and at some point the market correction will be so great and rapid, that it will be looked back upon as a generational panic, like the "Black Monday" stock market crash of October 28, 1929.

The weird delusional state of Wall Street

The phrase "weird delusional state" is taken from Salmon's quote above.

If you listen to CNBC or Bloomberg TV, you hear absolutely ridiculous statements about "green shoots" and "end of recession." A few weeks ago, the "experts" were certain that the recession would last into 2010, but now they're saying the recession is already over, and that the economy will spurt upward in the next couple of quarters. If you remember that they've been saying the same thing each quarter for a couple of years, it makes you want to vomit.

Let's begin with the following chart from Decision Point:

Earnings, price/earnings ratios, yields and prices -- 1926 to the present <font size=-2>(Source: Decision Point)</font>

Earnings, price/earnings ratios, yields and prices -- 1926 to the present (Source: Decision Point)

The top of this chart shows the S&P 500 index which is at a near historic all-time highs.

The second graph shows corporate (GAAP or "as reported") earnings. Corporate earnings have been falling sharply, and are now at the levels of the mid 1970s.

The third graph shows price/earnings ratios (or "valuations"), based on as-reported corporate earnings. They've gone off the charts.

Current valuations, based on reported earnings, are well over 100, according to the "official" S&P 500 P/E ratios, from the Standard & Poors spreadsheet.

And talk about delusions, I just can't get over the use of "operating earnings" on CNBC and Bloomberg TV. Analytically, "operating earnings" are COMPLETELY MEANINGLESS, but they're quoted constantly by the so-called experts.

(For discussions of valuations and price/earnings ratios, see "Wall Street Journal sharply revises its fantasy price/earnings computations," and "Laszlo Birinyi provides insight on his fantasy price/earnings computations," and "Wall Street Journal and Birinyi Associates are lying about P/E ratios.")

Incidentally, the Wall Street Journal and Birinyi Associates have apparently completely given up using fantasy "operating earnings," as can be seen from the latest WSJ page on P/E ratios:

    Dow Industrial            15.34
    Dow Transportation      4568.06
    Dow Utility               12.04

    Nasdaq Composite          42.02
    Russell 2000                nil
    S&P 500                   68.26

    All are based on trailing 12 months of as-reported earnings. 
    Sources: Birinyi Associates, WSJ Market Data Group

WSJ is now using reported earnings. This may be my own fantasy, but I like to think that it was pressure from this web site that caused WSJ to change its policy. I also don't know where the 68.26 figure for the S&P 500 P/E index comes from, since the "official" S&P source mentioned above gives a figure well above 100. Still, the 68.26 figure is a lot more honest than the "operating earnings" figures that WSJ was using earlier.

Another area where Wall Street is in a "weird delusional state" is in real estate. Every day in the financial news, they report some detail in the real estate picture that's "some good news" or "a sign of hope."

What they don't mention is the larger trends, particularly in the area of commercial real estate.

For example, Bloomberg reports the following:

"Commercial Property Values Fall as Rent Drop Forecast

Aug. 19 -- Commercial real estate values in the U.S. fell 27 percent in the year through June and rents for offices, shops and warehouse space may continue to drop through 2010 as the recession saps jobs and consumer spending.

The Moody's/REAL Commercial Property Price Indices fell 1 percent in June and are down 36 percent from their October 2007 peak, Moody's Investors Service said in a report today. A rebound isn't likely until the second half of next year, the National Association of Realtors forecast in a separate report.

Unemployment of 9.4 percent, falling industrial production and a drop in consumer spending curbed property demand, NAR said. Falling rental income and scarce credit are hurting both landlords and investors in securities backed by commercial property loans. Defaults and late payments on commercial mortgage-backed securities may surpass 7 percent by year-end, according to research firm Reis Inc."

I've put together some graphics from the Calculated Risk blog:

Top: Percentage of subprime loans in foreclosure and delinquency, 2005-present; Middle: Same for prime loans; Bottom: Falling prices in residential and commercial real estate. <font face=Arial size=-2>(Source: Calculated Risk)</font>

Top: Percentage of subprime loans in foreclosure and delinquency, 2005-present; Middle: Same for prime loans; Bottom: Falling prices in residential and commercial real estate. (Source: Calculated Risk)

The graph on top shows the percentage of subprime mortgage loans in delinquency and foreclosure. The rates are now above 40%. Some people are calling this "good news" because it appears that the plunge is at a slightly decelerating negative growth rate.

Even if that were true, it would still mean that the foreclosure rate would not return to levels below 15% for at least a couple of years. But it's also possible that the delinquency rate slowed slightly because of all the stimulus money, and that it's poised to start up again.

The middle graph shows the same for prime loans. These loans historically have a foreclosure rate below 3%, but this year the foreclosure rate has been accelerating upward.

The bottom graph shows that commercial real estate price collapses are now catching up to residential real estate price collapses. This has been predicted for a couple of years, but now it's happening in full force.

Incidentally, in the next few days I'm going to be posting an analysis showing that the real estate bubble actually began in 1995, the same as the dot-com bubble. The significance of this fact is that we can apply the Law of Mean Reversion and conclude that real estate prices will actually be falling for the next decade.

Capitulation and short-selling

Salmon's quote, above, starts with "The markets haven't capitulated yet." In order to understand what's going on with the market today, you have to understand the capitulation concept.

As I explained last year in "The origins of the hare-brained 'capitulation' fallacy," investors and analysts today are expecting a repeat of the "false panic of 1987." It was a false panic because the market was underpriced at the time, unlike today when the market is still overpriced by a factor of 160%, according to my Dow Jones historical page.

According to the hare-brained capitulation theory, the markets will fall 10% or 20% or 30% very quickly, indicating that investors have "capitulated," and then the market will resume its former bubble growth.

However, it appears more and more that what we're seeing today is a kind of an "upside capitulation" in progress, based on investors who "go short," or sell stocks that they don't own, because they believe that stock prices will fall.

In selling short, you borrow some shares of stock from your stock broker, and you sell them at the current market price. At a later time, say 30 or 60 days later, you're required to purchase your own shares of stock so that you can return them to your stock broker. If you guessed right, that the stock price is going down, then you're buying the stocks at a much lower price than you received when you sold them, so you make a lot of money; if you guess wrong, and the stock price goes up, then you can lose a great deal of money.

Now, the standard capitulation theory is that people who purchase and hold stocks will continue to hold them even when the market is going down, because they think that the market will eventually start going up again. Capitulation occurs when an investor gives up and decides that the market is going to continue going down, so he sells his stocks and takes his losses. While a lot of investors are capitulating, the volume of selling forces the market further down, until all the capitulators are out of the market. At that time, the market can start going up again.

According to Higgenbotham, a member of the Generational Dynamics forum, what we're experiencing now is being driven by short-sellers. It's a kind of "upside capitulation" situation. There have been many investors holding short positions, because they believe that the market is going to go down again, at which point they'll make a lot of money.

But if the market keeps going up, as has been happening almost continuously since March, then the short sellers are forced to provide more and more money to their stock brokers, who want to make sure that they'll be paid for the stock shares that they lent to the short-selling investors. If the market keeps going up, the short-sellers are forced to provide more and more money, and eventually they'll be "squeezed" out of the market. They'll be forced to give up their short positions, and take their losses.

Whenever a short seller leaves the market, he has to purchase stock shares to replace the shares he's borrowed. Short sellers leaving the market thus can force the market up even further. It's widely believed that this is what's going on. For example, this past Thursday, August 20, Art Cashin appeared on CNBC and stated his opinion that much of that week's market rally was caused by "short covering," or short sellers leaving the market.

According to Higgenbotham, when enough of these short-sellers are forced out of the market, then this "upside capitulation" will occur. The market will stop going up, and will start going down again. Higgenbotham believes that this reversal may lead to a larger panic.

So now we're at a fascinating point in time where we have two conflicting views of what's going to happen:

The standard "capitulation" view that a 10% or 20% or 30% correction is due, after which the market will start rising again.

Higgenbotham's "upside capitulation" view that when all the short sellers are squeezed out, the market will fall again, possibly causing a larger panic.

What both of these views have in common is the expectation of a sharp fall in the markets in the next few weeks.

S&P 500 Short Interest Ratio, July 2008 to July 2009

S&P 500 Short Interest Ratio, July 2008 to July 2009

Matt Stiles of the Futronomics blog supports the view that short-sellers are controlling the market. The Short Interest Ratio is a measure of the number of short sellers in the market. This graph shows that short selling has been generally increasing since the mid-March stock market lows (with a brief respite in mid-May), continuing upward until mid-July, and falling after that.

According to Stiles: "The shorts appear to be getting frustrated as even bad news (retail sales, consumer confidence, bank failures) is happily bought. The bi-weekly short interest report shows short interest falling in the last two weeks of July, even as the market rallied - consistent with the short squeeze thesis. As mentioned earlier this week, the markets tend to take "the path of maximum frustration" at major turns. It will be attempted to ensure that as few as possible are allowed to benefit from another leg down in the stock market. And notice how short interest is much lower than it was at this time last year."

It's worth repeating that, from the point of view of Generational Dynamics, when this widely predicted correction occurs, the market will continue to fall, to well below the Dow 3000 range, since we're in an era of a generational crash.

The Short-Selling Drama

In the past, I've strongly advised web site readers not to try short selling, unless they were very sophisticated traders. There are two reasons for this: First, a long bear market rally can exhaust all your funds with short covering. (Remember that John Maynard Keynes said that the market can remain irrational for longer than you can remain solvent.) And second, it's not clear that short sellers will be able to collect the money due them when a full-scale generational panic occurs.

However, there ARE some sophisticated traders in the Financial Topics thread of the Generational Dynamics forum.

Higgenbotham and several others have been maintaining their short positions through the current rally, and have been risking more and more of their net worth. Higgenbotham himself has reported that 2% then 4% of his net worth was at risk, increasing as time goes on. It's personally very painful for me to see people that I've gotten to know going through this turmoil.

However, Higgenbotham knows what he's doing. He's done detailed studies of past generational crashes, including the Panic of 1857, the South Sea Bubble, the Tulipomania bubble, even going back to the 1340s collapse of the Florentine banks (Peruzzi, Bardi, etc.).

On Saturday, he posted the following:

"Back to the big theoretical GD picture. The bubble extensions beyond natural limits due to interventions can be summarized as:

No government attempt to extend the bubble
1637 Tulip Mania and 1720 South Sea Bubble
Bubbles burst the equivalent of second half of July 2009

Some government attempt to extend the bubble
1930 Dow rebound high
Bubble burst the equivalent of first half of August 2009

Extreme government attempts to extend the bubble
2009 Dow rebound high
Bubble has not burst as of August 23, 2009 (let's make it Sunday)

The report above is projecting that this bubble will burst in the first half of September between [S&P 500 index] 1028 and 1052. The high Friday was around 1028.

I have no strong notions at this point about how far the Bernanke experiment will extend this bubble. After Friday's action, I plan to sit short and wait. I guess the only thing I would continue to put forth is that nobody will figure it out exactly. Very few will be short at the peak. As of Friday's close, I am the only person I know of who is short (besides 2 people on this forum - freddyv and wvbill). I'm not in awe of this bubble because it's just another bubble (I am disgusted by it because this whole bubble apparatus/bureaucracy is a useless time and money drain on hard working people and prevents productive activity). So I remain short, take my hit, and wait. Friday it extended beyond all previous generational bubbles so far as I can tell. That much I think I know. I got an e-mail from a former S&P floor trader this morning and he said I don't know how you can take this. That's why the phone calls go back and forth as described in the above report. As for me, I don't really care whether it's over now, at 1032, 1040, or 1052 (and it will almost definitely be some other number that nobody has thought of). In the big picture it makes no difference, but if it extends beyond the area that I've mapped out as my limit, I will take my loss there. That would destroy about 10% of my net worth and help to prove the Maximum Ruin theory."

The last line refers to the Principle of Maximum Ruin that I've discussed many times on this web site. (See, for example, "As new stock bubble expands, the Principle of Maximum Ruin looms larger.")

What all of this shows is how deadly dangerous this market is today, in the midst of a generational crash, even for sophisticated traders. For all web site readers, my strong recommendation remains the same: Keep your assets in cash.

The summer doldrums

It almost seems as if nothing has been going on in the world this summer.

The Sri Lanka civil war is over. The only news about the Darfur war is the so-called peace negotiations. Israel and Gaza are arguing about what happened in their last war. Pakistan refugees are returning to their homes in Swat Valley. There have been major suicide bomber attacks in Iraq and Afghanistan, but no one cares with Obama, rather than Bush, in office.

The big stories of the last couple of weeks have been the hurricane that hit Taiwan, the wildfires in Athens, the Afghan elections, the release of the convicted Lockerbie bomber. Ahmadinejad is putting a couple of women in his cabinet. These are important stories on a regional basis, but they have little geopolitical significance.

The same kind of thing is true in the financial world. Q2 corporate earnings are down 28% from last year. But earlier estimates were that they would be down 35%, so a massive 28% fall in earnings is taken as good news. The use of "operating earnings" has become common and unquestioned, even though they're analytically meaningless. Every tiny bit of good news is emphasized, while the underlying realities are being totally ignored.

In fact, if you look at what happened last summer, it was almost the same story. The stock market was little changed all summer. Nothing happened until after Labor Day, when the Fannie/Freddie and Lehman crises broke at the same time.

That's just how things are in August. Everyone is on vacation or taking the day off. Everyone is on auto-pilot, and even terrorists can't break through the calm.

So it's quite possible that the current situation will continue at least until Labor Day. After that, things should start moving along, for good or ill.

(Comments: For reader comments, questions and discussion, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (24-Aug-2009) Permanent Link
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