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Generational Dynamics Web Log for 5-Oct-2009
Confusion and the Principle of Maximum Ruin reign in the stock markets

Web Log - October, 2009

Confusion and the Principle of Maximum Ruin reign in the stock markets

Is the bear market rally finally over?

I've just moved to a new apartment in Cambridge, Mass. For the last few weeks I've been distracted by packing and moving boxes and furniture. Now I'm distracted by unpacking boxes and searching for missing things.

Even with all that going on, I still couldn't miss the gathering disaster in the stock markets and financial markets in general.

Right now, there's a great deal of confusion. The mainstream analysts have no idea what's going on. There are some non-mainstream analysts who realize how great the danger is, but anyone who talks about it is quickly marginalized.

On Wednesday, I saw CNBC anchor Joe Kernen gloating about how dumb the "bears" have been. He was mocking all the people who said the market would go down, and laughed at them in view of the "best" quarter for the S&P in many years. If anything is a sign of danger, this kind of gloating surely must be.

On Friday, the September jobs report came out, and it was an utter disaster:

"U.S. Economy: September Job Losses Exceed Forecast

Oct. 2 (Bloomberg) -- U.S. job losses accelerated last month and the unemployment rate climbed to the highest level since 1983, stark reminders of how the worst financial crisis in more than seven decades may undermine consumer spending and economic growth in the months ahead.

Hours after today’s Labor Department report, President Barack Obama said he’s working to “explore any and all additional measures” to spur growth. ...

Payrolls dropped by 263,000 in September, exceeding the median forecast in Bloomberg’s survey, with losses extending from cash-strapped state and local governments to retailers to builders, today’s report showed. The jobless rate rose to 9.8 percent from 9.7 percent in August, while working hours matched a record low. ...

A Commerce Department report today showed that orders placed with factories fell unexpectedly in August, restrained by long-lasting items such as commercial aircraft and construction machinery. Bookings fell 0.8 percent after a revised 1.4 percent increase in July that was larger than previously estimated. Excluding transportation equipment, orders rose 0.4 percent.

Obama called today’s report a “sobering reminder that progress comes in fits and starts” in remarks at the White House after returning from Copenhagen, where he made an unsuccessful bid for Chicago to host the 2016 Olympic Games. ...

September’s losses bring total jobs lost since the recession began in December 2007 to 7.2 million, the biggest decline since the Great Depression.

Payrolls were expected to drop 175,000, the median of 84 estimates in a Bloomberg News survey of economists. Forecasts ranged from decreases of 260,000 to 100,000. Job losses peaked at 741,000 in January, the most since 1949. The September unemployment rate matched the median projection. ...

The Labor Department today also published its preliminary estimate for the annual benchmark revisions to payrolls that will be issued in February. They showed the economy may have lost an additional 824,000 jobs in the 12 months ended March 2009. The data currently show a 4.8 million drop in employment during that time.

The projected decrease was three times larger than the historical average, the Labor Department said. Most of the drop occurred in the first quarter of this year, probably due to an increase in business closings, the government said."

The last couple of paragraphs are interesting, because they expose a flaw in the "birth/death model" that the Labor Department uses to estimate the unemployment rate. Mike "Mish" Shedlock has been commenting on this flaw for months, and says that the current estimates are still "wildly optimistic."

Commenting on the jobs report, Ken Langone, former CEO of Home Depot, appeared on Bloomberg tv to say that there was a huge disconnect between the economy and the stock market, and that the U.S. is in "horrible economic storm." He agrees that the unemployment picture is much worse than government figures indicate (some of this is paraphrasing):

"We had a 9.8% unemployment rate this morning. That's peanuts. 38% of the people who have jobs today are worried about losing their jobs in the next 12 months.

What is the mindset of a person who's afraid of losing his job? "Honey, if you can't eat it, don't buy it. We're not going to go on a vacation. We're not going to put a new roof on the house - we're going to repair the old roof. We're not going to put a bathroom or a kitchen in." ...

[With regard to the stock market] All of the people that I respect, as investors and as people, are all scratching their heads saying, "We don't get it."

This stock market rise over the last 7 months -- and you look at the economy -- and I spend a lot of my time now reaching out to companies running businesses -- and I'm getting the same thing from everybody -- it's terrible, it's getting worse, September was worse than August. ...

And by the way, this stimulus package, I'm sorry it's an enormous waste. ... It's not creating jobs.

This "cash for clunkers" we know now, it was doing nothing but pulling orders forward. No net change in aggregate daemand over a period of months or years. ...

I know of one agency in Washington, I can't say who because I don't want to get people in trouble. Last year they were given $3 million for their operation. And this is an activity that doesn't create jobs. This year, they were given $6 billion, and they were told, go spend it. Go get rid of the money." Not, "Come back and tell us how many jobs yuo've created." This stimulus package, in my opinion, is going to backfire. ...

If we in business ever did what all these so-called sagacious economists from the government are telling us -- "it's getting better" and "things are looking up" -- we would be investigated by the SEC for consumer fraud."

Christina Romer, chairman of the White House’s Council of Economic Advisers, and the worst bubblehead in Washington except for Paul Krugman, came on to respond to Langone. She said, "You're right that the jobs number is disappointing. We like the market had been expecting less job loss, so that's unfortunate. On the other hand, this is how real recoveries happen. They come in fits and starts, and and I think what this is is a fit."

Well, I'm glad she cleared that up.

People like Romer and Krugman are complete idiots and don't have the vaguest idea what's coming, even though they claim to be economists.

Ben Bernanke

But what about Ben Bernanke? I've harshly criticized his policies, but I've also said that "I have a lot of respect for him," and I certainly don't think he's an idiot like Romer and Krugman.

So what about Bernanke? I've had to think about him a lot in the past few days, after a co-worked said to me, "Look, how can you claim to know what's going on, and claim that Ben Bernanke doesn't. Are you really saying that you're the only person who's intelligent, and everyone else is stupid?"

It's a good question. It's true that most journalists and politicians really are incredibly stupid and ignorant. In the case of the Iraq war, this was shown by articles in the Congressional Quarterly, where the editor asked Washington journalists, analysts and politicians simple basic questions about what was going on in Iraq. These were people who represented themselves as experts on Iraq, but they didn't know the differences between Sunni and Shi'ite, and they didn't know that al-Qaeda is operating in Iraq, or that al-Qaeda is a Sunni organization.

There's been no similar Congressional Quarterly study on so-called Washington experts and economists on the financial crisis, but I doubt all but 0.001% of these experts could explain, for example, what a "collateralized debt obligation (CDO)" is, and how it was used to create the financial crisis.

I actually went to a great deal of trouble to learn how they worked (see "A primer on financial engineering and structured finance") so that I could write about them on this web site, and I'm not even being paid, but I doubt that almost any of those so-called Washington experts who ARE being paid to be journalists or analysts bothered to figure out what was going on.

So back to Ben Bernanke. I believe that there's a good chance that he knows exactly what a CDO is, and how it was used to create the financial crisis. As head of the Princeton University Economics Department, I have no doubt that he knows a very great deal about what's going on, unlike the standard Washington idiot.

So why do I know what's coming, and he doesn't? I think the answer comes from the following key question:

"Suppose (hypothetically) that Ben Bernanke has applied his macroeconomic models, and performed all the necessary analyses, and suppose that he's concluded that there will be a major stock market crash, with, say 99% probability. What would he be doing and saying today?"

When you ask the question that way, then the answer is completely obvious: He'd be saying and doing exactly what he IS saying and doing, and HAS BEEN saying and doing since the crisis began in August 2007.

He certainly couldn't announce to the world, "My analysis is that there will be a major stock market crash, with 99% probability." If he said anything like that, he would infuriate everyone on both the left and right, he'd be fired as Fed chairman, he'd cause a national and worldwide panic, and he'd be personally blamed for CAUSING the stock market crash, whenever it occurred.

That's simply not an option. The only option available to him is to do what he's doing -- talk about "green shoots," and become the grandfather of many stimulus, quantitative easing and bailout plans, all the time hoping, hoping, hoping for a miracle, the other 1%, and no stock market crash.

So that provides the answer to my co-worker's question. If you apply pure logic, then you can't conclude anything from what Bernanke says or does, because he'd say and do the same thing whether he believes that a stock market crash is coming or not.

From the point of view of Generational Dynamics, there isn't even a 1% chance of avoiding a stock market crash, but that's beside the point. For Bernanke, there's a tiny of sliver of hope for him to grasp, and he'll do so, even though his economic models tell him that there's really no hope at all.

The power of hope

When people are anxious and scared, they'll do what Bernanke is doing -- grasp at any sliver of hope available to them, and lie to themselves and others about it. The stock market rally has turned into an extremely dangerous bubble that has hurt a lot of people, and will hurt a lot more when the bubble deflates.

The "mainstream" journalists and analysts have it all figured out. There are mainstream bulls and bears. The bulls think the stock market will keep going up forever. The bears think that it will pull back slightly, then will keep going up forever.

The "mainstream" is guided by the following beliefs:

The possibility of another Great Depression has been completely eliminated by the clever policies of the Obama administration.
We almost got spun into a Great Depression a year ago when Lehman collapsed a year ago, but Geithner, Summers and Bernanke got us out of it through bailouts, stimulus, and quantitative easing.
Thus, nothing that happened prior to WW II is relevant.
Thus -- and this is the most important belief of all -- the worst MUST be over, because the financial crisis has now lasted over two years, and nothing since WW II has lasted this long.
Thus, any "green shoot" is a sign that an explosive recovery is imminent, and anything else (like the increasingly disastrous unemployment numbers) are "outliers," and irrelevant.

It's worth mentioning one major expected green shoot that hasn't happened. Corporate earnings have been falling rapidly since fourth quarter 2007. Each quarter since then, the journalists and analysts have solemnly declared that earnings growth would exceed 50% within a quarter or two. This is a never-ending prediction that's been wrong every quarter. In January of this year, analysts were predicting explosive earnings growth by the third quarter. Well now, third quarter 2009 earnings are coming out, and once again, the growth is negative, according to CNBC earnings central. Earnings appear to have fallen 25% from third quarter of last year -- and remember that in third quarter of last year, they were down 20% from the previous year. That means that corporate earnings have fallen 40% in two years, and are still falling.

The main thing holding the mainstream journalists and analysts together is that they can't believe this crisis isn't over. No crisis in their lifetime has lasted this long, so it's IMPOSSIBLE that this crisis will continue. It HAS to be over, irrespective of any actual facts.

It's once again time to post this quote from John Kenneth Galbraith's 1954 book The Great Crash - 1929. It describes how the "Principle of Maximum Ruin" played out in 1929:

"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.

The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. ... The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or fourth of the purchase price in the next twenty-four months. ... The ruthlessness of [the stock market was] remarkable." (p. 108)

This is the text from which I derived the Principle of Maximum Ruin so many years ago -- that the current stock market will ruin the maximum number of people to the maximum extent possible. The rally that started last March, and is ending just now (or may not even be ending) has sucked huge amounts of money from short sellers, and will suck more huge amounts of money from those holding stock.

Web site readers used to ask me, several years ago, exactly how the Principle of Maximum Ruin would work, and I said that I honestly didn't know how it would work, only that it would work.

But now we really see well it works. A lot of people were comparing this rally to the 1930 rally, and when this one lasted longer, they said, "See? This isn't like the Great Depression. This rally is lasting much longer, so it's OK to assume that the market will keep going up and up." Thus you get people like Joe Kernen gloating.

As Galbraith said, "Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune."

As for me, I'm going to go back to unpacking boxes now. I'm still pretty wiped out from moving, and my writing for this web site has suffered as a result. Hopefully, things will be back on track in a few more days.

(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.) (5-Oct-2009) Permanent Link
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Generational Dynamics Web Log for 5-Oct-2009 Confusion and the Principle of Maximum Ruin reign in the stock markets

Ben Bernanke

The power of hope

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Generational Dynamics Web Log for 5-Oct-2009
Confusion and the Principle of Maximum Ruin reign in the stock markets