Posted At : July 23, 2009 12:19 PM
*Tale of two markets*
It is the best of times – The joy of stimulation
In what seems like an act of defiance, the market continues to make new highs. Investors are clearly betting on a rapid recovery, and the news has been pretty good. By all accounts, the economy is improving, and the Leading Indicators, which include the stock market, say just that. This is right in line for what we have been saying for sometime. The stimulus would have the desired affect. Just ask Caterpillar (CAT), who reported far better earnings than expected, which even they admit was directly related to the governments stimulus spending. Add in 0% interest rates to banks, which is an indirect form of stimulus, and you’ve got welfare for the rich guys. Is it really any surprise that Goldman and JPMorgan are making record profits on the underwriting and trading side of the business? Hell, if I could eliminate 80% of my competition, borrow at 0% and have the government as my bodyguard, my profits would grow too! Although, under the radar, JPMorgan’s consumer credit, credit card, and other business groups are losing money big-time. How does it feel to know that we bailed out Goldman who then parlayed it into record profits which will translate into multi-million dollar bonuses (as the rest of the country wallows)? Gotta love socialism, as long as your friends with Politburo members that is!
The third quarter may be positive in terms of GDP. And that is possible, but only for statistical and not for fundamental reasons. For instance, lower imports are a net positive for GDP. But lower imports mean a weaker economy. Government spending adds to GDP. Normally, if the government spends too much, then we get inflation, which is subtracted from nominal GDP to give us real (after-inflation) GDP. But inflation is low and getting lower, so there is not going to be much to subtract from nominal GDP. Are government spending and massive deficits a sign of fundamental strength? It is quite usual for there to be a positive quarter in the middle of a recession. Watch the fundamentals: industrial production, unemployment, capacity utilization, tax receipts, etc. When those turn up, or at least level off, the recession is over. Then we get to the long recovery. That said, the market is currently going up and looks like it’s going higher because the data implies a recovering economy. I think the biggest thing keeping this market rising is the large negative investor sentiment. Put simply, too many people are bearish and if it went down too many people would be right. It NEVER works that way. As the market goes higher, more and more folks will become “believers” and subsequently more bullish. Then and only then will some catalyst shake the foundation. For e time being, the trend is your friend and although you should never fight the trend, today’s fire danger is “extreme”.
It was the worst of times – Reality check around the bend
So let’s be real. What happens when the government stops giving us our stimulation? I think you know. Japan tried this, for about the last 20 years, and the best they could get was a one quarter blip up for their GDP, and then right back into the doldrums. Are we Japan? Heck no! They have money, we don’t. This country is driven by consumer spending. Over 70% of our GDP is driven from consumer spending. Unfortunately for those that think this is going to be a normal recession with a V shaped recovery, spending is D-E-A-D! The demographics are clear. The 78 million baby boomers have now passed their peak spending years and are turning from net spenders to net savers. These are the same people who are retired, close to retirement or one day HOPE to retire, that are shell-shocked from their 401k’s turning into 201k’s. Now add in a rapidly rising savings rate that is likely to go from 0% just a few short months ago to upwards of 10-12%, and you’ve got a lot of lost spending.
Worst of all right now is the massive deleveraging that is going on. We hear this phrase all the time, but most really understand its consequences. Deleveraging is the destruction of assets with too many chasing too few liquid assets. The first nail in the coffin was tapped in during 2004 when the banking authorities decided it would be OK to allow five banks to increase their leverage from 12:1 up to 40:1. Which five banks? I bet you can guess: Bear Stearns, Lehman, Merrill Lynch, JPMorgan, and Goldman Sachs. How did that work out for us? Forty times leverage means that if you lose a measly 2.5%, you wipe out all your capital. And we watched as banks too big to fail were bailed out with taxpayer dollars. Slowly, banks are buying time, writing down assets. This is not really a bad strategy as time heals a lot of bad debts, especially at a 0% Fed Funds rate. Banks that are reporting so far this quarter seem to be saying that the write-offs will start to level off in about two quarters, although that the level may stay higher than we think for longer than we think. There are a lot of assets to write off, and they are just now getting to the commercial real estate problems. This is going to take time.
The next crises and thus the catalyst will likely occur in Europe and will hit us just as hard. Once upon a time, UK regulators allowed 20:1 leverage on a regular basis. It is now almost 40:1. The assets of UK banks are about five times as large as UK GDP. By comparison, for the US the ratio is barely 2:1. Think about that for a second. The UK has banking assets which are five times as large as the annual domestic output of the country. They also had a housing bubble. They have their own bailouts to deal with, which are massive and will potentially get much larger. Just wait, it gets better with the Euro-zone.
Leverage in Europe is now 35:1. How did 35:1 work out for the US? Given the massive credit problems that Euro-zone banks have with emerging markets as well as Spain’s housing bubble, which is every bit as bad as that of the US, and pain is inevitable. The European Central Bank, at least as of now, cannot step in and start saving individual banks. How do you save a Spanish bank and not an Austrian bank? Austria’s banks have made large loans to Eastern Europe, in Euros and Swiss francs, and are going to have large losses, far more than 3%, which would wipe out their capital. But bank assets in Austria are 4 times GDP. What we have are banks that are too big to save for relatively small Austria as well as for Italy, Spain, Greece, etc. Even neutral Switzerland is a scary place. We think of Switzerland as a stodgy, by-the-numbers, clockwork type of banking country. Yet somewhere, somehow, UBS and Credit Suisse ran up a little leverage. Before the crisis, they were over 40:1. And now they’re nearly at a nosebleed-high 70!
Regards – Keith Springer