Agora Financial’s Rude Awakening

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Laguna Beach, California

• Markets slip again on weak housing data, economic outlook,
• Greenspan speaks: what the great contrarian indicator had to say this time,
• The stock market vs. the economy; who to believe, and plenty more…

Eric Fry, reporting from Laguna Beach, California…

“So while I look at the housing market as something that gives me grave concern, we are finally beginning to see the seeds of a bottoming,” Alan Greenspan declared Tuesday to a friendly crowd at the National Association of Realtors conference in Washington.

And yet, the Dow slipped another 184 points yesterday, as if utterly ignoring Greenspan’s confident declaration. The tumbling Dow also seemed to be thumbing its nose at Greenspan’s pronouncement that “it’s very easy to see” that the recovery in the capital markets “is going to continue for an indefinite period.”

A couple bad days in the stock market do not make a reliable trend, of course. But unbeknownst to Greenspan, neither do a couple good months. Stock prices have been inflating. There’s no denying that. But meanwhile, the economy has continued to deflate. There is no denying that either. So what is an investor to do? Trust the stock market or trust the economy?

The answer to this question is never clear, except in retrospect. But one thing is always clear: never trust Alan Greenspan’s predictions. “Whatever virtues Greenspan may have displayed during his 19-year tenure as America’s most famous bureaucrat,” we observed in a former edition of the Rude Awakening, “clairvoyance was not one of them. Indeed, his feeble powers of prediction are legendary. Every time he looks into the future, it refuses to look back…

“We admire this cowboy for climbing back onto the same mustang that keeps bucking him off,” we continued, “but that doesn’t mean we expect him to remain in the saddle for very long.”

Indeed, Greenspan seems to spend a good deal more time dusting off his chaps than holding the reins. And yet, the former Fed Chairman continues to draw $100,000 speaking engagements as if he actually had something useful to say. Hiring Greenspan to offer guidance on financial market trends is little like hiring Charlie Manson to lead an anger-management class. There are probably better qualified candidates.

Let us not forget that Mr. Greenspan is the same individual who declared in November of 2006, “Most of the negatives in housing are probably behind us. The fourth quarter should be reasonably good, certainly better than the third quarter.”

Not content to make only a boneheaded prediction about the housing market, Greenspan embellished his November 2006 remarks by volunteering a boneheaded prediction about the U.S. economy. “A lot of people are going to lose their homes,” he said. “It’s a family tragedy. It’s not an economic – or macroeconomic — tragedy.”

Obviously, Greenspan was dead wrong. If he had offered 100 different forecasts in November of 2006, none of them could have been more wrong than the forecast he actually offered. Therefore, the former Fed Chairman’s recent confident assurances about the housing market impart neither confidence nor assurance.

In addition, Greenspan’s latest public appearance seemed to break new ground, as his oracular pronouncements featured more “psycho-babble” then “Fed-speak.” Here’s a representative sample:

“Let me just say that in the most recent period, even after the incredible shock to the world economy that occurred as a consequence of the $35 trillion collapse of equity prices, we saw a bottoming and indeed that bottoming essentially reflected the fact that there is a limit to how far human fear can go.

“All of our history, or I should say our psychological history, shows the fact that we adjust to extraordinary circumstances. And we’re starting to adjust here because history tells us that all measures of fear…tend to have an upside and a downside range; they are range bound. We cannot get too euphoric; we cannot get too fearful. The markets turn on you. And the market started to turn in November of last year and flattened out…and when fear began to ebb, we began to see stock prices move up and this essentially added $10 trillion of market value from March 9th…”

So you see, dear investor, this stock market stuff is not really about dollars and cents after all – and its certainly not about the legacy of colossal errors made by a former Fed Chairman – it’s about the limitations of human fear. Because fear is “range bound,” says Greenspan, so too are the consequences of wayward capitalism. The Dow simply cannot drop to 5,000, if Greenspan’s theory holds, because that would be way too scary.

Ummm…okay.

Your editors have encountered more intelligent theories from 5-year olds. But that does not mean we are rushing to judgment. 5-year olds are right sometimes. But this we know: The future is utterly unknowable, no matter how many predictions Alan Greenspan makes…and no matter how many wacky theories he advances. The future is utterly unknowable…almost.

One thing we know:

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He Who Borrows the Most, Wins
by Niels Jensen

“Never in the history of the world has there been a situation so bad that the government can’t make it worse.” -Unknown

The stock market might bounce for a while, global currencies might stabilize for a while, but don’t be deceived, large problems remain…very large problems. And the price to fix these problems will run into the tens of trillions of dollars. That’s the kind of price tag that could ruin a national currency or two…even the world’s reserve currency.

While equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as ‘just’ another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away.

The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-April 2009 is almost certainly a bear market rally. As one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932. Bear market rallies can be extremely powerful and hence deceiving.

But the problems are not over yet. Not by a long stretch. It will take longer than 18 months to unwind the excesses of the past 25 years. Analysts at Morgan Stanley reckon that the 15 largest banks, which between them have shrunk their balance sheets by about $3.6 trillion so far in this crisis, will shed another $2 trillion in 2009. The US financial sector debt load (as a % of GDP) is now 117%. In the early days of the great bull market in 1982, the same number was 22%. Households are not much better off than the banks, with total household debt now at 96% of GDP vs. 47% in 1982.

The IMF reckons that both European and US banks – but in particular the European ones – are well behind the curve in terms of recognizing their credit crunch related losses. According to the IMF, there is at least another $1.5 trillion to come.

As the recession bites into the lives of ordinary people, banks will face losses not only on sub-prime mortgages but on all loan products. In fact, sub-prime is indeed a small fraction of the total loan book for the US banking sector. Prime and Alt-A mortgages, together with commercial real estate loans total about seven times the size of the subprime market.

Delinquencies are now on the rise on all mortgage products; however, whereas sub-prime started to deteriorate as early as 2007, it is only recently that delinquencies related to Alt-A mortgages have taken off, and prime and jumbo loans are only now starting to suffer.

These defaulting mortgages pose a very serious threat to the U.S. economy, but they are only part of the economic crisis worldwide. By far my biggest concern at the moment is the enormity of the debt problem facing most OECD countries. In the March issue of the Absolute Return Letter, I referred to an important study conducted by Carmen Reinhart and Kenneth Rogoff back in December of last year.

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion. And Reinhart and Rogoff’s historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The true cost is important, because it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world’s bond markets. Even using the relatively conservative IMF estimates, the twelve largest industrialized countries of the world will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach. Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn’t even bother to produce a worst case scenario – it all got too depressing!

I need to put the $33 trillion into perspective. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term.

There is a third route, of course. Governments could print money for themselves, which they could then use to purchase their own bonds. We call that process inflation…and it is already underway.

Ed. Note: A version of this column originally appeared in the May 11, 2009 edition of “Outside the Box.” More info here.

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[Rude Endnote: Most markets in Europe and Asia halted at Wall Street’s signal yesterday.

As we write, London’s FTSE is basically unchanged while France’s CAC and Germany’s DAX are lower by around half a percent each.

In your editor’s neck of the woods, Hong Kong’s Hang Seng slid over 3% while Japan’s Nikkei 225 fell 2.65%. But they weren’t the worst of the bunch.

And here is where your editor vents a little…

Down Under the Aussies suffered a 3.4% blow to the All Ordinaries index after treasurer Wayne Swan on Tuesday announced a A$32.1 billion ($24.3 billion) fiscal deficit this year and forecast that it would rise to A$57.6 billion in 2009-10 – the largest in the country’s history.

It is worth noting that Australia entered the global economic mess in a relatively strong position, having posted a budget surplus of A$19.7 billion just one year ago. Where did all the money go? Ask the country’s double-talking jackass of a Prime Minister, Kevin Rudd.

When it comes to splashing cash around, Mr. Rudd makes more mess than an epileptic pit bull in a bathtub full of Jell-O. Since October of last year, the average Aussie family of four has received A$2,900 in government handouts – A$1,000 for each child and an additional A$900 if dad earns less than A$80,000 per year. K-Rudd also shelled out A$14.1 billion in payments to pensioners, a conspicuous, core Labor constituency.

So profligate has the Australian government become that it’s rather more difficult to avoid receiving cash handouts than to accept them. If you are old… or entering the property market for the first time… or earn less than 125% of the average Aussie’s salary… or simply manage to find a member of the opposite sex to procreate with, Kevin Rudd will be there to lend you some of your grandchildren’s unearned wages to help you out.

We mention the indebted progeny there because, as usual, the government borrowed the money to fund this handout soiree. Over the coming two years the Rudd’s Canberra cadre will increase the nation’s net debt from next to zero to somewhere in the vicinity of A$200 billion.

At some point in the future the Australian people will have to pay all this money back…plus interest. But with what?

Faced with contracting tax revenues as the Aussie economy slows (Tuesday’s budget wrote down A$23 billion in projected tax revenues for the year), Mr. Swan rushed to defend the heretofore-unseen levels of borrowing and Keynesian-style stimulus packages.

Borrowing to offset revenue declines, Mr. Swan wrote in an op-ed in The Australian, is a course that “practically all reputable economists advocate” and “practically all developed nations around the world are following.”

So, Mr. Swan, do those “reputable economists” you so vaguely refer to park their cars outside offices in Washington D.C.? Might they take their lunch breaks along the banks of the Thames? Do they draw paychecks from Japanese “zombie banks?” Have you checked to see how those economies are doing right now?

And what if a “reputable economist” told you to jump of a cliff, Mr. Swan? Oh wait, we already know the answer to that one.

We’ll be back with more Rude views tomorrow. If you feel inclined to shoot us an email, by all means please do so. The address is below.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com