Why
Hasn’t “IT” Happened Yet?
Originally
Written in 2003
To
listen to some bears (The real bears, not the Wall Street phonies
that, in a bold move of bearishness, reduced their stock allocations
from 75% to 70%) over the past few years, you would have thought
we would all be in breadlines and soup kitchens by now. So far,
all of the ranting about doom and gloom sounds more like the boy
who cried wolf than accurate forecasting.
No,
I don’t believe we have breadlines in our future, but when
IT happens, things are going to get much worse than most can imagine.
But “IT” hasn’t happened yet. Even though the
markets have lost over $6 trillion of value according to the NYSE
and the Nasdaq, IT still hasn’t happened yet.
What
is IT? Why hasn’t IT happened and when will it?
IT
is a financial disruption. IT is an irreversible downward spiral
that takes everything down with it. IT will be started by a catalyst,
a spark that will get everybody’s attention. But IT is already
built into the economy prior to the spark, like a bunch of oil rags
waiting for a match. Some of the candidates for the catalyst include
the following:
>
Crash of the Dollar
>
Stock Market Crash
>
Credit Crunch
>
Derivative meltdown at a major bank (JP Morgan/Citicorp…)
>
Nuclear War
>
Major terrorist attack on the US (Nuke, Bio, Chem)
>
Major Corporate Debt Default
>
Major Municipal Default
>
Foreign Dumping of Bonds
>
Interest rate spike
Above
are the matches. By themselves, most can be weathered. But when
combined with the poor fundamentals of the economy and market, they
can turn into an inferno. Below are some of the oily rags, waiting
to ignite when a lit match drops on them.
>
Massive amounts of derivatives
>
Devaluation of the Dollar
>
Overvalued stock market
>
Massive build up of corporate debt
>
Massive build up of personal debt
>
Under-funded pensions
>
Housing bubble
>
Low cash levels in mutual funds
>
Poor earnings
>
Deflation
>
Municipal deficits
But
IT may not happen as many expect. Many investors are waiting for
something sudden, a market crash or a geo-political event. They
want to see the fire before they believe there is danger. If you
were to ask most people, they would tell you that things haven’t
really changed that much for them over the past 3 years. Yes, their
401k is down “but it’ll come back” is their attitude.
Investor attitudes are much too complacent. They see nothing to
worry about.
Liabilities have been outpacing income for several years. But
since Year 2000, income growth has slowed while expenses have continued
to accelerate. People clearly don't "get it."
Source of Data: Fed Reserve; Format CIS
And
why hasn’t IT happened yet? Because the Fed has played Fire
Chief and kept liquidity flowing. But there is only so long that
the Fed can keep the spigots wide open. All they are doing is delaying
the inevitable, not curing it. Adding liquidity has made many of
our economic problems worse, not better.
The
Crash in 1987 was a shocker to almost everyone. Alan Greenspan was
on the phone to the major banks that afternoon offering liquidity
to anyone that needed it and asking traders and firms to offer more
generous terms with regards to settlement of trades. The downturn
in 1997 was saved by the Fed adding liquidity and helping prop up
some poor countries. In 1998, the Long Term Capital debacle caught
almost everyone flat-footed. Along came the Fed to the rescue and
voila, problem solved. Then came Y2K and the Fed just automatically
turned on the printing presses to prevent any problems. All of these
problems had similar characteristics - they were sudden and solved
by the Fed with increased liquidity.
This chart shows that the fabled liquidity that Wall Street
crows about doesn't exist. This chart is a comparison of M2 (liquid
money) to the NYSE capitalization. (If the Nasdaq's capitalization
were included the chart would look even worse.) Liquidity bottomed
out in the 1st quarter of Year 2000. It is only slightly higher
today, but not enough to make a case for a bull run based on liquidity.
Source: Federal Reserve/NYSE ; Format: CIS
In
fact, the Fed’s solutions have contributed to IT, making IT
worse. Too much liquidity has driven stock prices to overvaluation.
Too much liquidity has made interest rates so low, corporations
and individuals have taken on unmanageable debt loads. Too much
liquidity has driven up the housing bubble. Too much liquidity has
devalued the Dollar. Adding more liquidity doesn’t solve any
of these problems, it just delays the inevitable, when IT happens.
When
will IT happen? It already is. IT is happening all around us. The
“oily rags” are there for everybody to see. Debt continues
to pile up. The market is still over valued. The Dollar is sagging.
No, these aren’t things that have “always been going
on” as some pyromaniacs on Wall Street would have you believe.
The
catalysts are also there for everybody to see. No, they haven’t
happened yet, but we are getting close. We had a close call with
a credit crunch last year in the bond market. North Korea is not
going quietly into the night. We have reduced the threat of domestic
terrorism, but not eliminated it. The potential for a stock market
crash is always there with a market so overvalued. Derivatives are
only getting worse, now totaling more than $61 trillion at the top
ten US banks according to the Comptroller of Currency. (How risky
is this? The total of derivatives is 6 times bigger than the entire
US GDP.)
What
are the odds of any one of the catalysts happening? It varies. I
would put the odds of a nuclear war at very, very low. (I imagine
if you talk to the North Koreans, they might think differently.)
The odds of a derivative meltdown taking down a major bank is much
higher. Barings Bank’s failure and Long Term Capital’s
failure have shown us that derivatives can cause financial disaster.
The top banks are playing with matches, big matches, and there is
almost no Federal regulation on derivatives. Warren Buffett referred
to derivatives as financial time bombs.
The
odds are that the catalyst will come from the credit markets. Maybe
foreigners will start to dump US bonds. If they do this, it could
cause US interest rates to spike up. Could this happen? Right now,
the ECB (European Central Bank) is selling all of its Fannie Mae
and Freddie Mac bonds due to the problems with the huge mortgage
originators’ balance sheets. They are also recommending that
all of the other Central Banks in Europe do the same.
And
when IT does happen, it is likely to have a domino effect. Foreign
dumping of US debt could cause rates to skyrocket. This will likely
cause the Dollar to crash. This will also lead to a market decline/crash.
(In case you haven’t noticed, the Dollar has been declining
for most of the year, down about 30% off the high. With The ECB
announcement, it appears Foreigners are starting to dump US debt.
Rates have been climbing for the past few weeks. And the stock market
seems to be topping out. The question is how far will it decline?)
It
is also important to understand the destruction a major long term
bear market does to an economy. There is an old joke that says a
recession is when your neighbor loses his job, a depression is when
you lose yours. There will be no quick fix to what ails the US economy.
Adding liquidity is the Fed’s only answer, but too much liquidity
is the cause of the problem, not the answer.
Retired
investors will have to go back to work. Older workers can’t
afford to retire. (Already happening.) Consumers slow their spending
to concentrate on paying down debt instead of shopping. An economy
that is only sputtering along goes into a nose-dive without the
consumer propping it up. And with unemployment rising, it doesn’t
have enough jobs for everybody that needs one.
There
is enough smoke to know there are still problems with the US markets
and economy. Anyone that is tired of hearing about all of the dire
predictions from the bears should be careful. Anyone that is waiting
for IT to arrive before they act is playing a dangerous game. Now
is the time to act to protect assets.
Maybe
IT will unfold slowly. Maybe IT will be a sudden event. It doesn’t
matter to Cornerstone Investment Services because we are investing
with the oily rags in mind, not the matches. Waiting for the matches
to ignite before you take action will be too late. The fundamentals
are the oil rags, and the oily rags are smoldering. Don’t
wait for the fire.
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