Last Friday, I wrote about the condition of the credit market and how it was ominous for stocks. Well, there is no relief yet. Things are worse, as banks are only willing to lend to one another at rates too high to justify borrowing. Overnight LIBOR hit 6.88% today, and 3-month LIBOR was a record 350 basis points higher than 3-month T-bill rates. Here is a graph of that difference, the TED Spread, which, in calmer times, used to stay well under 50 basis points:
“The money markets have completely broken down, with no trading taking place at all,” said Christoph Rieger, a fixed- income strategist at Dresdner Kleinwort in Frankfurt. “There is no market any more. Central banks are the only providers of cash to the market, no-one else is lending.”
Credit markets have seized up, tipping banks toward insolvency and forcing U.S. and European governments to rescue five banks in the past two days, including Dexia SA, the world’s biggest lender to local governments, and Wachovia Corp. Money- market rates climbed even after the Federal Reserve yesterday more than doubled the size of its dollar-swap line with foreign central banks to $620 billion. Banks borrowed dollars from the ECB at almost six times the Fed’s benchmark interest rate today.
The two-month Libor rose to 5.13 percent today, also a record. Libor, set by 16 banks including Citigroup Inc. and UBS AG in a daily survey by the BBA, is used to calculate rates on $360 trillion of financial products worldwide, from home loans to credit derivatives.
After a massive sell-off in the equity markets, you would typically look for a powerful bounce, and while US futures are indicating an open of a couple of percentage points over yesterday’s close, I suspect that stocks won’t have much more steam than that, maybe a few percent in all.
While we dropped a lot in one day yesterday, the Dow only closed at 10,365, less than 500 points beneath its intraday July 14 low. I’m looking for another 1000 points on the downside within a few weeks before calling for a meaningful bear market rally. There is so much emotion out there that anything is possible, but that also means that whatever happens will happen soon.
Consider that the market dropped about 2.5% at the open, before the vote was on the floor, and that Europe had been trading down 4% before Wall Street even had breakfast. Stocks around the world were having an awful day this morning, even though almost everyone assumed the bill was a done deal.
It is unfortunate that the market hasn’t held up long enough for the bill to pass in one form or another, since today’s drop just gives the congress critters an even greater sense of their own importance.
This market is headed way down no matter what, due in large part to 100 years of stupidity and malfeasance from Congress (the Federal Reserve Act, FDIC insurance, Fannie and Freddie, etc.). Government enabled bankers to run bigger and bigger scams, until the whole debt-laden economy became a house of cards. So yes, Congress caused the market to crash.
Funny how people forget these things. It just goes to show how market prices are at least as much about psychology as fundamentals.
At their core, stocks represent two things: a claim on any future earnings that might be generated, and a company’s net assets. These values are both dependent on people’s sentiments about the future, which swing from optimism to pessimism over time scales as small as an hour or as long as several decades.
Earnings and asset prices are highly variable, especially when debt is employed as liberally as it has been lately. Debt overload destroys economies, because it creates massive distortions in asset prices and risk perception. The boom phase is the destructive phase, because those distortions result in waste. The bust is simply taking an honest accounting of that waste, and it cannot be stopped, and should not be fought, because it restores sanity in the form of market-clearing prices.
Leverage works both ways.
Busts destroy both earnings and net asset values. As asset values drop, leverage increases the destruction of equity. Lehman, Bear Stearns and others were levered 30:1, so their equity went POOF with just a 3% decrease in asset prices. A retail margin stock account can be levered 3:1, so if somebody put it all into Apple at 180 in August, they would have been wiped out by last week.
Recently, even big industrial firms have levered up so that they could grow-grow-grow and vest those stock options. In the bust, their earnings and asset values (real estate, equipment, subsidiaries) drop, but the debt doesn’t go away. It should therefore come as no surprise that equity values routinely drop by 75% or more in bear markets, but it always does, because each generation has to make its own mistakes.
By the numbers.
Here’s a little back of the envelope calculation I use to sober up the buy-and-holders:
Everyone knows about PEs. For the market as a whole, 10 is pretty cheap, and 20 is pretty expensive. Now, PEs are not everything, since you have to look at the earnings cycle, too. A lot of big gold miners had very high or infinite PEs when the metal was under $300, but they were still a great buy. Lehman and Bear Stearns had PEs last year of about 10.
Earnings for the market as a whole are very volatile. (S&P publishes historical data here — big Excel file available.) Forget about “operating earnings.” I believe it was Charlie Munger, the Berkshire partner who has not turned communist in his old age, who said that every time you hear operating earnings, you should substitute the phrase “bullshit earnings.” What you want are real, reported earnings. PEs should be based on the last year’s bottom line, not what a bunch of ass-kissing analysts are told to tell you they think this year’s or next year’s earnings will be.
For this discussion I prefer to use the S&P 500, since it is a broad index with copious data available:
S&P 500 earnings peaked about about $80 for the index in 2006, up from a little trough of $44 in 2001. The index peaked last year a bit north of 1550, for a PE on peak (real trailing) earnings of just under 20. Pretty darned rich when you consider that earnings were about to fall off a cliff, though the aforementioned cheerleaders kept telling us how cheap stocks were at the time.
According to S&P, the first two quarters of 2008 have come in with earnings of about $15.50 and $13.20, respectively, for an annualized rate of something like $57. Apply today’s S&P 500 closing price of 1106 and you see that we are on track for a PE of 19.4 if earnings stay steady from here.
But real bear markets end with PEs under 10. In bear markets, social mood becomes more pessimistic and people have less faith in future earnings. The multiple hovered around 8 in the doldrums of the late 1970s and early 1980s, and bottomed at about 7 in 1932. Let’s be nice and apply a PE of 10 to today’s $57 in somewhat bullshit forward earnings: that of course would give us 570 on the S&P, a drop of over 60% from last October (this would correspond to about 5000 on the Dow).
Think earnings will be even worse next year than in the little 2001-2002 recession? Well, better revise those figures accordingly. I personally assume at least a 50% drop in earnings from 2006 and a PE under 10, for a Dow somewhere under 3500. That is, if all goes well.
Bear markets happen. It’s the stock market, people.
You see, it’s no big deal for stock markets to fall by well over 50%, if not 90%. It’s just big deal for Americans, because they have been lulled into complacency by a 26-year bull market. They should have been saving more all these years, and in a more reliable form than the stock market. Too bad their great-grandparents weren’t around to warn them.
Well, there you have it. Paulson got his 700 big ones (to start) but Congress is going to make him ask again for some of it (like they’ll say no). Executive compensation cuts? Well, deduction caps and no new golden parachutes for the biggest beggars. Equity? Well, warrants, and Paulson gets to say how many, what price, etc. Majority stakes only in some circumstances. Boy, Congress really fought this thing once it learned how its constituents felt.
Futures traders are just beside themselves (with apathy):
So, where do we go from here? As I have been saying, we still have a crash to take care of. Maybe it starts this week, maybe next week, maybe December, but a year from now the buy and hold crowd will be lucky if the Dow is closer to 10,000 than 5,000. This bill won’t do a thing to stimulate lending. We are just turning Japanese, without the exports or savings.
As a short, I won’t look this gift horse in the mouth. Paulson bought his buddies time to unload the remainder their personal securities, but the bailout also adds a few girders to bolster counterparties on the losing side of a crash. My biggest fear these days is that so many securities dealers could go broke at once that the Options Clearing Corporation can’t make up for bankrupt put sellers. That is my version of TEOTWAWKI.
So, are there no libertarians in financial crises? I railed against this thing, but the bankers make the rules in this new zero-sum game, or rather negative-sum game (wealth is going to money heaven). For those who stay in, it is every trader for himself.
Here’s a pdf of the full draft of the bill at it stands tonight.
Many standard fear gauges remain near their most elevated levels of the bust so far. From highly emotional conditions like these, we should expect a big move in equity prices. The question is whether the next emotion is relief or all-out panic.
If the fundamentals were not so horrible and stock prices not so high (with earnings falling off a cliff, real PEs are in the stratosphere and dividend yields are pathetic), this would be a promising time to go long, at least for a trade. As is, that would be Russian Roulette, because it would be hard to imagine a market more primed to absolutely crash than this one.
With open talk of a depression from the Secretary of the Treasury, and the President comparing the financial system to a “house of cards,” the Dow Jones Industrial Average registers the same opinion about the economy as it did in mid-2006, when talk of Goldilocks was in the air. Something has to give.
Click image for larger view. Source: Yahoo! Finance.
Last week (Sept 15th-19th) a huge amount of steam was let out out of the market, first from the bears, and then from the bulls. By Friday afternoon, traders expressed physical and emotional exhaustion, and volume dried up. It was an eerie feeling.
That week started off in a fright, with new lows on the Dow, T-bills under 0.1% and a VIX over 40. In a lesser bear market, Thursday’s bailout announcement should have marked a substantial bottom (by no means the bottom, but at least the basis for a tradeable rally).
However, the 1000 point, three-hour rally from 2:30PM on Thursday to 11:00AM on Friday hardly set up the basis for a sustained rise, since where else could stocks go but down after such a move? The very violence of it showed how much fear was out there by Thursday morning. We were truly looking into the abyss, that netherworld below 10,000.
After the short-squeeze ran out of steam, prices dribbled down from Friday afternoon to this Wednesday on low volume and volatility, before a little follow-up rally Thursday and Friday relieved the very-near-term oversold condition. The Dow rests this weekend at 11,143, awaiting what will surely be a wise edict from the philosophers in our legislature. 11,143 is a number neither too ugly sounding nor too pollyannaish, square in the middle, with plenty of room on either side (at least for the near-term).
Fear is still highly elevated, no doubt stoked among the general public by the scare tactics and demeanor of Messrs. Bernanke and Paulson. Over the last week, even people who did not support Ron Paul for president have begun to acknowledge the magnitude of the problem. The question is, what are they going to to about it, and when?
To see where Mr. Market’s next move is coming from, follow his rates, not his stocks.
The credit market isn’t waiting for anyone, public nor Paulson. As far as banks are concerned, it’s already TEOTWAWKI, and that is important because changes in credit markets precede changes in equity markets. Two summers ago, while Goldilocks was still enjoying her porridge, bond traders were looking out the window and deciding to pay a premium for long-term debt over short-term (an inverted yield curve is almost always followed 12-18 months later by a recession).
Short-term Treasury yields of course are extremely compressed. 3-month T-bill yield here:
Click image for larger view. Source: Yahoo! Finance
Here is the TED spread, the difference between LIBOR (the rate that banks outside the US Fed system lend one another overnight) and 90 day Treasuries. A wide spread indicates reluctance to lend, i.e., a lack of trust between banks.
Here’s another scary picture from the credit markets, the discount rate spread, the difference in yield between AA and A2/P2 rated commercial paper (short-term corporate debt such as trade receivables). This is why non-Treasury money market funds are so risky (and why Paulson wants to bail them out):
Fear bloodhounds should also be trained on the Chicago Board of Exchange Volatility Index, a measure of expected volatility in the S&P 500, as indicated by near-term options prices. From summer 2006 to summer 2007, the VIX dipped under 10 at times, truly the calm before the storm, registering the very apex of the decades of unfounded optimism and imprudence that brought about this mess. During the dot-com bust, it nudged over 40 on occasion, a number that was breached intraday in the pre-bailout depths of last Thursday. Two-year view here:
I’m sick of hearing the phase “America’s crumbling infrastructure” from the press and politicians. They have been pushing this theme for at least 18 months now. Observers should look for the motive behind all such recurring news themes, because nothing gets on the air on into print without one.
In this case, we are clearly being prepped for New Deal #2, involving at least the following programs:
Green energy waste. The Tennessee Valley Authority with a touchy, feely twist. Al Gore, administrator?
Neverending War in Asia. That’ll lick unemployment for good!
From Bloomberg, here are the latest brilliant ideas from the Senate:
Sept. 25 (Bloomberg) — Senate Democrats proposed a $56 billion economic stimulus package that would increase government spending on unemployment benefits, food stamps, infrastructure projects, aid to state governments and heating aid to the poor.
Senate Majority leader Harry Reid, a Nevada Democrat, said today that the legislation is needed to help millions of Americans struggling with the slow economy.
“We must not forget Main Street as we work to address the crisis on Wall Street,” he said, adding that the plan would “create hundreds of thousands of good-paying American jobs and prevent cuts in critical services for millions of Americans.”…
The Senate plan would extend unemployment benefits by as many as 13 weeks, expand food stamp aid and provide states coping with high Medicaid costs with an additional $20 billion in federal assistance.
The plan would also spend $11 billion on highway and other transportation projects, $5.1 billion for heating assistance to the poor, $1.2 billion for the National Institutes of Health and $250 million for NASA.
Will Keynesianism never die?
Politicians and bankers love this repressive and discredited doctrine because it justifies all manner of scams. Today’s professors won’t admit it, but they haven’t changed a bit since falling hook, line and sinker for Orwellian nonsense that intentionally punishes savings and private investment, maintains a dumb consumer class, and allocates full freedom and power only to a ruling class of “philosopher kings”. They tinker around the edges of this egomaniac’s* theory, but they assure us that without the State pulling the levers (following their guidance of course), the economy will crumble down to the stone age.
The last thing America needs in a Depression is more government involvement in the economy, especially not government jobs for government-designed projects. This just steals from the sensible and allocates to the connected, while wasting the capital on unneeded projects with negative returns.
Relax, go for a drive.
The highway and other infrastructure in the US is among the best in the world, especially the road system. I have driven in a lot of places, and nothing beats four lanes each way with stadium lighting, fast and even drainage, huge reflective and logical signage, and perfectly cambered cloverleafs. It is just a joy to drive when you come back after being away. And by the way, American motorists, even New Yorkers, are very safe and considerate by world standards. The are not the Swiss, but we can’t all be.
* Here is a character study (PDF) of the most-revered economist of the 20th century by one of the smartest and most honest economists of the same, Murray Rothbard, who’s writing happens to be a joy to read. How many Keynesian professors can you say that about?
WASHINGTON (AP) – Warned of a possible financial panic, key Republicans and Democrats reported agreement in principle Thursday on a $700 billion bailout of the financial industry and said they would present it to the Bush administration in hopes of a vote within days.
Emerging from a two-hour negotiating session, Sen. Chris Dodd, D-Conn., the Banking Committee chairman said, “We are very confident that we can act expeditiously.”
“I now expect that we will indeed have a plan that can pass the House, pass the Senate (and) be signed by the president,” said Sen. Bob Bennett, R-Utah….
Tony Fratto, the White House deputy press secretary said the announcement was “a good sign that progress is being made.”
“We’ll want to hear from (Treasury) Secretary (Henry) Paulson, and take a look at the details. We look forward to a good discussion at the meeting this afternoon,” he said….
But there were fresh signs of trouble in the House Republican Caucus. A group of GOP lawmakers circulated an alternative designed to attract private capital back into the credit markets with less government intrusion.
Really? Someone is defending the free market?
Under the proposal, the government would provide insurance to companies that agree to buy frozen assets, rather than purchase them directly as envisioned under the administration’s plan. The firms would have to pay insurance premiums to the Treasury Department for the coverage.
I really got my hopes up there for a minute. Not. This sounds like a phoney, roundabout way to offload the losses to the Treasury. There is no difference whether the Treasury buys the bad debt for more than it is worth or insures it for below market rates; the taxpayer takes the loss either way.
What if in response to the overwhelming public opposition, which is surprising even me, Team Banker yanks the bailout? The market will crash, bailout or no bailout, but with no bailout, they can say “I told you so.”
Then when people are really hurting, I mean jumping out of windows hurting, they can come back with emergency powers, Obama or no Obama.
Don’t think they aren’t considering it. These guys are all high-IQ players who think moves ahead and make contingency plans, and they are getting desperate.
Any serious student of the Great Depression will sooner or later come across a very interesting story from the summer of 1933. Somehow I doubt Bernanke discussed this in his Princeton courses.
Not all libertarians are as cynical* as I am. Like giving money to Ron Paul’s campaign (which I did, because it was always about the message, not winning), fighting the bailout may be futile in the end, but at least you can look back and say that you made the effort.
Mish is on top of a massive campaign to do the right thing, with resources and guidance for contacting congresscritters, many of whom are reporting that this is the biggest public response that they have ever seen. If you are of a mind to make some noise, head over there.
Mish has drawn up an open letter to Congress with suggestions for removing some of the road blocks that government has placed in way of the market, which would allow our financial system to right itself with no handouts. Passing such a bill would be the most sensible thing Congress has ever done.
Also consider pointing your Congressional ‘representatives’ to Fund manager John Hussman’s plan, which involves more government involvement (so it stands a better chance with Congress than Mish’s, since it gives them something to do, not undo), but is far more sensible than the Paulson plan.
*My own belief is that educating yourself and others about fractional reserve banking and other scams, while protecting your own assets or even making money on the short side, is good for everyone. It leaves more capital in sane hands and preserves knowledge that can be redeployed at home or elsewhere, whether in the coming years or many decades from now. That’s not cynicism, but realistic hope. Civilization will flourish again, sometime, somewhere, hopefully on earth, hopefully among humans, and hopefully in my lifetime.
All of a sudden, the economy is in dire danger of unknown horrors, we are hearing from Bernanke, Paulson, Bush, and the US press, especially the financial press. Unless the bailout passes, and RIGHT NOW, stocks will crash, your bank will fail, your home will keep losing value, and your employer will go broke and fire you. All of the bankers’ stooges who were trying to get us to look the other way since the credit markets started to freeze up 13 months ago are trying to scare the daylights out of the US public. How to avert the crisis? Give the con men who created it a blank check drawn on the US Treasury, of course.
This campaign reminded me of a spot-on comedy skit by the British Comics, Bird and Fortune, that popped up on YouTube 12 months ago, back when nearly all of my acquaintances all thought I was nuts for stocking up on put options and gold.
I recommend the whole thing, but the end (jump to 7:20 if you’re in a hurry) was particularly prescient. I transcribed it below, but it’s more fun to watch:
These are the lines was I reminded of today:
Interviewer: “But now, you see, the people are saying that now the crisis is going to turn into financial meltdown. I mean can that be avoided?”
Investment banker: “It can be avoided, provided that governments and central banks give us, the financial speculators, back the money that we’ve lost.”
Interviewer: “But isn’t that rewarding greed and stupidity?
Investment banker: “No, no. It’s rewarding what the Prime Minister, Gordon Brown, called “the ingenuity of the markets.”"
Interviewer: “I see…and, and …
Investment banker: “We don’t want this money to spend on ourselves. We want this money just to go into the markets so that we can go on borrowing and lending money as if nothing had happened without thinking too much about it.”
Interviewer: “Yes, but, if the worst came to the worst, and you didn’t get this money, what then?”
Investment banker: “Well then, there would be another market crash, and then I would say to you what people like me always say, that it’s not us that would suffer, it’s your pension fund.”
Interviewer: “Thank you very much.”
George Bush, tonight: “The stock market could drop even more, which would reduce the value of your retirement account.”
Call the bluff.
I have zero hope for a sensible outcome from the US government. Politicians are not debating the concept of bailouts and moral hazard; they are debating which irresponsible parties get how much. ‘Compromises’ will be reached that allow for grandstanding all around, but the core of the bill will give bankers what they want.
The executive salary cap for bailout recipients is a red herring. Manhattanites will figure out other ways to get their hands on these trillions, ways that don’t involve holding executive titles at big banks. Those banks are dead in the water anyway — it wouldn’t surprise me if they were completely nationalized over time. Another dispute is over equity — the government will get its equity position, sure, but the equity is worthless. And of course, everyone wants to throw in money for the idiots who are underwater on their mortgages — they’ll get theirs, if not in this round, the next.
By the way, anyone else notice the tactical similarity to how seven Septembers ago we were subjected to the same kind of scare tactics and rhetorical bombardment while another huge and unconstitutional bill was being rushed through Congress?
All over but the shouting.
We will get a depression. We’ve got it already. If US still had any character, this would be a short and relatively painless lesson in giving government too much power, which really means giving power to bankers. I say painless not because nobody will go broke — they will, in spades — but the pain will be like the first weeks in fat camp or reform school, not the gulags.
There will be no reformation this time. Americans of all intelligences are confused and ethically bankrupt after 100 years of saturation in nationalist and socialist propaganda by schools and media. This lack of a moral compass or common sense assures us that this will be the worst depression in our history, and maybe the last.
As the depression deepens, a terrified populace will allow the government to grab more and more power, until society is completely transformed. Remember those emergency powers that the executive granted itself last year? You better believe they are being readied. This stuff happens, folks. This is what human beings do to themselves, with great consistency. Freedom and prosperity are the exceptions to the rule as far as history is concerned.
PS — Buy the bailout rumor, sell the news? If I had to pick a date for the start of the Crash, it would be the day after Congress passes this bill.
Disclosure: I’m short the equity markets with put options and inverse ETFs. See disclaimer.