Panic Before The Panic. Good Read.
Forecast for 1999: The Gathering Storm
…panic before Panic
The sudden volatility on world markets of September has given way to an eerie calm on Wall Street, and a return of crowd euphoria. With religious fervor, investors now believe in the power of the Federal Reserve to rescue the market from the very jaws of disaster. Looking beyond the moment, my forecast for 1999 is for the onset of severe recession, due to a combination of three fundamental destabilizing factors:
1. A worldwide credit-debt bubble of historic extremes, including an enormous bad debt burden. 2. Stock equity overvaluation, and 3. Effect of the Year 2000 computer bug (Y2K).
Factors 1 and 2 are the culmination of a decades-long global mania of wild speculation, reckless spending and borrowing, public and private. They contain no inherently accurate timing indicators for an end to the mania and economic collapse. It is well known, for example, that an absurdly high-priced stock can always become more outrageously overpriced, as long as one more fool remains alive to buy it. With the presence of factors 1 and 2 alone, the economy and market could in principle continue their advance for years to come. However, with Y2K, for the first and probably only time in history an indicator's future schedule is known to high precision. We may therefore consider Y2K as a trigger for the other two destabilizing factors, in the same way that a chemical explosive triggers the fission of plutonium in a nuclear bomb.
Japan officially admits a bad debt level of $1.2 trillion. Martin Weiss (martinweiss.com) now estimates the actual figure is $2 trillion, with an additional $1 trillion hidden in Japanese shell corporations' offshore accounts, the total equal to 60% of Japan's GDP. Total bad debt worldwide is estimated at $4 trillion, out of a total debt of $60 trillion.
Much has been said about Japan's debts; however this is a worldwide problem. A good way to measure its extent is to look at the ratio of total (public and private) debt to the GDP of a country. For the US, the total debt is now $21 trillion, with a GDP of $7.5 trillion, the ratio is at an all time high of 2.8. Just before the Great Depression of the 1930s, it was a mere 1.8. The historical average is around 1.0. Economists have now shown that the severity of a deflationary recession is directly related to the level of debt outstanding at its beginning. Crucial is the quality of the debt, a measure of the financial strength of borrowers. Today, debtor weakness is at an all time high. To illustrate this, commercial banks had 42 cents in reserve for every dollar of short term debt in 1929; today, only 14 cents on the dollar.
Derivatives are a new ingredient in the debt mix, only a couple of decades old. They are a gigantic "loose cannon" consisting of around $70 trillion worth of risky, highly leveraged investments similar to options, except they are not traded on exchanges, and are totally unregulated. They deal with everything conceivable, from junk bonds to real estate and futures on foreign currencies. A few large failures in derivatives would likely have a devastating result in the credit markets.
For years after the horrific experience of the1930s, most people shunned debt and credit as a moral leprosy. After World War II , this mindset could not withstand the enormous pent-up demand from two decades of deprivation. The mass-psychology flipped back from austerity to the easy ways of the 1920s. Credit is not only encouraged, but a status symbol in itself. A consumer's borrowing power has almost replaced income or monetary net worth as a measure of personal prestige. A blizzard of aggressively pitched credit card application forms arrive daily by post; the tube spills forth ads for debt consolidation, bankruptcy lawyers, home equity loans, payday advances. They promise deliverance unto bliss to the most unregenerate of habitual deadbeats, drowning out the heretofore ubiquitous automobile salesman.
Equity overvaluation: The world has now reached the final stages of the most powerful stock-market mania in history. Like the 17th century Dutch tulip bulb frenzy and the 18th century South Sea Bubble, it is about to blow its top. Here are four methods of measuring the valuation of the market:
1. Price / dividend yield: historical average = 23, reached 40 in 1929 before crash, is now 70. (a New York Fed study shows yields are low because stock prices are high, not because dividends are out of favor)
2. Price / peak earnings ratio: historical average = 12, was 22 in 1929, is now 30. (Peak earnings are calculated for the previous 5 years, to average out "noise" in earnings figures)
3. Price / book value, historical average = 1.6, is now 6.0.
4. Stock Prices / commodity prices : historical average = 6, is now 34.
According to these traditional valuation methods, the US stock market is presently overvalued by at least 100%.
And the market P/E ratio may be worse than advertised. The lead editorial in the Apr 12, '99 Barron's reveals a common corporate practice of leaving employee stock options off the books; not counting them as an expense. Warren Buffett asks, "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?" Taking stock options into account, British analyst Andrew Smithers figures the actual P/E ratio of the S&P 500 at the end of 1998 is 63, almost five times the historical average.
According to Nick Guarino of the Wall Street Underground, large mutual funds have borrowed huge sums against their stock holdings, for two purposes: to avoid the necessity of selling shares for redemption, and to manipulate market prices ever higher. Fund managers invest this money in high-leverage derivatives. He states:
"Many stock market mutual funds are, in essence, flat dead broke. If they had to liquidate to return investor's money, they would go under. Their massive derivative positions and borrowing, coupled with the biggest drop in cash flows in four years, means that liquidation will collapse the stock market and put them under water".
What lesson did investors absorb from the Crash of 1987? Rest assured it was not the correct one. Rather, they learned that today's New Era Economy can easily shrug off such an event as if it were the sniffles, that every correction will be followed by a roaring bull taking off for new highs.
The Negative-wealth Effect: When a stock market declines significantly, investors feel poorer, and reduce spending accordingly, from fear of unemployment, debt defaults, etc. This slows the economy, which in turn reacts back upon the market. This negative-feedback effect can snowball into a recession, given the presence of destabilizing factors of excessive debt, and overvalued equities.
During a bear market, from panic and from the negative-wealth feedback effect, the market usually plunges through the "proper valuation" like a pendulum, dropping to extremes on the low side, as it had reached extremes on the high side. Broker-brainwashed investors who "remained fully invested" were crushed by the declining market. From 1929 to 1932, the market lost 90% of its value in this way, and did not recover fully until the 1950s. Likewise, in the bear market of 1973-74 values dropped around 55%, and did not recover until 15 years later. Some of the "Nifty Fifty" stocks of that era, such as Polaroid, have still not recovered.
Dynamics of Bull and Bear Markets: During a bull market, economic and political events prove less serious than feared. The market reacts by rallying sharply, climbing the Wall of Worry as the anxiety dissipates. In a bear market, events prove more damaging than investors had expected. The market does not go down in a straight line. In the hopeful interludes, it rallies. When positive expectations are disappointed, the market drops to new lows, down what Robert Prechter calls the Slope of Hope. If rapidly cascading bad news works itself sufficiently into the collective unconscious, a crash can occur; as a mob stampedes for the exits after the cry of Fire.
Y2K is not a product of the fevered imagination of some Oliver Stone of finance. While the Last Trumpet will not sound and the sky will not roll up like a window shade, the bug will be a serious hit on the economy. Effects of Y2K can be divided into four categories: 1. Costs of remediation and purchase of new software, including bugs in the new software, 2. The effects of possible panic on banks and other financial institutions, caused mainly by uncertainty and stonewalling by government and business. 3. Litigation costs, and 4. The actual economic damage from malfunctions and shutdowns caused by the bug itself.
Effects 1, 2, and 3 are beginning now, and will increase steadily into 1999. Effect 4 will likely begin in late 1999. Result: failure of about 10% of US companies; a higher percentage overseas. (Martin Weiss). Ed Yardeni, chief economist at Deutsche Grenfell Bank, estimates Y2K alone would cause a recession equal to the 1973-74 oil embargo. Sources such as the World Bank, the US Senate y2k committee, the Gartner Group, Capers Jones and other private research firms support these conclusions.
The US and a few other countries are relatively ahead in the task of fixing the bug. The rest of the world, especially Asia, is lagging far behind, partly due to their obvious priority of dealing with their financial crisis. However, since companies' and agencies' Y2K-compliant computers must interact with other entities' non-compliant computers, the problem cannot be isolated; it is truly global.
The US individual savings rate, which has fluctuated between + 4% to +8% for many decades, has suddenly declined into negative territory in September '98, for the first time since 1933. Consumers feel confident, fortified by their stock wealth; they spend as if there is no tomorrow, ignoring the gathering storm. Brazil's currency has already de facto devalued by 30%. When this becomes obvious to the international speculators propping up the Brazilian economy, the last firewall protecting the US from the global deflation juggernaut will crumble.
Worldwide, fiat money and gold are locked in an epic battle for survival. To expand the credit-prosperity bubble without limit, central bankers must completely detach their currencies from gold, degrading it to a commodity like wheat or pork bellies. Reinforcing the present slump, according to gold analyst Larry Edelson, is one fundamental fact: that central bankers are running low on currency reserves, requiring them to sell their other assets, together with the analogous response of ordinary citizens of countries in Asia and elsewhere to the ongoing debt crisis: sell gold to raise emergency cash. Until the major fiat currency, the US dollar, collapses, this and the long term fiat plan keeps gold chained to its 20 year bear market. When the illusions come to grief and the dollar bubble bursts, the indestructible metal will arise from the ashes like the Phoenix. Edelson predicts a possible low of $180-200/oz in a classic bear-panic climax, damaging production and thus reducing supply levels, setting the stage for a gold renaissance, the price doubling "in a heartbeat"!
A few characteristics of historical investment manias: (Prechter):
1. A mania is born of a long-term, often-corrected bull market.
2. During the mania, the investing public begins to absorb the idea that the long term trend is always up, and begins to act as if the trend over any period is always up, ignoring the fact that after a high-powered bear market, getting back one's investment and "breaking even" typically requires several decades.
3. The mania itself produces a powerful, persistent rise with remarkably fewer, briefer, and/or smaller setbacks.
4. It involves broad participation by the public.
5. It ends in times of historic overvaluation by all traditional measures.
The oft-repeated New Era argument that new technological developments will continue to power the bull market onward and upward is unfortunately the identical one made in previous market manias of the '20s and the early '70s. Every extreme was thoroughly rationalized at the time of its creation. In spite of the most assiduous justification, high flying high-tech stocks always met their downfall, good and hard, in subsequent panics and corrections.
Will the Fed interest rate cuts stem the tide? During the early 30's, the Fed lowered rates eight times. The Dow got smashed. In the 90s, Japan lowered its rates to microscopic levels; the Nikkei is still headed south. Will today's "mixed economy", with government making up half the GDP, cushion the blow? Maybe, but government finances are in worse shape than advertised. The so-called budget surplus is sleight of hand. Many favorite New Class programs, e.g. the Department of Education and HUD, are kept off the books; the real deficit is $230 billion, and it will balloon to $500+ billion when the recession kicks in. Forgotten fatal errors of the 1930s reappear in force: trade protectionism, currency controls, and Keynesianism.
Since early 1998, a curious "hidden bear" phenomenon has affected the market. While a few dozen high flying big-cap stocks have kept the Dow and Nasdaq averages soaring, owners of thousands of other stocks have found themselves marooned in a parched desert of declining prices. Several theories have emerged to explain this. One is fear: mutual fund managers gravitate towards big-cap companies for their high liquidity, for easy exit during a market downturn. Another idea is simply that global deflation has begun to hit these smaller companies' earnings hard, and the price declines are merely a reflection of this.
What is the likely sequel to the hidden bear phenomenon? We can only observe the past. It has appeared before, twice in this century. 1929 and 1972.
At a distance the real New Paradigm wears a suit and tie. As he approaches we get a better view of the fellow; he has a big round furry face, button-shaped ears, beady eyes and teeth the size of railroad spikes.
The moral of this story? It takes the form of a small bit of advice: panic before the Panic.
gold-eagle.com |
