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Why Hasn’t “IT” Happened Yet?
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:
Ø Crash of the Dollar
Ø Stock Market Crash
Ø Credit Crunch
Ø Derivative meltdown at a major bank (JP Morgan/Citicorp…)
Ø Nuclear War
Ø Major terrorist attack on the US (Nuke, Bio, Chem)
Ø Major Corporate Debt Default
Ø Major Municipal Default
Ø Foreign Dumping of Bonds
Ø 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 matches drop on them.
ü Massive amounts of derivatives
ü Devaluation of the Dollar
ü Overvalued stock market
ü Massive build up of corporate debt
ü Massive build up of personal debt
ü Under-funded pensions
ü Housing bubble
ü Low cash levels in mutual funds
ü Poor earnings
ü Deflation
ü 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 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. |
