As many of our long-term readers know, we have been very negative on the stock market and economy ever since we first started writing these comments at the beginning of 2000. We have tried to explain the way we see the financial environment even if we were hoping to be wrong the whole time.
Lately, we have predicted that the severe U.S. recession we see ahead will spread abroad into a global recession and a global deflationary bear market for stocks. On the other hand most investors believed that if there were a break in food prices, energy prices and other commodities the stock market would rise accordingly. They felt the pressures of inflation and corporate margins would tend to ease both here and abroad. In the face of this almost unanimous feeling we also forecast that most commodities would decline as a result of the "demand destruction" caused by the global recession and that, combined with debt deleveraging, lead to a global deflationary bear market. We attached the "Cycle of Deflation" chart (which we authored) numerous times over the past 8 years. We will attach the chart to this comment and as you can see in the chart, the latest prediction we made was that there will be a race to lower rates worldwide and that the terms "competitive devaluation" and "beggar-thy-neighbor" will be terms used broadly over the next few year. This started to become evident earlier today when the ECB, in a switch of emphasis, let it be known it was now more concerned about the lack of growth than the onset of inflation. In our view this statement was meant to set up expectations of an imminent rate cut.
We never got the capitulation we expected after the market peaked in 2000 mainly due to the fact that the Fed lowered interest rates 14 times from 6.5% in 2000 to 1% in June of 2003. The Fed maintained Fed Funds rate at the extremely low level of 1% for a year until June of 2004. This loose monetary environment jump-started the housing market and prevented the stock market from undergoing a final capitulation. A new bull market started from the outrageously high valuation level of 26 times earnings at the time. We understand that we looked foolish as the stock market rose from 2003 to 2007 accompanied by unprecedented valuations in real estate.
The real estate bubble actually began as the stock market started down in 2000 and eventually rose to levels relative to incomes and rents that were twice the levels of the highest ratios in history. Housing prices started to rise significantly in the mid- 1990s when the Clinton administration put pressure on Fannie Mae and Freddie Mac to increase their purchases of mortgages for low income borrowers. Banks were also accused of "redlining", a term used to describe a policy of not providing enough mortgages to certain low income areas. Regulators subsequently put subtle pressure on banks to increase lending for home purchases in low-income neighborhoods. However, the boom really took off seriously in the early 2000s when Wall Street started packaging all these toxic mortgages and selling them to worldwide clients (who should have known better). It was also spurred by mortgages featuring no down payment, no verification of assets and income, initial low teaser rates and outright fraud. At one point the SEC allowed the top five investment banks to increase their asset-to-capital ratios from 12 to 1 to 40 to 1. Combine this with Greenspan lowering rates to 1% from 6.5% and keeping them there for a year as we described above. He then encouraged new home buyers to get into these wild complicated mortgages that would reset at much higher interest rates. We wrote about this in late 2003 when we did a special report called, "Real Estate-The Catalyst for the Deflationary Bear Market", available on the left hand side of our home page. The home prices subsequently rose from record valuation metrics to twice the normal HIGH valuations over the next two years. Doesn't that remind you of what happened to stocks in the late 1990s?
The special report we wrote (again on left side of home page) "How We Got Into This Mess", was followed up with "How to Get Out of the Mess". How we got into this mess was described above. In our opinion, the bottom line of "How to Get Out of this Mess" is to let the free markets work to find a bottom without government intervention. It concludes by stating that if the government gets involved to attempt to stop the housing market from finding a natural bottom it will only postpone the inevitable and may make it worse.
This brings us to the latest "Wall Street Bailout". While the market has been rallying and declining on changes in the odds that congress will pass the Paulson plan, we think that the market will go down much further whether the bill passes or not. After all, the plan in place, which now includes a bunch of "add-ons", will not help an extremely serious problem very much at all and we think that investors are seeing right through the "mirage". (Furthermore the market only now is waking up to the fact that the real economy is in for a hard landing in any event.) The "Plan" only deals with the left hand side of the balance sheets (assets) of these financial companies' and leaves the right side (liabilities and equity) alone. This means the government will buy toxic assets on the left side (assets) and leave the right side alone to fend for itself. The bailout means that if the government pays the same or a little more for the toxic assets on their books, it will increase the cash available and decrease the toxic asset by the same amount. This does not improve the stockholder's equity that is needed to encourage the bank to make loans and give relief for the credit crises we are in presently. The institutions that are the weakest will sell the government their toxic assets but the increase in cash will not be enough to encourage the institution to make loans to consumers and businesses that are in desperate need for cash.
In addition the market today seemed to wake up to the realization that the economy is in for a hard landing no matter what happens to the Paulson proposal. As a result of recently released negative data on consumer spending, autos sales, the PMI report and initial unemployment claims, a number of economists that had been in denial now concede that we are in a recession that is likely to persist well into 2009. We previously thought that passage of even a highly flawed bailout plan would result in a rally. That may still happen, but the prospects have dimmed significantly by an economy pulling in the opposite direction.
Again, we honestly hope that we will be wrong about this highly negative assessment of the financial and economic environment. Please let us know what we are missing so we can change our stance.
