CICERO (106BC - 43 BC), 55BC
The “bubbles” have burst. The “bubbles” I am referring to (not necessarily in any meaningful order) are: Residential Housing, the Stock Market, Commodity Prices, Bank Credit, All Bonds collateralized by other assets such as Mortgages, Credit Cards, Rents etc, Derivatives of any kind, the US and Foreign Economies, and anything else you can think of that uses leverage. When interest rates are held artificially low, personal and Government spending run amuck, and credit is given to one and all without regard to repayment, you get bubbles.
I have attached some charts that tell the sad story of the consequences of too much credit. The chart below shows the poor consumer’s ratio of installment debt to personal income (in %). It’s no coincidence that the ratio is at all time historical highs. Just imagine what happens when you assemble a pool of this kind of debt (Credit Cards) and issue Bonds secured by the cash flow of debt payments. When credit card debt is not paid, the bonds can’t pay their principal and interest, and the holders of this toxic asset are out of luck.
What’s next for credit card debt and bonds issued against them? More credit contraction and/or Bail Outs. So the Consumer is up to his norkis in debt and now unemployment is on the rise. The chart below shows the unemployment rate (inverted scale). Below +1 is abnormal and recessionary. It probably will go to +2 or more over the next twelve months. This event has happened only 3 times since December 1968. The consumer is in trouble.
Next we have a friendly chart of what Economists call the Monetary Base. The in crowd calls it High Powered Money. The Monetary Base consists of Currency in circulation (which the Federal Reserve does not control, and Bank Reserves (which the Federal Reserve does control). This “money” determines how much Money Supply can be created (“Printed”). In the Depression, currency in circulation increased dramatically due to bank failures, (the folks decided to take their money out of the banks and put it in their mattress). This in turn decreased the amount of money the banking system had to lend (Money Supply), which added fuel to the fire in aiding and abetting the depression. Normally when this indicator rises you can expect the Inflation Rate to rise within 6 to 18 months. The Federal Reserve increased the Monetary Base materially the past two months. Note the current spike reflecting their pumping reserves into the banking system. The reserves were increased to save our wonderful Financial System. Expect bigger spikes over the next 12 months.
Below is the S&P 500 Stock Index Annual compound yield including Dividends, from December 1901 to October 2008. Note the negative yield in October 2008, is the lowest since the Great Depression and World War 2. Also shown is the Annual Compound % Change in the S&P 500 earnings per share. The earnings from the fourth Quarter 2008 through 2009 are estimates made by our trusted stock brokerage financial analysts. It is highly probable that their estimates are too high.
The stock market Gurus have decided the market has hit bottom, and we should all be buying. Note in the Depression, the largest decline occurred well after the initial collapse in October, 1929.
The pundits talked about a de-coupling of our Economy from the rest of the World. They were obviously wrong. What happens in the US affects the Economies and Markets of the World. The US and World economies are and have been in a recession. In my opinion this will be a long and drawn out decline. Rising Unemployment and the decline of Business and Consumer spending will continue to drive down the Economy. The Federal Reserve and your and my Congress have created an expansion of the Credit, Bank Reserves, and Money Supply that is unparalleled in our wonderful but short history. Although these actions are inflationary in the long run, they will tend to stabilize credit over the next 12 months. Below is a chart of my leading indicators through September 2008.
The indicator is below -1 and heading towards -2. Below or equal to -1 is a recession. I think the above chart will approach or decline more than the 1974 recession. Note, I have estimated the recession lasting through 2009.
So what does this all mean? We have a major adjustment in our Economy regarding spending and credit habits, a credit contraction, a major asset contraction (housing, commodities and the stock market) and increasing US debt and Money Supply. This translates to Deflation and Inflation. Debt contractions are Deflationary and Increasing Money Supply is Inflationary. It is the War of the Gilas Monsters.
In the great depression, 90 day T-Bill rates were negative, and 30 year Treasury Bonds yielded less than 3.00%. As of November 3, 2008 the 90 day T-Bill Yielded .49% and the 30 Year Treasury bond Yield was 4.321% and appears to be rising. The Bond market is of no current help, other than reflecting the tug and pull of the contrasting economic conditions. The short rates reflect fear, and the long rates reflect inflation expectations, yet the spread on 10 year T-Bills and the 10 Year US Inflation index Bond implies low inflation expectations. The War is on. The winner will be determined within 12 months.
The stock market has been seriously injured, and should take a long time to recover. The average investor has lost 50% of his capital and is not real happy. Retirement plans have been destroyed. The mob psychology of a Bear Market is ugly. Many of the participants do not return to the market for long periods of time. In the 1974 fall, many individual investors “swore off” the stock market and never returned. The only thing that brought the market back was time and Retirement Plans.
The Chart below indicates the Annual yield that occurred if you bought the S&P 500 Index and held it for 10 years, and collected all the dividends. For the 10 years ended October 31, 2008 the Annual Yield (with monthly compounding) for 10 years was .22%. That means for a $1 invested in October 1999, you would have got back $1.022 for a profit of 2 Cents. Not real shiny. However, don’t give up on the market since the average annual yield for a 10 Year holding period from December 1909 to the present was 9.3861%. That means you would make $2.5471 times your investment in 10 years for a profit of $1.5471.
So the question is - if you are a long term investor, do you invest now?
Those that invested in October 1919 and sold in October 1929 received a 10 Year yield of 12.92% (not bad). If you had invested in October 1929 and sold in October 1939 you would have a yield of minus 1.20% (not so good). If you invested in October 1929 and sold 1 year later in October 1930, you would have a minus 32.61% yield. However, if you had the good fortune to invest at the all time market low of 4.77 in June 1932, and sold one year later in June 1933, your yield would have been 126.01%.
My answer is simple. Due to the damage done to the market by the recent collapse, I think new lows are ahead. I would rather preserve capital and watch from the sidelines as events unfold. Market bottoms are impossible to time, but easily recognized after they occur. To miss a bottom is not a sin: to buy into a false bottom is. In the interim, I choose to preserve Capital.
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