Investors are “bloodied and confused,” says Warren Buffett, “much as though they were small birds that had strayed into a badminton game…”
By the end of 2008, $30-$40 trillion had been lost, in stocks, housing and derivatives. Investors breathed a sigh of relief when December 31 finally came. But then came 2009! World markets have fallen 18% so far this year…2009 is on track to lose far more than even 2008, which was the worst year in stock market history.
What has gone wrong?
Today, we’re going to retrace our steps. In order to understand where we’re going, we have to spend a minute remembering where we’ve come from.
First, the biggest bubble in history sprang a major leak in the summer of ’07. Then came the autumn of 2008, and it was losing air from every seam. The biggest bubble in history might be expected to lead to the biggest bust in history. And so it has…
“Let it burn itself out,” was our advice. Instead, the feds sounded the alarm, slid down the pole, and rushed to put the fire out. But the more money and credit they pumped on the flames, the worse the fire seemed to get.
The Federal Reserve, under the leadership of Ben Bernanke, called out all the fire trucks and opened up all the hoses. Rates were cut to zero…and the Fed expanded its balance sheet – increasing the amount of credit available to the banking system – by nearly $1 trillion.
And the Federal government – under the leadership of George W. Bush – rushed out a tax rebate…and then a rescue bill. Together, they cost a bit more than $1 trillion.
None of this rescuing has done any good. Every bank and business that has gotten help has deteriorated, as near as we can tell. The feds let Lehman go bust and we were done with it. But they saved insurance giant, AIG. Now, AIG is in trouble again. And today’s paper tells us that the feds have stepped in…this time to put in a further $30 billion and “take a controlling stake in two of the stricken insurer’s largest divisions.”
Hey…so now the feds are in the insurance business too.
And here comes the new administration with another $825 billion bailout and the kind of budget that takes our breath away.
If Mr. Obama gets his way, he will soak the rich and squeeze the military; everyone else will be showered with benefits. There’s a health care initiative, for example, that will cost more than $600 billion. And there’s even a plan to provide higher education for everyone.
Republicans are gearing up for a fight. They owe many of their careers to military contractors and are looking forward to cushy jobs with defense businesses should the voters ever catch on and boot them out of office. They’ll fight to keep the U.S. spending money as if we were at war. The Republicans don’t appreciate it much either when people on their high-dollar-donor lists are hit with higher taxes.
Democrats are readying for a dust-up too. They’ve dreamed of moments like this – it is as if the police and the alarm companies had all gone on strike at the same time. They’re planning to rob every bank in town – and expect to get thanked for it. It is not often that they can divvy up trillions in boondoggles…and pretend it is in the national interest.
With this worldwide financial meltdown you can get away with anything. People have come to believe things so absurd you’d think even a Democrat would laugh at them. Most think you can give money to failing companies…and somehow they’ll be healthy businesses again. Some believe that you can print up paper money – and that it will be as good as the real thing. Almost all of them think spending money on anything, no matter how stupid, actually helps the economy. If it were only that easy!
Obama says he’s preparing for a fight too. Which is fine with us; we like a good fight. Even one that is rigged. And this one surely is. Just look a chart of government spending over the last 30 years. What you see is that there is nothing extraordinary about what Obama is doing. Every year, through Republican and Democratic administrations…from Ronald Reagan to Barack Obama…the Republicans and Democrats pretended to fight about how much money the government spent. And every year the trend continued: higher spending, higher deficits. It didn’t seem to matter who was president, or what was going on. Each year, spending rose…and so did the real deficits. That too is a feature of the post-war consumer economy. And that, too, is probably coming to an end.
*** After all this fire fighting…you might think that the blaze would be under control by now. Not at all.
On Friday, the Dow lost a further 119 points. It’s clearly ready for a rally…but there is none in sight – yet.
Oil is at $44. Gold lost ground too…it’s down to $942.
We recall that last December, as stock prices were collapsing, Warren Buffett stepped up and put his money and his mouth in the same place. He was buying stocks, he said.
But buying stocks proved a bad place for both his money and his mouth. Stocks continued falling. And so did the economy that is supposed to support them. Economic output in the United States is falling at a 6.5% rate – the fastest drop in 26 years. And now Buffett says the economy will be a “shambles” this year. His own company, Berkshire Hathaway, reported profits down 96% from the year before…and is trading at only about half its peak. In other words, Berkshire shareholders have lost half their money.
And here’s a good question for you, dear reader: If the smartest investor in the world can’t make money in this market, how do you expect to?
If we were you, we wouldn’t even try. You see, this is not a recession…and it’s not a buying opportunity. It’s a depression. And at this stage in a depression, the best thing to do is to sell stocks, not buy them. Because they have further to fall…and because they could take a long, long time to recover.
We’ve explained the difference between a recession and a depression before. But we’ll do it again. A recession is a pause in an otherwise healthy, growing economy. A depression is when the economy drops dead. And when it drops dead, the assets that people owned – stocks, bonds, houses, derivatives, debt – are called into question. What are they worth, now that the economy that created them no longer exists? That’s the big question. The U.S. economy has been expanding for the last 60 years – largely by increasing consumer spending and debt. Now, neither consumer spending nor debt is increasing. In the last 6 months, consumers have suddenly reversed their free-spending ways. Borrowers and lenders have repented too. But if it is no longer an economy that grows by increasing consumption and debt…how does it grow at all? And what about all those businesses that are set up to provide products and services to the consumer economy? A nd what about all the debts and obligations that the consumer economy produced; what are they worth?
That’s what everyone wants to know. So the markets have entered into a period of vigorous price discovery. Some things are still valuable, of course. A house, for example. But many things aren’t as valuable as they used to be. The house won’t be worth as much if people can’t borrow to buy it…or if potential buyers can’t get a job. And the mortgage debt that the house carried…which was recycled into a leveraged debt instrument…is bound to be worth a lot less than people once thought.
But it takes time to sort out the good assets from the bad ones. How much does the business owe? To whom? Who owes it money? Will the debtor be able to pay? And what about those strange piece of paper – CDOs, MBOs, SIVs – in the company vault? What are they worth?
For a while, people are so afraid of making the wrong move that markets freeze up. No one wants to lend when he doesn’t know if he’s going to get his money back. That’s called a ‘credit crunch.’ And no one wants to buy when he has no idea what things are worth. That’s when markets go “no bid.”
But eventually – unless the feds stop the process – things sort themselves out. Businesses go broke. Homeowners are defenestrated. Automobiles go back to the dealers’ lots. Prices sink to a level where people are able to buy. And the whole process starts over again.
This can take a long, long time…especially when government is trying to stop it.
*** “We must kill zombie banks or face a lost American decade,” says James Baker, U.S. Treasury Secretary under Ronald Reagan and U.S. Secretary of State under George Bush I. Japan is still trying to adjust to the realities of its post-bubble world…after the initial crash 19 years ago. It propped up banks instead of fixing them, he says. The banks were kept alive…but not performing their function. Result: a lost decade. Maybe two.
In the United States, in the ’30s, on the other hand, the zombie banks were allowed to die. More than 1,000 banks were buried. Still, the economy didn’t really recover until after WWII – some 2 decades after the crash of ’29.
Maybe killing the zombie banks isn’t enough. Zombie companies must be allowed to fail, too. And zombie homeowners. And all the zombie investments made in the preceding bubble years.
Of course, that is what is needed. A period of creative destruction. But in this period of discovery, we don’t know who’s a zombie and who’s not. Not yet. It will take time to find out. A new economic model must take shape. Then, the markets must tell us what things are still valuable…and what they are worth.
An example: a mall. Shopping malls were designed for an economy in which consumption increased at a more-or-less predictable rate. As consumption increased, mall owners could project how much retail space they could let out…and what yield it would produce. Based on those figures, banks could lend against the value of the mall…and investors could put their money to work building new malls.
But that economy is missing and presumed dead. Consumption is no longer increasing, it’s declining. And the biggest consuming group – the baby boomers – seem to be changing their habits forever. From here on out, they are likely to be saving money for their retirements…not spending.
What is that mall worth now? What do the projections show? The commercial property loans used to build the mall were based on projections made years ago; what are those loans worth now?
We’re all waiting to find out. A new economy needs to arise, step over the corpse of the dead one, and get moving. What kind of economy? We don’t know… When will it happen? We don’t know that either. What companies will prosper…which ones will fail?
We wish we could tell you.
In the meantime, all we have is guesses… Stay tuned for more…tomorrow.
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