Just when you thought it was all baked into the cake…whammo! Another pie to the face. Get ready for more pies.
In fact, you could take your pick of pies this morning. The most painful pie was yesterday’s 4.3% decline on the All Ords. It was the worst day of the year for Australian stocks. Unemployment called in at 4.5% and said it would be ticking higher this year too. Given last night’s news stream from East and West, it does not look like a happy Friday.
Splat! Bloomberg reports that Bank of America is seeking loan guarantees from the U.S. government to absorb losses from its acquisition of Merrill Lynch. “Details are likely to be disclosed on Jan. 20…That’s when Bank of America may post its first quarterly loss in 17 years as it digests the purchases of Merrill Lynch and Countrywide Financial Corp. The combined company has already received $25 billion from the U.S.”
Did someone say indigestion?
Remember that BoA is trying to swallow Merrill and all its fourth quarter losses. But the whole acquisition seems to have lodged in the throat of America’s largest bank (by assets). It will take more liquidity from TARP (or somewhere) to wash it down. Meanwhile, the stock declined by as much as 30% during the day, before closing down “just” 18%.
If this leaves a bad taste in your mouth, it probably should, and we’re not just talking owners of BoA stock. While Main Street businesses fail left and right, the Feds keep pouring money in to keep America’s largest financial franchises on their feet. Yet little seems to have been solved. About the only good news is that if the Feds decide to nationalise BoA, they won’t have to change the name it all, unless they choose to call it the Bank of Amerika.
But ideology aside, the main issue is the one Ben Bernanke brought up earlier this week in London. The TARP money disappeared onto bank balance sheets and did not reappear as consumer or business lending. Nor could it. The money merely papered over the losses taken by banks and brokers and allowed them (for a time) to maintain adequate capital against the falling value of their assets.
Those assets, however, are still falling. Remember what Bernanke said in London the other day. He said hard-to-value assets on bank balance sheets, “significantly increases uncertainty about the underlying value of these institutions.” But about the only way to increase certainty is to find a real value-which is likely (at least according to market prices) to be so low that it would either wipe out existing equity capital at major institutions or require wholesale bailouts or nationalisation of key firms.
Exactly which assets have increased in value this year on bank loan books? Residential real estate, commercial real estate, and virtually any kind of securitised or collateralised loan book is probably worth less now than it was this time last year. You begin to wonder how much, er, “capital” it will take from the government to make up for the loan losses faced by the financial industry this year, of it is even possible.
But not everyone is clowning around. JP Morgan Chief Jamie Dimon told yesterday’s Financial Times that, “The worst of the economic situation is not yet behind us. It looks as if it will continue to deteriorate for most of 2009. In terms of our sector, we expect consumer loans and credit cards to continue to get worse.”
Dimon’s words explain how JP Morgan could also have received $25 billion in money from the TARP, yet have loaned out just $100 million in loans in the most recent quarter, according to the company’s fourth report released yesterday. Amazingly, Dimon’s company managed a net profit in the fourth quarter on-get this-accounting gains related to its acquisition of defunct mortgage lender Washington Mutual.
We kid you not.
Here’s the thing. If Dimon and others in the industry admit more loan losses are all but inevitable, and further, that the demand for loans is actually falling, what does that say about the economic prospects from recovery in 2009? Daloob. That’s what it says.
More seriously, investors should fundamentally re-examine the issue of whether the financial system has stabilised at all from August of last year. “Banks are insolvent now,” Paul Miller told Bloomberg earlier this week. Miller is a bank analyst at Friedman Billings Ramsey & Co. in Arlington, Virginia.
He estimates the Feds will have to pony up another US$1-2 trillion to keep U.S. financial institutions solvent this year. “Until you address this shortfall, banks will continue to be credit hoarders and destroyers as they shrink their balance sheets.” We have no reason to believe the situation is fundamentally better in Australia, at least in terms of increased bank lending to business and consumers this year. Banks are taking less risk, not more.
The news is not much better in the “real” economy. Yesterday in Japan, data showed that Japanese machinery orders fell 16.2% in November. That’s a two-decade low. In Europe, the European Central Bank finally got on the rate cut express and cut interest rates to 2%. Only two stops or 200 basis points to go! Zero-bound global interest rates here we come.
Perhaps this litany of negative economic news explains the ugly action yesterday in Australia. As bad as the financial crisis was in 2008, it’s now apparent that the economic crisis in 2009-an earnings recession, higher unemployment, less bank lending, more government bailouts-will not be good for stock prices.
In the words of Fed President Janet Yellen, “It now looks likely that the data will show worldwide recession in late 2008 and early 2009, with a more severe and long-lasting contraction in many industrial countries.”
The question is how much worse it will get for stocks. Yesterday we articulated what we believe is the “worst case” scenario, a retesting of the 2003 lows. But while we are exploring the dark possibilities of 2009, let’s acknowledge that markets rarely merely “retest” their previous lows.
When a market tests a low and breaks through it, it keeps on going. That is, bear markets over shoot on the downside in the same way bull markets over shoot on the upside. For example, we can think of two factors that could send stock markets reeling much lower than 2003 lows.
Again, we don’t mention them as a kind of financial horror movie. But this could be the year when your fundamental assumptions about using the stock market as a high interest savings account are tested and found wanting. It is time to think about it seriously and ask yourself what you’d do.
First up is Societe General economist Albert Edwards. He told Dow Jones Newswires yesterday that the S&P 500 could face another 40% decline. He’d telling investors to “bail out” on stocks. The reason? A super bust in China.
“In 2009 it is not the mounting risk of depression in developed economies that will come as a major surprise,” Edwards wrote to clients, “it is economic implosion in China and the global and geopolitical risk thereof.”
Australian investors would know this risk all too well. Just ask investors in Rio Tinto. But is it hyperbole? Are analysts-the same ones who were outdoing each other for growth predictions during the boom-now out bidding each other in calamity scenarios? Well, we don’t think Edwards is.
He says that the raft of economic and earnings data from the fourth quarter and early signs of economic activity in the first quarter indicate, “Something far worse than deep recession.” That would be the “D” word. And we don’t mean daloob. We mean depression.
Edwards amplifies a point we made the other day: the viability of the regime in China depends on political stability, which itself stems from at least 8% growth and employment growth. With growth well below that, Edwards predicts a “mega devaluation” of the Chinese currency by officials in order to jolt the economy.
Thus we’d enter a world of super-charged competitive currency devaluations and, Edwards suggests, perhaps even 1930s-style trade wars. Governments would try to out de-value each other in order to favor exporters. And if that didn’t work, monetary and fiscal policy by other means would be used to keep up domestic employment.
Here’s a question though, if nobody is buying anything, how can people everywhere stay employed making things?
The second factor that could send markets lower is the collapse of the “stock market as retirement account idea.” Specifically, in America and Australia, the pension system is heavily invested in the stock market. Rather than investing in safe, boring bonds with low and steady yields (which no longer keep up with inflation) pension funds have steadily increased the equity allocation of American and Australian retirement assets.
For example, in 1983, reports our colleague Eric Fry from Long Beach, the California Public Employees’ Retirement System (CALPERS) had just 28% of its assets in equities. By 2000, CALPERS had 70% of its assets in stocks. All of which was fine when stocks were going up.
In late 2007, CALPERS was fully funded, meaning it had sufficient assets to meet all of its pension obligations. One credit crisis later, and its just 70% funded. The $400 billion behemoth of the state retirement funds lost millions in a variety of ways. Some was lost in commercial real estate and mortgage backed securities. Other millions were lost adhering to an asset allocation model based partly on “socially responsible investing,” which turns out to be morally pleasing but financially suicidal.
In any event, both public and private pensions invested heavily in America’s housing boom and its stock boom. In Australia, Superannuation funds are heavily invested in the resource boom. But now what?
According to Flow of Funds data from the U.S. Federal Reserve (page 102), U.S. households have some $71.1 trillion in assets. It is the composition of those assets that is troubling if you’re trying to sort out what’s ahead for the stock market. The composition of Australian assets, though we can’t be sure, is probably roughly divided between real estate and equities.
For example, thirty percent of U.S. household assets are in tangible assets, or residential housing. Though there are local exceptions, house prices continue to fall. That makes the value of non-tangible assets even more important to household net worth. Yet those aren’t so flash either.
The Fed says 63% of U.S. household assets are “financial assets.” The largest single component of household financial assets are pension funds, which stand at $11.5 trillion or 16% of total household assets. Next come individually held shares in corporate equity at $7.2 trillion and 10%, respectively. And then you have mutual fund shares at $4.2 trillion and 6%, respectively.
The Fed doesn’t publish its next Flow of Funds report until March. That data will include the effects of 24% decline on the Dow in the fourth quarter (from 11,715 to 8,668) and a 30% decline on the S&P 500 (from 1,300 to 903). Can you imagine what the household asset and net worth numbers will look like taking into account this performance?
But even before a shocking fourth quarter it was already alarming. The value of household corporate equities fell by $943 billion between the second and third quarters. Mutual fund shares fell by $598 billion. And pension fund reserves fell by $601 billion.
That’s a $2.1 trillion loss in household assets in one quarter, which explains the nearly $2.8 trillion loss in total household net worth from $59.3 trillion to $56.5 trillion (most of the rest of the loss came from a $574 billion decline in the value of household real estate).
And so here’s the question: if most household assets are financial in nature, and one quarter of all household assets are pension fund assets heavily invested in equities, and another quarter of household assets ($11.4 trillion) are invested in mutual fund shares and corporate equities, how long do you think it will be before a chart like the one below causes American investors to significantly reduce the amount of retirement savings they’ve allocated to stocks?
Dow Jones Wilshire 5000 Total Market Index
You might have noticed in the figures above that the dollar amount of household assets in mutual fund shares and corporate equities exceeds the current market capitalisation of the stock market. Even in this era of fictitious capitalism, this is not possible. According to the Dow Jones Wilshire 5000 Total Market Index, which roughly tracks the total market cap of publicly listed U.S. stocks, U.S. stocks lost nearly $5 trillion in value in the fourth quarter of last year.
That means household net worth is in decline from the Q3 figures published by the Fed. Granted, a decline is not the same as free fall. But you can imagine what would happen if, en masse, pension fund managers and individual investors decided to make a substantial reduction in their equity asset allocation based on horrible Q4 results. Spooked by big losses and a world full of struggling economies, not to mention a shrinking risk premium in stocks, who is prepared in 2009 to stay invested for the long haul?
We suspect that the wealthiest of Australian and American investors are reaching the limits of their patience and ready to make a major decision about how they manage their wealth and capital. This is also a perfectly normal example of the economic cycles that coincide with demographics. Unfortunately, it also leads to what our friend Jim Davidson calls a “Generational Depression.”
“One explanation for this [market cycle] is human psychology. After a depression, the generation that suffered through it is very careful and conservative. Lenders make only totally safe loans. Investors only invest in sure things. It was 1954 before the Dow reached the level it had attained in the boom of the 1920s. (Likewise, it may not be until the 2030s until the highs of 2007 are reached again.)”
“Then about 30 to 40 years after a depression, a new generation begins to take over. Its members have little memory of the crash. They think their elders are overcautious old fuddy-duddies who are missing profit opportunities.
“And, in a way, the young people are right. It’s time to be more aggressive. Think of the 1950s and 1960s. As this new generation takes control of banks, corporations, government and other institutions, caution is eventually thrown to the winds.
“By about 75 years (an average lifetime) after the last crash, there’s almost no one around who remembers what it was like. Stocks and real estate have gone up for as long as these people can remember. The stage is set for another depression, caused by cheap money, bad loans and foolish investments of the boom generation.
“That’s where we are now.”
Sounds grim. And it is. But Jim also points out that investors who find a way to keep their capital safe are, at the bottom of the cycle, in the position of buying up the best investments in the world when no one wants them.
And if there is any saving grace in a modern world where booms and busts seem to be happening with greater speed and ferocity, it’s that this global recession and credit depression may cause a final correction in asset values in a matter of months, not years.
This leaves open the possibility for a stock market bottom later this year, while the economy bottoms next year or the year after. Buyers be ready! But beware!
Standing in the way of the natural operation of the market is increasing government intervention, which is going to drag the whole process out. And about the only good thing we can say about that is that it should be for gold.
But we can see that we have said too much already! It’s a long reckoning today. But there’s a lot to reckon with! And we did not have a chance to revisit our discussion about land banks and using big chunks of debt to capitalise banks (think Bad Banks.) More on that next week. Until then!
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