Survival of the Longest

This article was written on Sunday, October 12.

What a week! What a month! The S&P 500 started around $1,250 a month ago, was as high as $1,200 at some point two weeks ago, and, doing what no one had ever imagined it could, dropped below $850 last Friday. I gave out an $800 target in August last year, which the S&P 500 is on its way to test now. It was an easy target to give since it was the low of the 2001-2003 bear market. Even the market is quite oversold, and due to for a dead cat bouncing. I now doubt that $800 will be the bottom for the bear market, and there is no support whatsoever in sight once $800 is decisively broken, until around $4-500.

After the 1987 crash, the government implemented the so-called "circuit breaker system" which they hoped would prevent a one-day crash of 20%. However, people are always smarter than the system and will always find a way to get around it. Instead of dropping 20% in one day, we did it 5% a day on average, and easily beat the 20% record in 1987 by a wide margin last week. The next thing government can try is market holiday(s), and eventually bank holidays, like in the 1930s.

Early this year, Jeremy Grantham of GMO predicted, in an interview with Barron’s, that the S&P 500 would drop to 1,100 by 2010. A lot of people just laughed at him - was this crazy old man out of his mind? Now, it is like Hamlet’s last line “all the rest is silence." We should always listen to an old man who experienced the nifty-fifty losing 80% of their market value in 1970s, and has studied extensively the great depression of 1930s. He probably regrets now that his 1,100 target given was too conservative. Actually, 1,100 now becomes an important resistance point for the upcoming dead cat bouncing or bear market rally.

Jeremy derived his 1,100 target with a more normalized P/E of 11-12 as a norm for a very long term capital market. If I use the more representative bear market P/E value of 6-7, I would come up with a target of around 600-$700 range. At the extreme of this bear market a few years down the road, the S&P 500 might very well overshoot and drop all the way to the 400 level, which was the launch pad for the last leg of the last bull market after the early 1990s recession. Everything is back to square one and this 20 year return of a bull market turns out to be in vain.

How long will this bear market last? Well, the 1930s great depression caused a bear market lasting over two decades, from 1929 to 1952. It was not until 1958 that the market came back to the old 1929 peak, three decades later. And the 1970s market was not much better, lasting 14-16 years from 1966 or 1968 to 1982. Even then, the bear market took until 1992, 24 years later, to reach its 1968 peak.

My most optimistic forecast is it will last another 4-5 years from today, or about 12 years if we count year 2000 as the starting point. If we use the commodity super-cycle by Jim Rogers, which usually runs opposite to the general equity market and lasts until 2020, as Jim predicts, it will be also a two decade bear market for equities, consistent with both the 1970s and the 1930s. When will the S&P 500 be back to last October's peak? At least 24 years from 2000, or 2024. A few chart technicians today think that the Dow can drop all the way to 1,000, back to the 1982 level. Even if it is possible, I think it will more likely bottom at one of the lower Fibonacci level between 14,000 and 1,000. Which one of them is yet to be seen in future years, but my guess is around 4-5,000.

The current market crash is not like 1987, which recovered in a relatively short time since the fundamentals were strong, stocks were in an uptrend and we didn’t have the economic bloodline of a credit cut-off then. There is another fundamental factor now supporting a long lasting bear market than in the 1970s. This time, it is demographic. Setting aside the whole investment banking sector being wiped out and OTC derivatives, for the public, the more important factor is that baby boomers are not comfortable with this market turmoil since last year, and want to lock in their nest eggs and cash out, which has caused more baby boomers to do the same.

They don't want to take the risk of sitting through this credit crisis and bear market, since no one knows how long it will last. What happens if it lasts as long as two decades? Time is not on their side. How can we blame them? With the real estate market at free-fall and no sight of its bottom, it is only natural for them to protect their only remaining nest eggs. And they will never get back into the stock market again after cashing out, due to growing risk-averse profile with increasing age. Their only concern is to protect their cash. This is why you see US treasuries reaching so high these days with yields at 0%, the so-called safe haven vehicle. Maybe stocks in the future will be “undervalued” at 50% of book value, 70% of intrinsic value, P/E at 6, PEG less than 1, but who cares? Yes, inflation is gradually eating their money away, but let us worry about that later when inflation reaches double digits.

The above discussion about baby boomers is not new; as early as 2001, Wharton professors Andrew Abel and Jeremy Siegel voiced concern about the herd behavior of the baby boomer generation, andsuggested their cashing out simultaneously would cause a stock market meltdown around 2010. What an accurate prediction that is, he only missed by two years. At the same time, who wants to be the last one to cash out in 2010 at the lowest price by holding the bag, anyway? I think the 2010 bottom prediction by these professors is still one of the valid bottoms, and probably the most important one in this bear market reaching the 4-500 target discussed earlier after the upcoming dead cat bouncing rally.

Here is a brief discussion on Warren Buffett’s investment in both GE (GE) and Goldman Sachs (GS). Investment in perpetual preferred stocks is usually a good way to invest in good business as long as the firms survive, and obviously Buffett thinks both will. I tend to agree. However, even if both GE and Goldman survive, not many people realize these investments are at the large expense of the existing common shareholders. In GE’s case, GE is using Buffett’s name and investment to raise $12 billion in a separate public offering to dilute their common shares, not counting on the $3 billion of GE warrants, causing potential more dilution. Almost all GE industrial units are doing fine since they are usually #1 or #2 in the sector and have some monopoly price power. The biggest risk for GE is their GE Capital unit, which never reveals its portfolio based on illiquid asset securitization and OTC derivatives, similar to highly leveraged investment banks.

And, unfortunately, it accounts for half of GE's earning power. If GE Capital is in the same trouble, GE will likely have to shut down this division, write down large losses of its portfolio and lose half of their earning power but as a conglomerate, they will still survive. The problem is, in an economic depression with decreasing revenue and much worse profit margin, GE’s earning will be depressed substantially, but will still have to honor the large interest payment to Buffett on the new preferreds before common shareholders see their dividends.

In Goldman’s case, it is even more so, and a much riskier investment than GE. The largest expense for investment banks is compensation, and they always issue many new shares to retain talents besides cash bonuses every year. That is typical and part of their incentive program. In an economic depression, there are likely no banking deals, not much trading activities, and especially no more highly profitable structured products like before. Goldman’s net income could be running less than $1 billion at its worst years (like Morgan Stanley's (MS) today). However, they have to pay Buffett $500 million, 10% interest of his $5 billion investment, every year. What is left for common shareholders with their shares diluting heavily each year? The incentive program becomes a demoralized program. Both deals are really very negative to common shareholders, taking a large piece of the net income pie and shifting from commons to preferreds.

From where the stock price and credit derivative swap are trading at for Morgan Stanley, it is pointing them to be another Lehman.  What is also interesting is that there has been a very popular blog in China, discussing in detail a high level special interest group inside China's SWF and banking system, using their relationship with top managers of Morgan Stanley and Blackstone (BX) for alleged corruptions, kickbacks, abusing power, questionable investments going sour, luxurious life style, etc.

Usually, the Chinese government would have ordered the removal of such kind of “un-harmonized” blogs right away, but not in this case. There is wide speculation of anger by some government officials toward the China SWF fund investing in Morgan Stanley, Blackstone and all the US home mortgages and derivatives, decisions dictated by Morgan Stanley, for the purpose of nurturing their own personal relationship and self-interest but letting the whole country down. It is always a bad thing to make your investors angry by losing their money; and especially this time, as it is their boss, the Chinese government, which now realizes that they would never get any return, and worse, may be on the edge of getting wiped out on their investments.

There are also many angry investors in this country too, causing the House to defeat the $700 billion bail out plan initially. Without Wall Street’s creativity on structured products, the subprime crisis could have been easily contained, even with widespread abusive lending practices. The problem is that for each $1 of subprime mortgages, Wall Street created $10 CDO products; then the math geeks at structured product groups escalated the $10 CDOs by creating another $100 OTC derivatives out of thin air (refer to my previous article “Why Wall St. Needed Credit Default Swaps”). Now, suddenly, a $700 billion default in subprime would cause $7 trillion default in CDOs and $70 trillion losses in CDSs, a crisis 100 times larger than it should be.

Now you know why Wall Street is so profitable: In only the past 5-10 years' time, they have already sucked the blood and “profit” of not only this generation but the next. If the government is serious about the bailout, the size will likely be 100 times larger than $700 billions.

Not long ago, with no market for CDOs, Merrill (MER) was forced to sell CDOs at 20 cents on the dollar by creating a market. But that was not the most interesting part, Merrill had to self-finance 15 cents out of 20 themselves, leaving a suspicion that those CDOs were really only worth 5 cents. This act forced other banks to mark down CDOs in their portfolio further, however, at 20 cents, not at 5 cents, helping other banks to shore up the value of their portfolio than they are really worth. Even so, any asset writedown has to be matched by equity. There is really no more equity to write down for many banks, and no way to raise new equity, only heading liquidation. Since debt stays the same, debt to equity ratio, or so-called "equity ratio', has to be reduced in the current deleveraging process, not to be increased. As a result, a writedown causes more writedowns, and it becomes a death spiral of no way out situation.

In the summer of 2007 (note, not this past summer but the one before), Jeremy Grantham also predicted that half of the hedge funds would get wiped out, and that more than half of the private equity funds would vanish. Let us just look at the private equity sector. In the boom years, they achieved 50% return easily. Let us look at a hypothetical deal in which PE Firm A, with 2+20 fee structure, purchased Company B at $4B with $2B borrowing at 6%, netting $1B in two years by IPO, a very typical deal in the good old days. It is 50% return ($1B/$2B investment) for the PE firm. But for you, as a PE investor, your share of return is: $1B profit - $0.08B fee (2%*$2B*2 yr) - $0.2B PE profit cut - $0.24B interest ($2B*6%*2 yr) = $0.48B, or 24% return ($0.48B/$2B). Suddenly, the same deal seems to achieve 50% return (for them), but the real return for clients is only half of that.

Now let us use the same example, but this time, let us say the equity market enters into a couple years of bear market as of now. The same deal now takes five years instead of two years to spin off in an IPO. What would the return for PE clients be?

The answer is ZERO. It is: $1B profit - $0.2B fee (2%*$2B*5 yr) - $0.2B PE profit cut - $0.6B interest ($2B*6%*5 yr) = zero. Five years for nothing. The extra three years of interest payments and excessive 2+20 fee structure eat all the remaining profit. For all the corporate pension funds, state and local government retirement funds, endowment funds and foundations rushing to invest 10-20% of their investments into private equities, do they realize that investing in 5% US treasury per year (27% for 5 years compounding) would actually offer better return and carry no risk at all (except the risk of holding the US dollar)?

In the above calculation, I didn’t factor in a long recession with a decade of bear market, resulting in reduced revenue with deteriorating profit margin, and potentially large loss instead of profit for businesses they purchased. No need to show more calculations. This is why Jeremy was so confident about his prediction still in the middle of the bull market last year, with a margin of safety by predicting only half of them dead. Now with time against them, no credit for any financing, and no equity market for IPO for a decade for them to cash out and dump the risk to the public, the likely scenario is that the whole private equity sector will get wiped out in two years, by 2010, just like the investment bank sector.

For a decade long recession and likely depression, the only firms that will survive are those preserving cash by cutting workforce, stopping capital expenditure, R&D and IT investments, cutting stock dividends including preferred dividends, and no more stock buyback, even with stock prices going to zero. Things will get very nasty, and only firms that can still manage to generate net cashflow during depressions are survivors, as in the 1930s and 1970s. Newer companies with experimental technologies will be vulnerable and regarded as nonessential, and undercapitalized private firms will be in trouble since the IPO window will be shut for an unforeseeable future. Venture capital firms will have to hold on to their investments forever, at least another decade, without IPO in sight, until all of their cash is burnt out. Many firms relying on bank financing will not survive. The only businesses that will survive are likely the cashflow positive energy firms and mining producers.

Pretty soon, people will realize that holding cash in US dollars is also not right due to the quick deterioration of US dollar. The current rise in the US dollar is due to a short term disappearance of money supply, since no bank wants to lend any money out. Once the government socializes the banking industry and floods the system with worthless paper, people will downgrade US treasuries before rating agencies do, since the US government is buying and holding the worst quality mortgages and CDOs dumped by the banks.

In a normal bankruptcy process for investment banks, common stocks, preferreds and subordinated debts would get wiped out, and bondholders would act as a cushion and suffer some losses; but usually customers and trade partners are protected. The current bailout plan, and the previous BSC bailout and AIG bailout, are all using taxpayers' money to bail out the bondholders and perferreds which are held mostly by institutions. It is basically to wipe out the individual investor, then to use taxpayers' money to protect the large institutions. Individuals have already dumped stocks, institutions have already dumped bonds, derivatives such as CDOs and CDSs, and the next thing that will happen is that both, especially foreign central banks, will dump US treasuries too, by buying the ultimate asset everyone in the world trusts – gold.

The reason is that people will realize that this is worse than the 1930s; at least then, fiat money was backed by gold. Now the US dollar is only backed by liabilities of anover $10 trillion national debt and 10 times larger unfunded obligations and promises, if we include Medicare, Medicaid, social securities, pension liabilities, Fan and Fred’s trillion mortgages, and the future purchases of the whole defunct banking industry, auto industry, airline industry, etc. etc. The government can’t only socialize the money-losing sectors, and taxpayers and lawmakers have only so much patience and can’t tolerate this forever. Pretty soon, the government will need to take over a profit sector, such as energy firms, to offset some of the losses. It is going down the slippery path of socialism quickly.

This is going to be a nuclear winter for many years to come. No wonder George Soros, many years ago, correctly predicted that there will be an end of globalization and the death of capitalism. This is the payback time for all the abuses a few elites have done to our whole society, with the public now footing their bills. If the G7 is serious about bailing out the global economy, the only way to do it is to have double digit hyperinflation to inflate the whole world out of depression at any costs. And they have to do it now. It can’t be half-hearted either, otherwise it will end up being the worst nightmare of hyperinflation combined with great depression. This means that all commodities will skyrocket and the current slump of commodities will provide the best buying opportunity before oil goes to $200 and gold to $2000. When people lose faith in fiat money, the next thing to happen is barter, like in the Weimer Republic, where only commodities, especially gold, were treated as money.

In this difficult period, do nothing and hold nothing but gold. Only gold, the ultimate asset that has survived the longest in human history, can save us now.

A specter is haunting the world – the specter of gold, while the old fiat money has lost all its powers.

Comments

[a believer:]

Only gold can save us now? I doubt it. You are assuming large numbers of people will start to value good as a medium of exchange, which to me is unlikely.

No, what will 'save us now' is providing REAL goods and services that other people want and need.

Right now, I would take Leveraged Debt off that list.

2008 Oct 15 12:37 PM

[OilyGasMiner:]

Thomas good observation on the circuity breaker "work around". The question is: is there a difference between dropping 20% in one day opposed to over a week? In the short term? long term?

I do think you are on the right track with the recessionary forecast. However what has me up at night, is trying to assess given market factors, HOW LONG it will last? will be see a "U" shape recovery? "V" shaped recovery?orrrrrrrrrr an "L" and simply flat line for a while.

Anyone?

2008 Oct 15 12:39 PM

[blacksilver:]

long all metals not just gold,watch copper could still dip maybe to a 1.00-1.25
good article

2008 Oct 15 12:43 PM

[Prudent Man...:]

Who used the web in 1933 so anyone silly enough to compare the age of worthless custom derivatives with today's economy is fighting the last war?

This problem was created by the use of non-standard, non-transparent custom derivatives and the statists in Washington don't want the "smartest guys in the room" to pay for their virtual fraud, Just mark these derivatives to their zero value and we will be on the way to solving the problems. Its not the economy it is the Banking and Washington Bureaucrats with conductors Greenspan, Dodd, Barney F... and the rest of the greedy Congress. destroying Free Markets.

My paid off home will be here regardless of what these greedy oafs do. Unless we have an Obama defense Dept. which will allow the terrorists to turn it to rubble.

We are politically looking at economics when we should be looking at National Defense and Homeland Security. The economy will do o.k. if the government stays out. The Depression ended when we supplied both the "Allies" and Hitler with the products of our Military/Business Complex not any economic policy from FDR who believed hard working men like my father should have a job moving dirt from one side of the road to the other. Now we have Government Controlled Capitalism and business decisions will be based upon political power and contributions.

We have had worst housing busts the past five decades but we had transparency. We didn't have transparency because Congress didn't want it. Bigger interestate banks, dump Glass-Steagall adding risk to commercial banks, and allow worthless derivatives to go wild. I thought that LTCM, with their two Nobel winners would bring an end to this. Now we have the Enron Adviser getting on so he can joining the group of Esteem losers Arafat, Carter, Scholes and Merton - all bankrupt or bailed out by the government.

One of the great out comes of all of this is that the voters, if they ever did, will not believe Congress, Banks and Wall Street for decades and those thieves know it that is why they are the tube every day telling us that all of this mess will not cost taxpayers. Bull! It will but it wouldn't if we had integrity in our investment, banking and political institutions which will never happen in my life as the voters really believe these folks look out for their best interests.

2008 Oct 15 12:45 PM

[phdinsuntan...:]

gold remains constant in recessions,
so you will have bullets at the end,
commodities will skyrocket ? not when
the GDP is falling, maybe in 2010-11
but is too early now. Sell @ 888 if it goes there...

2008 Oct 15 12:49 PM

[Knisar:]

Most impressive article, very convincing, the only very blatant sounding comments on Gold, make one suspect if there is a conflict of interest, from the Gold business.

2008 Oct 15 12:52 PM

[RSAAKS:]

The market is not going down because of herd mentality of the baby boomers, It is the herd mentality of hedge funds and mutual funds that is causing this melt down. Unless the hedge funds are regulated like mutual funds, and there is some transparency of what the hedge funds are doing, this market is not coming back/ Individuals will surely be out at some point, whether now or in a year, if down turn persists. Going forward, funds will simply be selling to each other and will have very little individual participation directly or via funds.

2008 Oct 15 02:11 PM

[Chris B:]

FIRST...
What has technical analysis chart reading ever sucessfully and consistently predicted? Gold prices? Hardly. I could piss a zig zag on the ground and a TA person would tell me where I was going to piss next.

Predictions of S&P 100 or 10,000 are about this useful if you don't consider EARNINGS, which are the fundamentals underlying stock prices.

SECOND...
Why should we expect gold to go up more than it already has? Will inflation rates increase, even as unemployment rises, demand for cash increases, interest rate expectations increase over the next 1-2 yrs, and commodity demand decreases?

THIRD...
Why would anyone invest in gold? If you invest in GLD, you accept counterparty risk during the only time that you would wish to be invested in gold - during meltdowns that increase counterparty risk!

If you take physical delivery, you're paying a 10-50% premium on the value of the gold for someone to coin it and retail it / deliver it to you. That's IF they don't dilute it at the core and rip you off even more. Then you have to store it safely and insure it. Thus you take on the risk of being forced to open your safe at gunpoint one day, even as you pay carrying costs for this privledge. Then, if all hell does break loose, you'll have a hard time spending your collector coins at the bread market or even finding a safe way of exhanging them for whatever is of value or using it to get a job. Then, if we really got to Zimbabwe standards of living, wouldn't a passport, canned goods, an education or trade skills, children willing to fight for you, and foreign currency accounts be more useful than collector coins? After all, at that point, the smart people escape! If you cling to your hard-to-safely-transpo... gold and don't leave, you'll end up like the European nobility of the pre-Nazi era - dead and looted.

Thus gold fails at every reason for owning it, unless you think you can pick zig zags in the charts.

2008 Oct 15 04:04 PM

[T.Carbello:]

TA is not just charting. Charts are visual compliments and the simplification of historical prices and values of securities.

2008 Oct 15 06:14 PM

[Alan von Al...:]

Great article, Thomas. Thank you.

"The only businesses that will survive are likely the cashflow positive energy firms and mining producers" - yep - and farmers who own their equipment, land, savings to self-finance seasonal expense.

2008 Oct 15 11:29 PM

[phat cat:]

Right on Thomas. I can't agree with you.

If we are to stretch our imagination a bit more, it's not unforeseeable that we may be in whole lot of trouble more. With the Americans used to all the excesses and increasingly belligerent, and the developing countries like China, Russia and Easter Bloc just starting to taste the fruit of capitalism, a prolonged deep recession will lead to....WWIII. It will start with finger pointing backed by religious backlash (just see how Obama is being labeled as an Islamic terrorist!!! just ridiculous), followed by a mass scramble for resources, then a flared up nationalism, finally armageddon, created by ourselves.

The solution? Not clear. We need wise/responsible leaders who can see big pictures (not just finding Russia across the pond) and people start to take responsibilities for their own actions. We created this debt problem, we are the ones who are spending money we don't have, and we are just as greedy as those people on Wall Street. We know it, if put Joe Plummer on the trading floor, he will do exactly the same! It's time to tighten our belts and start to prepare for a long winter... and gold is not a bad idea at all (physical only, those ETFs might just be as worthless as the Lehman shares in the brokerage account)

2008 Oct 16 06:10 AM

[phat cat:]

I meant:

Right on Thomas. I can't agree with you MORE!

2008 Oct 16 06:12 AM