Wrong Great Depression Lessons Will Haunt Equities in 2009

All the ingredients for another major downside move (below 700) in the S&P 500 are now in place. A slew of economic data over the holidays proves that the world's emerging markets have finally entered a decisive contraction phase, which means significantly lower asset valuations and collapsing consumer demand throughout the developing world. And, as far as the domestic environment is concerned, rather than focusing on systemic risks, the Fed and the Treasury have embarked on a series of monetary policy and bailout decisions which are almost entirely predicated on the hope that the US economy will take a turn for the better in late 2009 or early 2010.

The case for short equity positions (ADRE, DIA, EEM, QQQQ, SPY, XLF) could not be stronger and is, in fact, fortified by the fact that the very concept of systemic risk is either horribly misunderstood or simply ignored. One component of systemic risk is public confidence that failing banks will not wipe out family savings. The other is the guarantee that essential day-to-day business (exchange of food and essential commodities) can be conducted under logical assessments of counterparty risk, as opposed to a virtual standstill in the credit markets. The third, and perhaps most important, component of systemic risk is the ratio of productive and non-productive (e.g. financially engineered products) assets within a particular economic matrix.

Drawing from studies of the Great Depression, policy-makers like Ben Bernanke are convinced that if the apparently vital constituents of the economy (AIG, C, GE, GM, GS and now GMAC) are kept alive long enough, a sustained uptrend in asset valuations, household wealth and home prices at some point in the future will return those constituents to health and prosperity. The difference between the 1929-1933 period and today, however, is stark. Shortly after the First World War, debt was mainly being incurred by industry to finance expansion. Over the previous two decades, a huge proportion of total outstanding debt has been incurred to promote financial activity bearing no relationship whatsoever to identifiable industrial or agricultural growth.

In 1982, financial institutions accounted for 5% of total corporate profits; that number rose to 41% by 2007. In 1995, the face value of asset-backed securities stood at $108 billion; within the following decade, that number had risen to $1.24 trillion. The notional value of bond default-related insurance products, which were hardly known in the early 1990s, reached $250 trillion-plus by the first quarter of this year. The Bank for International Settlements estimated that the underlying amount of over-the-counter derivatives exceeded $685 trillion as of the end of June. The daily turnover in the foreign exchange market was almost $2 trillion prior to the start of the credit crunch.

Quite clearly, policy-makers needed to distinguish between the systemic mechanisms which threatened the viability of the domestic economy, and the global economy in certain instances, on one hand and the risks posed by the largely non-productive debt and derivatives bubble on the other. The critical "systemic challenges" of protecting savings and moving credit to the engines which drive an economy cannot be confused with bailouts, many of which have been undertaken for failed business models or for business models which are evolving with each passing day.

What the equity markets are now confronted with in forthcoming months is a real contraction in business activity, further erosions in asset values, a huge downsizing of balance sheets in the banking and finance sector, a conclusive decline (and adjustment) in corporate earnings in line with the new business reality and dwindling household wealth. A cyclical bottom-picking approach is without foundation. Investors need to position themselves accordingly.

Disclosure: Author holds short positions in EEM, SPY, XLF

Comments

[PGAJAMIE411:]

Shit!

2008 Dec 31 07:29 AM

[GPC MD:]

In open and intelligent assessment of the risks involved in the macro world.

2008 Dec 31 09:23 AM

[secmaven:]

The financial talking heads would disagree!

2008 Dec 31 11:12 AM

[Trading to Win:]

Rakesh,

Have you read the book The Final Crash?

Here are a few choice quotes:

'It appears that we may be facing a meltdown rather than just a temporary slowdown, perhaps the greatest since the dawn of the Industrial Revolution.'

'Debt is utterly endemic throughout western economies: not just at government level but for individuals, corporations and financial markets alike.'

'It could prove to be the final crash for western stock markets as they wither in proportion to the deflating economies they represent.'

'The bursting of the 1980s property bubble hamstrung the Japanese financial system as banks became completely risk averse and ceased to lend money: activity ground to a halt. This is they key weakness of a debt-driven economy where constant new loans are required to continue the charade whereby growth is not organic but artificial.'

'A catch-22 situation exists whereby consumer spending is supported by consumer confidence which is supported in turn by higher house prices and home equity extraction.'

'The knock-on effect of a generational low in interest rates has inflated every asset to the hilt: there is now nothing left to pump. When the final crash comes, every active participant in the primary and secondary bubble areas will be blown away. A deflationary pin-prick now looms large.'

Happy New Year to you!!!

2008 Dec 31 01:02 PM

[carey_jim:]

I'm still in the middle of my personal own analysis of our current economic problems but my first conclusions are more optimistic than yours.

We are now facing similar dislocations that were faced during the 1930s because of technological advances, and not only because of inevitable human folly and mismanagement.

In the thirties, such technological innovations as mass electrification of factories, refrigeration, the use of trucks for distribution of goods, telephone service for the entire country, radios for the entire population, the electrification and mechanization of farms (electric milking machines) and many other revolutionary technological devices made work much more efficient, depressing prices, and made large numbers of unskilled workers unnecessary.

People think that the 40 hour work week was a great social advance when it was established in the United States by the Roosevelt administration in 1938, but it was really a social and economic necessity because there was not enough work during the Great Depression and work had become much more efficient.

The 40 hour week was a way of allowing workers to continue working, 'part-time' without thinking of themselves as part-time workers.

When we remember that there were basically no fringe benefits (pensions, health care, vacations, etc.) attached to jobs in the 1930s, we can understand that there was no downside to reducing the work week from 60 hours (typically workers worked 10 hours a day six days a week) to 40. In fact, businesses welcomed the 40 hour work week because they could hire more people and have a happier work force.

It is interesting in this regard to remember that Roosevelt said that one of his great regrets was that he was unable to reduce the work week to four days instead of five.

I think we are facing the same kind of problems with our modern technological innovations which center around communications and the ending of the brick and mortar stage of doing business.

There will be dislocations but I don't think we need to be as pessimistic as you seem to be about solutions. I don't have time to explore some interesting solutions now but I'll do so in the future.

The bottom line for Seeking Alpha is that new investment opportunities (and vehicles) might arise in surprising places and some older ones might either die out completely or become highly unprofitable.

2008 Dec 31 02:07 PM

[PROXIMO:]

This author's articles always inform and usually go deep, which is why I enjoy reading them. As opposed to the preponderance of raw sewage that is routinely laid out in many of the columns of the other alleged experts.

2008 Dec 31 02:21 PM

[SeekingTruth:]

Was not much of this

" TOO BIG TO FAIL , TOO INCOMPETENT TO COMPETE"

brought on by the actual status quo/modus operandi, but called the "New Paradigm" junket launched by our Corporate PR and skilled propagandists in the late 80's and early 90's??
We have a nation preoccupied to enter the engine boiler room to fiddle with the machinery in order to squeeze out a few more RPM's and HP from the engine, when what we need "first" are better Chartists, Navigators, and Skippers to keep us off the rocks, the sand bars, and the ice bergs, and on an intelligent course with high payback while the engine improvements are taking place.
Additionally, more raw HP and speed are of little or no use if we speeding faster in the wrong direction, we just get further from our desired destinations at a faster rate.
Unless we can somehow improve our economic and political systems across the board, little hope of significant improvements can be expected. This remains to be seen.

2008 Dec 31 04:40 PM

[Gtarras:]

Proximo
I would not be so quick about declaring the author's knowledge as deep. I personally can not speak for all he areas the author puts his opinion forward on, but in the area of my expertise, the author is usually mislead and is misleading the readers. The area is synthetic credit (ie CDSs), structured credit (ABS, CDOs), and the area of banking affected by the above.

There is always a group of people around what I call "clever fools". These folks sound smart (and they are smart), and can logically argue their views, but the specialists would always see deep flaws in their logic. for they lack the experience.

My opinion too. Could be wrong. But. For what its worth.

2008 Dec 31 09:05 PM

[Kunst:]

Once again, the world will not end this year.

Jan 01 03:15 AM

[Griz:]

I have one question: Is more credit the answer?

Jan 01 01:01 PM

[Kunst:]

Like more heroin is the answer for the addict.


On Jan 01 01:01 PM Griz wrote:

> I have one question: Is more credit the answer?

Jan 01 04:41 PM

[Griz:]

LOL.

Kunst you got it exactly!


On Jan 01 04:41 PM Kunst wrote:

> Like more heroin is the answer for the addict.

Jan 01 11:25 PM

[Rakesh Saxena:]

Thanks. I will get my hands on the book shortly. - Rakesh


On Dec 31 01:02 PM Debt Junkie Scum wrote:

> Rakesh,
>
> Have you read the book The Final Crash?
>
> Here are a few choice quotes:
>
> 'It appears that we may be facing a meltdown rather than just a temporary
> slowdown, perhaps the greatest since the dawn of the Industrial Revolution.'
>
>
> 'Debt is utterly endemic throughout western economies: not just at
> government level but for individuals, corporations and financial
> markets alike.'
>
> 'It could prove to be the final crash for western stock markets as
> they wither in proportion to the deflating economies they represent.'
>
>
> 'The bursting of the 1980s property bubble hamstrung the Japanese
> financial system as banks became completely risk averse and ceased
> to lend money: activity ground to a halt. This is they key weakness
> of a debt-driven economy where constant new loans are required to
> continue the charade whereby growth is not organic but artificial.'
>
>
> 'A catch-22 situation exists whereby consumer spending is supported
> by consumer confidence which is supported in turn by higher house
> prices and home equity extraction.'
>
> 'The knock-on effect of a generational low in interest rates has
> inflated every asset to the hilt: there is now nothing left to pump.
> When the final crash comes, every active participant in the primary
> and secondary bubble areas will be blown away. A deflationary pin-prick
> now looms large.'
>
> Happy New Year to you!!!

Jan 02 03:26 AM