The DJIA has risen upwards of 60% since March this year. As each day passes, the belief that we have entered a long bull market, like the one that began in 1983 and ended in 2000, is strengthened. We at Keystone State Capital are skeptical of the possibility of another bull onslaught anytime soon. The reasons for our conviction are galore, while the rationale for staying invested is hard to find and more importantly, hard to digest.
Some of the key indicators and reasons for a second wave in this historic slump/depression are as follows:
1. Fall in Mortgage Demand
2. Rise in inventories
3. Total Credit
4. High Private Debt in the country
5. Limited arsenal with the Federal Reserve
6. Kondratieff Wave
7. Futility of Government efforts
8. Price to Earnings ratio, Unprecedented rise in the market
9. Sentiment Indicators
1. Fall in Mortgage demand
The supply and demand for mortgages is at a 12 year low. Mortgages are a huge source of financing for home purchases and the continual decline in mortgage creation is a clear indication of a fall in home prices. However, home prices have continually risen over the last 6 months due to a rise in speculation. Another housing bubble is unlikely to form since the bubbles are usually fueled by mortgage creation in its infancy, and that piece is missing in the housing picture. The mortgage rates recently fell to a multi decade low of 4.71% (30 year average). The lower mortgage rates reflect a lower demand for housing by Americans, a long term trend that has just begun.
The recent increases in home prices have been led by speculation and will end as the lack of mortgage availability and demand start to take effect. We can say with certainty that as the depression progresses, mortgage rates will fall to rates as low as 1% (30 year), because of low demand. However, these rates will be available to only those with good credit scores, while those with poor histories may still pay higher rates.
2. Rise in Inventories
Inventories are highly responsive to the business cycle. During the start of a bull market, companies build up inventory, ordering larger and larger amounts of goods in anticipation of more demand. The effort to hoard finished goods accelerates as prices start to rise since businesses expect to sell the goods at a higher level in the future. As a result, the anticipation of higher prices becomes a self fulfilling prophecy, due to lesser goods available for purchase.
As prices rise, so do Interest rates, leading to a decline in total credit available for production. This causes consumption to fall, causing losses to businesses. As businesses notice falling prices, they try to dump their hoarded finished goods, fearing even further price declines. This emptying of warehouses makes prices fall even more due to a surge in products on sale. As businesses fail, so do their lenders, leading to a recession. This is the inventory cycle. This theory is evidenced through the following graph on the inventory to sales ratio in the motor vehicle industry. Here, the motor vehicle and parts dealer inventories fell from October 2008 until October 2009.
The fall in the inventories is a sign that the surplus produce has been dumped and that the price would face less downward pressures. However, recent increase in the sentiment amongst businesses and an expectation of higher demand and prices in the future is causing inventories to rise again. The increase in inventories can be extremely harmful since when the demand starts to fall again, the businesses would again dump this inventory and that would cause greater price declines and greater losses to the businesses who were expecting higher revenue per unit. Such failures would again cause the banks to restrict credit and that would make the country suffer more.
3. Total Credit
Total credit extended by banks has fallen continually since the start of the recession. Credit is used by most companies in the country, and therefore the threat of a sudden reduction in availability of credit intensified fears of a major downturn. As the credit keeps falling, it becomes difficult for businesses to maintain production and they start to layoff surplus labor. The total money lent through credit lines has fallen over 10% in the last year. In addition, credit for consumers has fallen since the 3rd Quarter of 2008. (see below)
According to a survey conducted by the Federal Reserve, 15% of the commercial banks restricted credit in the three months up to October, while 16% of the banks lowered credit availability to the smaller companies. In addition, more than a quarter of the total banks reduced residential real estate loans during the same period. It has also become difficult for real estate developers to seek funds from banks and they are turning to more private sources for financing.
Banks have increased their loan loss reserves (the reserves they set aside to cover for future expected losses from non performing loans) by 25% over the last 2 years. However, this increase in reserves comes at the expense of potential loans and prevents small and large businesses from maintaining full employment. A chief symptom of a recession is lesser loan availability and until that changes its direction the economy will not either.
4. High Private Debt in the country:
Reams of sheets have been filled by economists worried about the heavily leveraged consumers and businesses. We however find the fear completely justified. The real and the most important reason why there can be no recovery in the next 5 years is the overburdened household in this country. The households are neck deep in debt and are desperately trying to survive by reducing their borrowing and paying off their debt. The best precedent we have for such a sequence of events is that of the Great Depression. During the 1920s, the private debt built up in the country took the businesses and consumers 10 years to whittle down. It should be no different this time.
As people deleverage, they save their incomes to pay off the debt, that debt money is not relent since the leveraged up do not borrow any more. The borrowing does not pickup until the debt is down. The best solution to the problem of high debt is massive defaults and bank failures. This would allow the indebtedness to fall and the failed banks would be acquired by the healthy ones sooner, giving way to a healthy economy once again.
According to the Fed, the household debt came down from 135% of the GDP to 122% of the GDP between 2007 and 2009. The slow pace of decline in debt is an indicator that the slump might continue for long. The household debt must decline to 50% of the GDP before the recession is over.
5. Limited Arsenal with the Federal Reserve
The Federal Reserve lowered the Federal Funds Rate to 0% from 5.5% in July 2007. The Federal Funds Rate (FFR) is the rate banks charge to each other for funds. The Federal Reserve lowers the FFR whenever it wants to make money cheap; it does that by increasing the total reserves available at banks. The Federal Reserve also runs the discount window, which is used by banks to borrow directly from the Federal Reserve. The Discount window has been used extensively to lend hundreds of billions of Dollars since 2008.
In addition, the Fed introduced a guarantee scheme for the Money Market Mutual Funds in September 2008. Money market mutual funds buy short term debt from public companies. As Lehman Brothers (OTC:LEHMQ) defaulted on its debt, many money market mutual funds lost money since they had bought Lehman’s debt. As a result, they restricted credit and there developed a huge shortage of capital. The Federal Reserve then stepped in to guarantee the returns of all money market mutual funds. This step generated confidence in the system, but was still insufficient to convince the banks to lend, whose debt was not guaranteed by the Federal Reserve.
The Fed has increased the total amount of money issued by it from $850 billion to $2.1 trillion within a year. It had taken the Fed 14 years to double the monetary base from 1994 to 2008, while it took just a few months to double it again in the 3rd Quarter of 2008. Despite these additions, the total credit issued by the banks has declined continuously.
Even though the Federal Reserve has employed most of the tools at its disposal, it has yet to solve the biggest problem facing the country, high indebtedness of the households. The Federal Reserve, in fact, has no tools to control borrowing, it can only control lending. Therefore, even if the banks were to begin to lend normally, the economy would still face problems since the total money loaned out by banks would remain low. Hence, we would conclude that the Federal Reserve, though vastly stabilizing is still sterile before the massive deleveraging we would see in the coming years.
6. Kondratieff Wave
Kondratieff Cycles are long cycles that have an average length of between 55-65 years. Each cycle depicts waves of inflation and deflation, lasting usually the same time. As a cycle begins, inflation is low, but constantly rising; this portion of the cycle lasts 10-15 years, culminating in high inflation, as seen during the First World War and the 1970s. Then comes a time of falling inflation (constant reduction in the rate of annual price increases), culminating in Deflation.
The importance of the Kondratieff cycle is derived from the deflationary pressures last year. We understand the current cycle to have begun around 1932, at the lows in the stock market during the Great Depression. Then came the era of rising inflation, culminating in the 1970s, when we saw high inflation. That period was followed by falling inflation, which we saw between 1982 and 2007. We expect that period to have ended, and the period of deflation to have begun. This deflation started in 2007-2008, and should last till at least 2012-2014. The same pattern is mapped in the cycle from 1896-1932. Here, inflation started rising until it zoomed during the First World War, followed by falling inflation and then deflation during the Depression in the 30s.
The graph shows the 4 most recent Kondratieff cycles. The first 2 lasted around 55-65 years, while the last 2 have been more disorderly. However, the sum of the duration of the 2 last Kondratieff cycles is 36+78 = 114, which when divided by 2 gives us 57 years. The Kondratieff cycles were discovered by Nikolai Kondratiev, a Russian economist in 1925.
7. Futility of Government efforts
The government has tried its hand at many different life saving schemes since 2008. The chief of which is the TARP (The Troubled Asset Relief Program). The TARP was formed to recapitalize the banks, which had lost equity due to the increase in delinquencies on mortgages. The TARP bailed out many banks and was largely able to convince the bigger banks to lend again. As the graph on total lending clearly shows, the government efforts have not been entirely successful since the credit levels have deteriorated consistently since last year.
The other important scheme from the government was the $787 billion stimulus, which was designed to increase consumption. This effort has completely failed. First of all, any government borrowing is bad for the economy since the government borrows scarce capital that would otherwise have been lent to the private sector to produce. This causes a reduction in the supply of goods in the economy and makes everyone poorer as a result. However, there is a school of economics that believes that during recessions the government should step in to borrow and spend since banks usually do not lend to businesses at that time anyways. This effort may bring fruits in some situations, unless if there is deleveraging going on. If the process of deleveraging has not concluded, then no amount of bank willingness can help the economy since the borrowers themselves are less eager to borrow.
The other wasteful and time consuming tactic was the mortgage bailout plan, which intended to keep mortgage holders in their homes by having the banks reduce their mortgage balances. Around 650,000 mortgages were put on a new trial modification, with the promise that they’d be made permanent eventually. This program has yielded poor results since most mortgages have not been made permanent in almost 10 months, much longer than the estimated required time period of 3 months. Also, it is highly unlikely that people who do receive permanent mortgages will not become delinquent again, since more than 50% of the people who received modifications in 2008 were again delinquent within 6 months. The government’s efforts might be honest and helpful but they are not sufficient to stop the wave of foreclosures coming in the next few years.
8. Price to Earnings ratio, Unprecedented rise in the market
The Price to Earnings ratio shows how expensive stocks are at any given time. The below graph shows that the P/E ratio fluctuates during cycles. It often becomes too high during booms and become too low during busts. It usually tops around 30 or above and bottoms around 5. It bottomed at close to 5 in 1932 as well as in 1982. Both these years marked the end of long and deep recessions. During these recessions, both earnings and stock prices fell, however stocks fell faster than earnings, causing the P/E ratio to become too low. Conversely, in 1929 and 2000, the stock price increases had superseded the increase in earnings and that led to a high P/E ratio.
Since 2000, the P/E ratio has fallen from close to 43 to 20.06 in December 2009. We expect the P/E ratio to reach its historical low of 5 by the end of the depression. All of the fundamental reasons support this technical analysis.
Another piece of statistical data suggests that the market’s historical ascent, starting in March 2009 and still continuing, is close to a reversal. The DJIA has not risen so much in such less time in recorded history. A few large climbs and the subsequent declines are stated below.
11/13/1929 - 4/17/1930 (106 days) the market rose 48%. The market fell 85% for the next 2 years, until 1932.
3/31/1938 - 11/9/1938 (a period of 153 days) the market rose 59.8%. The market fell 40% over the next 4 years, until 1942.
03/09/2009 till now (a period of 250 days) the market has risen 65% so far. We expect the market to fall 70-80% form these levels over the next two to four years.
9. Sentiment Indicators
Sentiment indicators are contrarian indicators. They track the sentiments of traders to know when they are betting on an instrument collectively. This alerts the contrarian (one who usually takes positions opposite to those of the masses) to stay away from those particular trades, if not take the opposite position. The use of sentiment indicators is widespread amongst technical analysts, and is often best left to the professional. These indicators are not scientific but work on a simple logical rationale that once a majority of traders become bullish on a particular instrument, they are assumed to have already taken suitable positions and that only a small minority has been left with enough spare cash and the ability to buy more of that instrument so as to keep its price high. As usually happens, this minority decides not to buy that instrument and hence there are no new buyers, so the prices start to fall.
A few good examples of these sentiment indicators are from recent times. In March 2008, Gold peaked at $1032 an ounce; the sentiment index showed that 98% of the traders were bullish on Gold, and sure enough, Gold prices fell after that.
In January this year, the Dollar index was at 90, after having risen from 70 in May 2008, surprising most traders who were betting that it would decline. At 90, 96% of the traders were betting that the Dollar would keep rising in value, but not ironically, the Dollar started to fall soon after, and has reached a level of 74 in December 2009.
The sentiment indicator has good predictive value and is mostly right when sentiments are at extremes. The traders, having noticed a 65% increase in the S&P 500 since March 2009, are again extremely bullish and more than 90% of them are betting that the market would continue to rise. We believe this is a good enough reason to be bearish on the market. On a more personal level, we find it difficult to believe that so many traders could ever be right altogether. Baron Rothschild, member of the Rothschild family said that you should “buy when there is blood in the street”. As far as we can see, there is no blood on the streets right now, only euphoria and celebration.
The only solution to the crisis is letting the households and businesses deleverage as soon as possible. The governments should allow and encourage the banks to file for bankruptcy so they can start afresh. The sooner the debt levels come down, the sooner we would see a recovery.