Friday's $700 billion bailout was the latest in a string of attempts to address credit constipation. So what impact have it and past efforts had on markets? We compiled a chart showing when the bailouts were initiated and what happened to the Dow Jones Industrial Average afterward.
As we see from Figure 1, the first time the Fed and government intervened was when Bear Stearns got into serious trouble in the second week of March. The Fed intervened and provided guarantees to JP Morgan (JPM) so a quick deal could be done after close of markets on March 14 - 15, thereby averting what many felt could have caused a financial meltdown. As we see from the chart, it helped the Dow mount a two-month rally that ended in the third week of May.
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Figure 1 – Daily chart of the Dow Jones Industrial Average showing the impact of each successive attempt to rescue beleagured companies or stop the carnage on Wall Street, culminating with the approval of the latest $700 billion bailout Friday. Chart by Metastock.com
Next, the Indy Mac takeover was announced July 11, followed by the SEC naked short ban announcement July 15 and action July 21. That intervention triple play had the effect of buoying the Dow until the end of August.
Right after Labor Day, we learned that Fannie Mae (FNM) and Freddie Mac (FRE) needed a federal bailout. Obviously the short ban hadn't helped them but immediately instead of rallying, stocks dropped. Then the Fed had to step in to rescue (AIG) September 16, which caused markets to drop again.
After the SEC decision to stop naked short selling did little to stop the drop in stocks, it announced a short selling ban for 799 financial companies September 17. A few days later that was extended to include companies like General Electric (GE). As we see from the chart, that caused a two day blip, then the carnage resumed.
The collapse of Washington Mutual and subsequent bailout caused a smaller blip that lasted just two days. Finally, we see the impact of the passage of the $700 billion bailout Friday which caused the Dow to drop by 157 points after rallying more than 300 points earlier in the day.
As we pointed out last week, the ban on naked shorting was long overdue if only because it allowed some players to effectively counterfeit shares. Why it has been allowed for so long is beyond comprehension. But the outright ban on short selling of any kind on more than 800 companies is ludicrous.
And bailouts, while seemingly well-intentioned, appear to be having a diminishing impact with the latest bailout actually having the opposite of the desired effect, at least on stocks. Question is, will it be any more effective than past bailouts for the economy?
U.S. stocks lost more than $1 trillion this week and homeowners have lost roughly $3 trillion this year (according to the Case-Shiller Index), exposing the insignificance of recent government and Fed bailouts.
Here is another chart that shows just how bad our debt situation has grown in the last two decades. This next chart shows the ratio of total credit market debt (debt at all levels from household and corporate to government) to GDP. Since 2000 it has grown 25% faster than our economy. This ratio has doubled since 1982.
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Figure 2 – Total credit market debt to GDP percentage, showing that we hit nearly 350% in Q12008. This rate of debt increase is clearly unsustainable but more alarming is what will happen when we have a significant economic slowdown.
As of the first quarter 2008, U.S. debt was nearly 350% of GDP but that's not the scary part. Look what happened the last time we had a really serious slowdown in the early 1930s. GDP fell by 45% but debt only grew bigger, jumping from 155% in 1929 to 260% by 1932 as the economy worsened – a 67% increase in just three years.
A similar economic meltdown again, which is now looking increasingly likely, would push our total debt to GDP ratio to nearly 600%!
Now go back and take a look at our chart in our Sept 19 newsletter showing U.S. Treasury Income Flows, see http://tradesystemguru.com/content/view/214/58/#TIC. As you can see, Treasury is having a hard time selling enough now to pay the $33 billion each month our current $400 billion debt costs. Now add the cost of a host of bailouts combined with falling revenues a recession would cause. Imagine what that combination would do to interest rates… and at the worst possible time.
I don't mean to scare anyone but forewarned is forearmed. Better to hope for the best but plan for the worst than get broadsided without warning.
Disclosure: none.
