The Market's Disassociation with Reality

In the beginning of the 2001 film Blow, which told the story of one of the 1970s largest cocaine importers; the father of the boy who would become the cocaine dealer tells him during a family financial crisis “ Money isn't real, George. It doesn't matter. It only seems like it does”.

The line stuck with me. Not in the sense that money isn't important or shouldn't be desired, but that money is an abstract idea, whose value is often disassociated from any practical or economic reality. Ask any professional poker player who during the year will see his or her cash reserves swing wildly, and they will tell you, that if you hold money to be something sacred then you will never make it in the money making game.

On October 3^rd 2008, Congress passed the 700 billion dollar bailout package that we were told was going to rescue the financial sector and save the economy from imminent collapse. To me, and most other folks, this is an abstract number. I think that even to Saudi Arabian royalty, the value of 700 billion dollars is something they probably would have a hard time getting their minds around. Suppose it was a one trillion dollar bailout package, would our perception of it change? After all, at these levels, what's 300 billion dollars between political parties (and the taxpayer)?

Want another really big number? How about ten trillion, which is the approximate national debt of the United States. Of course, even if it was 100 trillion, I doubt that it would elicit a reaction, since at these levels its impossible to put a value as to what this number actually means. You can divide the ten trillion by the population of the United States, and get a dept per individual number of around $33,000. This is a more manageable figure, but again, what does it mean? Does it mean that at some point I am going to have to cough up the thirty-three grand?

Here is another really big number, and I promise it will be the last one, 26,983,080,000,000. That's almost 27 trillion, and it is the approximate value of all the residential real estate in the United States. By doing a quick internet search, I found that about 102 million people own their own home, and the average price of a U.S home is around $264,540. Multiply one by the other and you get approximately 27 trillion.

I admit that I can be off by a few trillion, but at these levels a few trillion is as they say, a drop in the bucket. Actually, every number in this paragraph except for the number of people owning their own home is at best, a poor approximation. No one really knows what a home is actually worth until it is sold, so it becomes impossible to estimate the total value of the U.S real estate now, and especially into the future. But since this is all hearsay anyway lets go with the 27 trillion. Suppose that real estate prices drop another 10%., a very realistic scenario. This mean a loss of 2.7 trillion in the nation's residential real estate value. I am not even considering commercial real estate. Subtract the mighty bailout package of 700 billion from the 2.7 trillion, and we are still in the hole for two trillion dollars.

What if real estate prices fall by 20%, or more? Think it can't happen? Not here? In the 1980s and 1990s, following their own real estate bubble, Japan experienced a real estate market drop that lasted for more than 15 years. In some Japanese regions, prices dropped by more then 80%. We also have to keep in mind that Japan is one of the most densely populated countries, with very limited areas left for development. Now compare that with the U.S, which has plenty of buildable living space, and the outlook for a quick fix appears even more grim.

Okay, enough with the real estate already. Like me, you are probably more interested in the real action, and these days the real action is in the stock market. On October 3^rd, the day the bailout bill was passed, the S&P 500 closed at 1,099.23, and yesterday rested at 998.01. These are smaller numbers than the ones we have dealt with thus far, but they are nevertheless numbers whose values are somewhat abstract. The S&P 500 is an index that represents the value of the 500 market-value weighted companies that it is comprised of. Of course, these days the market value of those 500 companies swings several percent on an hourly bases. So no one really knows what the value of those companies or the S&P 500 should be. What we do know is that the market values of these companies is usually several times their actually book values. This is because investors factor in the company's future earnings and growth into the stock price.

However, just like with real estate prices, there is absolutely no reason why the S&P can't fall any further. Even if the value of the S&P 500 index dropped by 50%, most of the companies that make up the index would still be trading well above their book values. Let's face it, there have been plenty of market crashes, where the stock indexes fell by more than 40%, and we aren't even close to that.

Do I really think that the scenarios I just described will come to fruition in the near future? I can honestly say that I don't know, and I hope not. But I also think that it is extremely important that we understand and prepare for outcomes that might bring some economic hardships. We won't hear even the possibility of these scenarios, from politicians who will say and do anything to make us believe that everything is going just as planned, at least while they are in office. And representatives from Wall Street will also continue to preach to us that the markets are safe and secure in order to realize their own agendas. After all, a boat salesman is not going to tell you that his boats are leaking. So it is up to the individual to make up his/her own mind, and to realize, that most economic and financial figures are representations of information that is at best outdated by the time you read it, and at worst a complete misrepresentation of reality even at the time of their compilation.

Comments

[moc1166:]

Thank you!

Someone who has told the truth. Now if this truth could be spread in the national media as fast as the false information that is out there.

There is no credit crisis. I still get the same amount of junk mail and phone calls offering me credit. I have actually received more in the last few weeks than ever before.

Now that gas prices have come down and people"s budgets are falling back into line there will be a turnaround. It is just going to take time. Some knee jerk reaction from the government is not going to solve the problem no matter how much money they throw at it.

2008 Oct 15 08:18 AM

[win:]

"Let's face it, there have been plenty of market crashes, where the stock indexes fell by more than 40%, and we aren't even close to that."

Really? Now that is really stretching the numbers.

Check your math, sir. From peak to trough - from October 2007 to October 10, 2008, the SP 500 fell from 1560 to 844. 40% off of 1560 is SP 936. We fell 46% from peak to the recent trough.

2008 Oct 15 08:33 AM

[SusanGrisanti:]

This is excellent information, after all money is just a tool, and like any other tool some folks are better managers of it than others. If corporations ran their business like the US has, they'd all be out of business.

2008 Oct 15 08:41 AM

[xsuddensam:]

The politicians and bankers are being disingenuous. They are trying to assure a very concerned public that this credit crisis is manageable and that there is no need for panic. Yes, the immedate credit crisis may be manageable, but they are not giving us fair warning regarding the oncoming meltdown of insurance companies, credit default swaps and commercial real estate and consumer credit loans. Treasury and the Fed will not be able to print their way out of these huge onrushing financial problems. A catastrophe is looming and nobody is sounding the alarm.

2008 Oct 15 08:48 AM

[john1940:]

Common sense and realistic viewpoints have no place on financial blogs. Last summer Morgan Stanley published a favorable report on AIG, LEH, etc. 90 days later they were gone. This is the approach investors want.

2008 Oct 15 09:37 AM

[carey_jim:]

A good way to think of large numbers is to compare them to something.

For example, if the population of America is roughly 300,000 people then:

1 billion dollars represents about 3 dollars for each person.

1 trillion dollar represents about 3,000 dollars per person (a thousand billion.)

The 700 billion dollar bailout represents, therefore, about 2700 dollars per person.

As far as predicting the future, history teaches us how difficult that is. For example, most people thought that World War I would last a couple of weeks at most, and almost no one predicted the French Revolution. Almost everyone in America and Europe underestimated the danger of Hitler and the Nazis. These are not isolated examples.

Your point that "money is an abstract idea, whose value is often disassociated from any practical or economic reality" is true but not often understood.

What modern mathematical economics fails to understand is that people are not simply driven to maximize pleasure as represented abstractly by so many units of cash in the bank, but instead people are complex, social animals driven by a need to excel and find prestige and power in various social activities.

The Soviet Union should have taught us that the same striving for prestige and privilege can occur under "socialism" (state capitalism) as under any system. The only difference is the way we keep score.

"The difference between men and boys is the price of their toys" was probably first uttered by by an astonished mother comparing her son and husband, but it is true nevertheless.

2008 Oct 15 09:44 AM

[Kelly Liebe...:]

"So it is up to the individual to make up his/her own mind, and to realize, that most economic and financial figures are representations of information that is at best outdated by the time you read it, and at worst a complete misrepresentation of reality even at the time of their compilation"

World economic meltdown. period. You have been warned. Now, prepare yourself.

2008 Oct 15 09:48 AM

[wallyjm:]

money here is fiat money and just has value based on faith. many stocks have tangible value and real weath.

2008 Oct 15 01:10 PM

[Here's a th...:]

Gennady,
Nicely written I look forward to reading more from you.

2008 Oct 15 01:43 PM

[nova:]

Unfortunately, politicians and economists do not understand and comprehend the gravity of the present economic & political catastrophe facing the world.

Everybody is looking for an "easy" and painless solution. However, there is none available anymore. The present situation reminds me a cancer: either a patient deals with it early and decisively or the patient is doomed.

So far, the time and money were wasted on bandages...
The US Fed and Treasury remind me Don Quixote and Sancho Pansa instead of serious efforts to address and manage the situation.

2008 Oct 15 09:25 PM

[Moon Kil Woong:]

Ummm US real estate is only $15.7 trillion. US debt is more factoring in off balance sheet costs (around an estimated $18 trillion). The CDS (credit default swap market/racket is $61 trillion. So as you can see a lot of gambling on real estate occurred with no regulation occurred among bankrupt institutions. Who will foot the bill? The US net worth is only $71.5 trillion. Hmmm, sounds like another Iceland situation except even Russia couldn't loan us enough money to dig us out of this hole.

As of today of the $71.5 trillion we has about $8 trillion just dissapeared in the stock market... So now we have $63.5 trillion and if real estate drops another 10$ we loose 1.5 trillion more = $62 trillion. Argh... it looks worse and worse...

2008 Oct 15 11:06 PM

[imab:]

At today's closing, the the S&P 500 is off 43% from it's historical high. The only reason why it may go down further is because buyers are reluctant to buy. The reasons are self made, just like buyers make up reasons to buy at the height of the internet bubble, they are not buying now for all the reasons they can think of. As long as buyers refuse to buy the market will go down further.
However, at a certain price, greed will take over as everyone likes a bargain. At what price will buyers believe the market is a bargain nobody knows. But when there are ample bargain hunters coming in, then the market stops going down. I personally believe we are within 3 months and 15 - 20% from the bottom based on todays closing. At that time, I'll be betting the farm as this will be the bargain of a lifetime.

John

2008 Oct 16 12:00 AM

[Diegojames:]

These are trivial numbers with attachments some might find entertaining.
The REALITY is the ECONOMY OF THE USA is damaged by a FALSE system of POLITICAL INTERACTION with FINANCIAL INSTITUTIONS.

THERE IS NO EXAMPLE IN HISTORY WHERE PROPERTY WAS GIVEN TO THE MASSES WITH PHONY FINANCING.

I need a new car with a hybrid power plant ,perhaps turbo diesel and silver-zinc batteries or CNG spiked with additives.Oh I forgot we have let our auto industry fail. I need my retirement money replaced because I do not want to live in a YURT because some idiot in CONGRESS living with a Fannie-Freddie management member did sweetheart deals for other Congressman and presidential candidates WITH lobby money.

So some number crunching "QUANT" may see a potential 15% drop below previous lows for major oil companies or late cyclical S and P 500 industrials but I will be buying COP, CVX , MDR, and AA , PCCAR, TCK as the DOW crosses 7800 with everything I can beg, borrow or steal(now that it is legal)

I will park half my cash in ALCOA-AA- when its dividend becomes 5% or greater. Aluminum is always in demand and everything will be smaller and lighter in the future. 5% is better than TREASURIES. More later my wife caught me stealing her jewelry.

DIEGOJAMES
PORTER RANCH , CALIFORNIA
STILL SUNNY AFTER THE FIRES

2008 Oct 16 12:23 AM

[TinyMIghty:]

I will consider to invest my money when the DOW goes down to the 1/3 of October 2007 high. Since the economy runs on the highly leveraged pace of 1 to 30, it might be a O.K. number to get back to the normal leverage of 1 to 9 ratio. It is still high for me since I do not need any credit to manage my fianance, but commercial banks are running on that rate. I am going to wait to see where and when this credibility issues of the financial institutions and the U.S. government are going to settle.

2008 Oct 16 12:34 AM