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To See the Future

This newsletter was originally published on June 10th at TheDraconian.com

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This week we'll review the markets and see if we can catch a glimpse of the future.  We'll also talk about another potential booby trap to watch out for.  But before we do, we'll try and get some historical context.  As is our custom, we shall look beyond the traditional world of economics and politics to see what we can learn.

30,000 years of barbarism

The First Galactic Empire had endured for tens of thousands of years.  It had included all the planets of the Galaxy in a centralized rule, sometimes tyrannical, sometimes benevolent, always orderly.  Human beings had forgotten that any other form of existence could be.

-Isaac Asimov, Second Foundation

Let that sink in for a moment.

Remember the days when none of us could fathom a U.S. economy that barely grows or a housing market that never goes down?  Remember when we thought 5% unemployment was where we'd always stay and that the stock market would go up every decade?  We forgot that things could be different, despite centuries of evidence to the contrary.  We have learned our lesson now, yes?  Our history is a history of unforeseen change.

If you're unfamiliar with Isaac Asimov's Foundation trilogy, you need to know that it's one of the most important works in the world of science fiction.  If you're a fan of literature, it belongs on your bookshelf.  The story centers on Hari Seldon, a genius mathematician who develops a new science that can accurately predict the broad path of the future.  He foresees, against all popular opinion, that the mighty Empire, having enjoyed tens of thousands of years of unified peace and prosperity, is actually on the brink of collapse, a collapse that will thrust the entire galaxy into 30,000 years of chaos and barbarism.  Averting the collapse is impossible, but Seldon proposes a plan to reduce the coming Dark Age from 30,000 years to a single millennium.  Exactly how this happens is told in Foundation and subsequent books.

Like all great science fiction, Asimov's works are a comment on society.  In fact, he drew most of the inspiration for his Foundation series from Edward Gibbon's The History of the Decline and Fall of the Roman Empire, the definitive chronicle of the dark years that followed one of history's greatest empires.   Asimov wrote the original trilogy in the early 1950's, a time when the U.S. was finally emerging from it's own miniature Dark Age.  A lot of major stuff was published during that era which today is recognized as the golden age of science fiction.  It was a difficult time for the world, a time when a lot needed to be said about society.  Sci-fi legends like Asimov, Robert Heinlein, and Arthur C. Clarke did the philosophical heavy lifting and taught us about the world and ourselves in the process.

If you've been reading The Draconian for any length of time, you know that it's our belief that we are at the beginning of an era of hardship.  For lack of a more precise estimate, we think it will last for a decade or so.  During this period everyone will sacrifice, and the sacrifice will take different forms depending on how much money you make.  If you make a lot of money, you'll have to contribute in the form of higher taxes and tougher policies on top-decile pay.  If you don't make a lot of money, you'll have to contribute in the form of reduced entitlements and benefits.  All of us will have to contribute in the form of a more difficult, more competitive job market and a permanently higher natural rate of unemployment.  Business will be slower; incomes will stagnate.  The risk of inflation is still quite a ways out, and that will be another way that we all pay.  That might be the final way we buy our departure from this debt-fueled gravy train.

This is not a popular view at present.

Unfortunately, we are not geniuses like Hari Seldon and we don't have a plan to shrink this decade of hardship into just one year.  You may have noticed that the leaders of the U.S. Empire think they aregeniuses and have been trying with all their might to soften this forthcoming decade of hardship through bailouts, stimulus, and good ol' fashioned money-printing.  Those of you that are paying attention will also notice that these actions are exacerbating many of the problems that brought about the crisis in the first place.  We have treated the symptoms but have made little attempt to cure the disease.

Elder wisdom

It's been a full generational cycle since our last era of major hardship and sacrifice, the one that Asimov wrote about under the guise of distant galaxies, alien spaceships, and sentient robots.  There have certainly been no shortage of books on the economy in the last couple years.  A few are even pretty good, but sometimes I learn a little more about where we are today by going further back and revisiting some of that classic science fiction.  It's why I read Isaac Asimov.

It's also why I read Richard Russell.

Richard Russell was part of the GI generation, who grew up during the Depression and fought in WWII.  There aren't many of his kind still around.  Even fewer are actively writing about the markets today.  Russell certainly has his share of critics, most of whom harp on his never-ending pessimism of fiat currencies and undying love of gold, but he brings a perspective that's unique.  In short, he has seen things that the rest of us haven't.

Something he wrote over on Dow Theory Letters last week really stuck with me:

I'm aware that many of my subscribers are skeptical of my warnings regarding the years ahead.  The generations since the end of World War II have never experienced hard times.  I'm aware that it is difficult to envision what you have never experienced.  If I have one unusual talent, it's the ability to envision vast change.

I've been reading his newsletter since 2003.  I've read enough to know that he's right about as often as he's wrong (the best any of us can hope for, I suppose).  But I don't read his newsletter for specific recommendations on this or that.  I read it to be reminded of all that came before me and the generations that currently populate the country.  It's one of the few places I can go to get that.  For the most part, we have lost our tangible, living connection to the last era of national crisis.  The folks who have real memories of the Depression and War, whose values were permanently re-shaped by those dark times, have almost died out.

It's worth mentioning that the dawn of the Great Depression crisis was a time when those people who had actual memories of the Civil War, the previous major national crisis, had mostly died out.  Very few people in the late 1920's had the capacity to imagine life being any other way.  And when the Civil War cleaved the nation in two, there weren't many still around who actually experienced the chaos and barbarism of life in Revolutionary America.  Things had been going pretty well for about 70 years; who could have possibly imagined such a traumatic affair was right around the corner?

I'm sure there's a reason why history writes itself this way.  Just as we all forget the lessons we were supposed to have learned, something happens to teach us again, something that will keep us from ever forgetting.  But then we die, and the cycle repeats for a new wave of generations.

I guess this is why I cling so tightly to living perspectives from that era, perspectives like Richard Russell's.  My grandfather on my mother's side came from a wealthy family that lost everything in the crash; as a young adult he was shipped off to Germany to fight on the ground.  I know little beyond the facts I've been told and little about the kind of person he was, evidence that has now been swallowed by history.  He died when I was very young, but what I wouldn't give to really get to know him today.

He certainly wasn't the only young man to have an experience like that, to lose everything and risk his entire future in a bloody war.  If you're fortunate enough to know someone in the family -- a parent, grandparent, or maybe a great great-uncle -- ask them about eras of sweeping change.  Ask them what they think of things today and if the rest of us are too narrow with our view of the present and future.

When I was a child, my parents instilled in me a genuine respect for others, particularly my elders.  I suppose that is the kind of thing that one can teach, but we really have to learn for ourselves the true value of our elders' experience.  Unfortunately, most of them are gone by the time we mature to an age where we recognize the importance of this.  When we are finally ready to drink from that fountain of wisdom, it's all dried up.

One of the great ironies of life and history, I guess.

Risks that few are talking about

If you follow John Hussman, you've noticed that in the year since the crisis he has been talking primarily about two things:

  1. The U.S. policy of defending bondholders who made bad loans.
  2. A second round of credit strains triggered by a second round mortgage rate resets.

As for the defense of bondholders, I continue to believe it's a policy of madness.  People that make risky loans should have to pay the price if the loans go bad, not the taxpayer.  With those kinds of consequences, maybe your bank and your pension fund will think twice before making risky moves to pick up another percent or two of yield.  I know that sounds common sense, but an idea like that apparently qualifies as too draconian for our pain-sensitive society.  Heaven forbid a large financial institution makes a loan and doesn't get 100 cents back on the dollar!

The bailout reaction of the EU debt crisis is an extension of that mindset.  They avoided a panic, yes.  But they made the problem worse.  Within the sphere of politics, I will be paying close attention to trends toward any reluctance to make bondholders whole when the debts go bad.  I'll let you know if I identify anything on this front.  It will be a step in the right direction for our system.

As for the second round of credit strains, all you regular readers should now be familiar with this old chart:

Here's a revised version:

As you can see, 2009 was a lull for mortgage resets.  In retrospect, that was probably the best thing the credit markets and financial system could have asked for.  It did a lot to temporarily calm things down on the credit front.

Keep in mind that what first broke the back of the market was the resetting of all those subprime loans.  All those subprime borrowers initially got their loans with awesome terms like low teaser rates, 0% down payments, and the option to pay only the interest each month.  Those awesome terms only lasted for a couple of years, not that the bankers really talked about what life would be like once their mortgage reset.  That didn't start happening until 2007.  The fantasy terms disappeared and those borrowers' monthly payments went way, way up.  They could afford the fantasy terms but real-life terms were way too expensive so they stopped paying their mortgage, a decision made much easier after they'd seen their house lose 20, 30, or 40 percent of its value.  "Screw this!" they said.  "This is the bank's problem now!"

Then the whole financial system fell apart.

I know you guys have all heard that story before, but get ready to hear it again through this fall and winter of 2011.  It won't play out exactly as it did, nor will the system react in the same way.  The Fed & Treasury have made clear through their policy that they will not let systemically important firms implode and will inject them with enough capital to keep them solvent (aka Japanese Zombie Bank Policy).  The new, surprisingly-soft financial regulation measures won't interfere too much with the way of life that large banks have recently enjoyed.  So there won't be an industry meltdown a la Fall 2008.

But there will be some effects.  I know everybody is desensitized to Really Big Numbers right now, but if you think a TRILLION DOLLARS of resetting mortgages in the next year or two -- mortgages that are resetting from awesome terms to considerably less-awesome terms -- won't have an effect on the system, then I don't think I can't help you.  Loans that are good right now will go bad, and these new delinquencies will have systemic and economic consequences.  The market will react accordingly when one day it wakes up and realizes that this could pose a threat.  Recall that Greece didn't go bad overnight, though the market's reaction to it would indicate otherwise.  One week the market thought it wasn't a big risk and the next week it did.

We talked about booby traps a couple of weeks agoThis new round of resetting mortgages is a booby trap that the market hasn't stumbled into yet.

The good news is that things will be looking much better on this front by 2013!  A few years after that, we might actually have a normal mortgage market again.

Market recap

In short, volatility continues:

For all you technicians out there, I've got my eye on a few key levels:

1220 - We're still a long way from the high.  A close above that level would be positive, indicative of a resumption of the cyclical bull market that began last spring.

The 200 day moving average - Since we violated the 200 day moving average, I would be much less inclined to buy on dips now.  If you still haven't taken profits on any gains on your equities yet, look to do so on the next rally.  What's most disturbing is that the market has rallied twice right up to that 200 day moving average, bumped its head, and sold back down.

1040ish - This is where most of the technical support is, and this is the level at which the market has recently rallied off of.  A decisive close below this level would be very, very bad.

976 - This represents a 20% decline for the market from its cyclical bull peak.  While 10% is the level that generally describes a "market correction", 20% is the level that generally describes a "bear market".   If we break 976 on the S&P it will officially be a cyclical bear market (within a secular bear market).  As you can imagine, that's not a good sign.  There is little technical support beyond that, so the market will sell off until it finds a new low.  The only significant price is 666.79, the bottom of the market last March.  The closer we get to that level, the more I'd want to buy higher-flying growth stocks that will most likely be beaten down on fears of a sluggish economy.

In the last couple of weeks I've mentioned that I'm starting to see some semi-compelling values in specific stocks.  Things aren't as cheap as they might get over the course of this year and next, but more sensible valuations are a good sign.  If you are bored and desperate to invest in something, there are far worse places you can go than strong, stable companies trading at fair multiples, especially if they have prospects for growth.  Especially if that growth will be happening in Asia and not Europe.  All the better if they pay a dividend.

McDonald's is a name that fits those criteria.  Colgate Palmolive is another one to look at, as well as Du Pont, Verizon, and Becton Dickinson.  Same with the integrated oil & gas companies that have been unfairly dragged down with BP.

Are these boring companies?  Yes, these are boring companies.  Does that make me a boring guy?  Yes, it makes me a boring guy.  But that doesn't bother me because I think I'll make more money over the next decade with boring strategies than the guy who goes all in on the bank stocks or chases other hot, shiny sectors.

In 2020 or 2025 when we've worked out real solutions to our economic problems and the dark times have officially passed (don't worry, they will).  When the future is once again filled with hope and optimism, my goal is to have a few bucks at the ready so I can waste no time getting out there and having some fun.

After such sacrifice, we'll all certainly need it. 

Disclosure: No Positions

Disclosure: No positions