Drip, Drip, Drip: Then the Dam Collapses

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So do stock
markets.

Day after
day, there is bad news from the banking sector in Europe and America.
There is bad news from the housing markets all over the world. There
is bad news from the Institute for Supply Management, which reports
on the state of suppliers. The service sector in January fell to
41.9%, with 50% as the borderline between contraction and expansion.
In December, it was 54.4%. This is a very sharp decline.

The drip,
drip, drip of bad news has a cumulative effect. It undermines investors’
confidence in the economy. This calls the stock market into question.

PANIC
SELLING

Panic selling
does not hit a market without warning, smashing it into a meltdown
that lasts for years. It hits after years of nagging doubts, followed
by months of bad news in relentless sound bites, and then one unpredictable
event that triggers a massive one-day sell-off, which is followed
by more days of sell-offs.

Woe unto the
investor who is caught fully invested in that initial sell-off.
He will look in horror, paralyzed, denying the obvious. The market
keeps going down, day after day. Tout TV commentators (age 30) interview
fund managers, who deny that it’s a meltdown, recommend “buying
sector stocks,” and say, “Buy on the dips.” Dips? The market is
collapsing. Then the poor soul who bought and held finally calls
his broker or sends a message to his retirement fund: “Sell!”

Too late.

Once smashed,
a market can take years to recover. Gold and silver did not recover
for 21 years, 1980—2001.

We have seen
this kind of sell-off more recently. It began on March 24, 2000.
On that day, the NASDAQ peaked, intra-day, at 5132.52. It closed
at 5048. This marked the end of the dot-com bubble. You
need to see a graph of that collapse
, just to remind yourself
of just how bad it can be next time.

It bottomed
on October 9, 2002 at 1114.

On January
2, 2002, it closed at 2059. That was down 60% from the peak. The
chart of that decline looked bad. But wasn’t good news straight
ahead? Hadn’t the bad news been discounted? No. The NASDAQ fell
another 46% over the next ten months. Look
at the chart.

Today, it
is in the range of 2300.

The consumer
price index has risen by over 20%, 2000 to 2008. (www.bls.gov).
It rose by 15%, 2002—2008. So, discounting for price inflation,
the NASDAQ is lower today than it was in early January, 2002. Plus,
the person who bought and held in 2002 suffered a 46% loss of capital
in 2002. Had he sold in January and repurchased in October in a
tax-deferred IRA or other retirement fund, he would have avoided
this loss.

I know people
who told me in January, 2000, that the NASDAQ’s price/earnings ratio
of 206 was reasonable. I thought it wasn’t, and I warned my readers
to sell in February and March.

No one on
Tout TV ever mentions this. No one says, “This can easily happen
again.” No one says, “The NASDAQ has been in a bear market ever
since March 24, 2000. The recovery after October 2002 is a bear
market rally. That rally is fading.”

VOLATILITY

Day after
day, the Dow is up or down 100 points or more, sometimes 200, sometimes
more. Why? If the best forecasting minds on earth agree on the value
of shares, shouldn’t the Dow rise or fall by under 50 points? Shouldn’t
there be a trend, one way or the other?

We are seeing
massive moves in and out of shares. The experts are not only not
agreed, they are not agreed in a fundamental way. These are not
random moves, in the sense of movements in response to unknown changes
in perception at the margin. These are clashes between fundamental
views of the future of this stock market and the international economy.

Yes, these
views are at the margin. All economic change is at the margin. But
these are much larger moves than normal. The investors at the margin
are much more aggressive, and they do not agree on what is coming.

The investor
with money in his pension fund looks at these swings, and he has
to wonder: “What’s going on? Why is the stock market so volatile?
Why are downward moves so big? Why does the market rebound briefly,
then fall again?”

He sees volatility,
and he senses confusion at the top. The big boys who allocate enormous
pools of money just cannot get their act together. Yes, there are
always bulls and bears, but the bears rarely are in a position to
swing the market this widely. When they are in this position, this
indicates that the stock market is at a crossroads.

Volatility
is great for about 3% of commodity futures speculators. These are
the people who make money. But volatility is not good for stock
market investors. It points to major changes in both the economy
and the market.

Most stock
investors do not want volatility. They want steady capital gains,
year after year. They have not gotten this since March, 2000. What
they have gotten is a nearly flat Dow Jones and S&P 500, and a much
lower NASDAQ, accompanied by steady price inflation. They are getting
poor slowly. They have not yet lost hope in the stock brokers’ mantra,
“The U.S. stock market has risen by 7% per annum.” Not in 1966—1982.
Not since 2000.

The victims
who invest in a broad index of stocks have lost money for eight
years. They refuse to change. They refuse to call their fund managers
and say: “Sell my stocks and move the money into a money market
fund.”

Yet they watch
what is happening, and they get nervous. They refuse to sell. The
smart ones who have automatic investing each paycheck have most
of this money go into stocks. But they don’t like what they hear
about subprime loans. They don’t like what they see in the stock
market charts.

We are now
entering the doubt stage. It has taken eight years of negative returns
in stocks. These years can never be recovered.

Meanwhile,
gold went from under $300 to over $900.

The stock
market touts who never told you to buy gold now tell you it’s too
risky. The “Wall Street Journal” ran a story, “How to Survive The
New Gold Rush” on January 29. What was the advice? Don’t buy gold.
Why not? (1) Gold can be “extremely volatile.” (2) Gold “hasn’t
always kept up with inflation.” (3) Better to invest in a commodities
funds, “advisers say.” What advisors? The blind boneheads who didn’t
put gold in their portfolios or recommend gold, from $257 to $900.
Instead, they said “buy an index fund of U.S. stocks.” And what
did that do for investors after March, 2000? Nothing, at best. Capital
losses at worst (NASDAQ).

In short,
these unnamed advisors are losers until proven innocent. Losers
deeply resent winners. They deeply resent gold because gold’s rising
price announces: “The policies of the Federal Reserve System, the
U.S. Treasury, and Wall Street have produced losses for eight years.”

THE
PSYCHOLOGY OF FEAR

Some of my
subscribers have read my warnings about real estate, Federal spending,
and the tight-money policies of Bernanke’s FED for two years.

Others have
refused to read my reports.

A few people
have taken me seriously and have reallocated their portfolios. They
got out of stocks and into other asset classes, such as gold.

But most readers
have just sat there. They have nodded in agreement, but they have
not picked up the phone to call their broker or pension fund manager
to tell them to sell their shares.

The average
investor doesn’t read information sources like mine. They prefer
to rely on the mainstream financial press, which is advertising-supported.
They prefer to read articles that are favorable to stocks, which
is what mainstream financial press advertisers are paying editorial
departments to publish.

But doubts
are growing. Day after day, the news from the banks, from the American
auto industry, and from the housing sector is depressing. The drip-drip-drip
factor is eroding the foundation of confidence that is necessary
to sustain rising stock markets.

We are seeing
the undermining of the foundation of the bulls: investor optimism.
There is no way that the news coming out of the financial sector
can be interpreted as optimistic. The good news relates to specific
companies. The bad news applies to entire sectors of the economy,
and two of the biggest, housing and autos, are in trouble. General
Motors lost $39 billion in 2007. How does any company lose that
much money and still stay in business? Yet the recession has not
hit yet.

THE
NEXT SUBPRIME LOAN CRISIS

In the February
13 issue of “USA Today,” on the front page of the Moneyline section,
we read this headline: “Car loans stretch to 7 years or longer.”
The subhead is accurate: “Down the road, risky practice could hurt
sales.” But it was not sufficiently scary. Here is what is should
have read:

Auto
industry adopts subprime loans. Owners will walk away when their
cars’ equity is gone.

The depreciation
effect in autos is constant and unrelenting. Unlike houses, which
used to appreciate — if owners put enough maintenance money
into them — cars depreciate from the moment the new owner drives
off the lot. Seven years out, nobody but poor people and me will
buy that car.

Here is some
car buyer who doesn’t understand compound interest, equity, and
upside-down loans. He just wants a new car. He cannot afford to
buy one for cash. He has no savings. But he wants that new car.
So, he signs his name on a $25,000 car loan that he will be paying
for when the car is worth $2,500.

Using an amortization
calculator, we find that a $25,000 loan at 6.5% for 7 years requires
a monthly payment of $371.24. That means $4,455 a year. What will
the car be worth in year 7? Probably less than $4,455.

Then there
is the question of falling demand for cars. In years five through
seven, he will not buy a new car. Why not? Because his old car,
which he will still owe money for, will have no equity. He will
still be in debt. The debt will exceed the re-sale price of the
car. The only way that he will get enough money to pay off the loan
is for the new car company to offer to buy it at a trade-in price
large enough to pay off his debt: above market value.

Alternatively,
the car company will re-finance his old loan and apply it to a new
loan. But then the new loan is really upside-down.

The entire
auto industry will be forced to extend subprime loans to buyers
who are ever deeper in debt. These are subprime buyers of depreciating
assets. They are the people who will default on their home loans
and walk away. They will walk away from auto loans, too.

America’s
two consumer industries, housing and autos, are now utterly dependent
on long-term debt. They cannot survive without massive permanent
debt. The public accepts this, and therefore submits to lifetime
debt. They do not intend to pay it off. They intend to roll it over.

This is also
the assumption of the U.S. Treasury. Its debt is perpetual. It is
for consumption — the purchase of votes — and not production.
The voters have accepted lifelong debt, at an ever-expanding rate,
as basic to all politics. This attitude is universal in the West.
It is not confined to the United States.

“Deficits
don’t matter.” This is what politicians proclaim to voters, and
economists then affirm as the well-paid court prophets of the modern
world. Debt is forever. The pious Christian in the pew prays, “Forgive
us our debts, as we forgive our debtors” (Matthew 6:12). But when
the ultimate debtors — the banks and the governments —
decide to inflate away their debts, the pious souls who prayed that
prayer and voted for the politics of debt will at last understand
that God is not mocked. “For they have sown the wind, and they shall
reap the whirlwind” (Hosea 8:7a).

CONCLUSION

The volatility
of stocks point to economic conditions that are not understood.
The economic fools in high places who approved the subprime loans
that are now going bad did not see what was coming until July, 2007.
These fools committed their firms and their clients to debt packages
that were toxic. They did not understand their credit portfolios
any more than the subprime borrowers understood the adjustable rate
loan contracts that they signed.

Governments
and central banks are now bailing out the dim-witted bankers to
the tune of billions of low-interest loans and direct funding. Governments
are also offering band aids — or proposals for band aids —
to postpone the debtors’ day of reckoning. But politicians know
whose bread must be buttered: the multinational bankers’ bread.
They will be bailed out. The home owners, busted, will return from
whence they came: the land of the renters.

No one really
cares. They don’t care that large banks are too big to fail. They
don’t care that small home owners are too small to be worth saving.
As long as the government intervenes to keep the debt structure
alive, voters don’t care whose money gets used to do the bailing.

We are addicted
to debt. But as the addiction grows, it becomes too big not to fail.
It will fail. The question is: In what way? Outright default or
mass inflation? I predict mass inflation.

But not yet.
Not this year. The downward pressure of the contracting housing
sector and autos will keep downward pressure on prices.

The
drip, drip, drip of bad economic news will eventually break the
average mutual fund investor’s will to resist this downward pressure.

“Sell!”

“To whom?
At what price?”
February
18, 2008

Gary
North [send him mail]
is the author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 20-volume series, An
Economic Commentary on the Bible
.

Gary
North Archives

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