Wednesday, December 17, 2008

America- Driving in Reverse

America- Driving in Reverse

The past few years America has changed for the worse. The old theme of working hard to succeed has changed. It has changed in schools, the workplace and in our government system. These changing conditions have accelerated the past year causing financial turmoil. In the years ahead America can change the course we have entered or capitalism as our founding fathers set out as building blocks to breed a strong America will be crushed.

The rate of the past years market decline is unprecedented. Some stocks lost 80-90% of their value in a matter of months. Bear markets, the bad ones, lose 75-95% of their value while normal bear markets lose about 30%. Bear markets feed fear while bull markets feed greed. This time around the fear is warranted as recent policies of the past 10 years have challenged our system. Democracies have historically lasted 200 years. Is our time up?

America has gone from a country that rewards people whether they study hard in school or practice hard in a sport. Now we teach our kids that winning doesn’t matter. A kid will play equal with others on their team no matter how hard the kid practices or tries. Why should the kid give 100% in practice when there is no reward? Some coaches not only give equal playing time but also change the starting lineup so everyone starts. In some cases the numbers of members of the team have doubled. (i.e. a basketball team with 20 players.) Youth sports are very important and give a child life long lessons. How about the recent move in not to keep score or change the score of the game at halftime back to zero? A player is unlikely to excel if they know it doesn’t matter how hard they try or how good they play. In the end everyone is treated equal. This idealism leans toward a socialist state.

On the academic side a socialist state would mean no grades just pass/fail. Is this starting to happen? Unfortunately in some schools it is a reality. Some teachers think they should give test as it puts too much of a mental stress on the student. Our school system has fallen sharply worldwide with the Far East countries outpacing the US. In the end the idea of not grading a student would be a great tragedy.

The relationship between sports in a socialist state to the current economy boils down to an idealism that companies can’t fail or should not be allowed to fail. Does that sound familiar in the current environment? Bear markets are normal and make the markets stronger for the next bull market. Recessions do the same for the economy. It makes the ensuing recovery stronger. A forest that burns down is natural and makes the forest recovery stronger in the long run. Thousands of companies go out of business in a recession but thousands more are started in its place. Industries change over the years. Trying to save the automakers is a joke. In the long run only the strong ones survive. Remember the Yugo or AMC? The auto companies produced too many vehicles. In the end consumers purchase cars that fit their needs. If they are bailed out it is another clear sign of a new socialist America. Why are we bailing out Chrysler? They are a private company that is owned by a hedge fund. The hedge fund doesn’t want to put any more money into them so why should we? In time a few of the current automakers will be out of business.

What does the lack of bankruptcies and the lack of competition in sports and schools have to do with the current stock market woes? The market is signaling an end of capitalism and a move toward socialism. How about the call this summer for taxing the oil companies using a windfall profits tax? We tried that in 1973-74 and it failed. The markets will drop another 50-70% from there current levels of 9,000 in the DOW. Companies who do make a ton of money will be taxed while others will be bailed out. Growth will stagnate and P/E’s will collapse even further.

All the government regulators and regulations are set-up to catch or backstop anything detrimental to the economy. We are in a society that can’t and will not accept failure. Many of these policies and regulations have created a larger and more inefficient system that cuts into pure capitalism. Back in the late Clinton era of the 1990’s government policies encouraged a free and simple loan system. We went from very little money down loans to a just sign here policy. No down payment, no problem. Freddie and Fannie Mae were forced by Congress into a policy where everyone should have the American dream with very few questions asked. Both Fannie and Freddie loved the increased leverage as management reaped in enormous bonuses. Management was able to maximize their bonuses by manipulating their EPS as we later found out at the expense of the US taxpayer. The down payments of 20% were foregone in favor of buy now and worry later. It’s amazing as countries like China just loosened their housing standards from a 28% down payment to 20%.

Congressman could boast about how people can now purchase one, two or more homes without a problem. People were putting down a token down payment or nothing at all. Many would sell before their home was ever completed. In 2002 recession, government decided to put the afterburners on housing. Most of the loans were packaged on Wall Street where these loans were securitized. Wall Street complained about needing more leverage and in 2002 the current Treasury secretary, Henry Paulson who then was the chairman of Goldman Sachs achieved their goal. Investment houses like Goldman, Bear Stearns, Morgan Stanley and Lehman could use $1 of assets and levered to 40 to 1 from a previous 22 to 1. Banks can do 13 to 1. All this new leverage created more greed. Wall Street was getting rich with all the leverage and fees and the Congressman were happy to create jobs and increased wealth.

In a free capitalist market, excesses in both directions happen. It was very obvious that a bubble in housing started in 2005. Mortgage brokers were making more money than doctors. As with the 1998-2000 stock market bubble where brokers flocked into the business, the boom in realtors and mortgage brokers was a telling tale of another bust to happen. With the stock market in a bear market people thought that housing could never go down. It was treated as a no lose situation. The excess in housing prices and supply was fed by low rates and leverage. Unfortunately too many houses were built. There are in some areas like Sarasota, Florida a 10 year of supply of condo’s on the market. When the bubble burst fingers were pointed in all directions.

Earlier this year the FED opened the printing presses hoping that lower rates would end the spiraling deflation and drop in housing prices. Housing prices need to fall another 20% just to get into their 100 year moving average. They will probably drop further (total of 25-35%) as things tend to under shoot once they have overshot to the upside. All that wealth created in the housing boom has evaporated. Add de-leveraging to the equation and things will get worse especially when the government tries to interfere. Instead of creating rising home prices with the printing presses the prices of oil jumped as did other commodities. Interesting to note that gas prices went from $2 to $4.50 with NO gas lines occurring at the stations. OPEC countries are just as leveraged as the US in building their infrastructure with rising oil prices feeding the frenzy. Oil tankers were filled and waiting off shore as the prices surged higher .Commodity funds joined in the ranks speculating on higher prices. Airlines and trucks also panicked and locked in high prices for the next few years. The government blamed the speculators but it turned out to be a scapegoat especially in an election year. The sharp collapse of oil always occurs after a bubble has formed no matter what type of commodity. Now with prices down to $1.50, OPEC’s high leverage will keep them from cutting supply much as they need to pay down their leverage and maintain a high level of cash flow. The old supply demand equation kicked in.

The combination of a commodity bubble and a drop in wealth of home prices are some major causes of the current recession. The current freefall of oil prices will help just a little underweighting the huge drop in wealth from dropping home and financial market values. This double whammy is being fueled by government policies on fixing the problems. I don’t think people realize that the government is the American people. They think by letting the government pay for this and that the individual will be spared.

The past years decision and the ones occurring with Obama next year will set the direction of prosperity for the next 20 years. If we don’t avoid more socialism activities in the next year then free capitalism will NOT be saved. Unfortunately we are starting out with one foot in the grave which is what the stock market is telling us. The current drop of 45-50% at the lows this year will turn into 80-95% declines overall once this bear market bottoms unless American addresses some important fundamental issues.

The majority of companies should NOT be saved and should enter bankruptcy if they fail. New ones will develop. Over 1500 banks went into bankruptcy in the 1990-1992 period and the system survived.
People are complaining about jobs loses but the current rate of unemployment is nothing near the Great depression levels of the 28-30% or the early 1980’s of 12-14%. In fact 20 years ago FULL employment was considered to be in the 5-6% range. In the past 5-10 years the rate has stayed below 6%. Do not increase the size of the government as a means of reducing unemployment.
The size and scope of company and pension liability will be the next shoe to drop. There is no way with all the loss of capital by insurance companies they will be able to pay out the claims on annuities’ and other benefits. Our government can not keep the current rate of retirement benefits that are currently in place. There are just not enough funds to cover all the retirees and their benefits. Social security is another area that will have problems, but not nearly as bad as governmental workers retirement benefits at all levels of government.
One way that government tries to lessen the burden is by inflating their way out. It is ironic that Bernanke’s thesis of how he would have avoided the great depression by throwing money out of a helicopter (hence the nickname helicopter)? Bernanke turns out to be in the same seat of needing to drop rates to zero? Now we have an old timer in Paul Volker who came along in the late 1970’s to stop inflation in the Carter administration. Looks like the game plan is to start inflating but tell the US tax payers don’t worry about it because we have Volker to mop it up.
Another policy that hasn’t been talked about yet is the immigration issue. Next year Obama will open the country up to illegals. He will state that they will soak up the excess housing (and jobs). He will state that a new police force will be started that will point directly to him. (Like in Russia).
Obama will state that we need not worry about the budget or spending deficits in time of stress. Isn’t this one reason why it got us here in the first place?
The past few years’ dollar collapse will help with exports. A strong currency is a must. No country has prospered with a collapsing currency. Luckily the dollar reversed its fall the last few months as the world still believes the dollar is a flight to safety. However, the dollar will collapse next year if the current conditions exist.

What will happen to the stock market? It’s pretty simple. It will also collapse especially when corporate bond yields still reflect near bankruptcy pricing. The S&P yields around 4-5% while high quality corporate bonds yield 7-10%. Why would anyone buy stocks when stocks are last in the bankruptcy line? The biggest concern is a socialist government changing the rules and taking over the bankruptcy line from bonds, preferred and common to government, bonds, preferred and common. The S&P needs to drop in halve to reflect a proper yield. That would bring the S&P to 1992 and 1993 levels or 400-450. Corporate bond yields could fall but that is unlikely with so many companies lined with debt. The leverage buyouts and high debt levels resulting from these buyouts are done for a long time. Eventually as the debt comes due in the next few years a final conclusion of existence or nonexistence will be reckoned. There are so many companies that have 1 billion in current assets and 10-12 billion in debt. They assumed the cash flow could keep paying the interest payments however a slowing economy put that idea into the drain. The Tribune Company had a leverage buyout last year and just filed for bankruptcy.

Millions will be made by those who wait till the market gets down under 5,000 in the DOW. What would make this scenario change?

Let companies go bankrupt. The system picks up the pieces of these companies and puts them back together if they are still viable. Remember K-Mart and some airlines? Failure of companies breeds new companies and an overall stronger company base.
We need to pass a TAX CUT for companies. America’s corporate tax rate is the second highest in the world behind Japan. A tax cut will add new jobs. These new jobs will stimulate more spending by both the corporation and consumer. This will make corporations more profitable and send the stock market skyward bringing BACK some of the wealth that was destroyed the past few years. Insurance companies’ portfolio and people’s retirement accounts will rebound. A tax cut will also bring America’s tax rate in line with the world. U.S based companies won’t hide money overseas.
Cut government spending and the overall size. There is too much red tape that doesn’t work. The Sarbanes-Oxley bill on disclosure didn’t work. It didn’t stop corporate corruption rather it just added to more paperwork at corporations’ expense.
Keep a strong dollar policy. There has NEVER been a country that had a diving currency and prospered.
Change the mark to market rules on bonds that don’t trade often ie. Mortgages and Municipal bonds. Instead they should be market monthly on ACTUAL monthly cash flow smoothed out over 3 months. These bonds don’t trade like stocks thus shouldn’t be treated as such.

There are many companies that will lead the next bull market. However if we don’t get a corporate tax cut and move toward free market capitalism, the best trade for the next few years will be gold at $600 or buy it in the Spring. Current weak foreign government balance sheets will force selling of gold to raise capital. Gold will then rocket to $2,000-3,000 in a few years as the government inflates their way out of debt and low housing prices. It will be similar to the 1979-1982 period revisited.

Another trade will be a falling dollar as foreign countries decide that their money is better and safer in their own country. With a skyrocketing deficit, raising money to pay for the debt will be difficult. One can buy foreign currency paper or funds that are diversified.

Below are the next leaders of the next bull market. If we get 2 of the above scenarios like a corporate tax cut and letting companies go bankrupt the market will result in a 100-200% rally within a few years. For now that scenario looks like it won’t happen and the market will continue its spiral down to DOW 3,000-5,000 within the next few years. Too much debt, government control and de-leveraging will put downward pressure on stocks. Hopefully free market capitalism will live for more generations.