Market Update

On February 19th, the bear market we have suffered from in stocks was confirmed. According to Dow Theory, the “50% principle” was violated.

Question: What does that really mean?
Answer: The bull market started in 1982 with the Dow Industrials at 777 points. The height of the bull market reached 14,165 points in October of 2007, 25 years later. The halfway level of that entire 25 year gain is 7,471 Dow Industrial points (50% of the gain from 777 points to 14,165 points is 6,694 points gained on the DJIA. 777 added to 6694 equals 7471 points which represents the 50% level of the gain of the bull market). Dow Theory states that if the 50% level is violated on the downside, the bear market is confirmed. If the market had stopped above the 50% level (7471 points), then the bear market would not have been confirmed. Now, the market is trading beneath the 50% level.

Understanding the Numbers Behind the Banking Crisis

Lots of numbers have been thrown around in an effort to point out the magnitude of the financial crisis we are enduring. Putting them into perspective regarding the banking system gives us a little bit better understanding of what is happening mathematically. The Federal Reserve statistical release published on February 11th, and a recent New York Times article, discussed the commercial bank’s financial needs as being greater than first thought. NYU Professor Nouriel Roubini is the current Wall Street guru of economics. He estimates that the big American Banks are at risk for $1.8 trillion of losses from bad loans. To put this in perspective, The Federal Reserve Board publishes monthly statistics in a category entitled “Large Domestically Chartered Commercial Banks”. The most recent total assets of those banks is $6,848,000,000,000 ($6.8 trillion). Look at the bank’s assets as equal to all of a family’s assets by adding up the value of the family’s cars, real estate, retirement plans and cash. Those are a family’s total assets.

The published total liabilities of the banks on February 11th were $6,031,000,000,000 providing for a total bank net worth of $807 billion ($6.838T – $6.031T = $807 billion). The net worth of the family would be determined after the family had paid all of its mortgages and indebtedness. After that, what is left over is the family’s net worth. If Professor Roubini is correct, the $1.8 trillion of estimated losses would wipe out the commercial bank’s capital of $807 billion, and another $1 trillion would be required. The banks do not have that additional capital, but the Fed has already provided for other funds, if necessary, with standby loans.

The Fed has added money to the bank’s net worth in the form of both preferred stock and stand-by loans. And they have set aside a contingency fund of up to $1 trillion for bad loans as mentioned above. If all of that materializes, then there will be a capital shortage of $500 billion necessary for the banks to continue to operate. Nobody has figured out where that $500 billion is coming from but the Treasury Department is trying to put together private money to fund this anticipated $500 billion shortfall.

EXAMPLE

Bank (or families)	Total Assets	$6.8 trillion
Less bank (families) Banks (families)	Loans and bills Net worth	$6.0 trillion $ .8 trillion
Less bank (families) Banks (families)	Investment losses Negative net worth	$1.8 trillion $1.0 trillion
Plus Fed Capital	Bail-out loans Available for new loans	$1.0 trillion 0 trillion (*)

(*) At this point there is no money for the banks to carry on business (or for the family to eat and pay bills), so $500 billion is needed to support and expand the banking business. Historically, $500 billion has been able to carry loans of sixteen times the $500 billion of capital, or $8 trillion of loans. (Left out of this example is “loan loss reserves”, which have already been used anyway, “tiered” capital, and a fistful of other statistical categories that are irrelevant for this example).

The government has caused the money supply to explode. Since Dr. Berneke has been Chairman of the Fed, $3 trillion new dollars have been created. Theoretically, that should cover the majority of the losses that are estimated to exist, except for the $500 billion that may be necessary to recapitalize banks, mentioned above.

Question: Is there any history for this?
Answer: There is some history from the Savings and Loan Crisis of the 1980s. The losses at the time were estimated to be $350 billion. The eventual loss to taxpayers was “only” $130 billion.

Question: Why was there such a great variance between the estimate of losses and the actual losses?
Answer: As in today’s market, real estate prices crashed. Many banking institutions were “technically bankrupt” if the value of their real estate loans were priced at market value. Several of those banks were allowed to continue to exist on the Fed’s “watch list”. As real estate values improved, the prospects of those lenders improved, and they came20out of that disastrous period a little better than they had estimated. We are in a similar economic pattern now as there’s no market at the present time for all the failed real estate assets currently financed by the U. S. banking system.

Conclusion

The proper investment position is to build up one’s cash. Huge opportunities are becoming available in the stock market, and in the real estate market. And, there is some good news:

1.	Gold and the dollar are going up together. The U. S. controls more Gold in our money supply than Germany, France, Japan, England, and China combined. In all monetary collapses in history, economies have reverted to gold and silver species as money. If that happened in this era, and we are forced to go back to a hard metal standard, the U. S. would again be “in the chips”. Our gold reserves would be converted to dollars at a much greater rate of exchange than $985 an ounce.
2.	The U. S. is the longest-lasting government on earth, and it’s only 230 years old. We remain the world’s largest economy, greater than all of Europe combined, and greater than England, Japan and China combined. We are so important to the world’s economy that we will be given all the help by foreign economies that they can provide to ensure our future economic success, because we are the world’s largest customer, by far
3.	American households had assets of $45 trillion, most of which are in real estate, stocks and bonds, and cash. That’s a huge amount of wealth, and it may very well be enough to see us through this current dilemma, even though a good deal of that wealth has been revalued downwards. We still own the same percentages of companies we have invested stock in, plus our homes, and so forth. We have had our homes and our other a ssets devalued, which is what happens when an inflationary run-up collapses, like that sponsored by former Fed chairman Greenspan, over the last couple of decades.

Our profligate spending and borrowing, both as individuals and as a government, has stressed the system beyond its ability to function normally. We have been living the grand life in this country since the end of WWII by living off of debt, credit and fiat money. The purchasing power of the dollar during those years has been pounded by inflation, and the size of the government has increased dramatically.

Corporate earnings are down about 38%, contributing to the market’s huge losses. Gone are the days of lending by banks with (1) “no money down”, (2) “no income documentation necessary”, and (3) “payments optional”, that enabled this current housing boom, and consequent bust. The markets have been stretched beyond their ability to service the current pressures of paying even the interest on the debt in our economy.

Who knows where the markets will settle. Stay in cash, and accumulate cash, if possible. Hopefully, time will cure these problems, and nobody, absolutely nobody, knows how much time will be required. Nor does anyone know which direction the stock market will head over the ensuing 12 months.

Carpe Diem.
George Rauch
February 27, 2009

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