Morgan Stanley in Europe signals a "Full House" sell signal on stocks. - 8-Jun-07 - Generational Dynamics

Generational Dynamics Web Log for 8-Jun-07

Morgan Stanley in Europe signals a "Full House" sell signal on stocks.

Saying that stocks could fall by 14% in the next few months, a Morgan Stanley European strategy report says that all three of its major leading indicators -- bond yields, manufacturing forecasts and P/E ratios -- were signalling a market about to lose value.

"Such a full house sell signal across these three indicators is rare, and has occurred only five times since 1980," said analyst Teun Draaisma in a European strategy research report. "Equities have always been down in the next 6 months, on average by 15%."

This forecast actually is consistent with other forecasts that the market is "overdue for a correction," meaning that even the usually exuberant analysts realize that every once in a while a continually rising market has to fall, at least a little.

What none of these forecasts are taking into account is the possibility of a full scale generational stock market panic.

From the point of view of Generational Dynamics, a generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash. We're now overdue for the next one. It could happen next week, next month or next year.

From the point of view of Generational Dynamics, it's easy to prove that a new financial crisis is coming, just by showing that various trend variables -- international account balances, public debt, market capitalization -- are all increasing uncontrollably, with no real attempt being made to stop them. And lately we've seen that the Chinese economy continues to explode out of control, even though Chinese officials have to tried to bring down the huge imbalances for five years and have failed completely. This past week's fall in the Shanghai stock market has alarmed Chinese officials greatly, as they wait to see what's going to happen next.

Wall Street's stock market indices in Thursday all fell 1.5% to 1.8%, and as I write this on Thursday evening (approaching noon Friday in Tokyo), the Tokyo and Hong Kong indices are down 1.6%.

One possible scenario is this: the markets will fall a little further, then level off and start to rise again. I've personally been surprised by how frequently that's happened.

But there's another scenario, and this one must occur at some point in the not to distant future: The markets will fall perhaps 1% or 2% a day for a few days, and then full-scale generational panic will set in, and the markets will fall 20% over a period of just a few days.

No one is expecting this because there hasn't been anything like in our lifetimes -- since 1929. (As I've indicated a number of times, the so-called panic of 1987 was a "false panic," since the market was underpriced at that time. Today, the market is overpriced by a factor of more than 250%, just like 1929.)

I've posted warnings two or three times in the past that such a panic may be close at hand, and the market has recovered each time. However, on each such occasion, the negative signals were stronger than the last time.

In this case, we have the Morgan Stanley "full house" signal, which indicates that many parts of the economy are increasingly in trouble.

But more important, we have increased awareness of the weakness of the Chinese economy, including the March statement by Chinese premier Wen Jiabao said that China is "unsteady, unbalanced, uncoordinated and unsustainable." As I wrote in January, 2005, China is becoming increasingly unstable and approaching a civil war, and the increasing financial instability of China means that this day may be approaching quickly.

Once again I urge all my readers to get out of the stock market, and I'd like to add a little more information in response to a couple of reader questions that I've gotten in the last couple of days.

Let me summarize a few points:

A good place to keep your money nowadays is to leave it as cash. Even if you don't believe that there's going to be a panic, at least take the word of the Morgan Stanley advisors and get out of stocks, because you'll still lose 15% according to them.

If you put your money into a savings, checking or money market account, make sure that the account is guaranteed to be "FDIC Insured." There are many accounts that are NOT insured, or are insured by a vulnerable state organization. Make sure that it's "FDIC insured."
Many money market funds, investment trusts, mutual funds, and so forth take your money and invest the money in stocks, meaning that the fund is only as secure as the stock market.
The FDIC web site has articles providing further information, and also lists of additional resources. If you have money in the bank, you should take the time to read this material.
I googled the phrase, "fdic insured money market funds" and got a number of hits. For example, one hit takes you to an Ameriprise Financial page, listing three money market funds, one of which is FDIC insured and two of which are not. Make sure that you only go with FDIC insured accounts.

One web site reader wrote this to me yesterday:

"I read your recent log posting and noticed that money market funds are not recommended. After seeing that I checked out my 401k options and discovered that there are no federally insured CDs available. The only option that comes close is a CD which is backed by an insurance company and their backing is provided by investment grade bonds, etc. Should I stick with my money market fund or should I transfer to a CD? Please note that I am not soliciting advice, merely an opinion and will not hold you responsible for my investment decisions. (I've been around lawyers too long!!!)"

The insurance company will go bankrupt, and you will lose your money. The best bet is to sell your holdings and either keep them in cash, or put them into an FDIC account.

Another choice is to purchase short-term (6 or 12 month) Treasury bonds. You can purchase these online, for no commission, at http://treasurydirect.gov . I don't think long-term (5 or 10 or 30 year) Treasury bonds are a good idea, because there are hundreds of billions of dollars worth of them languishing in central banks around the world, especially China and Japan, and in case of an international financial crisis, these would all be dumped on the market, making them nearly worthless. Stick with short-term bonds.

Some people wonder why I don't recommend buying gold. Gold is a risky purchase, though probably safer than stocks. Gold has had it's own spike in prices, as part of the general worldwide commodities bubble, and when the commodities bubble bursts, the price of gold may fall sharply. The price of gold may spike up in case of a major war, but you probably won't be able to buy food with gold if financial institutions are shut down for a while. If you're in the mood to take some risk, then gold may be the way to go, but remember that it is a risk.

As recently wrote, even selling stocks short on the market is a bad idea. "Going short" is a way of betting that stocks will go down, and that should be a good idea.
However, the current massive worldwide liquidity bubble would immediately start contracting, raising interest rates enormously, and making credit almost impossible to get. There would be massive bankruptcies, and even escrow accounts would be vulnerable, depending on how they're set up.
One web site reader wrote the following to me:

"I don't quite follow you there, are you saying the brokerages mostly go bankrupt (probability of that is close to zero, even if their customers lost 90% of their assets the brokerages aren't likely to go bankrupt. And even if it a firm does go bankrupt, the money is insured, so the insurers would also have to be bankrupt. We have much more restrictive margin use rules today than they did in 1929, and even back then, I've never heard of a short seller who was somehow unable to collect the money he made from the crash (if you know otherwise I'd be very interested in reading up on it)."

I'll give a general response and a specific response.
The general response is that financial managers have created $600 trillion in derivative instruments, mostly credit derivatives, based on public companies worth about $30 trillion worldwide. These are infintely more debauched than margin abuses were in the 1920s. The worldwide economy is a huge pyramid scheme or Ponzi scheme. When it crashes, almost everything will be wiped out. There's nothing that you'll be able to count on.
The specific response is that brokerage houses can indeed go bankrupt, and have already done so. Here's an excerpt from a recent article on the subject:

"A bankruptcy development that has Wall Street worried
NEW YORK: A week ago, Judge Burton Lifland of the U.S. Bankruptcy Court in New York ordered the investment bank Bear Stearns to pay almost $160 million to investors in a hedge fund for doing business with that fund but failing to detect that it was a fraud.
The case has been received with true fear on Wall Street, where servicing hedge funds is a business so lucrative that it makes the go-go years of taking technology companies public look quaint. For one, hedge funds do billions of dollars of business in multiple parts of the bank, while many technology companies promptly evaporated after going public. ...
Prime brokerage is the business of servicing hedge funds — finding and lending stock to allow hedge funds to short (a bet the price will fall), financing trades (leverage) and structuring swaps, among other things (services vary by firm). Wall Street firms earned $8 billion to $10 billion from prime brokerage activities last year.
Hedge fund relationships forged through prime brokerage relationships are critical to banks who can then deliver countless other services to hedge funds: trading over-the-counter derivatives, selling exotic stock or bond deals or structuring hedges. If prime brokerage is an increasingly commoditized product, its significance in generating business is not.
The relationship between prime brokers and hedge funds is a naturally strained one: Prime brokers want as much information as possible and hedge funds want to give them as little as possible.
After all, most banks are in the same business as hedge funds — looking for investment ideas and making money from them. Most hedge funds use multiple prime brokers.
In general, prime brokers operate with the assurance that if a client blows up, they are not on the line for the losses. Unless they have actual knowledge of a fraud, they should be O.K.
Until now. ..."

Now, Bear Stearns was forced to pay the $160 million based on a technical point, but as I've pointed out before, every action of every person with access to money is going to be carefully examined and audited once the crash occurs, and any irregularity will be punished severely. So no account is safe, even those of brokerages.

Another web site reader sent me the following reminiscence (slightly modified to disguise the identity):

"Some days I wish this nonsense would end, yet I feel a real fear about what is coming. At times it is very intense and at other times it dissipates almost to nothing. It goes back and forth, round and round. It's almost like being tortured.

See, I can still remember looking into my Grandfather's face when he was old. I'll never forget the real and intense fear I saw in his face as long as I live. My Dad's father, who was 87 (born in 1902) was was getting forgetful and one morning a look of intense fear came over his face and he announced, "I have no money!" He was reliving the Depression. My Dad, a Silent born in 1933, very patiently took all of his bank statements out of the drawer and proceeded to show him how much money he had. A look of relief came over my Grandfather's face and he slumped down into the chair and said "Oh." I should also say that my Dad never talked about that incident. I knew it was too painful for him to talk about. ...

This is a risky time to be living no matter what you do. Those who survive this will be extremely shrewd AND extremely lucky. Nothing is safe, I'm afraid. The best investment will be one that nobody gave a thought to, like pepper during WWII or something like that. I think you and I think too much alike. That article you wrote about religion is the only thing I've ever seen on the subject that articulates most of my philosophy. Unfortunately, it will probably turn a lot of people off. And that "Full House" signal that Morgan Stanley announced ... will only be the beginning. It may be this month. If it is, there will probably be a brief relief period before it gets worse. That would be the best case for everyone, but I'm not so sure it can work that way. The Fed has been withdrawing liquidity for a year but private liquidity is still raging out of control."

This is relevant to our lives today because there are actually a lot of people, especially young people, looking forward to a major financial or war crisis, because they're simply looking for a change, any kind of change. I've had to tell more than one person to be careful what you wish for. The day that the stock market crashes will be the worst day of your life. (8-Jun-07) Permanent Link
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Generational Dynamics Web Log for 8-Jun-07 Morgan Stanley in Europe signals a "Full House" sell signal on stocks.

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Generational Dynamics Web Log for 8-Jun-07
Morgan Stanley in Europe signals a "Full House" sell signal on stocks.