Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 23-Jun-2008
Questions from readers on finance and investing

Web Log - June, 2008

Questions from readers on finance and investing

On fraud, the FDIC, China, and other subjects.

Normally I try to work the responses to the most common reader comments and questions into regular web log articles, but there have been a spate of financial and related questions lately, so it's time to devote an article to them.

Almost every journalist, pundit, analyst, and advisor has some financial stake in today's market, and their answers to financial advice questions are influenced by what is most likely to make money for themselves. I have nothing at stake except my own credibility, so my answers will be a lot more cautious than answers by others.

The stench of corruption

"I have been working in the financial sector since 1970 but I have never seen before (not even at Drexel Burnham in the late 1980s) the kind of extremely questionable practices, cover-ups, fraudulent behavior, and lack of transparency (coming so shortly after Enron blew up) by financial firms, the government and its agencies. In fact, if I weren't an incorrigible optimist who believes that what hasn't killed me yet (motorcycles, drinking and smoking heavily and ...) makes me stronger I would fall into a deep depression at the sight of the current financial environment and the government's lies."

The stench of corruption and fraud is beyond belief. I would never have believed it possible, even a few years ago.

I don't get depressed either. I just get more and more furious at the utter stupidity of these people. See: "'Operation Malicious Mortgage' indicts 406 people including Bear Stearns execs"

Are you bullish on America?

"[You wrote in a recent article:] "And I'm still bullish on America. I'm underweight emerging markets, and I'm overweight US stocks."

How can you rectify this statement with predicting a 3% probablity of a major crash each week? I think you are correct in foreseeing a tragic market in the next year. If you are overweight US stocks you should evaluate your reasoning for that."

Thanks for pointing out the lack of clarity in this passage. I changed the text so that it's clearer that the sentences you're quoting do not represent my view.

If I owned stock after all I'd written on my web site, I wouldn't have any credibility whatsoever. Hell, I wouldn't even have credibility with myself. To be clear: I own no stocks.

On the other hand, I'm QUITE bullish on America doing well during the coming financial crisis and Clash of Civilizations world war.

"If you must own stocks right now I recommend ..."

When the crash happens, even the "good" stocks will fail. That's because investors having to meet margin calls will need to sell even their "good" stocks to get cash.

It's been a year since the credit crisis started

"It`s been one year that the credit crisis started and still no crash....Do you think you are wrong? No depression...Why is it taking that long...No event a bear market...The dow is down 12% from a all time high...Does look tome like 1929...What do you think?"

The Fed has been very skillful in postponing a crash through narrowly targeted injections of liquidity -- something that wasn't understood or considered in 1929. There would have been a crash in October of last year, if not for the aggressive actions of the Fed.

And in March of this year, a Bear Stearns bankruptcy would have caused a worldwide crash if the Fed hadn't made a historic intervention. There's no doubt about this - Ben Bernanke said so in testifying before Congress.

Meanwhile, the underlying problems have been worsening, because the credit and real estate bubbles have continued to lead, pulling trillions of dollars out of the financial system. It's like high blood pressure being a "hidden killer" -- it's invisible until one day it kills you.

As for the stock market, it HAS to continue falling because corporate earnings and earnings estimates have been falling. What people who keep hoping for a rally don't understand is that price/earnings ratios (also called valuations) are already being pushed to stratospheric levels again, and that can't be sustained even if you ignore the possibility of a crash. See: "Stock markets plunge on unemployment and historic oil price spike" and: "Price/earnings stock index continues to surge higher and higher."

As regular readers know, every week or two I post the table of S&P 500 average corporate earnings estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters.

Here's the latest table for second quarter earnings:

  Date    2Q Earnings estimate as of that date
  ------- ------------------------------------
  Jan  1:              +4.7%
  Feb  6:              +3.5%
  Apr  1:              -2.0%
  Jun  6:              -7.3%
  Jun 13:              -8.1%
  Jun 20:              -9.0%

As keeps happening, quarter after quarter, initial rosy earnings estimates are proven wrong, as actual numbers come out, and the estimates keep getting worse, week after week after week.

The basic mathematics hasn't changed in the six years that I've been running this site. The stock market is overpriced by a factor of well over 200%, and by the Law of Mean Reversion, a crash must occur. See: "How to compute the 'real value' of the stock market."

What's the best place to live?

"Firstly, thanks for the regular and insightful articles. I appreciate the effort you put into this website and it's given me many things to think about. A question if you've got time: I belong to the 'GenX' age group, am an American living in Asia (China) and am wondering where might be the safest place for me to consider settling down within the next few years. Do you think my fears of returning to the US are exaggerated? Might there be a somewhat safer place to call 'home'?"

Thanks for the compliments. I've been asked this question several times before, and I wish that I could answer it, but there's really no way to tell what regions of the world will be safer than others. My guess is that the less populated areas will be safer than more populated areas. I suppose that some place in the middle of Siberia might be pretty safe. On the other hand, a farm in the middle of Kansas might be pretty safe too.

The problem with China is that it's so densely populated and so economically and socially unstable, that it must be very hard to find a safe place there. See: "China is 'unsteady, unbalanced, uncoordinated and unsustainable.'"

One thing that I strongly suggest is that you obtain enough supplies -- dried or canned food, water, medicines, etc. -- so that you and your family can live without leaving your home for a few weeks. This is useful in preparing for a flood, a war, or a bird flu pandemic.

On the American Red Cross web site, you'll see instructions for preparing your own survival kit. You can also purchase a ready-made survival kit from the Red Cross store. Costs: $30-70.

"Thank you for your reply. I am working in the hospitality industry here in China. Would you have any idea regarding a timeline as to if/when Sino US relations could sour to the point of making it unpleasant/unsafe to continue to live in this country."

It's impossible to predict this, and you can show this using the concepts of Chaos Theory. Can you predict when the next hurricane will occur? You've probably heard about the "butterfly effect" that says that when a butterfly flaps its wings in China it might (or might not) cause a chain reaction that leads to a hurricane in North America. The same is true of starting a generational Crisis war. Someone in Washington or Tokyo or Taipai might say something (or fail to say something) that causes some kind of chain reaction of events that leads to war. All we can say for certain is that the probability of war increases with each passing day.

"One last question: if widespread conflict erupts do you think the US would reinstate the draft in order to fill the military's ranks?"

I think that this is almost an absolute certainty.

Why are the Chinese buying US dollars?

"[According to one blogger,] the Chinese printing presses are running like mad, selling Yuan (Renmimbi) to buy dollars. This suppressed the value of the Yuan, kept Chinese exports flowing and allowed China to maintain its currency peg. These policies are also causing the Chinese economy to overheat, and a significant factor behind the rise in commodity prices.

I'm pretty sure I have seen the same kind of analysis from you but I don't understand some of basic principles, if they are even correct: Why would the Chinese be buying US dollars when the value of our dollar is going to complete shit?"

Here's a better way of saying it: What the Chinese do is turn out huge amounts of manufactured goods, which they sell to the US to get US dollars. Since the US is a debtor country, China then uses its surplus dollars to purchase Treasury bonds. That's why China has almost a trillion dollars worth of Treasuries in its vaults.

"2) How and why would China choose to suppress the value of it's dollar by buying ours just to keep exports flowing and how exactly would that "peg" China's currency to ours?"

For many years, the Chinese pegged the yuan to the dollar (8.2 yuan to the dollar) at a fixed conversion rate. That way, they could keep the yuan from appreciating as the dollar got weaker, and they could keep selling their manufactured goods to the US at low prices.

This created a major frenzy in Washington in 2004-05, because politicians were blaming the Chinese for the loss of manufacturing jobs in America. Congress was threatening sanctions on China unless China let the yuan appreciate. Finally they did, in 2006 I think. See: "Stock market frenzy follows Washington yuan-bashing" and: "US dollar weakness and China's growing economic strength dominate World Economic Forum."

"I get that China might choose to do something sort of shifty to increase it's exports, perhaps, but in the net sum gain I don't see how they are benefiting here. I don't understand why they would make those choices given that they could just chose to not buy us dollars, let their currency float, and perhaps fair just as well or better against our currency. What (do you think) I am missing here?"

China's economic bubble depends on selling lots of stuff to the US. If China revalued the yuan too much, then Chinese goods would become more expensive in the US, which means we'd import less, which would cause a recession in China.

This kind of stuff is typical of a generational Unraveling and Crisis era, when everything goes crazy economically. That certainly happened in the US with the dot-com bubble, then the housing and credit bubbles. The craziness is the same but the symptoms are different depending on whether you're a creditor or debtor nation.

Take another look at this for a perspective on what the US was like when it was a creditor nation: "The bubble that broke the world."

Right now, China's stock markets are crashing big time, and there are plenty of good reasons to believe that China will have some sort of financial crisis once the Olympics games end. See: "Shanghai China stock market and Baltic Dry Index are crashing sharply."

Whether that will be a small financial crisis or a large one remains to be seen.

Are FDIC-insured accounts safe?

"So anyway, I have a modest sum of cash lying around and I'd like to be able to feed and house my family within the foreseeable future. Is there a single investment available on this planet that is not as fickle as Wall Street and Washington DC?"

The only investment I'd suggest are short-term Treasuries and FDIC-insured certificates of deposit (CDs). Or cash.

"I was wondering if you think having money in savings, even FDIC insured accounts is safe. If the financial meltdown is severe enough, will the government be able to pay to recover all those funds?"

Not completely, as I wrote about last year: "Is your bank deposit protected by the FDIC?" Basically, if a major banking crisis occurred, then the FDIC would run out of money.

The question is how long you want to leave your money in the bank. My guess is that there'll still be time to get it, once the banks start failing, but not a lot of time, so you should be prepared to move quickly. Also, larger accounts are likely to be frozen before smaller accounts.

"In addition, I quite frankly don't trust guarantees from the FDIC nor treasury, especially with the t-bill cycle circumvented by more reliable currencies."

Once the crisis begins, there's no guarantee that promises made before that time will be honored. See: "Questions and answers about the 'credit crunch'" and: "Will hyper-inflation make the dollar worthless (like the Weimar republic)?"

Where to put money so it's safe is a big problem. Putting it into a bank risks losing in case of bank failure. Keeping it in your home risks robbery. Keeping it in a safe in your home risks the possibility that in a major emergency you won't have time to get to the safe. Obviously, the best solution depends on each person's circumstances.

Does ending the gold standard create a new paradigm?

"I was looking at the DOW Jones chart you have demonstrated being way above the long term mean. One thing I was wondering if that since the dollar was removed from the gold standard in 1971, if stock prices have been overinflated significantly due to inflation, i.e. the change in 1971 have led to a new paradigm. And when inflation is taken into account, maybe the prices aren't really so far above trend.

For example, you can see that gold prices were steady until 1971 also. Perhaps stock prices have been growing more exponentially because of inflation? Is there any possibility to this?"

There really isn't. Gold is just another commodity, so ending the gold standard wouldn't have affected much beyond the commodities markets. As far as stocks are concerned, ending the gold standard probably affected the share prices for manufacturers of jewelry and dental supplies, but I don't think it would affect much more. Also, please note that inflation was taken into account in all my long-term trend charts.

What if the Bear Stearns crisis had happened on a Monday?

"Just a couple thoughts I'm having after this strange week. It seems like stocks are inching higher in the face of bad news until they crash. To paraphrase Galbraith, people think the worst is reasonably over, so those beliefs lead to a rising market which tends to reinforce the view that the worst is reasonably over until the catalyst comes."

I actually think that things are happening in a different order than they happened in 1929.

In 1929, there was a panic, but then a post-crash three-year period with a continuing bear market. I believe that we've already entered what corresponds to the post-crash period, with the actual panic delayed.

I'm reasonably certain that the panic would have occurred last October if it hadn't been for such aggressive Fed intervention. And I KNOW it would have occurred in March if the Fed hadn't intervened so aggressively to save Bear Stearns.

In fact, if I understand you correctly, I think you're saying the same thing, when you refer to Galbraith's remark, which applied to the 1929 post-crash period.

"That's exactly how I see it. In fact, I remarked to the mailman (when he mentioned that he was thinking about buying back into the market with his retirement money) that having the weekend to patch up Bear Stearns probably made the difference between whether a panic would have already occurred or whether it will occur later. If Bear Stearns had collapsed on Monday, Tuesday, Wednesday, or Thursday instead of Friday, there would not have been enough time to patch it up and a panic would have occurred. I agree there will still be a panic after this secondary high is complete, whenever that is. After this panic occurs, the vast majority will think the worst is over and buy (or hold) stocks. But the worst will not be over and stocks will continue to decline for a number of years. You know, after the 1929 crash, the low in the Dow Jones was 198 in November and the Dow made a substantial recovery to 294 in April of 1930. Therefore, those who know their market history will probably try to buy a post crash low. It's my guess that there will be no recovery after this upcoming crash and stocks will move lower for years. That is how Maximum Ruin will be accomplished this time."

What you're saying makes a lot of sense. (23-Jun-2008) Permanent Link
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