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 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 26-Jul-2010
26-Jul-10 News -- Markets shrug off flawed European stress tests

Web Log - July, 2010

26-Jul-10 News -- Markets shrug off flawed European stress tests

The 'rule of 20' - another away to cheat on stock valuations

Markets shrug off flawed European stress tests

European politicians and financial execs were in a tizzy all last week because they were afraid that the results of the stress tests of European banks, which were to be released at 5 pm on Friday in Europe (noon, NY time), would be bad.

They needn't have worried. Of the 91 banks being tested, only 7 failed -- one German bank, one Greek bank, and 5 regional Spanish banks (cajas). And all seven of the 'failed' banks are going to raise enough capital to make sure that the markets are calm when they open on Monday, according to the Independent.

The consensus of financial pundit opinion over the weekend seems to be that the tests were a "joke," or "flawed," or "cyncially calibrated" or "not rigorous," but that the markets won't care.

"If you tried to test the safety of cars or children’s toys using the same method the European Union applied in its stress tests on banks, you would end up in jail," said Walter Münchau of Financial Times (Access). "How so? Simply because the testing mechanism was calibrated to fix the result. The purpose of the exercise was to ensure that the only banks that failed it were those that would have to be restructured anyway."

Let's recall how the financial crisis came about. First there was a global real estate bubble that artificially raised the prices of homes by a factor of 2 or 3. Then the bankers figured out a way to create artificial securities (collateralized debt obligations, or CDOs, backed by mortgages) that leveraged even the bloated real estate prices by a factor of 5 or 10. Thus, tens of trillions of dollars of these synthetic securities, now known as "toxic assets," were created and sold at prices 10 to 30 times their real market value.

These synthetic securities are in financial portfolios around the world -- individual investors, banks, country treasuries, etc. These securities were used as collateral for further bad loans, or to pay off labor unions with extravagant wage and benefit guarantees. Everybody had an angle, and everyone was out to screw other people.

One of the problems with the European bank stress tests is that not all the toxic assets were required to be marked to the market value. This is the same problem with American banks. Regulators have told banks to continue to defraud their investors by misrepresenting the values of the toxic assets on their balance sheets. Anyone who buys stock in banks, based on the asset values shown in the banks' balance sheets, is a victim of fraud, perpetrated by the banks with the full cooperation of the regulators.

The biggest and most serious problem with the European stress tests, according to Münchau, is that they ignore the problem of sovereign default. For example, it's all but certain that Greek debt is going to default, and any bank that has invested in Greek bonds is going to lose a lot of money. But the stress tests almost completely ignore that problem.

As Münchau points out, "The stress tests follow a pattern that has been evident since the outbreak of the acute phase of the financial crisis in September 2008. The EU’s approach to the financial sector has been to apply patchwork fixes – a blanket bail-out, some not very serious recapitalisation plans, plus loads of liquidity – rather than solve the problem."

In other words, in Europe as in America, the same kinds of fraud that have been going on for years are still going on.

You might wonder whether these politicians and financial people have any plans. The answer is "Yes, they have a plan." The plan is to pray that the world economy will begin to grow again as it did in the mid 2000s decade, and "grow the economy out of debt."

This is like a person racking up more and more credit card debt, hoping that his salary increases will eventually allow him to pay them off. There are two flaws in that reasoning. One is that he may not get the salary increases. And the other is that if he does get the salary increases, then his wife will just get him to rack up even greater credit card debt. Nothing will change until the buy is bankrupt.

The same flaws are apparent in the world economy plan. First the economy may not grow. And second, even if it does grow, then the labor unions and the liberals and progressives would make sure that any additional funds are used for more union wages and social programs.

The above is actually sort of a mathematical proof that a much worse crisis is going to come soon. Since no steps except "patchword fixes" will ever be taken to resolve the problems, the only thing that will end the crisis is the international form of bankruptcy.

From the point of view of Generational Dynamics, nothing has changed. Generational Dynamics predicts that we're headed for the biggest financial crisis in history with mathematical certainty. These stress tests are just game-playing along the way.

The Rule of 20

I heard a financial analyst mention the "rule of 20" on Bloomberg TV the other day. In checking it out, I discovered an interesting historical artifact of one of the many ways that researchers justified the dot-com and subsequent bubbles.

The Great Depression survivors were very cautious investors, and never allowed any of the debauched practices that caused the Depression. However, those survivors pretty much disappeared (retired or died) by the mid-1990s, and the Boomers and Gen-Xers who took over had no particular reluctance to refrain from any kind of financial debauchery whatsoever.

The paper, "Tactical Asset Allocation: Follow the Rule of 20" (PDF), by Glenn Tanner, appearing in the Journal of Financial and Strategic Decisions in 1999, is a great illustration of how this particular kind of debauchery took place.

Here are the first few paragraphs from that paper:

"The false alarms set off by high market PE ratios in 1995-1996 have motivated many market participants to look for new asset allocation signals. The Rule of 20 appears to be a strong candidate to replace the PE ratio for market watchers. The Rule of 20 is simply a modification of the PE (market PE + annual inflation) that recognizes that PE’s should be high in periods of low inflation. This paper examines the forecasting performance of The Rule of 20 relative to the PE ratio. Using a 60-year data set, the R20 measure showed better forecasting performance than the PE for 3-month, 6-month, and 12-month market changes. An experiment performed on a sub-sample of the data suggests that the R20 measure could have been used as a profitable asset allocation tool. ...

One of the most often-cited indications of stock market overvaluation is a high price earnings ratio. The widely reported version of the PE ratio is simple to calculate – it is the ratio of current stock price to the sum of the four most recent quarterly accounting earnings per share, or the number of dollars that investors are willing to pay per dollar of earnings. Thus, according to conventional wisdom, the higher the PE ratio of the market (the more investors are willing to pay for earnings), the more overvalued the market is likely to be; lower PE ratios indicate a good time to buy. This idea has been empirically tested by Bleiberg (1989) and Good (1991); both studies found that market PE ratios were inversely correlated with subsequent market returns – low PE ratios signaled high market returns and high PE ratios were generally followed by low market returns.

Recent market performance has motivated traders to look for improvements on the PE ratio. Those who believe that high PE’s are a danger signal likely missed out on the 30%-plus market returns in 1995, which came in the midst of PE ratios in the 21-to-22 range. Many traders explained this apparent contradiction by claiming that the high PE ratios were justified by low inflation.1 This explanation yielded a derivative of the PE ratio as a market predictor – the Rule of 20. The measure is calculated by adding the annualized inflation rate to the market PE ratio.

The name comes from the supposedly key point of the measure – if the measure is under 20, expect the market to do well; if over 20, be wary of a declining market."

These words are so full of irony that they're laughable.

Tanner apparently was not aware, or did not believe, that the market was in the middle of the dot-com bubble in 1999. What he was saying was that if you used the traditional measure of stock valuation (the price/earnings ratio that the old geezers who had survived the Great Depression used), then you missed out on the dot-com bubble.

As I've said many times, the historical P/E average (stock price divided by one year trailing earnings) is around 14. Since 1995, the P/E ratio has been far above the historical average, and by the Law of Mean Reversion will have to fall down to a value well below average (around 5) for the same period of time, around 15 years. (See "How to compute the 'real value' of the stock market.")

The "Rule of 20" is a way of ignoring the realities of stock valuation, and is interesting for its historical value. In a period of near-zero inflation, like today, it justifies a P/E ratio of 20, which is absurd.

In recent years, the financial analysts have dreamed up even more imaginative ways to deal with high P/E ratios. The one we've discussed most often is to use "operating earnings" rather than real earnings. Operating earnings are a fiction computed by ignoring one-time expenses in computing earnings. This effectively pushes earnings up artificially high, and lowers P/E ratios.

For the survivors of the Great Depression, valid computations of price/earnings ratios were the best guide to investing in stocks. The Boomers and Gen-Xers did everything in their power to distort the P/E ratios to justify the stock market bubble. With the coming financial crisis, we're all going to pay the price.

Additional links

Safeway supermarkets cut its 2010 earnings forecasts substantially, saying that price deflation caught them by surprise. Safeway had "expected the recovery to start right around now with a little more momentum and a little more pricing power," but found instead that "Deflation continues in price per item and is not expected to significantly improve until the fourth quarter." Reuters

Former Fed Governor Lawrence Lindsey predicted that the Fed will have to take additional easing steps because of deflation. "It will be obvious for the Federal Reserve by the end of this year that we are entering in a deflationary trap and I would expect some response by the Fed by that time." Bloomberg

Last year's H1N1 swine flu pandemic turned out to be nowhere near as bad as had been feared, but the danger hasn't ended. A new mutation is spreading rapidly among swine in Iowa and Illinois. The new mutation has not yet been transmitted from swine to humans, but that could change, resulting in a much worse pandemic than last year's. Recombinomics

With Israel-Turkey relations disintegrating since the flotilla incident, relations between Syria and Turkey are becoming much friendlier, and tens of thousands of Syrian shoppers are flocking to the city of Gaziantep in southeastern Turkey for bargain hunting. NY Times

China is building a fleet of aircraft carriers and, at the same time, developing land-based anti-ship ballistic missiles that can destroy America's aircraft carriers. Asia Times

China is making huge investments in Pakistan's energy infrastructure, but the U.S. will oppose a Chinese nuclear reactor sale to Pakistan on the grounds of preventing nuclear proliferation. Washington Times

The use of internet among rebels in Kashmir to promote Kashmiri independence is small but growing. The Hindu

The situation in Somalia continues to deteriorate as tens of thousands of people have tried to flee the conflict, but are being turned back by the refugee camps in surrounding regions. Eurasia Review

During WW II, Switzerland was preparing for a major Nazi invasion that never came. In preparation, the Swiss build large underground bunkers, designed to hide their soldiers, along with weapons, ammunition and other supplies. These fortifications were maintained until the 1990s. Time

(Comments: For reader comments, questions and discussion, see the 26-Jul-10 News -- Markets shrug off flawed European stress tests thread of the Generational Dynamics forum. Comments may be posted anonymously.) (26-Jul-2010) Permanent Link
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