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Generational Dynamics Web Log for 19-May-2008
Price/earnings stock index continues to surge higher and higher

Web Log - May, 2008

Price/earnings stock index continues to surge higher and higher

I can hardly believe my eyes:


S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 16-May-2008. <font face=Arial size=-2>(Source: MarketGauge ® by DataView, LLC)</font>
S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 16-May-2008. (Source: MarketGauge ® by DataView, LLC)

The above is Friday's version of the graph that appears on this web site's home page. The historical average is 14, but it's been well above average since 1995, indicating that we're in a 13 year old stock market bubble. By the Law of Mean Reversion, we can expect a 13-year long correction.

For the last couple of years, the P/E ratio has been holding steady around 18, but in the last month it's been taking off again, and even appears to be accelerating upward.

This is just incredible. Just when I think that Wall Street investors have become so insane that they can't possibly get any worse, they always find a way. The insanity is becoming breathtakingly amazing. It's hard to find the words to describe it.

"Insanity in individuals is something rare - but in groups, parties, nations and epochs, it is the rule." -- Friedrich Nietzsche

I used to think that was a joke, but it's incredibly true, and it's now one of my favorite quotes.

A web site reader has called my attention to a quote by President Herbert Hoover from May 1, 1930, six months after the 1929 stock market crash:

"1930: The Worst Is Over

WASHINGTON: Attributing the Wall Street crash of last fall to the "inexorable consequences of the destructive forces of booms" and paying tribute to the American people for their "unity of action in time of national emergency," President Hoover addressed the United States Chamber of Commerce here tonight [May 1]. "We have been passing through one of those great economic storms which periodically bring hardship and suffering to our people," said Mr. Hoover. "While the stock exchange crash occurred only six months ago, I am convinced that we have now passed the worst, and with continued unity and effort we shall rapidly recover."

The world was in a hypnotic fog in 1930, and they're in a hypnotic fog today.

Other people's money

Actually, I'm going to discuss the REALLY cynical explanation.

Over the past five years, I've increasingly been discussing the high levels of financial debauchery and depravity that gave rise to the current situation.

At first I was just talking about it in terms of an occasional bit of embezzlement by someone who'd lost some money. But I've been documenting example after example, and the stench of corruption keeps increasing. From homeowners lying on their applications to financial institutions defrauding investors with faulty CDO securities, the stench of corruption is pervasive, across all institutions, from top to bottom.

In my previous article, I discussed how all mainstream economists since Greenspan was at the Fed, including professors of economics and Nobel prize winners, have all been talking sheer nonsense. And as my cynicism has increased, I conclude that the same corruption that permeated financial and real estate institutions also permeated university economics departments.

Now we have a new mystery: Why the sudden and completely unexpected surge in the price/earnings ratios? Are investors that stupid?

That explanation becomes increasingly suspect, as the number of incredibly stupid people keeps growing. After all, there must be SOMEONE who has some sense.

I've now become so cynical that I don't believe it's stupidity. I believe that P/E ratios are going up so high again because investors are investing other people's money in order to claim the commissions and fees that go along with it. In other words, why assume that the massive fraud stopped in 2007, when it's a perfectly reasonable explanation for the insanity that's going on in 2008?

I'd be willing to bet someone a lunch that the investors that are pushing up P/E ratios right now are investing other people's money, but making bonuses, fees and commissions.

Earnings estimates continue to fall

The reason that the price/earnings index is rising is because corporate earnings estimates keep falling. Each week I post the table of corporate earnings estimates, based on figures from CNBC Earnings Central supplied by Thomson Reuters. Here's the latest version:

  Date    1Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct 23:             +10.0%
  Jan  1:              +5.7%
  Feb  6:              +2.6%
  Feb 29:              -1.1%
  Mar  7:              -4.3%
  Mar 14:              -7.8%
  Mar 21:              -7.9%
  Mar 28:              -9.3%
  Apr  4:             -12.2%
  Apr 11:             -14.1%
  Apr 18:             -14.6%
  Apr 25:             -14.1%
  May  2:             -15.0%
  May  9:             -17.4%
  May 16:             -17.5%

According to the pundits, investors have been keeping the market in a "trading range" for several weeks now, meaning that the major indexes have been bouncing up and down within a fairly narrow range of values. Pundits say that a "breakout" could happen at any time -- and it could happen in either direction, up or down.

In this environment, what is extremely ominous for the market is this amazing increase in price/earnings ratios that's come about in the last couple of months, after holding steady for four years.

These sharply reduced earnings estimates, resulting in increased P/E ratios, strongly suggest that the trading range "breakout" will be in the downward direction. One can't say that for sure, of course, because Wall Street investors are in a such a huge denial fantasy that anything might happen. Still, even in this fantasyland world, it's likely that investors will push P/E ratios down again, meaning that stocks will fall.

American International Group (AIG)

One of the reasons for the lowered earnings estimates was incredibly bad news last week from American International Group (AIG), the world's largest insurance company.

First, some brief history. Late last year, AIG was out front bragging about how clever they were, having avoided the credit crunch suffered by less sophisticated financial institutions. Here's how CNBC's Jim Cramer described the situation:

"AIG had been the biggest proponent of "super senior," meaning they repeatedly said that their collateralized debt obligation (CDO) exposure was of the kind that was intelligent, measured and thoughtful. They talked endlessly about how their due diligence made the difference and that unlike all of the other buyers, they kicked the tires three times and never bought the plain ol' CDOs. Then they brought in professors from Wharton to be sure that even if all heck broke loose and they were being too aggressive, they would be hedged.

They also were the first to give you the percentages of how much could go bad and that even in the worst-case scenario, they were overcapitalized. And, most important, they were insurers, no need to mark to market, they can play it all out. ...

What they did buy -- they assured us in that big teach-in dog-and-pony show in December -- was the extra-special nature of their particular buys and that, unlike everyone else, risk officers scrutinized every single piece of paper that went into their super senior insurance, meaning only the top-top part of a CDO-squared, the part where everything had to default ahead of it; they made a point of how impossible that would be.

It was all nonsense. Every bit of it. It was all Enron, frankly, unless they genuinely drank their own Kool-Aid about risk management and extra-mile supervision."

The teach-in dog-and-pony show was in December.

In February, AIG said that inadequate internal controls, as determined by its outside auditing firm PricewaterhouseCoopers, had led to "material weakness" in financial reporting relating to the fair valuation of credit default swap (CDS) portfolio obligations. The writedowns totaled around $6.2 billion. This was a complete shock to the financial community, in view of AIG's previous statements.

(For those interested in the math behind the creation of CDOs and CDSs, see "A primer on financial engineering and structured finance." For a discussion of credit default swap (CDS) counterparty risk, see "Brilliant Nobel Prize winners in Economics blame credit bubble on 'the news.'")

Last week, AIG announced massive first quarter losses, including an additional $7.81 billion in asset writedowns. However, this bad news didn't perturb investors much, because they've adopted the view that "the more disastrous the news, the closer we are to the end."

But is AIG close to the end of its writedowns? They certainly aren't saying so. That assertion is blatantly missing from AIG's press release. All it does is explain what happened so far:

"Commenting on first quarter 2008 results, AIG President and Chief Executive Officer Martin J. Sullivan said, "AIG's results do not reflect the underlying strengths and potential of AIG; rather they reflect the extremely adverse external conditions affecting the spectrum of companies exposed to the U.S. residential housing, credit and capital markets. ...

"While we anticipated a difficult trading environment, the severity of the unrealized valuation losses and decline in value of our investments were beyond our expectations. Current market conditions also contributed to a significant decline in partnership income compared to a record level in the first quarter of 2007, as well as to declines in mutual fund income. However, the underlying fundamentals of our core businesses remain solid, and several performed quite well in the quarter, despite the challenging environment many faced."

The interesting thing about this is that it evinces absolutely no indication of what happened and why it happened. It's as if some evil magician had waved a magic wand that made AIG's assets worthless, and there's every indication that the magic wand will be waved again at some unpredictable time, and more AIG assets will be written down.

The other interesting thing is that these combined $14 billion writedowns are in "credit default swap (CDS) portfolio obligations." As I explained recently, there are $45 trillion in CDSs that form long "chains," where a default of one firm could trigger a whole chain of additional defaults in other firms.

AIG lost $14 billion, which is a heck of a lot of money. Here's my guess as to what happened.

First, the rate of housing foreclosures is soaring, much faster than analysts had predicted. California has just passed a milestone: There are now over 1,000 foreclosures every day in California. Can you imagine that? Every day, 1,000 more families are turned out of their homes because of a foreclosure.

We can pretty safely assume that the CDOs that are backed by these foreclosed mortgages are themselves defaulting more and more, far faster than analysts had predicted. In fact, we recently posted some data indicating that the rate of CDO defaults is accelerating.

Therefore, we can pretty safely assume that the CDSs -- the credit default swaps written as insurance on the CDOs -- are being called in for payment. Something like that must be how AIG lost its $14 billion in "credit default swap (CDS) portfolio obligations."

And there's simply no reason at all to assume that there won't more of these. In fact, it's certain there will be, with foreclosure rates accelerating.

What would happen if AIG didn't have $14 billion to spare? In other words, suppose that writedowns had driven AIG into bankruptcy? We already know the answer to that question, because it's the same thing that would have happened if Bear Stearns had been permitted to default in March. According to Fed Chairman Ben Bernanke testifying before Congress, there would likely have been a major worldwide financial crisis if Bear had been allowed to default.

With $45 trillion in CDSs outstanding in the world, and with real estate foreclosures accelerating, it's only a matter of time before some institution will go bankrupt because of CDO defaults. That will be a memorable time.

And in this environment, we have investors pushing price/earnings ratios up to stratospheric level.

As I've said, I keep trying to figure out what the hell is going on in the world. What Wall Street is doing is absolutely beyond belief. The craziness and insanity, the resistance to seeing what's going on right before their eyes, can barely be grasped.

La Valse Mille Temps

I like to post this song every now and then, because it should be the theme song for the utter craziness going on, as the world appears increasingly to be spinning out of control.

It's a Jacques Brel song, "La Valse Mille Temps" or "Carousel" in the English version. Play the MP3 version of the song and sing along:

    We're on a ferris wheel
    A crazy ferris wheel
    A wheel within a wheel
    That suddenly reveals
    The stars begin to reel
    And down again around
    And up again around
    And up again around
    So high above the ground
    We feel we gotta yell
    We're on a carousel
    A crazy carousel.

(By the way, the above song is quite different from the original French song by Jacques Brel. Check out this hilarious video of Jacques Brel himself singing "La Valse Mille Temps," presented with English subtitles.)

As before, I nominate "La Valse Mille Temps" as the theme song for these times, as the crazy carousel goes spinning out of control, and we head for the greatest financial disaster in the history of the world. LAH luh LAH luh. (19-May-2008) Permanent Link
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