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Generational Dynamics Web Log for 6-Aug-2008
Wall Street stock prices soar amid terrible earnings news

Web Log - August, 2008

Wall Street stock prices soar amid terrible earnings news

A year after the global credit crisis began, investors are convinced that it has to be over.

Wall Street stock indexes spiked 3% in the last two days, despite the shocking $821 million earnings loss during the second quarter. This was THREE TIMES worse than analysts expected. There is no way to interpret this situation as anything but incredibly disastrous, but investors weren't fazed, as the bought lots of stocks.

On top of this, the foreclosure rate keeps rising, and regional bank failures are expected to increase substantially. Furthermore, second quarter earnings estimates have notched a little bit lower, as indicated by the following update, based on cumulative figures from CNBC earnings central:

  Date    2Q Earnings growth estimate as of that date
  ------- -------------------------------------------
  Jan  1:              +4.7%
  Feb  6:              +3.5%
  Apr  1:              -2.0%   Start of quarter
  Jun  6:              -7.3%
  Jun 13:              -8.1%
  Jun 20:              -9.0%
  Jun 27:             -11.3%   End of quarter
  Jul  3:             -12.4%
  Jul  8:             -13.0%
  Jul 11:             -14.7%
  Jul 18:             -17.1%
  Jul 25:             -17.9%
  Aug  1:             -20.4%
  Aug  4:             -20.4%  Mon
  Aug  5:             -20.4%  Tue
  Aug  6:             -20.5%  Wed

What's going on? Why are investors ignoring what's going on?

As far as I can tell, investors simply can't believe that these problems can possibly continue much long. The global credit crisis began a year ago, and none of these people can believe that it will go on. I've heard even normally cautious financial pundits say, "We may have a bumpy ride for the next months, but the S&P and Dow indexes will be up by the end of the year." This conclusion is not based on a shred of evidence, except "nothing like this has happened in my lifetime." And if there's going to be a major stock market rally, these dim bulbs don't want to risk missing out.

I've quoted the following paragraph from John Kenneth Galbraith's 1954 book The Great Crash - 1929, a dozen times before, but you can't read it too many times, where he contrasted the 1929 with previous panics:

"A common feature of all these earlier troubles [previous panics] was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune.

The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. ... The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or fourth of the purchase price in the next twenty-four months. ... The ruthlessness of [the stock market was] remarkable." (p. 108)

This is what's going on today. Today's financial managers, none of whom have any personal memory of the Great Depression, simply cannot bring themselves to believe that this can continue.

This leads to what I've been calling the Principle of Maximum Ruin. Investors continue to lose money in the market, since they can't believe that bad news will continue. The maximum number of investors are ruined to the maximum extent possible - the Principle of Maximum Ruin.

When I was watching cartoons on TV in the 1950s, there was always an inviolable rule: What goes up, must come down. This rule needed no proof; nothing else was conceivably possible.

Today's investors have an equally inviolable belief: What goes down must come back up. This rule needs no proof; nothing else is conceivably possible. The above quote from Galbraith's book shows how the same inviolable belief was held by investors in 1929. The rule needed no proof then either. Nonetheless, it turned out to be disastrously wrong.

A fall in earnings estimates means an increase of price/earnings ratios estimates. Here's the Friday's version of the graphic that appears on the bottom of the home page of this web site:


S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 1-Aug-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 1-Aug-2008. (Source: MarketGauge ® by DataView, LLC)

It now looks as if a new trend has been established. For two years, investors had been tuning their buy/sell algorithms to maintain price/earnings ratios (also called "valuations") of almost exactly 18. But now they've re-tuned their computer software to target valuations around 21.

I've written this recently, and a web site reader sent me the following comment:

"Regarding your observation that the trading programs appear to have reset their P/E multiple targets for 21 - I've been watching the DJIA over the past few weeks wondering when it was going to sink below 10,000 and it suddenly struck me today as I looked at the index that the P/E multiple targets have probably been reset to prevent that. A below 10,000 dip would be a powerful psychological blow to the market and could lead to full-blown panic selling. It seems like the Principal of Maximum Ruin has been kicked into operation."

This comment goes much farther than I ever went -- the writer implies that that "they" are actually conspiring to keep the market indexes up.

Now, I almost always reject conspiracy theories as a matter of course, but there's actually a precedent in this case to support the conspirational theory.

In 1929, a banker consortium got together to support the market. They believed that the market collapse was simply a matter of "confidence," and they felt that the market bubble would start growing again, if only they could restore confidence. That worked for a day or two, but no longer. It was only years later that the 1920s stock market was recognized by everyone as a bubble.

Today it's widely believed that the only problem with the stock market is a lack of confidence. 99 and 44/100% of the analysts, journalists and politicians have ABSOLUTELY NO IDEA what's going on, and think that just by jawboning, the market bubble can start growing again.

Furthermore, there's an actual government-sponsored group that's been set up to play the part that the informal banker consortium played in 1929.

The Plunge Protection Team (PPT) is the whimsical name used in a 1997 Washington Post story.

The real name of the group is the "Working Group on Financial Markets," and it's in the Treasury Dept. The working group languished for several years, but was reactivated 1 years ago by Treasury Secretary Hank Paulson.

So I have to admit that the comment above might quite possibly be correct. In my opinion, it's not possible for the P/E index to have remained constant at 18 for two years, and now to have adjusted to 21 in the last month, without some coordination. I had assumed that the coordination was unconscious, but now when I read the above comment, and I think about what happened in 1929, I have to agree that there may be some conscious coordination. It may have been informal, or may have been done formally through the "PPT", but either way there must be some conscious coordination.

Incidentally, if there is formal coordination, then it's against the law -- it violates securities laws and antitrust laws. It was just last month that the SEC blamed the stock market problems on "false rumors." Conspiring to lower stock prices is, of course, completely illegal and worthy of the harshest punishment. But conspiring to keep stock prices up? Well, that's such a good thing, that it must be ok.

It's thought that one of the reasons for the stock market surge is that commodity prices have been falling, especially oil prices. Now, I don't believe that there's been any conspiracy by speculators to keep commodity prices up, and I don't believe that the current fall is related to any action (or inaction) by speculators.

Related Articles

Baltic Dry Index
Wall Street stock prices soar amid terrible earnings news: A year after the global credit crisis began, investors are convinced that it has to be over.... (6-Aug-2008)
Shanghai China stock market and Baltic Dry Index are crashing sharply: Developing country economies all appear to be collapsing.... (13-Jun-2008)
UN expert calls biofuels a "crime against humanity": Separately, Oxfam says that biofuels won't work, and they "trample" poor people.... (7-Nov-07)
China heading for deflation as manufacturing index shows weakness: There are signs that China's bubble economy may be bursting... (2-Aug-05)
The mysterious Baltic Dry Index reveals a great deal about the Chinese economy: China is causing wild volatility and turmoil in shipping, iron ore and steel prices,... (5-Jul-05)
Worldwide shipping is slowing down, indicating a softening of world economic growth: Have you ever heard of the 'Baltic Dry Index'? It's been falling sharply.... (14-Jun-05)

The Baltic Dry Index, which measures the demand for ocean transportation of dry goods, has been plunging for 18 weeks in a row.

The only reasonable explanation for all this is that demand for many commodities has been falling, and that seems obviously to be caused by a slowing of China's economy. This view is supported by the fact that the Shanghai stock market has falled by over 50% since October, 2007.

In January, 2005, I wrote "China approaches Civil War," and the reasons given at that time haven't changed. China has held off peasant unrest by the massive economic bubble that the country has sustained for many years. If commodity prices continue to fall, it will probably mean that China's economy is entering a recession, and this will certain generate many more peasant demonstrations and result. At some point, one of those demonstrations will trigger a nationwide rebellion, and a civil war.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (6-Aug-2008) Permanent Link
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