Imaginary wealth: why the credit crisis will not go away

published 1 April 2008

From the Great Depression, to the UK crash in 1972, to now bear markets all look pretty similar. The US housing crisis has triggered a recession and if history is anything to go by, this is just the beginning. But don't despair - we'll show you a new place to put your money

The "Primary Bear Market" that started in the year 2000 and, in our view never ended, has unquestionably resumed as a result of the reversal of global liquidity. We are now embroiled in potentially the worst credit contraction of any readers' experience and the implications are alarming.

Asset prices that specifically benefited from the preceding credit expansion will be the victims and will include most global equity markets, commercial and residential property and collectibles such as fine art and stamp collections. The duration is likely to be at least long enough to test the stock market lows set in March 2003 when the FTSE 100 was at 3278.

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A great depressing drama

Since two weeks ago a great drama has been played out as the Fed, led by Ben Bernanke, the world's greatest expert on the Great Depression of the 1930s, invoked an act of that time and stepped in to save Bear Stearns. Martin Wolf, in the FT, said "Bear Stearns was deemed too systemically important to fail".

The latest Securities and Exchange Commission filing in November 2007 saw that Bear Stearns' holdings of derivative contracts totalled $13.4 trillion - an amount equivalent to 25% of the total world's GDP their asset base was only $80 billion. However, according to the Bank for International Settlements, following the netting off of the contracts, the amount would be reduced to about 2% of that huge figure, $270 billion. Nonetheless, the Fed obviously thought that if Bear Stearns failed, the unravelling of those contracts might have been too tumultuous and disastrous for counterparties and even the security of the world's financial systems.

Disarmed was it worth it?

The Fed safely returned the pin to the hand grenade, effectively disarming it for the time being. Bear Stearns is to be purchased by JP Morgan, the original agreement was at $2 per share but now the talk is of $10 per share, an horrendous loss for shareholders. Because as recently as January 2007 Bear Stearns stock traded at $172.

Interestingly, one third of the shares are owned by Bear Stearns' employees for some, their personal wealth has been smashed to pieces. Worse still, a lot of them would have borrowed against the security. We wait to hear the sorry tales that will ensue from these early victims of the credit contraction.

The rescuing of Bear Stearns was coupled with further Fed easing, another huge 75 basis points off the Fed's funds rate bringing it down to 2.25%. The market, on the back of this extraordinary activity, moved strongly higher, led mainly by the oversold financial sector. The dollar also bounced and commodities, including gold, sold off.

A boom from failure

The stock market was further buoyed because the failure of a big Wall Street institution has in the past often signalled a market bottom. Examples of this are Continental Illinois in 1984, Drexel Burnham Lambert in 1990, Kidder Peabody in 1994 and Long Term Capital Management in 1998. JP Morgan said that following each of these events over the next twelve months the US stock market rose by an average of 17%.

Primary bear markets decline over a period usually measured in years and during that process move from being too dear to too cheap. Historically, this has meant that when too cheap market P/E ratios are in single figures and dividend yields are above 6%. According to the Financial Times, the US stock market is currently yielding 2.4%, with a P/E ratio of 16. As we have explained in the past, long term real stock market total returns average 7% per annum. For the seventeen years from 1983 to 2000 the S&P 500 delivered much more, real returns of 14% per annum. Since 2000, returns are below zero, a condition we would not expect to end for another five to ten years to bring long term average returns back to 7% per annum.

Let's not speak too soon

Below we print two historic charts. The first is the US stock market from 1928-1932. It comprises a series of wrenching downward moves with impressive retracements. The key points to note are that each rally failed to rise above the previous high and that the 30-week moving average virtually sat over the price throughout. There is an arrow to October 1930, when the then president, Herbert Hoover, addressed the annual convention of the American Bankers Association and said "During the past year you have carried the credit system of the nation safely through a most difficult crisis. In this success you have demonstrated not only the soundness of the credit system, but also the capacity of the bankers in emergency." You can imagine George Bush saying that today! At that point, the American stock market was just below 200, having fallen from 400 a year earlier. By mid 1932, it would be at its Great Depression low of 40.

The second chart is the UK stock market from 1970 to 1974, which from 1972 fell 75% and has very similar characteristics.

Our infant bear market

Now look at the three current charts the S&P 500, the UK All Share Index and the German DAX all three, to our eye, are in the early stages of a primary bear market. Whilst the 30-week moving average sits above future price action, we would consider these primary bear markets to be secure and ongoing. We would estimate they will fall at least 50% from here.

There could be true drama as investor unease steadily rises

The Volatility Index (VIX), one of our Four Horses of the Financial Apocalypse, continues at an elevated level. The rising 30-week moving average is in support and each progressive pull-back has been to a higher level than previous. The VIX says that investors' sensitivity to risk is progressively increasing. In our view, we are gradually coming to a point where the action could suddenly become truly dramatic, probably when the VIX exceeds the last twelve month's highs.

Central to everything is the US housing market where prices are truly collapsing as waves of foreclosures overwhelm. Although there was some relief when it was reported that existing home sales in February rose 2.9%, that was still 23.8% below February 2007. Inventories also improved from 10.2 months' supply to 9.6 months' supply, but this is still twice the level in 2005. The National Association of Realtors, who have a deeply vested interest in the recovery of the market, said that in February house prices fell 8.2% compared to a year ago, the biggest monthly drop since records began in 1968.

Whilst house prices continue to fall, negative equity engulfs an ever-widening group. As a developer client of ours who lives in Florida recently said "There is no market. The only sales taking place are of repossessed houses".

US housing the primary cause of a US recession

It is blindingly obvious to us that this American housing market story, irrespective of other possibly conflicting data, will bring consumers to their knees and be the primary cause of a US recession that could get very ugly. In just the last three weeks since the previous issue, the following economic news has been published:

US retail sales in February down 0.6%.
Henry Paulson, US Treasury Secretary, said "The economy has turned down sharply."
US families are going into this recession with less real income than in previous recessions.
OECD said that in the second quarter the US economy will grind to a halt as it struggles under the weight of what could be the worst housing slump in history.
Chicago Federal Reserve Bank's National Activity Index sent a signal that a recession had probably begun in the US. The three-month average score for that index fell below -0.7 "threshold" to -0.87 for February. A strong sign that the economy is already in recession.
The Conference Board Consumer Confidence Index fell a large 11.9 to 64.5. The report also said that consumer expectations are at the lowest point since 1973.
US durable goods orders were down 1.7% in February. Excluding transport, core orders fell 2.66% driven by the steepest decline in machinery orders on record.

Imaginary wealth

Roger Bootle, an economist we hold in great esteem, recently said "The essential truth is that umpteen billions of dollars have been magicked out of nowhere and must return whence they came, no amount of financial gerrymandering can obscure or diminish this point". He further said "Do not expect the current market turmoil to go away easily or quickly. It is not imaginable or fanciful, on the contrary it is the direct result of the creation, on a massive scale, of imaginary wealth in the housing and financial markets of the world, a mirror of what happened in the 1920s America and 1980s Japan".

Investing in Taiwan: an alternative

We search continuously for the next outstanding investment opportunity. The outcome of Taiwan's election this week may lead us to one. Ma Ying-jeou won Taiwan's presidential election last Saturday, pledging to open direct air links with China within a year and abolish restrictions on cross-Strait business. This political move towards China is tremendously important and will give huge support to the economy, which has been progressively decoupling.

Exports to the US are up 8.9% year-on-year, slowing from the 9.8% year-on-year growth posted last November.
Exports to mainland China and Hong Kong up 26.1% year-on-year, accelerating from 20.5% in November.
Exports to other Asian economies up 31.8% year-on-year, rising from 28.1% in November.

By John Robson & Andrew Selsby at fullCircle Asset Management, as published in the threesixty Newsletter, a fortnightly newsletter that gives insight into the investment markets.