Thursday, October 15, 2009

Is it real - or Irrational Exuberance?

The headlines in today's Wall Street J0urnal were glaring and unmistakable:

DOW At 10000 as Crisis Ebbs

In other words, we are expected to believe the last few months of "rally" are real, and the magic number is bona fide- spearheading a new onrush to wealth. But can it be believed? is it truly a marker of being out of the recession, or is it a dupe's snare?

There are a number of unsettling warning indicators that are being ignored except by a few. This negligence leads the scrutinizing genuine investor (as opposed to speculator) to believe what we are actually seeing is what former Fed Chairman Allan Greenspan once referred to as "irrational exuberance". That is, the mindless predisposition to feed and fuel another speculative bubble merely because the DOW is rising.

Let's look at some of these:

1) High unemployment

The unemployment rate remains at 9.8% and according to more serious stats, is probably closer to 15%. As I have remarked in earlier posts last year, the BLS unemployment statistic is inherently lowballed and hence flawed, because it drops non-workers off the rolls after 6 months- relabelling them as "discouraged". This simply isn't cricket, and leads to an artificiality in the numbers, much like the "consumer price index" (which excludes health care costs, fuel and food costs) does with inflation.

As I pointed some weeks ago on this blog, protracted low unemployment means that either: a) people will not be able to spend adequately to prop up consumption (which constitutes 70% of the national GDP) or b) they will have to go into debt to finance spending.

(1) means corporate profits must continue to retreat and any growth is therefore unreal- based on inflated P-E ratios and rising risk tolerance. (2) means more leveraging of the economy, which is exactly what initiated the real estate bubble.

Let's go on:

2) The dollar's value is decreasing, in inverse proportion to the rise in equities. The increased propensity to take on market risk is pushing it lower. The U.S. Dollar Index, a measure of the dollar's value against a slew of currencies fell to 75.49 on Wednesday, from 75.94 on Tuesday. This means the practical-trade in value of our currency vs. world currencies is at about 75 cents. An effective devaluation. Looking at the value of the Euro in the same timespan confirms this, as it was at $1.4919 Wednesday up from $1.4829.

What's going on? Why is the dollar value falling as the DOW goes up?

Simply put, dollars are being removed from real (productive) markets and injected into speculative or phantom money markets via the stock market. When I use the term "phantom money" I mean that the value varies almost daily based on the P-E or price to earning ratio. Because people received too little in real income, and so could not generate actual savings, they've tried to make up for it in the stock market via speculation. This is somewhat analogous to a poor schlub who barely has ten bucks to his name in discretionary weekly income, but uses it to play the lotto in the hope it will deliver actual wealth. No it won't. The odds are his real remaining money will simply be bled down.

Let's take another example: In the early 80s, the constant shrinkage of bank (pass book) interest rates, as well as CDs, forced vulnerable people to chase yield in risky vehicles for which they were never prepared. These items drove millions of average Janes and Joes into the 'market' who otherwise may never have ventured there. Just as, before 1929, millions of ordinary folk were driven into the infamous 'investment trusts' that caused them to lose everything.

The more recent (ca. pre-2000) piling into the market with 401ks, IRAs, etc, resulted in a hitherto never-before -seen phenomenon. What mass speculation did was to drive P/E ratios to incredible overpriced magnitudes. In some cases some equities, and mutual funds, were trading at over 70 time earnings. Invest one buck and get $70 back. It was better than playing the slots in Vegas on a good day.

People actually came to believe they could reach retirement based on ginned up returns from such speculative investment rather than plain old, unsexy, slow but steady saving. They were way wrong, and learned the lesson in the 2001 post 9/11 crash, and more recently in the mortgage -bubble generated crash.

What I'm getting at here is that the inverse dollar value-equities relationship is a nasty warning sign. It is telling the investor who has more than air between the ears that he's playing with his hard earned money much like the guy who earns $150 a week and is trying to double it playing slots, or the lotto.

Meanwhile, this chasing of phantom gains by speculation in the stock market - in fact - has caused the underfunding, under-investment in the REAL economy. Not the speculative one. Thus, as money has been removed from the spending stream and injected into speculation, real corporate infrastructure - including for better (improved) plant, research, labor was removed. Are you still scratching your head wondering why, if the DOW is so big and cool, the employers and corporations still aren't hiring people?

THAT is the question you ought to be asking.

The dollar's slide is also tied directly to the lack of national savings, which though it had slightly improved during the worst of the recession, is now retreating again. Granted a 2.7% rate is better than 0.7% from 2007, but it is still less than it was in December. (3.9%)

One thing the Fed could do to address the dollar value-equity imbalance is to raise interest rates. Not much, just to 0.5% or better 0.75%. This would have multiple benefits, not least of which is to protect the dollar from further retreat. It would also help other nations, such as Canada, to continue their own path out of recession. As it is, the increase of the loonie's value vs. the U.S dollar is stalling economic growth for Canucks.

Of course, the Wall street boys will weep and gnash their teeth, and we can't have that, can we?

3) There has been no true regulatory reform put into place.

Wall Street is basically carrying on as it always has, and there is no accountability, none. This sets the stage for yet another bubble based on derelict and obscure financial instruments, which will ensnare the unwary. Lest people- common investors forget, the "insurer of insurers" AIG, failed precisely because it sold vast amounts of CDS or credit default swaps without properly covering their own positions. Trillions of these yet remain on banks' books as "toxic waste".

What has to be taken away from the AIG, Lehman experience is that these damned CDS are totally toxic devices which need to be strictly regulated. (My own take is that they need to be outright outlawed, but no one will ever permit that to be done, too much common sense. And besides, there's a sucker born every minute who might buy them).

At the very least, only those who actually own the underlying REAL bonds ought to be able to purchase them. You can't do it on other people's money. If a true government regulation was passed simply requiring this, the result would be to tame a horrific financially destructive force and also cut the overblown price of CDS.

But nothing has been done!

Hence, the potential to craft new, more devastating ones persists, and any in the stock market - or even owning a bond fund or mutual fund, need to be very aware of that.

My personal opinion is that I would not set one investing "foot" in the market until every last CDS is cleaned out, OR (better) strict federal legislation is passed to control their creation.

Now, it is true many forlorn 401k owners have lost over 50% because of the 2008 meltdown. And they are impatient to get their hard earned money back. But they really ought to have understood from the get go that the 401k was never originally designed as a speculative-investing plan but as a SAVING plan. The original 401k was designed to allow workers to put money away each week, not to gamble it on stocks, or mutual funds (see also: The Great 401k Hoax, by William Wolman and Anne Colamosca)

Another point you need to know: if a share of anything goes down by 20%, it requires an advance of 25% to get back just to the breakeven point. If the value of a share drops 40 percent (as has occurred with some recent mutual fund hits since last year), you need a 66.7 % advance to break even. If the share drops 50% - as already noted- a 100% gain must be registered to return to ‘break-even’ (i.e. you’re not losing more than what you already paid).

Most realistic prognoses for most stocks and especially mutual funds (such as appear in 401ks) disclose at most only a 3-4% gain or return per year. If you experienced a 40% drop and are trying to earn it back, this means at least 16 2/3 years at 4% per annum. If you were 60 when your mutual funds blew out a 40% drop hole, it means you won't make it back to where you were (before the fall) until you are 76-plus.

But things get worse. In the above Pollyanna scenario no one is reckoning in taxes, or fund fees. Assuming 1% for each of those, means your after tax, after fees collected real return is only 2% per year. That means you will need to wait 33 1/3 years to get back to break even!

Perhaps, just perhaps, you'd have been better off with plain old saving (say in T-bonds or CDs) rather than being in the market in the first place!

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