Ishrc � Discussion Threads

[simon gordon] 28/3/2008 19:45

How We Got Into This Mess!

Comstock Partners Team - 28/3/08:

This Special Report will deal with the possibility that the market move of the past five years was not the bull market that everyone else believes, but instead a very strong counter-trend move in a secular bear market. As everyone now knows, there was a truly unbelievable financial mania in the late 1990s that produced a severe bear market and a mild recession. This was followed by 14 rate reductions by the Fed that produced an unprecedented rise of the housing market and doubling of the stock market over the following five years. The amazing part of this rise of these two markets was that they both started their run in 2002 from levels that were previously considered extremely expensive and only seen at tops-- not bottoms.

The stock market and economy experienced the greatest financial mania of all time in the late 1990s. Companies were going public without earnings and sometimes without revenues and doubling or tripling the same day as the IPO. It seemed like almost any company that had a dot com at the end of their name climbed to levels that stock market students will find astonishing and will wonder how something so absurd could have occurred for such a long period of time. Stock market analysts were competing with each other as to what their targets were on any company that had anything to do with the internet. An obscure analyst came on CNBC and became instantly famous when he predicted that Amazon would rise to $400 a share from the then-current price of about $150. As a result of this interview, he was hired by Merrill Lynch where he continued to make similar outrageous predictions. However, many of these outrageous predictions came to pass (including Amazon) because the market environment was so insane. Eventually almost all of his stocks collapsed in the bear market.

There were many events during the late 1990s financial mania that could have severely broken the market. We had a currency crisis in Asia when the Thailand Bat crashed and took out a couple of hedge funds with it. We had a worldwide panic when Alan Greenspan warned about the "irrational exuberance" of investors near the end of 1996. Then there was Long Term Capital Management, a hedge fund managed by a bunch of PhDs and Nobel Prize winners, that blew up in 1998. All of these events caused significant declines in the market, but all of those declines proved to be great buying opportunities as the market continued up through the end of the twentieth century.

The most useful metric for stock market valuation, the P/E ratio for S&P 500 reported trailing earnings, traded in a range of around 10 to 20 for almost 100 years. It typically rose to around 20 before peaking at the end of bull markets and declined to around 10 at the trough of bear markets. Sometimes the market rose to a little higher than 20 at peaks and sometimes the bear markets took the valuations to a little under 10, but for the sake of simplicity, think in terms of around 10 to 20 as the history of peak and trough valuations. During the financial mania of the late 1990s the PE ratio of the S&P 500 rose to around 40 or double the typical peak of 20. After what was discussed in the previous paragraph you can see that with all of the insanity going on in the markets this shouldn't be a surprise.

The market started down slowly in 2000 -- it was mainly the dot com bubble stocks that started down at the beginning of the year. The rest of the stocks started catching up with the dot com decline by September of 2000. The market continued to decline through 2001, and most of 2002 taking the S&P 500 down about 50% and the NASDAQ down about 80%. The S&P declined from about 1525 to just under 800 while the NASDAQ declined from about 5000 to 1100. The Dow Jones Industrials declined from 11,900 to about 7200 or about 40%. These declines would be, under normal circumstances, enough to believe that the bear market corrected the excesses of the late 1990s and that we should be off and running with a new bull market.

There were three things that we thought had to take place before the market made a valid significant bottom. First, the market trough of 775 for the S&P 500 was still at 26 times earnings (or higher than every market peak in stock market history until the bubble of the late 1990s). We would have expected the market to trade closer to 10 times earnings or less since that is where most market troughs traded at historically. Since then the PE has declined to around 20 times earnings today (typical at market peaks not troughs) even with the market doubling due to the earnings increases.

Second, the debt build up during the late 1990s was never liquidated as you would have expected in a recession. Instead, we experienced one of the mildest recessions in history with minimal effect on the public and no debt liquidation at all.

Third, the bear market of early 2000 to October of 2002 never experienced the public capitulation that we expected and discussed in our comments all through the year 2002. The liquidation of equity mutual funds was less than 1% of total equity mutual funds after the largest inflow of money into these same equity mutual funds in the first 2 quarters of 2000, coinciding with the peak in the market. The typical liquidations of equity mutual funds was 8% & 14% in the market breaks of 1987 and 1973-74 respectively. It was hard to believe the stock market was on its way to starting a new bull trend with this relatively minor public capitulation after the greatest financial mania of all time.

Again, the S&P 500 did rise from 775 in October 2002 to 1575 in October 2007 while the Dow Jones Industrials rose from 7200 to 14,200. The NASDAQ rose from 1100 to 2900 for a percentage gain of 170%, but remained well below the 5000 level reached in early 2000. The main reason for this increase in stock prices before the typical wash out and capitulation that is typically experienced before a rise like this was the impact of the Fed. Alan Greenspan's rate reductions of both the Fed Funds rate and the Discount Rate from 6% to 1% not only propelled the stock market to just about double, but also propelled the value of residential homes in many areas of the country to also double. We did understand that the Fed would attempt to start a new bull market in stocks and real estate with these reductions, but found it hard to believe that this new bubble could occur from the elevated valuation levels of both stocks and real estate. And we were sure that if the markets did rise from these levels that it could only be because of government intervention to stimulate the economy and stock market.

We have already mentioned that the PE of the S&P 500 at the October 2002 bottom was actually 20% higher than the PE typically seen at peaks. But that wasn't the main asset category that was spurred upwards by the rate reductions. The main asset category was real estate that was trading at the highest levels in real estate history, measured by the most accepted metrics-- price to rents and price to wages (see attached charts). As stated in the "special report" written in 2003, residential homes were trading at the highest levels in history!! Now these same metrics have risen so far that they would have been off of the charts used in 2003. These rate reductions drove real estate (especially single family residences) to double in many areas of the Country from 2002 to 2006, even from these outrageous valuation levels. The main areas experiencing increases were Florida, Arizona, California, and Las Vegas. All of these areas are showing the greatest declines now.

It was not just the 14 rate reductions that drove the prices higher, but Chairman Greenspan also encouraged new home owners to take on the risky adjustable rate and teaser rate mortgages in 2003. You will find his comments in an earlier "special report" written in September 2003 titled "Real Estate-The Catalyst for the Deflationary Bear Market" below.

September 2003--"One of the amazing aspects of the massive refinancing of homes, which is effectively piling on consumer debt at record levels, is the fact that this is being done with the blessings of our esteemed Federal Reserve Chairman, Alan Greenspan. In various testimonies he has stated that borrowing the equity in consumers' homes is helping the economy and he supports it. Imagine the head of the Central Bank of the world's largest economy becoming a cheerleader for individuals to continue borrowing on the equity of their homes while they have already incurred a record amount of debt and the homeowners' equity is falling to record lows. Could the Fed Chairman actually think it is appropriate to use ones' home as an ATM cash machine?"

Home price increases generated a wealth effect even greater than the wealth effect of stocks during the financial mania of the late 1990s because home equity is a much more significant part of most individuals' net worth. However, it doesn't stop there-- the rise in home values and the feeling that it was a one-way street (real estate can only go up since they can't make more land) drove homeowners to take out additional loans on their homes to invest in more real estate, the stock market, and/or consume goods. As you could imagine, the debt levels were driven to record highs and the amount of debt needed to be generated to increase $1 of GDP rose to records (chart showing this is attached). It now takes $3.50 of debt to produce $1 or GDP, up from $1.50 in 1982. What do you think happens to GDP under debt liquidations like we are experiencing now. This debt liquidation will continue as the housing prices continue their downward spiral as the excess inventories of close to five million homes is cleared out. This could wipe out as much as $6 trillion of wealth as housing values could drop to as much as $15 trillion from $21 trillion.

This circuitous investment cycle drove stocks and real estate to outrageous levels that have just started to correct, and will probably take both markets down to the levels of October 2002 and drive the country into a recession that could rival or exceed the worst post war recession of 1973-74. The major problem that took place during the housing bubble was the fact that the banks and financial institutions that supplied the mortagages did not perform their normal duties of making loans and overseeing them over the life of the loan. Instead, they accomodated Wall Street by packaging them and selling them which created a situation of benign neglect.

Superficially, it would seem as if the Fed can come to the rescue again. The problem with the Fed continuing to rescue the economy and stock market is that the total U.S. debt (both public and private) has increased substantially over the past 5 years to $49 trillion and the public sector debt is less than $8 trillion. The debt that has been generated by the private sector has grown to such a level that the Fed no longer has control. In fact, the main thing the Fed is accomplishing with these rate reductions and other "liquidity" measures is to drive down the US dollar. Soon they will realize that this is all they are accomplishing.

It is our contention that this latest "bull market" over the past five (2002-2007) years should have never taken place without a more significant recession (that would have reduced debt and encouraged savings) and a more severe stock market "wash-out". This would have gone far to correct the severe imbalances caused by the financial mania of the late 1990s, but unfortunately that did not happen. Right now the Fed is trying the same thing that seemed to work in 2001 & 2002. Actually, all they did was postpone what should have happened in 2003 to the present period. However, now they are attempting to manipulate the credit markets, stock market, and housing market by lowering rates, reducing regulatory restrictions (FRE & FNM), and encouraging special auctions to generate more "liquidity". They can throw as much liquidity as they have (about $900 billion unless they decide to print more) at the various problems as they sprout up, but it is futile.

The capitalistic system typically undergoes mild recessions that correct imbalances built up during the expansion. When these recessions are not allowed to occur, the imbalances just get worse and eventually results in a much deeper recession, or even depression. After the country goes through an incredible spending spree financed with debt, there has to be a period of cleansing. And if this indulgence is accompanied by almost everyone moving into homes they cannot afford or buying second and third homes based on unlimited credit, causing an incredible housing bubble that has to be corrected, it makes the problem much worse. There is nothing the Fed can do to stop housing prices from continuing to decline and commercial real estate will be the next shoe to fall.

The period of cleansing is called a recession, but if the government and Fed continue to interfere and maybe postpone it again, the recession might turn into a depression. Let's hope the Fed and the Administration realize what is inevitable soon, or it could really get nasty!!!

[simon gordon] 22/3/2008 13:24

Warren Buffet - 2003:

Buffett warns on investment 'time bomb'

The rapidly growing trade in derivatives poses a "mega-catastrophic risk" for the economy and most shares are still "too expensive", legendary investor Warren Buffett has warned.

The world's second-richest man made the comments in his famous and plain-spoken "annual letter to shareholders", excerpts of which have been published by Fortune magazine.

The derivatives market has exploded in recent years, with investment banks selling billions of dollars worth of these investments to clients as a way to off-load or manage market risk.

But Mr Buffett argues that such highly complex financial instruments are time bombs and "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system.

Derivatives are financial instruments that allow investors to speculate on the future price of, for example, commodities or shares - without buying the underlying investment.

Derivates like futures, options and swaps were developed to allow investors hedge risks in financial markets - in effect buy insurance against market movements -, but have quickly become a means of investment in their own right.

Outstanding derivatives contracts - excluding those traded on exchanges such as the International Petroleum Exchange - are worth close to $85 trillion, according to the International Swaps and Derivatives Association.

Some derivatives contracts, Mr Buffett says, appear to have been devised by "madmen".

He warns that derivatives can push companies onto a "spiral that can lead to a corporate meltdown", like the demise of the notorious hedge fund Long-Term Capital Management in 1998.

Derivatives also pose a dangerous incentive for false accounting, Mr Buffett says.

The profits and losses from derivates deals are booked straight away, even though no actual money changes hand. In many cases the real costs hit companies only many years later.

This can result in nasty accounting errors. Some of them spring from "honest" optimism. But others are the result of "huge-scale fraud", and Mr Buffett points to the US energy market, which relied for most of its deals on derivatives trading and resulted in the collapse of Enron.

Berkshire Hathaway, the investment group led by Mr Buffett, is pulling out of the market, closing down the derivatives trading subsidiary it bought as part of a huge reinsurance company a few years ago.

In his letter Mr Buffett compares the derivatives business to "hell... easy to enter and almost impossible to exit", and predicts that it will take years to unwind the complex deals struck by its subsidiary General Re Securities.

[simon gordon] 20/3/2008 17:10

Avner Mandelman - 15/3/08:

A History Lesson: Beware the makings of an echo crash

Some of the best investment advice comes from old movies. In a memorable scene, Groucho Marx is caught in flagrante delicto by his movie wife, the redoubtable Margaret Dumont. Groucho brazenly denies everything, and when Ms. Dumont points to the woman by his bedside, he utters the immortal line: "Who would you believe, your eyes or me?"

This sentence should be engraved on every investor's Internet screen - especially when listening to a Fed chairman, past or present, speak about the economy or the market. I was reminded of these words after reading Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve, written by two respectable fund managers, William Fleckenstein and Fred Sheehan.

The book takes a cudgel to Alan Greenspan's reputation by showing, in effect, that Greenspan suppressed most dissent within the Fed, didn't "take away the punch bowl when the party got going" (in the words of an old Fed chairman) and so allowed small bubbles to build, instead of letting them pop.

But because there's a limit even to the Fed's power, several delayed bubbles are now bursting at once, and there's nothing the Fed can do about it. Indeed, if the Fed tries (as it is doing now, by printing more money), it will only make the situation worse.

How much worse? That is, when will the bear market bottom, and how low can it go? These are hard questions to answer, but if you promise to take the following with a big grain of salt, I'll give it a try, by resorting to two historical comparisons of suspect relevance: first, the 1929 big crash and its echo crash; and second, the effect of the first two years of a new U.S. president.

The famous crash began in October, 1929. Its first drop lasted almost three years, until the middle of 1932, and destroyed 90 per cent of the value of the Dow, which then was the most famous market index. Starting in mid-1932, the Dow began a rise that lasted nearly five years, until its peak at early 1937. This was the first crash and its first recovery; this is what most market historians refer to when they talk about the crash.

But there's more, because after the first huge drop and its recovery came the next downleg - an echo crash - in which the Dow lost half its value in one year. It wasn't as big as the first 90-per-cent meltdown, but it was horrible enough, and far quicker, too. A year later, the Dow began to recover, though a fat lot of good it did to most investors, who had no money left to take advantage of the bargains. It would take 13 long years before the Dow regained its 1937 high.

What's the relevance to today? First off, take that grain of salt as you promised, then consider this: The Dow hit a peak in January, 2000 (the Nasdaq lasted two additional months), then plunged for nearly three years, similar to the 1929-32 period. This time the Dow erased only 39 per cent of its value, but Nasdaq, which arguably has been the dominant index for the past 25 years, fell 84 per cent, similar to the 90-per-cent decline of the Dow during the 1929-32 crash.

The market then rallied beginning in October, 2002, and peaked exactly five years later, in October, 2007 (equivalent to the 1932-37 period), before starting to tumble, which it is still doing.

Where and when is the bottom, then? Hang on to that salt grain again, because if the scenario holds, the bottom can occur some time in September to November this year. Maybe.

And how low can it go? The Dow already has fallen 16 per cent to 11,951, the Nasdaq 22 per cent to 2,212. To complete the analogy of a second crash, the Dow would have to fall to 8,900 (proportionally), or 26 per cent further, while the Nasdaq would have to fall to 1,429, or 35 per cent more from where it is now. That's if the market replicates the echo crash of the 1930s.

Will it? I don't know, of course. At Giraffe, we invest stock by stock, based on fundamentals, but we see enough fundamental disasters out there (and several big disasters of which you'll hear soon) to say that, perhaps, the above grain of salt should be a small one.

What is the second historical comparison? It's the first two years of a new U.S. president. These are nearly always bad economically, because the new leader, if he or she is smart, gives the economy as much bitter medicine as possible, to get it going again in time for re-election.

The only one who didn't do this was Bush senior, and he was defeated the second time around. Whoever is elected president now is unlikely to forget this, so in 2009, the bitter medicine would likely start - and the Fed (ostensibly independent) could toughen up its stance, because with the recent avalanche of money printing, inflation is already accelerating.

If Fed chairman Ben Bernanke had read the book trashing Greenspan's reputation, he may just decide to do a Paul Volcker and raise interest rates to quash inflation, so as not to get a similar book written about him. This could throw the economy into a real tailspin big enough to make the echo crash scenario come true. The market looks six months ahead, and it, like Marx's spurned wife, believes only its eyes, not what the Fed tells it. So do we at Giraffe - and so should you.

Avner Mandelman is president and chief investment officer of Giraffe Capital Corp. and the author of The Sleuth Investor. [e-mail]

[simon gordon] 20/3/2008 13:04

Telegraph - 20/3/08:

The stock market in the 1970s and today
By George G Blakey

If the role of the stock market in the economy is primarily to raise capital for industry and provide liquidity for investors, its performance has come to be seen as a guage of the health of that economy in the same way as the movement of an individual share price is supposed to reflect the state of the underlying company.

Thus anyone looking at stock market and share price activity in recent weeks and months would have to assume that the economy is in a state of extreme agitation. The FTSE100 can swing a hundred points either side of its opening price on a single trading day, and daily share price movements in the 5-10 per cent range have become commonplace.

Clearly such extreme behaviour is not an accurate reflection of the state of the economy, or of a company's trading record, and it is difficult not to conclude that the stock market is more about perception than reality.

While it is tempting to to blame today's chaotic market conditions on the complications resulting from the introduction of countless new exchange-traded derivatives over the past decade, there's nothing new about booms and busts.

They originate in periods of credit expansion and end in periods of credit contraction, a sequence that gives banks a pivotal role to play. This was very much the case in 1972-1975.

The abolition of credit controls and the opening up of competition in 1971 paved the way for the secondary banks and the hire-purchase companies to make inroads into what had once been the exclusive preserve of the big commercial banks, and all went on a lending spree, principally funding property investment.

When it all came tumbling down, thanks to a soaring oil price and a domestic background of strict price controls coupled with a wages free-for-all, the banks ran for cover and called in their loans. The fact that many borrowers were unable to repay them meant that the banks were in big trouble.

One by one the secondary banks collapsed, and rumours swirled around the clearing banks, prompting the Bank of England to issue a denial that that National Westminster Bank had ever requested or been offered large scale support as its shares slipped below par.

Any parallels with today? Yes, to the extent that once again the banks are playing a central role. Their enthusiastic embrace of the new financial instruments, principally those derived from "securitisation", means that if credit expansion is amplified, so is its subsequent contraction.

After all, "securitisation" is just another name for "monetisation of debt", a process of financial alchemy whereby one man's debit is transmuted into another man's credit. Add in a liberal dose of gearing and the sky's the limit.

No wonder the rumours are swirling around the banks again, and this time denials of problems are not going to cut much ice in the light of the disasters that have befallen their American counterparts.

This one is going to run and run, and when triple A mortgage-backed securities are getting tarred with the subprime brush,one lesson we can heed from 1974 is the advice Jim Slater gave to his shareholders in May of that year when the stock market was poised to halve again, "Cash is the best investment now".

• George G Blakey is the author of A History of the London Stock Market 1945-2007, published by Harriman House (www.harriman-house.com/historystockmarket).

[insipiens] 20/3/2008 12:08

its not a very liquid market so when the best offer or bid is withdrawn it reverts to the MM spread which is quite wide. Nothing to worry about unless you're margined. Just have to check the offer price hasn't spiked when you click that buy button.

Looks like we're at a support level unless credit crunch gets worse. 6.3% yield?

[jonwig] 20/3/2008 11:17

Thanks, Simon.
When I do buy some, I'll know to be careful ... though they only seem to last a matter of seconds.

[simon gordon] 20/3/2008 11:12

I phoned iShares and Selftrade about this and was told by both, it was nothing to do with them.

Some buyers and sellers are getting screwed by these spikes.

[jonwig] 20/3/2008 11:00

Hi, Simon.
What are all these spikes about with SLXX? (Like 08:00 and 09:30 today.)
Any idea?

[simon gordon] 20/3/2008 09:50

Daily Mail - 20/3/08:

'For the first time, the number of UK mortgages on buy-to-let properties has just risen above the one million mark. Ten years ago, there were only 29,000.

The classic buy-to-let is a newbuild, two-bedroom flat. According to the latest figures, the total outstanding UK buy-to-let debt is some £122billion.

That is the equivalent of the Gross National Product of South Africa.'

[simon gordon] 15/3/2008 19:56

Timesonline - 28/208:

Quantum's Jim Rogers says US 'out of control'

Jim Rogers - who co-founded the now closed Quantum Fund with George Soros - told 750 global fund managers in Tokyo today that, America is "completely out of control", there will be a 20-year bull market in commodities and that prices will be in turmoil.
And he also warned that it "made sense" if global competition for resources ended in armed conflict.

Mr Rogers told delegates to the CLSA investment forum that the prices of all agricultural products would "explode" in coming years and that the price of gold, which hit an all-time high of $964 an ounce yesterday, will continue its surge to as much as $3,500 an ounce.

Gold would continue to rise, the analyst Christopher Wood told fund managers, "because it is the exact opposite of a structured finance product".

In a blistering attack on US monetary policy and the "helicopter cash drop" responses of the Federal Reserve, Mr Rogers described the American dollar as a "terribly flawed currency".

He said that the plan by Ben Bernanke, the Fed Chairman, to "crank up the money-printing machines and run them until we run out of trees" had exposed America's weakest point to her rivals and enemies.

The dollar may have declined recently, he added, "but you ain't seen nothing yet".

Talking to a room almost exclusively populated with Japan-focused equity investors, Mr Rogers recommended an immediate language course in Mandarin and a switch into commodities - the second-biggest market in the world behind foreign exchange.

Mr Rogers said that historic drains on wheat, corn and other soft commodity inventories have created market dynamics that could lead to severe food shortages.

The outlook over the next two decades would see prices of everything from cotton and sugar to lead and nickel "going through the roof".

Heavily playing down the prospects of a big recovery in Japan, Mr Rogers said that the country's demographics - as the fastest-ageing country in the world - would cause it greater problems and an ever-diminishing quality of life for ordinary Japanese.

But he also said that other countries - including Britain, Italy, China and the US - should take note of what their own demographics would look like without the effect of immigration.

"Japan will be the perfect laboratory for the world to watch how a demographic crisis plays out," he said.

[simon gordon] 15/3/2008 10:22

Hi Jon,

It is done.

Cheers...

[jonwig] 15/3/2008 10:08

Hi, Simon.

Sorry to be off-topic here, but I'm seriously thinking of putting some of my new ISA cash into SLXX.

Any chance you could slip this into the header?

[simon gordon] 14/3/2008 20:49

Ken Murray - 12/3/08:

American Banks Face Collapse

Ken Murray, Chief Executive of Blue Planet Investment Management, comments:

"The grave and mounting liquidity problems faced by banks, culminating in yesterday's announcement by the Fed that it is to inject yet more liquidity into the US banking system by extending its securities lending function, is a further sign that the American banking system is on the verge of collapse."

Central Banks have injected hundreds of billions of dollars of liquidity into the banking system since last August. Despite this, the financial position of US and investment banks continues to deteriorate. This conveys a serious message; banks are becoming increasingly insolvent. It is a message that few in equity markets seem to understand. This loss of liquidity is a result of the market for securitised bank assets and syndicated loans drying up. So assets that were previously sold on for cash now have to be retained on balance sheet. The only buyer in the market now is the Fed.

This latest move also gives credence to market rumours that Bear Stearns is experiencing liquidity problems. In our judgement many others are in the same boat.

Bizarrely, many stock-market investors see these ever larger injections of liquidity as positive. Time and time again the market spikes up on their announcement. The fact that banks NEED all this liquidity is a clear and unequivocal sign that banks are becoming increasing insolvent and that the problems they face are getting worse. Indeed many would now be insolvent were it not for the support of Central Banks. If the ailing banks were seen in human terms, as a patient requiring increasingly large transfusions of blood to stay alive instead of capital, I wonder how many investors would conclude that the patient's health was improving. One pint of blood on Monday, two on Tuesday, six on Friday. Is the patient's health improving or are they dying?

The current situation in the US banking market is without precedent. Never before in a time of near full employment and record corporate profitability have we seen such huge levels of bad debts. By our own estimates bad debts in the US banking market are likely to rise to somewhere in the order of $300bn to $450bn. Other estimates set the figure much higher. This is important because the bad debts that have been incurred so far are entirely due to poor underwriting as opposed to a downturn in economic activity. However, a downturn in economic activity is now occurring and, if the US economy is heading for recession as we forecast in 2007, it will give rise to a huge layer of additional bad debts. One that it simply cannot shoulder. It is perfectly conceivable that bad debts may rise to somewhere in the order of $500bn. To put the scale of these losses into perspective the total equity of the US's top 100 banks stood at $800bn at the end of the third quarter 2007. Losses of $500bn would wipe out 63% of their capital bases and leave many of them insolvent.

Murray comments: "The Fed's current policies have nothing to do with stimulating demand as many seem to think. They are about trying to stave off the collapse of the American banking system. It is that serious and it is not clear that the Fed will succeed in its objective. Furthermore, their policy of aggressively expanding the money supply is stoking an inflationary fire that is already ablaze. Inflation is rising sharply all over the World and interest rates, including those in the US, will, contrary to current market perception, have to rise to deal with that. History has taught us that the necessary rise in interest rates will be to a level in excess of the rate of inflation. The Fed will soon have to abandon its rate cutting strategy and increase rates to deal with the worst inflation problem in decades – one that it has created. Do not be surprised if interest rates rise to in excess of ten percent within a year or two. The prognosis for the US economy and its banks is bleak and is aggravated by an inept central bank that is making matters worse "

[simon gordon] 12/3/2008 20:16

• DEFCONOMY FIVE

How you'll know we're here: The housing downturn turns into a free fall, making it the worst collapse in our country's history. That not only triggers massive numbers of foreclosures and lost household wealth, but it also sets off another large wave of bank write-downs.

Odds we get here: Roubini told me that it's "extremely likely, even unavoidable" that we hit this stage because "the excess supply of new homes in the market is like we've never seen before." Prices, he believes, "need to fall another 10 to 20 percent before that clears."

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• DEFCONOMY FOUR

How you'll know we're here: Americans upside-down on their mortgages and unable to pay their home equity loans begin defaulting on other debt, like credit cards, car loans and student loans. In addition, bond insurance companies lose their perfect credit ratings, forcing already troubled banks to write down another $150 billion.

Odds we get here: High. Roubini says that 8 million households are already upside-down on their mortgages and he thinks we could see that number go to between 16 million and 24 million by the end of 2009. A lot of those people, he believes, will simply walk away from their homes and send their keys back to the bank.

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• DEFCONOMY THREE

How you'll know we're here: Some banks begin to crack under the pressure of continuing write-downs and mounting defaults by consumers. A national or large regional bank finally collapses, triggering hedge fund failures and general chaos on Wall Street, potentially leading to a 1987-style market crash.

Odds we get here: Very good. Roubini says that we'll likely socialize the losses, "effectively nationalizing the mortgages or the banks." It would be, he told me, "like Northern Rock (the large bank in England that was recently taken over by the British government) times three." He thinks the stock market will head south throughout the year as fears about a severe recession are confirmed.

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• DEFCONOMY TWO

How you'll know we're here: Most forms of credit (both to consumers and businesses) become virtually nonexistent. That results in a "vicious circle" of additional write-downs, stock market losses, and bank collapses, which leads to even less credit being available.

Odds we get here: Good. Roubini says that credit conditions are becoming worse everyday across a variety of markets and won't be getting better anytime soon. Without extra credit available, people might have to actually (gasp!) live within their means.

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• DEFCONOMY ONE

How you'll know we're here: Welcome back to 1929. A full economic meltdown results in a complete failure of the underlying financial system. What will be known to future generations as "The Greater Depression" has arrived.

Odds we get here: Not likely. Roubini believes that this will be a "very painful and severe recession" that could last for 18 months or more, but it will be more like 1981 than 1929. Families may be eating soup again, but at least it'll be in their own kitchens.

[simon gordon] 12/3/2008 19:55

Emirates 24/7 - 9/3/08:

The fallout from US meltdown

New York University's Professor Nouriel Roubini thinks the US is heading for the worst recession for 30 years, and a $1 trillion (Dh3.67 trillion) financial meltdown as the current financial crisis hits the US consumer. He told the Hedge Funds World 2008 conference in Dubai last week what to expect in a gloomy presentation.

For the record he believes the US entered a recession last December and will now endure four to six quarters of declining growth, making this the worst recession since the early 1980s and possibly as bad as 1973-4.

The NYU economist is definitely amongst the most pessimistic forecasters on the US economic outlook, but he is by no means on the lunatic fringe. Much of what he extrapolates is based on data where it is easier to see continued weakness than a sudden renaissance in activity. The nub of his argument is that US house prices have fallen by around 10 per cent and are set to decline by 25-30 per cent before bottoming out.

This will be a $6trn loss of wealth to the US consumer, and will result in total write downs of more than $1trn for the US banks. Now household spending accounts for 71 per cent of the US economy, compared for example to just five per cent for technology in 2000, so this is far more important than the dot-com crash to the economy. And it will be compounded by the ongoing credit crunch in financial markets.

Professor Roubini pointed out that securitization activity is down by 95 per cent on a year ago. Then you have to consider an impending commercial real estate collapse, the decimation of leveraged buy-out loans, the monoline insurance rating problem and over borrowing by some corporates.

According to Professor Roubini monetary and fiscal stimulation will prevent a repeat of the Great Depression of the 1930s but this will be the worst recession in a generation.

The glut of houses and cars is too high, many households will be effectively bankrupt and the unregulated shadow financial system of hedge funds and special investment vehicles will slow the recovery.

For the wider global economy his message is that the US recession will spread with similar property-driven recessions in the UK, Spain, Italy, Ireland and Portugal. Chinese exports will also dive with the US consumer buying less in the shops, and all the emerging markets will take a tumble.

The knock-on effect in energy markets will be a sharp reversion from recent record prices for oil and gas. But at the same time Professor Roubini says the Fed will cut interest rates below two per cent and possibly to zero, leading to further falls in the value of the US dollar and therefore higher gold prices.

In the Gulf States a lower oil price would be bad news for revenues, although accumulated cash piles from the past six years of high oil prices will allow government spending to continue largely unchecked. Only new projects would suffer, and with $3.4trn of work-in-progress there is already a concern that this is beyond the capacity of manpower and materials available.

However, very low interest rates would be wholly inappropriate for the Gulf and yet inevitable because of the dollar peg. As in Hong Kong this would almost certainly mean higher real estate prices.

Local stocks would also likely benefit as interest on bank accounts would plunge and discourage the holding of cash.

Indeed, the pressures on the Gulf currencies would be so intense that this might well be the death knell for the dollar peg. On the other hand, several other speakers at the Hedge Funds World 2008 event in Dubai thought that the US dollar was approaching the bottom of its recent decline.

And even if Professor Roubini is right then a series of recessions in European countries would surely start to correct an over-valued euro.

But if he has got his forecast right then sovereign wealth funds have been far too early in buying shares in global banks hit by sub prime as the worst stock declines have yet to come.

Professor Roubini notes that the S&P 500 is down 14 per cent from its peak, and expects it to at least repeat the 28 per cent average decline of past bear markets.

It looks as though the only people who will make money will be short sellers and the hedge funds, although the latter are going to have to live without the huge leverage that has helped them deliver stellar returns in recent years.

Yet even in a global recession some asset classes will do well. Gold and precious metals should benefit hugely from the tsunami of liquidity injected by the Fed to keep the global economy afloat. And that could well go for commodities in general.

For the Gulf States the outlook still looks positive. Low interest rates would keep real estate and local stock markets buoyant, while commodity price inflation would keep the cash rolling in.

There would also be some serious bargains overseas for petrodollar investors but patience is needed to wait for the best distressed bargain sales.

[insipiens] 29/2/2008 10:41

All this talk about US ending up like Japan is just complete boll*cks

Japan has a high saving rates - vast difference to the West. We're going to see stagflation in the US because they don't fight inflation there. Hence why $ is tumbling.....Big problems in 5 years time, but for now just like the early 70s.

Thats why I'm accumulating asset backed shares - ETFs in commodities/land and vastly cash generative shares.

Being in cash will put anyone in the poor house IMO.

[simon gordon] 26/2/2008 20:29

'Investing = f(dopamine flow); money=> peace of mind

Neuroeconomics is a new science that is taking the investing world by storm, though, until recently, it was confined to the academic circles. Now, through his book, 'Your Money and Your Brain - How the New Science of Neuroeconomics' Can Make you Rich, Jason Zweig has tried to take neuroeconomics to the layman. The subject, as Zweig defines it, is "a hybrid of neuroscience, economics and psychology," which helps us understand "what drives investing behaviour not only on the theoretical or practical level, but as a basic biological function."

Zweig is a senior writer for the Money magazine and has been a guest columnist for Time and cnn.com. He is also the editor of the revised edition of Benjamin Graham's 'The Intelligent Investor'. In an interview to Vivek Kaul, Zweig speaks on Neuroeconomics and his philosophy of investing.

You seem to suggest in your book that investors should not fall for the story behind the stock. What else does one look at, then?

The key is to understand a crucial distinction, first drawn by the great investor Benjamin Graham, who was Warren Buffett's teacher.

Stocks and businesses are not the same thing. Stocks flit around all the time; you can watch them moving up and down on your computer screen all day long.

In New York, it's not unusual for the price of a stock to change at least 10,000 times in a single day of dealing, and I imagine it's not very different in Mumbai.

Stock prices are in constant flux, but business values are not. The underlying value of an ongoing enterprise does not change every day. Something like 99% of all the trading activity in the typical stock is meaningless.

The future value of a business has nothing to do with the current price of its stock. What you should do is learn to look past the noisy twitching of stock prices to the enduring value of businesses as living organisms.

Is the business run by honest people who treat outside investors fairly? Does it make products or provide services for which customers are willing to pay higher prices if necessary? Can you understand its financial statements?

These constitute the reality of the business and determine its future value. The "story" behind the stock is almost certainly nothing more than the stampede of thousands of speculators in and out of the shares.

Train yourself to ignore them.

"The best financial decisions draw on the dual strengths of your investing brain: intuition and analysis, feeling and thinking," you write. Isn't there a dichotomy there?

Yes, there is. But let's get our terminology straight, and again we can do so by going back to Benjamin Graham.

Graham's formal definition has never been improved upon: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return."

Notice carefully that this is neither an "or" nor an "and/ or" definition; all three components - analysis, safety, and an adequate result - must be present. If any of them is missing, you are not investing.

You are speculating. In India, as in the United States, most people who call themselves "investors" are not investors at all. They are speculators.

In the short run, particularly while the Indian capital markets are rapidly developing, speculators may be able to earn high returns by rapidly trading stocks without doing thorough analysis.

But in the long run, you cannot earn sustainably high returns from mere "gut feelings."

I find it striking that in a society with cultural traditions of great patience and acute analytical ability, so many people trade as if their knickers were afire, scoffing at the long term and analysing nothing but the craziness of the crowd.

There is no doubt in my mind that Indians have the potential to lead the world in investment skill. But, so far as I can tell from my faraway vantage point, what most Indians do is not investing.

In my own portfolio, I do not invest with the next year in mind, nor even with the next decade in mind. I invest with the next century in mind; that is when my heirs will benefit from my decisions.

I do not care what stock prices do this afternoon, or this week, or this month, or this year. I care whether business values are rising.

That is what it means to be an investor.

You have written about the link between dopamine and the way investors invest.

What's the link?

Dopamine makes us pursue whatever we think will be rewarding. When we earn more than we expected, that generates a "positive prediction error" - a flood of dopamine that signals to our bodies that something good has happened.

After only a few repetitions, the dopamine is released in our brains, not when we earn the actual gain, but when we believe we know that the gain is coming.

It is not the reward but the prediction of it that generates pleasure in the brain. I call this the "prediction addiction."

You become addicted to your own belief that you are about to make money. Like any addict, when the reward does not come, you will go into a painful withdrawal.

Why do investors get greedy? Even Isaac Newton lost most of his money in the South Sea Bubble. What does Neuroeconomics have to say on that?

Greed is generated in the same regions of the brain that produce pleasure when we find food or shelter or love. These basic reward circuits are among the oldest systems in the human brain.

Geniuses have them, too. Brilliant people are better at generating great ideas than the rest of us, but they are no better at controlling their own emotions than you or I.

We get greedy because the anticipation of profits activates the dopamine system in the brain, flooding our neurons with a signal of excitement.

Newton was not just one of the smartest men of all time, but was also very well-informed financially; he was the master of the Royal Mint.

So he certainly knew better in the "thinking" part of his brain. But his "feeling" brain was swept away with greed.

If you do not put policies and procedures in place, in advance, to control your emotions, you will never be able to resist the siren song of the markets when the markets go mad.

Common sense and good judgment are vastly more valuable than intelligence.

.........'

[insipiens] 22/2/2008 10:16

you might enjoy this snippet from a well known chartist:

"The Technical View: It is intriguing that at the moment the FTSE 100 is getting squeezed into an ever narrowing triangle formation. This trading range is now just 120 points wide between 5,880 and 6,000. The fact that it is so narrow suggests that we are now just a day or two away from a breakout, and one that could be very powerful indeed.

The $64,000 question is which direction the break will occur with all the "professional" chartists going for a big move to the downside. Only a few fundamentalists may back the upside scenario based on say, oil and mining stocks delivering a push to the area of the 200 day moving average at 6,359. Either way it is a nail biter."