Sunday, October 10, 2010

The Peril Of False Bottoms

¹²The Bear's Lair: The Peril Of False Bottoms

Observers have been startled by the recent slowing of U.S. economic recovery. A recession as deep as that of 2008-09 would normally be followed by a recovery of exceptional vigor. Austrian and other anti-Keynesian commentators, myself included, have pointed the finger of blame at the excessive fiscal stimulus of 2009-10 and at the locked-in Fed zero rate monetary policy.

However, there is a further factor that should not be neglected; the formation in 2009 of
"false bottoms" in both the U.S. stock market and the housing market, at prices far above the likely long-run price equilibrium of the assets concerned.
By Martin Hutchinson | 9 August 2010

"False bottoms" can occur in two ways, both of them caused by government policy. In one, markets find what appears on valuation considerations to be a true bottom, but some half-witted government policy (or the delayed results of a previous one) then causes market and valuation dynamics to change, after which equilibrium is only possible at a lower level. This happened three times during the Great Depression.

After the 1929 crash, the stock market established a new level at about half the peak value, which if not a true bottom appeared to be one. Then the Smoot-Hawley tariff and equivalent actions by other governments caused world trade to go into a sharp decline [[actually, world trade was virtually extinguished: normxxx]], causing the market's equilibrium price to lurch downwards. Before that had stabilized, the default of the N.Y. Bank of United States caused liquidity in the U.S. and global banking systems to collapse, which the Fed did nothing to prevent. [[There is more than a little evidence that Treasury Secretary Andrew Mellon simply did not want to help that "New York Jew" bank, mostly for reasons of outright racial prejudice. Ironic that the financial markets crash of 2008 which almost exactly repeated the earlier collapse was also precipitated by a "New York Jew" bank— Lehman Bros.— the only TBTF bank not rescued by the Fed in 2008/2009.: normxxx]].

That led to the Creditanstalt crash of May 1931 [[which crash was more than a little facilitated by the deliberate actions of the French government: normxxx]] and the subsequent decision by Britain in September to go off the Gold Standard. Those events caused a further lurch downwards, the largest of the period— 1931, not 1929, was the US stock market's worst year of the 20th century in terms of price decline. By December 1931, the market was again finding a true bottom— in Britain, which by now was well run on the economic side, the market and the economy began to recover in the last months of 1931.

However, President Hoover, incapable of letting well enough alone [[he was determined to "balance the budget"— as was FDR also on the eve of the 1936 elections, with similar results, ie, the crash of 1937: normxxx]], then put in a severe tax increase, raising the top rate of U.S. federal income tax from 25% to 63%. That caused a further lurch downwards to a market double bottom in June 1932 and February 1933, with the market recovering sharply only after Franklin Roosevelt took over in March 1933 [[and instituted a regime of overt inflation which, nevertheless, produced a marked improvement in the economy and reduced the unemployment rolls by 50% by 1937: normxxx]]. Roosevelt meddled incessantly with the economy, so the Great Depression lasted another eight years, but his mistakes were individually smaller than those of Hoover and the Fed [[and mostly due to the misguided economic theories of the times: normxxx]].

The other kind of false bottom occurs when government policy errs in the opposite direction after a financial crash, flooding the market with liquidity or other artificial support and causing it to [prematurely] bottom out at a level that is still far above [its natural] long-term equilibrium. It can surely now be agreed that Alan Greenspan's Fed made this mistake in 2002-03. By flooding the market with liquidity, it prevented the major stock market crash that was inevitable, after the 1997-2000 bubble, from finding a true bottom. It caused the stock market to turn upwards in early 2003 from a level of close to 8,000 on the Dow Jones index, around double that at which it had stood in the decidedly non-bear market period of February 1995. Notoriously, Greenspan's reflation also caused a housing bubble.

Another example, which again came back to haunt the U.S. economy: President Ford, only weeks after producing the "Whip Inflation Now" buttons in November 1974, turned policy around 180 degrees to fight recession, and the Fed dropped interest rates sharply. As a result inflation was not "whipped" and returned in much more virulent form five years later.

A third example occurred in the commodity markets: the London Tin Crisis of 1985-86. In the early 1980s, demand for tin went into long-term decline, as the world moved over to aluminum cans. The International Tin Council, which had been formed in 1956 as a cartel of the world's major tin producing countries, attempted to prop up the tin price at a floor of $8,500 per ton by massive purchasing of tin stocks. However, in October 1985, the ITC ran out of money and was declared bankrupt.

This resulted in the price of tin halving in the next six months, and both production and prices remained deeply depressed for two decades as the massive tin glut was worked down. [[Let us hope that the housing glut does not take so long to work off!: normxxx]] Only after 2003 or so were inventories worked off. By 2008, the huge global tin stocks had been run down, the price had risen to over $20,000 per ton, and there was much speculation about the world running out of tin altogether within two decades.

It can thus be seen that government meddling can prevent markets from finding a true bottom. I.e., by creating new problems that undermine market support or by artificially propping up the market, and so preventing it from bottoming out. This can create immense new difficulties. That's only to be expected.

At a false market bottom, there are by definition not enough true buyers to match the sellers, either because further government actions have suppressed buyer demand or because the price remains too high for the market to clear. Consequently, those who buy at a false bottom, whether through failure to react to new negative government actions or through artificial encouragement by government programs, are destined to lose money, increasing the eventual level of market distress above the level it would naturally have reached. This additional distress in turn suppresses buying appetite further, increases perceived market risk, reduces available buying capital and prolongs the downturn, often for several years.

During the recent contortions, the U.S. monetary and fiscal authorities have established false bottoms in two markets. The first is housing, where subsidies to first-time buyers, ultra-low mortgage rates, government guarantees on $700,000 home mortgages and foreclosure-avoidance schemes have prevented the housing market from falling even to its average level where the average house price is about 3.4 times average earnings. House prices are currently 47% above their level in January 2000, according to the S&P Case-Shiller 20-city index, compared to a 49% rise in the CPI since that time— in other words, they are in real terms at the same level as at the top of an immense speculative boom.

The decline in new home sales to all-time lows following the elimination of the homebuyer tax credit is sufficient indication that the market has further to fall. In a free market, home prices would probably have bottomed out at price levels about 15%-20% below those prevailing currently. At those price levels, buyers now restricted to 80% finance would have come to believe that housing had become truly a bargain. A Case-Shiller average index of about 120-125 would appear to buyers comparable to its level of around 70 in the early 1990s, at the bottom of the last housing bear market.

However, with additional buyers having been sucked into the market, it is now likely that house prices will fall [far] further than this. Indeed, if the appalling suggestion put forward last week that the government through Fannie Mae and Freddie Mac 'forgive' $1 trillion of defaulted home mortgages is put into effect, they will undoubtedly do so. Nothing could be more designed to destroy confidence in the housing market than a massive subsidy to the most foolish and improvident homebuyers, at the expense of the thrifty and careful renters who are the major source of potential new demand for housing.

If the buyer pool is attacked in this way, or forced into unnecessary losses by being made to buy too soon, house prices may not bottom out at the market-clearing level of about 120-125 on the Case-Shiller index, but continue falling. The market is then likely to become pathological; all homebuyers who bought within the last decade will be underwater (those who have re-mortgaged hugely so) and home prices may go into a downward spiral like stocks in 1931-32. Default rates on home mortgages will approach the levels of the worst years of the 1930s and market confidence will take a decade to rebuild.

There is, however, a second false bottom that has been created by mistaken government policy, and that is in the stock market. In early 1995, before monetary policy was fatally undermined, the Dow Jones index was trading at around 4,000— indeed it first broke through 4,000 the day after the Humphrey-Hawkins meeting with Congress at which Greenspan, elliptically as always, announced his conversion to confetti money. That was not a bear market level; the index was almost 50% above the historic peak it had reached less than eight years earlier, before the Crash of 1987.

Scaling up by nominal GDP since then suggests a Dow Jones index of no more than 7,900 for a "middling" level of the market, not a bottom. However, with the exception of a few trading days early last year, the market has consistently traded well above this level. Currently at around [11,000], the market is [almost 40%] above its appropriate "middling" target.

The "trailing" P/E10 ratio [[aka, Shiller's CAPE: normxxx]] of 20.4 on the Standard and Poor's 500 is also well above its historic average, even though corporate and bank earnings are currently inflated by ultra-low financing costs and a steep yield curve. Thus at some point we can expect reality to intrude, and the market to drop to its likely cycle low in the region of 5,000 on the Dow Jones index. As with housing, the maintenance of the market above its equilibrium level is likely to involve costs, as buyers are sucked in to incur losses they need not have suffered.

[ Normxxx Here:  Or take the lesser-known "Tobin’s q". A calculation, named for the late economist James Tobin, that compares stock prices with the replacement cost of company assets. It has a very similar track record to the Shiller PE.

q on the market is about
1 today, says economic consultant Andrew Smithers. The historic average is just 0.64. By this measure, the market would have to fall a third just to reach its average.

According to John Hussman,
"Earlier this year, the market was more overvalued than at any point prior to the late-1990's bubble, and is currently [at or] near the same level of overvaluation as the 1972 and 1987 market peaks. At present, [all estimates of forward return] concur that the S&P 500 is most likely priced to deliver a 10-year total return of roughly
6%, albeit with the likelihood of significant interim volatility.

Stocks are emphatically not cheap on a historical basis. Analysts who encourage investors to take a different view on valuations should at least be expected to present similarly extensive historical evidence supporting those perspectives."  ]
Once the market drops towards its cycle low, there will be fewer bargain hunters than there should be, since they will have been wiped out by the renewed drop. Hence, as in 1931-32, the market is likely to drop further below its equilibrium level, bottoming out at a level that will prove highly damaging to the productive economy, and perhaps remaining there for some considerable period. It must be remembered that even in 1949, 17 years after the 1932 market bottom, stocks traded on a P/E of less than 7 times, at prices less than half the level of 1929.

If retiring baby boomers suffer a market that is still around Dow 6,000-7,000 in 2030, their 401(K) accounts and other pensions will have left them penniless. Even many of those lucky enough to have final salary schemes in which their employer assumes the market risk will be out of luck; their employers will simply default on the impossible actuarial burden they incurred.

There is one caveat; we might see a decade or so of rampant inflation like the late 1970s. That would push equilibrium price levels in both housing and stocks up towards their current false bottoms. Needless to say, however, that would impose its own costs!

The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put out by Wall Street houses remains far below that of "buy" recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

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