The Size Of The Correction Is Equal To The Claptrap That Preceded It

Bill Bonner - Tue 05 Aug, 2008

So far, the sub-prime mortgages have been the focus of losses.

London, England

Let us keep looking through our binoculars...

We are trying to see the big picture, trying to understand what is really going on. We can imagine ourselves like Caesar – watching the action at Alesia from a nearby hill – or like Lee looking at Cemetery Ridge at the Confederates tried to push back the Yankees. Which way is the battle going? Who’s going to sweep the field...who’s going to carry the day...? Caesar won at Alesia with a combination of strategy, planning, and discipline. But Lee lost at Gettysburg for lack of resources...bad luck...and bad tactics. And now...General Bernanke is losing too...

Yesterday’s news described another day of deflation. The Dow lost 42 points. Oil fell almost $4, to $121. The commodity index, the CRB, dropped 18 points. And gold lost nearly $10, ending the day at $907.

What to make of it?

Banking has always been a boom and bust business. Bankers tend to act like retail investors who just happen to have a lot of money. They lend to whatever is fashionable...then, when the go-go businesses go bust, the bankers look for the next opportunity to lose money.

The retail investor doesn’t know anything about investing or economics either. Instead, he watches television or reads the papers. Gradually, he forms the opinions that turn him into a chump for Wall Street – ready to buy financial products because he’s heard someone say they make good “investments.”

In the 1997-2007, the retail lumpenhouseholder developed an extraordinary hallucination; he came to believe that he could make money simply by buying a house and living in it. Of course, the little guys are always susceptible to delusions – especially those that flatter them or offer them something-for-nothing; that’s how democracy works. But what was really remarkable, in the ’97 – ’07 period, was that sophisticated bankers and brokers came to believe the same thing – that they could get rich by buying and trading the mortgage contracts of people who thought they’d never have to pay back their mortgages.

Of course, the whole thing blew up last year. The marginal homeowner is in trouble – with more mortgage than house. And the marginal banker is in trouble too – he owns the mortgage! So far, houses have fallen about 20%, with another 10% to 30% left to go. And the banks have written off about $476 billion worth of bad credits – according to the Int’l Institute of Finance – with maybe another half a trillion in mortgage-related losses.

So far, the sub-prime mortgages have been the focus of losses. But now the Alt-A and Prime mortgages are getting into trouble too – with delinquency rates in both categories on the rise.

Nothing astonishing about this picture. A correction is always equal and opposite to the claptrap that preceded it. The housing hallucination was a whopper. So is the correction. The housing bubble caused big increases in nominal GDP, retail spending, and corporate profits (from the financial sector). Now, the GDP is flattening out, retail spending is softening and corporate profits have been crushed.

Taken altogether, guess how much money the Dow stocks are making? These are the companies that form the backbone of American commerce and industry. Guess again. Because if you put them all together, says Barrons, you’d have a loss of more than $80 billion. The last time there was such a loss in the Dow was 75 years ago – in the Great Depression.

This is an encouraging word to many observers. They note that the last time Dow earnings went negative proved to be a very good time to buy stocks. After ’32, stocks in the US went up 373%.

But wait, they went up AFTER having lost about 85%. The Dow in ’32 rose from a low of 41...with stocks trading at only 5 to 8 times trailing earnings (in terms of current negative earnings, the P/Es were meaningless). In other words, the stock-market had been crushed before it rose again.

Today’s stock-market has not yet been crushed. In fact, the Dow itself is only a bit lower than its all-time high.

The correction has taken the wind out of Wall Street’s sales. But, so far, it has done very limited damage to US stocks. Most likely, more pain lies ahead...before another upswing.

Hey, don’t take our word for it. No less an authority than Alan Greenspan himself says there is more suffering ahead...and there is no less an authority than Alan Greenspan.

The auto business is being corrected – severely. One of the biggest losers on the Dow was – no surprise – General Motors. It lost $11 a share in the second quarter– which is almost unbelievable, for a share that sells for $10. And Chrysler’s latest attempt to raise money fell $6 billion short. The auto industry will probably go broke – and be nationalized, like housing.

More opinions:

*** A correction is always equal and opposite to the deception that preceded it. You can quote us on that, dear reader.

A correction is always deflationary too. Delusions and hopes push up asset prices. Reality and despair pull them back down. The latest figures show M2 – a measure of the money supply – no longer growing. True, the feds are desperately trying to increase the money supply with bailouts and tax rebates. But the bankers are running scared. They get their hands on some hard cash...and they want to hold onto it as long as possible. They figure they might need it.

This is the phenomenon that Keynes described as “pushing on a string.” The feds push. But the string bends.

Of course, it’s not just the bankers. Remember, bankers act like retail investors – and householders. And right now, they’re all feeling a bit under stress and looking for stray coins under the seat cushions.

Unemployment is rising. It is projected to hit more than 6% before the end of the year. In the last major recession – of the early ‘90s – unemployment hit 7.8%. It could well reach up to 7% or 8%...or higher...this time too.

The combination of falling employment (including overtime and so forth) and falling house prices makes it almost impossible for the consumer to continue consuming in the manner to which he has become accustomed. We are watching the retail sales figures closely for proof. Broadly, from our great distance, the figures show little sign of a let-up in consumer spending. But when you look more closely, the picture is more interesting.

Consumer spending continued to rise in the last quarter, for example. But three important nuances:

First, most of the growth in consumption spending is no longer coming from the consumer. It is the government that is doing the spending. The feds are stepping up to the plate to try to compensate for weakening consumer spending (they don’t know they are doing this...they are just doing what comes naturally). Federal government spending rose at a real rate of 6.7% in the last quarter, while personal consumption rose only 1.5%.

Second, consumer spending is not even keeping up with consumer incomes. The feds handed out billions in tax rebates, which boosted incomes by 4% -- more than twice the level of consumer spending increases. This tells us that consumers are trying to cut back.

But third, they’re finding it especially hard to cut back because prices are still rising. Ah, here’s the real complication. It’s a deflationary correction – we see that clearly, through our binoculars. But consumer prices are still going up. In June, consumer prices rose 0.8%. Doesn’t seem like much, but multiply that times twelve and you have an annual rate of nearly 10%. Prices for the essentials – food and fuel – have risen so much that the consumer has to spend all his money just to keep up. The broad figures show consumer spending rising...but the consumer is actually consuming less. He’s eating out less – so the restaurants are failing. He’s buying less – so the retailers are hurting. And he’s driving less – so gasoline sales, in gallons, are actually going down.

And pity the poor baby boomers! They’ve lived their whole lives with a pot of honey in their hands. Save money? Why bother? Na na na na live for today! The economy was always expanding...they were always getting richer...jobs were always plentiful...and so were credit cards. Now though, the tables are turning against the boomers. When companies lay off employees – they get rid of the middle-aged, expensive workers -- the baby boomers. And since the poor boomers never bothered to save money – and since their houses are losing value – they now face retirement with no money in their pockets and no way to get more.

And now, even when they save money, they get kicked in the derriere. Interest rates are so low, they make almost nothing.

What are the poor baby boomers to do? D-O-W-N-S-I-Z-E in a hurry...

*** Zimbabwe with oil...

That’s today’s Venezuela...more tomorrow...

Bill Bonner
The Daily Reckoning