BUD BREWER
One Man's Opinion
Two Reasons the Stock Market will Struggle
April 2, 2009: As of today, the stock markets have turned up from what may be a bottom for this cycle. At least it feels like it and the current power of the rise has increased the Standard and Poor Index by 25%. The question now is: will stock prices continue to rise reflecting a turn about in domestic economic activity and the resumption of growth? I will be surprised if we see much positive change in the domestic economy for some period of time and I believe that stock valuations in general will have difficulty rising back to PE ratios we considered normal during this last decade. It isn’t that consumers will not begin to buy things again, nor is it that our big manufacturing companies don’t experience some recovery in sales revenue. The problem is going to come from two sources and overcoming the negative effect of these two sources on the value of securities is going to take time. Oh sure, there will be exceptions but these two forces upon the general level of enthusiasm individual investors will have for owning stocks is going to cause significant reduction in the amount of funds they allocate to stock ownership.
The two forces are: 1.) higher excise taxes and higher individual and corporate income and capital gain tax rates and, 2.) inflation or the depreciation in the purchasing power of the U.S. Dollar.
Now Lets examine why the two forces are likely to occur and what is or has caused their probability to rise. Readers of this person’s “blogs” over the past two or three years have become familiar with my concern about the parabolic rise in the price of housing here in the United States, especially the West, and the potential for a sharp correction in the value of that stock as the Baby Boomer generation begins to settle into retirement. Downsizing their life style to coincide with retirement level income and moving into more modest desert or retirement communities is and will bring a large excess supply of upper and middle income scale homes onto the market. The problem is that the X generation, the one following the Baby Boomers, is only 71 Million in size, some 8 million less than the Boomer generation. I had predicted that beginning in about 2010 and continuing for the next 12 years or so, this phenomenon would begin to affect the prices of housing and the home building industry would experience a steady decline in activity.
What I underestimated in the past two years was the full consequence of this eventuality upon the home mortgage industry, as well as the investment banks and commercial banks serving the public. Home mortgages meeting certain criteria are either held in the issuing bank’s portfolio or sold by the bank to investors or to Federal National Mortgage Company (FNMA), a quasi government/independent sponsored organization that borrows money from the Public by issuing bonds mostly guaranteed by the U.S. Government and buys the mortgages for their own portfolio. Regulations covering the amount of equity or reserves FNMA would have to hold against their bond portfolio were not only lax but declining as the government encouraged the reduction or more modest restriction for requirements to qualify for the FNMA to purchase loans from banks or mortgage companies. This policy was actively promoted by the more liberal members of the U.S. Congress. These lower restrictions assisted the marginal home buyer to be able to afford a mortgage on the home they wanted to buy even when they had little down payment or earnings below the historical benchmark for the assumption of such debt. It soon became clear that a strange thing was happening in the mortgage banking industry. Investment banks were buying up mortgages, almost any mortgage, even those issued by mortgage companies who did little due diligence on the home buyer and who had very low if any requirement for the buyer to have appropriate equity as a part of the cost of the home. These sub-prime loans were then sold by the issuer to FNMA or investment banks that bundled them into securities and sold these securities as marketable cash flow investments with both long and short term maturity. The collateral backing these loans was suspicious right from the start since there was, many cases, a point in time after the mortgage loan was executed that the rate of interest would be adjusted well above the sort of teaser rate level offered to induce the home buyer to assume an obligation they could little afford. Now, as the Investment Banks realized, there was considerable risk for the buyers of these securities so some clever financial genius came up with the idea of insuring them by introducing an instrument that looked like insurance, smelled like insurance and in fact was pretty close to being insurance but was issued by two counterparties without over site of their structure or infrastructure and with out any reserves for loss. This instrument is called a “Credit Default Swap” or CDS. For an annual fee, it effectively transfers the risk of any given contract or potential transaction from a buyer of a CDS to the seller. Over the years Investment Bankers have been creating these instruments and selling them as if they were cash equivalents. Corporations, banks and governments all over the World bought them or sold them in order to transfer risk. Now the problem is that the security’s collateral backing up the risk transfer was the mortgages that were issued on homes and that began to experience a decline in price. With marginal buyers having so little equity in their home, they soon realized they were under water on their loan and stopped making payments. Home prices across the country began to fall.
The decline in the asset value underpinning all of these exotic financial entities forced corporations, hedge funds or individuals trading them or holding them on their balance sheet to mark the value of their assets down and include that write off in their earnings. This “mark to market” accounting principle resulted in our major banks and financial corporations quckly getting to a point where they technically were insolvent.
Seeing the potential melt down of equity in the financial industry and the disastrous effect it would have on the economy, the Bush Administration’s Treasury Secretary, Henry Paulson and the Federal Reserve Chairman Ben Bernanke came to Congress with the news that it they didn’t fund a huge transfer of cash immediately to several stressed Wall Street Banks, the financial system would collapse. He asked for $700 Billion but the Congress pared that back to $300 Billion. More money was needed as the investment banks like Lehman filed for Chapter 11 reorganization under the bankruptcy laws. Since Lehman was a big player in the derivative markets, this had a drastic effect upon asset values all over the world. The CDS and relative derivative instruments have grown to what some say may be in the tens of Trillions of dollars and that doesn’t speak well for the hope that this financial break down will be short lived. As a result of the selling of all securities to reduce risk or raise cash to become more defensive, the stock markets around the world have fallen off a cliff down almost 50%.
Compounding the problem is the fact that Barack Obama has been elected to the highest office in the World and heads an administration that in spite of his exceptional campaign oratory skills is learning how to govern in an “on the job training” mode. The exceptionally incompetent Nancy Pelosi leads a 55% majority in the House of Representatives and has already demonstrated through her preference for liberal leaning legislation that she has little or no real knowledge of how the world really works. Their first response has been to pass huge stimulus bills adorned with pork barrel ear marks that are indicative of how little confidence this Congress has in the resilience of the American worker. The President has sponsored and Congress passed budgets and off balance sheet spending that will burden American Taxpayers to the extent of $10-15 Trillion dollars over the coming decade. This burden will be in the form of higher personal and corporate income taxes. While the American economy can and will survive, it will be at the expense of higher individual and corporate tax rates along with a plethora of some needed, most unneeded, regulation and that fact will be a terrific headwind for future growth. In the stock market during a period like this, investors may find specific stocks to trade but it is highly likely that neither the economy nor the stock market will have much nominal growth and probably no real growth at all over the next few years.
With the prospective huge increase in government debt, it is likely that the Federal Reserve will have to create more money by issuing huge amounts of additional Treasury notes and longer term obligations. In order to keep interest rates under control, the Federal Reserve will be actively buying much of this paper thereby increasing the money supply. All this currency floating around the world is highly likely to cause inflation that devalues our currency. It will be a challenge for investors to balance their investments of equity and fixed income in pursuit of preserving their wealth.
For the moment, as this huge encroachment into the ownership and management of corporations in both manufacturing and finance take place, the equity markets will be hard pressed to provide investors with stability of returns. It is therefore probably the best strategy to keep a high percentage of cash equivalents and fixed income securities in one’s portfolio.
One Man’s Opinion—-Bud Brewer
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