Just Like Japanese Bailout Buckets
Do you remember what practically everyone said after the Japanese stock market began falling apart in January 1990?
"Don't worry," they said. "Japan has the most dynamic economy in the world…it's just a temporary pull-back."
Well, that was 17 years ago. Japanese stocks pulled back…and kept pulling back for more than a decade. Only recently have they begun to move forward again…and they're still far cheaper than they were at the end of the Reagan years.
And do you remember how American economists and pundits criticized the Japanese? They refused to let their big banks fail, said the critics…and thus stretched out the pain of a correction.
"We wouldn't do something that stupid," they seemed to say.
And do you remember how here at The Daily Reckoning we predicted that the United States would follow Japan into a long, deflationary slump? You do? Well, forget it…we were obviously wrong. Or, at least seven years too early…because we made that prediction back in 1999!
Still, we were right in predicting that when the water started coming over the gunwales, English-speaking financial authorities would race to the pumps at least as fast as their Japanese counterparts.
Today comes word that the feds are bailing out the big banks as fast as their buckets allow. It is the biggest bailout in five years, say the reports…with big banks averaging about $2.7 billion per day in loans from the Fed. These injections of cash are said to be 'forced' by the Fed itself…rather that the result of desperation on the part of member banks. Still, recent estimates put the increase in U.S. money at nearly 50%, annualized.
The Bank of Britain took the high road on these bailouts - until yesterday.
Mark Gilbert explains:
"The Bank of England, by contrast, has been adamant that it won't rescue the money markets by accepting low-grade collateral, or by offering three-month cash. Indeed, the Fed and the ECB were rebuked yesterday, albeit obliquely, by U.K. central bank Governor Mervyn King for bailing out commercial banks.
"'The provision of such liquidity support undermines the efficient pricing of risk by providing ex post insurance for risky behavior,' King said in a copy of testimony he plans to deliver to the U.K. Parliament's Treasury Committee on Sept. 20. 'That encourages excessive risk-taking, and sows the seeds of a future financial crisis.'
"Victoria Mortgage Funding Ltd., a U.K. company that lent about 300 million pounds ($609 million) in subprime mortgages to British borrowers, was placed into administration earlier this week, the U.K. equivalent of Chapter 11. Victoria couldn't secure enough funding to stay in business."
But then came the news that house prices in Britain fell in August - for the first time in two years. Practically in the same flurry of news reports we found the BOE offering to prop up Northern Rock, a major source of funds for UK property speculators. (More below…)
But at least there are still a few voices of rectitude and probity. Out comes that sly fox, Alan Greenspan, announcing that he doesn't approve of such rescue efforts and opposes an emergency rate cut!
Could this be the same Alan "Bubbles" Greenspan who allowed, encouraged and facilitated history's largest credit bubble ever? We haven't checked the fingerprints, but we believe it is.
And it makes sense. The man is a scoundrel but not a fool. He sees trouble coming…and he's getting as far away from it as possible. Since a real rescue is probably impossible at this stage, he will begin criticizing the rescuers…laying the blame squarely where it does not belong - on his successors.
Of course, the rescuers are bound to make the situation worse - just as they did in Japan…and just as they always do. Capitalism functions best without bailouts. Leaky, overloaded, lost vessels sink; the sea-lanes and ports are opened to new ships and better captains.
But tomorrow's captains don't vote, make campaign contributions, work in the big banks, or have lunch with Fed governors. It's today's captains who get the favors…and money - whether they speak Japanese…or English.
We've been reading Richard Russell, one of the greatest stock market observers in the country, for at least 10 years. Now in his mid-80s, Russell has seen it all. And he thinks we're in a bull market.
Though we've been reading for a long time, we have never figured out how Dow Theory (his system) works. There are a lot of indicators and technical enhancements involved, but it appears to us to come down to this:
When prices are moving up, we are in a bull market. When prices are going down, we are in a bear market. When we are in a bull market - as Russell believes we are now - how long will it continue? Until prices go down!
After the epic high of 2000, Russell maintained that the Dow would probably remain in a bear market until an epic low was reached. This made sense to us. At least in broad outline. We buy when prices are low. So, we'll wait for another epic low. What the heck…we know it is coming sooner or later. In the meantime, taking the long view, everything is going downhill.
But now, Russell says stocks are in a bull market…with another big burst of gains coming. How long will it last? Until it comes to an end, says Russell. How high will it go? Until it reaches its peak, he explains.
The Dow only went down only about 20%, after January 2000, so it never got to an epic low; it never even reverted to the mean. Instead, stocks have been expensive since the mid-'90s. From here, maybe they'll go higher. Maybe they won't.
We don't know what to make of Russell's system, but we have a deep respect for the man's experience and intuition. When he says stocks are headed higher…we pay attention.
Why would stocks go up from here? Could it be just the final stage of a credit bubble…could it be the bailout cash will float them up…
…or, could it be that stocks' earnings will rise?
Colleague Chris Mayer ruminates:
"You know the big debate about profit margins. They are near all-time highs. The mean-reversion guys (Granthan, et al) say they will come back to trend. Others (GaveKal) believe the economy is fundamentally different now.
"But what if the high profit margins (and high return on assets) are due to understated book values (because of the cost accounting assumptions) and that the actual cost to replace these assets - because of inflation - is actually much much higher?
"Then, what happens is that as companies replace plant and equipment or expand, capex expenses should rise. This won't show up in earnings right away, because of the delay between capex and when they start hitting the P&L in the form of depreciation charges.
"But is becomes a stiff headwind against earnings after a while. Earnings fall as they reflect more truly the cost of the assets used, and profit margins fall, book values rise, returns on equity fall…stuff starts to move back to trend…
"Obviously, this doesn't affect all industries equally…but it could be a contributing factor to a potential decline in earnings…
"And, of course, it would mean the market price has to come down some. Bad for stocks generally."
We suspect Chris is right. American companies have borrowed heavily. But much of the money has gone into bonuses, fees, buybacks and other non-capital investments. When they actually have to replace plant and equipment, to keep up with foreign competitors, they're going to find themselves a little short.
You can read more insights from Chris Mayer here:
"What's the matter?" we asked.
We have been working with a group from Ireland. Last night, late, after a good meal, well lavaged with liquor, a few of them had tears in their eyes.
"Liam has been telling us about his dead pets…" one young woman explained.
A tall young man, his dark hair swept back, making him look a little like Yeats himself, continued:
"Yes, I remember Fluffy…and Hammy…they were such good dogs. Followed me around. They slept on my bed…though Hammy moved around so much at night I had to keep him out of the bedroom. He would follow me to school when I was about 6 or 7. I had to take him back to the house and lock him inside, and then go back to school.
"All seven of my pets…4 dogs…and 3 cats…all dead now…
"…it's overwhelming really…even now, I can barely stand to talk about them."
"Liam is a poet, you know. And like all the Irish, he gets very sentimental when he drinks."
Have a nice weekend,
The Daily Reckoning
Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter publishing companies, and the author of the free daily e-mail The Daily Reckoning. Bill's passion for international travel and big ideas are reflected in the company he's successfully built. In 1979, he began publishing International Living and Hulbert's Financial Digest. Since then, Agora has grown to include dozens of newsletters focusing on finance, health and travel. Since the early '90s Bill has vigorously expanded from Agora's home base in Baltimore, opening offices in London, Paris, Bonn, Waterford, Ireland and Johannesburg, South Africa.