TIN MAN -- SCARECROW AND DOROTHY
Lions and tigers and bears!
What sort of an animal is that?
It-it-it-it - it's a huge one!
Dorothy had a rational, natural fear of lions and tigers, but its bears that I want to talk about. One particular species of bear - the Secular Wall Street Bear.
No matter what you might hear on CNBC, the Secular Wall Street Bear is the biggest, baddest, species of bear in the world..and its back.
In investing, financial markets have market trends that can be classified as primary trends, secondary trends (short-term), and secular trends (long-term).Ben Bernanke has a problem. Or should I say - the American people have a problem and Federal Reserve Chief Ben Bernanke doesn't have a solution.
A bull market is a prolonged period of time when prices are rising in a financial market faster than their historical average, in contrast to a bear market which is a prolonged period of time when prices are falling.
You see, the Federal Reserve has to make a choice: save the real estate and stock market bubbles, or save the dollar. You can't have both.
Don't believe me? Let me show you then.
Since the Federal Reserve panicked in January of 2001, the Real Estate Bubble has become the most important driver of the American economy. Equity extraction from housing alone accounted for 7.5% of household disposable income in 2005. I've seen estimates that half of all the jobs created during the last five years were RE related (selling houses, loaning mortgages, building the houses). The only thing generating significant economic activity under Dubya has been Real Estate.
The problem is that all this real estate activity is speculation. In 2005 nearly a quarter of all new mortgages were Interest-Only. As many as 72% of all mortgages in some areas in early 2006 were ARM's, despite the home buyers knowing that interest rates were going up. Quite simply, it means that they can't really afford to buy the house. The housing affordability index in California has fallen to its lowest level since 1989, right before a 30% drop in housing prices.
And yet, home buyers are remarkably positive about the future.
A recent national survey of homeowners by the L.A. Times shows 'widespread faith in the real estate market.' The worst possible scenario, that prices would 'stay the same' over the next three years, was selected by just 5 percent of homeowners. That total was less than the 6 percent who said they expect to see a rise of 31 percent or more. No matter how much talk of a bubble there may be, homeowners continue to demonstrate that they have no clue about the ramifications of one. And this is in an environment in which prices actually are falling! The denial runs so deep, it's not even denial anymore. It's some kind of epic disconnect between the reality of a newly falling housing market and an unwritten social contract that says home prices do not fall.Of course, this is all very natural. The tops of bull markets are generally marked by dumb money buying and smart money selling. It's a sort of Social Darwinism in action. I wouldn't be surprised if a lot of today's RE speculators also bought tech stocks in 1999.
The fact is that the Real Estate Bubble has already started to burst. Here's some raw data:
# Refis are hovering at their lowest levels in five years.
# The National Association of Homebuilder survey index has dropped from a high of 55 in June and July 2005 to a reading of 32 in May 2006. Excluding a reading of 30 in the month following the 9/11 disaster in 2001, the current reading is the lowest reading since January of 2001.
# The Census Bureau reported the inventory of new houses for sale was 1.56 million units in the fourth quarter of 2005. This was the highest reading ever.
# The NAR reports as of April 2006 the inventory of existing homes for sale had risen to 3.38 million units, a rise 48.6% in 16 months.
# Meanwhile, RE transactions are dropping. the Federal Housing Finance Board (FHFB) showed drops ranged from 11% in the southern midsection of the country around Texas, to 42% in the Great Plains states, and 44% in New England. Compared with the fourth quarter of 2004, volume was down 23% nationally.
# The stocks of large, national homebuilders have dropped by as much as 50% in the past year.
# Foreclosure rate are up by a third over last year nationally.
# Short Sales have returned to the market.
# Business magazines are broadcasting this coming RE Bust. Forbes named it simply Implosion.
Sounds pretty bad, huh? Unfortunately it gets worse. A lot worse!
You see, the Real Estate Bubble isn't the only bubble in America. In fact, it isn't even the biggest bubble.
I'm going to throw some charts at you in order to frame a picture. Then I'll try to explain what I think will happen next.
It may not be obvious to you, but all of these charts tell the same story, but from different perspectives. It goes something like this:
Americans don't make what they consume anymore. For instance, America imports 50% more than it exports every month. Where do we find the capital to do this? Normally it would come from savings, but Americans don't save anymore either. Therefore, America has to borrow. Who do we borrow from? The same people we buy our products from - Asia. America soaks up nearly 70% of the world's savings every year. What's more, this trend is accelerating.
Almost 50% of our government debt is owned by foreign governments. To chase a tangent for a moment, if Bush were to decide to go to war with China right now, without firing a single shot China could crash America's bond market. China could simply dump hundreds of billions of dollars of treasuries and agency bonds on the open market and bankrupt us. Without any savings, the Fed would have to monetize all that debt and that would send inflation skyrocketing.
So what exactly does all this mean?
To borrow a Wall Street phrase: Trees don't grow to the sky.
We can't simply borrow and spend forever. There are consequences to our actions, and those consequences are about to arrive. What does the Federal Reserve think is about to happen?
The U.S. current account balance on international transactions in goods and services has deteriorated significantly over the last fifteen years. Since recording a small surplus in 1991, it has swelled to a deficit in 2005 of more than 6% of GDP, the highest such ratio in over 40 years. In the past, other countries with a current account deficit above 5% of GDP have typically faced worsening borrowing terms, either in the form of reduced borrowing opportunities or increased interest charges. By that standard, some would argue that the U.S. is overdue for such adjustments, including a significant fall in the value of the dollar.What does Asian banks think is about to happen?
Asian countries need to prepare for a possible sharp fall in the dollar and should allow their currencies to appreciate collectively if that happens, a senior Asian Development Bank official said Tuesday.What does the IMF think is going to happen?
The International Monetary Fund on Wednesday stepped up the pressure for far-reaching shifts in exchange rates, declaring that the dollar will have to depreciate "significantly" over the medium term if global economic imbalances are to be resolved in an orderly fashion.What does the investors like Bill Gross say?
Do you see a pattern forming here? The dollar needs to drop. The dollar should drop. The dollar will eventually drop.
But what about our foreign creditors? They lent us nearly $3 Trillion in dollar-denominated debt. Will they be happy to see their investments decline in value by at least 30%? Obviously that will not make them happy.
Will they grin and bear it? Would you? If you knew for a fact that your investment was going to decline by at least 30% if you did nothing, you would do something. Don't be surprised if our foreign creditors decide to do something as well. Especially when you consider that two of our major foreign creditors are Russia and China, and several smaller creditors are OPEC nations.
Some would say say that they already have suffered from this drop. However, the popular USD Index is almost totally made up European currencies. Europe is not our creditors, nor our major trade partners.
Our real creditors and trade partners are represented on this chart. And as you can see, the dollar value is more than three time higher than it was in 1980. This is despite the fact that America was the largest creditor nation in the world in 1980, and is now, by far, the world's largest debtor nation.
While our foreign creditors own plenty of our government debt, they also own lots of our corporate debt and equities. If they decided to start selling their investments this will have all sorts of cascading effects.
* First of all, it would drive down the dollar. That would cause import prices to rise.
* Since we no longer have many major industries in this country, we would be forced to continue to buy those imports, which would cause (more) price inflation.
* The stock market would take a big hit. Besides hurting the bottom line of companies and investors, it would be a body blow to a pension system that is already wobbling. This is at a time when the Baby Boomers are about to retire.
* Interest rates would rise dramatically when those bonds start getting sold. They would also rise in response to the increase of price inflation.
At this point it is worth noting that the government's economic numbers are a joke. If the government reported inflation, GDP, and unemployment numbers using the same calculations they did 50 years ago: the inflation rate would be between 8% and 10%, the unemployment rate would be north of 10%, and the GDP would be negative right now.
So where does that leave the Fed? On one side you have inflation fears, and the higher interest rates that typically come with it, is crushing the stock market. Those fears are well-founded. The CRB Index (a basket of commodities) is now in its fifth year of a bull market. Also, the Fed's dramatic rate cutting in their 2001 panic unleashed a virtual wall of money on the markets which has created massive monetary inflation. All that monetary inflation depresses the value of those dollar-based assets from our foreign creditors.
In order to protect the dollar the Fed needs to fight inflation, and its main tool to fight inflation is higher interest rates. Higher interest rates have the dual effects of reducing price inflation and making America more attractive to foreign lenders. America requires $2 Billion in loans every single day in order to maintain our lifestyles.
The problem is that higher interest rates will drive up mortgage rates. Higher mortgage rates will implode an already shaky real estate market.
Keep in mind that the real estate market is 10 times as large as the stock market. A RE bear market would simply wipe out tens of thousands of over-extended American consumers. It would cause hundreds of thousands of other households to watch their home values drop below the size of their mortgages.
If you want to see how bad a RE bear market can get, look no further than Japan. Between 1990 and 2005 real estate prices in Japan dropped more than 50%.
And speaking of Japan, they are leaving their zero interest rate policy (ZIRP). Being the biggest savers in the world, Japan has flooded the world with loans over the last 15 years. Getting literally no return on investment at home, Japanese investors have searched the world for a higher return. Now that interest rates are finally heading up, that money is starting to find its way home.
This is drying up liquidity all over the world. This declining liquidity is effecting the world's stock markets first. The stock markets of developing countries have dropped by as much as 40% in just a couple months. For now investment money has sought safety in treasuries, but don't expect that to last.
So on one side the Fed needs to raise interest rates to fight inflation and keep foreign creditors happy. But mostly to protect the dollar during a time of record trade and budget deficits.
On the other side the Fed needs lower interest rates to keep the RE Bubble from imploding and the stock market from crashing.
Doing nothing is not really an option.
What do I think will happen? I think we are headed towards an Argentina-scenerio.
Argentina also had massive foreign debt, huge trade and budget deficits, and an overvalued currency. The government tried to find "a balence" and failed, because a balence didn't really exist. In the end Argentina suffered both a deflationary depression and hyperinflation. Normally those two things are incompatible, but the Argentinian Peso fell even faster than their monetary base contracted.
So what does this have to do with The Wizard of Oz and Dorothy?
First of all, The Wizard of Oz had deeper meanings. It was a statement about politics and economics.
# the Scarecrow - the wise, but naive western farmersThe Wicked Witch of the East (a.k.a Eastern bankers) were also members of the Federal Reserve. And Dorothy's shoes were originally silver, not ruby, because silver was money that the eastern bankers hated but could not destroy. Even after silver was demonitized in 1893 it continued to be used in coins until the 1960's.
# the Tin Woodman - the dehumanized, Eastern factory workers
# the Wicked Witch of the East - the Eastern bankers who controlled the people (the Munchkins)
# the Good Witch of the North - New England, a stronghold of Populists
# the Wizard - President Grover Cleveland, or Republican Presidential candidate William McKinley
# the Cowardly Lion - Democratic-Populist Presidential candidate William Jennings Bryan
# Dorothy - a young Mary Lease; or the good-natured American people
# Dorothy's silver shoes - represents the 'silver standard' (acc. to the Populists, "the free and unlimited coinage of silver")
# the Yellow Brick road - the 'gold standard' - paved with gold, but leads nowhere
# the land of Oz - oz. is the standard abbreviation for ounce, in accordance with the other symbolism
# Emerald City - Washington, D.C., with a greenish color associated with greenbacks
See, and you thought The Wizard of Oz was just about flying monkeys.