The Rude Awakening
Chang Mai, Thailand
Thursday, June 7, 2007 ------------------------- - "Irreparable cracks in the financial system",
- Going long skepticism…with leverage,
- Investor's "Owy," tightening the global liquidity belt and more…
------------------------- Eric Fry, reporting from the wine country of Sonoma, California… The stock market fell down and went boom yesterday…which gave investors a great big "Owy!" Unfortunately, no matter how convincingly investors may have grimaced, screamed or writhed in pain, Mama Bernanke never rushed to their side with a spritz of financial Bactine, nor even a hug and a "There, there…You're okay." Nothing…Just pain. The pain might not have seemed so unbearable if folks had known in advance that bad things sometimes happen in the stock market. But almost no professional investor, or Wall Street strategist, or rah-rah financial news network, or Fed chairman, or Fed governor, or next-door neighbor ever bothered to mention the fact that bad things sometimes happen to good stock markets, especially when good stock markets has been too good for too long. Words of caution have only been issuing from voices out on the lunatic fringe…like those at the Rude Awakening and the Daily Reckoning. Way out there, where mainstream minds fear to tread, cautionary voices have offered occasional words of caution. Of course, a couple of rough days in the stock market doesn't nullify several months' worth of profits, much less signal the denouement of our long-running global bull market in stocks. Two bad days are just two bad days. Hmmm…too bad. But, year-to-date, the Dow still boasts a sizeable single-digit gain, and over the last 12 months, it boasts a sizeable double-digit gain. Not bad for a year's work. Therefore, most investors, we would imagine, will want to stay the course. They will want to trust in the global equity markets to recover from their swoon to deliver even more substantial gains. Your editors at the Rude Awakening would not rule out this pleasing possibility, but would opt for fear over greed. Why not take the summer off? Please allow us to express a rare, unequivocal opinion: the global equity markets offer far more risk than reward at current valuations. What's more, the prospect of rising interest rates and falling earnings growth does not tickle our fancy. Lastly, we are not wowed by the increasing volatility in the global monetary system (read: dollar weakness). Net-net, we are not suggesting that investors should sell everything and run for the hills; a brisk walk would probably suffice, as Marc Faber explains below…. --- The Survival Report --- WARNING! Brace yourself for the most shocking money implosion of the last 76 years, as a "Second Wave of Housing Hurt" crashes down… Why Your House Could be Worth 43% Less by 2011 Thought you were "done" with the property bust? Think again - then get ready as a whole "second wave" of falling prices sparks the worst property-led recession of the last 76 years! Get your triple-edged "housing hedge" strategy report FREE right here: The Survival Report ----------------------------------- What if Stocks Fall?
By Marc Faber I have mentioned in the past that the first signs of credit tightening would be visible in the performance of US brokerage stocks. Recent pronounced weakness not only of brokerage shares, but also of other financial stocks and, in particular, sub-prime lenders, would seem to confirm that the "irreparable cracks in the financial system", about which we wrote in the January issue of my Gloom, Boom and Doom Report, are now spreading. These cracks are now causing some "illiquidity", not only in the household sector but elsewhere in the system as well. This illiquidity, sooner or later, will pressure share prices. 
First, it is important to understand that mortgage debt has begun to grow at a slower pace largely because home prices are no longer appreciating. The growth in the mortgage market was about equal to nominal GDP growth between 1980 and 2000. But, in the 2000 to 2006 period, a massive breakout from the trend occurred and, combined with a decline in the saving rate, drove consumption and GDP growth. But, as home prices began to decline in 2006, and as problems in the subprime lending market became evident, lending standards were tightened to their highest level in 15 years. Declining home prices and tighter lending standards brought about a slowdown, not only in mortgage debt growth, but also in overall debt growth. Mortgage debt, which grew at an annual rate of 10.2% in the second quarter of 2006, declined to an annual growth rate of 8.6% in the third quarter and to 6.4% in the fourth quarter. It is likely that mortgage debt growth slowed down further in the first quarter of 2007, and will decline even more in the second quarter given the problems in the sub-prime lending industry and the tight lending standards. In the meantime, household debt growth in the United States has declined from a peak of 11.9% in the third quarter of 2005 to 6.6% annual rate in the fourth quarter of 2006. According to Merrill Lynch economist, David Rosenberg, the fourth-quarter 2006 annual credit growth was the slowest since the third quarter of 1998 and the sixth consecutive quarterly deceleration, "which hasn't happened since 1956". Now, ceteris paribus, this significant slowdown in mortgage and household debt accumulation would have already brought about a significant slowdown, or even a decline, in US consumption. However, because of the stock market rally in the fourth quarter of 2006, equity wealth increased by 4.2%, or an annual rate of 18%. This fortuitous trend has continued so far in 2007. Moreover, as David Rosenberg notes, "just as households are beginning to curb their appetite for debt, the once-dormant corporate sector stepped up its borrowing sharply in Q4. Net debt raised by the non-financial corporate sector steamed ahead at a 10.9% annual rate in Q4, almost double the Q3 pace (of 5.9% annualized) and the strongest pickup in seven years. You have to go all the way back to the cash-burn era of 2000 Q2 to see the last time that the corporate sector outdid the household sector in terms of debt buildup." And as David Rosenberg correctly suspects, corporate borrowings have been rising along with M&A activity. The deterioration in household debt growth hasn't yet led to a consumer spending decline; but, very clearly, retail sales are now growing more slowly. Continuous consumption growth was therefore driven less by household debt growth in the fourth quarter of last year and the first quarter of this year, than by the continuation of an increase in household wealth and the selling of US equities by the household sector. But herein lies the problem. If declining home prices are now joined by declining equity prices that are either declining or no longer rising, it will only be a matter of time before consumer confidence declines and consumer spending slows to a crawl. Slower consumption growth, as a result of tighter lending standards and flat or declining equity prices, should have the following consequences. The US trade and current account deficit will no longer expand at an accelerating rate. This should lead to a relative tightening of global liquidity, which would likely be unfavourable for asset prices but could temporarily strengthen the US dollar and even more so the Yen. The full extent of the sub-prime lending problems isn't known. However, since at least 12% of the mortgage market - whose total size is over US$1.2 trillion - is comprised of sub-prime loans, the fall-out could be considerably worse than expected. This certainly seems to be indicated by the recent poor performance of banking stocks and, as indicated above, brokerage shares. And what's bad for financial stocks is probably terrible for the overall stock market. Here's why: Earnings in the financial sector of the stock market have risen 14-fold since 1990 to an annualised US$251 billion, whereas the rest of corporate earnings experienced only a fourfold increase, to US$636 billion. I have mentioned in earlier reports that if we were to include in the financial sector's earnings their profits from speculating in all kinds of derivatives and financial products by industrial and multinational companies, the profit contribution from financial earnings to S&P 500 total earnings would be more like 45%. Also, the recent contribution to profit growth would amount to around 70%! Therefore, I suppose that if asset markets failed to appreciate further, financial earnings would begin to decline and likely pressure S&P 500 earnings. (Aside from the financial sector, the energy and material sectors have in recent years also boosted S&P earnings. Never before have energy and financials contributed so much to the S&P profit pool.) In the past, poor performance of financial stocks has always been an unfavorable indicator for the entire stock market. In an economy that has become addicted to credit growth, this should be even more so! The other point to remember is that if corporate profits no longer expand, the ammunition used by the corporate sector to take over other companies and to buy back their own shares is likely to diminish. Last year, a record US$548 billion worth of shares were retired by corporations buying back their own shares and by acquisition-minded private equity funds. Any reduction of this activity in 2007, when simultaneously the increasingly "illiquid" household sector is likely to diminish its equity purchases further, is going to have an unfavorable impact on the stock market. I may add that, sooner or later, private equity funds will place the acquired companies back on the stock market and so increase the supply of equities through high IPO activity. If the assumption is correct that global liquidity is tightening - at least relatively - the asset markets that benefited the most from surplus liquidity should come under some pressure. I am thinking here in particular of the extended emerging stock markets, which in this scenario could be vulnerable to corrections of between 20% and 40%.Tread lightly. --- The Ultimate Dollar Hedge --- Introducing: Zero-Downside Gold. The following report, "Gold $2000" will outline five new ways to play gold and hedge your dollar bets. Also included is a zero-downside gold strategy. Get Your Report Here: Gold $2000 (But you have to jump on this before June 19, 2007… or the doors on this could slam shut to you forever…) ---------------------------------- Did You Notice…? Be Skeptical
By Dan Denning It's too late to "sell in May," but still early enough to sell in June. Be skeptical, dear reader. Very skeptical. Go long skepticism, with leverage even. We recall the great lengths that many Wall Street cheerleaders went to in 1999 and 2000 to justify sky-high valuations on the tech-fueled Nasdaq. Extreme "new era" rationalization was necessary because most of the Nasdaq's companies either had no earnings, or investors were paying for earnings 50-years out. If you stop to be sensible about it for a second, you're reminded that stocks are ultimately a claim on cash-flow. While you can get away with projections that never materialize for a few quarters, money eventually talks. And if it doesn't, investors usually walk. That's why traditional methods of valuation focus on the present value of future cash flow and what price to pay for it today. The faster a company, say a small company, is growing its cash flow (and hopefully its net income) the more you might be willing to pay now for future cash flow. "Sell in May and go away," we repeat the old adage. Why do stocks tend to do all their heavy lifting between November and May? No theories here. It could happen again. We look around and find a hard time identifying sources to send stocks higher. Happy Investing. | 
