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October 14, 2008

The Survival of the Longest
by Thomas Tan

What a week! What a month! S&P 500 started around $1,250 a month ago, was as high as $1,200 at some point two weeks ago, no one had ever imagined it could drop below $850 last Friday. I gave out $800 target in August last year at one of my old articles, which S&P 500 is on its way to test now. It was an easy target to give since it was the low of the 2001-2003 bear market. Even the market is quite oversold, and due to for a dead cat bouncing, I doubt now $800 will be the bottom for the bear market, and there is no support whatsoever in sight once $800 is decisively broken, until around $4-500.

After the 1987 crash, government has implemented the so-called circuit breaker system which they hope would prevent a one-day crash of 20%. However, people are always smarter than the system and will always find a way to get around it. Instead of dropping 20% in one day, let us do it 5% a day on average, and easily beat the 20% record in 1987 by a wide margin last week. The next thing government can try is market holiday(s) and eventually bank holidays like in 1930s.

Early this year, Jeremy Grantham of GMO predicted at his interview with Barron's that S&P 500 would drop to $1,100 by 2010. A lot of people just laughed at him, was this crazy old man out of his mind? Now it is like Hamlet's last line 'all rest is silence'. We always should listen to an old man who has experienced the nifty-fifty losing 80% of their market value in 1970s, and has studied extensively the great depression of 1930s. He probably regrets now that his $1,100 target given was too conservative. Actually now $1,100 becomes an important resistance point for the upcoming dead cat bouncing or bear market rally. Jeremy derived his $1,100 target with a more normalized P/E of 11-12 as a norm for a very long term capital market. If I use the more representative bear market P/E value of 6-7, I would come up with a target of around $600-$700 range. At the extreme of this bear market a few years down the road, S&P 500 might very well overshoot and drop all the way to the $400 level, which is the launch pad for last leg of the past bull market after early 1990s recession. Everything is back to square one and 20 year's return of bull market turns out to be in vain.

How long will this bear market last? Well, 1930s great depression caused a bear market lasting over 2 decades, from 1929 to 1952. It was only until 1958 that market came back to the old 1929 peak, 3 decades later. And 1970s was not much better, lasting 14-16 years from 1966 or 1968 to 1982. Even bear market ended quicker for 1970s, it was until 1992 or 24 years later to reach 1968 peak. My most optimistic forecast is it will last another 4-5 years from now, or about 12 years if we count year 2000 as the starting point. If we use the commodity super-cycle by Jim Rogers, which usually runs opposite to the general equity market and lasts until 2020 as Jim predicts, it will be also a 2 decade bear market for equities, consistent with both 1970s and 1930s. When will S&P 500 be back to last October peak? At least 24 years from 2000, or 2024. A few chart technicians today think Dow can drop all the way to $1,000, back to the 1982 level. Even it is possible, but I think it might bottom at one of the lower Fibonacci level between $14,000 and $1,000. Which one of them is yet to be seen in future years but my guess is around $4-5,000.

The current market crash is not like 1987, which recovered in a relatively short time since the fundamental was strong, stock was in an uptrend and it didn't have the economic bloodline of credit cut off then. There is another fundamental factor now supporting a long lasting bear market than 1970s. This time, it is demographic. Setting aside the whole investment banking sector being wiped out and OTC derivatives, for the public, the more important factor is that baby boomers are not comfortable with this market turmoil since last year, and want to lock in their nest eggs and to cash out, which has caused more baby boomers to do the same. They don't want to take the risk of sitting through this credit crisis and bear market, since no one knows how long it will last. What happens if it lasts as long as 2 decades? Time is not on their side. How can we blame them? With the real estate market at free-fall and no sight of its bottom, it is only natural for them to protect their only remaining nest eggs. And they will never get back into the stock market again after cashing out, due to growing risk adverse profile with increasing age. All the concern is to protect their cash. This is why you see US treasuries reaching so high these days with yield at 0%, the so-called safe haven vehicle. Maybe stocks in the future will be "undervalued" at 50% of book value, 70% of intrinsic value, P/E at 6, PEG less than 1, but who cares. Yes, inflation is gradually eating their money away, well, let us worry about that later when inflation reaches double digit.

The above discussion about baby boomers is not new, as early as 2001, Wharton professors of Andrew Abel and Jeremy Siegel have voiced concern about the herd behavior of baby boomer generation and their cashing out simultaneously will cause a stock market meltdown around 2010. What an accurate prediction that is, only miss by 2 years. At the same time, who wants to be the last one to cash out in 2010 at the lowest price by holding the bag anyway? I think 2010 bottom prediction by professors is still one of the valid bottoms, and probably the most important one in this bear market, reaching $4-500 target discussed earlier after the upcoming dead cat bouncing rally.

Here is a brief discussion on Warren Buffett's investment in both GE and Goldman Sachs. Investment in perpetual preferred stocks is usually a good way to invest in good business as long as the firms survive, and obviously Buffett thinks both will. I tend to agree too. However, even both GE and Goldman survive, not many people realize these investments are at the large expense of the existing common shareholders. In GE's case, GE is using Buffett's name and investment to raise $12 billion in a separate public offering to dilute their common shares, not counting on the $3 billion of GE warrants, causing potential more dilution. Almost all GE industrial units are doing fine since they are usually #1 or #2 in the sector and have some monopoly price power. The biggest risk for GE is their GE capital unit, which never reveals their portfolio based on illiquid asset securitization and OTC derivatives, similar to highly leverage investment banks. And unfortunately it accounts for half of the GE earning power. If GE Capital is in the same trouble, GE will likely have to shut down this division, write down large losses of their portfolio and lose half of their earning power but as a conglomerate, they will still survive. The problem is in an economic depression with decreasing revenue and much worse profit margin, GE's earning will be depressed substantially, but still has to honor the large interest payment to Buffett on the new preferreds before common shareholders see their dividends.

In Goldman's case, it is even more so and a much risky investment than GE. The largest expense for investment banks is compensation, and they always issue many new shares to retain talents besides cash bonuses every year. That is typical and part of their incentive program. In an economic depression, there is likely no banking deals, not much trading activities, especially no more highly profitable structured products like before. Goldman's net income could be running less than $1 billion at its worst years (like Morgan Stanley today). However, they have to pay Buffett $500 million, 10% interest of his $5 billion investment every year. What is left for common shareholders with their shares diluting heavily each year? The incentive program becomes a demoralized program. Both deals are really very negative to common shareholders, taking a large piece of the net income pie and shifting from commons to preferreds.

From where the stock price and credit derivative swap are trading at for Morgan Stanley, it is pointing them to be another Lehman. The original tentative discussion with Mitsubishi UFJ Financial Group by investing $9 billion for 21% stake then can buy the whole Company last Friday. No wonder people are questioning whether this deal makes any financial sense at all. What is also interesting is that there has been a very popular blog in China, discussing in detail a high level special interest group inside China SWF and banking system, using their relationship with top managers of Morgan Stanley and Blackstone for alleged corruptions, kickbacks, abusing power, questionable investments going sour, luxurious life style, etc. Usually Chinese government would have ordered the removal of such kind of "un-harmonized" blogs right away, but not in this case. There is wide speculation of anger by some government officials toward the China SWF fund investing in Morgan Stanley, Blackstone and all the US home mortgages and derivatives, for the purpose of nurturing their own personal relationship and self-interest but letting the whole country down. It is always a bad thing to make your investors angry by losing their money, especially this time it is their boss, the Chinese government which now realizes that they would never get any return and worse at the edge of getting wiped out on their investments.

There are also many angry investors in this country too, causing the House to defeat the $700 billion bail out plan initially. If without Wall St.'s creativity on structured products, subprime crisis could be easily contained, even with widespread abusive lending practices. The problem is for $1 of subprime mortgages, Wall St. created $10 CDO products, then the math geeks at structured product groups escalated the $10 CDOs by creating another $100 OTC derivatives out of thin air (refer to my previous article "Why Wall St. Needed Credit Default Swaps?"). Now suddenly, a $700 billion default in subprime would cause $7 trillion default in CDOs and $70 trillion losses in CDSs, a crisis 100 times larger than it should be. Now you know why Wall St. is so profitable because in only past 5-10 year's time, they have already sucked the blood and "profit" of not only this generation but the next. If government is serious about bailout, the size will likely be 100 times larger than $700 billions.

Not long ago, with no market for CDOs, Merrill was forced to sell CDOs at 20 cents on the dollar by creating a market. But that was not the most interesting part, Merrill had to self finance 15 cents out of 20 themselves, leaving a suspicion that those CDOs were really only worth 5 cents. This act forced other banks to mark down CDOs in their portfolio further, however, at 20 cents not at 5 cents, helping other banks to shore up the value of their portfolio than they are really worth. Even so, any asset writedown has to be matched by equity. There is really no more equity to write down for many banks, and no way to raise new equity, only heading liquidation. Since debt stays the same, debt to equity ratio, or so-called equity ratio, has to be reduced in the current deleveraging process, not to be increased. As a result, a writedown causes more writedowns, and it becomes a death spiral of no way out situation.

In the summer of 2007 last year (not 2008 this year), Jeremy Grantham also predicted half of the hedge fund will get wiped out, and more than half of the private equity will vanish. Let us just look at private equity sector. In the boom years, they can achieve 50% return easily. Let us look at a hypothetical deal that a PE Firm A with 2+20 fee structure, purchased Company B at $4B with $2B borrowing at 6%, netting $1B in 2 years by IPO, a very typical deal in the good old days. It is 50% return ($1B/$2B investment) for the PE firm. But for you as a PE investor, your share of return is: $1B profit - $0.08B fee (2%*$2B*2 yr) - $0.2B PE profit cut - $0.24B interest ($2B*6%*2 yr) = $0.48B, or 24% return ($0.48B/$2B). Suddenly the same deal seems to achieve 50% return (for them), the real return for clients is only half of it.

Now let us use the same example above but let us say the equity market enters into a couple years of bear market as of now. The same deal now takes 5 years instead of 2 years to spin off in an IPO. What would the return for PE clients be?

The answer is ZERO. It is: $1B profit - $0.2B fee (2%*$2B*5 yr) - $0.2B PE profit cut - $0.6B interest ($2B*6%*5 yr) = zero. 5 years for nothing. The extra 3 years of interest payments and excessive 2+20 fee structure eat all the remaining profit. For all the corporate pension funds, state and local government retirement funds, endowment funds and foundations rushing to invest 10-20% of their investments into private equities, do they realize investing in 5% US treasury per year (27% for 5 years compounding) would actually offer better return and carry no risk at all (except the risk of holding US dollar)?

In the above calculation, I didn't factor in a long recession with a decade of bear market, resulting reduced revenue with deteriorating profit margin, and potentially large loss instead of profit for business they purchased. No need to show more calculations. This is why Jeremy was so confident about his prediction still in the middle of the bull market last year, with margin of safety by predicting only half of them dead. Now with time against them, no credit for any financing, and no equity market for IPO for a decade for them to cash out and dump the risk to the public, the likely scenario is the whole private equity sector will get wiped out in 2 years by 2010, just like the investment bank sector.

For a decade long recession and likely depression, the only firms that will survive are those preserving cash by cutting workforce, stopping capital expenditure, R&D and IT investments, cutting stock dividends including preferred dividends, no more stock buyback even stock prices going to zero. Things will get very nasty, only firms that can still manage to generate net cashflow during depression are survivors, like in 1930s and 1970s. Newer companies with experimental technologies will be vulnerable and regarded as nonessential, and undercapitalized private firms will be in trouble since IPO window will be shut for an unforeseeable future. Venture capital firms will have to hold on to their investments forever, at least another decade, without IPO in sight, until all their cash being burnt out. Many firms relying on bank financing will not survive. The only business will survive are likely the cashflow positive energy firms and mining producers.

Pretty soon, people will realize holding cash in US dollar is also not right due to quick deterioration of US dollar. The current rise in US dollar is due to short term disappearance of money supply since no bank wants to lend any money out. Once the government socializes the banking industry and flooding the system with worthless paper, people will downgrade US treasuries before rating agencies do, since US government is buying and holding the worst quality mortgages and CDOs dumped by the banks.

In a normal bankruptcy process for investment banks, common stocks, preferreds and subordinated debts would get wiped out, and bondholders would act as cushion and suffer some losses, but usually customers and trade partners are protected. The current bailout plan, and the previous BSC bailout, AIG bailout, are all using taxpayer's money to bail out the bondholders and perferreds which are held mostly by institutions. It is basically to wipe out the individual investors then to use taxpayer's money to protect the large institutions. Individuals have already dumped stocks, institutions have already dumped bonds, derivatives such as CDOs and CDSs, the next thing will happen is that both, especially foreign central banks, will dump US treasuries too by buying the ultimate asset everyone in the world trusts - Gold. The reason is people will realize this is worse than 1930s, at least then, fiat money was backed by gold, now US dollar is only backed by liabilities of over $10 trillion national debt and 10 times larger unfunded obligations and promises if we include Medicare, Medicaid, social securities, pension liabilities, Fan and Fred's trillion mortgages, and the future purchases of the whole defunct banking industry, auto industry, airline industry, etc. etc. Government can't only socialize the money losing sectors, and taxpayers and lawmakers have only so much patience and can't tolerate this forever. Pretty soon, government will need to take over a profit sector, such as energy firms, to offset some of the losses. It is going down the slippery path of socialism quickly.

This is going to be a nuclear winter for many years to come. No wonder many years ago, George Soros has correctly predicted that there is going to be the end of globalization, and the death of capitalism. This is the payback time for all the abuses few elites have done to our whole society but the public is now footing their bills. If G7 is serious about bailing out the global economy, the only way to do it is to have double digit hyperinflation to inflate the whole world out of depression at any costs. And they have to do it now. They can't be half-hearted either, otherwise it will end up to be the worst nightmare of hyperinflation combined with great depression. This means all commodities will skyrocket and the current slump of commodities would provide the best buying opportunity before oil goes to $200 and gold to $2000. When people lose faith in fiat money, next thing to happen is barter like Weimer Republic, where only commodities, especially gold, are treated as money.

In this difficult period, do nothing and hold nothing but gold. Only gold, the ultimate asset that has survived the longest in human history, can save us now.

A specter is haunting the world - the specter of gold, while the old fiat money has lost all its powers.

Thomas Tan, CFA, MBA
www.investorwalk.com

Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.

Copyright © 2006-2009 Thomas Z. Tan

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