The End is Nigh
"It's a recession when your neighbour loses his job. It's a depression when you lose your own." - Harry S. Truman
The stock market has crashed. Pretending it is anything else is futile. What has for years been predicted by the perma bears has come to pass. But now that it has happened we can begin to focus on the recovery. The end is nigh. While it will be a severe recession or even a mild depression, either of which will grip us for more than a few years and maybe a decade or more as it is with Japan, we can with the mind boggling collapse of the past two weeks begin to focus on how to get out of this mess.
First, some perspective on the depth of this stock market crash. Over the past two weeks the S&P 500 fell 25.9 per cent, the Dow Jones Industrials 24.2 per cent, the NASDAQ 24.5 per cent, the TSX Composite 25.1 per cent, TSX Financials 21.2 per cent, TSX Energy 39.2 per cent and the TSX Gold 15.5 per cent. The damage was worldwide - Tokyo Nikkei Dow 30.4 per cent, Hong Kong Hang Seng 20.8 per cent, FTSE (London) 22.7 per cent, CAC 40 (France) 23.7 per cent and the DAX (Germany) 25.1 per cent. While this crash happened over a two-week period, we note that the two-day crash of October 28-29, 1929 fell 23.6 per cent and the one-day crash of October 19, 1987 fell 22.6 per cent (Dow Jones Industrials in both cases).
By most measures of previous stock market crashes we should be at or very near a low for this phase of the bear market. October 19 was the low in 1987, while in 1929 the low was seen nearly a month later, on November 13, but it was another 13.6 per cent lower. A two-day rally was quickly wiped before leading to the final low. As we note, the end is nigh.
In 1987 fears of a severe recession or even a depression never materialized. Yes, there was a recession, and a painful one, especially to the real estate sector and the fallout from the savings and loan scandal and junk bond scandals, but the actual recessionary period did not fully materialize until the early 1990s. The final lows of that three-year bear period were seen in October 1990. The exact date of the low was October 11, 1990. Eighteen-year cycles in the stock market are not unusual so history in that respect could be repeating itself almost to the date. The recessionary period was more or less spread over a 3 to 4 year period and we did not begin to fully take off on the stock market until 1995.
The 1929 crash was not the end but the beginning of the decade-long nightmare of the Great Depression. After a sucker rally that took us into April/May 1930 the stock market really began to descend, not bottoming until July 1932 as the DJI lost some 89 per cent from the September 1929 highs. The highs of 1929 were not taken out until 1954. The 1987 crash was mild by comparison, with the highs of August 1987 gone for good in early 1991.
In terms of severity, this bear market over the past year has not quite set any records but we note that no bottom has yet been confirmed. Taking it from the high to where we were a year later, the 1937-38 collapse remains the true daddy of the bears, followed very closely by the 1929-30 one-year period, although clearly that collapse didn't stop there. We list the really big ones, all of which were in the 40 per cent range. On a couple below we went that extra month or so to find the bottom of the collapse. All data is weekly close to weekly close.
March 1937 to March 1938 - 49.1 per cent
September 1929 to September 1930 - 46.2 per cent
October 1919 to December 1920 - 44.2 per cent
September 1973 to September 1974 - 40.8 per cent
October 2007 to October 2008 - 40.3 per cent
November 1916 to December 1917 - 40.1 per cent
January 1907 to January 1908 - 39.2 per cent
The volatility during the past two weeks has been nothing short of incredible. On Friday the Dow Jones Industrials ranged 1,216 points top to bottom and we closed 678 points off of the low of the day. Volatility as measured by the VIX indicator hit a record high of 76.94 this past week, with a record close at 69.95. This exceeded the highs seen at the stock market lows of the 1997 Asian crisis, the 1998 Asian/Russian/Long Term Capital Management crisis, the 2001September 11 collapse and 2002 tech wreck/dot-com bust. It is difficult to say that this is as high as it has ever been because the VIX has only been tracked since 1990. This is though a record for the indicator since it has been tracked. If fear and greed are irrational events then the VIX measured maximum irrationality.
Last week we surmised that the lows of 2002 were going to be tested in this bear market. We were flabbergasted to see that we came so close to those lows this past week. This may cause us to reassess our final lows for this bear market. The DJI low in 2002 was 7,177. The low thus far in 2008 is 7,774. The S&P 500 hit a low in 2002 of 769 while the low Friday was 840. The TSX Composite by contrast hit a low of 5,678 in October 2002 while Friday our low was 8,850. By comparison the TSX is clearly outperforming. But then the TSX Composite far surpassed its 2000 highs compared to the S&P 500 and the DJI. The lows of 2002 were hit during the week ending October 11, 2002. Flash forward six years: between October 2007 and October 2008 we are down 40.3 per cent and once again we are hitting lows. Will history be repeated? We think so but obviously we have some work to do to confirm that a low is in. As well we note that last year's high was made on October 11, 2007. One year anniversaries are very important in cycles.
There has been some interesting symmetry in this crash in comparison with the 1929 crash. Technical Analyst Michael Jenkins in his recent newsletter (October 10, 2008) pointed out this symmetry. Despite the differences in time (1929 crash took 71 days top to bottom and the 2008 crash has taken 363 days thus far) Mr. Jenkins noted the strong similarities in the patterns. A pivot line can be drawn at A on the 1929 chart. The distance A to B is very similar to the distance A to C. Note how afterwards the 1930 sucker rally only took us back to the pivot line. AB = 96.1 points, AC = 94.6 points.
Similarly the 2008 crash can have a pivot line drawn at A. Using the same symmetry the distance AB = 356.0 points and the distance AC = 379.50 points. Odds are therefore reasonable that we may have seen our low for the crash phase. But as Mr. Jenkins points out we can't even begin to think that we may be past this crash phase until we have had at least 3 consecutive days of higher bottoms. We would agree with that. If the 1929-1930 analogy holds at all we could expect an irregular rally that might last 3-5 months and take us back to that pivot line near 1220. That would be a 35 per cent rally from Friday's closing levels. It is during this phase that investors should restructure their portfolios.
Of course the recovery from these levels may play out differently but given the level of fear in the market, the huge volatility and the symmetry at work odds are telling us that we may be at least at a temporary important low. Crash lows are always made at maximum fear. While bottom pickers may wish to rush in now (if they haven't already) one still may wish to see some confirmation first.
Has there been anywhere to hide in this market? It is all relative. As our table below attests, hiding in gold since this crisis got underway at the end of August has slightly outperformed hiding in Treasury Bills and is just below hiding in 5-10 year bonds. However, over the five-year and 10-year periods gold has been a superior investment, exceeded only by holding oil or in the TSX Energy Index. Over the past five and ten years the S&P 500 has been a loser. Hiding in gold for this year has been somewhat below hiding in Treasury Bills or 5-10 year bonds.
|Asset or Index||Since August 29, 2008||Since December 31, 2007||5 Years||10 Years|
|Treasury Bills *||2.20%||2.75%||3.15%||3.57%|
|5 - 10 Year Bonds *||3.42%||3.56%||4.08%||4.70%|
In times of stress gold has proven to be a valuable store of wealth. There is a time to own gold and a time not to own it. Since 1998-99 owning gold has proven to be a solid long-term investment. The Dow Jones Industrial/Gold ratio peaked near 45 in 1999. Today it sits at 9.71, clearly breaking down this past week from what appears as a double top formation. We are targeting at least 6.6 on this move and we suspect that before this is finished it is possible that we will equal the 1:1 ratio seen at the highs of 1980. At the depths of the Great Depression the DJI/Gold ratio was 2:1.
For the past few weeks it has been difficult to explain why gold has not exploded to the upside. Certainly from January to March this year, a period that culminated in the Bear Stearns collapse, gold and gold stocks were the place to be. Gold soared over 17 per cent and the Gold Bugs Index (HUI) was up 24 per cent while the Dow Jones Industrials was falling nine per cent from December 31, 2007.
Of course one of the prime reasons holding gold back has been the recent revival and strength of the US Dollar. While it is difficult to explain this seeming contradiction there are some explanations. First there is the perception that Europe in particular is worse off than the US. For sure given the most recently available GDP data the US economy is outperforming. That is US Dollar positive. Secondly the authorities have worked hard to change the perception of the US Dollar. And yes there may have been activity by the Plunge Protection Team (Working Group on Financial Markets signed into existence March 18, 1988).
As well as part of recent financial activities we note the Federal Reserve conducted a huge currency swap with foreign central banks swapping US Dollars for other currencies. The US Dollars in turn is being used by the foreign central banks to purchase unprecedented amounts of US Treasuries primarily Treasury Bills (or of late the term Cash Management Bills of which there has been countless auctions). We note in examination of the Federal Reserve statistics that the memorandum item of marketable securities held in custody for foreign official and international accounts has soared in recent weeks up another $19.5 billion this past week. Purchases are primarily US Treasury bills, notes and bonds even as at the same time they shed agency paper (Freddie and Fannie). These purchases are both propping up the US Treasury market (primarily TBills where short rates have fallen almost to zero) and also propping up the US Dollar.
During the early part of the year besides gold stocks rising we note that oil and energy stocks were also rising. Given the action in the earlier part of the year we admit we were lulled into believing that the same would generally hold this time around. A correction, yes, in gold and oil and energy stocks but not the devastating collapse that took place. Nothing was spared in the recent collapse and energy stocks proved to be the weakest. Energy stocks today trade on a P/E basis as if oil were at $20-$25 not the $78 it is still at. This despite the fact that the Amex Oil & Gas Index (XOI) is at levels last seen when oil prices were near $60 back in 2006. Similarly the Gold stocks (HUI) are trading at levels last seen when Gold was $450-$500. That these stocks are stretch beyond belief is an understatement.
This has been an unprecedented period. The comparisons with the Great Depression are there; both periods saw a speculative housing bubble, a huge consumer credit boom with excess debt, and a wave of new innovative financial products on Wall Street using massive leverage. Both periods also were presided over by a wave of deregulation in financial markets, and in the US an unpopular, lame-duck Republican President who had no idea how to cope with the problem. Curiously, Canada was also presided over by a Conservative Government whose policies eventually made things worse. Could history once again be repeating itself? In 1932 the US threw off the unpopular Republican President while in Canada a Conservative government was elected in 1930.
But the differences in the two periods are even more striking, and that is why while many will certainly suffer with reduced portfolios and there will be job losses (the 107 thousand jobs recently announced for September aside most of which were part time), we should not see the grinding poverty and gloom that pervaded the Great Depression. Today the level of social programs of welfare and unemployment insurance are far better than they were in the 1930s, if they existed at all. While almost 30 million Americans subsist on food stamps at least they have food stamps. During the 1920s society was still primarily agrarian and the farm sector had been in a depression most of the 1920s. Today Canada's main exports are oil and high tech goods. The farm sector over the past decade has enjoyed considerable prosperity.
Unemployment in the 1930s rose rapidly to the 25 per cent level, and besides the farm sector it was the manufacturing sector that was exceptionally hard hit. Today we are a service society with sophisticated well paying jobs in the health, high tech and financial sectors. Plus the public sector plays a much greater role in society today than it did in the 1930's. We are largely an urban service society. Thus far we have not yet seen a contraction in GDP (mild in Canada and none in the US) but it is expected that we will. We should not, however, see the depth of the contractions of the 1930s.
Finally the modern tools of monetary and fiscal policy are far more sophisticated today than they were during the 1930s. While we can argue whether the gold standard that prevailed back then was a problem, holding back the monetary authorities (and banks) for money supply expansion, the reality is the lack of a gold standard today allowed the monetary authorities (and banks) to expand money supply and debt to an unsustainable level that helped contribute to this crash. In the late 1920's high leverage was 10 to 1. In the recent markets it was not unusual for banks, brokers hedge funds and others to be employing leverage as high as 60 to 80 to 1.
We have noted that there have been discussions and a call for a new Bretton Woods agreement. At its basis would be some limited return to a gold standard. Money should be worth something and not just so much paper. There is also a growing question of the US$. With the US so dependent on others to provide the financing for its debt, it is questionable as to whether the US$ should remain the world's reserve currency.
The monetary authorities led by Treasury Secretary Henry Paulson have taken unprecedented steps now to stem this crisis. They have moved quickly from the infamous $700 billion bailout plan to taking equity stakes in the banks. This is on the level of the Resolution Finance Corp. that was created in 1932 to directly lend government money to the banks. The pumping of equity into the banks pretty much means the nationalization of the banking system, a step that would appear to make the Republican capitalists of the US (and even Canada) cringe. But the nationalization of the banking system is nothing new and today Britain, Iceland and others in Europe are doing same thing. Call it welfare for the capitalists. We can only hope the treat the people in a similar manner.
The big question is, how are they going to pay for it? If they pay for it by issuing debt, the debt of the USA (already $9 trillion and rising rapidly) will soar. Already they have lifted the debt ceiling to around $11.5 trillion to accommodate the $700 billion bailout, the bailout of Freddie and Fannie, AIG and a host of others. The other way is to print money as it would be the Federal Reserve who would take the equity positions by injecting funds directly into the banks. Remember the Federal Reserve is essentially a private corporation and they basically can do whatever they want. In Canada the Bank of Canada is agent of the Government of Canada.
Either way is potentially inflationary or hyperinflationary impact of massive Fed injections should not be underestimated. Whether you effectively print money or borrow it via debt (we put less chance that this will happen because the huge dependence on foreign lenders who will become increasingly reluctant to finance the USA's financial mess) both should result in a falling US dollar and rising gold prices. The Federal Reserve has already turned its balance sheet into a junk bond portfolio and will see it deteriorate further. There of course remains the chance that if the equity injections work, the Fed or the Treasury may actually make a profit on the transaction. But that could be years away.
There are a few things that the world must avoid or must do to get through this period. First we must avoid the trade protectionism that plagued the world in the 1930s. Smoot-Hawley and trade protectionism turned a bad depression into the Great Depression. Secondly, and we put lower odds on its possibility, the world must avoid the march to war that was seen in the 1930s. The Great Depression saw one solution and one leader in America and another solution and very different leader in Germany. Many in the West admired Hitler and would have been happy to see America and Britain in particular join him. But the support for that approach was too weak and was a view primarily held amongst the elites. The people chose the social welfare approach over the blame game that took place in Germany. Both were agents of change and hope but one was false promises while the other actually delivered.
Governments must also be prepared to run deficits. The problem here is that while Canada is in relatively good shape to do so, the US is not. While Canada has rid itself of its former budget surpluses the US long ago not only rid itself of the surpluses of the late 1990's it went into massive deficits to finance illegal wars and give tax breaks that largely benefited corporations and wealthy individuals. In the US the debt has doubled during the years of George W. Bush. All of the solutions currently being proposed will only make the deficit even larger. Attempts to bring budget expenditures in line with falling income will only add to what is sure to be a downward spiral. Canada will also go into deficits but again any attempt to bring expenditures into line with falling revenues will only add to the downward spiral.
The monetary authorities led by Bernanke and Paulson have moved quickly to try and stem the crisis. This was a failure of the 1930s. They have lowered interest rates rather than hike them as they did in the 1930s. Still there remains the possibility that while deflation may not be the bug-a-boo that it was in the 1930s, it may turn out that inflation because of massive monetary expansion will prove to be a major problem this time around. Couple that with the fact that much of the debt is owned by foreigners and you know they will not be happy with a monetizing of their debt holdings. They may even demand a say in how the US reconstructs itself. If so then it will be very hard on the people of the US as the interests of the bond holders will be held above the welfare of the people.
No matter how we look at it, the coming period will be extremely difficult. We suspect that there will be social strife and possibly even riots as there was in the 1930's. There is also the risk of a world war being started to mask the coming difficulties. The US under the circumstances is ill-prepared financially to fight another war but that may not stop them.
The war for oil which we expected to dominate the first part of this century is already under way. As well an overcrowded world is faced with a deteriorating environment, global warming and declining food and water. This promises then to be a century of war over oil, food and water. With sharp differences growing between the West (US) and the East (Russia and maybe China) there is a real risk of war. The dictatorial capitalist model of China (and to a lesser extent Russia) may be adopted here. We are already a growing surveillance society and in the US Homeland Security has all the apparatus of a police state.
We do not expect the coming period to be as bad as the Great Depression, but it will be difficult. We believe that we are at or close to a temporary bottom. But it will take considerable time to rebuild confidence in the financial system that has been wracked by a crisis of confidence due to credit. The Eurodollars and Commercial Paper markets, the prime sources of financing for banks and corporations and financial institutions, are still extremely expensive, with wide spreads to government borrowing costs and official Bank rates. Banks are still not lending to each other. Many borrowers are experiencing severe difficulties in raising funds. Most impacted are municipalities and even US States as California is already flashing a cup needing funds.
Still we firmly believe that before this crisis is over, gold (and silver and platinum as they are seen as secondary money) will continue to benefit either from the crisis of confidence or the fact that the monetary authorities are inflating their way out of the crisis. The latter will certainly be a catalyst for gold. Since the authorities do not wish to see a repeat of the Great Depression they will chose inflation over deflation any time. The events of the past two weeks were we believe a culminating collapse. And now the hard part begins of repairing the damage. It will be difficult and prolonged but the world is not coming to an end. In that respect the end is nigh, but it is not a sign that we collapse into huge despair and poverty. Another 1930s style depression is just not in the works.
Note: Chart created using Omega TradeStation. Chart data supplied by Dial Data.