Surfing the Tsunami

By: Doug Wakefield | Sat, Jul 23, 2005
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In December 2004 we watched the devastating impact of a Tsunami. For those living away from the area, what we saw, horrifying as it was, was impossible to grasp. How could so much destruction occur? How could over 240,000 people die from a natural disaster that started from shifting plates on the earth's floor? How can water top speeds of 500 mph? We heard stories of individuals looking at the ocean as it pulled back hundreds of yards from the beach only to then be totally surprised by the high wall of water that returned. It left the observer no time to prepare.

Today, as we look at our financial markets, most of the talk is of comfortable retirements, funded pension plans, and safe Social Security and Medicare Benefits. And yet, as the event of last December has shown, things are not always what they seem and they can change quickly. Now is the time for every investor to ask, "What evidence is there that a major decline could occur in the financial markets and what actions can I take to address any systemic risks?"

As we look out across the exchanges, everything appears calm. The bond market continues the bull that started in the early 1980's. The Dow Jones Industrial, after dipping below 7200 in 2002, looks to be safely resting on a 10,000 floor. Nationally, real estate has appreciated moderately for years, and substantially in the last few.

However, as we look below the happy talk about "how the Dow has held strong above the 10,000 level since late 2003" or "how resilient the American markets are", we begin to notice that long term investing records are still tarnished by the "downturn" of 2000 - 2002. When we consider that the S&P500 is still down 10.64% over the 6-year period ending June 30, 2005, or that the Dow is down 3.17% during the same timeframe, then the first signs of concern start to creep into our thinking.

Some dismiss 2000 - 2002 as an aberration that was dealt with by the Federal Reserve lowering interest rates and making credit readily available to help kick start our economy. Most Wall Street pundits and government officials continue to talk about "comfortable retirements" and our "strengthening economy".

If they are right, then we can feel confident that the breather the Dow has taken between 10,000 and 11,000 over the last 19 months is but a pause before it resumes upward movement as reflected by our stronger economy. Articles like this can be dismissed as nothing more that another hair shirt who is worried over nothing because he has read too many gloom and doom newsletters and scary books (though, in my defense, the majority of books that I have read were written prior to 2000).

If, on the other hand, the information presented is from various U.S. government sources, then we must take the data over the rhetoric and prepare for the wave that is coming. Let us leave the surface statistics and look beneath to see if we can better understand our current situation. We need not look too far. All we need is to go to the trouble of downloading a few government documents.

The pressure point that we will review first is the American consumer. Since June of 1999, national income has increased from $8,161 billion to $ 10,913 billion (as of March 2005).1 While an increase of 34% in 6 years may sound like a good thing, we need to examine this information in light of inflation and debt. During this same period, consumer credit went from $1,347 billion to $2,129 billion, an increase of 58%.2 I'm sure we can all share numerous stories of the telemarketer or the credit card applications in the mail. We have everything under the sun bought on credit. When we run up our credit card, if we are having trouble paying it off, we can always roll the balance to another credit card that has a zero percent interest for a period of time. Sure, the interest rate may be higher, but there always seems to be another sub-prime lender who would love to get our business. If the credit gets too far out of hand, we'll just start over by taking a home equity loan to pay them all off. Our homes have turned into another major source of cash flow. What could be better: our house value goes up, we take out another loan, pay off our revolving debts, and in no time our home price has climbed enough again to withdraw even more cash from the ATM machine. In regards to the perpetual upward motion of housing prices, the LA Times shows how deluded the minds of LA homeowners have become. Many actually believe that home prices will continue to move up by 22% a year for the next ten years.3

Are these just pockets where "froth" has crept into the local housing market, or are there signs of a much larger problem? Fortunately, the Federal Reserve leaders, who tell us that there is only "froth" in some local housing markets, are the same group that prepares the Flow of Funds Report. These numbers give a much deeper and different view of things that have impacted the price of real estate.

In June of 1999, total mortgages in the USA stood at $6,021 billion. At the end of March 2005, the number is $10,774.4 This is a 79% increase. Keep in mind our incomes have only risen 34% while our credit card bill has grown by 58%. So, what have we, as a nation, done? The answer is painful, if not obvious. We have borrowed the money with our homes as collateral for the loan. As our credit has gotten increasingly splotchy and our cash flow needs have increased, institutions have lowered their lending standards and moved toward riskier finance products. In a May 5th 2005 report issued by Fannie Mae, we see that the share of interest only Adjustable Rate Mortgages (ARMs) "A" paper selling in the Mortgage Backed Securities (MBS) market has grown from 3% in 2001 to 50.9% in 2004 while ARMs for the same class and timeframe have grown from 18% to 72.1%. The Jumbo MBS market has grown from 5.4% to 52.5% during the same period. In addition to this we learn that the sub-prime MBS finished 2004 with 66% of their loans as 2 year ARMs. In other words 66% of these notes face a likely upward adjustment in payments as early as 2006.5 These are astonishing numbers.

Ok, before we go any further, let's look at this huge and growing risk that will affect our financial markets. The question is not if, but when. In a society where everything is focused on how we can make payments, versus what can we afford to purchase, the lending environment must become more lax when the consumer starts tapping out. If we cannot afford the house payment with a fixed mortgage, we can buy the house with a lower payment with the understanding that the payments will adjust upward in the future. If we still cannot afford the payment, the lender cuts the loan terms to interest only for a period of time, so that even less may be required of our consumer today. Tomorrow, well, why worry about that today? Besides, house prices have been increasing and players in the real estate game, like condoflip.com, give us the impression that our property will only be valued higher in 2 - 4 years when we look to either refinance or sell. So again, we ask, what's the problem?

On the surface, nothing. But let's look at this a little closer. If this only affected the consumer doing this, then this would only be an issue for the lending institution reckless enough to allow it. However, since each of these mortgages are packaged in groups and sold in the bond markets as mortgage backed securities to investors, it becomes a concern. When those investors are mutual funds, large endowments, or pension funds, the problem now becomes an issue for thousands of investors who never intended to flip condos. Pretty pie graphs and the last quarterly statement are nice, but they do not go far enough in disclosing the true risk each investor is taking.

While it would be easy to blame one politician, investment institution, or Federal Reserve official and demand changes, the size of the markets make it extremely improbable that one individual could "fix" these problems. History reveals that the pressures we now face have been building for decades.

As explained further in my article "A High Wall", Keynes believed that the way to keep an economy from recession was to keep consumers spending. He advocated slashing personal savings as a means to achieve increased consumption. As a nation, we have fully embraced Keynes' idea. From June 1999 to March 2005 we have seen national savings increase from $1,619 billion to $1,819 billion.6 To place these numbers in context, this is a 10% rise during a period where national incomes went up 34%, consumer credit went up 58%, and total mortgages went up 72%.

But why would John Maynard Keynes have so much influence? In a nutshell, take a group of people who have experienced economic calamity, promise them a "safety net" so it wouldn't happen again, present printing more money by expanding credit as the best option for "strengthening the economy", and tell them that by spending more they can pull themselves out of their own problems. Tell me if that sounds familiar? It should.

Incredibly, this idea, presented as the solution to America's Great Depression, actually created the problem in the first place. In the 1920's, we had created so much money through massive credit and lending programs, markets (and eventually prices) became inflated. The problem was that the weight of the debt repayment was too much for the consumer to bear. As banks began collapsing and people became increasingly afraid of what was happening, the euphoria of the twenties became the Crash of '29 and the ensuing depression.

The problem we face today is forgetfulness. Since the US went off the gold standard in 1971, our dilemma is now compounded. Bailouts and inflating our way out of our debts has become a staple in the American economy. Many of us remember major bailouts over the last 30 years. Who could forget Chrysler in 1978, Continental Illinois (the seventh largest bank at the time) in 1982, the S&L Crisis in 1989, the Mexico Peso devaluation in 1995, and the collapse of Long Term Capital (the largest hedge fund in the world at the time) in 1998? In a classic fallacy of composition, most investors seem at ease with the "bailout" of the US economy in 2001. One can debate whether it works or not to bail out companies. Bailing out countries, even temporarily, has always proved disastrous.

We started the year 2001 with a Fed Funds rate of 6.5%. By the end of the year it was 1.75%.7 History has revealed multiple times that when credit is cheap and accessible, the floodgates to spending are opened. From June 1999 until June 2005 we have seen the amount of money, as measured by M3, in our country increase from $6,237 billion to $9,727 billion.8 This is an increase of 55% in 6 years. The dictionary definition of inflation is "an increase in the volume of money or credit relative to available goods, resulting in a substantial rise in the general price level." This makes it plain to see why assets have gone up in value and why it has been hard to keep of with the cost of living. Oddly enough, the Consumer Price Index (CPI) has gone up only 17%, from 497.9 in June 1999 to 582.6 in June 2005.9 So, according to these numbers, inflation has only gone up 17% while the money supply has grown by 55%. Imagine listening to an investment advisor try to explain to you two investment statements. One reveals a 17% gain and the other a 55% gain, just a slight discrepancy.

While I could show many other numbers emphasizing the tremendous pressure being placed on the markets, I will leave that to another day. Like a real Tsunami, these numbers, and the ramifications behind them, are frightening. They could leave us numb and apathetic or we could dismiss this information, thinking our lives have too much stress right now and there is nothing we can do about this anyway. If these are your thoughts, I implore you to start learning from the many great sources about the money game. Don't think, "They are smart and I am dumb". Until we come to our own conclusions, versus blindly accepting those of others, we are all susceptible to a great deal of risk. We must stop asking, "What was the bottom line last quarter?" and start asking, "What are the chances of losing a substantial amount of my portfolio in the future?"

In 2000 - 2002, I was at the mercy of the market, hoping that the bull market would return. I will never expose those I serve to that risk again. Reading and researching has brought me to the conclusion that markets move in cycles and I must act accordingly to benefit from what comes next. The markets movement is beyond my control. Positioning my clients properly to benefit from the highest probability of what is to come is my job, and even more, my duty.

For the thousands who lived near and around the Indian Ocean, they had no warning. Yes, today the warning systems are in place, but only after the tragic event. Fortunately, investors today have a great deal of information warning them of events to come. History warns us to avoid the pitfalls of not heeding its voice. My desire is that many people could learn to profit from the decline, in order that when it comes, they may be able to help those who have had no opportunity to do so. For those today that have many opportunities, but continue to deny that Tsunami's occur in the financial markets, I only stand amazed at the blatant denial of reality.

Sources:
1. National Income- The Bureau of Economic Analysis
http://www.bea.gov/bea/dn/nipaweb/SelectTable.asp?Popular=Y
2. Consumer credit- The Federal Reserve
http://www.federalreserve.gov/releases/g19/Current/
http://www.federalreserve.gov/releases/g19/20000307/
3. John Mauldin, Thoughts on the Housing Bubble, July 1, 2005.
http://www.safehaven.com/showarticle.cfm?id=3369
4. Total Mortgages (L.217- Flow of Funds Report)
http://www.federalreserve.gov/releases/Z1/20040610/z1.pdf
http://www.federalreserve.gov/releases/z1/current/z1.pdf
5. Fannie Mae, The Home Price Outlook, Thomas Lawler, SVP Risk Policy, May 5, 2005
http://www.nahb.org/fileUpload_details.aspx?contentTypeID=3&contentID=31952&subContentID=15418
6. National Savings- The Bureau of Economic Analysis
http://www.bea.gov/bea/dn/nipaweb/TableView.asp#Mid
7. Feds Funds Rates.2001- The Federal Reserve
http://www.federalreserve.gov/fomc/fundsrate.htm
8. Money Supply (M3) - The Federal Reserve
http://www.federalreserve.gov/releases/h6/hist/h6hist1.txt
9. Consumer Price Index- Economagic.com
http://www.economagic.com/em-cgi/data.exe/blscu/CUUR0000AA0

I would also like to express my appreciation to Doug Gillespie, www.gillespieresearch.com, and Rob Peebles, www.prudentbear.com, for their assistance with finding some of the data.


 

Doug Wakefield

Author: Doug Wakefield

Doug Wakefield,
President
Best Minds Inc., A Registered Investment Advisor

Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and individual psychology.

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