Risk & Opportunity

A quarterly political and economic newsletter published by Michael Cuddehe

Q3 '08

Market Meltdown into the Election

The collapsing credit bubble tsunami has hit the financial sector with full force. In a few short months America’s storied investment banking industry is history. Bear Stearns…gone! Merrill Lynch…gone! Lehman Brothers…gone! The remaining investment banks have either been bought out or have converted to commercial banks and are busy de-leveraging. Many other financial institutions have disappeared, and those that are still standing are on shaky ground. This financial crisis has even claimed its first nation — Iceland.

Meanwhile, the stock market is also taking a pounding. The Dow Industrials and S&P 500 have given back 90% of the ’02 – ’07 bull market and 45% of total value so far. Richard Russell estimates total U.S. market and real estate losses at $9 trillion, almost a full year’s GDP. Foreign markets have fared even worse. The Vanguard Emerging Market Index has given up 60% of total value. The bad news is that the stock market is a leading indicator. So far the contraction has been primarily a financial sector phenomenon. The shock wave is only beginning to hit the general population. How long will it last? It will last until all the excess is wrung out of the system, which could happen quickly or it could take a decade or longer. How bad will it get? Considering that the recent expansion has been substandard by every measure, and was itself entirely driven by unprecedented deficit spending and borrowing, the downturn is most likely going to be pretty severe.

The U.S. has been living beyond its means for a long time. When Ronald Reagan entered the White House he inherited a $1 trillion national debt accumulated over 200 years. He added $1.6 trillion in his eight years. George Bush Sr. added another $1.6 trillion in his four years, and Bill Clinton another $1.5 trillion in his eight years. George W. Bush has equaled all three of his predecessors by adding another $4.5 trillion. The national debt now stands at $10 trillion, not counting unfunded liabilities such as Medicare and Social Security. Consumer debt has followed a similar trajectory. Total U.S. debt now stands at over $50 trillion, not counting unfunded liabilities. (See the Grandfather Economic Report for detail.) This unprecedented debt creation has been fueled by a national delusion that we could continue to live forever on borrowed money without paying the price.

The credit bubble collapse is ushering in a period of adjustment to a reality based lifestyle. This is necessarily going to be a painful process. We can only hope that the adjustment can be managed to avert a sudden and destructive collapse.

We face a major potential hazard going forward: our entire financial system operates on the faith-based “fractional reserve model.” If people lose faith in the system and begin demanding their money in large numbers, the system will collapse completely. That would look like an old fashioned “run on the bank.” However, now the entire system is globally integrated, and a run on one bank anywhere is a run on all. This is why the Feds have been so aggressive in backstopping any failing institutions, and also why the financial markets freaked out when they let Lehman Brothers go under.

Another major potential hazard is the approximately $60 trillion in outstanding credit default swaps. SEC Chairman Chris Cox gives an excellent explanation of the swap problem and what needs to be done about it in his 10/19 New York Times Op-ed piece, “Swapping Secrecy for Transparency.” What he fails to mention is that this entire problem mushroomed on his watch. The good news is that Lehman Brothers $400 billion portfolio of credit default swaps has recently been settled at a cost of only $5 billion. If that ratio holds, and if the process is carefully managed, the $60 trillion of outstanding swaps could be unwound for a cost of a mere $1 trillion.

Our financial authorities are fully aware of the problems and are doing everything they can to try to hold things together. It is likely they will be able to do so, at least for awhile — not certain but likely. But there will be a big price to pay. The deficits necessary to stem the tide will be huge. Various estimates are anywhere from $1 trillion to $4 trillion just next year! Most likely there will be at least several additional years of trillion dollar deficits. These massive deficits will threaten the stability of the dollar. Presently the dollar is rallying as huge short dollar positions are unwound. But the massive printing of dollars will eventually be reflected in the value of the dollar. If the world starts to bail on the dollar, the game is over.

I must confess that I have been taken by surprise by the severity of the breakdown in equities during the bullish phase of the Presidential Cycle. I had been expecting a major bear market beginning after the election. The collapse of the market during the lead up to the election is testimony to the utter incompetence of the Bush regime, which has all the monetary, fiscal and regulatory tools necessary to manage a traditional market rally going into the election.

The good news is that we are at that time of year when the stock market usually bottoms. Technical and sentiment indicators are oversold to extremes not seen since 1929, which would indicate at least a temporary bottom. Warren Buffet published an Op-ed piece in the 10/16 New York Times entitled “Buy American, I Am,” touting the values in U.S. equities. Bill Gross said he thinks that the steps that have been taken by the Feds will lead to market stabilization within weeks.

Politics

The presidential election cycle is mercifully coming to a close. After two years of steadily increasing hyperbole and spin, everyone is exhausted. Obama is leading in all of the polls, anywhere from two to sixteen points as of this writing. The political betting sites, which have a better track record than the polls, have Obama 85-15 to win. An objective observer would say this is Obama’s to lose, and he has shown himself to be a very steady hand under pressure, so it is unlikely that he will do anything to undermine himself. However, no one in America is objective about this one. Republicans are desperately trying to generate as much hysteria about an Obama victory as they can. Democrats are still feeling uneasy after the close losses in the last two presidential elections, and are worried that Republicans may somehow steal the election.

McCain has been steadily losing ground against the background of the Bush legacy, a crashing economy and a backlash from the selection of Sarah Palin as his VP. He has unsuccessfully tried a variety of tactics to try to change the trajectory of the campaign, and lately he has taken to ultra-sleazy Karl Rove style personal attacks, trying to paint Obama as un-American, dangerous and a friend to terrorists, and grossly misrepresenting Obama’s record and positions. The personal attacks, which were so effective against Kerry in ’04, do not seem to be helping McCain. Perhaps the American people have finally had enough of this kind of campaigning.

As he did against Clinton in the primaries, Obama is mostly ignoring the personal attacks and focusing on economic issues and his signature call for “change.” Sticking to the high road when hit by Republican sleaze attacks has been a losing strategy for Democrats during recent elections, and Obama is giving Democrats heartburn by consistently refusing to respond in kind. So far it seems to be a winning strategy for him, but as the great American philosopher Yogi Berra once said, “It ain’t over ‘til it’s over.”

For those political junkies who want to check the latest on the polls right down to the wire, FiveThirtyEight.com aggregates all of the polls, and Intrade and Iowa Electronic Market both run election futures markets.

Geopolitics

For the time being, geopolitical concerns have been eclipsed by the presidential election. The world is hoping for an Obama victory by an overwhelming margin. Polling around the world has shown the preference for Obama in the 80-90% range.

The financial meltdown has accelerated the global realignment begun in reaction to the Bush foreign policy. After the Georgia invasion, Russia began a campaign to reassure Europe that Georgia was a one-off deal and that Russia is not a threat. At the same time it is warning that the U.S. missile defense system will not be tolerated in Eastern Europe, and in a tit-for-tat move it is offering missile defense to Cuba.

Meanwhile, G7 leaders have called for a summit to update the global financial framework created at Bretton Woods after WW II. At the upcoming summit, to be held on November 15th, Washington will want to keep the focus on the need for a new global regulatory regime. But the special reserve status of the dollar is certain to come up. It may not happen all at once, but this summit will likely be the beginning of a formal process to replace or adjust the dollar’s supremacy as the global reserve currency. This will be a seismic event that will have a severe impact on U.S. living standards. It is probably in everyone’s interest that these changes not occur all at once, but the adjustment is going to happen and we should be prepared for it.

Summary

Market volatility and sentiment are at levels not seen since 1929. We can only hope that the actions of our financial and monetary authorities will halt the meltdown, at least for awhile, to allow preparations for an orderly decline. Historically, such extremes mark market lows, and I would expect at least a temporary low. We could even have a substantial rally coming up into the first quarter. I would consider such a rally as a last chance to get out of equities and put my house in order for the inevitable. I do not expect a final low in this bear market until at least the latter part of 2010.

Our next President is going to be starting out deep in the hole and will be spending at a minimum their entire first term repairing the extensive damage done by the Bush administration to our foreign relations and our economy, as well as cleaning up the corruption in the Justice Department and repairing the widespread damage to the function of government across the board. It is my hope that our next President will be able to unify the country to confront these serious challenges. If we see a continuation of the politics of division, mistrust and obstruction that have characterized recent years, things are going to get much, much worse.

Our departing President, George W. Bush, has left his own special mark on America and the world, so eloquently expressed recently by London mayor, Boris Johnson:

“However well-intentioned it was, the catastrophic and unpopular intervention in Iraq has served in some parts of the world to discredit the very idea of western democracy. The recent collapse of the banking system, and the humiliating resort to semi-socialist solutions, has done a great deal to discredit - in some people's eyes - the idea of free-market capitalism. Democracy and capitalism are the two great pillars of the American idea. To have rocked one of those pillars may be regarded as a misfortune. To have damaged the reputation of both, at home and abroad, is a pretty stunning achievement for an American president.”

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