What Could Go Wrong?
By Bob Wood, MMNS
As 2007 draws to a close, bullish promoters in the financial media continue to call for nothing but good times next year and for the foreseeable future. As a stock market Bear, or, as I prefer to be called, a realist, I always consider what could possibly go wrong to upset all those rosy predictions.
As luck would have it, I just happen to have a list right here. Letâ€™s start with one of the most obvious threats to the economy and the stock market: the credit crisis associated with the implosion of the housing and mortgage markets.
Rather than tell you in my own words why I think this will continue as a major story in 2008, here are some pertinent words from Jim Willie of the goldenjackass.com report.
â€˜â€™My contention is that the entire US financial engineering contraption is being dissolved, a crumbling pile of wreckage, with evidence of fraud throughout the structure. It is an historically unprecedented failure in innovation, a reckless extension to develop the inflation-based system.
â€˜â€™Such a system is destined for the scrap heap though, since every bubble in history suffered a contraction, this one no different, only bigger. The threat to the entire banking system has never been this great since the Great Depression.
â€˜â€™When comparison after comparison is made to magnitudes of this or fact factor never being so great since the Great Depression, one must raise the possibility that conditions are indeed similar and approaching such an outcome, but with central bank reactions assured.
â€˜â€™The Euro Central Bank infusion of $500 billion is such a powerful reaction, enough to soil the boxer shorts of any Deflation Theorist. My contention is that the inflation forces will ramp up considerably, in offset to the deflation forces building momentum, enough to create massive scheiss storms. The lightning, high winds, and resulting destruction will be enormous. Opportunity abounds.â€™â€™
Of course, Willie is not alone in his dire outlook for the mortgage market, investment banks, or the solvency of our commercial banks. Politicians in both parties are calling for government intervention, otherwise known as bailouts. Of course, government bailouts are typically funded with taxpayer money, or, as in this case, additional money printing by the Federal Reserve.
Actually, the Federal Reserve and even European central banks are already printing money at an alarming rate. The inflationary ramifications of such reckless money printing should be obvious to all. When inflation rises, living standards fall. When living standards fall, discretionary spending also falls. Judge for yourself the resulting implications for our wider economy.
Central to the credit crisis and bailout attempts by central banks around the world are some of todayâ€™s more extreme predictions about housing prices. For example, Robert Schiller at Yale University believes that housing prices could drop as much as 50%. Can you imagine the cascading effect on investment and commercial banks if his prediction proves even remotely accurate?
Next, letâ€™s look at energy markets. While the price of oil is nearing $100/barrel, many domestic energy companies have not seen matching rises in their share prices, as we would expect. This disparity results from rapidly rising costs of production and the fact that 80% of the worldâ€™s energy supply is located in countries that are pursuing nationalization of their energy resources. Countries such as Russia, Venezuela, and Iran sit on large supplies of oil and natural gas. Isnâ€™t it obvious that the potential is high for the Bush administrationâ€™s policies towards those countries to backfire and result in even higher energy prices?
Letâ€™s consider another area that I see as a large indicator of trouble in our economy, which, for some reason. gets very little mention in the financial media. The fact that we must borrow over $2 billion/day — every day — from foreigners should be a sign that the U.S. is not the financial powerhouse it claims to be. Isnâ€™t this yet another indication that the federal government is essentially bankrupt? Our government is running the biggest Ponzi scheme ever seen in the history of the world! We must borrow money just to pay interest on money we borrowed in the past! I wonder how long this can continue!
Yet another issue, which is totally misrepresented by financial media promoters (with CNBCâ€™s Larry Kudlow potentially the biggest offender of all), is whether or not the stock market is reasonably priced. What an investor pays for a stock is obviously central to what that investor can expect to earn over time. As of today, the S&P 500 sells at about 19 times trailing earnings. This rate is not now, nor has it ever been, a sign that stocks are selling at reasonable prices. The stock market is not â€˜â€™ dirt cheap,â€™â€™ as Kudlow claims.
Bullish promoters would have you believe that the stock market, selling at 19 times earnings, represents value when compared to the price of bonds. Being a realist, I believe we should look at each in isolation. Regardless of the selling price of bonds, stocks that sell at 19 times earnings do not represent compelling value. An investor buying a company that sells at 19 times earnings accepts an earnings yield in the first year of just over 5%.
If that investor were buying a bond yielding 5%, which came with a guarantee for recovery of the original investment, he could be excused for paying such a high price. But the same investor who settles for a 5% yield when buying risky assets such as stocks is not getting a bargain. Over the past 100 years, bull markets have typically topped out when valuations went this high. Even if our economy was truly strong, the upside potential for the stock market would be limited at best.
One other potentially major threat to our economy and stock markets exists, though it, too, is willfully ignored by the mediaâ€™s bullish promoters. We are presently involved in two wars, which are overseen by what history may label as the biggest bunglers of foreign policy since the Reagan administration.
That we are losing wars both in Iraq and Afghanistan should be evident to any objective observer. Logically, we know that we are losing these wars because we certainly are not winning them! As time goes on, the cost of these wars continues to escalate beyond anything we ever imagined at their onset.
This past week, Congress capitulated to yet another Bush administration demand for billions more in funding. This latest installment, $70 billion, will soon be added to the billions already squandered in these efforts. One little detail about that $70 billion commitment has been consciously avoided. We donâ€™t happen to have $70 billion to spend on wars or anything else for that matter! That money will also be borrowed from foreigners, as has every other dollar spent on the wars to date.
This new debt will be added to all of the old debt, with the Bush administration having recklessly spent borrowed money in untold ways. The national debt has risen by about $4 trillion since this incompetent administration took power. Credible estimates on the eventual cost of losing these wars now ranges from $1 to more than $2 trillion. All of this money must be borrowed from foreigners. Is this yet another sign of a strong economy?
My list of what potentially could go wrong in the coming year includes other things, but these represent the most obvious — and the most threatening. As investors, each of you should compile your own list and assign the likely possibility for each to occurr — and the damage that could be done to your investments.
Looking over my own list has me investing as defensively as I can remember. I see much more downside potential than upside, even in occasional good times, with stock market valuations where they currently are. Given my list, Iâ€™m looking for the best ways to make money in a down market, and thatâ€™s something that could go right!
Have a great week.
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.