The Survival of the Longest

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  • Wed, Oct 22, 2008 - 01:04am

    Golden Age

    Golden Age

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    The Survival of the Longest

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.

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.

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.

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.

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 the 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,
decisions dictated by Morgan Stanley, 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.

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

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.

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.

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. It 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 will 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.

  • Thu, Oct 23, 2008 - 06:17am



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    Re: The Survival of the Longest

I have come for your gold…

  • Thu, Oct 23, 2008 - 06:42pm



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    Re: The Survival of the Longest

Lord Humongous,


I am with you. I have a minivan I can mount some weapons on, plus I can make sandwiches or bar b q if you prefer, for outings of rape and pillage when the Economic Apocalypse happens.




 Peace Bro, and don’t let that head swelling bother you, keep your mask on and it should keep your skull intact. 



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