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A GLOBAL RECESSION IS AHEAD

Excerpt from the WELLINGTON LETTER, August 5, 2008.

.....................Bridgewater Associates’ recent estimate of losses from mortgage-related securities in the financial institutions is $1.6 trillion. If you look at the leverage ratios of these firms, they seem to average around 25 to 1. That means each dollar of capital supports $25 of assets. If $1.6 trillion has gone up in smoke, than we multiply that times 25, and get a reduction in lending capacity of $40 trillion.

The world's economic product (similar to a country's GDP) is around $55 trillion. So we can see that the reduction in lending capacity is 80% of what the world produces each year. However, we also have to consider how many institutions, banks or financial firms, have severely cut their lending voluntarily just to be more cautious.

And then we have Wall Street's incredible money machine, which pooled loans of all types and resold them via certificates, coming to a screeching halt. In fact, that was one of the largest contributors to worldwide liquidity creation. European banks also participated in such techniques. This involved trillions of dollars.

The result is that money will be very tough to borrow over the next many years. The bad stuff has to be liquidated first before new credit can be created. And when money creation flips from creating tens of trillions of dollars to liquidating similar amounts, you have a drastic change in liquidity. And that can only result in a serious, long-term recession, globally.

People ask me, why haven't we seen the U.S. economy plunge into a deep recession? There are several reasons:

  1. The recession is being hidden by the government intentionally depressing the official inflation numbers. We are already in a meaningful recession. I have discussed this many times in past issues. GDP is calculated by taking the numbers for goods and services, and then deducting the rate of inflation. But actual inflation, as calculated in 1980, is now at 12.6%. Deduct this from the 5% nominal GDP growth, and we get negative 6-7% GDP.

          James Turk of the excellent FGMR report, calls attention to an interesting website for this. John

Williams, who publishes Shadow Government Statistics, (www.shadowstats.com), writes:

Inflation Explosion Likely to Continue…Adjusted to pre-Clinton (1990) methodology, annual

CPI growth rose to roughly 8.3% from 7.5% in May, while the SGS-Alternate Consumer Inflation Measure, which reverses gimmicked changes to official CPI reporting methodologies back to 1980, rose to a 27-year high of roughly 12.6% in June, up from 11.8% in May.

  1. U.S. firms have outsourced a lot of manufacturing to firms abroad. In other words, large U.S. firms have become "platform" companies, which do research, design, and then market. Ex.: Nike. But they don't manufacture very much. These foreign outsourcing firms now have the burden of having factories and tens of thousands of employees. When sales decline, the U.S. firms just reduce orders. The outsourcing firm has the problem of firing employees and idling the factories. In other words, we have pushed many of the problems of a recession to the less-developed countries. That's why we think that the emerging stock markets will have a much more severe plunge over the next several years.
  1. Individuals had substantial monetary reserves from the refinancing boom. I wrote over one year ago that these reserves might last a year or so, and then the consumer would see his assets depleted. The home ATM machine is closed. Corporations will follow the same path. They had large cash reserves going into the recession, but as it becomes more difficult to get loans or sell commercial paper, the cash hoards get depleted in a recession as profits turn to losses. This is a lagging factor, and may take another year to fully emerge.

The Fannie Mae and Freddie Mac bailouts

Excerpt from the WELLINGTON LETTER, July 16, 2008.

..................Predictably the stock market opened strongly Monday morning. But the rally lasted only 5 minutes, taking the DJI to a gain of about 120 points. Then the smart traders, noting that really not much had changed, hit the financial stocks again. The DJI closed with a loss of 45 points.

Banks and finance firms worldwide have so far reported losses of about $410 billion in writedowns and losses. There is much more to come, but they can't do it all at once, as they have to raise new capital every time they take more writedowns. Ray Dalio, founder of the huge hedge fund, Bridgewater, estimates losses of $1.6 TRILLION. My estimate for the next 10 years is much higher.

Think of the implications: Where will these financial firms find the capital to compensate for these losses? Are there any investment firms or Sovereign Wealth funds willing to provide such capital, especially those who were too early at the end of last year, and now are sitting on multi-billion dollar losses on these investments? Bankruptcies, or "shotgun weddings," are inevitable. In fact, last year I predicted that some of the major U.S. financial institutions would eventually be controlled by foreign entities. Guess what: now legislation is being considered which would give a blessing to foreign firms wanting to own more than 25% of such institutions. The groundwork for the inevitable is being laid.


(for website: Excerpt from Wellington Letter June 9, 2008)

 THE CREDIT CRISIS: STILL IN THE EARLY PHASE

.................................The very successful hedge fund firm T2 Partners in March wrote in a report:  "We are seeing only the tip of the iceberg: An enormous wave of defaults, foreclosures and auctions is just beginning to hit the U.S. We believe it will get so bad that large-scale federal government intervention is likely."

Jim Bianco, head of Bianco Research, a very astute analyst of the credit markets, said in March:  "Equity guys are completely clueless as to how bad it is in the credit markets. They're as bad as they've been since the Great Depression." (Quote from Barron's.)

This week we heard about proposals circulating in Congress that it’s time for STIMULUS PLAN #2. And where do they get the money for these bailouts? No, it's not the printing press. Now we have computers that can create billions of dollars instantaneously out of thin air. No paper required. The turmoil in the financial markets will worsen. Later this year, there is a good chance for a crisis. Will the Fed be able to handle that? No one knows.


THE NEXT FINANCIAL CRISIS

Sheila C. Bair, the head of the Federal Deposit Insurance Corp (FDIC), said that another wave of U.S. credit stress was coming, involving non-mortgage loans. She said delinquency rates on loans for construction, development, commercial and consumer debt were rising.

Here are some of the areas outside of residential mortgage loans:

 

1. Construction: Costs to developers have risen to the point where even new hotel construction is stopping. At the high costs of materials today, the economics just don't work out.

 

2. Commercial & Consumer debt: As business slows, profits decline and in many cases turn to losses. Remember, profits are the very top of the revenue pyramid. Just a small decline in sales can cause profits to vanish. Losses mean debt gets difficult to service. Many loans have been securitized, i.e., put into pools, in which pension plans and other investors could buy participations. It's much like the mortgage-related CDO's that blew up last year. Commercial and consumer debt will implode next year.

 

3. Development: Developers who are in the middle of construction can't stop. They have to finish the construction. They hope they'll be able to sell part of whatever they are building before completion, but that's hope, far removed from reality in today's environment.

The economists who talk about a “Goldilocks” economy, predicting good times ahead, are missing something important. Usually recessions occur when the consumer has exhausted his buying power, rising inflation causes the central bank (the Fed in the U.S.) to hike interest rates, retail sales decline and the entire economy contracts. This usually triggers problems in the financial sectors because of rising defaults.  But this time, the situation is reversed, which is unusual. It's the implosion of the highly leveraged financial derivatives that is causing a gigantic deleveraging of the financial system. That means contraction of credit. You can't have a contraction in the credit markets without an economic contraction. And this the crucial point.

By the fall of this year, we will see the recessionary economy kick in and start doing its destructive work. We haven't even seen that part of the normal recession yet. That will accelerate the credit market contraction, and probably bring one, or several, crises. The person who is elected president will have a job similar to the captain of the Titanic.

 

Bert Dohmen

Bert Dohmen's WELLINGTON LETTER

 


 

THE DERIVATIVE BUBBLE:  NEW REVELATIONS

The problems of last year are still festering. Earlier this year, we learned about Auction Rate Securities for the first time. When the Port Authority of New York suddenly had to pay 20% interest on its debt, versus just 4% the prior week, these instruments became more widely known. 

Hundreds of firms had invested in these so-called "safe money market instruments." Now they are trying to get their money out, mostly unsuccessfully.

Companies invested their operating cash in these, and pension plans did the same, thinking they were as good or better than money market funds. And then they blew up. Currently there is no market for these securities. But there are $330 billion of them outstanding. So far, 15 lawsuits have been filed, and they are seeking "class action status." The brokers who sold these are also being sued.  Investment banks are trying to refinance some of these, but the amounts are from $1 billion to $4 billion in many cases, much too small in relation to the size of the problem. An additional problem for the holders of these securities is accounting for the losses of these complicated instruments.

Another class of financial instruments that came to light late last year is SIV’s (Structured Investment Vehicles). These are off-balance sheet entities the major banks created to speculate, using high leverage, in mortgage-backed securities. They didn't want the shareholders to know, so these SIV's didn't appear on the financial statements. Until they blew up, only a few people knew they existed.

Now we hear of another derivative, previously unknown to us, and probably most professional investors, Constant Proportion Debt Obligations (CPDOs). Who thinks up these names? They are designed for institutional investors who want to make a bet on the credit-worthiness of debt of the largest corporations. Therefore, the ratings are crucial, and these ratings are issued by firms such as S&P, Moody's and Fitch.

Apparently, the bond rating firm of MOODY’s made another mistake in its ratings. The firm blames this one on a “computer glitch.” It resulted in billions of these strange derivatives having AAA- ratings, or 7 grades higher than they should have been. That's quite a glitch. Institutional investors reportedly lost billions of dollars as the value of these instruments plunged as much as 60%. A British newspaper that reviewed internal documents said that Moody’s senior staff was aware of the problem as early as the first part of 2007. However, the firm maintained the ratings, and adjusted some of the assumptions going into the ratings. In college, we used to call that working the problem backwards, or fudging.

Last year we also warned of the Credit Default Swaps, a huge problem that will produce some big waves later this year. There are $45 trillion of these derivatives, which are basically insurance speculations on mortgage derivatives. The amount is almost as large as the GDP of the entire world. With billions and trillions of dollars of derivatives imploding, the poor homeowner who can’t pay his mortgage is still being blamed for the financial crisis. He is a convenient scapegoat. He has little to do with the crisis. He was only the spark that started holders of all derivatives to question their value. After that, the gigantic global debt pyramid, designed primarily on Wall Street, started to crumble. Greed took over in many other sectors, even in corporate and governmental pensions. Everyone wanted to increase the “alpha,” i.e., out performance. 

So, who is to blame? As con artists always say, you can’t con an honest person. Therefore, we shouldn’t feel sorry for the cons, nor for the holders of these securities. But in the end, the taxpayer, who had nothing to do with all this, and did not benefit, will be presented with the bill. Moral of the story: Never invest in something you don't understand. If the salesman (broker) can't explain it so you can understand it, forget about it.

 

Bert Dohmen

Bert Dohmen's WELLINGTON LETTER

 


BARGAIN HUNTERS—TOO EARLY

Construction starts on new U.S. homes rose by a big 8.2% in April and applications for new building permits rose for the first time in five months. Many observers consider this positive. My reaction was, do we really need more houses when there is already a glut of about 3.5 million unused homes on the market now?

 The bargain hunters were buying the homebuilder stocks over the last 5 months, causing the sector to rally. Now the rally is over. New lows should be ahead. Prediction: There will be a bankruptcy, or bailout, of at least one major homebuilder this year, which will shake up investors in this sector.  

Bargain hunters are also out in force in the residential home area. In Florida, prices dropped 29% but sales surged 41% over the same month last year. That's encouraging. It shows that during the bubble, prices soared too high, to levels that became unaffordable and uneconomical. Last year, I said that residential prices would eventually get back to 2003 levels, which is when the boom started. That's where demand can come in. In Florida, they must be approaching those levels.

But that doesn't resolve the nation’s problem of 3.5 million unoccupied homes.  Two major homebuilders, TOL and HOV, just reported earnings. They were dismal. The CEO of Toll Brothers, Robert Toll, said:  “Demand continues to be weak in most markets as our clients worry about selling their existing homes or entering the market before prices stabilize.” 

According to Senator Christopher Dodd, there are about 12 million homes worth less than the mortgages. That means these homeowners have little to lose by just walking away.

 

Bert Dohmen

Bert Dohmen's WELLINGTON LETTER


BUYING OPPORTUNITY FOR A TRADE                                                       

Excerpt from the WELLINGTON LETTER, late April , 2008                                                             

........................... Bernanke recently commented on the U.S. situation with that of Japan in the 1990s, and even with the Great Depression in the U.S., probably because private sector analysts, such as ourselves, had made such comparisons. Of course, he says that the current situation is much different. What else can he say? He says that in the 1930s the Fed let the financial crisis infect the entire economy. The Fed will not allow that to happen now. But in early 2007, he also said that the subprime mortgage problem couldn’t possibly infect the rest of the credit markets. Now it has.

He rejected a comparison with Japan in the 1990s. He said that Japan did not act to get bad loans off the banks’ balance sheets, which stopped lending. The Fed will not make the same mistake. However, that’s exactly the problem now. Only U.S. banks are more proactive. They are now busily raising new capital by selling stock or convertible securities. This dilutes the current shareholders, who will take painful hits. But at least the firms stay in business, and eventually may start lending again.

At least Ben finally seems to recognize the seriousness of the situation; otherwise, he wouldn’t make these comparisons. And that’s the first step to finding a solution. Then the question becomes, is the problem solvable? He may know the problems of the 1930s and of Japan in the 1990s, but is he and his crew astute enough to find the solutions?

There are so many rescue plans in the works, at the Fed, in Congress, and in Europe, that it’s hard to keep up with them. The IMF (International Monetary Fund) is floating a proposal to have the governments, i.e., taxpayers, buy all the unsalable paper (CDOs, Mortgage Backed securities, etc.) from the banks so that banks can start lending again. The government would then hold these until such a time that they can be sold. I ask, if the taxpayers are asked to take such a risk, will the banks give us taxpayers some of the profits they made over the last 5 years?

CONCLUSION

The (technical) signals for the U.S. market are positive right now. No one can know how long a rally will last. Instead of relying on guesses, we prefer to let our technical indicators tell us when the end of a rally has been reached.

Last time we also wrote: “We will watch carefully over the next week or two for a confirmation of a tradable rally. However, only experienced investors should try to play such rallies.” Well, it seems that we are there.

(Recommendations are excerpted out of fairness to subscribers)

 


A  DECOMPRESSION RALLY

Excerpt from the WELLINGTON LETTER, April 7, 2008

...................The FHFB authorized Federal Home Loan Banks to increase their purchases of agency mortgage-backed securities. This could provide more than $100 billion in additional liquidity to the FNMA and Freddie Mac’s mortgage-backed securities. Also, the reserve requirements of the latter two were lowered, allowing them to add another $200 billion to the mortgages they buy.

As you can see, money is pouring into the financial markets. But will that allow the average homeowner to qualify for a mortgage under current conditions? Will it prevent foreclosures? Will it get the homebuyers to go out looking? And will they be able to get a mortgage when they want to buy?

The Fed is now committed to take $200 billion of non-government debt-securities, AAA rated, as collateral on loans it makes. Many of these securities may be downgraded to AA, which means they would be selling for around 25 cents on the dollar. Will the Fed still take them? Even the AAA stuff is probably not worth more than 75% of par. Obviously, when the Fed is willing to take such confetti as collateral, it means there is a huge financial crisis.

THE FED: WILL THEY RUN OUT OF MONEY?

So far the Fed has used 50% of its balance sheet in the bailouts. That’s about $400 billion. Is the remaining $400 billion sufficient to prevent the collapse of the CDS market? Should they even try? Important questions. 

People say that the Fed can “print” all the money they want. Actually, it’s the Bureau of Engraving that prints money. They have the latest, high-speed Heidelberg presses. I know, I saw them. These presses obviously are from Germany, which during the hyperinflation after WWI found that the printing presses were too slow to keep up with inflation. That has been corrected. Our Fed chairman, Helicopter Ben, may eventually do what he suggested five years ago, namely throw money out of helicopters. We have some exciting times ahead of us.

It’s obvious that a panic hit Wall Street and Washington, and the Fed is now pushing the gas pedal to the floorboard. Look at some of the Federal Reserve charts.

The first chart is Money Supply MZM. From Jan. 21 to Mar. 24, which doesn’t even include the Bear Stearns crisis, MZM is growing at a huge 37% annual rate. That confirms that the Fed is in crisis mode, and doesn’t want a repeat of the 1930s. This is extraordinary growth.


ASLEEP AT THE WHEEL

Excerpt from the WELLINGTON LETTER, March 17, 2008.

.................Throughout 2007, Wall Street analysts and money managers told investors that the subprime problem was too small to infect other areas. We heard how “minute” the size of that market was compared to the entire debt market; they told us that earnings were greater and would be even greater in 2008. And every time that the stock market plunged, they insisted that “the market is wrong,” and that “the only thing we have to fear is fear itself.”

Well, all of that was garbage and a prescription for ruin. We repeated again and again that we are seeing an implosion of the greatest credit bubble the world had ever seen. Therefore, earnings were irrelevant, as they show the past. The driving force in the markets is availability of credit. When it expands, the markets go up, and earnings follow. When credit availability decelerates, and then even contracts as it is doing now, you always have a bear market and recession. And the severity of these events is directly proportionate to the contraction.

Therefore, whenever you see an analyst on TV talking about the “great future earnings,” hit the mute button. He has no idea about what’s going on. Until one month ago, Intel was on everyone’s “buy” list. In early March, it announced disappointment. Sandisk, a maker of flash memory chips, announced that prices of its product would decline by 50% because of a glut. What a surprise! You can imagine what such a decline means for profits. The CEO of Cisco late last year proclaimed on national TV that he had never seen conditions this good. Just two months later, he was talking about abrupt weakness.

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RECOGNITION!

Excerpt from the WELLINGTON LETTER, February 18, 2008.

...................Yes, historical numbers are strong. But that’s history. Just a few months ago, the CEO of Cisco had a glowing report about the firm and the economic environment. I think he even said that he had never seen conditions so good. Well, his report on Feb. 6 was downright gloomy. They reported excellent results, (that’s the past) but then said the future would be worse than they had expected just recently. The stock plunged over 10% in after-hour trading.

The economy, especially the housing sector, continues to worsen. Economist Nouriel Roubini, who has been one of the very few economists who saw the current housing and credit crises coming, just said that this year 20 million homes will see their values decline to below the size of their mortgages. That will cause homeowners to just walk away from their houses, and let the lenders worry about selling the house.

On Feb. 13, Lehman Brothers said in a report that sell-offs in leveraged loans and CMBS (commercial mortgaged backed securities) have recently deepened. The firm believes that defaults in these products could spread to the “synthetic CDOs,” potentially causing a more “dramatic unwind.” I guess that could earn a crash.

Lehman is concerned about exposure to synthetic CDOs by broker-dealers—more nuclear waste.

A few months ago, it was the SIVs, i.e., off-balance sheet entities formed by the largest banks to speculate in the derivative markets. It’s estimated that the problem is bigger than $100 billion. Even industry insiders have said they had never heard of these entities before. How can you hide a $100 billion problem?

There are so many problems, which have not yet been divulged. And each one will cause a further contraction of credit. Our long-time subscribers, who have been with us for more than 20 years, know that my Theory of Liquidity, which has made it possible for us to catch major turns over the years, says that when credit contracts, the investment markets and the economy must decline. There is no alternative.

Margin debt in the stock market has always been a great indicator of bull and bear markets. When traders increase their margin debt, you are in a bull market, and when it contracts, you are in a bear market. Well, margin debt is now down about $60 billion (end of December) from the peak of $381 billion in July last year. That’s an indication of a bear market.

BEWARE! THE SHORT TO INTERMEDIATE TERM

...................Complacency is still very high. Just watch financial TV and see all the Wall Street guys, who have been telling you to bargain hunting during the entire decline. They are still talking about the “bargains.” Of course, the bargains are getting cheaper and cheaper. You won’t see a good bottom until there is actual fear and these people advise to just “hold but do no new buying.”

Human nature never changes. Emotions and fundamentals are usually wrong. You have to look ahead, not at what earnings and other fundamentals were in the past year.

The rally so far is weak. That’s a problem. Conditions are worsening. We are just a few weeks into the “recognition phase” of the bear market and the recession. The bulls are all hoping for a rally, so they can raise cash. But “hope” is a very poor investment tool. In fact, when you start hoping, it’s the best sell signal you can get. And that’s what the majority of money managers will soon learn.

Bloomberg reports that Goldman Sachs Group Inc. had its first-quarter profit estimate cut a hefty 51% by Fox-Pitt Kelton Cochran Caronia Waller. The analysts wrote that GS faces “continued challenges in credit markets” and may report a $1.7 billion writedown from leveraged loans. GS stock is down from 250 in October of last year to 175 on Feb. 15. That’s 30% in just four months. So much for being a long-term investor. GS won’t see that high again for many years. You can put that forecast in your trade journal.

Leading U.S. electronics retailer Best Buy Co. cut its full-year earnings forecast Friday, citing weaker-than-expected revenue growth in January.

Yet, analysts in the media tell us the “the market is cheap.” But is it? Actually, it’s far overvalued, as we have been saying. These analysts are still using profit forecasts from last year. But things change. As our colleague John Mauldin points out, in January 2007, the earnings forecast for the S&P 500 index was $89.10 per share. As we know now, the actual number for the year was $71.56, a miss by 20%.

In March of last year, the S&P earnings forecast was for $92.30 for 2008. At the end of last year, this forecast was reduced to $83.98. And now, they are projecting only $71.20. But for the four quarters ending in June this year, they are forecasting only $65.15. We can see that the expected decline is now running about 35%. And the P/E ratio would be 21. That’s hardly “cheap.” In fact, it’s close to what we saw at the bull market top in the year 2000.

And remember, these are just forecasts. Everything is deteriorating much faster than the greater majority had expected. If the 35% earnings decline turns into a 50% decline, we should expect a market decline of a similar amplitude. Of course, that’s for the big cap stocks. The small caps will be decimated. Why? In a recession, they can’t get bank loans—and go out of business.


Excerpt from January 7, 2008 Wellington Letter

Bear Market Confirmed!

........  In the meantime, the large financial firms are rushing to the Middle East and Asia trying to find capital for their firms so that the firms don’t fall below required capital ratios, which would threaten their very existence. Much bigger write-downs of assets held by these firms will occur in 2008, meaning they need to get even larger capital infusions than have been announced.

The world’s greatest credit bubble in history is imploding. At the same time, our central bankers, especially in the U.S., are totally unprepared to handle it. They have repeatedly shown over the past 12 months that they do not even recognize the severity of the problem, much less come up with a solution.

And that’s how a financial crisis evolves and naïve investors are used to taking stocks off of the hands of the professionals who don’t want them.

A survey of the biggest money managers was conducted by CNBC. As you will see, they don’t share my bearish opinion.

Only 2% thought the chance of recession is over 50%. More than 50% of managers believe the S&P 500 will finish up at least at 8% in the coming year, while financials will be the strongest sector and materials will be the weakest. Out of these, 33% said the index would gain 8%, while 23% expect a gain of more than 10%.

Well, we shall see. However, history shows that the majority is usually wrong.

An old Wall Street rule is that if January is down, the rest of the year is down, and if the first week of January is down, then the entire month will be down. Furthermore, if the first day of the year is down, then chances are high that the week will be down. So far, it looks like it will be a down year, according to these rules. Of course, based on our analysis, we are very confident that the year will be down, probably hard.

The market was down in December. If it’s down in January, it would be the first time since 1943 that the market has been down in both months.


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