Is this the Modern 1931?
by Thomas P. Au, CFA, Author & Market Analyst. March 13, 2007
Last week, I read with great interest Doug Kass' 1937 déjà vu piece, based on similarities of technical patterns between then and now. That's a scary proposition, at least if one remembers what lurked around the corner. (And it doesn't help that the Olympics took place in Berlin, Germany, in 1936, and will take place in Beijing, China in 2008, God willing.) So 1937 isn't the analogy I'd use. But I think that Doug's asking questions regarding the right decade, the 1930s, and will reiterate a question I've asked before: Is this "1931?"
Why not say that 2007 will be like 1937 or even 1929? A superficial response would be that 2007 is a pre-Presidential election year, like 1931, whereas 1937 and 1929 were post-election years. A better answer is that 2007 could represent a potential fundamental economic turning point in a similar manner to 1931. That's because the 1929-1932 crash actually took place in two stages. In the first stage, from late 1929 through the end of 1930, the market corrected the overvaluation excesses, relative to then-prevailing fundamentals. Specifically, the Dow pulled back from 381 to under 200, which represented fair value for the time. In the second stage, from 1931 to mid-1932, the market fell to 41, nearly 90% off the 1929 peak, because the fundamentals themselves collapsed, with my estimate of "investment value" of the Dow(based on book value and dividends) falling from 202 at the end of 1930, to 82, at the end of 1932.
A similar set of events may be unfolding this decade. The bulls rightly point out that we've had our correction of earlier valuation excesses. This took place primarily as a result of the (first?) bear market of 2000-2002, together with recent earnings growth in excess of stock price gains. But they may be underestimating the potential for a collapse in fundamentals such as earnings and dividends. Recent stateside growth has taken place because consumers have been willing to spend in excess of wage growth (and able to do so because of easy money and a buoyant housing market that led to "capital" income). With housing now in a tailspin, this source of "income" is gone, at the same time that overleveraged consumers are now demanding higher wages in their role as employees, to compensate. Both effects threaten to crimp corporate profit margins, as happened in the 1930s. The remaining ingredient then, and possibly now, was the rising cost of imports, as many other countries elected to "opt out" of the global economic system. All this could lead to a second (down) leg of the bear market. Yes, the Fed did manage to head off this event from occurring right after 2002, but it may have been a case of delaying, rather than preventing, the inevitable.
More recently, subprime lending seems to have been the "canary in a coal mine." It would be nice if the collapse of New Century Financial was "merely" a case of one imprudent, overleveraged lender getting its just desserts. But the fact of the matter is, New Century has stopped making loans (with Novastar and Accredit Home Lenders headed the same way) because other lenders will no longer fund it. This echoes a 1930s event called disintermediation, which in its rawest form, consists of everyone putting their money under a mattress. This threat is made worse, as Doug pointed out, by the fact that hedge funds hold much of the existing subprime paper in the form of "mortgage-backed" securities.
And its consequences were perhaps best described by George Soros in his theory of reflexivity. Sub-prime lenders had their role in society because their aggressive lending pushed up house prices across the board, thereby reducing the loan to "value" (LTV) ratio of all houses, and improving the collateral of all lenders. Likewise, when the spigot is turned off at the (subprime) margin, it may force homeowners to dump their houses at distressed prices, reducing the value of real estate generally, and making formerly sound loans, unsound, causing another round of domino effects. The resulting credit losses would severely crimp overall corporate profits, independently of any knock-on effects that may result from the likely job losses in the mortgage and housing industries.
Can we look to the Fed for relief? The Fed has done an admirable job (in the past decade, at least), of firefighting some pretty major threats, like Long Term Capital, Y2K, and the turn of the century bear market. But our relying on it to continue to do so would be a case of "fighting the last war," which involved serious, but singular, issues. But what if there are several major problem areas to be dealt with at the same time? What's worse, what happens if there is series of events that require conflicting prescriptions; e.g., a credit collapse that necessitates a fight against deflation, combined with a spike in oil prices, falling dollar, etc. that creates inflationary pressures?
My best guess is that the U. S. economy is a tad stronger than Doug Kass seems to give it credit for (pun intended), although not nearly as "bulletproof" as the bulls seem to think. Specifically, I believe that it is just strong enough to weather the collapse of the housing bubble and the resulting concomitant decrease in consumer spending. But stateside growth will have been pushed so close to the brink by all this, that one more nudge would push it into negative territory. That shock could be exogenous, a terrorist attack or a hedge fund collapse, or something systemic, such as an unraveling of the Chinese banking system as a result of the bad loans linked to capital goods overspending in that country. That's why weakness in the Chinese market may have been "the last straw" of the recent rally.
All this could bring about a market crash scenario as laid out in my "When, Why and How, Stocks Will Fall piece." Based on events (so far!), I still don't see it happening this year. But that's cutting it very close to the line, and a call of "not in 2007" has no margin of safety.
© 2007 Thomas P. Au
Thomas P. Au, CFA | Author & Market Analyst, R. W. Wentworth | New York City, NY | Email