Bailing Out The Banks

London, England

Is our “Crash Alert” flag still on the mast? Yes it is...

“Stocks dive on bail-out rejection,” says the headline on today’s Financial Times.

“Panic grips world’s markets,” says The Guardian.

“Staring into the abyss,” shouts the Daily Telegraph.

“Sell! Sell! Sell!” was the advice from the Independent.

Writers had an easy time of it this morning as world stock markets had their worst day since Morgan Stanley began following them 38 years ago. The headlines practically wrote themselves. The MSCI was down 6%.

The House voted down the $700 billion bailout. Investors were downcast. They had hoped for an easy, quick rescue. The Dow fell 777 points – its worse day ever. For the S&P, it was the worse day since ’87. The Fed, however, didn’t want to leave investors disappointed.

“Fed pumps further $630 billion into financial system,” is the headline story from Bloomberg.

Let’s see, $630 billion is not much less than $700 billion. And here, the Fed acted on its own authority, needing no permission from the foot-draggers in Congress.

The Fed is “flooding banks with cash to alleviate the worst banking crisis since the Great Depression,” continued the story.

In the US, the feds seized Washington Mutual last week. This week, Wachovia is the latest victim – selling itself in a hurry to Citigroup.

“Wachovia...we are here,” said its ad campaign. Bye bye...

Regional banks are falling hard too – shares of National City, based in Cleveland, dropped 45%.

In England, Bradford and Bingley...and in Belgium, Fortis... were on the rescue list on Monday. Today, Hypo Real Estate, a large property lender in Germany, was thrown a lifeline by the government after its shares fell 71%. Iceland took control of one of its largest lenders too – Glitnir. And Dexia, in Brussels, is said to be getting desperate.

And the poor Irish! Their luck seemed to run out yesterday. The Dublin market sold off ...as banking shares suffered their biggest one-day sell-off in 20 years. Anglo Irish Bank, a major property lender, dropped 45%. Regulators gathered round...wondering how to keep Ireland’s banks in business.

“Banks saved...” says the FT. All over the world, the rescue teams are at work. Bailing out the banks...forcing mergers and takeovers...nationalizing...

Meanwhile, oil slid 9%. Investors see the world slowing down – meaning, there will be less demand for oil. Last week, the Baltic Dry Index fell 25% -- 10% on Friday alone. The index measures shipping costs...and roughly correlates with globalization, commodity prices and Chinese output. Typically, ships pick up iron ore or copper or wheat from, say, Brazil and deliver it to Asia. When orders fall, so does the index. Now, it’s almost in free-fall...down a full 70% from its May peak.

What this is telling us is that there has been no post-Olympic resurgence in China...at least not yet. Remember, in preparation for the games, the Chinese ordered their heavy industries to shut down. They were trying to give the athletes some air. Once the Olympics were over, these industries were supposed to rev up again – putting in huge new orders for raw materials.

So far...the boats are still riding high in the water. In fact, ships leaving Brazil are putting to sea empty – partly because Asian buyers are balking at Vale’s mid-contract price increase. Vale is the largest iron ore producer in the world. Sales must be falling...

What really is going on?

You will remember our dictum, dear reader: a correction is equal and opposite to the deception that preceded it. You can quote us, if you like.

The deception of the Late Bubble Period was mammoth. People deceived themselves in such extravagant and absurd ways, it took our breath away. That has been our beat, here at the Daily Reckoning, for the last 9 years – describing the delusions and hallucinations of the bubble era.

Now, it’s the correction that is taking our breath away.

More thoughts:

*** European central banks are selling less gold. They used to keep the price down – perhaps not intentionally – by selling tons of the stuff every year. It was mad, of course. The British government – under then-chancellor of the exchequer, now Prime Minister Gordon Brown – actually sold a huge quantity of gold in 1998/99 at the lowest price in two decades. This was the famous “Brown Bottom” to the gold market. Soon after, we came out with our Trade of the Decade – selling stocks on rallies, buy gold on dips.

Since then, the price of gold has risen from $260 to over $1,000...and recently pulled back to the low 900s. Stocks, at least in nominal terms, fell heavily in ’01-’02...then rallied back to about where they had been at the end of the ‘90s.

Our guess was that the stock market peaked out in January 2000. Since then, we’ve taken the to-and-fro of stock prices as market noise...misleading investors into thinking there is another great bull trend underway...and making it hard to hear what the market is really saying. In real terms...that is, adjusted for inflation...there is no doubt about it. The Dow is down about 30% in terms of consumer prices...and down 75% in terms of gold and oil.

Now, after all this time...the nominal trend of stock prices seems to be going down too.

It’s easier to follow the real trend in stocks by looking at price to earnings ratios than actual prices. You will see that the stock market follows long, broad trends – roughly coinciding with movements in the credit cycle. When people are feeling confident...they lend at lower rates...and they buy stocks at higher prices. More or less. At the top of the cycle, they’ll pay 20...30...50 times annual earnings for a stock. At the bottom, they want a more immediate and more sure pay off; stocks typically sell for only 5 times earnings.

Where are we now?

We are between 15 and 20. Not terribly high...but a long way to go before the market bottoms out.

As to the other side of the trade, European central banks have finally realized that selling their most important asset into a rising market was not such a good idea after all. They’re now curtailing gold sales.

And from the US, we hear that dealers are running out of bullion coins. No wonder; these coins are the cheapest and easiest way to protect yourself from the risks of inflation (and, under certain conditions, deflation too).

One of the nice things about bullion coins is that once you buy them and put them away, they tend to stay put. You see the gold price going down and you may be tempted to call your broker and say: ‘let’s sell out that gold ETF.’ But you are less likely to get out your coins and lug them to the dealer. Not only is it more trouble, but coins are regarded as a kind of insurance...a kind of patrimony...that you sell only as a last resort. In a long bull market, coins are the perfect way to hold gold; you’re less tempted to get rid of them when the price dips. So, you end up riding the long wave all the way to its end.

Then, of course, you’re also likely to forget to sell. But that’s a story for another day.

*** How about that Warren Buffett! He bought $5 billion worth of Goldman preferred. The stock gives him a 10% annual dividend. Plus, he got warrants good for another 5 big bills worth. These come with a strike price of $115 a share – a discount of more than 15% from Friday’s closing price. That alone has a value – probably about $2 billion...which puts Buffett’s effective yield at 17% (according to a calculation in Barron’s). The old man from Omaha is showing those New York slicks a trick or two.

P.S. If you enjoyed this article then we encourage you to sign up for the free Fleet Street Daily eletter. Learn what you can expect from today's markets -- and how to prosper in the face of uncertainty. You won't find more thought provoking writing anywhere on the Internet.

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Bailing Out The Banks

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