The Financial Markets – More Complex Than A Dostoevsky Novel

The trouble with following the financial news is that there is so much of it. Everyday brings new information, new facts, new theories — dozens of them. The financial news becomes like a dense Russian novel, with so many characters coming and going that we forget the plot.

Of course, if you’re reading Dostoevsky this summer, you can always stop, flip back and figure out what is going on. In the financial markets you can never stop. The news just keeps coming...the absurd characters keep popping up...the intrigues and sub-plots get denser and more confused.

And yet, it’s in the financial markets that the plot really matters. A serious investor is probably better off with neither television nor newspapers to distract him. In fact, he would probably be better off never reading the Daily Reckoning either. It would force him to pay attention to only what he actually knows or can find out. He might study a local bank, for example...meet its management, explore its ledgers, and parse its financial statements. He might find that it is a good investment — or a bad one. In so doing, he is much more likely to be right than the fellow who reads Barron’s and decides that it is a good time to get back into the bank shares.

But here at the Daily Reckoning, we are not investors. Our job is to keep an eye on the financial news and try to make sense of it. It is a vast and confusing story; our mission is to try to keep track of the main plot.

Yesterday brought more complicating details. The Dow sold off another 109 points. Oil rose $3.44. The dollar was up slightly...still at $1.49 per euro. And the price of gold leaped up $16.90. The 10-year T-note rose to yield 3.94%.

We suggested a possible plot outline yesterday:

Boy meets girl. Boy and girl go on spending spree. Wall Street and Washington collude to cause them to spend more than they could afford and to go much further into debt than they should. Boy and girl can’t pay their debts; they’re losing their houses. The moneybags who lent to them are going bust.

Subplot: meanwhile, on the other side of the planet, the foreigners who kept selling them gadgets and gizmos are running into trouble. So, they’re buying less stuff to make gadgets and gizmos with. And, wouldn’t you know it, the people who sell them stuff — oil, copper, coal and so forth — are also running low on cash, because the price of their stuff is falling.

As the curtain went down last week, it looked as though the whole world economy were sinking into a soft, slow, Japan-like mud.

The storyline seems solid enough. The facts seem to fit more or less. But we have a strong feeling that there are more twists and turns in this plot...and that, when the show is over, the story will turn out be very different.

In the first place, the boys and girls may be in bigger trouble than we’ve seen so far — and there may be more of them.

"Skies Darken for Retailing as Spree Fades," says a headline in the Wall Street Journal. US retail sales fell in July for the first time in 5 months. Rising sales were misleading anyway; they were more a reflection of higher prices and rebate checks than of an actual increase in either the consumers’ willingness or ability to spend more.

Meredith Whitney, one of the few professional analysts who foresaw the sub-prime crisis, says that the downturn will be more severe than people yet realize. One in ten households over-extended itself in the bubble period, she points out.

Bankruptcy, default, and foreclosure rates will inevitably worsen as these Jacks and Jills roll down the hill.

One in four houses sold in America today is sold at a loss, says a report on CNNMoney. That totes up to a lot of losses for the whole financial chain...the homeowner, the mortgage company, the builder, the real estate agent, and the investor who bought a mortgage-backed security.

Toll Bros., one of the country’s biggest builders, announced that revenues were still going down.

And the banks sold off on Wall Street. Anyone waiting for the financial industry to return to the glory days of 2006 may have a long wait. As a credit-fueled boom turns into a bubble, it takes more and more lending to produce an additional increment of GDP growth. In the real boom years after WWII, it took about $1.40 worth of credit to produce $1 worth of GDP growth. The ratio rose sharply after the Reagan Revolution...and now stands at about $6 of credit to every extra dollar of GDP. Of course, that is why Wall Street made so much money — it was selling credit. But it’s also why that story is history; that show is over. As the cost of growth — in terms of credit — rises, so does the cost in terms of debt service. Even at 5%, the cost of $6 of credit is 30 cents per year. If it produces $1 of GDP growth, that extra output would need a 30% profit margin to break even. Not very likely.

While the US may be in greater trouble than the markets realize, China may be in less. In other words, the slump in the West may not be so soft. In the East, it may not be in a slump at all. Retail sales in the US are falling, but sales in China are going up at 23% per year. Even after inflation, they’re going up at 15% -- the fastest pace in 9 years. Sales of gasoline are increasing at a 55% annual rate.

Incomes are rising too — real, after inflation, incomes are going up at an 8% annual rate.

In other words, maybe China is not slowing down very much, after all.

Remember, if these big, emerging economies can continue to grow, it will keep the pressure on prices for raw materials. This then makes the situation worse for Americans; they pay more for food and fuel...even as their incomes and assets fall in price.

*** "Oh yes, we met a couple of years ago," said a new friend at a party last night. "You said to buy gold. At the time I thought it was a little flakey...buying gold, that is. But then the price went up...and I thought of you."

"Well, it isn’t going up now..." we replied. "But we wouldn’t give up on it. Not yet. Most analysts think the crisis in the financial sector is pretty much over. They think we’ve seen the worst. They don’t expect any more major banking failures. They think the dollar is coming back. And they expect the rate of inflation to moderate. They’re looking for a huge soft landing for the entire world economy.

"But financial analysis, at least on this kind of macro level, is mostly fraud. It’s impossible to keep track of all the various inputs — many of them purely psychological or emotional — and make a logical judgment about what will happen. You can form an opinion. But your opinion is usually driven by some kind of philosophical prejudice. Say, for example, you just don’t like to see all those Wall Street hotshots making huge bonuses for doing something that you know is mostly a kind of razz-ma-tazz designed to wow the little guys in the market. Then, you’re sure that they’re going to get their comeuppance, one way or another. So you look around and try to find justifications for your point of view. And, there are so many facts and theories around, that you can always find whatever you’re looking for.

"You know, things in the financial markets have been going very well for a very long time. Major stock market indices are down only about 15% from record highs. No major economy is even — for now — in a recession. Unemployment in the US still hasn’t rise to 6%. Gold is no higher than it was 28 years ago — in nominal terms. People still lend money to the world’s biggest debtor — the US government — at only 3.94% for 10 years. And the dollar is still taken as a ‘store of value,’ even though there are trillions of them in central bank vaults...and a whole rickety tower of dollar-based credits reaching up to the sun.

"But investors talk as though it were the end of the world. It’s not. It’s only the beginning of a major correction...and probably, only the beginning of the beginning.

"And when it is over, people will want more than 10% yield before they will lend to the feds. The world’s monetary system will probably have collapsed and been replaced with something new. Stocks will probably sell for less than 8 times earnings. Ten percent of the US population will probably have gone bust — that’s 30 million people. And gold will probably sell for more than $2,000 an ounce.

"Of course," we had to admit... "between here and there, anything could happen."

*** "Won’t these string beans ever stop," our cook wanted to know. She’s already filled the freezer with them...and already stuffed every jar we own with canned green beans. And she’s served them up at every meal in every possible way. Fried. Steamed. Grilled. Boiled. Braised. In soufflés. In casseroles. In soups. In stews. In salads. She’s probably slipped them into some desserts too, but we didn’t detect them.

Damien had just come up to the kitchen with another 5 gallon bucket full of them.

"Oh no...not more green beans," said Edward. "We eat green beans all the time. I’ll never want to see another green bean as long as I live."

"Then don’t look in the pantry," said the cook.

P.S. If you enjoyed this article you can find out more about our free email, The Right Side by clicking here.

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