Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

Revisiting the Dow’s 1933-1936 Rally

Probably one of the craziest suppositions now is to project a 100% gain for U.S. stocks over the next few years. After all, everyone, and I mean everyone is suffering big losses in the market this year and nobody truly believes equities will start a bull market any time soon.

Stocks can muster a convincing bear market rally following a crash. This last occurred in the 1930s as the Dow almost doubled between 1933 until 1937.

Investors forget that previous secular bear markets, even during the Great Depression, resulted in formidable short-term gains for bottom fishers. Stocks might still break their October 2002 lows before stabilizing or reversing; at some point, however, the market will rebound, if only for 12-36 months.

If you believe this economic recession will be severe, and I do, then it won’t be a straight line down for stocks.

I continue to focus on the 1930s for historical guidance today because it was a full-blown credit crisis accompanied by bank failures, massive deflation and a double-digit decline in GDP output.

In many ways, the situation now is far worse than back in the 1930s simply because the debt super-cycle is colossal. Governments, businesses and individuals hold more net debt than at any other time in history. Deflation, which has arrived with a vengeance since July, makes debt servicing more expensive because assets they represent become harder to finance in a contracting economy. Those same assets, including real estate and stocks, for example, continue to decline in value further compounding the cost of borrowing or debt servicing.

From its peak in 1929 until 1932, the Dow Jones Industrials crashed a cumulative 86%. But starting in 1933 the Dow raced ahead with a 66.7% gain. From 1933 until 1937, the Dow doubled in value. By 1937, the global economy began deteriorating once more combined with political turmoil in Europe. The Dow plunged 33% in 1937 and began a five-year bear market until 1942. But if an investor bought stocks in late 1932 he still would have been sitting on a profit by the end of 1937 – despite the big drop that year. It’s a different story if an investor bought equities in 1929; he would have waited 25 years to break-even.

Guessing the market’s direction is largely a waste of time and I don’t scratch my head every day wondering where stocks are heading. Yet it’s instructive to see what happened in the early 1930s because we’re on the same path. And judging by the last deflation, we’re probably going to see new lows first for stocks followed by a major rally in the context of a secular bear market, similar to the 1933 to 1936 rally.

The Beginning of the End for U.S. Auto Manufacturing

In 1955, U.S. manufacturing was approximately 55% of the nation’s GDP. Today, manufacturing is barely 15% of GDP as the United States and other industrialized countries continue to transition to service-based economies. Unfortunately, the backbone of American industry is now coming apart at the seams and desperately hungry for a government bailout.

In 2004, I predicted that one of the Big Three auto companies would fail in a few years. Though not a bold forecast by any measure – the autos were long bleeding before 2004. My target back then was Ford. At the time, I was the editor of the now defunct Renegade Investor. I plugged put options on Ford Motor and made a profit on that trade; now I wish I had purchased long-term LEAP put options. Ford in July 2004 traded north of $13; today, Ford Motor fetches just $1.76.

Detroit is home to America’s Big Three auto companies. It’s also home to one of the worst contractions in manufacturing activity accompanied by seemingly never ending losses.

General Motors (GM), Ford and Chrysler are bleeding profusely and need emergency cash funding right away. Of the three, General Motors is headed into bankruptcy first, unless the government comes to the rescue. The world’s second largest car company (Toyota is now #1) has enough cash to last until January at the latest; Chrysler and Ford probably have enough funding for another 6-12 months; beyond that period, it’s Game Over.

The scope of Washington’s bailout reach is now extending: mortgages, banking, investment banking, insurance and, now, auto manufacturing. Pretty soon it might extend to the airlines, real estate companies and who knows, maybe even every industry that comprises the S&P 500 Index. This whole bailout thing is totally out of control.

Should the government let the Big Three fail? Combined, these three goliaths employ more than 300,000 people worldwide with most of that total in the United States. The pressure is on the government to bailout the autos. Paulson isn’t too keen on extending TARP to the auto companies but Obama certainly is. I reckon Detroit’s odds of obtaining a bailout are pretty good.

With the economy showing no signs of bottoming as we shortly conclude a miserable 2008 for investors it would only seem prudent to remain underweighted stocks. The market shows no convincing ability to bottom; every major rally is met by big selling as investors eagerly grab short-term gains to raise cash.

This recession will be a long, drawn out affair, probably lasting throughout 2009, possibly 2010. Housing is at the core of this secular bear market. I don’t see housing bottoming or at least stabilizing until at least mid-2009 with inventories still rising in Q3. Mortgage rates, which declined following the initial Paulson Fannie Mae and Freddie Mac government guarantee in September, have since risen again. Mortgage rates must come down.

It’s now time for America to become thrifty again. The correlation between a rise in the savings rate and corporate earnings growth is negative. Earnings expectations remain too bullish for 2009 and must still be revised lower. Earlier this fall I had expected a rally following the post-October 9 crash; thus far, the Dow is up just 7% off its low for the year or 42% off its October 2007 high. Now I’m beginning to think we might test fresh lows and soon.

The Dow will test its October 2002 low of 7,286. In my mind, there’s no way this bear market is not as severe as the 2002 debacle. It’s much worse.

Should stocks decline another 15% from current levels the Dow would sit 57% off its best level in October 2007 but still about 30% above the trough of the 1932 lows. From October 1929 until late 1932, the Dow collapsed a cumulative 86%. I doubt we’ll see that sort of spectacular decline; yet it’s pretty likely that a 42% peak-to-trough loss thus far won’t kill this bear.

If one of the Big Three is allowed to fail, watch out. That would trigger another crash. The market is drunk, expecting another industry bailout. Let’s not disappoint Mr. Market.

Credit Storm Hits Farmers

From their lows earlier this year the grains complex has plunged about 40%, with corn, soybeans, wheat and rice all down hard since mid-July. That’s consistent with the CRB Index, now off more than 40% since hitting an all-time high in early July.

But if the credit crisis finally caught up to commodities in July after six straight years of big gains, then the same credit phenomenon might propel the grains higher eventually. That’s because crop yields are now shrinking again after a harvest boom in 2008; projections for grain harvests in 2009, however, look grim.

Many farmers in the United States and especially overseas in the emerging markets are increasingly being denied credit to fund purchases of fertilizer (potash) and machinery – vital inputs necessary to boost crop output. Without external financing, farmers must delay or reduce plantings. Worse, grain processing companies that typically extend credit to farmers, like Cargill and Archer-Daniels Midland, are now tightening terms and in some cases, denying weaker borrowers credit altogether since September.

According to the USDA, global inventories of corn, wheat and soybeans before the harvest in the Northern Hemisphere next year will be the second lowest since 1974 or enough for 67 days of consumption compared with 144 days of supplies in 1986. The chances are quite high that another round of food shortages will emerge again next year as grain prices recover. In April, the United Nations proclaimed that over 30 countries were facing food shortages as rice and other grains went through the roof during the first quarter. Prices have since declined sharply and food riots have eased.

According to AgResources, a Chicago-based agriculture consultancy firm since 1979, “stockpiles are going to be extremely tight. The world cannot afford any dislocation in production next year or there will be a real shortage.”

The credit crisis therefore will adversely impact crop output in 2009. This implies a major reversal lies ahead for the grains complex and investors should start building fresh positions.

Until July, most commodities, including the grains, also provided portfolios with invaluable portfolio diversification as stocks swooned. I suspect the bull market in the grains is far from over with the entire sector now trading well below their inflation-adjusted highs in 1980 and since July, about 40% off their nominal highs. The grains are cheap.

The world will continue to consume foodstuffs. People might reduce spending on discretionary items like cars, holidays and electronics. But it’s a pretty safe bet that consumers won’t compromise their diets. The grains might just lead a commodity recovery in 2009 as demand continues to flourish while net supplies are shrinking, exacerbated by the ongoing credit squeeze.

Big Rate Cuts Fail to Halt Stock Swoon

The European Central Bank (ECB) and the Bank of England made bold interest rate cuts yesterday with the British cutting rates to their lowest levels since 1955. Despite aggressive interest rate cuts by global central banks over the last 60 days, markets remain on edge and unable to find any semblance of balance.

In the United States, a post-Obama-elect victory on Tuesday failed to carry through into Wednesday’s trading with the Dow dropping 486 points and again on Thrusday, dropping another 443.

Europe is rapidly sliding into deflation since August with wholesale and retail price pressures declining sharply accompanied by tumbling euro. It’s not a pretty picture in Europe. Worse, Eastern Europe is leveraged to the global growth cycle – literally – and borrowed money is now leaving these markets as investors unwind risk.

Central banks are quickly running out of bullets, namely the scope to cut interest rates. Once rates hit zero percent, there’s a chance they can even head into negative territory.

The Japanese now have rates at just 0.30% after cutting their base rate last week. It’s not impossible that other industrialized countries will also face a similar conundrum if they can’t arrest falling prices. Interest rates did turn negative in the United States in the 1930s as the demand for ultra-safe Treasury bills propelled rates into negative territory, meaning investors actually paid the government to hold paper and not vice versa.

Central banks have numerous policy-setting tools at their disposal to combat this credit crisis, including SWAP agreements, intervention in foreign exchange markets and an arsenal of market-based tools that most of us have never even heard of. Bernanke and his European counterpart, Trichet, will throw everything they’ve got at this crisis until markets stabilize. After more than 15 months, however, both central banks have failed to calm investors.

Deflation is now investor enemy number one. The violent transition from inflation since July to deflation starting in September has been awfully alarming. Asset values continue to plunge virtually everywhere, including real estate, stocks, bonds and non-dollar currencies. My generation and even my father’s generation have never seen such an accelerated decline in asset prices in such a short period of time.

I’m actually hoping inflation makes a big comeback over the next 24 months because in that environment investors can make money. Deflation, however, is a much harder market to work with and, historically, investors have been clobbered trying to navigate through its rough waters. Case in point; since August 2007 most investors have lost money.

The extremely high degree of global market correlation makes this crisis even more dangerous because everyone is now in the same boat. It doesn’t matter where you invest or in what currency; the odds are high you’re losing big money.

Deflation makes harboring debt highly expensive and destroys both individual and corporate balance sheets faster than any other monetary phenomenon.

For individuals, asset allocation is now a major priority because of the high degree of correlation between assets. Make sure you have the right balance of stocks, bonds, currencies, alternative investments and, especially in this environment, reverse-index funds to offset your equity portfolio losses.

Deflation is a living hell. Let’s hope inflation returns soon.

I’ll be in-transit on Monday. My next post is on Tuesday. Have a good weekend.

Reckless UBS Tarnishes Switzerland’s Image

Global investors are still reeling from the ongoing and seemingly never-ending losses incurred by Switzerland’s largest bank, Union Bank of Switzerland (UBS). Yet as the Zurich-based bank is chastised by its shareholders and clients, the bank will emerge stronger going forward as it embraces less risk and returns to its core business – banking.

UBS earns the distinctive booby-prize for losses suffered in the subprime and auction rate securities fiasco – responsible for more than 15% of the global total thus far. That sum is north of $50 billion now and probably heading even higher as other structured products and derivative based securities in its clogged portfolio continue to unwind.

In late October, the Swiss National Bank and the Swiss government plugged UBS’s balance sheet by collateralizing over $50 billion dollars worth of distressed and near worthless synthetic securities. This move, in part, was an emergency response to the European Union’s blanket guarantee of deposits starting on October 1, following Ireland’s precedent. Swiss banks don’t offer full deposit guarantees; without some sort of backstop, UBS would have continued to bleed deposits.

Switzerland’s image has been badly damaged by UBS’s misguided investment adventures. The country’s blue-chip reputation was tarnished by the massive write-downs over the last 12 months and many investors have fled the bank, including private banking clients worried about the banks’ solvency until recently.

In retrospect, UBS should have avoided buying U.S. investment banks.

The fist big mistake was acquiring Paine-Weber and Warburg Pincus more than ten years ago. This was the beginning of the end for UBS as it lunged into lucrative but ultimately dangerous investment banking ventures. UBS should have stuck to traditional banking.

UBS will survive. The damage has been enormous since the onset of the credit crisis with several hundred billion dollars lost by global financial institutions. Most banks have been reckless, including UBS. Yet I imagine UBS and other Swiss banks, largely unaffected by misguided adventures in banking, will grow even stronger in the years ahead as Switzerland regains its title as the capital of private banking.

I’ll bet on Switzerland. It’s still the best country in the world to park your assets, including physical gold, which might one day be confiscated by global governments ahead of a new monetary or foreign-exchange regime.

Obama Honeymoon Opportunity to Sell Stocks

Global markets rejoiced Obama’s victory yesterday with Asia up sharply on Wednesday. The market finished strongly on Tuesday, a rarity these days since stocks typically decline off their session highs. Any intermittent rally in a bear market should be viewed as an opportunity to sell stocks.

But investors should continue to accumulate busted credits like investment-grade corporate bonds, TIPs and municipal bonds – all trading at hugely attractive levels following a blowout in September and October.

If you must add equities at these levels then consider convertible bonds where premiums have collapsed and yields trading at 1994 levels. Convertibles provide the best equity-linked values with high income and the scope for attractive conversion rates into common stocks. Convertibles, until recently, were basically dysfunctional or barely trading; many hedge funds have tanked because convertible arbitrage has failed as a hedging strategy in 2008. But the values now are enormous.

Previous “honeymoon” periods for the markets following a newly elected president show a generally rising trend for several weeks followed by a decline later. I expect the markets to remain steady over the next few weeks as we conclude Q3 earnings season, credit stress eases further and stocks muster a long overdue bear market rally following weeks of protracted selling that culminated into a crash in early October.

Obama won’t change much as it pertains to the markets. In fact, he’ll probably raise dividend tax rates to 20% from 15% now and perhaps even abolish short-term capital gains or raise capital gains tax rates. Either way, the markets won’t get help from Obama.

U.S. stocks are now about 20% above their October lows as measured by the S&P 500 Index. I suspect we’ll continue to move higher heading into December. But make no mistake about it; this is not the start of a new bull market. The economy is deteriorating, earnings expectations are still too optimistic and the consumer is starting to increase his savings.

Deflation is now a central theme for global central banks as they wrestle with rapidly declining asset values in stocks, real estate, bonds and most alternative investments, including hedge funds. It’s a mistake to believe the stock market has bottomed because six months from now the economy will look much worse, not better. Don’t be fooled again by this bear.

S&P 500 Still Not Cheap

With global equities finally posting a winning week heading into Monday’s trading, it’s no surprise that pundits are calling another market bottom. I’m not so sure. This is probably another in a series of painful bear market rallies that will eventually see newer lows as the global economy continues to contract, corporate earnings decline and domestic consumption in the United States and abroad wanes. Since August 2007, the market has logged four bear market rallies and all of them ended badly.

From its lows earlier in October the S&P 500 Index has gained 15%, the Dow is up 18% and the S&P 600 Index of smaller stocks has risen 22%. The MSCI World Index has gained 7% from its lows, constricted in great part by a surging American dollar, which dilutes the gains from foreign currency-denominated stocks.

But are stocks really cheap?

Global equities are now trading at their lowest trailing price-to-earnings multiple since the 1970s at just 10.3 times earnings. The majority of global markets have been mauled lately and virtually all of them sell at less than 12 times earnings and some below ten. Europe, the Pacific and Latin America all trade at compelling levels.

Yet U.S. stocks don’t necessarily appear that cheap when compared to international equities or when priced in relation to their 12-month earnings and dividend payments.

The S&P 500 Index trades at 21.3 times trailing 12-month earnings and yields 3.2% in dividends.

According to Wigmore (data from 1985), U.S. stocks peaked in 1929 trading at 30 times earnings and harboring a 3% dividend yield. But by 1932, U.S. equities traded at just 10 times earnings and yielded a fat 12.5% dividend yield.

Stocks thereafter embarked on a big rally of 67% in 1933 and another 38% in 1935. This followed the incredibly painful crash from October 1929 until late 1932 when the Dow collapsed a cumulative 87%.

Historical data therefore suggests that U.S. stocks are still not huge bargains. It also suggests that we’re still in the throes of a bear market rally.

In October 2002 the Dow bottomed at 7,286 before embarking on its historical run to 14,000 by October 2007. I have a hard time believing we can hold above 9,000; the global economy is much worse today compared to 2002 and U.S. stocks are likely to retest the lows of 7,286 on the Dow in this bear market only because the economic environment is far worse compared to just six years ago.

If you subscribe to this view, then stocks, especially U.S. equities, are not in the bargain zone yet. From peak-to-trough, U.S. stocks plunged about 45% before last week’s recovery. From 1929 to 1932, the Dow collapsed 87%. Though this bear market might not be as damaging as 1929, in many ways it’s much worse. Investors today have never lived through a full-blown credit crisis and we still don’t know to how to gauge the full impact of events since August 2007.

To be sure a host of indicators continue to improve lately. These include a falling VIX Index, a revival of the commercial-paper market (thanks to the Fed), narrowing credit spreads and an easing of three-month LIBOR, now at 3.03% from 3.51% a week earlier at 4.85% at the height of the panic about two weeks ago. This is all good news.

But as the credit crisis continues to relax, the damage has already largely been done to the real economy. Credit is still hard to secure, consumers aren’t spending, retail sales are grim and layoffs are now widespread. Mortgage rates remain elevated. Also, consumers will eventually start saving again and that is only bearish for corporate earnings. If consumers save, they don’t spend.

We’re now transitioning from one crisis to another, or going from the tail-end of a credit squeeze to a deep global recession that affects broad consumption. I highly doubt the market has discounted all the bad news. I also find it hard to believe that the Panic of 2008 and its horrific trail of damage, namely the destruction of wealth, will keep the market above water for very long. Dow 7,286 is coming. Stay defensive.

I'll be in-transit to the Sovereign Society Offshore Advantage conference on Tuesday. See you Wednesday.