Last Friday's message - see http://www.garyascott.com/market/606/ - reviewed 100 + years of stock market,economy and social development. The chart in that message made one clearpoint. For over the past 100 years markets have moved in 30-yearcycles. Another fact the chart revealed was that half that cycle is a long15-year downturn.
Another vital reality we did not discuss in that last message is that therewas a U.S. banking crisis in the middle of each crash.
Look at the 100 year chart of the S&P again - see http://www.garyascott.com/market/606/ -
Note the crash of1907, the crash of 1929 and the crash of 1975. Each of these serious dipswas caused by a bad bank crash.
The 1907-drop was salvaged by JP Morgan who brought in 100 million dollarsof gold from Europe.
The 20s crash was staved by government intervention and FDR New Deal.
The 1970-drop was bailed out when Richard Nixon unhinged the dollar fromsilver and let it float in foreign exchange markets.
Essentially Nixon's move shaved half the dollar's purchasing power andreduced vast amounts of debt that could be paid off with cheapdollars. The Fed raised interest rates, cranked out money like mad (whichled to inflation in the early 80s) and arranged mergers with some hugebanks that had collapsed.
What can we learn from this history?
First, we can start watching for the next bank crash. This could save ussome money by making sure we don't use weak banks, but more importantly thenext crash can give us several early indicators.
It can warn us not to panic if we are in equity markets when the crashcomes. If you think that markets have seemed bad in recent weeks, chancesare they will feel much worse during the crash. This will be a time tohold onto the correct shares, because in each of these panics markets havereally oversold.
Second, there will be opportunities for enormous profits for those who havethe guts (or the understanding) to buy during the bank crash (and sellshortly after). Note in the chart how each bank crash was followed by avery sharp recovery, before the market began to slide again.
Selling shortly after the crash takes place is important because there willbe plenty of buyers. The harsh dip and recovery is a part of the marketpsychology that ultimately leads to the bottom of the market. The sharpupswing on the heels of the bank crisis creates a euphoria that everythingis finally all right and sucks the remaining investors (who still have notforgotten the run up to 1999) into one more peak. Many investors will beconvinced that good times have come again and they will get clobbered yetone more time!
Here are the key points to this message that are absolutely vital not toforget. Expect a bank crisis. Watch for it. Start to buy the minute youfeel the crash begin and you see markets start to fall. Be ready to exitthe minute a bail out soothes the market jitters and the markets start toclimb. Do not think that the upswing will last forever! Take your profitsand run.
To this end I am watching now and though I do not have any more foresightthan you do, I have been through this before so I am watchingalready. Recently a reader wrote:
"Dear Gary: According to Lyndon LaRouche all US Banks in this country havebeen insolvent for the last 4 years. The US Debt bubble is about to burstwhich means our economy is about to collapse according to the researchLaRouche has done. He puts the date this could happen by this October.TheDirector Generalof the Bank of Japan made a statementon July12,thatthere is a worldwide move on right now to dump the US dollar whichwill collapse the worldeconomy. It is unstoppable and is in process now.The dollar is essentially in a state of free fall. "
My feeling is that these predictions are a bit ahead of the actualreality, but I am watching. This weekend I spent several hours pouringthrough publications issued by the Federal Reserve Bank of St. Louis. (I doeven this for all of you.) This is really dry stuff full of high-soundingtheory, but perhaps little sense.
However the July 200 issue of the Fed's Monetary Trends was titled"The Condition of Banks-What Are Examiners Finding?" This article pointsout that banks are rated on six aspects of operation (C) capitalprotection, (A) asset quality, (M) management competence, (E) earningsstrength, (L) liquidity risk and (S) sensitivity to market risk.
Every bank is inspected at least once every 18 months and rated one(best) to five (worst) on each of these six aspects. This article includeda chart showing the increase in down grades from 1 or 2 to 3 or below. Thechart dated back to 1987 and showed a significant increase in downgrades in1991 (last recession) and shows that the downgrades are minimal to date.
This would suggest that a disaster is not imminent yet.This is not to say that we should believe everything published by theFed. In fact The Fed's July-August Review included five articles from the26th Annual Economic Policy Conference, which was devoted to the subject ofthe importance of transparency in the conduct of monetary policy.In other words, the whole world is asking, "Should monetary authoritiestell the truth and let people know what they are doing?"
The fact that this question must be asked means we must always be on guard.Watch the big banks as well. Recently Merrill Lynch reported that theirprofits in the second quarter rose 17% to $634 million even after payingout a $100 million fine for misleading investors (so much for the punitivepowers against deceit and corruption in our system). Citigroup announced asurprisingly strong increase 15% in quarterly profits to 4.1 billion andJ.P. Morgan Chase trebled their profits to 1 billion.
However at least two of these banks (Citibank and J.P. Morgan Chase) areembroiled in the Enron collapse and a deepening of the investigations inthis area could reduce confidence in U.S. banking quickly.
Another danger we must watch is that U.S. banks are allowed to hold anunlimited amount of reserves in quasi-government home loan agencies such asGinnie Mae and Freddie Mac.
A message written years ago - see http://www.garyascott.com/articles/210/told of the buildup of big bank loans to telecom companies (such asWorldcom) and showed how America's booming housing market has swayed thegovernment-backed home loan agencies, Fannie Mae and Freddie Mac, to takegreater and greater risks. U.S. house pricing is notoriously cyclical. Thedrop in Wall Street can push housing prices down. A recent article in TheEconomist magazine (April 15-page 79) tells how the agencies have increasedlending at a 20% per annum rate. They have 1.4 trillion of debt and atcurrent expansion will bear risk on more than half of U.S. residenceswithin three years. These agencies are listed on Wall Street and should beprivate companies. Yet they gain benefits from their quasi-official stateand have $32.00 of debt for only one dollar of capital whereas large bankshave $11.50 of debt per dollar of capital. Their implicit governmentguarantee allows them to borrow cheaply, yet they are making the samemistakes savings and loans made in the 80s. They pay officials and staffway above public and most private sector rates. Even worse they are movinginto "sub-prime" lending which carries higher risks.
Now here is the crunch. A dangerous house of cards has been built becausethese agencies are exempt from rules, which limit banks from holding toomuch exposure in any one company. Banks can hold all they want of thisstuff. Today, one third of total bank capital in the U.S. is this federalagency debt and equity, a highly concentrated risk!
So banks could look safer than they are. In other words keep your eyes open!
This leads us to the question, where then should we invest? I answer thisquestion in tomorrow's message. Until then, good investing!
P.S. We are adding accommodations at Merrily Farms. Our upcomingInternational Business Made EZ course this October - see http://www.garyascott.com/courses/ - has filledup faster than ever before. Due to this we are adding accommodations so wecan have allow another five to seven delegates to attend. If you areinterested in joining us for the glorious colors of fall (see the pictureshere, here, here)