IMF director Dominique Strauss-Kahn tried to kick-start stalled G7 negotiations in Washington this weekend by reminding everyone what was at stake. “Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown,” he said.
It doesn’t get much more direct than that. The truth is, governments are trying to do the impossible. They are trying to make bad loans turn good by propping them up with extra money, money that comes from out the blue. And instead of encouraging household saving that would form the base for future productive investment, governments are encouraging more consumption and nursing along trillions in mal-investment (housing-related securities).
Debt-based consumption and the securitisation of those debts are what brought us to the point of systemic crisis in the first place. Had markets been allowed to work, the over-leveraged financial firms would have failed, a deep recession would have ensued, and consumers-cut-off from credit-would be forced to save rather than consume.
So far, though, efforts to save the system by propping up bad debts are only weakening confidence in the system itself. It’s happened with surprising speed. My friend John Robb writes that it’s a cascading collapse of ever larger bubbles. It starts small and grows to encompass the entire global financial system.
- Small. A belief in the US consumer. US subprime mortgages collapse. US prime mortgages and US commercial real-estate and consumer credit follow.
- Big. A belief in the Shadow Banking system. The investment banking system implodes. Hedge funds liquidate. Money markets/commercial paper seize up. Financial insurance evaporates.
- Bigger. A belief in the global banking and market system. Systemic bank failures. Global markets crunch.
- Huge. A belief in the US as a global economic power. US treasuries and the dollar crash. Numerous national bankruptcies
A critical point to realise for investor is that creating more debt and credit is not going to solve the problem. The bad debts need to be liquidated and the people who made them need to be replaced by better capitalists who can put available savings to a productive use. Yet propping up the people who got us into this mess with more money is precisely the response we are headed for. In an interview with CNBC last week, Jim Rogers predicted an ‘Inflation Holocaust.’
In an effort to save their own skins and prevent consumers around the world from a very healthy and natural return to living within their means, global politicians are again making a bogus promise that everything will be fine if we just borrow more money. By doing so, they’ve upped the ante in the crisis and put the entire financial system-in its current form-at risk.
Will the 2003 lows on the ASX and Dow be taken out?
Before we get to the larger question of what will happen to the global financial system, let’s return to the more immediate question of what stock markets are going to do when they open Monday (assuming they do, in fact, open for business as usual). Without a clear plan emerging (as of yet) from the G20 meeting in Washington (it followed the G7 meeting), the futures in Asia are down, although the ASX/200 futures are up 27 points as of this writing.
Where stocks go from here depends on what they are pricing in. Remember, stock markets are forward looking. The market tries to determine the current value of future earnings. There are two factors that cloud that picture right now: the credit crunch and a global recession.
The crisis in the financial sector was not successfully quarantined. Banks are not only unwilling to lend to one another, but to anyone at all. Hence the freeze in the short-term commercial paper market. Companies that relied on the money market and commercial paper market to fund payrolls and inventory now have to go straight to the local central bank. Wire service reports from the U.S. suggest General Motors may soon borrow directly from the Fed.
The earnings picture is nearly impossible to paint if the credit markets remain locked up like this. We simply don’t know who can get credit from the Central Banks and who can’t. Who will fail and who will survive? Who will have to cut prices or slash payrolls?
The other factor weighing on shares is the emerging fact that we are facing a synchronised global recession. If consumers are also denied access to credit, consumption must decline as savings rates rise. Unless retailers slash prices (and profit margins) we don’t see how they will sustain revenues for the last quarter of 2008 and the first quarter of 2009, much less increase them.
That means stocks would have to begin factoring in a dramatic decline in consumer spending and 2009 earnings. The analysts would prefer to do this in piecemeal fashion. The market will likely do it in a few lump sums.
3,500 or Taking out the 2003 Low?
Last week we published analysis by our chartist and Swarm Trader Gabriel Andre. Gabriel said the first line of resistance for the ASX/200 would be at 4,300. That support was taken out on Friday. If the index is unable to regain it, Gabriel highlighted the next line of resistance at 3,500. That decline would be just 460 points from current levels-or 11.6% in percentage terms (one very bad day of trading or two awful days, at this rate).
An 11.6% decline from the current levels would put Aussie stocks back at 2004 levels. You’d have to think that the big blue chip miners would start to look extremely attractive at those prices-once (and if) the banking crisis is quarantined (via nationalisation and equity stakes). Cashed-up private investors might be willing to come in from the sidelines at that point, lured by the valuations.
But we have drawn a third line on the index where the 2003 lows are. We should consider the possibility that the current crisis is going to wipe out all of the equity gains that began with the low-interest rate cycle in 2003. The March, 2003 low on the ASX was 2,715. A fall to that level form 3,960 would represent a decline of 31%.
Obviously a decline of that magnitude on top of the 40% drop from the October 2007 high is astonishing. Remember, the closing high for the ASX/200 was 6,853 on November f1st of 2008. A decline to 2,715 or below would represent a 60% fall on the index (which curiously coincides with one of Gabriel’s key Fibonacci retracement levels.)
2003-2007: A Bear Market Rally
Could the market really give up 60% from its all time highs? The argument to support this retracement starts with the claim that this bear market began in 2000, not in 2007. Stocks declined for three years as the market purged the easy money created in the tech boom.
Then a host of a factors-cheap exports from China and Asia to keep down consumer price inflation in the West, low interest rates to fuel simultaneous booms in housing, shares, bonds and commodities-conspired to prevent the bear market from doing its work. Globalisation and interest rates banded together to give us a mighty, but unsustainable boom.
In essence, this view suggests that the entire rally from 2003 to 2007 was simply a rate-fuelled rally in the midst of a secular bear market. It you accept that view, then it becomes quite easy to see how the 2003 lows could be challenged. And if the view is correct, they won’t just be challenged, they’ll be taken out and a new low established.
For this scenario to unfold, you’d have nothing less than a global financial system reboot. It would represent the complete collapse of the global system in which American consumption, fuelled by credit, is the engine of global growth. It would also mark an emphatic end to the system whereby global exporters keep their currencies artificially cheap against the U.S. dollar in order to remain attractive to the U.S. market.
You could also expect to see a sudden and violent end to the habit of recycling trade surpluses in the U.S. stock and bond market (a form of vendor financing that no longer makes sense when your customers are broke and can’t get credit.) The Treasury market would see much higher interest rates and the U.S. dollar would crash (especially against gold, oil, and commodities, giving us the ‘Inflationary Holocaust’ predicted by Jim Rogers).
This series of system shocks would eventually bring about the long-anticipated “global rebalancing,” where Americans save more out of necessity and the developing world eventually consumes more of its own production. On the American side, it means lower levels of consumption, more saving, paying down debt, and investment in real wealth production (infrastructure and energy rather than residential housing and shopping malls).
For the developing world, it means more investment in domestic infrastructure and the domestic economy. Savings will have to be unleased locally to finance this investment, rather than loaned to rich Western countries to finance deficit spending. And with rising per capita incomes and the beginning (yikes) of consumer credit, you’d expect to see higher rates of consumption on consumer and durable goods, all of which is resource intensive and in the long-run, very good for Australia.
But all of that is an enormous shift, a huge wealth transfer from the consumption and debt based economies of the industrialised world to commodity producers and high-savings nations in Asia. It is the Money Migration at light-speed. It creates real wealth for investors while destroying bogus balance sheet value for bankers.
In the meantime, you can expect global policy makers to try and engineer some replacement for the broken system of global finance. Italian Prime Minister Silvio Berlusconi called for a new “Bretton Woods.” It will involve ever greater monetary cooperation and centralisation.
It is worth noting that the G7 nations think they will be the architects of the new financial system. It has not occurred to them that perhaps the global balance of economic power is now tilting away from Europe and America toward something else entirely. More on where this leads in tomorrow’s regularly scheduled Daily Reckoning.
The Best Value in the Resource Share Market
For now, suffice it to say that there IS real economic growth in Asia. And once the global economy emerges from the recession induced by the collapse of the leveraged credit bubble, demand for the resources to build the developing world will resume. Valuations in the resource sector will not be driven by speculative money hitching a ride on soaring commodities prices (the first phase of the commodity boom).
Instead, valuations will be driven by solid balance sheets, excellent projects, and good management (the second phase of the commodity boom). For Aussie resource share investors, it means it will be your best chance since 1987 to buy best-of-breed resource companies leveraged to the urbanisation, industrialisation, and infrastructure trends that are making Asia the new engine of global growth.
But how do you know where to begin your search? In light of the crisis and the appetite for helpful analysis, we’ve elected to publish a small section of the latest issue of Diggers and Drillers, normally available only to paid subscribers. In it, you’ll find what editor Al Robinson is doing now to turn this crisis into an opportunity.
Al has selected his four favourite cash-rich Aussie companies to emerge from the crisis stronger. To protect the investment made by paid-up subscribers, you won’t read about those four in this free sample. But we have given you a table of ten firms Al researched and what he found.
How to Find the Safest, Cheapest Resource Stocks During the Crisis
By Al Robinson, Diggers and Drillers
How do you know which undervalued stocks will survive the mauling in finance? You search for the ones with quality assets and cash. Cheap mining and energy companies can use cash to shield their currently-oversold mining, oil, and gold assets.The businesses survive. The cheap assets live on and rise to their real value.
That means steady, satisfying, long-term investment gains for you if you play your cards right in the next few months. I’ve scanned the entire resource market and laid out the ten of the most cash-greedy stocks. They have some of the most profitable assets; oil wells, coal mines, gold reserves and iron deposits. All are going on a massive sale this month.
But these ten companies are sitting on a $2.1 billion mountain of cash. That’s your ticket to safety.
Ten Oversold Resource Firms, Each with a Shield of Cash
This selection includes both producers and juniors. It includes energy and mining stocks. It includes small-caps and mid-caps. It’s a table with variety. But they all have big cash accounts in common. Of the resource shares in the top 300 listed Australian companies, these companies have the most liquid backing. They ooze safety compared to the rest of the market. They’re getting cheaper just as fast though.
They have minimal short-term debt maturing in the next year. That’s just as crucial as the cash balance itself. These companies have liquid assets unsoiled by heavy borrowing. They aren’t leveraged to the credit crunch through debt exposure. They are leveraged to the resource boom through asset exposure.
All up, these 10 stocks have over $2.1 billion in cash on hand right now. Their market cap is $6.2 billion. Over 35% of the equity here is un-invested and un-spent.
Credit stretches and contracts like a length of elastic. That gives credit-based companies a wild ride up and a wild ride down. But cash doesn’t stretch. It’s solid. It sits there. It does nothing until you need it. That time has come.
Overall the companies above have less than $1 million in short term debt. It’s insignificant. And above all, every single firm owns a quality project that the market is chronically devaluing this month.
Six are energy stocks. That’s not surprising, considering the massive boom in energy company cash-flows over the last year and a bit. Oil, gas and coal assets have leapt in price. Liquidity has flowed to the companies that own them. These ones held onto it.
But the juniors have cash too – if you’re brave enough. Some aren’t producing yet. They’ve filled their wallets with clever financing methods instead. And the juniors on that list are still getting a lot of attention from important investors.
The Daily Reckoning Australia