All the stock-market gains since Alan Greenspan warned on "irrational exuberance" have gone...
HERE'S A THOUGHT for you, writes Dan Denning in Melbourne for the Daily Reckoning Australia.
The economy is turning into Barack Obama's Iraq. Have a think on that and we'll get back to it in a moment.
Meanwhile, there is not much we can tell you that you don't already know about the global rout in stocks. Wall Street is at twelve-year lows. The FTSE is at six-year lows. And here in Australia the market has opened lower than its five-year low, as you'd expect after such a wretched overnight performance on global markets.
On a side note, a large cloud of brown plane tree leaves has just blown down the street across the way. We're watching from our perch on the second floor of the Old Hat Factory. Gale force winds are blowing through Victoria today.
Back to the markets and the banks. Moody's has said that the AA1 ratings on the Commonwealth Bank, ANZ, and Westpac are no longer secure. Moody's analyst Patrick Winsbury said the Aussie banks could survive the global collapse better than most, but that "The negative outlook reflects the potential for the deepening global economic downturn to have a protracted impact on the banks' asset quality and earnings."
If the Aussie banks are re-rated by investors (downgraded), it's exactly the sort of thing that will lead to taking out the 2003 lows in the 2,700 range. That may sound severe-wiping out all the gains of an epic resource bull market. But keep in mind, the Dow crashed under 7,000 – a place it hasn't seen since 1997.
The Aussie indices, meantime, are highly vulnerable to the big four banks and the big two miners. You can see that Rio and Macquarie Group (which we included as an example of how discredited the investment banking model is now) lead the charge lower.
But over the last year, the big four and BHP have managed to fight earnings gravity. If that changes for whatever reason – like seven of Australia's top ten trading partners being in a recession – the lows will be taken out. And probably sooner rather than later.
Put plain and simple: All the gains in equities since Alan Greenspan uttered his famous words about irrational exuberance have been wiped out. All that remains to know now is how irrational the downside would be. The good news is that you're seeing signs of capitulation. Investors are giving up on stocks for the long-term.
For example, we got a text message this morning from a long-time bull. He always finds reasons to disagree with our analysis. He texted early this morning after watching Wall Street's depressed closing.
That's not quite a buy signal. But it's not a bad sign either.
Across the world, the trouble is with the banks. HSBC will slash its dividend and do a US$17.7 billion rights issue to shore up its capital. Will shareholders pony up...?
In the United States, AIG reported a fresh $61.7 billion loss. The company guaranteed some $450 billion in credit default swaps. European banks are its big counter parties, with some $300 billion in exposure outstanding.
You can see why the US government is flushing money down AIG as fast as it can. If AIG is downgraded, it triggers more losses for European banks, which already have problems on their Eastern front to begin with. In fact, the more we think about it, the more we agree with John Robb that this is not just a stress test of financial firms. It's a stress test for national governments.
Banks and governments have co-evolved to get to this point where we are today in the modern world (where interconnectedness and complexity threaten to crash the system). The "Cash Nexus" as historian Niall Ferguson calls it, is the murky relationship between fractional reserve banking, perpetual government debt, and the fiscal warfare/welfare state. That is, governments would never have the money to build powerful military machines without modern bank financing and the bond market (where banks buy and sell government debt, bridging the gap between private capital and government borrowing).
Similarly, banks could never have gotten as large without the regulatory and legal framework set up to favor them. And of course it would favor them.
A few things have changed in the last ten years. The main one is that leaders have become looters, be they political or corporate. On the political side, instead of conventional armed conflict, which had diminishing marginal returns (in addition to being really unpopular in a culture addicted to leisure) governments have gotten into all sorts of other wars, mostly against their own people (War on Poverty, War on Drugs, War on This, War on That, War on Everything, War on You.)
And for their part, the banks and even non-bank lenders figured out that if the government was going to encourage home ownership for political reasons by discouraging rigorous lending standards, then the best way to deal with the increased risk was to sell it!
Alan Greenspan called this "disaggregation" of risk. But obviously securitization did not lower systemic risk. It heightened it. But for a little while anyway, the banks and bankers made a mint off of the government's desire to gear the entire national economy towards the goal of home ownership. This happened in Ireland, the UK, the US, and Australia to name few English-speaking companies.
You'll forgive us if we don't quite have our head wrapped around the idea yet. It's a work in progress. But yes, we are suggesting that the co-evolution of the modern welfare/warfare state and the financial system has been impacted by a financial meteorite of sorts.
The co-dependency has always required a little inflation to keep it going. But lately, the last one hundred years or so, it's turned into a lot of inflation. The expansion of global money supply through fiat money (i.e. not backed by a tightly supplied physical commodity, such as – say – the Gold Bullion which underpinned the world's money for the previous 5,000-odd years) and widespread credit has created an inherently unstable scale of modern living. We have a living arrangement that uses resources too quickly and too inefficiently. And now we have bumped into that fact in a rather abrupt way.
A re-localization of the economy would be something to think about and even plan for. If the centralization of money and power has reached its useful limits, then you'd think we'd be moving away from it. Yet in Washington, Canberra, Paris, London, Tokyo, and Berlin everyone wants government to get bigger and spend more and take a larger role in the economy.
The response to the crisis has become activist and interventionist. This, ironically, echoes the ideological response of the Bush Administration in Iraq.
So meet the new boss...making the exact same strategic mistake as the old boss, only in a different theatre.