The Meltdown Begins
John Browne
Saturday, Nov. 10, 2007
This week on CNBC's "Kudlow & Company," Larry Kudlow asked us panelists, "How come, if things are so bad, [the markets] are so good?"
It was a most interesting question, but very hard to answer in a TV sound bite. So, I will try to explain now, for our readers.
The short answer to the great Larry Kudlow's question is that there is a massive disconnect between "reality" and "sentiment," as well as between our economy and the markets.
How does such a disconnect occur, particularly in our modern age of instant communications?
The main problem is that Wall Street and its friends in the media appear to have placed their bets on never-ending growth and a bull market.
Reality is systematically ridiculed or dismissed as wildly bearish, while any bullish sign is embellished. This creates confusion, even in the minds of the pro-bull cheerleaders themselves.
In addition, many so-called experts look "at" the headlines rather than deeply into them. These same experts appear to be genuinely confused.
For example, last week we had official figures on economic growth (GDP) and on jobs. Looking "at" them, both were heralded as over-the-top positive, "blow-out figures"!
So, what do they look like when we look "into" them, instead?
First, jobs were indisputably up, in total. Good news, you might think.
But the rise was largely in the parasitic, wealth-consuming public sector, up by 65,000 jobs.
Temporary jobs were up by 20,000. So are companies so nervous about the future that they are replacing full-time with temporary jobs? If so, that is "bad" not "good" news.
Meanwhile, in the wealth-creating private sector, and in the construction sector, jobs were understandably down by 5,000.
In the manufacturing sector, jobs were down by 25,000. In the crucial pre-holiday period, retail jobs were down by 22,000.
These figures were not good news at all.
Even the fall in jobless claims hides the fact that as the unemployed become long-term unemployed, their entitlements fall off. It's not that fewer people are out of work. They just stop being counted.
Next, our "blow-out" GDP numbers.
Annualized, third-quarter GDP showed a rise of 3.9 percent. It was greeted with whoops of joy as yet another "blow-out" number. Great news, no?
Well, looking at the more realistic year-on-year number, the same figure shows a more modest, 2.9 percent increase — more than 25 percent less!
Then we have to remember that, in order to account for inflation, these numbers are adjusted downwards by, what is known as the "GDP deflator."
Well, of course, the lower the inflation rate used as the deflator, the higher the GDP figure looks.
Our readers will know that we have long pointed out how our government has distorted — politically "cooked" — the official inflation rate downwards to lower our government's cost of debt and Social Security payments while retaining more economic management credibility.
Despite the protests of the Wall Street cheerleaders, we doubt that many of our readers are experiencing Main Street inflation as low as 2 percent.
We believe that our true, "un-cooked" inflation rate is between 6 and 8 percent.
We wonder what our true nominal GDP would look like if it were deflated not by our "politically cooked" inflation deflator of 2.3 percent but by a more realistic inflation deflator of say 7 percent, or three times more severe?
Our recommendation is that investors remain extremely skeptical of government statistics, if they wish to be aware of what is "really" going on.
If you have been tracking the plunge of the U.S. dollar, you will have realized by now that foreigners and currency dealers have seen the lie in our distorted "official" inflation rate, for some time.
Now, at long last, we hear, even Wall Street experts and their cheerleaders say that inflation is now a "clear and present danger." Surprise, surprise, reality is dawning on them!
Our readers will remember that we have warned for many months of looming stagflation — which is financial inflation and economic recession at the same time. Today, I heard the first mention of it, by one of the cheerleaders, in fact.
As the stock markets adjust downwards, a little, they show us again that, in fact, reality is dawning.
Sadly, the full glare of sunlight has yet to arrive.
In addition to the gradual dawning of the reality of an economic recession, I now see increasing evidence of a deepening financial crisis.
Tuesday, a Financial Times headline ran, "Banks are braced for months of pressure." Wednesday their deadline was, "Risk rises of asset fire sale."
We know that, in 2008, over $500 billion of adjustable-rate mortgages (ARMS) are due to reset. In 2009, a further $300 billion are due for reset. In advance of this, mortgage default and non-performance figures are already rising fast.
In the meantime, the amount of "toxic waste" mortgage-related derivatives is already estimated to reach $250 billion.
We have heard, so far, from Merrill Lynch, Citigroup, Morgan Stanley and now Wachovia. But it is unclear how much more they could announce, and who else will have to write-down big losses.
In this case, I do not believe that no news is good news!
There are some more large shoes waiting to drop in banking. When they do, before the advent in 2008 of the new, post-Enron accounting rules, I believe they could strain the nerves of many in the financial markets, let alone stock markets.
I now see the dawning of the economic and financial "reality" of which we have warned for many months and the serious risk of an economic and financial meltdown.
We already have a crisis of confidence and thing are looking worse, not better, with each passing day. Investors should take steps to adjust their portfolios to the possibility of a collapse of confidence.
So, as Larry Kudlow says, "Fasten your seat belts!" It is now a time for conservative investors to think less of return "on" capital and more of return "of" capital!
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