The
BIG Picture Transcript
December 22,
2007
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Part 3 Real
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Part
1
Forecast
2007: How Well the Predictions Went
The
Bull Market
Part
2
The
Credit Crisis
Part
3
The
Crime of the Century
Forecast
2007: How Well the Predictions Went
Hello, way back here.
Boy: What is it?
Well, actually, it's a time machine. I call it a way-back. We just set it, turn it on, open the door and there we are.
JOHN: And welcome to the Financial Sense Newshour year in review with Jim Puplava and John Loeffler here. And Jim, I always like these programs. These are the fun ones of the year because we stop, take a pause, take out the way-back machine, look back at the beginning of the year, see what was said on the program – not just by people here in the studio, but also by our guests – what were our predictions, and their predictions as well, and how accurate they were. Let's see what the score is.
So how are we going to splay this all out in a way that people can understand? I know we have seven areas that we're going to be looking at and they are: The forecast that we did at the beginning of the year for 2007 – what? We predicted a bull market, a credit crisis, the rise of the price of oil, but oil becoming more and more of a security and monetary issue; something you're calling the crime of the century; and monetary and fiscal stimulus and then the rise in inflation which we're going to see probably again in this year. So how would you like to tackle this? This is a big chunk to bite here.
JIM: The amazing thing is you look back, John, some of the bigger issues, where did they originate, how far did they go, where are they leading us. So we're going to try to cover this over a two-week period because there is simply too much material here to cover in one issue. And I just want to let our listeners know that these next two shows this week and next week are not going to be our regular shows. It's more like an extensive Big Picture. We're not going to have the experts with us, and we're not going to be doing Q-line calls. Unfortunately, there is just too much material. But we're going to try to get through this –we'll take a look at some sound bites made through the year, either by officials or people on the show or actually ourselves in terms of how this thing unfolded. So, I guess back to you, John. Where do we begin? [2:42]
JOHN: First of all, I'm glad you didn't say that we're not going to have a normal show. There is nothing normal about you or me in any way, shape or form. Okay? That's what makes the program, I guess. Number two, why don't we just start out with a clip. We're going to hear a lot of clips of things that people said. This was a discussion here with Frank Barbera, Peter Schiff, James Turk and Bill Powers. That will kick us off here on the football game of the year.
JIM: Let me bring Jim Turk in here. And Jim, you have written that in an inflationary era, which I think many of us all believe that we're in, be very careful about things going into a crash or deflating tremendously because of the amount of reinflation or inflation that's being poured into the system. You pick up a copy of The Economist, go to the back of the magazine every week and take a look at global money supply. It’s being cranked all around the globe. So I'd like to get your take on real estate.
JAMES TURK: Two things. First of all, I agree with what Frank was saying that there is going to be some kind of financial institution impact on this. If you go back to the 1980s, for example, with the real estate collapse then, it literally brought down the Savings and Loan industry. I don't know what the weak spots are, but subprime lenders are obviously the first candidate, and that's probably going to spread to other areas as the problems with real estate become more apparent.
But in response to your question, Jim, about the inflation-deflation issue, in my mind it's really quite simple. You first have to adjust which currency you are going to measure prices in. If you measure the prices of homes in terms of gold, you're going to see deflation. In other words, the price of gold in dollar terms is going to rise and the price of homes in dollar terms is going to go down. But if you look at the price of homes in dollar terms (other than maybe some areas which are particularly unique because of circumstances of over building, condos in Florida – things of that nature), generally speaking, real estate is probably not going to be significantly impacted in dollar terms – much like it was in the 1970s. You had monetary problems that ultimately caused people to leave the dollar into tangible items. And real estate is a tangible item. There were areas in the 1970s that were particularly hard hit: Southern California for example during the Lockheed crisis, home prices went down. And this time around you're probably going to see areas hard hit as well in dollar terms, like I say, the condo market in Miami. But generally speaking, I think you're better off owning real estate than having dollars on deposit in a bank account. [5:09]
PETER: Well, fortunately though those aren't our only choices. Yeah, I think between dollars and real estate in middle America, you might be better off. But I don't think real estate is going to be a good inflation hedge, as I think people who have wealth in real estate are going to be a lot poorer as a result, relative to people around the world. So rather than having money in real estate if you're worried about the dollar going down in inflation, you should have your money in something else: like if you're going to own real estate, own commercial real estate in Europe or Asia, or own commodities, or own gold or just own bank deposits in foreign countries. [12:26]
JAMES: Yeah, I agree with you there.
PETER: You're going to be a lot better off there. I mean personally, I don't own any real estate. I have no problem renting beautiful houses for next to nothing and I use the income from my foreign investments to pay my rent. And eventually, when the dollar does collapse, even if real estate prices don't go down in dollars but they lose 90% of their value relative to everything else I own, then I'll sell some of the things that I own and buy real estate. [6:00]
BILL POWERS: I just want to make a comment as far as diversifying away from the dollar and that's something we're seeing increasingly from OPEC countries who had a real boon over the last couple of years as far as revenues. We're also seeing the Russians also move money away from dollars. That's something that is becoming much, much more common. I know especially in Muslim countries there is a strong affinity for gold, and not holding dollars. So I think that really what we're going to see as far as inflation goes, I think there's definitely going to be inflation in commodity prices – specifically oil because it is priced in dollars. We are seeing as the dollar will weaken, there's plenty of support for oil at $60, and well above that, for a variety of reasons, not just political but also geological reasons that I think oil will head a lot higher from today's levels. [6:51]
JIM: Well, speaking of oil, that round table was done the first week in January when John, you remember, oil was down to around $50 a barrel, and the guys were wearing short-sleeved shirts in New York. And the experts were telling us at that time that with oil at 50, we were heading to 30 and 40. I asked a question on that panel the first week on oil believing that fundamentals were pointing to higher, not lower prices. John, play that clip of Bill Powers and Joe Dancy responding to my question.
JIM: Let me bring up the issue of energy here because a lot of positive comments that you saw the opening day of the year, where the market went up and then it pulled back, was because of the sharp drop in energy. And the feeling is the global economy is slowing down. There's going to be less demand for energy, you've seen the CRB index breakdown, you've got oil prices at around $56 a barrel, you've got gold getting hammered in the markets. For Joe and Bill, I want you to come in and give your take on energy because the fundamentals, I think, have never been stronger for energy. And is what we're seeing in the market more market motivated than it is fundamental oriented?
BILL: Really my thought as far as what happened – and here we sit three trading days into the year and it's really been a very ugly episode so far this year, especially with crude going down close to $6 in two sessions – is what part of that was commodity prices (or at least on the NYMEX) were able to be pushed to extremes for relatively short periods of time. And I think a lot of that had to do with the very warm weather that we are experiencing. I mean, it really doesn't have anything to do with such a violent move over such a short period – anything to do with fundamental supply and demand. It has more to do with the outlook of weather for next week, or how warm it was over the holiday.
And really, I don't believe that we're going to see crude under $60 for very long. I certainly think that natural gas also, which has now fallen almost $3 over the last six weeks or so from $9 all of the way down to a little over $6, has support to trade in the 7.50 range for 2006. And I think crude could easily trade around $65, since I don't think the economy is going to affect it as far as dampening demand. That’s because if we go back –and history tells us, slowing economies don't necessarily mean dropping oil and gas prices – if you look at 1984, in inflation-adjusted dollars, crude oil traded between $55 and $65, but yet we had 7 ½% GDP growth that year. So clearly we could have high commodity prices and a fairly decent economy – as well as an economy that is slowing. [9:39]
FRANK BARBERA: I'd like to jump in on that for a second and just add to that the idea that there's a real U.S. centric view of the weather when it comes to energy, and we tend to look at our own inventory levels, and act like that is the sole driver for setting prices worldwide. And I think that's a big variable that a lot of people aren't taking into account: the fact that when you look at China's growth rate, India's growth rate, those economies are still in the early phases of an industrial revolution – the type of event you don't see more than once every hundred or two hundred years. It's a unique event. And within that type of growth process, even in years when the economy slows a bit, the demand for energy tends to consistently rise. It just doesn't rise as much. So I think there's a bit of a US centric view that is distorting the overall view on the commodities right now. It's a lot more bullish than people think. [10:31]
PETER SCHIFF: Of course in the long term, you've got a supply problem too. I mean even if demand is contracting, if supply contracts faster, prices can still go up. I think the recent move down in oil prices is not so much a function of the weather, that might have been one of the catalysts, I think it's a function of having 9000 hedge funds out there. A lot of them are in these markets. A lot of them are very leveraged. When you get 20% of the upside of someone else's money, there's a lot of reasons to take on a lot of leverage. And so what you see are moves [when] you have a lot of people coming to the same conclusion at the same time trying to get in and out of the market – and you can get big volatility. And I think this type of volatility is a function of the number of people in the market and how much leverage there is. And I think it can work just as quickly the other way. So as fast as oil prices are dropping they can go up almost as fast. [11:19]
JAMES: I agree with you on that, Peter. This week particularly it looked like it was a selling climax and was driven principally by margin selling, not by any kind of rational decision making. Just the tempo of the way the market was selling –the news items and everything else – this could very well be a selling climax, not only in commodities in general but gold and silver as well. [11:38]
JIM: I would throw something out and I don't know why the markets focus so much on the inventory numbers but I'm going to address this to Bill Powers. I'm looking at a graph of crude oil in terms of days of supply, and we're down to a little over 21 days supply. So you can trumpet all you want about all of these inventory levels, but we consume a lot more oil today than we did five or six years ago. So I think the more relevant figure is how many days of supply of oil do we have.
BILL: Yes. I would say that's an excellent point: days coverage is really the important number to look at, not the absolute level of inventories. One of the things that I have been somewhat surprised at is while we've had a weaker than expected inventory report this week, which has put a lot of faith in because it is a holiday-shortened week and a week like that you can get numbers that are well out of the range, but we've had the supply of crude really come down significantly over the last six weeks. And I think the trend is really what is important here, is that we're getting that back to inventory levels that are more normalized, and that are on an absolute basis, and actually at the lower end on a days coverage basis. So I think you're absolutely right. And fortunately there is going to be some very cold weather – at least hitting Chicago here in the next 10 days – so I think that it's very likely we will see a reversal very soon. [12:59]
[Phillip E. Colmar Sr. Editor, Global Fixed Income Strategy, BCA Research "Forecast 2007"]
JIM: One thing that you state in your forecast, which I highly agree with, and that is you doubt that asset inflation has come to an end. There’s still a lot of money out there that’s hunting desperately for returns. In fact, asset prices generally do well in an economic environment where there’s adequate liquidity. I think one of the amazing stories about this – and this gives evidence to this liquidity issue – is if you look at 2006, up until about August, all asset classes did well. I mean, oil was doing well up until August; bonds did well; stocks did well. It was pretty hard finding something that wasn’t doing well, other than real estate which was starting to soften.
PHILLIP COLMAR: And that’s true. And I think that again, you’re right, it does fold back onto a liquidity cycle or liquidity conditions (excess liquidity). One is that I guess the reasons for liquidity is probably important and that’s why it’s probably not going to dry up quickly. In the environment I expressed there, the structural environment which we’re in with rapid industrialization in many of these countries, is that you’re getting excess liquidity being built up in the places that are growing rapidly. Emerging Asia is a good example of that: A lot of growth in potential is occurring in emerging Asia; they’re building tremendous amounts of profit and therefore excess savings. And this is a region of the world, unlike the US, that saves a tremendous amount. So you have China, for example, over the last 5 years, savings rates have gone up from about 35% to 50%, which is not uncharacteristic with the rest of emerging Asia. At the same time, you’ve had windfall opportunities within the oil-based countries in the Middle East, and they to date haven’t spent to accumulate the excess savings. And for both of these reasons – emerging Asia and the oil countries – haven’t, while investing, invested nearly enough to absorb the excess savings. And as a result, the excess savings get recycled back into asset prices, and financial markets worldwide. But they’re not the only places. Latin America is also a net lender these days.
And other reasons for it is financial sector health is very strong worldwide, and they’re being able to fund a lot of their Capex expenditures out of cash flows. They’re not needing to go to the markets and borrow money. And they’re not using up the savings, which then stay within asset prices.
And I guess the final reason really for the liquidity story, which has been tremendously bullish in recent years, is financial innovation, if you will. Maybe to put it another way, these financial innovations have allowed corporations and consumers to really optimize their balance sheets – let me put it that way – and extract liquidity, or take on more leverage in assets they haven’t been able to before, such as housing, or elsewhere.
As well, when you end up with a stable environment (as I characterized at the beginning where growth is inherently self-regulating and somewhat stable, we’ve seen volatilities in growth worldwide decline dramatically) it encourages businesses – and will, as we see through M&A activity and LBOs – to take on more leverage to optimize shareholder value. And it allows the consumer to take on more, because they’re not worried about losing their jobs, and potentially not making mortgage payments. So that unleashes a lot of liquidity, which has been pretty bullish for asset prices in general. Combined with the fact that central banks, without inflation, they don’t need to overdo it – they don’t need to knock these economies over the head and extract liquidity rapidly. So we’re left with fairly abundant liquidity conditions worldwide which will feed into asset prices. [16:34]
JIM: Well, you know, John, I want to go to that final cut from Bank Credit’s forecast. They were predicting a mid-cycle slow down. In other words, we would not see a recession in the economy in 2007 – a point I agreed with. Just a short clip. Let's play that, if we could.
JIM: So your thesis that you’ve been predicting of a mid-cycle slowdown in the US economy – and certainly that played out last year – you see that playing out this year as well. In other words, maybe we get to 1 ½% to 2% growth rates in the economy but not a recession.
PHILLIP: We do think the mid-cycle slowdown has got a bit further, probably the first two quarters of this year. Probably in real growth terms I guess growth has dropped down to 2 ½-ish – it’s running at about now. Although we don’t do point forecasts. I mean in general we expect it to trend here, or maybe marginally weaker in the fourth quarter. So it’s not a real massive drop in any way – enough, because it’s below trend, to bring down inflationary pressures further; enough to encourage the central bank over time to ease. So I think it’s there. Maybe it doesn’t hit below 2 – gets down to 2 or something. But nonetheless, below trend for the next couple of quarters. I think that’s kind of where we see the environment, which isn’t that bad for profits: you get a bit of a disappointment and a couple of quarters from where expectations are, but you get the interest rate relief, as I said, to support conditions. And then ultimately, it will lead to a re-rating in equity prices. [18:10]
JOHN: All right. That was back on January 13th of 2007.
Let's turn our attention now to Dr. Marc Faber who publishes The Gloom Boom & Doom Report. And you began your interview with Dr. Faber discussing global liquidity and the debt supercycle which is a thesis that BCA promotes. So we're going to pick up on that discussion because it basically paints the picture of the liquidity injections that have become today's headlines when nobody was talking about it. This was on January 20 of 2007.
JIM: Marc, it’s interesting though as you’re talking about this liquidity and some of the disruptions that we have seen in various asset markets, the well respected Bank Credit Analyst in their forecast issue for 2007 has the headline which is Another Year of Riding the Liquidity Wave. Can central bankers pump out enough liquidity that maybe we can postpone this for another year or do we really get that lucky?
MARC FABER: Well, I’m just writing about this in my Gloom, Boom & Doom report because basically the theory of the Bank Credit Analyst is that we are in a debt supercycle. Let’s say you take the debt supercycle you could say started in the early 80s when debt to GDP was 130%, we’re now at 330%, and this would be by accounting standards of the government – let’s say private accounting standards would put the debt of the US government at much higher levels because of the unfunded liabilities. But let’s say we’re at 330%. Yeah, it’s possible we go to 400%, maybe to 500%. My point is – and I have here to also point out to another report that was written recently entitled Apocalypse Now.
This report makes the point that this year we are in one of the most dangerous financial situations and that we could experience very serious setbacks: a) in the global economy and b) in asset markets. And to that I have to say, I don’t know when the supercycle in debt and credit will end. It will end one day. And one day you will have apocalypse. So if someone came to you and said: “Look, the brakes on your car are going to fail one day you have the option: do you want to fix them or doing nothing about it.” My view as an investor is: it gradually doesn’t pay to be in financial assets. I think that all assets are vulnerable, but one of the least vulnerable is probably precious metals simply because in an inflationary cycle (which a debt supercycle would be) precious metals will do well anyway. And if the whole thing collapses it will be so ugly that you’d probably be happy to be in precious metals rather than in equities. [21:30]
JIM: You know, Marc, according to Austrian theory, you can avoid the day of reckoning by expanding credit faster and faster. In fact, Kurt Richebacher recently talked about how credit expansion has grown at a faster rate over the last 3 or 4 years, and especially when Mr. Greenspan began the most recent rate-raising cycle. Is it your opinion that one of the key indicators to watch –perhaps, this year – is what happens to credit growth, because I know commercial and industrial loans have already begun to slowdown? Is this something to keep our eyes on this year?
MARC: Yes, I’m sure, but I think that the key issue to watch is actually the performance of the stock market – specifically the emerging markets. If the emerging markets start to perform badly after their strong outperformance it’s kind of the canary in the coal mine. In other words, that would be the first signal that liquidity is somewhat tightening. Of course I look at credit growth figures and so forth, but equally the performance of: emerging markets and in my opinion, the increasing performance of financial stocks, brokerage stocks. The subprime lenders have already collapsed, they’re signaling essentially bad times ahead in the housing market, and much worse time than people expect in my opinion. And the brokerage stocks are still in the sky, but I think that once the brokerage stocks and emerging markets start to break that would be a signal to be very careful. [23:32]
JOHN: And that was back on January 20th of 2007.
JIM: I want to cover a point here that we've been making all year long, and that is it isn't only the dollar that has a problem. It's all of the currencies, John. We live in a fiat world. They are all printing money as global money supply across the globe rises at double digit rates. Let's go back to a clip made from that January 20th interview.
JIM: I want to move on to the dollar. We’ve seen in the last couple of years, central bank diversification outside of the dollar but nonetheless we have Asian and OPEC trade surpluses that are close to one trillion dollars a year. Where does the dollar go? If the dollar falls, how do you avoid inflation in the United States? In other words, you hear many on Wall Street and in Washington saying that the dollar needs to come down to fix our deficits. But if the dollar comes down, and we import so many things into this country, how do you avoid inflation?
MARC: Yes, that’s precisely a point. But I’d just like to mention one point. First of all, the dollar has been weak since, say, 2000, and we’re down 60% against the euro. I think for the next, say, 3 months the dollar is rather likely to stay here or could even rally somewhat against the euro. That I wouldn’t rule out, because if my scenario of rising interest rates in the US is correct that would be supportive of the US dollar for now. But of course, long term you have to bearish about the dollar. But as I mentioned on previous occasions to be bearish on the dollar one has to define bearish about the dollar against what. And to that I just have to say, we have a US monetary authority –the Federal Reserve – that prints money, but in other countries we also have paper money, and they also print money. And so I’m not sure that the dollar will collapse against say the euro. I rather think that all paper currencies will depreciate against gold and silver. Because for gold and silver, the supply of these commodities cannot be increased at the same rate as the supply of paper money can be increased. And so from a logical point of view these precious metals will appreciate in value against paper money simply because there will be more and more paper money around in the world. And if I look at the financial situation of not only the US but of other countries as well, and also central bankers and their attitude, then I’m convinced that they will all print money. There’s no other way out of the [German]. [26:57]
JOHN: That was back on January 20th of 2007. Now, we've heard from the experts. Now, let's look at some of the things that you've said, Jim, here on the program, and here's where...
JIM: Don't quote me.
JOHN: I'm not going to quote you. I'm going to play you. How is that? Here's where I get to hold your feet to the fire on this. The first BIG Picture of the year which was back on January 6, I asked you to identify the key economic issues, which at the time very few people were talking about. Notice that Marc Farber on January 20th was already talking about the subprime markets and nobody was talking about it for the most part there as far as an emerging crisis. But here's what you said regarding the same issue on January 6th.
JOHN: If we look at the future from where we stand right now at the portal of 2007, what do you think the key economic issues of the year are going to be?
JIM: I think number one on top of the agenda is going to be real estate, because this is the year where we know there is over one trillion dollars in mortgage resets on these variable rate loans. How much of that is going to sink the market? Let's face it, you've got a lot of people that have gotten into adjustable rate loans that could barely squeeze to get into a house to begin with, but they were doing it on the idea that the home will continue to appreciate: “Even though we're squeaking by, we'll make it up as our house appreciates.” Well, as we know, housing prices are coming down. They are not appreciating. And a lot of these people, now, are barely squeaking by. It's kind of like my Wheelers from my Day After Tomorrow. There's a certain segment of the housing market that – I mean these people are going to sink this year. Their homes are going to be foreclosed on. They are not going to be able to meet the higher interest payments. You already have subprime lenders that are going bankrupt. I think that is going to start to increase and accelerate as you move into the year.
So the real key this year in my mind is going to be real estate, and whether the real estate recession is going to sink the rest of the economy. And I think a lot of that is going to get into this second key economic question this year: will the Fed or will it not raise or lower interest rates? So what is the Fed going to do? The sooner the Fed begins to hyperinflate and lower interest rates, the better chance they have of staving off a recession and staving off a housing collapse. So what the Fed is going to do is going to be a second key economic issue.
And of course, thirdly, is we've seen this wonderful wave of back-to-back, more than four years of consecutive quarterly double-digit profit growth. I think that's going to come to an end this year. It's just a matter of does it get down into the high single digits – which is still respectable. And if interest rates come down, you can see expanding PE multiples in the market. So the profit question of what happens as the economy slows down, how that's going to impact corporate profits.
And then, I think, another issue is what happens to the rest of the world. That’s because in this global recovery, which has been synchronized globally, it's not just been the US, it's also been China and Asia that have been the economic drivers. China's industrialization, India's industrialization, the growing industrialization of Asia, of Vietnam, Korea, Indonesia – those countries are playing an ever increasing important role in terms of global economic growth. So if we begin to weaken, what happens over there? There are a lot of people saying Chinese economic growth is going to slow and have a hard landing. I don't buy that story. Maybe they don't grow their economy 11%, but maybe they grow their economy 9 or 10%. I certainly think India can grow their economy 7 or 8% this year. So what happens internationally to offset what is going on internally in the United States, I think that's another key driver. [31:06]
JOHN: And that was January 6th of this year. I also asked you about the stock market in that first show and for a summary of what you thought some of the issues were going to be.
JOHN: Let's make a jump here from the economy to the stock market. Here we are the first week in the year. The Dow Jones is down. The S&P is down. The only thing that's up right now is NASDAQ. So what are we looking for in 2007 as far as this goes?
JIM: 2007, the consensus forecast is for a higher stock market, both for the Dow Jones Industrial Average, which will be setting a record, and also for the S&P. The consensus is the S&P will go higher. The real bullish people think that the S&P finally takes out its old record set back in 2000. Higher stock markets all the way across the board, John – a higher Dow, higher S&P and a higher NASDAQ. [32:01]
JOHN: Obviously, everybody out there is giving their predictions and their prophesies right now. And if we have to say where the consensus falls – give it to me within one standard deviation – are they bullish? moderately bullish? bearish? What's the look?
JIM: Well, you know, the consensus forecast is a Dow (that we ended on this Friday that we're having this show at 12,398, down for the year from the highs of last year) over 13,000. You've got people at the very top like Bernie Schaeffer who sees the Dow going to 14,400. You've got Ralph Acampora who thinks the Dow will be at 14,200; Elaine Garzarelli, 14,200; Ed Yardeni, 14,000. You've got a lot of people in the 14,000 camp. You've got a lot of people in the upper 13,000 camp.
And maybe the broad majority, let's say the middle section of the forecast, is between 13,000 and 13,500. You even have a lot of people – about 5 or 6 – people that think the S&P 500 could take out its previous high set back in the year 2000. The NASDAQ, you know, it's got a long ways to go before it gets over 5000. Even the most bullish people that I saw on the NASDAQ, I think one was forecasting, I think, somewhere about 3000 on the NASDAQ, which would take it from where it is today at around 2400. But not much more bullish than that. So if you look at the theme of what they think is going on in the market, definitely, the Blue Chips are going to be the main beneficiaries of a slowing global economy and a slowing US economy. So that's why if you look at these forecasts, they see a higher Dow – a record Dow, that is; and a possibility of a new record in the S&P.
Certainly if we look at this decade, anything the S&P does this year could be record breaking, and especially if you're talking about the S&P going up from its current position of 1409 to a consensus position of 1500. I think the highest forecast for the S&P was, like, 1,619, and 1620. Those were sort of the two highest figures. But if you look at what people are saying: Blue Chips, the large cap growth stocks. And I happen to agree with that opinion, that's something we've held opinions on since last year when I forecast a new record on the Dow.
So higher markets overall, John, and it's going to be primarily oriented toward the large cap growth stocks as the economy begins to slow down. [34:51]
JOHN: And finally, in the course of our conversation on January 6 of this year you summarized the scenario that you thought would unfold before the Fed would begin to lower interest rates. Well, I have to admit: On this one you were right on in your predictions. So let’s go back to January 6th and listen to what you said would unfold as the year played out. Here’s that cut.
JOHN: Well, last year you were talking about first the gain, and then the pain – which is really a bummer because a lot of times the people who get the gain are not the same ones who take the pain. But why don’t you summarize here what you think is going to happen?
JIM: I think what we’re going to see in the first six months of the year are the disinflation theme. You’re going to see three things – and I think these three things all need to happen for the Fed to go on pause.
Number one, you are going to see asset deflation across the board. You’re going to see the stock market go down, you’re going to see asset classes across all categories begin to go down; and that’s going to start creating deflationary fears.
The second thing you’re going to see is a further acceleration in the real estate downturn as subprime lenders get into trouble, as the adjustable rate mortgages come up for resets here this year – because I think there’s a trillion dollars. So you see a further acceleration on the downside in real estate.
The third thing that needs to happen is you need to see a rapid deceleration in economic growth. So you start seeing asset markets deflate, real estate, stock market etc.; you start seeing real estate begin to fall apart – as some of the Fed governors were concerned about in the last FOMC meeting. And then a further downward trend in these economic numbers, and they start coming in and you start seeing corporate profits come in weaker in the first quarter. You start seeing some of the downward trends in the leading economic indicators – the ISM numbers really start to go into downturn.
And then when these three things happen you then set the stage for what I call reinflation. So the Fed needs to have the financial market behind it when it goes to reinflate, because if you didn’t, you would have the bond markets saying, “wait a minute, you’re saying there’s no inflation.” You have to have the bond market concerned about credit defaults, default swap premiums starting to increase, credit spreads starting to increase, and you have to scare the pajamas off the bond market. And when you have Paul McCulley go on CNBC and say, “Benny, Benny, Benny! Save us,” you will know we are getting ready for that turning point.
And the second half of the year is going to be the great reinflation effort where the Fed begins cutting interest rates. The markets will respond and you will get nominal values of assets really start to increase. So this year, the first part of the year, is disinflation. Look for that theme to start coming out. I saw it in the Fed minutes from December where you had two or three Fed governors talking about how they were worried about the trends in economic growth – and I’m talking about trends, I’m not just talking about one weeks data or two weeks data. They were worried about what was going on in real estate, the way that was unfolding. So you already have about three Fed governors (they wouldn’t mention them) that were concerned enough that they were saying, “hey, the language that we need to come out with accompanying this meeting is, hey, we could cut rates as well as raise rates depending on if these trends go forward.” But we know the Fed is creating inflation by keeping the money supply amply supplied to the financial system – they have to do that. [38:42]
JOHN: So to look at the entire year as we may possibly go, first of all, we see at the beginning of this year in reality we're tailing out the prediction from last year, “first gain and then pain.” So we get a little bit of pain. There will be disinflation followed by another round of reinflation. If we were to take a time machine and go forward to December 31st, take a snap shot of the way everything is, what would that picture look like? When we're sitting is there a year from now? What will you be saying?
JIM: Definitely, a higher stock market in nominal terms. The Dow is definitely going higher by the end of the year and I want to make that distinction. I think there is a very good possibility by the end of the year you could see the S&P 500 hit a new record –not so much for the NASDAQ. So I see higher nominal values in stock prices. I see higher oil prices from where we stand today; higher gold prices, higher silver prices. And I think the place to be besides that, and we'll get into this, in terms of investment themes because I'm going to bring a new investment theme to the forefront here that I think is going to unfold here in the next, not only couple of years, but I think you're going to see this unfold over the next 10 years, but the large cap growth stocks are going to be some of the places to be. I think that we will in nominal terms look at GDP and we'll avoid a recession in the sense that we may get down to a half a percent economic growth or maybe one percent economic growth by the fourth quarter, but when you consider in real terms the way they jerry-rig the inflation numbers, we'll be in a real recession, but in nominal terms will not be in a recession. [40:38]
JOHN: Boy, the one prediction that really stands out there is the “Save me! Obe Ben Bernanke,” because weren't they yelling that. Boy! by the time we got to the middle of summer, that is what you were hearing, wasn't it, and into the fall. Just listening to that whole clip right there from January 6th, you did rather well. Real estate did go down, the economy did slow down. In August we finally smashed into the capital market crisis. The stock market which you predicted we did see higher prices, a higher Dow and a new record for the S&P. So in this category, I think you did rather well. I give you an a A on that one. Okay?
JIM: Well, I'm going to probably be less generous. The one thing that I felt is we would get new records in the stock market, but John, there my timing was off. I got the general trend right, but not the timing. I thought the stock market gains would occur mainly in the second half of the year. And we did get a new record in the second half of the year when the Dow met 14,164. But what I missed out is especially after that sharp selloff that we saw in February is the tremendous climb that we saw almost straight up at a 45 degree angle from the end of February all of the way into that July period when the stock market hit its first...we clearly went over and touched the 14,000 level.
The other thing that I also missed was that I expected greater central bank cooperation once the Fed began to cut. So my timing was off there as well. We really didn't see that take place until the last couple of weeks when the central banks, for example, Canada and the UK cut interest rates. And then of course we got the coordinated liquidity injections that began last week. And then of course also the week that you and I talking, the ECB injecting nearly half a trillion dollars. I mean it's just incredible, the amount of liquidity that's coming into this market. So I got the trend right, but my timing was off, so I'm going to give myself a B. [42:42]
JOHN: You're listening to the Financial Sense Newshour at www.financialsense.com. We're doing our Year End Review which has become traditional here on the program.
The second thing we were going to cover here is the bull market in stocks, and despite the blowup of lenders in February of 2007, the market –the averages – continued to rise reaching record levels in July, and then a very sharp 10% correction – only to bounce back again and reach new records in October.
JIM: This gets back to what we said earlier in the year and what some of our experts also were saying at the beginning of the year. With money supply growth rates expanding aren't globe, there is plenty of liquidity around the globe looking for a home. So what you're seeing, John, is the nominal value of markets go up, even though they are actually deflating, for example, against real money; if you were to take the Dow since the year 2000 and deflate it by gold, it's been dropping in value. And this is a conversation, by the way, that I had with James Turk at the beginning of the year.
JIM: So if we were looking out and let's say, guys, we were getting together, it's December 31st, 2007, from where the stock market is today, do you expect it to be high your, or do you expect it to be lower?
JAMES: First, I expect in nominal dollar terms it to be higher, but in real gold purchasing power terms to be lower. You're going to be better off in the stock market than you are in a bank account, but you're not going to be as well off as you would be in precious metals. [44:26]
JIM: This gets back, John, to what I think were a number of structural of backdrops that favored higher equity prices this year. You had a growing amount of liquidity. You know, you hear that word over and over in the markets, liquidity, liquidity. When we're talking about liquidity, what we're talking about is money printing: money and credit are being created out of thin air. And those liquidity injections, you had a very favorable trend in the beginning of the year. You had private equity deals that were going on. And the other thing that I would contend is that valuations weren't overly expensive. So you had earnings yields on stocks that were much higher than let's say, bond yields and that always creates a positive spread or arbitrage for whether it's a private equity firm or a company to buy out somebody else because you can finance that for less than the return that you would get in stocks. You also had, in my opinion, a whole segment of the market, and these are large cap growth stocks that, in my opinion, had under performed in the bull market in this decade. There were companies out there –for example, such as General Electric, Microsoft, Johnson & Johnson, Cisco – that have consistently grown their earnings each year, and yet their stock prices went anywhere. And with strong global economic growth and a falling dollar, to me this was a scenario that favored large cap growth stocks, which meant, in this case the Dow and the S&P. And that's why, I believed stock prices would head higher and new records would be broken. [45:57]
JOHN: And some of those thoughts were echoed when you interviewed BCA at the beginning of the year. We'll go back here and listen to what they said about the stocks. This is January 13th of 2007.
JIM: Let’s talk about the stock market in general because generally investors have been cautious towards stocks. In fact, it’s very hard to read anything since the beginning of the year that isn’t negative. However, if you look on the other side, the sell-side equity strategists – I think it was the Wall Street Journal poll of equity strategists, the same thing with BusinessWeek – it was really hard to find a bear amongst them. Does that trouble you?
PHILLIP: It does trouble us. And it troubled us going into this year when we set out the Outlook. And you know we don’t like to sound like we’re with the consensus on the strategy, we start to question our theories when we are, but there’s no sense in being contrarian for the sake of being contrarian. We did see one of the things that, as you pointed out, which is it’s more important to see what investor skepticism is, rather than purely analysts and speculators. And we did see a lot of worries about housing, we saw a lot of worries about the Fed, we saw a lot of worries about how the economic environment will play out. People have fought it, equity rally in particular, the whole way up, which is probably why it has done well, and they still continue to be concerned. And we are seeing the strategists on the Street, although a lot of them were bullish coming into year end, a lot of them in recent days have switched pretty dramatically I think from chasing the recent trend. And so we find that encouraging I think. Again, we don’t like for personal uses to venture ourselves on where we differ, we just don’t want to disregard any of the other strategies on the Street. But it doesn’t worry us.
We think in the first quarter again it’s your risk opportunity, if you’re going to get a shakeout or correction it’s going to be here. Afterwards, the environment is still very positive towards equities. And like I said, there are a few support valves for equities heading forward. One is that valuations as I said were very attractive. And another area is really this whole corporate leveraging: people worrying about M&A activity and LBO activity being at extreme highs. But part of that is just because yields and corporate yields are extremely low in comparison to value. It’s pointing out the opportunity in the value within a lot of these equities and how in this environment a lot of those equities should be more leveraged, and that’s why the LBO activity is occurring. That is probably fairly bearish for corporate bonds and one of the reasons why we’re cautious – certainly cautious towards corporate bonds. But it’s a bullish argument to equities heading forward and we think some of these large caps – US equities, in particular – could do well, or emerging markets. And our portfolio, our asset allocation model has still been favorable, it’s still overweight equities and it’s really recently ratcheted up emerging market positions. So it’s taking an aggressive approach in the wake of this weakness, and it’s had a pretty strong track record in the last decade – outperformed every year. So we don’t take it lightly. It’s only one measure we use but nonetheless. [48:59]
JIM: You say that stocks are probably one of the last major asset classes to be re-rated in this asset inflation. Phil, are there any other assets that also have a lot of catch-up potential?
PHILLIP: Yes, I think so. Stocks are one of the largest asset classes with the most liquidity. It’s remarkable how it hasn’t been re-rated as much yet, and that there’s real opportunity there still. But there are other asset classes for investors. In particular, I can think of, within the emerging market theme, there are a lot of emerging market real estate markets: in particular the Chinese market, maybe Vietnam. There are a few real estate markets that have really lagged behind house price inflation everywhere else. We’ve had a bubble everywhere else. I mean German real estate is another good example. We’ve had a bubble-ish pricing everywhere else, and yet these ones have really lagged behind both houses prices elsewhere, and economic growth within these regions. They really haven’t kept pace. Now, there’s some issues with capital controls in China, or investment controls within China on some of the main cities, but there are a lot of second-tier cities that have opportunities. So there’s opportunities certainly through there, that I would think, anyway. [36:36]
JIM: You bring up a point –and this is probably a word of caution to those that are super bearish – that the Fed has sort of reloaded the chambers so to speak, because you have interest rates back up to 5 ¼, the budget deficit has dropped from 4% of GDP down to 2%, and we’ve got a bit of a dollar rally. And certainly, as we saw in the 2001 recession, all three of those tools were used to reflate the economy. And as I look at it the chambers are reloaded.
PHILLIP: Yes, I would agree – at this point they’re completely reloaded. There’s lots of room to provide this support if needed. One of the things you brought up there was the dollar and we are seeing dollar strength. We have a lot of questions on the dollar constantly about that. We’ve argued it should trade firm and will be firm – we’re seeing it now. One of the valves is obviously a weaker dollar to provide the stimulus. The thing is the structural backdrop I laid out at the beginning of a low inflationary world, when you have that world, everyone (particularly the emerging markets) they first of all rely on the US for demand. And a weak dollar deteriorates that demand – it really hurts them. But when you’re stuck in an environment with very low inflation there’s no risk to depreciating your currency. So what you end up with – and which characterizes currency markets really well over the last few years – has been competitive devaluation. You end up with that. And so they cut interest rates, provide stimulus, drop their currencies and resupport their economies without the risk of creating inflation or domestic inflation for them. So that’s the other valve where you get some stimulus in the system is you either get a dollar drop and provide stimulus, or you can also get a lot of liquidity from central banks worldwide who slash interest rates to prevent that. So I think there’s lots of room to have liquidity and stimulus and support worldwide. It’s in nobody’s interest to see these conditions fall apart, either here or in emerging Asia. So I think policy will be fairly stable and accommodative. [52:07]
JOHN: So here we are now, the markets are up, if we look at, say for example, the Dow at 6%, S&P is almost 2 ½% and NASDAQ 9% – that's for the whole year. But recently the markets have been selling off over credit concerns, so bearish sentiment is rising and the mood of the markets has turned towards pessimism once again. So given this backdrop as we head into the end of the year, do you expect the market to finish the year on a positive note, or which way will they go?
JIM: Yeah. I really do. I expect the gains will hold until the end of the year. If the markets start to falter, I think we could see some miracles. Maybe it begins with a speech by a Fed officials giving the market's hopes for more rate cuts. And that ignites a rally. Also I think you have these massive central bank injections, whether it's these new borrowing vehicles. I mean you've got close to 65 billion in new money going to be created in the next few weeks. At some point, the money goes somewhere. My best guess, John, it's going to be stocks. [53:06]
JOHN: Well, how about next year? Is it early, or how about a headstart for 2008 predictions.
JIM: You know, I haven't made up my mind yet, but a theme I'm sort of formulating and tossing around, it's almost a familiar theme: First the pain and then the gain. I do expect a rough patch with a lot of volatility in the first half of the year before I think global reinflation kicks in –and I want to stress this –it's going to have to be global or reinflation is not going to work. But if the Fed gets the cooperation of other central banks, then I believe you will see higher stock prices next year. Not because of economics improving, but because of asset inflation and that's a very important point.
We talk about these two economies, the financial economy and the real economy, and I think one of the problems that you've had, up until this point, the Fed has been treating this as some kind of mechanical problem: “The lending mechanisms, whether it's commercial paper or discount window haven’t been working well, so we are going to try some different fixes.” And so they are looking at it as a mechanical problem. I think what they have in front of them which they've been slow to recognize is they have an economic problem and they are going to have to get a handle on that because if the economy slows down or goes into a recession, the worse the subprime, the mortgage and the real estate problem gets. I've seen a bunch of estimates in terms of how bad the write-offs are. And back in September, they were estimating the write-offs from subprime were about 200 billion and then by the time we got to the end of October and November when this thing really started to blowup, you started the investment banks, the major money center banks started to report write-offs and looking to shore up their capital whether they were going to the Middle East and sovereign funds. And what happened then is they came out and the estimates now for write-offs were about 400 billion. However, if the economy goes into recession, that $400 billion number gets bigger and that's the issue I don't think the central banks have come to grips with. And it may take more market pain. It may have to be in the first couple of months in next year; you're going to get negative economic numbers, you're going to see a slowing economy – I expect the retail season for Christmas will probably be worse than expected. You're probably going to get more losses. You're going to get more companies that are going to announce probably the third or fourth week in January that they are going to miss their earnings estimates, so expect a lot of volatility so the message I would say is fasten your seatbelt. But, John, I think we're going to get through it. I'm not with the doom and gloomers that say this is the end. I think that's going to be the wrong message here.
JOHN: And welcome back to the second part of the BIG Picture in which we are doing as this is a year end review. We'll be doing that this week and this week on the program. Time to move on to one of this year's big stories which was the credit crisis. Actually, I shouldn't say “was.” It still is because it's ongoing. You wrote about this in your fictional piece, The Day After Tomorrow, some time back. When did you do that anyway?
JIM: 2005.
JOHN: 2005. But you it also did a piece in December of 2006 called The Next Rogue Wave and then again this year in your forecast pieces written in January. So we've been dealing with this credit issue going back over 24 months before it really washed over the public consciousness, shall we say.
JIM: And one point, the reason we brought it up is all credit crises begin with central bank policies. I mean if you take a look at the Greenspan policy to lower and slash interest rates back in 2001 to record low levels and then not only slash them to record low levels, he kept them there to really – it was right around April of 2004 when the Fed began to set the stage for raising interest rates. And actually, they were setting the stage for the next credit crisis because too much easy money, John, is the genesis behind all credit crises –whether it was the NASDAQ internet boom or the real estate boom. One of the interviews that we did this year was with Michael Panzner, and he wrote a book called Financial Armageddon. This is what he said about debt.
JIM: It reminds me of the old saying: eat, drink and be merry because tomorrow we die.
MICHAEL: Yes, I think that probably sums it up to a certain extent.
JIM: In your book, you identify four looming threats. Let’s begin with the first one – the ticking, debt-time-bomb.
MICHAEL: I think that debt is clearly, arguably, at the root of all evils in terms of the current circumstances we’re in. In essence, one could argue that most of the financial disasters that have occurred throughout history have been linked in one way, or another, to excessive use of debt, excessive use of leverage (people borrowing more than they’ll ever be able to pay back.) And I think just the scale that we’ve seen recently has just been so dramatic because you have technology, you have competition, you have globalization. And all these different forces coming together to essentially facilitate anybody who wants to borrow, and facilitate this growing crop of both banks and non-banks willing to satisfy those needs. So, I think it lies at the root of everything from my perspective. Clearly, people who have access to debt can buy more than they otherwise might; it does have a sort of narcotic-type influence on many people – if you can buy today and you don’t have to wait and save and scrimp then that has a considerable appeal. And I think it does create a situation where people are inherently hopeful: they borrow, and then begin to think it’s going to be better because “I’ve borrowed.” And it’s kind of a vicious circle, rather than a virtuous one. [3:13]
JIM: Now, in your chapter on debt you allude to the fact that governments have long looked at debt to finance deficits (deficit spending and shortfalls in the budget.) But Michael, how did our debt dynamic change under the Greenspan Fed?
MICHAEL: I’m not sure exactly the true motivation. I do believe that over the course of time, Alan Greenspan and company started to believe – to use a colloquialism - their own BS; that they could control the business cycle; that they could fine tune what was going on in the economy; that they could actually tweak the levers like the man behind the curtain in the Wizard of Oz and keep the whole show rolling. And I think in a sense it went to their head. That was certainly one factor.
I think we were in an era – and I allude to this in the book as well – of consumers as almost a religion, and people felt they had to keep up with the Jones’; they wanted what stores had to sell. And stores – if you like – were more than willing to accommodate those, even those who couldn’t afford it, by offering them credit terms. So in a sense, each pandered to each others’ needs: the needs of the consumer to borrow more (for example, the needs of the consumer to own their own home – which was the mantra, especially of the last decade or so); and the need for the US economy to expand in the face of incredible headwinds both domestically and from overseas.
So you take the two together – this idea that you can solve all problems with debt; and this incredible appeal of debt – and you get a pretty dangerous combination in my opinion. [4:53]
JIM: Let’s take a look at especially this new decade – the last 5 years – where lenders and borrowers have basically thrown caution to the wind. We saw the rise of 100% financing on homes – in fact, in many cases, 125%; we saw piggyback loans – you could put money down, and then the bank would quickly turn around, give you a piggyback loan so you could take all your equity out; we saw the rise of no-doc loans. It’s like if we were crazy in the 80s and 90s, and this new century, it’s like I don’t know how else to describe this [except] as absolutely being insane.
MICHAEL: Well, it is – and bankers certainly, if you like, threw their caution to the wind. But it’s very clear, one reason at least why they’ve done that is because in the past they have had to bear the consequences of their bad credit granting decision. With the rise of securitization – and mind you, in my opinion, securitization does have a number of benefits, but – the biggest downside is the introduction of what you might call moral hazard: bankers no longer being as incentivized to produce quality loans, but instead are focused on quantity because they receive a fee upfront. They shunt the loans along to somebody else, and they get repackaged, sliced and diced into securities; and then they can go out and reissue other mortgages, other debts, and repackage them in a kind of virtuous circle. The whole thing is a kind of perpetual motion machine. So I think that, again, that was an incentive system that facilitated this kind of behavior.
But it also comes down to the point I made earlier: people are more complacent. It’s inevitable. Minsky essentially alluded to it many times – the idea that essentially stability breeds its own failings to a certain extent: people get more complacent; they are willing to accept less in terms of greater risk. And in essence we also had another issues in that people became very short-term oriented. You have a incentive scheme in the hedge funds that I’m sure we’ll go into later, but this whole idea that people get rewarded on a much more frequent, much more regular basis – there’s no real link between how people get paid, and long-term performance, long-term interests; and in a sense, their incentive is to do as much as they can in the short run, and let somebody else worry about the problem later on. [7:26]
JOHN: Michael Panzner was talking about the role of Greenspan and you were too; and we've got an interesting excerpt here of what he said about the Fed being a stabilizing force after the United States abandoned the Gold Standard. But he also talks about the Fed itself being an invisible force.
GREENSPAN: You didn't need a central bank when we were on the gold standard which was back in the 19th century, and all of these automatic things occurred because people would buy and sell gold and the markets would do what Fed does now. But, most everybody in the world by the 1930s decided that the gold standard was strangling the economy; and universally this gold standard was abandoned. But! You need somebody to determine or some mechanism of how much money is out there because remember, the amount of money relates to the amount of inflation in an economy.
JON STEWART: I forget that? Or you? I’m sure I know that.
GREENSPAN: I just couldn’t be sure.
STEWART: No. I live by it.
GREENSPAN: In any event, the more money you have relative to the amount of goods, the more inflation you have and that's not good, so –
STEWART: So we're not a free market then? There is a benevolent hand that touches us.
GREENSPAN: Absolutely, you're quite correct to the extent there is a central bank governing the amount of money in the system that is not a free market. And most people call it regulation. [31:17]
STEWART: And so – and so we're really just deciding...because when you lower the interest rates and drive money to the stocks, that lowers the return people get on savings – at the bank.
GREENSPAN: Yes. Indeed.
STEWART: So they've made a choice, we would like to favor those who invest in the stock market and not those who invest in a bank? That helps us.
GREENSPAN: No. That's the way it comes out, but that's not the way –
STEWART: But explain that to me because it seems to me and that we favor investment, but we don't favor work, the vast majority of people work and they pay payroll taxes and they use banks. And then there is this whole other world of hedge funds and short bedding and – it seems like craps. And they keep saying, “don't worry about it. It's a free market. That's why we live in much bigger houses.” But it really isn't. It's the Fed or some other thing. No?
GREENSPAN: I think you'd better reread my book.
STEWART: All right. All right. But is it – am I wrong that we – I don't want to say penalize work, but by not making the choice to –
GREENSPAN: No. Actually, what a sound money system does is to stabilize all of the elements in it and reduces the uncertainty that people confront. And the one thing all human beings do when they are confronted with uncertainty is pull back, withdraw, disengage. And that mean means economic activity, which is really dealing with people, just goes straight down. And so the key problem – any central bank...
STEWART: It's all about perception then? It's about making people believe the system is sound. If the stock market is high, people feel confident in spending and if it lowers, they feel less confident.
GREENSPAN: Well, I think you have to recognize that there are certain aspects of human nature, which is essentially move exactly the way you defined it. The problem is periodically we all go a little bit euphoric until we get to the point where we are effectively assuming with confidence that everything is terrific, there will be no problems, nothing will ever happen, and then it dawns on us: No!
STEWART: And then we go the other way.
GREENSPAN: Exactly.
STEWART: Huge fear?
GREENSPAN: Fear. You know, I was telling my colleagues the other day, I said I've been dealing with these big mathematical models of forecasting the economy and I'm looking at what's going on the last few weeks and I say, you know, if I could figure out a way to determine whether or not people are more fearful or changing to euphoric and have a third way of figuring out which of the two things are working, I don't need any of this other stuff. I could forecast the economy better than any way I know. The trouble is that we can't figure that out. I said at the same meeting I was talking at that I've been in the forecasting business for 50 years –more than that actually; I hate to think about that, but any event – I'm no better than I ever was and nobody else is. Nobody is able – forecasting 50 years ago was as good or as bad as it is today and the reason is that human nature hasn't changed. We can't improve ourselves.
STEWART: You just bummed the [bleep] out of me. [12:57]
JOHN: That was an interview that was done on Comedy Central earlier this year, Jim.
JIM: We're talking about this credit crisis, John, and he alluded there that in that Greenspan clip that nobody can figure things out. You think things are going well and all of an a sudden you wake up one day and they are not going well. Something that always happens when a bubble bursts or let's say the economy has gone into recession. What is the typical response? The Fed comes in, responds by printing more money which leads to asset inflation and eventually another crisis. And we only have to go back to the year 2001. The economy was in a recession. We were in a bear market. Unwinding. The NASDAQ technology bubble, we got hit with 9/11. What happened? The Fed came in, slashed interest rates, massive amounts of liquidity and what happened as interest rates came down, it made it very attractive to go into real estate. Instead of real estate contracting in a recession, real estate went in the opposite direction. Consumers spent more. People borrowed more because rates were so cheap. Lenders got very careless because there was no longer a tie-in to the loans that were made because we'd gotten into the socialization of risk as this risk was spread out on a lot of these loans. They were securititized, packaged, repackaged, sold to investors so they weren't on the lenders books, but we had another bubble and now we're going through this crisis. I asked about this when we interviewed Peter Schiff earlier in the year when Peter came out with this book Crash Proof, John. Let's go to that one clip when we talked about these asset booms and crises. [14:12]
JOHN: And this is from March 10th of this year.
And Peter, I want to start out the beginning of our interview with a quote in the introduction of your book, and I’m going to read it – and then I want you to comment what happened:
When business in the United States underwent a mild contraction, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. The Fed succeeded, but it nearly destroyed the economies of the world in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market, triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in breaking the boom. But it was too late – the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching, and a consequent demoralizing of business confidence. As a result, the American economy collapsed.
Why don’t you tell our listeners who wrote that, and what changed his thinking?
PETER SCHIFF: Well, that was written by Alan Greenspan in an article that appeared in The Objectivist in Ayn Rand’s book Capitalism: The Unknown Ideal, [read] and Greenspan was talking about the Federal Reserve in the 1920s, and their efforts to prop up the economy through inflation; and their efforts to prop up the British pound. Greenspan was a good Austrian economist back then, and he understood money, and the business cycle. And the point of, in the book, why I wanted to begin with that passage is because it describes exactly what’s been going on: where the Federal Reserve created a bubble in the stock market, the excess credit that they created went into stocks, and produced a speculative bubble. When that bubble burst, the Fed pumped in even more liquidity, which instead went into the real estate market and fed an even bigger speculative bubble there, which is now beginning to finally unravel. You’re seeing what’s happening with the subprime market – that’s just the tip of the iceberg. But the Fed creates these bubbles, and ultimately they burst.
And the interesting thing is that Greenspan talks about the Fed’s efforts to rein in – you know, they recognize the error of their ways, and they try to withdraw the excess liquidity. Ben Bernanke has already said that he sees that effort as a mistake, and he would never rein in liquidity. All he would do is print more – that’s when he made his speech about dropping money from helicopters. According to Ben Bernanke, what the Fed did wrong was stopping the credit; he thinks you can keep a boom going indefinitely if you just print enough money. And of course, that would have been an even bigger disaster than a depression because that would have produced hyperinflation, or something that was experienced say in the Weimar Republic, Germany. But unfortunately, that could be something that could be in our future, if Ben Bernanke actually carries through with his promise to prevent these speculative imbalances from deflating or unwinding. [17:24]
JIM: Peter and I also talk about this subprime issue crisis and the bubble bursting in real estate. At the time of that interview, we got our first subprime blowup in February which was with the intermediate lenders going under. They told us, and you remember this, John: The crisis was over, it was contained and all was well. In fact, if you look at the stock market from the end of February all of the way up to its July high, that was the thinking; that “okay, there is a crisis here, we've got it covered, it's contained, you don't need to worry about it.” In reality, all was not well as we were to find out later on in the year and we would revisit that crisis again in August. Let's go back to the interview with Schiff.
JIM: I want to move on to some of the problems that you highlight in your book. And one you get to is real estate. Recently, the media and the Fed has said that the real estate markets have stabilized. I take it you don’t agree with that assumption.
PETER: No, I mean they’ve just topped out. It’s just starting to fall apart. This thing has been a giant bubble. It’s finally starting to blow up. And some of the most amazing things about it – I saw this guy on Freddie Mac (and you know no one talks about this – it’s amazing this isn’t a front page story) – just recently last week, they announced they were going to tighten their standards with respect to subprime mortgages that they buy. Going forward (it’s starting in a few months), they are not going to buy mortgages where there is a strong likelihood that the person can’t make the payment and it’s going to end in default. Now, that’s an amazing statement because it means up that until that point they were buying those mortgages. Well, why are they buying mortgages where there is a strong likelihood that the guy can’t make the payment? It doesn’t make any sense. And why only limit that to subprime? Basically, they are saying, “okay, for people who have bad credit, we think they are going to default, we’re not going to buy the mortgage; but if they have good credit and we think that they are going to default we’re still going to buy it.” It’s incredible.
But why would they even do it? And the reporter on CNBC – I saw the guy interviewed – asked him, “well, isn’t this a little late. Isn’t this like closing the barn door after the horses have left?” And he said, “no, no, no. It’s not late. We couldn’t have done it any sooner.” And the guy asks, “what do you mean? Why couldn’t you have done it sooner.” And what his answer was: “Well, up until recently, people were making money buying real estate, and real estate prices were rising, and so we didn’t want to tell people who were buying real estate, because they thought it would go up, we didn’t want to tell them that they were wrong. We didn’t want to substitute our judgment for theirs, so we didn’t want to interfere with the process.”
Basically, what he is saying is they knew that people were lying about their income, were buying houses that they couldn’t afford because they thought they were going to get rich speculating in real estate. They knew that. They didn’t want to interfere. And this is Freddie Mac. I mean this is amazing stuff. But now that the bets are going bad, now they want to stop people. But of course, no one is going to do it anymore – the party is over. But the problem is: you’ve got all of these millions of people who bought houses where they had a teaser rate where the first two or three years they could afford the payment, but when the payment is reset to reflect the real mortgage they can’t make the payments. But you know, when somebody was looking at a house, buying a $500,000 house, where they expected it to go up 20% a year, they really didn’t care so they said, “well, okay, we’ll sign on to this mortgage where for the first two years we only have to pay 3 or 4% interest. We can afford those payments. In three years the payments double. We can’t afford those, but who cares? We’ll be rich by then. We’re going to make hundreds of thousands of dollars on the appreciation so it really doesn’t matter what the mortgage payment is in three years. It doesn’t matter because we’ll be rich.”
Well, all of a sudden, three years come and the property didn’t go up – it’s the same or it went down. Well, now they can’t afford it. And this is the situation that we’re in. And this is just the beginning because it’s not just subprime. Right? It’s not just people with bad credit who are in over their heads. Everybody bought property they can’t afford. I mean, why do you think there are so many interest-only mortgages in the prime universe. Why do you think there are so many adjustable-rate mortgages among prime borrowers? Because they couldn’t afford the fixed, that’s why. People are in over their heads, and they didn’t care because they thought they were buying into a goose that lays the golden egg. Nobody cared what they paid.
In fact, In my book, I pointed out that rising real estate prices...It was counterintuitive – people think “real estate is going up in price, it’s making it less affordable.” No. It was making it more affordable because people were factoring in the appreciation into their decision. So if you were to buy a house and thought it was going appreciate by $100,000 a year, if your mortgage payments were $50,000 a year, the net cost of buying the house was a positive $50,000. You got paid to buy it. It was actually calculated into your income. It made it cheaper. But the minute people stopped factoring in appreciation all of a sudden the real cost of home ownership becomes obvious when the house isn’t paying you – “wait a minute, I’ve got to pay a mortgage; I’ve got to pay the insurance; I’ve got to pay the maintenance.” So flat real estate prices make real estate very, very expensive. And of course, people aren’t going to buy it. But this is going to be a real collapse. [22:04]
JOHN: Once again, that was back on March 10th of this year, you and Peter Schiff. And what's important, I think, to emphasize this, Jim, is what he is saying right there. Someone listening today could say, “oh, yeah, we know that. That's what this whole flap has been about; right?” But you need to understand that it was even Alan Greenspan who was saying – remember his interviews after his book came out, Age Of Turbulence, he said, “well, we just didn't see it coming.”
Well, now, wait a minute. Peter Schiff saw it coming; right? So why didn’t you see it coming?
JIM: Yeah. And I think it's just hogwash they didn't see this coming because you can't go out and slash interest rates –and, John, you remember, just before Greenspan began raising interest rates in 2004 that speech he gave and he said, “you know what, one of the best deals out there right now are variable-rate mortgages.” So here the Fed was coming out and encouraging people to go out and get a variable-rate mortgage, you know, a month or two before they started hiking rates. How can you sit there and talk about a lending process? When I wrote The Day After Tomorrow, which was in 2006, and it was all about real estate and housing, when I was interviewing the lenders in this project that I talked about, Big Sky Ranch, the amazing thing about those interviews is they told me: Everyone –and I'm not going to mention the names of the companies – they were pushing these interest-only variable-rate mortgages.
And I can remember a conversation I had with one of the largest lenders in this country and the loan officer said: Look at it this way. The average Californian only stays in his home three-to-five years, so why would you want to out and pay 1% more on a 30-year mortgage when you're probably only going to stay in this home three-to-five years, so look at how much money you save by going to an adjustable rate for three years. It's much, much lower. You can buy a bigger house. You can afford more options.” And this is what lenders were basically pushing to all of the homeowners.