November 26, 2008 4:49PM

A Thanksgiving Stock Market Reminder

By Elizabeth MacDonald

Ronald Reagan once said, “The nine most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’”

Keep those words in mind as the government bailout grows to about $7 tn, and federal officials improvise on the run.

We are still seeing the running (away) of the bulls, as shares in the financial sector continue to resemble a gigantic turkey shoot.

However, stock market history shows that just as today’s downturn has been pathologically violent, you can expect a vicious, ferocious upswing–as the massive government-created liquidity awaits a vent hole. The name of the game now on Wall Street is how to play the coming TARP bubble, as there is a Swiss mountain range of liquidity out there waiting to be deployed.

Because remember, just as every boom comes to an end, so does every recession. Remember, too, that panic is just as infectious as blind optimism, as an analyst once wisely noted.

Belt-tightening is the order of the day on both Main Street and Wall Street–though still not when it comes to top executive bonuses, earned on fake profits created during the credit bubble, as few are forfeiting them, insiders on Wall Street hasten to add.

So where are we now in the housing and credit crisis? And what does stock market history tell us?

An Update on the Crisis

US bank writedowns and losses to date are at around $500 bn plus. Bank writedowns and losses worldwide are at $690 bn, according to Bloomberg, which adds that total bank capital raised at financials around the globe is about $714 bn.

Total writedowns worldwide expected: $1.6 tn. Analysts estimate there could be $657 bn more in losses and writedowns at the world’s financials, as banks are finding it hard to raise capital in the jaws of this crisis.

Meanwhile the Federal Reserve balance sheet has ballooned to $3 tn.

The Stock Market Now

Looking back at prior bubbles, when they have burst, the market has almost always overcorrected.

Analysts note however, that after the tech bubble burst in 2000, the stock market didn’t hit the lows it should have. That’s because before it could, the housing and credit bubble kicked in from 2002 to 2006.

Stock markets around the world are now on sale, as share prices drop.

The current bear market as measured by the Dow Jones Industrial Average has now eclipsed the 1973-1974 bear market drop of 45% from its closing peak. At its most recent low, the DJIA was off 47% from its record close of 14164.53 set on October 9, 2007, making this the worst bear market on record since the 1937-1938 bear market.

Right now, for November 2008, the rolling 10-year return, before dividends, on the S&P 500 is negative 25.57%, according to one of the best Wall Street websites, Trader’s Narrative. Not the lowest, but quite low, the site says.

To put things in perspective, you’d have to go back to the summer of 1941 to find lower numbers, the site says.

“The lowest point, within the 100 year time frame used, is August 1939 which provided a soul-crushing 10 year return of negative 62%. Not at all surprising since [that was] the 10-year anniversary of the great bubble top of the 1920’s,” Trader’s Narrative adds.

This Is Not the 1930s

Belts are tightening across the country–which calls to mind what the actor Errol Flynn once quipped: “My problem is reconciling my gross habits with net income.”

And the government is injecting massive liquidity in record proportions.

“The government and the central banks are not sitting idly by as banks fail this time around,” says Raymond James market expert Jeffrey Saut, a must-read thinker on Wall Street. “We have automatic stabilizers in place like welfare and unemployment insurance, as well as deposit insurance (the Federal Deposit Insurance Corp. was born out of the Depression).”

During the Great Depression, by March 3, 1933, “scarcely a bank in the country was open to do business,” President Franklin D. Roosevelt said in his March 12, 1933 fireside chat, Saut notes.

That year, 4,000 banks failed. And unlike now, after the 1929 stock market crash, the government didn’t do much of anything until two years or so later. And when it acted, it exacerbated the situation.

For example, the Federal Reserve kept interest rates high at the same time the government enacted the Smoot Hawley Tariff, the largest tariff in American history, passing a big tax increase in a declining economy. The central bank also let the money supply contract by a third. All of these things combined turned an ordinary recession and market plunge into the worst economic disaster in American history.

Back in the 1930s, “GDP plunged 27%, real private investment collapsed 87%, consumer spending contracted by 41%, industrial production plunged 54%, personal income fell 25%, the unemployment rate soared to 30%, and half the nation’s homeowners defaulted (not 10%), and 10,000 banks failed,” Saut says.

“As over-saturated as we may be today, we don’t have that degree of excess capacity in the financial sector,” he says.

No where near 10,000 banks today have failed, and the Federal Reserve says unemployment could rise to 7.6% next year. The Philadelphia Federal Reserve Bank’s survey of economists shows a consensus belief that the recession started last April and that it will be over by next summer.

Today “may be something more than just a garden-variety recession, but it is not the Great Depression,” Saut says.

A Stock Market History

In 1997, the Dow first passed 9,000. So today, about a decade later, you have not only zero capital gains if you bought in 1997, but losses too, of course, if you were not paid dividends.

We’ve been here before. At the end of 1964, the Dow Jones Industrial Average traded at 874, the Economist Magazine notes. Some 17 years later, after the Vietnam War, the Arab Oil embargo, price controls, record inflation, the average had inched forward only to 875.

In the interim, the Dow closed above 1,000 in 1972, then dropped back to 616 by the end of 1974, rallied to 875 in 1975, then crept along for the next six years, sticking at 874 in 1981. The Dow then started to move in the late eighties, and, well, you know the rest.

“What we learn from history is that people don’t learn from history,” says legendary investor Warren Buffett says, whose own Berkshire Hathaway is down 41% this year as third quarter profits plunged 77%.

Expect Violent Upswings

How do you play the coming Tarp Bubble?

Analysts say you can expect a violent upswing, based on stock market history. Remember, the Dow’s 936-point gain on October 13th was notable because it climbed more in that one day than it did in the first 85 years of its existence (the Dow was founded in 1896).

Yes, just when you are convinced the stock market is showing you a bear market bottom it rearends you with another one. But stock valuations look attractive in historic terms.

Unfortunately, nobody knows when the stock market low will be. Remember what Buffett has also said: “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

Check out this interesting table:

Market Top        Bottom    Drop  Increase

May-‘46             Jun-‘49   30%    267%

Aug-‘56             Oct-‘57   22%    86%

Dec-‘61             Jun-‘62   28%    80%

Feb-‘66             Oct-‘66   22%    48%

Nov-‘68              May-‘70  36%    73%

Jan-‘73              Oct-‘74   48%    226%

Dec-‘76             Mar-‘78   19%    62%

Nov-‘80              Aug-‘82   28%    233%

Aug-‘87             Dec-‘87   35%    67%

Jul-‘90               Oct-‘90   20%    304%

Jul-‘98               Oct-‘98   20%    62%

Source: Sterling’s World Report

Corporate Earnings

The sour economy has caused analysts to lower their earnings forecasts on companies to the point whereby only 222 companies in the S&P 1500 have seen their earnings estimates increased, Saut notes.

Obviously, this decline in earnings expectations has a caused a recalibration of P/E multiples with an attendant “hit” to stock prices.

Moreover, the Wilshire 5000 index, the broadest measure of the U.S. markets, has now fallen by more than 50% since its peak 13 months ago, and Treasury yields also fell to record lows with the 30-year U.S. Treasury bond declining to lows last seen in the early 1960s, Saut notes.

The stock market right now is historically cheap. In America, Europe and Britain, the dividend yield is higher than short-term interest rates, a rare occurrence in the past half-century, reports indicate.

A good measure that shows how cheap the market is, is a neat little number called the dividend yield. To calculate it, you take a company’s annual dividend payments and divide that number by the company’s market cap, what the stock market is valuing the company’s shares at. The dividend yield is often expressed as a percentage.

Saut adds that interestingly, the combination of lower stock prices and higher Treasury prices has caused the dividend yield on the S&P 500 to exceed the yield on the 30-year Treasury bond for the first time since 1958.

Saut adds that Vivan Watsa, chief executive of Fairfax Financial Holdings “and one of the few investors who [has] played this downturn to a tee, turning $500 mn into more than $2 bn in the past year, has said that “while we believe the recession may be long and deep, we also believe that stock prices may have already discounted the worst of the economic decline. As value investors, we are finding an incredible number of investment opportunities across the world.”

Rule Changes = Volatility

Of course, the crisis is causing record stock price volatility.

Yes, we’re in panic mode, but could the market volatility also be blamed on the fact that the Treasury’s rules seem to change every hour?

Could this be one reason why 80 has become the new 20 on the Chicago Board Options Exchange volatility index for the S&P 500? The VIX shows the market’s expectation of 30-day volatility and is calculated using the implied volatilities of a wide range of S&P 500 index options. The higher the number, the more chaotic and volatile stock prices.

But should we also cut Treasury Secretary Henry Paulson some slack, as some analysts say he is trying to do his best to get us out of this crisis? His every appearance, trapped under a Bell Jar of scrutiny, has pressurized his explanations to unforgiving barometric degrees.

The Bailout Changes

The government resurrected just for Citigroup a version of the first iteration of the $700 bn Troubled Asset Relief Program [TARP], in which the government would buy at auction bad securities built during the credit bubble. The hope was that the auction would put some kind of floor price on these securities. Treasury TARP-edoed that version of the program within the last month or so.

But in an about-face, the government will now backstop $243 bn or so in Kryptonite mortgage-backed and commercial real-estate backed securities at Citigroup. And after the TARP auction idea was killed, the Federal Reserve quietly took on $52.5 bn in toxic securities from AIG, along with the $27 bn in securities it inherited from the bailout of Bear Stearns which merged with JPMorgan Chase.

Critics say that if the government can change TARP rules with ease, why then won’t the government stop the hammer blow of the mark to market rules which says companies must price and book securities on their financials against profits as if they were to sell them today in a market that’s as frozen over as the two moons of Mars?

Especially since TARP canceled its initial auction idea for these securities and in turn won’t help put a floor price under these securities?

This calls to mind what one market watcher aptly said, that we are no longer contending with what economist Joseph Schumpeter called creative destruction, where the free markets take out the weak, but the government’s brand of “selective destruction” with its improvised bailout.

Seesaw of Changes Continue

Other rule changes have left Wall Street heads rotating, and the market gyrating.

For example, Wall Street executives ask: Why did the Securities & Exchange Commission suddenly kill the uptick rule in the summer of 2007?

Generally speaking, the rule said that when a listed stock is sold in a short sale transaction, it must be sold short at a price above the price of the preceding sale. But the SEC killed the rule without comment in the summer of 2007, right when the crisis was about to blow. Traders and analysts say this opened a barn door of bearishness whereby traders could short stocks at prices below prior trades.

In a short sale, a trader borrows stock and then sells it, and when the price rises, it gives the borrowed shares back, pocketing the difference.

“Eliminating the short-sale ‘uptick rule’ was one of the dumbest decisions I have seen in 38 years in this business,” Raymond James’ Saut says.

Saut also cites as adding to uncertainty was the SEC’s decision to wipe out short sales for nearly 800 different companies’ shares, “some of which were not even financials.”

And Saut notes this development, according to The Wall Street Journal: “The New York Stock Exchange has begun allowing floor traders known as specialists to place orders for 30 minutes after the market closes in an unprecedented effort to deal with the wild swings in stock prices that have been occurring in the last minutes of trading.”

Saut says: “Blatantly, this ‘game changer’ is designed to manipulate stocks to show higher closing prices. No wonder the volatility has increased as participants are uncertain what ‘rules of the game’ will show up tomorrow.”

Wall Street Talks

There is seething, unrelenting anger among the rank and file as to why executives at Wall Street firms have yet to forfeit their bonuses, as Goldman Sachs top executives did (more than $250 mn in bonuses for the top four execs there in 2007).

No word yet whether top executives at Citigroup, Morgan Stanley, JPMorgan Chase, and Merrill Lynch will give up their bonuses, as Wall Street workers are getting laid off in record numbers, as Bloomberg terminals are getting yanked from desks, as workers are being told to pay for their own business expenses.

Remember what Congressional hearings revealed, that an employee at Standard & Poors emailed a co-worker, both of whom worked at the securities ratings shop which, along with Moody’s and Fitch, sewaraged its reputation by selling goldplated Triple-A ratings for rubbish securities now draped like a drunken paper daisy chain around the earth: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

I once talked to a top Bear Stearns executive, and I asked him what was on his mind, as I allowed that overstatement, knowing that this was the firm that would securitize the issuance from a fire hydrant or the effluence from a sewer pipe.

And he blamed the government for abolishing Glass Steagall, complaining that it was that move that got us into this mess. When it was bank executives themselves, with Japanese banks breathing down their communion-crisp collared necks, who had successfully lobbied Congress hard in the late ‘80s to tear down those walls between investment banking and commercial banking so they could make more profits.

Fatally ignoring the fact that Japanese banks were operating on microscopic, wafer-thin capital reserves to begin with.

The fellowship of juvenilia is growing apace as we continue to systematically take stakes in failing companies without forcing them to do the hard work to really, seriously restructure themselves once and for all–just as banks in Japan in the ‘90s covered up each others’ problems by buying equity stakes in each other.