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Macro Market Analysis: Why We’re Here and Where We’re Going

Posted on February 9, 2009 by Adam

Good morning, traders.

I wanted to kick this week off by taking a big picture view of the markets. As a swing trader, I am not usually in any of my trades for more than a couple weeks, at most, but I often find that getting a gauge on how the broader market is postured helps me to take smart risks.

This week will be centered around the market’s reaction to the bailout package, which will be announced tomorrow. The economic backdrop leading up to such a monolithic piece of legislation is a tangled web. I would like to spend some time trying to make sense of it.

The period from 2003 to 2006 was one where huge bets were placed on debt. I’m not just talking about risky mortgages. Sub-prime mortgages were just one form of debt that were engineered and pawned off to speculators. In those cases, the mortgage backed securities and collective debt obligations were often bought with huge amounts of leverage, which only compounded the problem.

But again, I am not only referring to the mortgage mess. The debt bubble was pervasive - spreading into consumer credit and corporate finance as well. Do you remember how every store you went to offered a different credit card? I remember shopping at the mall and being offered at least three different credit cards during the day. Everything from home equity loans to insurance seemed to be aimed at making money off of my debt.

Essentially, creditors were investing in the debt of anyone who would borrow money, on the hopes that more loans meant more money. The government didn’t help either; encouraging (and in some cases pushing) institutions like Fannie Mae to buy risky mortgages so that Joe Sixpack could own his own home. Neither did the Fed, failing to regulate the CDO’s that many experts place at the center of the crisis.

But I’m not blaming the government, nor am I placing the blame on financial institutions. A few years ago, most people would have praised them for the actions they took. Now, it appears that the debt bubble has burst. But where did we go wrong, and why now?

The answer lies in the distant past. Looking back to the 1920’s, we think of a time of prosperity - of post-war modernism and a sense of “normalcy” that overtook the country. In the aftermath of World War I, the United States economy become increasingly involved with that of Europe. In order to bolster the economy, Wall Street was keen on buying the debts of European governments and individuals who needed financial assistance with reconstruction efforts. In some cases, the investment in debt was encouraged by the government. Sound familiar? Leveraging debt was further spurred on by an extended period of reduced taxation and other fiscal policies that benefited corporations and Wall Street. Again… sound familiar?

A resurgence in the European economy helped to drive consumerism and business in the 1920’s. New technologies such as automobiles, radio, and film made their way onto the national stage. Cultural developments in music and art also helped to shape the tone of the era. In general, it was a prosperous time, nicknamed the “Roaring Twenties”. In many ways, the consumerism model of the 1920’s helped to shape the way we live today.

The roaring 20’s were also subject to an enormous debt bubble, expanding rapidly as speculators entered the market. A lack of government regulation allowed enormous amounts of leverage to enter the market - all made possible by borrowed money. As speculators borrowed more and more money, they began to pay higher and higher interest rates. While asset prices increased, they could afford to service their debt, but as the increase in asset prices began to slow, debtors could no longer afford the interest payments on the debt they had incurred.

Debtors began to default on their payments, and sold their assets, such as stocks bought on margin, to help cover their costs. The selloff in assets had a compound effect on the debt. As speculators lost more and more, they had to sell more and more to service their debt. This vicious cycle was epitomized by “Black Tuesday,” where stock prices began a long, precipitous collapse, leading to the great depression. The increase in debt defaults hurt the lenders as well. Many banks went bust because they made so many bad bets on “toxic debt”.

At the time, no safety net existed for the banking system. As depositors rushed to retrieve their deposits, the banks could not pay out the money they promised. Today, the government has pledged to protect the banking system, not only by insuring deposits, but by pledging to purchase $900 billion worth of the toxic debt owned by financial institutions, vis-a-vis the bailout package. No comment from me on that one.

We are very much in a debt bubble again. The following chart is borrowed from The Wall Street Examiner and shows how the debt bubble of the 1920’s compares to that of today:

How the amount of debt today compares to that leading up to the great depression. Courtesy of The Wall Street Examiner.

Total debt in 1929 reached 200% of the entire gross domestic product! On average, the country was spending twice as much as it produced. Just on an intuitive level, that cannot be healthy. We have seen the same pattern emerge again, only this time, we have reached nearly 300% of the GDP. Moreover, debt has been climbing steadily since the 1940’s, with only a brief pause during the early 1990’s.

Ever since the mid 1990’s, though, debt has been expanding at extreme rates. This problem has much deeper roots.

After World War II, cheap oil prices and the proliferation of the automobile prompted investment in a national highway system, rather than a railroad system or local community development. Americans developed this idea of the “McMansion”: a nice home in the suburbs with a two car garage. That became the American dream, which still plays out today. The suburbs are a wasteful and inefficient means of living - and are often ugly and environmentally devastating. How can we be productive living in a society where commuting 100 miles each day in a $25,000 hunk of steel becomes a necessity; where putting food on the table means shipping goods from all over the world to all sorts of processing centers before it finally ends up in a plastic container at your supermarket? When you consider the amount of resources it takes just to support our daily lifestyle, which is made inevitable by society, it seems absurd. How can we possibly be productive without borrowing enormous amounts of money?

We must consider the amount of resources we must invest in to support our American dream. It’s no wonder the demand for mortgages was so high - it is the American dream to own a home. The sub-prime mortgage mess is just the tip of the iceberg when it comes to the explosion of debt we’ve seen over the last 10-20 years. Since speculators have driven up the risk in investing in debt, deserving borrowers, such as small business owners, cannot afford to take out loans.

I love America, but our lifestyle, at least in its current form, is unsustainable. Over the next 5-10 years we will first see continued de-leveraging of the debt bubble. That means lower asset prices and a continued slump for stocks. We will need to see the dollar weaken, so that debtors can afford to pay off their debt to foreign creditors. As the dollar weakens, we will see strength in gold prices.

Once that situation resets, expect to see early strength among sectors that promote efficiency and productivity. Real estate prices in urban and industrial areas will be the first to recover, followed by new and developing sustainable communities. The automakers will eventually recover, but only those that win the sales war over smaller, more efficient cars.

Within the next 20 years, we will reach peak oil. We won’t stop using fossil fuels, but instead, we will move towards cleaner, more efficient fuels, such as natural gas. Expect alternative energy to prosper, but don’t expect oil and coal to go away. Reduced supply will support companies that explore and develop new oil resources.

That, of course, is an optimistic outlook, and just my outlook at that. I know this was long-winded, and a bit of a departure from my usual fare, but I hope you have found it informative and entertaining. As always:

Happy Trading!