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Can This Rally Last?

By John Browne

Senior Market Strategist, Euro Pacific Capital

March 28, 2008

As the markets closed on Friday, March 14^th, the $50 billion hedge fund, Carlyle Group, had collapsed, and questions were being asked about the viability of Bear Stearns. Having realized that Bear was close to insolvency, the Treasury and Fed worked overtime during the ensuing weekend to cobble together a bail out scheme that has since calmed the markets and encouraged a tepid rally. The salient question now is whether the rally can last.

With a counter-party involvement in a significant amount of the $43 trillion derivatives market, the collapse of Bear Stearns would have been the financial equivalent of an atom bomb. Its failure threatened not only the U.S. financial system, but also sophisticated financial markets in most of the world.

On March 17^th, the Fed’s emergency action to rescue Bear Stearns took most people by surprise. It gave rise to a sigh of relief from Wall Street and other financial markets, which expected a full one-percentage point drop in Fed rates the next day. Apparently, the foundations of a market rally were laid. The Fed cut its rates by 75 basis points to 2.25 percent and announced massive new financing arrangements. Although the measures were temporary, they nonetheless placated shattered nerves. But was that any justification for a real rally?

The feeling of relief extended to mild euphoria. For example, three major Wall Street investment banks reported earnings falls of between 42 and 57 percent…and the news was greeted as positive! The falls, after all, were less than fanciful Wall Street “estimates”. Since then, possibly led by the mythical “Plunge Protection Team”, stock markets around the world began to rise in thin trading. But the underlying issues remain extremely troubling.

It is true that markets had fallen significantly and under normal conditions a rally should be expected. The S&P 500 put in what appeared to be a convincing technical bottom. However, technical analysts forecast a volatile sideways trading band for the S&P 500, between 1,270 and 1,400, with a downward breakout being a cause for alarm.

Some two weeks into the rally, a series of statistics are emerging that point to increasing signs of economic recession in the United States.

On Monday, March 24^th, the market welcomed the news that sales of existing homes had risen by 2.9 percent in February, on an annualized (forecast?) basis, which was the first gain since July. Given lesser play was that the factual year-on-year figure, which showed a drop in existing home sales of some 24 percent. House prices also fell. But it appeared that Wall Street was unwilling to focus on the truth, apparently preferring to cling to straws of seemingly bullish information, even if grossly misleading.

The next day, The Wall Street Journal reported on how dependant the housing market is on jobs. It highlighted the Case-Shiller findings that U.S. housing prices had risen by 74 percent between 2000 and 2006. Over that time, “median household income rose just 15 percent,” a discrepancy that “made housing unaffordable for many Americans.”

That same day, it was reported that American consumer confidence was far weaker than expected, falling to the lowest levels since 1973, adding yet more fuel to the forces of recession.

Perhaps the worst set of recent statistics is the little discussed size of total residential housing debt, which is in the midst of a massive financial ‘deleveraging’. Management of this process debt will easily overwhelm the relatively modest financial resources of the U.S. government. Unless this enormous disparity is appreciated, investors are vulnerable to being suckered into ‘dead cat’ bounce rallies.

Professor Robert Shiller has determined that house prices rose in line with inflation, between 1900 and 1995, at 3.3 percent per annum. Beginning in 1996, the Greenspan property bubble drove average house prices to a position where, by 2007, they were some 40 percent above their aggregate century-long ‘trend’ value.

To “deleverage”, as Treasury Secretary Paulson so soothingly describes it, will require the squeezing out of this 40 percent of price inflation; or some $12 trillion! This figure, which excludes the deleveraging of other debt-ridden areas such as commercial real estate, credit cards and auto loans, is just $2 trillion short of our entire annual GDP! It is a gigantic figure, of which there is understandably little or no mention.

When note also is taken of the $436 billion the Fed has recently injected into our economy and the fact that it represents some 50 percent of the Fed’s balance sheet, a massive problem of relative size is manifest. It begs the question of whether the Fed has the resources to do anything but make a dent in the crisis.

Faced with these realities, it is unlikely that the Fed has much chance of averting a serious recession. If Congress fails to act soon, depression will threaten. The earnings of many corporations can then be expected to plummet, leading to a serious erosion of stock prices.

Congress now needs to find a ‘cause’, that is politically attractive, in order to stall a depression, by boosting it into a recovery bubble. Green alternative energy, for example, would provide an attractive political cause, justifying the authorization of massive government spending on an unprecedented scale.

The Fed will have to reduce interest rates still further and stand ready to fund many troubled banks to justify even a nominal rally in U.S. stock markets.

In short, if we are to stall a depression, we must necessarily experience both far greater inflation and lower interest rates. The result will be renewed downward pressure on the U.S. dollar and the unseen erosion of U.S. dollar based wealth.

Many dollar assets can be expected to fall in price, even in depreciating dollars. Investors should be skeptical of any intermediate dollar-based market rallies. Instead they should arm themselves with advice as to how to avert the serious dollar erosion of their portfolios.

John Browne is the Senior Market Strategist for Euro Pacific Capital, Inc. Mr. Brown is a distinguished former member of Britain's Parliament who served on the Treasury Select Committee, as Chairman of the Conservative Small Business Committee, and as a close associate of then-Prime Minister Margaret Thatcher. Among his many notable assignments, John served as a principal advisor to Mrs. Thatcher's government on issues related to the Soviet Union, and was the first to convince Thatcher of the growing stature of then Agriculture Minister Mikhail Gorbachev. As a partial result of Brown's advocacy, Thatcher famously pronounced that Gorbachev was a man the West "could do business with." A graduate of the Royal Military Academy Sandhurst, Britain's version of West Point and retired British army major, John served as a pilot, parachutist, and communications specialist in the elite Grenadiers of the Royal Guard.

In addition to careers in British politics and the military, John has a significant background, spanning some 37 years, in finance and business. After graduating from the Harvard Business School, John joined the New York firm of Morgan Stanley & Co as an investment banker. He has also worked with such firms as Barclays Bank and Citigroup. During his career he has served on the boards of numerous banks and international corporations, with a special interest in venture capital. He is a frequent guest on CNBC's Kudlow & Co. and the former editor of NewsMax Media's Financial Intelligence Report and Moneynews.com. He holds FINRA series 7 & 63 licenses.

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