The World Bank now says the global economy will contract by 2.9% this year instead of 1.7%. That could be right. But that’s not the reason stocks are falling. The rally that began in March has now run out of steam. It’s also run out of news events to send it higher. So what now?

Well, the primary trend—and by that we mean what we think the dominant trend is for the next few years—is the systematic reduction of debt in the household and business sectors. That ought to lead to write downs in asset prices and a general contraction in credit. Perhaps that is why—despite the mondo auction of $104 billion in new debt—even U.S. government bonds followed stocks and commodities down.

Let’s take a quick look at what the Federal Open Market Committee said yesterday in regard to U.S. interest rates. We’d planned to watch for language that tipped the Fed’s intentions regarding the bond market. It all begins with the bond vigilantes these days. So what did the Fed say?

It made clear low rates-at least the Fed’s target rate-are here to stay. “The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Whether the Fed can talk down or manipulate long-term rates into staying dormant is another matter. But it had more to say on the subject. “As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year.”

The important part here is “as previously announced.” This sounds a bit like, “I really mean it. I’ll do it. I’m dead serious. Don’t make me buy those mortgage bonds. I’ll do it if I have to. Don’t push me.”

In other words, the Fed is merely repeating what it said it would do earlier. It did not announce a new policy or its intention to expand quantitative easing to keep bond yields down. We imagine it would not want to advertise its willingness to keep buying bonds. That might induce a lot of selling and have the perverse effect of pushing U.S. yields up and investors into other assets.

But just for good measure the Fed repeated itself one more time. “In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.”

So it’s a waiting game now. The Fed hopes the economy recovers this year and that it can withdraw its massive liquidity measures before they leak through into the economy to cause inflation. So far, its credit facilities have not translated into an expansion in the money supply. That’s what the bond market fears (which is also why ten-year Treasury yields were up on the day).

We reckon investors and insiders will wait to wade back into the stock market until this correction (if that’s what it is) runs its course. After all, the insiders have not been buying the rally. They’ve been selling into it.

According to research service TrimTabs insiders of S&P 500 listed companies have unloaded $2.6bn in shares in June, compared with $120m in purchases. “The smartest players in the US stock market – the top insiders who run public companies – are not betting their own money on an economic recovery,” says TrimTabs CEO Charles Biderman.

So the American insiders are bearish. They’ve been net sellers for fourteen straight weeks, according to Ben Silverman at InsiderScore. If the inside money is getting out, we reckon shares are going to do some bottom searching over the next few weeks. The World Bank announcement, then, merely confirmed what the action in the market has been telling us for the last few weeks.

Insider selling is a particularly charged bit of investment intelligence. But in our experience it is a piece of information that confirms what is already apparent through an analysis of other technical and fundamental variables. It doesn’t necessarily tell you anything you can’t figure out by other means.

It’s true that the insiders may be selling because they have access to information not known by the general public (although trading on this information would, of course, not be legal…but there you go). And insider sales—at least on large stocks with lots of liquidity—are easier to conceal in the general course of trading. But the money flow and volume still tell the tale, especially with smaller stocks.

If you step away from the technical guts of the market for a moment, the larger question is whether this last financial year will trigger any shifts in the investment habits or psyche of the Australian public. Judging by the number of people who stayed in balanced or growth funds over the last year, the Australian public is brain dead (zombies!). But then, let’s be fair. Maybe they ARE keeping their eye on the bigger picture. They just see the picture slightly differently than other living, thinking people.

The bigger picture can be seen below, courtesy of Super Ratings, in the value of a balanced Aussie super fund versus cash since 2003. Cash is slow and plodding and lazy and conservative. Very turtelish. The balances super funds, on the other hands, had three ripper years up to 2007, and two disastrous ones since. Even after an epic charge in commodities, balances super has barely beaten cash. Hmmn.

The Tortoise Cash and the Balanced Hare

You can see that after reaching parity earlier this year (at the markets slow) balanced funds have since rebounded. But you have to wonder how balanced they really are. Balance-according to our Super expert Kris Sayce-is supposed to be a kind of middle ground between aggressive growth and conservative cash. It also sounds sensible. Who is against balance? It’s prudent, right?

But if we read the latest report right from Super Ratings, the median balanced fund has 60%-76% of its investment portfolio allocated to growth assets, the riskiest type! That sounds distinctly unbalanced. It sounds, in fact, really stupid, considering this is a bear market in stocks.

Balanced zombie minds will point out that on rolling five, seven, and ten-year periods, balanced funds are all still up (4.75%, 4.99%, and 5.07%, respectively). But we would humbly suggest that there’s never been a better time to question the basic assumptions about investing in balanced funds-or any funds for that matter.

That is, a passive approach that assumes markets always go up and time is on your side is probably going to get you slaughtered in the coming years. If inflation doesn’t kill you, a few bad years could. And if your rolling period coincides with some of the frequent 17-year periods in which stock markets do not go up at all-well then the whole idea of using the stock market as a retirement machine is as dead as a zombie.

Regards,
Dan Denning
Daily Reckoning Australia

June 26, 2009

The Fed and Zombie Investors was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Steer clear of the new gold rush,” urges Jason Zweig, a senior columnist at Money magazine.

“Don’t give in,” says Janice Revell, another senior hack at CNN’s glossy monthly. “Step out of the stock market, even temporarily, and you may miss the whole point of owning stocks.”

“Aw, just lend! Lend! LEND!” screams the Federal Reserve. Sporting its usual crystal meth grimace, it’s stumping up $200 billion in Treasury bills for desperate New York brokers to kick-start the world’s capital markets. And now they can use flakey mortgage-backed bonds as collateral.

Stepping in “to address liquidity pressures” like this — and getting your chums at all the other top central banks to do the same — looks like the next best thing to buying mortgage-backed bonds altogether. But while central banks surely don’t want to become “home buyer of last resort,” it’s got to be better than doing nothing. Right?

Acting early and often must work out cheaper in the end. Mustn’t it?

Well, you’ll never guess what. As anyone who ever fell for interest-free vendor financing knows only too well, the cheapest option — always and everywhere — is to avoid spending any money at all.

As a professional economist would put it, “We find no evidence that accommodating policies reduce fiscal costs.” That’s how two senior economists at the World Bank put it in a 2002 report studying 30 years of systemic banking crises across 94 countries.

Borderline crises hit 44 nations. And on average, the World Bank economists found, “governments spent an average of nearly 13 percent of GDP cleaning up their financial systems” as a result of the bailout programs they tried to implement.

“Indeed, each of the accommodating measures examined,” they continued — citing “open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated (and thus initially inadequate or partial) recapitalizations, and debtor bailout schemes — appears to significantly increase the costs of banking crises.”

Weird like pineapple on pizza, don’t you think? Because the seven central banks jumping to hit the panic button this week are all members of the World Bank. They actually helped found it back in 1944. More than that, the central banks led by Ben Bernanke, Jean-Claude Trichet, Mervyn King, and the rest all figure in this 2002 report.

All except the Swiss National Bank, that is…

1. S&L USA: The slow-motion savings and loan collapse in the United States destroyed some 1,400 institutions and took another 1,300 banks with it between 1984-1991. Direct cost to the U.S. taxpayer? Some $180 billion, or three percent of annual economic output.
2. Europe’s Bad Banks: Staff at the European Central Bank might like to recall the Greek and Italian bailouts of the early 1990s…or the $10 billion failure of France’s Credit Lyonnais in 1995…or Germany’s Girobank crisis in the mid-1970s?
3. Japan’s Lost Decade: The 1996 rescue of Japan’s zombie banks cost more than $100 billion in public funds. Two years later, the Obuchi Plan spent another $500 billion of taxpayers’ money — some 12 percent of Japan’s GDP — on loan losses, bank recapitalizations, and depositor protection.
4. The U.K.’s Repeat Failures: From the “second line” crisis of the mid-1970s to the collapse of Johnson Matthey in 1984, BCCI in 1991, Barings in 1995, and now Northern Rock in 2007, the U.K. authorities have repeatedly failed to spot trouble before wading in with taxpayers’ cash.
5. Canada, 1985: The Bank of Canada itself notes how the failure of 15 members of the Deposit Insurance Corp. — including two banks — accounted for less than one percent of the total banking system. Yet it led to long-term liquidity loans, funded by the public, plus 15 years of expensive court wrangling.
6. Sweden’s Systemic Crisis: In the early 1990s, two banks accounting for one-fifth of all Swedish banking assets were declared insolvent. By 1994, five of the six largest banks faced serious problems, costing taxpayers four percent of GDP in government support.

Don’t the current heads of the world’s biggest central banks ever flick through World Bank research reports while waiting to get their teeth straightened or beards trimmed?

But given the current collapse of real estate markets, banking models, hedge fund credit lines, and short-term liquidity the world over since last August — back when gold bullion traded one-third below today’s current price — who in their right mind would bother to read a study of 113 truly system-wide banking crises in 93 countries between 1970-2000?

No one running monetary or fiscal policy in the G-7 group of top economies, that’s for sure!

“If the countries in our sample had not pursued any such [supportive or bailout] policies, fiscal costs [borne in the end by the taxpayer] would have averaged about one percent of GDP — little more than one-tenth of what was actually spent,” write Patrick Honohan and Daniela Klingebiel in their report, published in January 2002.

What’s more, trying to bail out or support failing banks did nothing to reduce the economic drag that followed, according to Honohan and Klingebiel’s analysis. The so-called “output dip” never responded to government meddling — not unless the central bank stepped in to ease liquidity problems at crisis-hit banks with unlimited cheap loans.

That kind of support — exactly the support given to Northern Rock as it went belly up in September last year — is only one step removed from the marketwide support now being offered to New York brokers today. Yet it “actually appears to have prolonged crises,” write the two World Bank bean counters, “because recovery took longer” following liquidity loans to effectively insolvent banks.

In other words, the only sure way of prolonging a financial crisis is to try to delay it. Say, by putting taxpayers “on risk” with $200 billion in mortgage-backed loans.

“Things could have been worse,” the World Bank goes on. If every country hit by a systemic banking crisis during the 30 years to 2000 had piled in with liquidity support (like the G-7 central banks are offering today) or blanket depositor guarantees (as the U.K. government did with Northern Rock), the final bill of trying to clear up the mess early would have risen sharply.

Throw in regulatory forbearance — letting “zombie” banks continue their operations, even though they’re technically bust — plus repeated recapitalizations and debtor bailouts, and “fiscal costs would have reached more than 60 percent of GDP.”

Nasty rumors keep whacking “living dead” bank stocks in London, Tokyo, Frankfurt, La Defense, and Wall Street right now. And so far, taxpayers aren’t on the hook for recapitalizations; UBS and Citigroup have gone to Asian and petro-wealth funds for that. Ben Bernanke has so far only demanded that subprime lenders write off the value of outstanding loans, rather than calling on Congress to issue the checks directly.

But if the authorities sat on their hands during this crisis, the fiscal cost might equal one percent of GDP, the World Bank report suggests. Donning a cape, tights, and mask, instead — and pretending they can unwind the mal-investments caused by record low-interest rates from the Fed after the tech stock bubble burst — the cost may rise 60 times over.

That’s more than a 98 percent saving, if only the G-7 authorities would sit back and let the failed banks fail.

Put these findings to one side, however. Because what’s most remarkable about the World Bank study — other than the fact central bankers are so clearly ignoring it — is that anyone could ever imagine things differently.

Throwing “good money after bad” is a moral hazard that everyone’s grandma knows to avoid. And just like the truly historic bubble in credit that created it, the endgame for today’s official response to this historic banking crisis looks as inevitable as it’s sure to prove painful.

“Fiscal outlays are not the only economic costs of bank collapses,” note Honohan and Klingebiel. “The losses covered [by taxpayers] — which are caused by bad loan decisions — reflect wasted investable resources. Furthermore, a government’s assumption of large, unforeseen bailout costs can destabilize fiscal accounts, triggering high inflation and a currency collapse — costly in themselves — as well as adding to the dead-weight cost of taxation.”

High inflation and a currency collapse, you say? As a rule, smarter investors spotting this trouble in good time can switch into hard currency to hedge their domestic inflation risk.

But today’s systemic banking crisis crosses all developed economies…from North America to Japan and Australia onto Europe and the United Kingdom. So unlike the Asian crisis of 1997, you can’t flee the Thai baht by hedging with dollars today. Nor can you flee the Hungarian forint for the safety of French francs or Deutsche marks, as you could when 25 percent of Budapest’s banking assets were caught in a mass bank failure in 1993.

Where to go? What to use as a hedge against all currency risk?

Regards,
Adrian Ash
BullionVault
March 14, 2008

Central Bank Bailouts was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.