Week in Review 
For the week 8/13/2007 - 8/17/2007
Brian Trumbore
President/Editor, StocksandNews.com

Wall Street?and 1929

A strategist in Europe was quoted as saying this week, "We've had a long period of greed?and the chickens are coming home to roost." I've called the current era 'Great Gatsby II.'

Coincidentally, on Thursday I drove east a ways from Des Moines to exit 254 on Interstate 80 and the little town of West Branch, Iowa, birthplace of our 31st president, Herbert Hoover (b. 8/10/1874), and site of his impressive presidential library and museum. It's a bit of a hike and wasn't part of my original plan but I thought 'How could I pass it up at this time in the markets?'

Hoover, a famous engineer and great humanitarian, as well as commerce secretary under presidents Harding and Coolidge, came into office just 8 months before the crash of 1929. He had been troubled by the excesses in society and the markets, and it's interesting to note that both in the 1920s and today, the middle class was largely getting crushed while Wall Street and the elite partied.

Hoover asked the magazines and newspapers to run stories warning of the dangers of rampant speculation but his calls were largely ignored. Then on Oct. 19, ten days before Black Tuesday, Hoover requested an emergency analysis of the stock market from Thomas Lamont of J.P. Morgan.

"There is nothing in the present situation to suggest that the normal economic forces, working to correct excesses and to restore the proper balance of affairs, are not still operative and adequate," Lamont wrote. Kind of sounds like current Treasury Secretary Henry Paulson, a former Wall Street kingpin himself, doesn't it?

Hoover's treasury secretary, Andrew Mellon, had wanted to go back into private life but stayed on at Hoover's request when Herbert assumed office. Following Black Tuesday, and as the market began to swoon in earnest in 1930 after a brief rally, Mellon proclaimed:

"Let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate?It will purge the rottenness out of the system. People will work harder, live a moral life, values will be adjusted, and enterprising people will pick up the wrecks from less competent people."

Well, imagine if Hank Paulson made a statement like that today. It's probably what Federal Reserve Chairman Ben Bernanke thinks, but on Friday he came to the rescue, perhaps, in lowering the discount rate 50 basis points (from 6.25% to 5.75%); though this is the rate charged member banks, not you and I, and it's not the 5.25% rate that remains on fed funds, which has more to say with the level of economic activity. In other words, you could say the discount window, as it's called, is where they dish out the gruel during a crisis?kind of like a food pantry. But Wall Street still liked the move, at least for the time being, because it sees more handouts coming down the road, and maybe this will be the case.

But back to 1929, Hoover's Fed had actually reined in speculation in August, only to see National City Bank promise $100 million in fresh loans. To put it mildly, Hoover and Mellon were furious as this only added fuel to the fire, as future action would prove.

Well, you know the rest. Hoover not only made some big mistakes, such as in the Smoot-Hawley Tariff Act that exacerbated the emerging global depression, but being a private person, owing to his humble Quaker roots, at a time when he needed to be out front leading, wasn't a good thing. Between 1929 and 1932, U.S. GDP was cut in half and $3 billion in uninsured deposits lost as thousands of banks went under. Needless to say, the real estate boom of the 1920s was another victim.

Hoover had entered office as an activist president with a goal of firming up the middle class and taking care of the poor, especially children. [He later founded the forerunners to CARE and UNICEF.] In fact during his Inaugural Address, he set a goal of eradicating poverty across America.

So even during the evolving depression, Hoover wanted to fund his anti-poverty, pro-children programs while maintaining a balanced budget. As the economy swooned, though, this just wasn't possible so in 1932, Hoover raised the tax on the wealthiest from 24% to 55% in a last effort to come up with the funds. By this time he was very tired of the elite.

"The only trouble with capitalism is capitalists. They're too damned greedy!"

Time magazine quipped:

"Mellon pulled the whistle
Hoover rang the bell
Wall Street gave the signal
And the country went to hell."

The comparisons to today in the above history are quite telling, in the mind of your editor. And to those who say, well, the global economy is the strongest it's ever been, that was the largely the case, too, in 1929. Even then, without the mass communication tools of today, we were still very much connected.

Well, FDR came into office in 1933 and what was the first thing he did? Declare a 4-day bank holiday?a timeout. It was as if he told the bankers, 'You all go into your corners and think about the sins you committed the past 10+ years. All the stupid lending for crackpot schemes, the loans to fund real estate projects that made zero economic sense, and the illegal trading that was rampant in the markets and that proliferated under your watch.'

But even still, as you well know from your history books, it's not as if FDR had any real influence on the actual economy until war broke out. But where he was different from Hoover was he was a leader, and at least made Americans down on their luck feel a little better.

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So what of today and the crisis in the financial markets, globally, that started in the subprime mortgage market?loans made to people who for the most part didn't deserve them, who didn't do their homework, and are now up the creek without a paddle?

In one of the dumbest op-ed pieces in the history of mankind, one that received quite a bit of play, financial commentator Ben Stein, writing in the New York Times, tried to convince us that the current market turmoil was much ado about nothing; because when you break down the numbers, the subprime issue, versus the size of the total economy as well as the value of all financial assets in the U.S., is miniscule.

Stein wrote nothing of the impact on the consumer, insisting in true Thomas Lamont fashion that "This economy is extremely strong. Profits are superb. The world economy is exploding with growth?for now, the sell-off seems extreme, not to say nutty."

Heretofore, Ben Stein has more often than not been a voice of reason in his opinion pieces and I've quoted him favorably on more than one occasion. I think that's what so many of us found unbelievable when we saw this piece of trash.

Amazing that there are some out there who feel it's only about subprime mortgages, but before I go to Henry Kaufman for a more reasoned analysis, let's get one thing off the table.

Those who say the stock market is fairly valued today, citing a price/earnings multiple on the S&P 500 of around 17 based on trailing earnings, are only correct if they feel that decent earnings growth is going to continue well into the future. In that case I would agree; the market is fairly valued. But I believe corporate profits are on the verge of falling off a cliff, and, anyway, fairly valued is not the same as cheap.

Let's look, though, to what legendary economist Henry Kaufman wrote in an op-ed for the Wall Street Journal.

"Tremors from America's quaking subprime mortgage market have spread throughout the financial world. This latest disturbance in global financial markets is neither isolated nor idiosyncratic. It points to deeper, enduring changes in the structure of our markets - changes that have profoundly altered the behavior of market participants in ways that tend to encourage risk-taking beyond prudent limits. Just as troubling is the failure of official policy makers to effectively rein in such excesses, leaving our financial system vulnerable to similar turmoil in the near future?.

"(Structural) and institutional changes have, in turn, encouraged a new understanding among market participants of liquidity. In the decades that followed World War II, liquidity was by and large an asset-based concept. For business corporations, it meant the size of cash and very liquid assets, the maturity of receivables, the turnover of inventory, and the relationship of these assets to total liabilities. For households, liquidity primarily meant the maturity of financial assets being held for contingencies along with funds that reliably would be available later in life. In contrast, firms and households today often blur the distinction between liquidity and 'credit availability.' When thinking about liquid assets, present and future, it is now commonplace to think in terms of 'access' to liabilities."

[Ed. I just have to interject that this last paragraph is not only brilliant, it should be on a laminated card for every student in high school and college today. It's probably too late for Wall Street and Corporate America, however.]

On the topic of quantitative modeling Kaufman notes:

"(Models can't) take into account the impact of growing financial concentration in the making of markets and in the pricing of securities that are traded infrequently, or that have tailor-made attributes. And what about the risks to financial markets of a major military flare-up, the ravages of a pandemic flu, a terrorist attack that would immobilize computer networks, or even shifts in the broader monetary environment? Do the models quantify these and other profound risks in any meaningful way?"

Kaufman concludes:

"What is missing today is a comprehensive framework that pulls together financial-market behavior and economic behavior. The study of economics and finance has become highly specialized and compartmentalized within the academic community. This is, of course, another reflection of the increasingly specialized demands of our complex civilization. Regrettably, today's economics and finance professions have produced no minds with the analytical reach of Adam Smith, John Maynard Keynes or Milton Friedman.

"It is therefore urgent that the Fed take the lead in formulating a monetary policy approach that strikes the right balance between market discipline and government regulation. Until it does so, we will continue to see shocks of even greater intensity than the one now radiating outward from the quake in the U.S. subprime mortgage market."

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David Rosenberg, chief economist of Merrill Lynch, is another who has been all over the risks to our financial markets, though he is bit too sanguine for my book in terms of future growth prospects. That said, Rosenberg, in a piece for the Financial Times, summed it up. "The stresses to the system that started with the subprime mortgage upheaval have expanded not just into junk but also to high-grade corporate debt, to the prime mortgage sector and beyond the U.S. border to hedge funds in Europe and Australia."

There are innumerable examples of the above, with each day bringing, it seems, news of another hedge fund that has fallen prey to the contagion Ben Stein can't see. Personally, I couldn't give a damn about these guys, but their actions can, and have, nonetheless roiled markets, especially when they've loaded their portfolios with investments for which no one has a clue as to the true value, as in collateralized debt obligations.

And despite what Mr. Stein said up above, the subprime mess did indeed spread to the jumbo mortgage market, many of which go to the best credit risks. One outfit specializing in jumbos (technically, any mortgage over about $420,000?the Fannie/Freddie limit), Thornburg Mortgage, cut off funding them this week as the CEO said there was a "severe crisis" in his sector. Countless other mortgage lenders have closed their doors and laid everyone off (this part of the carnage has yet to be accurately tabulated), never to be seen or heard from again.

And then you have Countrywide Financial, the nation's largest mortgage lender with over 61,000 employees, as well as a large bank to boot (Countrywide Bank). Countrywide's operations seized up this week and it was forced to access its full credit line of $11.5 billion. Rumors spread that the bank was about to go under and in the Los Angeles area, as reported in a great story by the LA Times on Friday, even the likes of former NHL goalie Rogie Vachon were in line to get their money out. In Rogie's case he said his own deposits were over the insured limit?.good advice for all of us. Keep track of this.

Meanwhile, globally, the situation was chaotic with Tokyo's Nikkei index declining 5.4%, its worst performance since 9/11. There are signs the average consumer in Europe is beginning to cut back, and you had a large Aussie mortgage bank that couldn't refinance $5 billion to keep its operations afloat, while emerging market bourses were beginning to tank as well. Foreign direct investment in some Latin American nations, for example, could grind to a halt at a time when this has been fueling their growth.

The Fed itself, in slashing the discount rate, admitted the "downside risks to growth have increased appreciably," though the market liked that the Fed added it was "prepared to act as needed," which offered hope of actual cuts in the funds rate.

But in wrapping up this segment, here's a summary. CEO confidence is at a 5-year low and this obviously impacts capital spending; consumer confidence in America is plummeting; homebuilder confidence is at a 16-year low; the leveraged buyout era as we knew it is over (though here it's not such a bad thing for employees because all private-equity has been doing is raping and pillaging in taking out egregious dividends for itself, while loading up the company they had just acquired with humongous amounts of debt, thereby virtually assuring its future demise in any recession).

In the end, though, it all can still largely be reduced to real estate. It's always also been about affordability and far too many having stretched beyond their means. And now countless mortgage holders, at least in the U.S., face further damage in the form of resets. There is far more pain to come and millions of jobs to be lost in all housing-related industries. Good paying jobs, as President Bush would say.

But I fall down in the camp of those who say it is not up to government to bail out those who made poor decisions. Here I agree with former Treasury Secretary Mellon. Government is supposed to, however, attempt to provide a stable climate from which we can conduct our business and on this front history will show our current leadership failed in its latter years. President Bush, for example, was trumpeting record homeownership levels at a time when far too many were in way over their heads and were in the process of making mistakes for which they will pay for a long time.

It's a fine line, though, I'll grant you. The Federal Reserve, for one, doesn't want to see a deep recession, or worse. So it is attempting to figure out a formula that will lead to a more responsible environment for both investors and homebuyers without sending everyone out into the streets.

But the process set in motion today is also largely out of the Fed's control. One can always hope for the best, but as in the days before a hurricane, prepare for the worst.

Street Bytes

--You may want to glance at my current "Wall Street History" offering on volatility, if you think things have been particularly wild these days. Historically, this is nothing. That said, thanks to a 233-point rally on Friday the Dow Jones was able to pare its losses for the week to just 160, or 1.2%, as it closed at 13079. Thursday morning it was closer to 12500. The S&P 500 and Nasdaq also recorded losses of 0.5% and 1.6%, respectively, and all the broad market indices hit the magic 10% correction level at one point or another.

There was some other important financial news on the week. Earnings out of leading retailers Wal-Mart, Home Depot and Macy's all spoke of a dim outlook for second half activity, and overall retail sales for July were up just 0.3%. Friday's release on consumer confidence was also hideous.

This coming week, however, could be dominated by talk of Hurricane Dean if it were to enter the Gulf of Mexico and endanger our oil and gas infrastructure. We're also entering the two top vacation weeks for Wall Streeters and that could have an impact on the direction. But most importantly, we'll learn a lot more whether the credit crisis is in need of more Fed action, as well as learning of more bodies, I imagine.

--U.S. Treasury Yields

6-mo. 4.19% 2-yr. 4.17% 10-yr. 4.67% 30-yr. 4.98%

Short rates absolutely plummeted as bond traders treated as a certainty future Fed rate cuts, even if the Fed itself said otherwise, until Friday.

Fed Governor William Poole roiled the markets early on with his pronouncement that only a "calamity" justified a rate cut today. The sky is not falling with regards to the economy, he said, and the Fed should wait until its 9/18 meeting before acting. The Fed's decision on Friday to toy with the discount rate argued differently.

For the record, there was some news on inflation and both the core producer and consumer price indexes for July were tame. The core CPI, ex-food and energy, is now up 2.2% year over year. If the Fed is still worried about the CPI being over their 2% target, they are indeed nuts. [And, again, sports fans; I know the true rate of inflation is much higher, as in the cost of things you and I pay for, but the Fed doesn't act on that.]

--China's product safety issues continue as Mattel recalled another 19 million toys, including Batman and Barbie (the truth comes out?they are spies) due to more concerns over the use of lead paint, as well as magnets; though the latter is not necessarily China's fault, the magnets being a design flaw. China is responsible for 80% of the toy's being sold in America, which could be good news for the Island of Misfit Toys come Christmas. Time to gear up for the rush, guys.

[To prove China is serious about cleaning up its act, Vice Prime Minister Wu Yi was named to head up a product and food safety panel.]

--Nokia recalled 46 million cellphone batteries, also made in China by a Matsushita of Japan unit, because they overheat.

--In reading a piece on Japan in the July/August issue of The American (a new publication worth checking out), I couldn't help but include the following from Rowan Callick.

"(We, the U.S.,) ignore Japan at our peril. While China gets all the attention, Japan, still firmly ensconced in second place among the world's economic powers, is quietly enjoying its longest period of sustained growth since World War II. Japan's global brands have never been stronger: Toyota surpassed General Motors in car and truck sales for the first quarter of 2007, knocking it out of the world's top spot for the first time in 76 years; patent royalties deriving from Japanese inventiveness hit $4.2 billion in 2006. Sony and Canon, Honda and Panasonic, Fujitsu and Hitachi: throughout the world, Japanese brands are respected and profitable. By contrast, despite the best efforts of personal-computer giant Lenovo and white-goods producer Haier, China has yet to build a single brand that most Americans could name. Japan is back."

And Mr. Callick wrote this before the latest product safety concerns from the mainland emerged.

--In a bad sign of the times in biotech land, stalwart Amgen announced its first wide-scale layoffs?2,600. I also just saw that one of the big mortgage players alluded to above, First Magnus, laid off 6,000 in folding up its tent.

--And layoffs have started on Wall Street, with Bear Stearns handing out 240 pink slips to employees in its mortgage lending units. Recall, employment in the securities industry recently hit a peak, always a contrarian indicator.

--Dell restated four years of earnings after an intensive investigation but the changes are relatively minor; though it's still fraud, for crying out loud, and the SEC isn't done with the company. Meanwhile, rival Hewlett-Packard, which once had its own accounting issues, issued a solid earnings report.

--When I was at PIMCO, from time to time someone would come into our offices and talk about a product that was based on back-testing some model and my associate Andy and I would look at each other during the presentation and signal, 'This is the biggest bunch of crap we've ever heard.' Alas, many of the "quant" products have been huge successes, but now so many of them are doing the same thing, it's tough to separate yourself from the crowd. Which means you have to come up with a new model. Mine would be based in part on the price of beer. Or solely on it, actually.

--Here's a funny one. You could be a multi-millionaire, yet have trouble closing on a $500,000 mortgage this week; but the New York Giants and Jets had no problem obtaining a $1.3 billion loan for a new stadium. Undoubtedly, the CEOs at the banks that were part of the consortium will get their own luxury boxes, and at the end of the day in this chapter of Great Gatsby II, isn't that what's most important?

--I haven't finished with my fieldwork here in Iowa, so I'm holding off on more expansive commentary until next time. For now, as Rudy Giuliani noted this week during his visit?I have never seen more corn in my life!

Thanks to ethanol and booming exports, the economy is strong, as reflected in part by the housing market. The other day the second quarter figures were released and existing home sales in the state were up 4% over a year ago. This compares to declines of 41% in Florida, 37% in Nevada, 23% in Arizona, 21% in Tennessee, and 20% in California.

I'll explore next week whether Iowa is headed towards a bust.

[Separately on California?for the month of July, the six-county southern market saw the slowest home sales pace in 12 years, but the median home price was still up 3.7% from a year earlier thanks to the upper end of the market remaining strong while the lower end craters. But that was July?before the credit crunch that reached into the jumbo loan (read 'high-end') market.]

--The U.S. federal budget deficit could come in below $200 billion for the fiscal year ended Sept. 30. But the issue for F2008 is will the record revenue stream continue? [Not likely by my way of thinking] And can the government rein in spending, such as on Medicare and Medicaid, $560 billion, currently, Social Security, $516 billion, and the military, $437 billion? [Not likely.] Then there is the interest on the public debt, now a staggering $385 billion. You want to know why it's difficult to fund your favorite social welfare program? Look no further than this last figure.

--According to the National Association of Realtors, of the 149 metro areas they track, the place with the lowest median home price is Elmira, New York?just $71,700. No Elmira jokes allowed.

--If you are a Disney shareholder, you may want to know that traffic at its 2-year-old Hong Kong Disneyland may decline 20% in 2007 over the first year figure. This is not good. [South China Morning Post]

Foreign Affairs

Iraq: One thing we've learned in the 4 ? years of this war; if you start to feel optimistic, wait 24 hours. Such was the case with Tuesday's unfathomable massacre of the Yazidi sect near the Syrian border that killed 400; al Qaeda in Iraq clearly being responsible. The surge has worked in some respects by pushing al Qaeda outside the urban areas, but there are simply not enough U.S. troops to police the entire country and the Iraqi military is not capable of protecting its own.

That said; the White House and General Petraeus are both floating ideas for a drawdown in forces by next summer in order to maintain Congressional support.

Iran: And related to the above, the White House is preparing to name Iran's Revolutionary Guards as terrorists in order to go after its financial interests through increased sanctions that the administration is hoping it can get the UN Security Council to approve in September.

But that's only part of it. As the New York Post's Ralph Peters first brought up (and others have since followed), the move would establish a legal basis for air raids on IRG bases in Iran.

Israel: He's baaaack! Former prime minister Benjamin Netanyahu took 73% of the vote for the leadership of the Likud Party and it's only a matter of time before he once again holds the reins of state. Meanwhile, Hizbullah's Sheikh Nasrallah warned Israel that if it attacked his bases in Lebanon, he had some surprises up his sleeve. One thing you can count on when Netanyahu takes over and that is war.

Turkey: Big week coming up here as Islamist-AKP member Abdullah Gul, the foreign minister, announced he is running a second time for the presidency; an act that the secular military establishment blocked last spring and warned against following the recent election that solidified the AKP's power.

The vote in parliament starts Monday and Gul's election seems certain. Secularists have long said they will not accept Islamist control of all three major posts; the presidency, speaker, and prime minister. The risk of a coup has risen another 3- or 4-fold.

Russia: Terrorists of unknown origin (probably Chechens) blew up a train (no fatalities), while members of a heretofore unknown Neo-Nazi group were arrested following the release of a gruesome video clip (said to be authentic) that showed two men from the Caucasus being killed (one beheaded).

Separately, keep an eye on Kosovo. Its leaders remain hell-bent on declaring their independence from Serbia by year end. Russia isn't helping in negotiations with the U.S. and European Union as it adamantly supports Serbia. If and when the Albanian majority declares statehood, violence is a certainty and while the number of casualties won't approach those of the Balkan War, the scope of the brutality will.

And on Friday, Russian President Vladimir Putin announced his air force would restart Cold War-era bomber runs over the Atlantic, Arctic, and Pacific?just to remind us what a pain in the ass he can be.

India: Both sides of parliament blasted the prime minister for the nuclear deal with the United States, saying it gives up too much of India's sovereignty and control over its nuclear weapons program (which is hardly the case). The majority do not want closer ties with the U.S., in yet another example of just how hated we are these days, though members of parliament in India are also playing up to the sizable Muslim minority.

North Korea: The peasants can't catch a break. More historic flooding has left hundreds of thousands homeless and destroyed at least 10% of their farmland. The summit between North and South has also been put off until October.

Afghanistan: The tribal jirga was a total bust, though for the record Pakistan's President Musharraf did show up, three days late (last week I wrote he was a no-show). The 'council' was to adopt measures to combat terrorism in the region but instead, I imagine, they compared notes on the poppy crop. "Yes, our harvest was good?.and yours?"

Peru: An earthquake claimed over 500 lives.

European Union: You want some good news? At least 16 countries have seen an uptick in their birthrates from 2004 to 2006. As reported by USA Today, while the increases are small, at least it bucks a 20-year trend of declining fertility rates; a critically important issue as Europe faces gigantic costs in social services for its rapidly aging population.

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Pray for the men and women of our armed forces. And the miners and their families.

God bless America.

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Gold closed at $666
Oil, $71.98

Returns for the week 8/13-8/17

Dow Jones -1.2% [13079]
S&P 500 -0.5% [1445]
S&P MidCap -1.5%
Russell 2000 -0.4%
Nasdaq -1.6% [2505]

Returns for the period 1/1/07-8/17/07

Dow Jones +4.9%
S&P 500 +1.9%
S&P MidCap +4.2%
Russell 2000 -0.2%
Nasdaq +3.7%

Bulls 43.8 [unchanged]
Bears 32.6 [was 18.0 just three weeks earlier?Source: Chartcraft / Investors Intelligence]

Back to the fair now to check out the pigs?and eat a few pork sandwiches.

Have a great week. I appreciate your support.

Brian Trumbore

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