Worst Since 1930

October 14, 2002

After Wednesday's 2.9 percent decline in the Dow Industrials Index coupled with comparable retreats in Utilities, the S&P 500, and NASDAQ, investors are beginning to worry that we are entering a depression. Although economic activity does not yet reflect conditions of 1929 through 1933, it is disconcerting to note that the crash of 1929 did not immediately precipitate the business cycle implosion. Indeed, the depression materialized a year later. It takes time for people to run out of hope. Even as stock prices sink the mantra remains, "This could be the bottom."

Wall Street talks of a "final capitulation" that will mark the end of the bear market. This culmination of everything bad drives investors to one last selling frenzy before waking up to the fact that equities are undervalued. However, the price-to-earnings ratios remain historically high. This implies that a legitimate Dow Industrial Index could sink below my 7000 target to settle nearer to 5000.

If such a level is achieved, wealth will have dissipated beyond the point of no return. Any recovery will require government intervention, some artificial stimulus package. My first choice is "privatizing" a portion of Social Security. This would direct billions into equities. If not to raise prices, the President should seek to stabilize share values and calm the public.

Bank Failures

The Wall Street Journal highlighted Citicorp's continuing problems with an amusing twist. Solomon Smith Barney's former telecom analyst, Jack Grubman, is revealing that the banking/brokerage giant would not allow him to be candid about telecom issues because of the enormous banking business. In turn, the NASD is pressing Citibank for establishing unrealistic prices on telecom issues. The saga continues.

In the meantime, the word "derivatives" finally surfaced in discussions about J.P. Morgan Chase. As examiners uncover the exposure, many "insiders" fear the bank will be declared insolvent. Thus, two of the largest U.S. banking institutions are seriously on the ropes. If Continental Bank was "too big to fail" under Bush 41's administration, I believe Citibank and Chase will receive the same preferential status. However, their failures would not simply ripple through the banking industry. We would see a tidal wave sweeping small and intermediate banks away, not to mention any counter parties to Citibank or Chase derivatives.

Does anyone remember the Glass-Steagall Act of 1933? In 1999, Congress replaced Glass-Steagall with the Financial Modernization Act. The former prohibition against combining banking and investment services was lifted. Notice the timing. Glass-Steagall was enacted in 1933, the peak of the Great Depression. After its repeal, banks went headstrong into securities and the lucrative derivatives markets. Within three years, we are discovering that the former separation had significant efficacy then (in 1933), as it may have today. Sharing risk between investment assets and loan portfolios represents too much exposure. Further, there is an inherent lack of control when investment operations fail to properly communicate with banking.

Further, we see incentives to mislead one arm in favor of the other. A good stock recommendation insures continuing banking relationships. The investor becomes a sacrificial lamb. Yet, we read that our economy is based upon consumerism. By sacrificing the individual investor, these institutions have placed the entire economy at risk. Wealth evaporation has slowed economic growth that, in turn, depletes wealth which, in turn, slows the economy. This is the cycle.

I am not unique in my discovery of investor sentiment. "What's next?" As corporate scandal and Street dishonesty make headlines, the public's confidence turns to despair. This is hardly an environment for a recovery. Lacking fundamental encouragement, traders await technical confirmation of a bottom. Hopes hang on every rally. However, the overall complexion is extremely weak.

Last week, I reiterated my feeling that real estate was the next bubble. Again, this opinion is shared and has made its way into the news. Still, my assessment dates back to a time when housing values were making new highs and the boom seemed endless. The dangers here are so extraordinary that I almost don't want to bring them to light. Obviously a mortgage meltdown would be a banking meltdown. Unlike the Savings & Loan crisis of the 80's, the current real estate market is so overexposed that it rivals the March 2000 NASDAQ.

Like 1974/1975, metropolitan areas and associated suburbs could see a 70 percent decline in values. The only fundamental holding up this market are incredibly low interest rates. However, if banks are failing, they will need to find salvation somewhere. Despite Uncle Sam's rate adjustments, it is likely mortgage rates will increase to compensate for values that go south.

Employment...Means What?

J.P. Morgan Chase will relieve several thousand investment sector employees from paychecks. Financial institutions from coast to coast are doing the same. A sudden and sharp slowdown in auto/truck sales has dropped Ford's credit rating and Detroit's payrolls. Can we find a single shining star besides certain military industry companies?

New warnings suggest the U.S. is being targeted for a new round of terrorism. The Washington, D.C. sniper is an example of how single incidents can grip entire communities in paralyzing fear. While he or she has only killed seven victims, consumers have virtually locked themselves home, in anticipation of the perpetrator's eventual demise.

I used the word "only" because the number of U.S. citizens that will be at risk if we go to war will dwarf the number seven by factors in the thousands. Returning to my point, our enemies are conducting a different war... a modern war. The target is not simply people. Radical Islam is attacking modern economic structures because such structures threaten their ideals and existence. Thus, half a dozen homicide bombers strategically placed throughout the most popular urban and rural malls in the U.S. is all that is required to cripple the retail sector.

Americans are not like the Israelis. We have not lived with a constant threat of explosions and snipers in public places. We cannot accept indiscriminate random killings. We are not hardened by religious zeal. While we are a compassionate people, we are not particularly courageous. I don't say this in a pejorative sense. Certainly, the United States stands as the greatest superpower of all time. Our military is incomparable. Our technology is superlative. But, we are accustomed to the luxury of freedom.

Ask yourself whether a string of mall bombings before Christmas will impact your shopping or the attitude of friends, neighbors, and relatives. The answer is a resounding, "yes."

Most disturbing is the fact that so many of our enemies have been educated and trained within our home and the home of Western Europe. This new breed of Middle Easterner keenly understands what makes our economy tick. They have learned Economics 101 and Marketing 102. They comprehend supply-side accounting and economics. They have the knowledge necessary to stall our economic system with very little effort and few resources. The bombs that took down our loftiest towers of capitalism were our own means of transportation. The cost to terrorists was zero, but for their lives lost.

Within six months, homicide bombers could rocket U.S. unemployment to the highest levels of the previous century...inclusive of the Depression years. Understand that terrorism is an extraordinary event. There are no Fed policies specifically designed to alleviate the impact of terror. There is no fiscal policy that can combat random attacks. Even with the most sophisticated homeland security, Israel's daily experiences prove how impossible it is to prevent infiltration and success.

Our diverse population forecloses any sensible "profiling." Our sense of freedom forbids infringing upon our inalienable rights. Essentially, we are caught between our own ideals and the realities of modern warfare. In the old days, the objective was to win the battles on the battlefield. Today, the enemy realizes this conflict is impossible. A new form of attack is required to circumvent America's military sophistication and strength.

Wake up President Bush. Iraq doesn't really need weapons of mass destruction to cause mass destruction. In the modified words of a former president, we have fear to fear.

Gold Fails To Gain

Given the chaos in conventional markets, we would assume gold would make more progress. I still have the ultimate confidence gold will respond positively as the economic crisis worsens. But, gold is caught in the same liquidity crunch that is spiraling stocks lower. When there is no money, there is no money. This is to say that investors are rapidly running out of financial resources. Regardless of gold's potential to protect wealth, there is less wealth to protect. The former big consumers like Japan and the Middle East are in no condition to convert paper assets into gold. Investment paralysis is complete.

On Monday, I spoke on the Damian Vickers radio show. A caller was questioning the real estate bubble. In the course of conversation the question arose, what investments remain viable? When utility stocks sink by 50 percent, the malaise goes beyond growth stocks and permeates corporate bonds, commercial paper, and bank accounts.

The traditional answer is gold. But the current investor generation is unfamiliar with precious metals hedging. It has not been prevalent since the late 1970's.

Technically, December gold busted below the 20-day and 40-day averages. After meeting 32800 resistance, the interim trend line from the August low was violated, too. This suggests a trading range between 31200 support and 32800 resistance. Absent any fundamental influence, I expect this range to narrow into a new consolidation. A breach of 7000 in the Dow represents a catalyst that can propel investors toward gold and government paper. If the U.S. Dollar weakens, gold will be preferable under an assumption it will hold value against deteriorating dollar parity.

Currencies

Several subscribers called this week with concern that the U.S. Dollar could be testing support against the Euro currencies new strength. The chart continues presenting a consolidation, for now.

While there is a 16-day interim upward channel, today's action demonstrates 9900 resistance. The moving averages remain trend less despite the interim channel. Today's dip is likely to follow through tomorrow.

While I believe the Euro will eventually gain dominance, this is not the season. Germany turned in better than expected industrial output over last quarter and Europe seems poised to pull itself out of recession sooner than the U.S. Don't be fooled by appearances. Europe is in the same boat as the U.S. When this ship sinks, everyone must swim to a lifeboat.

I anticipate one more test of 9600 support in the Euro before it will muster enough momentum to breakout above 9950. Once beyond this resistance, I see the Euro climbing to 10500. In the meantime, our short option strangle appears to be the best strategy.

A number of subscribers have inquired about our Delta Neutral strategies that take advantage of current volatility while reducing risk and exposure. I will cover this next week if nothing monumental grabs my attention.

Gold is using for heat dissipation in some cars.

Gold Eagle twitter                Like Gold Eagle on Facebook