Why would you pay 40 times earnings for a homebuilder? It’s a fairly easy business to enter. No barriers to entry that a little money… a few connections… and a circular saw can’t overcome. With no barriers to entry, profit margins are always squeezed by competition. And growth is limited too… other builders are always starting up. If the investor paid 40 times earnings, he can only get 2.5% on his money — if the company pays out 100% in dividends! So, why pay so much?

The answer has two parts. First, China is providing stimulus to its economy on a mammoth scale. It gave the signal to its banks. The banks responded by opening the flood gates. Loans in the first half of the year measured three times those of the same period a year before. Naturally, this liquidity had an effect. The economy is booming. Everything credit can buy is being bought. But… as we at the Daily Reckoning know… you can’t buy real prosperity on credit.

The other reason for the bubble in builders’ shares is that investors – especially investors in China – have learned nothing from the crash of ’07-’08.

These are our little secrets, aren’t they, Dear Reader? The rest of the world seems unaware of how the investment markets work… and they think credit is Miracle Grow for the economy.

But markets are not mathematical, nor mechanical; they’re moral. Their purpose is not to make people wealthy, but to make them wise. And then… only for a while.

It they were mathematical you might make people richer by adding zeros. But it’s not that simple. Zimbabwe tried it; it doesn’t work. A Dear Reader gave us a $10 TRILLION dollar bill – real money printed by the Zimbabwean Treasury. That – and about $5 US dollars – will buy you a cup of coffee in Harare… if they have any.

If they were purely mathematical, you might be able to anticipate price movements with computers and Ph.Ds. in math… Many have tried it. As far as we know, none has ever really succeeded.

It’s not a mechanical system either. When prices go down, there are no screws you can tighten… no levers you can pull… Nor can you add more fuel or slather on more grease. It’s not that simple.

Instead, markets are complex natural systems… Like mistresses, they can be jiggled and jived… but they can never really be controlled or predicted. That’s what makes them so interesting, of course.

The markets are always teaching us… always correcting us… always giving us a kick in the pants. These are moral lessons… in the broad sense. That is, if you do the wrong thing you get punished for it. Step on a rake; it hits you in the face.

The purpose of a bear market is to correct the errors of the preceding boom. Most prominent among those errors is to think you can make money by speculating in the stock market. What this idea takes hold, good sense goes out the window. People will buy dot.coms with no business plans… and house builders at 40 times earnings!

But that’s how we’ll know when the correction is over – when people give up on the stock market… .when they want nothing more to do with it. Judging by today’s news… we’re still a long way from there.

Get ready for another crash… the next leg down of this historic correction… the next kick in the pants… the next moral lesson.

More thoughts…

*** If investors have learned nothing so far… neither have the feds. All over the world they’re trying to solve a problem caused by too much credit by providing more credit. Trillions’ worth…
We see the result of it in China… a country where the feds have money to spend… and the power to tell bankers what to do. The markets have gone wild…

In the US and Britain, they’ve been less successful. But they haven’t given up. On the contrary… they’ve put at risk an amount equal to nearly twice the GDP of the entire US economy… and now they’re talking about stimulus II… which will probably be followed by Stimulus III and Stimulus IV… until the whole thing finally explodes in a blaze of glory…

Consumers have wised up. They seem to have learned their lesson. Savings rates have gone from zero to 7% in the past 12 months – a remarkable turnaround. Frugality is back in fashion. Thrift has been put back in the dictionary. Consumers are tired of carrying huge debt loads. They’re eager to get rid of them as soon as they can.

But neither Wall Street, nor Washington, nor investors seemed to have learned much. Wall Street is still handing out billions in bonuses – leaving its firms short of capital reserves. Investors still seem ready to jump onto whatever wagon has the most other people on it. And while the private sector ran up trillions in debt in the bubble years; now, it’s the public sector’s turn.

In 1991, borrowing by government and the private sector put together was less than 5% of GDP. But by 1998, the private sector was on a binge. Every year for the following decade, households and businesses borrowed between 10% and 15% of GDP, while government continued to borrow modest amounts… less than 5% of GDP.

In 2008, the positions reversed dramatically. Private sector borrowing collapsed to below zero – meaning, the private sector was is paying off debt, not accumulating more of it. The public sector, on the other hand, has come to the rescue with borrowings between 10% and 15% of GDP.

Of course, this is classic counter-cyclical stimulus. What the private sector giveth up on… the public sector taketh up like an unexploded hand grenade. The politicians are now pulling the pin…

Yes, dear reader, there are still lessons to be learned.

But wait… isn’t counter-cyclical stimulus a good thing? Everyone says so. Without it, said Ben Bernanke, we might have entered a Second Great Depression. And we don’t know… maybe he’s right. The private sector is no longer borrowing and spending like it used to; now, the feds have to do it, right?

Where have you been, dear reader? That’s not the way it works. The credit explosion in the bubble years didn’t really make households richer – it made them poorer. That’s why they’re struggling to pay their bills now. And the credit explosion in the public sector now isn’t going to make people richer either; it’s going to make them poorer too. Soon, the US will be struggling to pay its debts too.

That’s the moral lesson: borrowing makes you poorer. Unless you’re using the money to increase output, there’s no economic health it in. In other words, if a factory sees an opportunity, it might borrow to expand. The extra output should produce enough profit to allow it to repay the loan… and come out ahead. But if you borrow to consume, at the end of the day you’re poorer.

That’s the lesson of the Bubble Years. That’s the lesson consumers need to learn every couple of generations. And now, they seem to have learned it. They remember that the economy ran hot in the bubble époque, but it didn’t do them any good. The stimulus of the era stimulated consumption, not genuine wealth-building.

And now cometh the feds. They’re borrowing and spending on a scale never before seen. The federal deficit is expected to come to $2 trillion this year. Trillion-dollar deficits are foreseen for the next 10 years. There seems to be no way out.

What the private sector took away – about $1.4 trillion of debt-induced spending – the public sector puts back. But will this spending produce any more real wealth than the private sector binge? Let’s see… the news reports tell us they are using it to fix toilets in national parks… cut down pine trees in rural Tennessee… and bail out the bankers on Wall Street.

Is this consumption or investment? If it is investment, is it wise investment? It’s not enough to invest; you have to put money into projects that pay off… that pay dividends… projects that give you the cashflow to pay back the debt! Will federal spending for the stimulus/bailout projects do that?

Don’t even wait for the answer, dear reader; you already know what it is.

Tomorrow… the vigilantes are back… the real showdown…

Source: Get Ready for Another Crash

“Psst…we’re breaking out of this joint…Saturday night…pass it on….”

Yes, dear reader…we’re breaking out… We’re not going to let these prison bars stop us. A whole generation of American investors is being fattened for slaughter…we’re not going to be among them.

Let’s look at yesterday’s headlines just to see what is going on.

The Dow rose 62 points yesterday. Oil held steady at $48. Gold went up $8. Yields are rising…but you still get paid nothing when you lend money to the U.S. government.

The economic news tells us that things are getting worse. Alcoa said it will lay off 13,500 workers. But all across the country, businesses are either laying off old workers or not hiring new ones. Most of the joblessness never makes the news – until it is already painful to the fellows without jobs. Small businesses don’t announce layoffs. Nor do they send out a press release when they decide not to hire a new kid at the carwash.

After the worst car sales in half a century, Toyota says it is shutting down its plant for 11 days.

And a figure out yesterday tells us that consumer bankruptcies rose 33% last year. But the crash came late in 2008; job cuts didn’t really begin until the last quarter. People didn’t have a chance to get their paperwork together. This year, the bankruptcy numbers should really soar.

Most likely, Americans are still in the dark about what is going on. Heck…their leaders are driving without headlights…why shouldn’t the lumpen too? People don’t seem too sore about what happened to them in ‘08. They’re still hopeful that a new administration will find a way to fix things. Yes, they’re planning on cutting back spending and saving money…but they have no idea how their attempts at thrift – magnified by millions of other citizens – will affect the economy.

Levy Forecasts, which was generally right about the financial crash, now says the “damage to the economy will rapidly accelerate the financial crisis.” In other words, the financial crash is causing an economic crash…which will cause a worse financial crash.

Profits are made at the margin. Most sales merely cover costs. It’s the marginal extra buyer – preferably the one who spends his savings, rather his salary – that provides business with profits. On a macro level, salaries are a cost to business. When a man spends his salary, business is merely getting back the money it paid out in labor costs. But when a man spends savings, the money falls to the bottom line as profit.

Who is going to spend savings in ‘09? Who is going to spend at all? That’s why business profits are going to fall harder than most people suspect. Unemployment is going up more than most people expect. And stocks are going down more than most people expect.

Barron’s survey of Wall Street’s “top strategists” tells us that the consensus among these fellows is that stock prices will go up 18% in 2009. But these are the same strategists who thought stock prices were going up in 2008 too – instead of crashing 35% – 40%.

Here at The Daily Reckoning, we’re with the Levy bros. Our guess is that stocks will rally…and then crash again, ending the year below where they began it.

There is no doubt that the U.S. economy has entered a major downturn…probably a generational slump, in which the errors of an entire generation will be corrected.

What do we mean by that? Well, since the early days of the first Reagan Administration Americans have been building fences, to keep themselves confined, and forging chains, to wrap around their own ankles. They built cars and houses that demanded more energy – when energy was becoming more expensive. They became accustomed to lifestyles that cost about 10% more than they earned. They began to think that houses and stocks would go up every year…and that foreigners would lend them money forever. Well…you know what happened. Every link was heated white hot in the furnace of mass delusion and hammered on the anvil of wishful thinking – while public officials urged them on!

Now, the whole country drags around these heavy chains of debt…private debt in all its forms – mortgages, student loans, credit cards, home equity lines, commercial loans, private equity finance, bridge loans, road loans, ditch loans. Last year, all of a sudden, this debt got so heavy, the poor debtors started to pitch over. Lenders looked around and worried, not about the return on their money, but the return OF their money. In many cases, it didn’t look like they’d get it back. That is what caused the ‘credit crisis’ – lenders closed their wallets to all borrowers – save one, the only borrower who was 100% sure to pay you back the money when you needed it, the U.S. government. As a result, bonds and gold were the only two major asset classes to go up last year. People bought government bonds to protect against the implosion of private debt. And they bought gold to protect against government bonds.

We recall Nassim Taleb’s turkeys. Until Thanksgiving, he says, the turkey lives well. Everyday, the food arrives. Everyday, he gets bigger and fatter. Then, one day, just before the third Thursday in November, when Americans celebrate their traditional Thanksgiving dinner…with no warning, comes the knife…the crash…the collapse…the discontinuity…the 7 sigma event in the turkey’s life that changes everything.

“That’s why we need to study history,” says Elizabeth, who is working on a master’s degree in 18th century French history at the Sorbonne. “If the turkeys had studied history, they might been warned. In early November, they might have started whispering to each other in the yard: ‘it’s a set-up…we’re all going to be sent to the ovens…break-out planned for tomorrow at dinner…pass it on.’ Then, while a few birds got into a squawk to provide a diversion, the others might have rushed the gate. Instead, they didn’t know what was coming and took it in the neck.”

There are plenty of histories of finance – oral and written. But investors pay no attention. One generation of turkeys learns. The next forgets. One makes money; the next loses it. Every generation has to get its own neck chopped in its own way.

*** With so many citizens groaning and collapsing under the weight of so much debt, it is entirely foreseeable that the feds should pretend to come to their aid. Today’s news tells us that Barack Obama’s rescue mission will bring about $770 billion of cash with it. This comes on top of other rescue missions mounted by the Bush Administration and the Federal Reserve. Altogether, the total cost of these mercy efforts is into the trillions.

In fact, this morning, the Congressional Budget Office has reported that the U.S. government will run a budget deficit of $1.2 trillion in 2009…and that’s not taking into account the stimulus programs.

We have explained why bailouts don’t work. You can’t solve a problem caused by too much debt by adding more debt. The ‘hair of the dog’ technique won’t work – not even if you throw in the whole pooch. But it will have an effect – it will increase the weight of debt to the whole society. The forges are hot again…the hammers are clanging…the smithies are sweaty; now they’re building new chains of debt – public debt. They’re putting up a chain-link fence around the entire United States…and shackling every citizen to a monumental ball. Next year alone, the U.S. federal deficit will go to $1.5 trillion to $2 trillion – or about $20,000 for every family in the country. Over the course of the slump, the total could run to $100,000 per family. This extra public debt is the only sure outcome of the bailout projects.

How will Americans possibly carry so much public debt – along with their already bone-crushing private debt – without collapsing? Who would lend these sub-prime borrowers so much money in the first place?

Give us 24 hours and we’ll have answers to those questions…and give you our break-out plan too. The rest of the turkeys may get the axe…but we’re headed over the fence. We’ve got wings, remember….

*** A dear reader writes: “I respectfully disagree with your assumption regarding the ‘bounce.’ One of the goals of the Bush Administration is to have significant government ‘equity’ presence in Wall Street. This is called ‘Privatization’ when it applies to Social Security – but whatever the Government ‘privatizes’ but retains a hand in, it really ’socializes.’

“Sufficient ‘equity’ has been poured into NYSE stocks, that the Government can manipulate the Dow (DJIA) much more than it could five years ago.

“As most people find the DJIA and the American economy synonymous, a slow and gentle rise in the Dow is cheering to many. So it is done.

“The Hunts attempted the same thing, with vastly different purpose, with the silver market some 30 years ago. They tried to corner it – and lost. The price went up – but they couldn’t get enough of a controlling share to ‘own’ the market, so they were left with vast holdings of massively overpriced silver.

“(I suspect that the fluctuations in oil prices may have been something similar, just from the pattern – but that’s sheer speculation.)

“We (the taxpayer) are gathering a massive market portfolio of overpriced equities. Like dime stocks, we can drive the price up; but it is so volatile, we cannot sell it all at the higher price – and that would crash the market soundly.

“Our acceleration into Market Socialism is another version of what Governments habitually do – play shell games with values, in order to reap profits. I’m sure that the Soviet Union allowed a little stock market to run here or there, eh? The NYSE is Uncle’s pet now, and it is on strings. Never mind that it is dead. It can still dance.”

*** England isn’t so merry these days. First, it is cold – temperatures fell to minus 10 centigrade, according to that reliable source of meteorological intelligence – the Sun. We knew it was cold because the Sun girl on page 3 had goose bumps all over her naked body. But at least she wasn’t sick with the flu. A record 2.4 million workers called in sick yesterday in England – one out of 12 staff was out. Another two million stayed at home because they don’t have jobs to go to. The financial storm that hit Britain last year continues to send waves over the island’s gunwhales. Big retailer Marks & Spencer said it is cutting 1,700 jobs today. And the firm founded by Josiah Wedgewood 250 years ago went bust. UK stocks are down about 40%. Houses are going down fast too. Unemployment is going up. And Britain’s most profitable industry – finance has gone into a slump. Apparently, half the country is either out of work, down with the flu, recovering from the flu, or pretending to have it so they don’t have to go to work.

Source: It’s the Economy, Stupid