The manure began accumulating when we rode up to the high pasture on Tuesday. More about that below…

In the meantime, the Dow rallied a bit yesterday – up 127 points…barely half of what it lost on Monday.
Is the bounce still bouncing? We don’t know. But we don’t trust it. They say the stock market ‘looks ahead.’ So, it is possible for it to see things we can’t see. On the other hand, what was it looking at two years ago? Didn’t it see the economy going over a cliff? Apparently not.

But investors tend to believe what they want to believe. And what they want to believe is that the stock market has had its vision corrected and now sees a recovery.

Our guess is that they are wrong on both scores. The stock market is just as blind now as it was in early 2007…and there is no recovery coming any time soon. As to the first point, we have no further evidence to present…but as to the second; at least we have a theory.

By our reckoning, this is not a recession…this is a depression. In a recession, the bull market formula still works. It just needs a little time to rest…catch its breath…work off inventories…and rebuild cash accounts. But in a depression, the formula stops working.

The basic formula that drove the U.S. economy for the last 60 years has been the expansion of consumer spending. At first, that spending was healthy spending. People had built up savings during the war. In the Eisenhower years, they were ready to get back to work in the consumer economy, get married, have children, and spend money. America was the world’s leading lender…leading exporter…leading manufacturer…and leading everything. Gradually though, having so many advantages caught up to the United States of America. By the ’70s, the Nixon administration thought it could do away with the gold backing for the currency. By the ’80s, the United States slipped from being a net creditor to being a net debtor to the rest of the world. By the ’90s, American consumers were spending more than they made…and by the ’00s they had given up saving all together – depending on the savings of poor people in China and elsewhere in order to continue living beyond their means.

Each time this system was faced with a recessionary correction, at least in the last 25 years, the feds tried to stimulate consumer spending with easier credit. And each time, consumers took the bait and got hooked on more debt. That’s why the financial industry expanded so much…it sold more and more debt in more and more grotesque and amazing ways.

This time is different. This time the feds have responded with zero interest rates…and $13 trillion worth of bailouts and boondoggles. But the old magic doesn’t seem to work anymore. This time, the formula no longer works. Consumers already have too much stuff – and no way to pay for it all. They have no choice; they have to cut back. This is not a pause in the long cycle of increasing consumption, debt and speculation. It is a reversal of the cycle – with less consumption and less debt (more savings). This is a depression.

If left alone, this cycle will see falling asset prices, falling bond prices and rising savings for many years. Stocks should sell down to levels where they are attractive again – at average P/Es below 8…7…or even 6. And with dividend yields above 5%.

Of course, when that happens people will have lost interest in stocks. The financial magazines will have pronounced the stock market “dead” and Jim Cramer will have been booted off the air.

By that time, the economy will have been restructured too. There will be less retail space. Many malls will have gone broke. Living standards in America and Britain will have gone down. And many of the people in the financial industry will be doing what they ought to have been doing all along – taking lunch counter orders.

Now, we turn to Addison for news on the global financial losses:

“Banks, brokerages, fund managers…you name the financial firm…they’ve now seen nearly $4.1 trillion in digits evaporate since the beginning of the credit crunch, says the International Monetary Fund (IMF) this morning.”

“More than half the losses – $2.7 trillion – were sustained by U.S. firms,” explains Addison in today’s issue of The 5 Min. Forecast.

“So far, global financial losses in this bust are almost equal to the entire market cap crunch of the tech bust early in the century:

“In an effort to paper over the losses abroad, the IMF has already funded over $55 billion in emergency loans to European nations including Hungary, Serbia, Romania, Iceland, Ukraine, Belarus and Latvia.

“Last week, Mexico became the first Latin American country to put up the white flag, asking for a $47 billion line of credit. Just yesterday, Columbia followed suit, seeking $10.4 billion. We’ll go out on a limb here… they won’t be the last.”

Each weekday, Addison brings readers the The 5 Min Forecast, an executive series e-letter that provides a quick and dirty analysis of daily economic and financial developments – in five minutes or less.

And back to Bill, with more thoughts:

Compuel is a huge valley…probably about 10,000 acres…above 3,000 meters in altitude. There are no trees. And a cold wind blows through the sage even in summer. This time of year, at least it is green.

The summer rains came late this year. A river runs through the center of the valley, wide and shallow…you can splash through it on horseback. For a few months of the year, it turns the center of the valley into wetlands. Later, in the winter months, it will be dry as Death Valley and as cold as a tax collector’s heart. But last week it was wet and marshy…with ducks flapping up suddenly wherever you go.

You can get to Compuel in a 4×4…but it is an almost impossible drive…not to mention dangerous. There are sections of the road that are hardly as wide as the wheelbase…with a 1,000 ft drop off the edge.

“It was probably an old Inca or pre-Inca trail,” explained Veronica. She was one of three archeologists who showed up at the house on Saturday. They asked if they could camp out and do some digging in the Indian ruins on the ranch.

“We won’t take anything. Besides, the law requires that anything we find belongs to the state,” she anticipated our questions.

“This area is very rich in archeological evidence,” Veronica continued. She was from Buenos Aires, a cheerful, talkative woman with a librarian’s air about her. With her was Paola…another archeologist from Buenos Aires …and Hector…an archeologist from Salta. They were trying to figure out dates.

“We don’t really know much about the Indians who were here before the Inca,” Veronica went on. “All we know is that they were brave and independent. This tribe resisted the Inca…and the Spanish. The Incas tried to subjugate them…forcing them to pay tribute. But they fought them off. I guess they figured that if they could beat the Incas they could also beat the Spanish. In fact, they were the last Indians in all of Argentina to surrender. And the story is that women took their babies up into what they call the ‘fortress’ – a natural stone formation – and threw them onto the rocks down below rather than see them enslaved by the conquistadors.

“But we don’t know much more than that. So we dig down to try to find bits of pottery…and seeds…and soil samples that will tell us what they ate and which groups of other tribes they were related to. Then, we put the pieces together and gradually develop a better picture of who they were and how they lived.

“That’s why we need to go to the ruins at Compuel.”

“How are you going to get there?” asked Jorge, the farm manager.

“We’re going to hike. What do you think…can we get there in 4 hours or so?”

“Ha…ha… it will take you at least 7 hours… depending on how strong you are. And of course, you will need a pack mule to carry your equipment.”

On horseback, you can get to Compuel from the ranch house in 4 hours. The trail is rugged…with the horses stepping from stone to stone in some areas. By the time we got there we were already tired and saddle-sore. When we arrived, the roundup had already begun. The vaqueros – our local cowboys – had already rounded up the cattle from the whole valley and driven them into a big stone corral. They were roping the calves and separating the bulls from the cows. Occasionally, a bull would charge…but the cowboys were fast, they dashed to the side and jumped up onto the stonewall. Their dogs stood on top of the stonewall watching attentively. This was a once-a-year spectacle they didn’t want to miss.

Source:  Is the Bounce Still Bouncing?

Now that it’s here, we turn our attention to trying to discern, “How bad can it get?” and “How long can it last?”

While such questions can never be answered with anything approaching absolute certainty, there are methods that can be used to assess what may lurk over the horizon. With that goal in mind, this article focuses on – and then expands upon – the recent work of two economists who painstakingly analyzed a substantial number of previous banking and currency crises in an attempt to derive potentially useful lessons. I have then taken their data and applied them to the current circumstances to see where we are, relative to those other experiences.

The Data

The data are from a study called “The Aftermath of Financial Crises” by Carmen M. Reinhart of University of Maryland and Kenneth S. Rogoff of Harvard University. In their study, the authors summarize the results of a broad sampling of banking crises, with between 13 to 22 crises analyzed for each of the variables.

The Reinhart/Rogoff study is based, in turn, on data extracted from an even more comprehensive study of events in 66 countries, titled “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises,” by the same authors.

I’ve summarized the findings from the latest study in the table below:

The economic measures in the left column show how far the U.S. situation has deteriorated so far. The next columns show the average historical deterioration and the worst case of the crisis analyzed.

I then applied these data to calculate the levels that the U.S. could reach if it followed the path of the historical examples. The projected level is based on the measure analyzed, either from the peak prior to the downturn (e.g., the S&P 500) or from the bottom prior to the downturn (e.g., the lows in unemployment). Thus, as you can see in the table here, the S&P 500 has already dropped from its October 2007 peak of 1565 down to 766. If this crisis were to end up being only “average,” then it would drop to 690.

If, however, the worst case of a 90% drop were to occur, as it did in Iceland last year, then the S&P 500 would trade down to the shocking level of 157. For further reference, if the current crisis were to cause the stock market to fall as sharply as in the Great Depression, the S&P would touch 469.

Duration of Crisis

As you can see in the summary table below, it took 3.4 years, on average, for the stock market to fall from the peak to the bottom. In the worst case, it took five years. With the recent peak in the S&P 500 occurring in October 2007 – just one and a half years ago – the crisis is likely to have some time to go before reaching even an average duration. More specifically, if this crisis turns out to be just “average,” we would not expect to see the low before the first quarter of 2011.

Crisis Horizon: Some Conclusions

The global economic situation continues to deteriorate on all fronts (see charts below).

Housing Prices Can Take Years to Decline	U.S. Federal Debt Is Likely to Jump from Crisis
Unemployment Could Jump over the Decade

Housing prices are down 28% from their bubble peak in 2006 but still have a ways down to go to get back to their pre-bubble levels. Even an average downturn will mean that housing remains a problem for several more years. Unless, of course, the government steps in to stave off those resets… a “solution” that carries with it a separate set of problems, making things worse. We continue to expect very serious problems in the commercial real estate sector.

The stock market is approaching a 50% decline, the average of what has been observed in past crises. Further slowing in U.S. corporate activities and profits means additional increases in unemployment, establishing a negative feedback loop that pushes corporate profits – and stock prices – even lower.

The only growth trend at this point is in government bailouts, which are in high gear, indicating we’ll experience the serious growth of outstanding debt seen in other crises. The elevated levels of government borrowing required to fund that spending are absorbing all available credit from foreigners, directly competing with business in need of the new financing that will be required to expand the economy. The combination of declining business activity, coupled with declining levels of household income, will result in declining tax revenues, increasing the budget deficit beyond the size of the new bailout programs. State and municipal governments across the nation are already being confronted with large shortfalls in their budgets, shortfalls that will only widen as the crisis worsens.

The combined business slowing and jobs contraction assure that the GDP will decline. Components of GDP having to do with necessities like food and shelter will continue to bump along regardless of the economic conditions, but the lack of growth in GDP could extend for years as it did in Japan and as it did after the 1929 stock crash.

Inflation/Deflation

Given that we are currently in a deflationary phase, it is easy to dismiss the case for inflation – and many do. We think that is a mistake. Even a summary tabulation of the unprecedented increases in government debt at this relatively early stage in the crisis make a compelling case for higher inflation, if for no other reason than that it shows clear intent on the part of the government to spend “whatever it takes” to offset the deflationary forces now stalking the land.

The research paints a dismal story of years of economic stagnation. In our view, the trend is now firmly established for dollar debasement, a debasement that will eventually overwhelm the deflationary pressures from collapsing asset values. Therefore, don’t listen to the happy faces on CNBC spouting off, for the umpteenth time since this crisis began, that now is the time to jump back in and buy stocks. It isn’t.

Be extremely skeptical when you hear some pundit pronouncing that this piece of short-term good news or another is an “all clear” signal. Until we start seeing a systematic improvement in the economic fundamentals – for example, an upward movement in consumer confidence – the only signal the economy will be hearing is that of a runaway train coming straight at it.

The numbers paint a dark picture… but it is in crises like today’s where unusually good opportunities arise for investors. Take our investors, for example, who made money shorting financials over the last year. The Casey Report focuses on recognizing and analyzing market trends way ahead of the investing crowd – a strategy that has already provided its subscribers with up to four-digit returns. The latest edition includes an update on the analysis you’ve read above. Try it risk-free for 3 full months, with our 100% money-back guarantee: click here to learn more.

Source: Bad, Worse, or Worst?

This from Taipan Daily

Which is better for playing the 2009 rally – small caps or large caps?

As a general rule of thumb, “small cap” stocks have a market cap of $1 billion or less. “Large caps,” in contrast, have market caps in the $10 billion range or higher… often much higher.

(Microsoft and GE, for example, have market caps in the neighborhood of $180 billion as of this writing. Exxon Mobil, the big dog on the block, is worth more than $400 billion.)

Small cap stocks have outperformed large caps for most of the decade, as you can see from the following chart.

From 2001 onward, the small cap stocks of the Russell 2000 Index trounced their S&P 500 peers in relative performance terms.

In 2006 the small cap outperformance trend peaked and stalled… came dramatically back on form in March of 2008… and then declined sharply again as markets fell apart.

Now let’s take a closer look at the same chart (daily view this time).

As you can see more clearly from the above chart, small caps peaked relative to large caps in September 2008.

This makes intuitive sense; as fear gripped the markets and panicked investors dumped shares left and right, the lesser known small cap names were hardest hit.

It appears, too, that the small cap exodus played itself out in late November/early December, as tensions eased and credit began to loosen somewhat.

In the context of what’s next for stocks, John Authers of the Financial Times points out that 2009 could wind up looking a bit like 1932.

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Get Ready for a Roller Coaster

In 1932 – the year FDR was elected President – stocks rallied 20% by early March. Then a vicious sell-off took the market to new lows… and then in July a new surge of optimism took hold, leading to 100%-plus gains in just two months. July 1932 wound up registering the all-time depression low.

So buckle your seatbelt, because there could be some wild trading days ahead.

I think, too, that if we do see a multi-month 2009 rally (or maybe even more than one), small caps could resume their outperformance trend. There are at least half a dozen reasons for this.

Small Cap Edge #1: Scrapping the $10 Rule.

Before the 2008 carnage, many institutional money managers had rules and restrictions on the books like “don’t buy stocks under $10” or “don’t buy stocks under XYZ market cap.”

Those rules made sense in more normal times, when there were plenty of higher-priced stocks to choose from. But now so many names have seen their share prices driven down to bargain-basement levels, the institutional $10 rule could be widely loosened if not scrapped.

On top of that, when animal spirits return to the markets – as they did with a vengeance in 1932 – there will also be a lot of temptation to scoop up the attractive large and mid-cap names that turned “small” by default.

Small Cap Edge #2: More Hidden Gems.

Truly great opportunities are often a result of market distortion. It requires a sustained period of sheer investor panic to create the kind of environment where $100 bills are left laying around on the sidewalk.

The investing equivalent of a $100 bill on the sidewalk is a company whose market cap is trading for less than its unrestricted cash in the bank, or whose lines of business and assets on the balance sheet represent eye-popping values in comparison to the discount Mr. Market has placed on the stock.

Simply by the nature of how Wall Street works, more of these “hidden gem” type opportunities are likely to be unearthed in the small cap arena. Diamonds in the rough don’t get market coverage from fifteen analysts and write-ups in USA Today – it’s much harder to find an edge in names that every mutual fund manager knows by heart.

For this reason, combined with what we just lived through, there could be more value to unlock in lesser known small caps.

Small Cap Edge #3: Survival of the Fittest.

The depths of the 2008 panic were so brutal that many of the weaker small cap players have been carried out. For those companies with too much leverage or precarious lines of business, the freezing of bank credit lines and sharp drop in commerce served as a death knell. This “culling of the herd” has left the 2009 crop of small cap survivors in stronger position.

(Remember, too, that small caps don’t get bailed out by the Treasury or the Fed. You have to be “too big to fail” to enjoy that dubious privilege.)

Small Cap Edge #4: A Crisis at the Top.

Whereas small caps were subject to the Darwinian hand of free markets, many large cap players (particularly in the financials) were bailed out. When Treasury Secretary Hank Paulson spoke of sweeping financial crisis, he was actually talking about the screw-ups of the biggest (and supposedly more sophisticated) players.

The injection of government funds in an effort to save jobs – and to spare the weaker of the “too big to fail” names from a harsh free market verdict – will not do much to enhance future competitiveness on the large cap side.

As Jim Grant points out, the large cap institutions who wake up in bed with the government may find that Uncle Sam has cramped their style, and thus their profit potential, for a long time to come. This could create an opening for scrappy small caps.

Small Cap Edge #5: More Diversity/Less Consumer Exposure.

Many of the large cap behemoths in the S&P 500 got that way by leveraging their exposure to the eighth wonder of the world: the all-singing, all-dancing, all-spending American consumer. For the better part of a quarter century, relying on the consumer to fuel growth was a great play. Not anymore.

Plenty of investors now lick their chops over depressed large cap values in the consumer-linked space, assuming that it’s only a matter of time before the future again resembles the past. But what if the past is gone for good? What if the “structural impairment” of baby boomer wallets is permanent, or at least long-lasting enough to keep the U.S. consumption glory days from ever returning?

If the world has indeed changed, and if adaptability and diversity are better strategies than big consumer-linked playbooks put together over the past quarter century, that reality could again favor the more nimble and diverse world of small caps.

Small Cap Edge #6: Gravity.

If a high-performance motorcycle (a.k.a. “crotch rocket”) and a supercharged Range Rover race each other off the line, who wins?

That’s easy – one is 2.8 tons of luxurious bulk. The other is basically an engine strapped to a wheel.

Small caps tend to outperform large caps in periods of expansion for a simple reason: it’s easier to blow the doors off performance-wise when you’re small and light. The more a company bulks up, the harder it becomes to “move the needle” in terms of profit growth.

Small caps could also be the benefactor of aggressive optimism in 2009. If the feeling takes hold that the war on deflation has been won – and just as importantly, that the banks are beginning to lend again – both those factors could act like a turbo-kicker for the “crotch rockets” of the investment world.

In conclusion: if you’re looking for long-term investment opportunities, there are bargains of the decade to be had in overlooked small caps now.

And if you’re ready to ride the 2009 roller coaster for big trading profits, small could still be the way to go.

Source: Six Reasons Why Small Caps Could Lead the 2009 Rally

This from Fleet Street Daily:

I attended a most interesting lecture last night at the London School of Economics. It left me feeling that anyone who rushes back into the stock market now must be barking mad (you’ll see why in a moment).

Entitled ‘The Subprime Crisis’, it was given by Professor Robert Shiller of Yale. Shiller’s well worth hearing on this stuff. A former advisor to new US Treasury boss Tim Geithner (“He had no idea this was coming”), Shiller forewarned of both the dotcom bubble and the more recent one in housing.

The lecture kicked off with a quick recap of how we got to where we are. These were the highlights:

• Psychological factors played a huge role. Irrational exuberance (a term coined by Alan Greenspan and borrowed by Shiller for the title of his 2000 book) caused bubbles to appear all across the world . Word spread that by simply buying stocks, or a house, you can become effortlessly wealthy. You can’t.
• Genuine financial advice was only available to the wealthy. Anyone who gives you free or “affordable” advice isn’t really advising you at all. They’re trying to sell to you. Hence many subprime borrowers got in over their heads – basic questions like “Can you afford this?” “What if interest rates rise, or you lose your job?” were left unasked.
• Individuals fell victim to Groupthink. Groupthink is where it’s in the interests of individuals to subordinate what they really think to what is acceptable to the consensus. Imagine a rating agency employee in 2006 saying to his boss: “I want to downgrade this debt. I think we’re going to have another Great Depression…” Not exactly a smart career move!

We were then shown charts of stock indices, p/e ratios and volatility going all the way back to 1870. Let’s start with the volatility.

There are only three points in history where we observe extreme volatility. One is right now. The others are 1987 and 1929.

The real terms p/e ratios chart was even scarier. The big bubble run up from 1982 to 2000 appears like the Matterhorn rising out of some hillocks. This, of course, is the bubble that’s now being corrected.

In percentage terms, we’ve only ever seen such a bubble once before since 1870. Yep, you guessed it…before 1929!

Why you should remain wary of equities

Shiller told us that, in real terms, the S&P fell 80% in the 1930s. So far it is only down 54%.

This means you still have a once-in-a-lifetime opportunity to lose a lot of money very quickly. Will you take it? I for one hope you don’t…

Most of us have never been in this position at any time before throughout our lifetimes. Who alive today has first-hand experience of investing during a prolonged, worldwide, stock market and real economy Depression?

All we have to go on is the lesson from history. And that lesson says…stay out! Keep your cash as cash.

Why some will try to lure you back in…and why they might succeed

I believe we’re seeing a lot of Groupthink in the financial sector right now. Finance types make their living from stocks markets. So it’s in their interests to talk the best stock market game they feel they can get away with.

They did it during the bubble, happily perpetuating the notion that stocks generally go up so go ahead and fill your boots.

That nonsense won’t fly now. But there’s another nonsense that will – the idea that the correction thus far has left an unprecedented number of “screaming bargains” for you to put your money into. Thanks to Groupthink, many commentators are now crowding round this dangerous consensus.

Right now is not a time to speculate. It’s a time to protect your money. The best way to do that is to hang onto it.

It’s tempting to feel ‘contrarian’…to think that you could be among the financially savvy if only you’re brave enough. That’s why this consensus will enjoy some success… for a bit.

But it’s a thin line between bravery and foolhardiness. Do you wish to gamble that you’ll fall on the right side?

Another reason investors might be suckered back in early is that they worry about missing the boat. But I’m going to paraphrase a much smarter bear than my average self – Albert Edwards of SocGen. Investors needn’t worry about missing the party this time.

You can afford to be late.

Source: This Man’s Message Could Save You From Financial Ruin