Market Review for Week Ending 4-17-09

Last week the market advanced 1.48%. Based upon my view of the market I felt the advances last week would not last. So far the gains in stocks have been on low levels of enthusiasm, which suggests to me that this is a traders market. A week ago the market gapped up because of good news from Wells Fargo and this morning the market gapped down because of troubling news from Bank of America. I mentioned last week that banks were not of the woods because of the potential for large losses in loans in commercial real estate, commercial business loans, and personal credit card debt. Bank of Americas report reinforced my concerns.

The recent rise in stocks has many investors opining that the worst is behind us. My best guess is that we remain in the eye of the storm with the potential for more downside. Today I want to discuss a component of the banking system that has me very worried but before I get “all negative” I want to share a few positive thoughts. First we received good news from one of our companies last week. The annual income that they plan on paying us was increased by 10%. In order to have Dependable Rising Income we need the companies we own to continue to funnel money to us and increase that income over time. Despite this unprecedented financial environment our stable of companies continues to provide for us.

The second positive thought I want to share is the future direction for stocks does not entirely determine whether we can make money. We are very fortunate to live in a time were so many unique investment vehicles exist that will allow us to prosper despite the direction of the stock market. The critical success factor going forward is in knowing what and when to invest your money in. For now the market must be approached from a “traders mentality” which requires a level of skill on the part of a money manager that very few people have the training to do. Fortunately for us I have spent a lot of time refining that skill and this should serve us well in this environment. I certainly do not have a crystal ball but while others were growing their money management practice by networking on the golf course I have been honing my craft watching and studying the markets relentlessly. So please do not interpret my negative tone as a lack of opportunity.

Today I want to discuss in some detail the subject of credit. This is an important subject because for quite some time our economy has hinged on the ability to borrow money to infinity. Our credit system has distorted the economic view for many years and I now believe the jig is up. One of the most frightening charts that I have seen is the one below.

This chart shows what our countries reported Gross Domestic Product (GDP) was as reported and what it would have been in the absence of Mortgage Equity Withdrawals (MEW). As you can see our troubles began in the year 2001. In that year reported GDP was less than 1% but when you subtract the money spent by people who borrowed out home equity it was negative. Bottom line is that if you subtract spending of home equity our GDP has averaged less than 1% per year since 2001. Now that home equity is all gone where will consumers get the money to spend?

OK now for the scary part of the credit story.

This weekend I spent many hours studying our banking system. Of most concern to me is this concept we have called a Fractional Reserve System. Follow me closely on this because it would not surprise me if the day will come were everyone will be talking about this and questioning the intelligence of it. Imagine that a person walks into a brand new bank and deposits $1,000. Under a fractional reserve system the bank is then allowed to lend out 90% of that deposit. So with a $1,000 deposit the bank is allowed to lend $900. That $900 is given to someone and then potentially deposited back into a bank. Out of that $900, the bank sets aside $90, and then loans out $810. This process continues until ultimately that initial deposit of $1,000 is lent out over 100 times. From the initial deposit of $1,000 there was $10,000 deposited into banks and $9,000 in loans made. The scary part is a deposit of $1,000 backs all of this. If everyone who made a deposit came into to claim his or her deposits the banking system would only have $1,000.

Personally I think it is dangerous enough to let a bank set aside 10% of a deposit and then lend out the balance. But what we actually have is the ability for the banking system to lend out 900% of an initial deposit. Nobody tracks what happens to an initial deposit and all money that enters a bank is treated the same. THIS IS VERY DANGEROUS AND WORRISOME to me.

In the past this has all worked out because most people pay back the money they borrow. But when the time comes (as in right now) that people in this chain cannot pay the money back the whole thing implodes. Please read this a few times because it is very simple yet difficult to wrap your mind around.

Perhaps this is the reason banks are not lending. Just last week General Growth Properties (GGP) filed for bankruptcy. It got very little press but it was the largest real estate bankruptcy in U.S. history. GGP owns malls throughout the country and has racked up 27 Billion in debt. Commercial lending is different than personal lending for banks build in a schedule that requires the borrower to refinance every few years. A commercial loan may require monthly payments for five years and then a balloon payment for the balance. This forces the borrower to refinance the deal all over again and it gives the bank a chance to raise the interest rate it is charging or walk away from the loan all together. If you read in the news that companies are struggling to “roll” their debt this is what it means. Apparently GGP was unable to successfully roll its debt and was forced into throwing in the towel.

When taken as a whole I see a country that has become dependent on debt and a system that may have far more losses built into it than imagined. A lot of effort is going into returning the credit system to what it was but I seriously doubt there are many “good loans” to be made at this time. This is one of the reasons I feel the worst is not yet behind us.

Looking toward the markets I still remain cautious and more inclined to go short than long. So far earnings announcements have not set the market back but there is still many more reports to come. Last week I listened to GE and Intel’s conference call and found their comments to be very guarded. I plan on listening to many more as they become available. If they all play there cards close to the vest that will tell me something. With that in mind, I will continue to watch the markets closely so you don’t have to.