Four bears stick to their guns

Sprott Asset Management’s “Night with the Bears”, offered much of what one would expect to hear at a survivalist meeting, but it was glitzy production attended by Toronto’s financial elite. The event’s organizer and speaker, Eric Sprott, chairman and CEO of Sprott Inc. conceded “he should have sold tickets.”

The draw for the event were the four commentators: Sprott, Nouriel Roubini, Meredith Whitney and Ian Gordon. All four have considerable global credibility for not only being pessimists who took flak before the financial crisis occurred, but who have been for the most part correct in their predictions.

None of them have changed their tone. Their single biggest message was there will be much more pain, before things get better.

Roubini, professor of economics at New York University’s Stern School of Business, dubbed “Dr. Doom” by the global press, was the main attraction for many in the audience. He has been calling for a meltdown of the financial system since 2005 and many of his economic predictions, including the pending insolvency for many financial institutions, have come to pass.

He pointed out the biggest threat the U.S. economy faces is being trapped in a L-shaped recession — a very real problem if the stimulus measures introduced by the government don’t take hold.

He expects this recession to create a U-shape and last at least 24 months, and most likely closer to 36 months. This is a far longer downturn than any of the recession we’ve experienced in the recent past.

Roubini says even he misjudged the amount of debt that U.S. financial institutions are currently carrying. Cumulatively on a global basis their debt to capitalization would suggest they are insolvent.

“About a year ago I came out with the study that suggested total losses of the U.S. banks and other financial institutions from bad loans and other assets would be at least a $1 trillion, maybe even as high as $2 trillion,” he said. “If you think that $2 trillion is a big number, recent work I’ve been doing suggests those losses could peak at something like $3.6 trillion.”

However, Roubini took one of the few positive stances on the evening suggest that policymakers are acting appropriately to combat the recession.

“Policymakers have realized there is a real risk of falling off the cliff into a deep near depression,” he said. “They are using the guns, the bazookas, the missiles, you name it: zero interest rates, quantitative easing, tripling the money supply. There will be a huge cost to this. Eventually it will increase public debt, they will need to raise taxes, and some countries will default. This will not be a free lunch.

He added, “There is light at the end of the tunnel and hopefully it’s not the light of an oncoming financial train wreck, as long as we do all the right things with monetary and fiscal policy.”

Roubini said that in light of the work yet to be done, the latest market uptick is nothing more than a bear market rally. Taking a shot at commentators who suggest markets are a leading indicator on the economy, he says the markets have been consistently failing to predict the recovery.

“We can get out of this mess and avoid a near depression. It’s going to take a lot of hard work by the U.S., China, and emerging markets,” he said. “Policy is actually going in the right direction but I think the optimists are ahead of the data. The markets are ahead of the data.”

Ian Gordon, economic forecaster and author of The Long Wave Analyst, was easily the most bearish commentator of the night. He insisted that the market is currently in the “winter,” or depression phase, of 60-year rolling market cycle, known as a Kondratieff cycle.

If history repeats this cycle, which it has since the 18th century, he suggests that the markets could be looking at a devaluation that would drive the Dow Jones Industrial Average down to 1,000, and real estate prices would drop to mid-1990 levels — a 64% drop.

Gordon says the severe depressions that end every cycle tend to be related to a collapse in global credit markets. In this particular cycle, it’s the U.S. as the world’s largest debtor nation trying to eliminate the $53 trillion in debt it is carrying. He’s concerned by the push by governments to ramp up stimulus spending.

“The whole problem that creates this cycle is the unwinding of debt. Here we are trying to solve the debt problem by creating more of it,” he said. “There are things we can do to make money in this kind of environment. The principal place to put that money is gold. Why gold? Because people are so frightened because we have economic and financial chaos.”

Not surprisingly, Sprott echoed Gordon’s sentiment on gold. Sprott has made his name on investing on hard assets and shorting companies that offer no “real value.” He outlined this approach again, pointing out just how flimsy the balance sheets of the world’s financial institutions are. He said many have equity worth less than 5% of their balance sheet.

“I’m a simple accountant. I’m going to go to your balance sheet. I’m going to look at your shareholder’s equity. I’m going to take off your intangible assets and I’m going to take off your good will — which is worth nothing — and I’m going to tell you what your capital ratio is,” he said. “Here it is. You have a real capital of 3% of your assets. If you lose 3 cents on the dollar, you’re out of the game.”

Sprott said cumulatively the world has $780 trillion dollars of derivatives, far outstripping the value of the world’s cumulative wealth.

“I have no idea what we’re deriving here. I think these are going to melt this system down,” he said. “Even when AIG says it has something like half a trillion of outstanding credit default swaps. They almost lost $200 billion of those, those are down 40%. You don’t want to even think about 40% of $680 billion [for one company]. The world has probably never made collectively $3 trillion in the history of mankind.”

Meredith Whitney, the former managing director of Oppenheimer & Co., who now manages her own firm, Meredith Whitney LLC, is a bank analyst who came to prominence with a sell recommendation on the U.S. banks back in 2007.

She fears, consumer credit, most notably credit cards, may be the next shoe to drop as the U.S. unwinds its debt levels. She expects a contraction in consumer lending could be as high as 55%. The knock-on effect for the American economy will be huge, since 90% of Americans carry a balance on consumer credit as both a way to manage cash flow and as backup funding for emergency purchases. That option will be removed from the U.S. consumer’s personal financial situation.

“There are $4.2 trillion in credit card lines outstanding, and about $800 billion of actively used credit card [debt] outstanding. Of the entire credit card lines outstanding, you will see 55% reduction in credit lines,” she said. “The psychological impact that will have on consumers will be profound — you no longer have a ‘what if?’ factor to your spending.”

(04/09/09)