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When the Math Doesn't Work



Note: Professor Fleckenstein provides his commentary every Wednesday evening for educational purposes - his insights are not intended as investment advice. You can find his daily comments at

There's nothing to discuss about the overnight action, and the early-morning activity in equities was similarly dull. The dullness continued until about midday, when the Nasdaq sprang to life, courtesy of a big move in the Sox, which wound up about 4% higher on the day. There was a certain amount of fever for Internet stocks, and I did notice that 3M(MMM:NYSE) was up about 3%, as well. Volume was a little higher than yesterday, but other than the strength in the Sox, it was another lackluster day.

Away from stocks, the dollar was slightly firmer, with no major changes. The precious metals were fractionally higher.

Insanity Reigns, Says Roach

Last night I had a chance to read the most recent article by Stephen Roach, titled "The Asset Economy." Stephen Roach is probably the lone economist working on Wall Street who understands what has been going on during Greenspan's tenure. Kudos to him for being willing to stand up tall and tell it like it is, amidst the ocean of dead fish surrounding him. His latest article has nothing in it that I didn't already know, but the way he wrote it really put the current speculative environment into perspective. Oftentimes, it's just that, perspective, which is needed. I urge everyone to read the article and think about its ramifications.

Gross Domestic-Asset Distortion

In any case, the point of his article is that beginning with the big equity bubble, folks started using their assets to live beyond their means. First it was stock-option wampum and other gains that resulted from the insanity. Now folks have been using their houses as ATMs. Roach's view is as follows:

"Stepping back from the data flow, it is important to appreciate the consequences of the asset economy. A more chilling picture emerges. Courtesy of the Great Bubble of the late 1990s, the American consumer discovered the sheer ecstasy of converting asset holdings into spending power. Households learned to spend beyond their means - as those means are defined by growth in disposable personal income. Yet when the equity bubble popped, the consumer never skipped a beat. There was a seamless transition to another asset class -- property. And the joys of asset-driven consumption continued unabated.

"Income-based consumption had, in effect, become passé, and American households went on an unprecedented debt binge. No one seemed to care that the personal saving rate had fallen from 5.7% in the pre-bubble days of early 1995 to 1.0% in late 2001 (and now stands at just 2.3%). In the asset economy, who needs to save out of his or her paychecks? Who needs to worry about debt? Asset markets, goes the argument, had emerged as a new and presumably permanent source of saving for the American consumer."

He continued: "I must confess to being just as suspicious of this new paradigm as I was of another such scheme back in the late 1990s. As the bursting of the equity bubble should forever remind us, there is no guarantee of permanence to asset values and the wealth effects they spawn."

Debunking Debt Serviceability

With that as a lead-in, I'd like to talk about the lunacy in real estate. One point Steve Roach doesn't make is that the math for housing simply doesn't work. Everybody in this country can't live in a $1 million house, or some higher-priced mansion. The income necessary to support the debt service just isn't there. Housing got a boost in the stock mania because people took their gains and rolled them into real estate. That was on shaky ground, as we dealt with the aftermath of the stock bubble. But then we got on "firmer" ground in the last 15 months or so, via all the government stimulus and low interest rates that sparked a speculative frenzy in housing, which continues to this day.

Collapsing Standards, Inflated Bubbles

Money coming into housing to chase a hot market is pushing up prices, which is not only allowing people to live beyond their means but also creating the capital gains to advance to the next bigger house, or multiple houses. Of course, the total collapse in lending standards has abetted this process, since folks can take out 100% loans (or more, in some cases). It's as though every lender feels that every borrower is a triple-A credit and can't possibly borrow too much.

We have seen drunken lending orgies in the past, and they always end in disaster. Just as the math hasn't worked for everyone to live in a super-expensive house, no matter their average income, the math doesn't work in lending, either. That's two pieces of the housing market where the math just does not work.

In the short run, saying that the math doesn't work doesn't matter. But in the long run, the math does matter. Let me give you an example: Back in 1980, when gold was $600 an ounce and interest rates were 12%, I remember thinking, how could anyone buy gold at that price instead of a Treasury bond? The math made no sense. In fact, for gold to keep up with the compound rate of return available from a Treasury (assuming the reinvestment rate was also 12%), the price of gold from 1980 to 2010 would have had to rise to almost $18,000 an ounce. That seemed impossible to me.

On the Trail of Timing

Often, we see situations where it's clear that things cannot conceivably work out. What I like to say is that it's completely and totally knowable that certain events are preordained. However, what's usually not knowable is the timing, which can only be ascertained as they are actually occurring. Thus, all we can do as investors is wait and see (and then pounce) if what we expect to occur actually does.

Bubblenomics: A Window into 'Home' Economics

Also, you can be very close to the end of some phenomenon that's completely and totally knowable, and you can look completely stupid as things get even wilder. Let me offer an example of that: In October 1999, I gave what I think is probably the best speech that I will ever make in my life, titled "Spinning Financial Illusions: The Story of Bubblenomics." (For those of you who believe that the housing bubble will never end, I encourage you to go back and read this speech, and think about what it was like at that time, when it seemed as though the stock mania would never end.)

Anyway, in reading the speech (which is posted on the Special Features section of the site), you'll see that my observations about what was happening and what would ultimately happen were fairly accurate. That said, in the five months after my speech, the Nasdaq doubled, making me look like a complete and total idiot, when in fact I was essentially dead-right. This happens all the time. Markets tend to make you look the silliest just before they're about to change.

Again, my point in bringing all this up is to lend some perspective to the lunacy in housing and the continued denial/semi-lunacy we see in equities. The Fed and the government have attempted to bail out the aftermath of our giant stock bubble with a leveraged real-estate bubble. This will end in disaster, guaranteed -- no ifs, ands, or buts about it -- though to repeat, what we cannot know is the timing.

Prudence Mocked by Markets

Meanwhile, the longer the insanity persists, the greater the frustration on the part of people who've acted prudently and tried to prepare themselves. I suspect that's what makes them angry, or causes some folks just to whine. But as I said earlier, that is the nature of markets. It's not easy getting rich. It's not easy making money in the markets, and folks shouldn't expect it to be easy. After all, if it were easy to make money and get rich, everyone would be, which is another mathematical absurdity.

Back during the stock mania, a legitimate complaint that I received from one sane fellow was the following: The problem with being a "level head" (his description of folks who didn't believe in the mania), as opposed to being a "bubble head" (his description of what I called Bubbleonians), is that when the aftermath of the stock mania played out, even level heads would have to suffer.

Paying the Piper for Fed 'Prosperity'

That was true then, and it will be true prospectively. It's one of my complaints about the irresponsible actions of the Fed. Everybody will be made to suffer, thanks to the incompetence and sheer arrogance of the Fed. That is one of the reasons why I have such contempt for Greenspan and the rest of the central planners at the Fed. I hope this long-winded rant helps put the present-day financial madness in America into perspective.

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