September 2009 Market Update – Lest We Forget

Lest we forget – a year ago this month the financial system as we know it began to melt down. Most analysts today admit it was a miracle that what the Federal Reserve and the Treasury Department did to shore up the collapsing dyke actually worked. It was a miracle primarily because no one, repeat no one, understood what was happening. The sequence of events reads like a description of Three Mile Island:

  • September 15, 2008 – The Dow drops 504.48 points after a weekend in which Lehman and Merrill succumbed. AIG stock tumbles 60%. Much of this fallout was unforeseen because no one understood the derivative and leverage network Lehman had created. The Prime Money Market fund broke the buck because of loans made to Lehman.
  • September 17th – Dow falls 449.36 after AIG rescue.
  • September 29th – Dow drops 777.68 after House rejects financial rescue package.
  • October 6th – Dow Closes below 10,000 for the first time in nearly four years.
  • October 9th – Relentless declines amount to a “slow motion crash”.
  • October 10th – Dow closes at 8,451.19; a 2,817.73 point drop since September 10th.

Dow Jones Chart


In hindsight, Richard Bookstaber, an MIT economist and inventor of many of the financial instruments that contributed to the crisis, states in his book Demons of Our Own Design; that the financial system that we have created in the last 20 years has three very dangerous characteristics;

1. Complexity – one event triggers multiple events that trigger more events as opposed to a linear system in which one thing happens at a time.

2. Tight Coupling – once a sequence of events is triggered the sequence cannot be stopped.Such as a space vehicle lift off, once the engines have ignited.

3. Liquidity – because interest rates have been low for so long it is cheap to borrow money and that money is looking for a home in high risk investments.

Richard Bookstaber has also testified before congress that in order to stabilize our markets, we must;

1. Eliminate derivative and other complicated instruments he and his cohorts developed.

2. Eliminate the high speed trading that characterizes today’s market place.

3. Rein in liquidity. Without leverage, derivatives dry up.

He also warns that trying to regulate derivatives will only make them more complex and hence more unstable. They must be outlawed; not regulated.


Mark Mobius, Manager of the Templeton Emerging Market fund that I had used for decades, is not as hopeful. He is also the Executive Chairman of Templeton in Singapore and oversees 25 billion in assets. Mr. Mobius predicts a new financial crisis will develop from the failure to effectively regulate derivatives and the extra global liquidity from stimulus spending.

“Political pressure from investment banks and all the people that make money in derivatives will prevent adequate regulation. Definitely we’re going to have another crisis coming down” he said in a phone interview with on July 13, 2009.

Mr. Mobius predicts a number of short “dramatic” corrections in the stock market in the short term saying that a 15 to 20 percent correction is nothing when people are nervous. A” very bad” crisis may emerge within five to seven years as stimulus money adds to financial volatility, he warned.


Joseph Stiglitz, Nobel Prize winning economist and former Chief Economist for the World Bank, says that the United States has failed to fix the underlying problem of it banking system. “In the U. S. and many other countries, the too-big-to-fail banks have become even bigger”, Stiglitz said in an interview in Paris on September 13, 2009. “The problems are worse than they were in 2007 before the crisis. The credit crisis is not behind us despite Wall Street prognostications to the contrary”.

Former Federal Reserve Chairman Paul Volcher agrees. He has advised the Obama administration to curtail the size of banks.

Unfortunately, the Obama administration must rely on the cooperation of the banking giants for the time being to provide stability to the financial system. Any attempt to rein them in would result in staunch resistance and the President has enough of that on his plate with health care reform. Hopefully 2010 will see the emphasis shift to financial reform.

Joseph Stiglitz is hopeful that the upcoming meeting of the G20 leaders in Pittsburg this month will apply pressure worldwide for reform.

Mr. Stiglitz sees an extended period of weakness in the economy and not enough growth to offset the increase in population. Without income, it will be hard for the U. S. consumer to generate the demand for imported goods the world economy demands.

He also says the Federal Reserve is in a quandary as to how to end the stimulus. Doing so may drive up the cost of borrowing and then where will we get the money to run the U. S. Government?

Joseph Stiglitz was in Paris to present a paper to the French President, Nicolas Sarkozy, urging the world leaders to drop the obsession with GDP as a measure of prosperity. He thinks other measures such as environmental sustainability should be included in the calculation of societal well being, not just the quantity of products and services produced.

In a speech on the 14th, French President Sarkozy said that focusing on GDP helped trigger the financial crisis and he has ordered the results of Stiglitz’s study to be incorporated in Frances’ economic analysis.

It is definitely time that we replaced our “more is better” value system. Defining prosperity as higher and ever higher profits will be our undoing if it has not already been.


The FDIC quietly closed two more banks over this last weekend. This brings us to a total of 92 banks thus far to 2009. There have been more bank failures in 2009 (with four more months to go) than in all of the previous 15 years combined.

So for economists to be calling a V shaped recovery or any recovery independent of the government stimulus ignores the fact that the credit system is still broken. The more likely scenario is an L shaped recovery of protracted slow growth.


This hope based rally has discounted into current prices extremely optimistic, probably unattainable, earnings for the fourth quarter. Although the market seems over priced with a current P/E ratio around 18 (the average being 14) it is out of the ball park at 130 times earnings for the 12 month period.

The truth is that investment grade corporate bonds have outperformed the S & P 500 by 70 basis points so far this year. So our strategy of protecting principal but maximizing yield appears to be spot on.

According to Davis Rosenberg, Chief Economist for Glusking and Sheff, practically 100% of the recovery in world economies can be attributed to the government stimulus programs. The jury is still very much out as to what economies will be able to do without those crutches. The trick will be for the central banks to remove the assistance in such a way as to not crater their economies by too swift action but not leave stimuli in place too long so that they trigger inflation.


What we seem to have is an economy that has stabilized due to massive injections of public money and a stock market that is running on froth and derivative trading.

Until stimulus money is withdrawn; the long term picture will remain uncertain. For a TRUE recovery to occur, it will require that the consumer start spending again to recreate lost jobs. If credit is still frozen and the consumer is still paying off debt, it is difficult to see how this will happen.

As for the redesign of a worldwide financial system that gives the individual investor a remote chance of being able to make and keep a profit in the markets, there is a lot of discussion but no action.

Until there is some action; my strategy is to guard your principal from rolling crisis the likes of which we witnessed, gratefully from the sidelines, just one year ago.