Misdiagnosing the Disease

World markets appear to be kicking off another week disappointed, as the G-20 meeting failed to accomplish anything other than talk.

I really don't know what was expected by all of these analysts, but it is clear there is very little consensus on what the problem is, let alone what a possible solution would look like. They all still seem to be clinging to the precedent of the last 30 years, when any little problem in the economy was quickly dealt with by politicians, and markets would respond favourably.

Clearly, the problems are far bigger than any of these people had imagined. Yet, somehow they manage to maintain their expectations for profit growth in this quarter over last year - and for the entirety of 2009. How is that possible, when retail sales are dropping like a stone and while unemployment and mass layoffs skyrocket? Good question.

From a technical perspective, I see no reason for the stock market to bottom here. The S&P 500 and the Nasdaq 100 both closed below previous weekly closes despite Thursday's absurd 11.3% rally from it's low. As I mentioned in The Largest Rallies Occur in Bear Markets, such a meteoric rise in the markets on a single day basis is nothing to be excited about, rather feared. These violent swings in the market suggest that participants have no clue what the value of businesses are. And when there is such uncertainty, the natural direction for stocks will be lower. Eventually, all hope will be lost and a meaningful multi-year bounce can then take root - even as economic fundamentals deteriorate. But in order for that to happen, I need to see forward earnings expectations slashed considerably. So much that they not only incorporate current economic weakness on a realistic basis, but that they also factor in future economic deterioration.

Unfortunately, as analysts make these adjustments, stock prices will be cascading even lower to reflect the lower "E" part of the P/E ratio. Currently, stocks are selling for about 18x earnings. The historical mean is 14. The Law of Mean Reversion states that, not only will prices invariably revert to their mean, but will usually overshoot the mean before reaching an extreme. I see no reason for this statistic to become invalid now, as it has worked for centuries. A total earnings number of $45-50 in 2009 for the S&P 500 remains my target, and I see no reason stocks will not trade at a multiple of 10x those earnings, as risk aversion grows. I see the possibility of this eventually being optimistic. But that depends on how our policy makers react to this new reality.

Which brings me to my next topic of "Depression Economics." All the talk about bailing out the big 3 automakers on both sides of the border goes in the category of making my above expectations optimistic. As does the recent application of nearly any kind of US financial company to become a bank holding company, making them eligible for bailout money. As does the entire $800 Billion Federal Bailout (TARP) or any other "stimulus packages" President-Elect Obama may have up his sleeve.

All of these politicians, from Jim Flaherty in Canada to Nancy Pelosi Stateside, are exercising backward economics. And it all stems from a misunderstanding of the problem. Here are what the real problems are:

1) Fractional Reserve Lending. Central banks minting money out of nothing and then lending it (at interest) to member banks who leverage it 10 to 1.
2) Government deficits. Deficits always result in higher taxes which make businesses uncompetitive and slow the economy in the future.
3) Poor lending standards. Government mandates of "affordable housing" inevitably lead to foreclosures and losses to holders of the mortgage security.
4) Lack of bank balance sheet transparency. Allowing for Level 3 accounting, where banks state how much they wish their assets were worth, and then recording it as such.
5) Interest rate micro-mismanagement by central banks. Misallocations of capital result from too high or too low interest rates.

All of the solutions offered by our politicians amount to more of the above. It defies logic that the solution can be the same as the problem. Our economy is in cardiac arrest. A defibrillator will jump start it but won't cure the disease. We need a transplant - an overhaul of our entire financial system. Here are my solutions:

1) Eliminate the Central Banks. Allow regular people to determine what money is (as they had done for millenia) and at what rate of interest it should be lent to others.
2) Demand that banks value their assets at realistic prices. If this means they go bankrupt, so be it. New banks will buy their assets and conduct business in a more responsible manner.
3) Get government out of the business of promoting growth. Business cycles will be so mild without the capital misallocations that the words "boom" and "bust" will essentially disappear from our vocabulary.

There have been literally dozens of government "solutions" to the economic problems we face. Our policy makers continue to diagnose the symptoms (falling stock prices, less lending, unemployment, business bankruptcies, etc) as the disease. It is no wonder their dozens of prescribed cures have accomplished nothing.

All along, a group of economists have been saying, "I told you so." Just as they did before and during the Great Depression. People would be wise to start listening to them. More information can be found at www.mises.org.

More information on the growing campaign to end the Federal Reserve can be found at www.endthefed.us