The New "New Deal"

INTRODUCTION:
In 1933, Franklin Roosevelt posed his "New Deal" which he began as a means for getting the US out of the Great Depression. He proposed a series of plans that would bring both short-term and long-term economic recovery to the U.S. by means of increasing government control on the economy and the money supply.

Now we are faced with a new and potentially larger market recession bearing its ugly head and so far its been nothing but chaos:

Overly anxious brokers with smokescreen and machine guns preying on unknowing investors frollicking around their cities. Soon housing prices sky-rocketed way past the point of being grounded...still higher and higher...only to lead to the antic "what goes up...must come down"...and boy did it come down. Higher interest rates to curb inflation drove the housing markets into a tumultous wipeout leaving them with nothing to cover their loans. Bad credit insurance deals (CDS/CDO) weren't able to cover the dramatic losses and defaults that were happening around creating an even bigger downward spiral effect. Bear down. Lehman down. $300 billion later and still no solution. We created a market in which liquidity was only on paper and paper was being burned. Bank after bank, Fund after fund, no solution for the dissolving credit market. Liquidity was just the beginning. "Trust"...not the end. Banks wouldn't loan to other banks. Funds couldn't cover. Down goes Wamu. AIG gets a hand but still can't get up. Fannie & Freddie barely doggie paddling... but wait! There's hope...a bailout in the mix! The Treasury to our rescue! A foolproof plan! $700 billion!! Tax Cuts! What a glorious day...oh wait...maybe I spoke to soon...maybe we're doomed...

SETUP:
This is just the beginning of it all...the beginning...I was listening to Jim Cramer the other night and he made a great point...and that was that we were not even beginning to hit the bottom point because we haven't seen the 3 signs to a bottom. We don't have earnings estimates being cut down much yet, we don't have inventory "liquidations" yet and we don't have any sign of economic turning around. Now granted he was talking specifically about the tech crash of 2001-2003 AND he was trying to ameliorate the pain of being on the receiving side of an ass-ramming by the NASDAQ AGAIN for the past 2 weeks, but it got me thinking...What needs to be done for the entire market both short-term and long-term? Do these signs apply to the entire economy? OF COURSE!! But what can the government, the Fed, the financial sector and the rest of the US do to ameliorate these conditions!?

(1) Cramer's 1st point generalized: Estimations being cut down relates to a shrinking economy. Until people stop thinking HERE and start thinking here, there will be problems with the way we approach investing because we need to re-adjust our portions. The economy is a lot of paper compared to the amount of actual profits and "sure" cash that are realized (aka M3). Think about it. In 2005, we had a GNP (value of all goods & services by the US only domestic + foreign) of just over $11 trillion. In that same year, the amount of shares of "paper" stock that were publicly traded in the US...$17 trillion (2005). [https://www.cia.gov/library/publications/the-world-factbook/geos/us.html#Econ]. So, if we total up the amount of worth by all publicly known companies, we will have $6 trillion or 54% more value invested into companies than they produce or a P/E 1.5x (that's cheap!). Furthermore, if you compare this number to M3 (~$10 trillion), we have 70% more value in the stock market than there is actual money supply circulating. Still, no biggie... But of course, if we compare this $17 trillion stock worth to the actual currency we have (~$800 billion in 2005), there is an astounding 2025% more value in our market than available, circulating US cash. [http://www.federalreserve.gov/paymentsystems/coin/currcircvalue.htm]

This also means that the velocity of money is ~20x. This is a very big key!! What happens if that velocity of money slowed down...say to 15...or 10 or 5 even? This $17 trillion worth of stock would be worth...well...alot less...

Now, let's take a look at the $17 trillion. It only accounts for actual stocks and their prices but it does not account for the derivatives market. In 2005, there was $298 trillion of cash in the the derivative market alone. Compared to the actual shares of the market, the "fake" asset market is worth about 20x more. Therefore, the velocity of currency with respect to this market is now at ~400x!!! That means that each dollar bill gets exchanged more once a day. WOW! The more important fact is that we are at pricing the market at ~30x its worth! ($315 trillion / $11 trillion ~ 30). Even the average S&P 500 is priced at a lowly 17x earnings...

Even if we were to take into consideration that there is $11 trillion federal debt, $315 trillion - $11 trillion = $304 trillion / $11 trillion ~ 28...price is 28 times actual GNP earnings. UNBELIEVEABLE!!

Note: Benjamin Graham, the father of modern day investing, believed that, on average, a P/E of 15-20 signaled a very fair-valued stock.

(2) Inventory decreases must be seen across the board. This is a supply side problem. It started with the overly zealous housing industry that peaked in the summer of 2007 and is now going to end with a huge shrink. Just look at the derivatives market...it is by far the biggest, most leveraged market which definitely affects the rest of main street and wall street. In 2008, the derivatives market is now valued at a "measly" $182.2 trillion...38% reduction from 2005 [http://en.wikipedia.org/wiki/Derivatives_market]. Using the S&P500 as an equally weighted approximation for % change in real stock prices, there is a -30% dropped between the end of 2005 and mid-2008. That means that the new stock market value is $11.9 trillion. Therefore, the total value is $194 trillion. Now, if we decrease GNP by 30% too (just for assumption purposes since data is not available), we have a P/E for 2008 of $194 trillion / $8 trillion = ~24 which still exceeds the average S&P500 P/E but is closer to a step closer to fair value. So what's next?

SOLUTION:

(3) The economic turnaround is still far from getting back to a fair price. There are three HUGE problems: credit market, inflation, and citizens. The derivatives market has created a highly over-valued, highly leveraged market that has been rolling faster than the tracks can be built. It has created distrust between financial institutions for lending and liquidity bailouts, and has made it difficult for even the average person to get a reasonable loan without getting whiplash from the huge interest rate (or the big "reject" stamped across their forehead). Inflation has posed a problem not with commodities but with the dollar value. Increasing the money supply by the amount necessary to rescue the economy from disaster is definitely in the multi-trillion dollars and this would definitely de-value the dollar comparatively to the rest of the world which wouldn't do anything but make it more difficult for anyone within the US to jump-start the US economy (which is what we need because we got way too much foreign obligations!!). Finally, the citizens of the US have been upset...about taxes, pensions, social security, healthcare, and the fact that more money is being taken away from their well-being and injected into the soul-less financial monster that gobbled up everyone's equity in the first place.

So, how to get out? How to get us back to the good ole 90s!? Well, I have a posed solution to this overvalued market that is definitely in-line with the $700 billion bailout (but is definitely not so...randomly picked):

Any scientist, engineer and even high school student knows that the best way to figure out an unknown problem is to pose a hypothesis based upon lemmas and assumptions (and previous findings), test that hypothesis with data, and then repeat until you get the necessary solution...an interative process. What if we take a sample size of the mortgage-backed assets and other derivative assets that have been structured so well that each tranche doesn't even know where it should belong? Let's take, say, 10% of those assets from each of the 4 big banks standing (JPM, BAC, C, WFC) with a contract to buy the rest of the 90% at average market price. The government (Treasury, Fed, who cares?!) will take a random sampling of 10% at 5 cents to the dollar respective to their price at say, oh, December 31, 2006, and then spend a month valuing these assets. After being able to decipher a somewhat better idea of the type of holdings that exist (don't need a pricing scheme...just a declaration of the top 10 holdings like in funds). From there, we put it visible on the market for a month or two to get an idea of the average market worth for these "assets made funds".

After getting a market price, we can go back a second time into each of the 4 banks and take the remaining 90% of the un-valued assets. I'm assuming that of the $298 trillion in the derivatives market in 2005, the 36% drop to 2008 was the worst-case percentage for the un-valued mortgage-backed / derivative assets. Therefore, if we take 10% @ 5 cents on the dollar would be $0.53 trillion previously sold on the market. The remaining 90% if bought at an assumed market price of 10 cents/$ would be ~$9 trillion.

The next step is liquidating this inventory. Now, my original plan would have been to liquidate it all on the market for a market price. However, I think we need to add in the fact that we have so much foreign debt. At this point, the dollar would have gone down significantly and the foreign investment would look relatively cheap. We could auction off some of these mortgage-backed assets to Japan and China in exchange for our Treasury Securities. If they are willing to a minimum 10 cents on the $ for them, we will be making our money back and getting back over $1 trillion worth of overseas US treasury securities decreasing our budget deficit. [http://en.wikipedia.org/wiki/United_States_public_debt] The remaining $8 trillion we can sell on the open market. The average market return is ~11% / year. [http://www.moneychimp.com/features/market_cagr.htm] Now the total foreseen public debt (unfunded obligations both current and forecasted for medicaid, healthcare, social security, etc for baby boomer era) for the US has been approximated at ~$60 trillion. If we can meet this 11% / year of market return for these assets (as the market slowly returns due credit markets beginning to lend and expand because these unknown mortgage-backed assets are now valued), then in 5-20 years (baby boomer time) we will have amassed $15 - $64 trillion to account for the public debt completely!

Note: In placing these assets back on the market, most or all of the money will be returned to government within a short to medium period of time along with a hopeful profit at the average market return. Therefore, inflation should be only in the short-term and in the long-term, we will not have any de-valued currency.

This solution will definitely take some negotiations with countries like Japan and China, and it is definitely based upon the fact that markets will be somewhat normally responsive to these dangerous, risky assets. However, I believe that treating them individually or at least grouping them appropriately will allow visibility into the structure (tranches) and contents of these assets.

This is the only way I see a rescue. What do you think?