Issue 21 • April 22, 2009

Bulls Beware: Despite
Recent Rally, the Secular
Bear Still Growls

The S&P 500 Index just enjoyed its best six-week rally since 1938 ... before plunging again Monday on renewed fears of growing losses in the financial sector.¹

Here’s the historical take away: Like the rally that occurred in 1938, this recent rally took place within an ongoing secular bear market in stocks.

1938 was a pretty good year for investors ... provided you were very nimble. After a steep plunge early in the year, the S&P 500 rallied to gain +24.6% by the end of 1938. But the rally would not be sustained.²

The Great Depression began to intensify again in 1938. Industrial production plunged, almost matching its extreme low in 1932. Job losses, which began to mount in 1937, peaked in mid-1938 with an unemployment rate of 20%. The economy rolled over again, contracting sharply that year.³

Not surprisingly, the stock market rolled over too. In fact, the S&P 500 Index resumed its secular bear market downtrend after 1938 ... plunging -37.7% over the next three-plus years.⁴

At Weiss Capital Management, we believe that investors could experience a similar secular bear market climate in coming years, characterized by uneven fits and starts in the economy, and persistent volatility in financial markets. We’re not out of the woods just yet ... not by a long shot.

In fact, there could be many false-starts in the months and years ahead, as the economy struggles through its most severe period of upheaval since the Great Depression.

Of course, there will be upside opportunities from time to time, like the rally we witnessed at the end of 2008, or more recently over the last six weeks. But ultimately, these upswings could easily give way to new market lows.

The problems dragging on our economy and financial markets persist. In fact, the number of delinquent home mortgage loans jumped by nearly 400,000 in December and January alone, according to the most recent data available. Alarmingly, new prime mortgage loan delinquencies soared almost 70% over the same period.⁵

This is no longer just a sub-prime problem. Now even the most credit-worthy borrowers in America are struggling to keep up their mortgage payments as home values continue to fall. As a result, losses will continue to pressure the financial sector as foreclosures increase.

Biggest Real Estate Bust in History

I’ve warned that there’s no quick fix to the nation’s banking troubles (See last week’s issue of Weiss Advice here). I warned that the mounting loan losses from the collapse in residential real estate were just the opening act of the crisis.

Two weeks ago, I explained how losses from commercial real estate loans were destined to accelerate ... not to mention losses from other consumer and small business loans. Since that issue of Weiss Advice, we’ve seen an avalanche of new evidence that confirms my fears.

On Thursday, General Growth Properties, the nation’s second largest owner of retail shopping malls, filed for Chapter 11 bankruptcy ... the biggest real estate failure in U.S. history.

The operator of upscale retail properties, including New York’s South Street Seaport and Boston’s Faneuil Hall Marketplace, was unable to refinance its $27 billion in debt with tight-fisted lenders in today’s credit crunch climate.⁶

Unfortunately, this failure may be only the tip of the iceberg for more commercial real estate losses ahead.

Another $814 billion of commercial mortgage debt is maturing in the next two years alone.⁷ Real estate values of all types are falling at record rates ... apartment complexes falling -11.5% year over year; office buildings, down -6.1%; industrial properties, off -3.3%.⁸

With credit markets still not functioning properly, and banks refusing to lend, we’re bound to see even more defaults and plunging property values in the commercial sector — that’s on top of losses from falling home values — that are still accelerating to the downside.⁹

This may be another chapter in the real estate crunch, but may also be the start of the next phase of this financial crisis likely to hammer the banking sector.

Wall Street’s Financial Shenanigans Mask Growing Losses

In spite of the bleak reality, banks moved sharply higher during the market’s recent rally. Unfortunately, I suspect this is just another dead cat bounce ... likely to end in more disappointment for investors.

The surge in bank stocks was due to first quarter financial results that were “better than expected,” but look carefully at the numbers and you’ll see the ugly truth.

On Monday, Bank of America was the latest to report a first quarter earnings “surprise,” but take a closer look below the surface and you’ll find plenty of accounting tricks and financial shell games are going on.

Although Bank of America put a rosy spin on its net income numbers, reserves for future loan losses surged 57% to $13.4 billion last quarter ... and bad debt charge-offs more than DOUBLED to nearly $7 billion from this time last year.¹⁰ I don’t know about you, but to me, this certainly doesn’t paint a rosy picture.

Next, take Citigroup’s financials. They are chock-full of gimmicks galore...

Last week, “Citi” claimed that it earned $1.6 billion in first quarter profits, but these surprisingly good results AREN’T all they’re cracked up to be.¹¹

Citi’s results were boosted significantly by a crazy quirk in accounting rules that allows a bank to book gains (at least on paper) when the price of its own debt securities fall in value.

Here’s how this gimmick worked to prop up Citi’s bottom line...

A neat little accounting trick, adopted in 2007, allowed Citigroup to benefit from the widening of its own credit derivative spreads, resulting in a net $2.5 billion boost to the bank’s fixed income trading revenue.¹²

Credit default swaps are like insurance policies designed to protect against a firm defaulting on its debt. In this case, Citigroup sold this default “protection” to other investors. So, as Citigroup’s finances got weaker in the first quarter, increasing the bank’s risk of default, it was perversely allowed to book paper gains as its own credit default swap spreads widened!

In other words, Citi profited because its risk of going belly-up increased ... only on Wall Street.

By this upside-down logic — the closer Citigroup gets to Chapter 11 — the more money it will earn from its derivatives trading! The same accounting gimmick gave a boost to results at Goldman Sachs and JP Morgan this quarter too.¹³

This market is tricky enough for investors to navigate as it is. But it’s made even more treacherous because of the ongoing shell games being played by these banks that are practically insolvent.

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

P.S.The market’s six-week rally may be history. Is your portfolio prepared for another roller-coaster ride to the downside? We offer a professionally managed investment program that can hedge your investments and help you potentially profit from the next market decline: the Weiss Bear Strategy. For more details, go here now.

¹ Bloomberg: “U.S. Stocks Tumble as Financials, Commodity Shares Retreat”, 4/20/09
² Bloomberg data: 4/21/09
³ Northern Trust Research: “The Great Depression – Just the Facts, Ma’am”, 2/9/09
⁴ Bloomberg data: 4/21/09
⁵ Federal Housing Finance Agency: news release, 4/21/09
⁶ Reuters: “General Growth files historic real estate bankruptcy”, 4/16/09
⁷ Ibid
⁸ Merrill Lynch Economic Commentary: “Deflation realities ... don’t ignore them”, 4/17/09
⁹ Ibid
¹⁰ Bloomberg: “U.S. Stocks Tumble as Financials, Commodity Shares Retreat”, 4/20/09
¹¹ Business Wire: “Citi Results: Any Reason to Cheer?”, 4/20/09
¹² Ibid
¹³ Ibid