Richard Russell’s Dow Theory Letter Issue 854 was published on February 9, 1983. At the time, the Dow Jones Industrial Average was at the 1,067.42 level.
Economic events never occur in a vacuum. Usually there is a string of events that leads from one event to another. One big event can lead to an even bigger event that overshadows the prior calamities that triggered the “big” event. This issue of Richard Russell’s Dow Theory Letters covers one market event that led to major crises that happened at different periods in time. The two events are joined at the hip based on the decline of oil prices. This led two separate major bailouts that resulted in structural shift in the way our brand of capitalism works.
Also, this Russell review will cover the topic of cycles in corporate cash and corporate indebtedness. We'll discuss, in brief, where we might be in this cycle.
The first event resulted in the Savings and Loan Crisis and is thought to have begun in 1986 due to the Tax Reform Act of 1986 culminating in the bailout of many banks and the eventual bankruptcy of the Federal Savings and Loan Insurance Corporation (FSLIC).
The second event resulted in the Mexican Peso Crisis with the outcome that major banking institutions like Citibank and Goldman Sachs needed to be bailed out. It is important to note that the Peso Crisis is considered to be as a result of the peso devaluation in 1994.
The true roots of both the S&L Crisis and the Peso Crisis is the decline of oil prices after the inflationary peak in 1980-1981. Richard Russell’s Dow Theory Letter Issue 854 highlights the seeds of destruction that were going to be much larger than even Russell could have imagined. However, if anyone wishes to understand how the snowball got rolling then this issue highlights the beginning.
The very first quote is an amazing insight of the American dependence of the high price of oil, Richard Russell says the following:
“We’re facing a situation (ironically) where the US is all for holding oil prices at a high level. The banks have lent huge sums of money both to private corporations and to oil producing nations-loans based on rising oil prices. If the oil price cracks badly, the banks are going to have major problems. On top of that, the US depends on oil taxes (so called “excess profits” tax) for huge chunks of tax income. If oil prices crack then the profits for the oil companies will dive (which they are already doing) and the tax short-fall will be horrendous. (page 1)”
This commentary is staggering in the fact that it was so prescient. The cracks in the armor of the American oil industry began in Texas when the easy money stopped raining down on oil dependent cities like Houston and Dallas. In a 1988 issue of Dow Theory Letters, Russell had the following to say:
“With oil prices caving in, Texas now has more people leaving the state than coming in.( Dow Theory Letters. March 9, 1988. page 6.)”
The decline in oil prices led to a decline of jobs for that industry which resulted in a decline in real estate prices as people left the state of Texas. Loans made by savings and loan institutions in the southwest U.S., to businesses and real estate investors, all went bad at the same time leading to the Savings and Loan Crisis (S&L Crisis). The S&L Crisis cost several hundreds of billions of dollars and still exist as an off-budget item as part of our national debt.
The decline in the price of oil also crushed foreign economies dependent on the commodity. The Mexican Peso Crisis, although officially listed as beginning in 1994, had its roots in the early 1980’s. The natural outcome of this crisis was the bailout of large banking institutions like Citibank and Goldman Sachs when the government stepped in and bought the bad debt held by the bank’s all in gamble.
Likewise, the current boom in commodity rich countries (although somewhat cooler at present) like Australia, Brazil, Russia, China and India could experience significant shocks to their system depending on the level of loans made as “investments” by foreign banking institutions based on the potential of future growth.
Few understood or believed the impact and importance of high oil prices to the American economy at the time. Even fewer understood the direct reliance of the U.S. government to high oil prices. Then as now, the elevated level of the price of gold is being wagered on by the U.S. government in a similar way that it was done when we had high prices in oil. The excessive printing of money through quantitative easing and other accommodative policies by the Federal Reserve is based on the elevated level in gold prices.
If the price of gold were to collapse then all bets are off. Unfortunately, many believe that a collapse in gold couldn’t happen while the government is bent on printing money out of thin air. However, the problem is that commodities like gold are prone to dramatic declines, especially when all bets are that it can’t or won’t happen.
Many die-hard gold investors/speculators are not making the connection between the government’s reliance and expectation of higher prices in gold. Worse still, gold investors mistakenly believe that the U.S. government wants to see a lower price in gold and that the only direction is up due to accommodative policies. This is far from the reality, as found out the hard way by the likes of billionaire money manager John Paulson. Waiting in the wings are other big-time money managers who will likely get bailed out of their money losing bets on gold’s elevated levels. Those that have leveraged their bets on gold and other commodities will be bailed out using taxpayers money and hidden as an off-budget items as part of the national debt. Suffice to say, despite all the carnage in the period from 1980 to 2007, the stock market managed to climb over 12 times.
Next up is a comment on how U.S. corporations were strapped with debt. Russell says the following:
“In the shorter term, the argument for holding stocks is that a low rate of inflation will be bullish for stocks. But that argument was never used in a situation like the current one - a situation in which corporations are loaded with debt. Whether these corporations can survive with debt ridden structure during a period of deflation remains to be seen. (page 3)”
This commentary is interesting because it was at the early stages of a secular bull market when the Dow Jones Industrial Average went from 1,000 to the peak of 14,164, an increase of over 12 times in 24 years (and this was just the “average”). Now, we seem to be in the early stages of a secular bear market with just the opposite scenario. Today, we’re being told of the immense cash hoard that corporations happen to be sitting on (WSJ article here). Furthermore, interest rates are at or near zero and likely to rise as opposed to rates falling from double digit heights in 1980.
We’re not impressed with the claims of corporate strength based on off-shore cash hoards. We believe that what we’re witness to is the corporate equivalent of high tide which is inevitably going to be followed by low tide. It is only a matter of time that it will be revealed that the idle cash of today will be the debt-laden corporation of tomorrow. Those that are clamoring (in some cases suing) for companies to disgorge their coffers of excess cash in the form of “special” dividends will not think twice, twenty years from now, that they had unwittingly contributed to the decline of the company that they’ve targeted.
