An antidote to happiness…

Monday, 19 February 2018
Melbourne, Australia
By Kris Sayce

  • The 10/90 rule
  • This is how the Financial Claims Scheme operates
  • How safe is your money in the bank?
  • A fall of 65–80% is coming

Stock markets have roared back to life.

The Aussie market is closing in again on 6,000 points. A 1% rise tomorrow would get us there.

Reason to celebrate?

Oh, come come. You know our beat.

We don’t celebrate…unless the market is in the midst of a crash…which is exactly where your editor, and our esteemed colleague, Vern Gowdie believe the market could soon be heading.

So as an antidote to stock market happiness, we give you Vern Gowdie. And with him, another reason why Aussie investors should worry about sky-high asset prices.

Vern’s special guest essay is below. But first, the markets…

Markets

Over the weekend, the Dow Jones Industrial Average closed up 19.01 points, or 0.08%.

The S&P 500 gained 1.02 points, or 0.04%.

In Europe, the Euro Stoxx 50 index added 37.17 points, for a 1.1% rise. Meanwhile, the FTSE 100 gained 0.83%, and Germany’s DAX index added 0.86%.

In Asian markets, Japan’s Nikkei 225 index is up 376.54 points, or 1.73%. China’s CSI 300 is closed in observance of the Spring Festival Golden Week holiday.

In Australia, the S&P/ASX 200 closed up 37.56 points, or 0.64%.

On the commodities markets, West Texas Intermediate crude oil is US$62.46 per barrel. Brent crude is US$65.41 per barrel.

Gold is trading for US$1,348.26 (AU$1,702.01) per troy ounce. Silver is US$16.69 (AU$21.06) per troy ounce.

The Aussie dollar is worth 79.21 US cents.

Bitcoin is US$10,469.51.

Turn that smile upside-down!

And now, over to Vern…

Cheers,
Kris


The 10/90 rule

We’ve all heard of the 80/20 rule. But in the case of the Australian financial system, it’s the 10/90 rule.

10% of the institutions have 90% of the deposits.

This concentration of deposits in so few institutions means the government has no choice other than to backstop the nine larger banks.

Allowing one or more of these nine banks to fail is not an option. Public confidence would be shattered. People would start second-guessing which major bank is next. A run on the banks would become a self-fulfilling prophecy.

The authorities might start with bail-ins from shareholders and investors in hybrids — investor capital could be fully or partially confiscated to recapitalise the ailing bank(s). Mergers between the big nine could be facilitated. The RBA (Reserve Bank of Australia) could print money to cover the deposit guarantee. Capital controls could be invoked.

There are a variety of measures the authorities have at their disposal to quell public anxiety and unrest.

With 90% of deposits held in nine banks, the government cannot allow any of them to fail. The contagion risk is far too great.

However, the same cannot be said of the other 75 banks.

As a last resort, APRA could trigger the Financial Claims Scheme (FCS) for any one of the smaller institutions.

This is how the Financial Claims Scheme operates

In the event that one or more of those ADIs (Authorise Deposit-taking Institutions) fails, this — according to an RBA paper titled ‘Depositor Protection in Australia’ — is how the FCS operates:

‘…The FCS is a form of deposit insurance that provides depositors with certainty that they will quickly recover their deposits (up to the predefined cap) in the event that an Australian ADI fails.

The FCS is administered by APRA and operates as follows.

  • The Scheme is activated at the discretion of the Australian Treasurer where APRA has applied to the Federal Court for an ADI to be wound up. This can only be done when APRA has appointed a statutory manager to assume control of an ADI and APRA considers that the ADI is insolvent and could not be restored to solvency within a reasonable period.
  • Upon its activation, APRA aims to make payments to account-holders up to the level of the cap as quickly as possible — generally within seven days of the date on which the FCS is activated.
  • The method of payout to depositors will depend on the circumstances of the failed ADI and APRA’s assessment of the cost-effectiveness of each option. Payment options include cheques drawn on the RBA, electronic transfer to a nominated account at another ADI, transfer of funds into a new account created by APRA at another ADI, and various modes of cash payments.

After APRA has exhausted all other avenues to ‘rescue’ an ADI, then, with the Treasurer’s approval, it’s off to court to have the ADI declared insolvent.

Once the court ratifies the windup, deposit holders should receive monies within seven days.

While the seven-day timeframe seems reasonably timely, it may take APRA weeks or months (but hopefully not years) to reach the windup stage.

Then you have to wait for the political and legal systems to grind their own gears.

While the bureaucracy goes through the processes and formalities, deposit holders had best prepare to wait and wait, and wait some more.

How safe is your money in the bank?

The financial system is the beating heart of modern society.

Without a viable banking system, the whole economy is at risk of grinding to a halt. If money stops flowing through the system, other vital economic organs — transport, food production, power supply, etc. — start to fail.

Therefore, my opinion on the safety of money in the bank is predicated on the assumption that the government will ‘move heaven and earth’ to maintain a functioning financial system.

Based on this view, deposits up to $250,000 per taxable entity per ADI are reasonably safe.

Any balance above $250,000 is at risk of confiscation.

Smaller institutions could be allowed to fail without risk of a systemic collapse in confidence. Deposit holders in the ‘too small to matter’ ADIs will need to be patient before being able to fully access their accounts.

The fragility in public confidence means the nine larger ADIs are ‘too big to fail’.

While the government moves to maintain or restore public confidence, one of the measures is likely to be capital controls (limited access to cash on a daily or weekly basis).

So how do we mitigate the potential risks?

Keep your deposits under $250,000 per taxable entity per ADI. Spread your deposits around a number of ADIs. Maintain a ‘cash stash’ of at least three to six months’ worth of living expenses.

As mentioned last week, the transfers — to and from accounts that keep the economy ticking over — will be conducted electronically.

A fall of 65–80% is coming

The end is nigh.

Or at least that’s how it looks from Hussman Funds’ latest valuation chart.

The multi-coloured lines represent five different valuation metrics, dating back to 1947.

Seven decades of data paints a picture of imminent danger.

The ‘0%’ line represents the historic average.

Movements above and below the 70-year average indicate when the US share market (S&P 500 index) is either under- or over-valued.



chart image

Source: Hussman Funds
Click to enlarge


The current reading is within a whisker of the extended valuation reading, recorded at the peak of the dotcom boom.

This means we are in very rarefied valuation territory.

It’s important to remember that the long-term wave patterns shown in this chart — down, up, down — represent the movement of a full market cycle.

The current reading is only one-half of the market cycle…the up phase. We are yet to experience the more destructive second half of the cycle.

How destructive might that be?

A return to the 0% line (long-term average), from the current level, would require a fall of 65%.

Should the US market fall further — to the low experienced in the early 1980s — the drop in value would be over 80%.

The downward phases of the dotcom and US housing bubbles both hovered around the 0% line. Therefore, it’s not too much of a stretch to envisage the next downward phase delivering a similar result. Which, I repeat, means a 65% fall from the current level.

However, the past two recoveries — following the bursting of the dotcom and housing bubbles — were ably assisted by the Fed’s stimulus packages.

What if the Fed is out of ammo and cannot marshal the forces necessary for another rescue mission?

It’s a distinct possibility.

And, should that possibility become a reality, a market left to fend for itself could fall to the lows of the early 1980s.

Only time will tell just how brutal the next US market collapse will be. But one thing is certain: Losses of up to 80% are most definitely to be avoided.

Regards,
Vern