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IT’S THE FUNDAMENTALS STUPID
Amid the recent stock market weakness, the pundits are virtually unanimous in their claims that good underlying economic fundamentals are being trumped by irrational fear. However, if investors understood just how bad the fundamentals for the U.S. economy really are, they would dump stocks even faster. So, contrary to the rhetoric, it is not that investors are being too fearful, but that they are being too complacent.
During the recent stock market rally investors ignored some very disturbing underlying economic fundamentals. Therefore, the current weakness in the market is not in conflict with the fundamentals, but completely consistent with them. Unfortunately for the overall economy, the re-assertion of fundamentals is not exclusive to the stock market. Here is a look at what will likely happen to other asset classes and our economy should investors refuse to blindly follow the Pied Pipers of Wall Street:
ONE BIG REASON WHY U.S. DOLLAR IS STILL “KING”
When the fundamentals are clear as mud, check out technical indicators.
Oh my, how quickly things have changed. Just a month ago, the fate of the U.S. dollar seemed all but sealed – down. The buck has been on a losing streak against other major foreign currencies for years, and few people expected the trend to reverse.
But the ongoing U.S. subprime mortgage crisis has apparently changed all that. “The dollar,” reports Bloomberg, “is no longer the currency you love to hate. Now, it’s the currency you can’t live without. Last week’s credit crunch has set off a worldwide rush for dollars as banks and fund managers scramble to pay back loans used to buy risky mortgage securities.” According to UBS, “the world’s second-largest foreign exchange dealer,” the dollar is only “likely to keep benefiting,” because despite all its bruises, it is “still a safe-haven currency.” UBS expects the USD to “gain to $1.32 per euro in three months” – over 300 pips below the level where the EUR/USD stands today. Big move.
All this puts the dollar in a very interesting position. On the one hand, the subprime woes spell big trouble ahead for the U.S. economy, which “should” send the USD down. On the other hand, the renewed worldwide demand for the greenback “should” send it higher. So how do you, a forex trader, decide which side to bet on: long or short?
When you are trading, it is always a good idea to keep an eye on technical market indicators ... especially at times like these, when “fundamentals” get as clear as mud. Elliott Wave International’s Currency Specialty Service said on August 13 that after the EUR/USD had finished five waves up at the recent all-time high, it has moved in a corrective ABC pattern from there. If you know the basics of Elliott wave analysis, you understand that after an ABC correction, prices should continue in the direction of the preceding five-wave impulse. That would imply a move higher for the EUR/USD.Link here. Where should your money be? – link.
THE BULL MARKET FOR GOLD
They say a picture is worth 1,000 words. This picture happens to be worth a 50-something-page essay, but for your sake, and mine, we will keep this to couple prevalent issues. The chart, courtesy of Kitco, is as of Friday a.m. trading – the end of another amazingly volatile week for global equities.
The first item of importance is the column labeled Chg% x = 1$USD, or the percent change in each particular currency compared to the USD. Besides the Canadian dollar, which is trading up because it got whacked on Thursday, the only two currencies showing strength are the Japanese Yen and Swiss Franc. These are the carry trade currencies. Essentially investors borrow the Yen and Franc at ultra-low interest rates and invest them abroad in higher yielding assets. To make these trades profitable, the Yen and Franc have to trade even or lower against the currency that denominates their higher yielding interests.
A common denominator, first brought to my attention during the February sell off, is the out performance of the Franc and the Yen against other major currencies of the world during major equities sell offs. This signifies, that the carry trader are forced to sell his/her assets, buy Yen or Franc, and repay the initial loan, hence causing strength in the Yen and Franc. Also, if a carry trader’s profits turn negative due to market volatility, they will be forced to liquidate their position and pay back their loan at a loss. This also causes strength in the carry trade currencies.
It is hard to say if a strong Yen/Franc causes carry traders to liquidate their equities, bringing about market woes and a stronger Yen/Franc ... or if market volatility forces these same traders to sell, cut their losses and buy back the Yen and Franc to pay back their loans. It is a chicken or egg question. In the case of the carry trade, I believe it is actually both, and it is easy to see the snowball effect created. Look for these currencies to strengthen further. This will be both a result and a cause of future market volatility.
The eventual unwinding of the carry trade, among other factors such as subprime concerns and credit woes, will rip liquidity from the markets, pushing along the bear market in equities. So where do investors turn?
The second item of importance to note is that gold is trading up in EVERY major currency in the world. This comes as a flight to quality during market volatility, and if you ask us gold bugs, it is long overdue. Around the gold watering hole, investors believe a true bull market in the yellow metal must be a global bull market. As you can see from the chart, this definitely holds true.
Gold is not a basic commodity, and it is not a currency either. It is a hybrid between the two. Now I read several gold articles and newsletters every day. I hear opinions from way opposite spectrums. On one side, you have a gold bug that feels the yellow metal has completely decupled from its inverse relationship with the dollar. This type of gold bull believes that the only thing pushing the gold bull market forward is supply and demand fundamentals. On the other side, you have an individual that believes gold to be the ultimate inflation hedge, and that the only thing that matters is the value of the currency going forward.
If you lived in Zimbabwe, where inflation is running at several thousand percent, you would definitely feel like gold is in a bull market. What if, at the same time, the Yen is going through a period of deflation and the price of gold is declining? This is why to accurately judge a true local bull market, you have to look at the supply and demand fundamentals. The supply and demand fundamentals give us a judge of mine production and the supply of gold from central banks. This will affect the price of gold in every currency of the world.
According to GFMS, global mine production in 2006 was 2,471 tonnes. A decade earlier, mine production was 4,127 tonnes. During both these periods, even with the change in tonnage, mine supply made up roughly 60% of total supply. A country like South Africa, which has historically produced a very extensive amount of gold, has a mine production level at a 22-year low.
And for demand, look at the ETFs from 2004. These have greatly increased the demand for gold and in 2006 ETF gold holdings have more than doubled their holdings since 2004. That is it for how the global bull market is shaping up. But, what does that mean to you? Well there are small-cap plays in all of this.Link here.
“When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” ~~ Citigroup CEO Chuck Prince, July 2007
How things have changed in the short space of a month. For, right up to the second half of July, world equity markets were still raging ahead in utter denial of the spreading cracks in the credit boom, with both the S&P and the emerging markets indices making new highs in that time. This was despite the fact that all the technicals were signaling the need for caution – elevated sentiment readings, record-high margin longs on the NYSE, record-low mutual fund liquid asset percentage holdings, a turn in the breadth of the market (that for the Nasdaq has, indeed, since hit multi-year new lows), volatility indices climbing with – rather than against – the rise in stocks.
More crucially, there was still an attempt to downplay the magnitude of the problems finally coming to boil in what has arguably been the most spectacular mass hysteria in the whole sorry history of financial market manias – the $multi-trillion Ponzi scheme of credit we have created since the collapse of the Technology frenzy.
We have long told anyone arguing that commodities have occasionally displayed bubble-like behaviour that they were no more susceptible to this kind of infection than any of a number of other asset classes – both conventional and “alternative” – and that this was unlikely to pass until we had removed the cause of all this mischief, namely, the credit bubble which had continuously been inflating prices everywhere you looked (though, ironically, everywhere the central banks were choosing not to look, at the same time).
The real bubble, we maintained, was in credit: all others – whether in copper futures, LBO targets, Patek Philippe watches, or Modern “art” – were ancillary to what the woefully uncomprehending ex-Fed Chairman once called a “conundrum”, but which was, in reality, all too understandable a phenomenon. In saying this, we would be assailed on the one side by starry-eyed mining promoters who would insist on telling us that our caution was misplaced. We “didn’t get it” because we did not understand China’s influence on the supply/demand dynamics of the metals concerned.
On the other hand, we have been haughtily dismissed by institutional investors who could very well scoff that, say, nickel might be overstretched in the near term, but who were still perfectly content to buy yet another gallimaufry of dubious, rag-tag credits from their over-eager investment bank account managers, each secure in the belief that the hocus-pocus which purported to value these baskets afforded him a wide margin of safety. As the events of the past few weeks have begun to reveal, however, this last presumption has proved just as fatal as all of its many less-than-illustrious predecessors in the perpetration of mathematical hubris.
Indeed, it is a compelling testimony to our capacity for pseudo-rational self-delusion that so many could still cling to the idea that something as intensely self-reinforcing as the financial markets – institutions in which those highly non-linear and inherently unquantifiable actors known as “human beings” are at play (and largely with Other People’s Money) – can ever yield to the same statistical calculus as a laboratory vessel full of inanimate gas particles.
Did no one stop to think that if their model was supposed to be so hot, then so, in all likelihood, was everyone else’s? Had they done so, they would have realized that not only must buying assumptions have become claustrophobically crowded (i.e., very efficiently irrational!), but that – far worse in its implications – once the market turned, all these blessed computers would be revealed to be disastrously mispriced in one horrible unison. After all, if everyone was running much the same CDO-analytical version of Deep Blue, did no one ever ask themselves whether there were really enough Gary Kasparov’s out there on whom to unload the junk once the models all began to flash “Sell!” at the same time?
Obviously not. And yet, even now there is a current of denial still insidiously at work in the minds of people who do not wish to acknowledge that their own deeds, as members of the undiscerning Herd, have given rise to what they insist on misconstruing as just one more “six sigma event”. Apart from “the problem is fully contained” school of hopeless little Dutch boys and the usual crowd of “buy the dips (preferably from me)” chancers, the air is filled with the dreary strains of that eternal Chorus intoning “the economic fundamentals are sound,” even as all manner of high-falutin’ investment schemes implode around us.
Has anyone noticed the strange fact that when asset prices are rising, their ascent is the inescapable consequence of a solid “fundamental” underpinning – no matter how unrealistic the valuations of the assets the pundit is touting have become. But when the same market suffers one of its periodic bouts of vertigo, then far from being an unbiased reflection of disembodied knowledge, the reversal can now only be ascribed to an access of the vapors on the part of a few ill-informed neurotics! What is more, this asymmetrical mental ratchet effect (parts the “model arrogance” discussed above, wishful thinking, and cynical salesmanship) misses the fact that just as financial market conditions exert a clear and undeniable influence on the real economy in the upswing, they can hardly fail to do so in the downleg as well.
We have lived through, these past few years, nothing less than the genesis of a Category Five, super-credit-cyclone – one whose terrifying eyewall is a screaming vortex of collateral-debt-derivative feedback. Once such a storm breaks, our asset-liability bind will be seen to be the critical weakness, the Mississippi levee whose failure could well swamp us all. Granted, it is the case that every debit has somewhere a corresponding credit, but this also means that everyman’s fate is intimately bound up with that of his neighbor.
As Fritz Machlup pointed out in the 1930s, if A lends to B who lends to C, who in turn lends to A, it is indeed the case that – at the aggregate level – everything seems to match up. But this does not mean that it also cancels out. If C encounters difficulties and informs B he is broke, B will default on A and A will then be unable to meet C’s call for the cash with which he hopes to disembarrass himself. All will be ruined together.
Therefore, even if we personally have not been knowingly playing the ragged edges of the credit game, the fact that the mighty hurricane which looms above us made its first landfall in the sprawling, plasterboard suburbs of subprime is no reason for complacency for, as is just beginning to be glimpsed, subprime is itself no more than a particularly indefensible subset of the far more widespread dangers we all now face. The world is not going to go into a tailspin because of the travails of 50-odd thousand poor fools whose painful desire to make a fast buck flipping condos met a none-too-choosy lender with similarly short-sighted motives.
The plain fact is, however, that Hurricane Cassandra (so named because no one would heed the many warnings given, instead of carrying on frenetically dancing the Chuck Prince Charleston) never limited herself to such a low-rent corner of the world. Rather, the whole colorful motley crew of hedge fund gunslingers, private equity barons, bond insurers, CDO traders and fixed-income investors ... the whole, out-of-control business of M&A, of vast share buybacks, and hence of main market equity outperformance, as well as emerging market re-rating ... the whole self-aggrandizing swagger of the Bulge Bracket bonus bonanza ... all of it – every last red cent of it – has been, in turn, cause and effect of the build-up of the storm system which now threatens to sweep this Big Easy of false prosperity away, leaving little but the matchwood of shattered dreams and disabused expectations in its wake.
If all of the foregoing does not strike a cautionary enough note to give you pause, when you hear the Siren whispers telling you to dive back in now that things are “cheap”, there is one last sobering question to contemplate. In the Austrian vision of the world, the business cycle is the credit cycle. Overeasy credit encourages too much investment in too many false projects. Financiers become reckless and entrepreneurs are mislead en masse to see real opportunity where there is only the shimmering mirage given off by hot money.
And the cycle tends to manifest itself in a lengthening of the productive structure, in undertaking investments increasingly removed from the immediate provision of consumer goods, and especially of consumer staples. Another crushing asymmetry comes to bear here. It is far easier to lengthen the structure – to use easy money and expensive shares to build plant, lay pipelines, and fill the factory with banks of gleaming, new, highly-specialized machinery – than it ever is to shorten it again – retooling the assembly line for a different use, bringing a different ore out of the mineshaft, even breaking the equipment profitably up for scrap – when the premises on which these bold steps were taken prove to be mere falsehoods spun amid the prevailing mood of financial incontinence.
If, therefore, the credit cycle really has turned here – and this is surely the best candidate for marking that decisive change of phase we have had for some years – we cannot fail to reckon with serious, real world implications as the squeeze progresses, as returns on investment falter, as orders are canceled and jobs begin to be lost.
Accordingly, as we try to extricate ourselves under from the falling masonry of financial foolhardiness, what we must be asking ourselves is which company (or, indeed, which resource) has received the greatest short-term boost from the recent asset inflation and has therefore become the most overextended and vulnerable to its subsequent evaporation.
Conversely, we must also try to identify those who have been conservative enough, or who will hence react sufficiently rapidly (or for which resource we will still find the matching of physical supply to genuine, end demand a considerable challenge) and who or what will therefore best weather the onrushing tempest, offering real, long-term value, no matter how beaten down the traded price becomes in the interim.
We suggest you draw the lesson from subprime and start by looking for the corporate equivalents of those who took out – as well as those who looked like geniuses for extending – larger and larger chunks of “NINJA” loans (“No Income, No Job or Assets”), even as the ship was visibly heading for the rocks. If you do, you are sure to find more than enough candidates to keep you out of mischief for some good while to come.Link here.
HELICOPTERS OVER WALL STREET
Federal Reserve Chairman Ben Bernanke first achieved fame with a November 2002 speech in which he repeated Milton Friedman’s assertion that the Fed could “drop money out of helicopters” if deflation or a credit crunch occurred. The Fed and the European Central Bank now appear to be doing this, having injected $300 billion into the world monetary system in the last two business days. What Bernanke did not tell us in 2002 was that his helicopter would hover only over Wall Street.
Friedman and Bernanke were quite right that dropping money from helicopters would provide reflation, although since 1931-32 the U.S. has not had an economy in which such an action would have been remotely appropriate. One can indeed imagine in a difficult economy the welcome whirr of chopper blades as the Bernanke helicopter carried out its mercy mission. It would hover lengthily over the rusting steel towns of Ohio and Western Pennsylvania, would circle twice over the wasteland of downtown Detroit, would avoid the major farm states, already excessively subsidized by the U.S. taxpayer, but would provide welcome relief to the ghettoes of Watts and the South Bronx. What it would not do, in a world of even reasonable equity, is spend any time over Wall Street.
The injection of money by the Fed and the ECB feeds directly into Wall Street. It is huge in amount, and it consists of short term loans granted by the central banks to banks and investment banks which had been unwilling to make interbank deposits except at a substantial premium over the central bank’s target short term interest rate. Admittedly the injections are only loans – but if they are not quickly removed they will have added around 2% to the U.S. and EU broad money supply. This will worsen the already serious global inflation problem. They will however bail out Wall Street and its European competitors.
The level of panic in financial markets is quite extraordinary. Stock prices are down less than 10% from their all time peaks, and still up on the year, while bond yields have retreated substantially from their recent highs and are well within their trading ranges of the year. The only general market factor that has changed significantly is that volatility has increased, even though at the end of the week it has gone nowhere very much.
The increased volatility is key to the entire market turbulence, because of what can only be described as a gross misuse of mathematics in the trading rooms of the world. In the capital markets of the 1960s and earlier, banks would no more have considered hiring mathematicians than they would have bet their entire capital in short term speculation. However, after the invention of the Black-Scholes options valuation model in 1973, mathematicians came into fashion. The model offered the enormous benefit of providing a “value”, however spurious, for any option position. This allowed banks to offer their clients options both direct and disguised while “marking to market” their trading positions at the close of each business day.
The model was however completely incomprehensible to non-mathematicians. Bank managements therefore decided to import some mathematicians to interpret it and act as risk managers. Having imported mathematicians, and recognized that if they were going to take on these huge risks they needed to be able to manage them, bank managements then asked the mathematicians to produce a risk management metric. Unfortunately bank managements did not suspect mathematics’ most closely guarded guilty secret: Only a tiny minority of possible equations are solvable using currently existing mathematical techniques. Rather than confessing failure and losing their jobs, which were paid beyond the wildest dreams of mathematical academia, the mathematicians therefore bent the reality to fit the equations they could solve, and came up with the “Value at Risk” methodology, which produced a risk management model that was convincing to top management and worked most of the time. The occasions on which the models did not work were dismissed as market anomalies.
Value at Risk suffers from two main defects. One is that it breaks down in times of market turbulence – the theoretical maximum “value at risk” can be an arbitrarily small fraction of the true risk when things go wrong. The other is the way VAR deals with volatility. Under VAR, the risk of a position depends on its volatility, so that if volatility changes suddenly the risk changes also. When volatility changes – either very volatile days are introduced into the average or options prices jump – the VAR of the position changes also.
If as in the last few weeks markets suddenly become more volatile after a lengthy period of calm the VAR of every position held by a large bank suddenly jumps, generally to a multiple of its previous level. In such cases, even if markets do not overall move that much (as they have not in equities markets) the bank has to reduce its positions. Since all participants are looking at the same volatilities, every bank and hedge fund is forced to unwind its trades and reduce its positions at the same time. Needless to say, this produces highly unstable markets, which themselves increase volatility and exacerbate the problem.
This is the first time the markets have done this since the introduction of VAR in the early 1990s, with the limited exception of the Long Term Capital Management crash in 1998. In 2000-2002, the equities bear market was not accompanied by any increase in volatility in other markets and was fairly orderly. This was a sign that the bear market, aborted by Alan Greenspan’s massive injection of liquidity into the U.S. economy, did not go nearly far enough to wipe out the over-optimism and gullibility of the late 1990s bubble.
Needless to say this bizarre effect of current risk management techniques has now resulted in a market panic, quite unjustified given the modest movements in the stock and bond markets themselves. The ECB and the Fed have reacted to the panic rather than the markets, and have bailed out European and U.S. banks with oceans of additional liquidity. This of course has introduced moral hazard into the system in large amounts, if we are unlucky and the central banks’ liquidity injections stabilize the market and allow unjustified speculation to resume. Hopefully the liquidity injections will not work and the long overdue corrective market crash will overwhelm the speculators.
Whether this somewhat artificial panic will cause the Fed to abandon inflation control altogether and drop interest rates remains to be seen. If it does so the rest of the world will suffer from a 1970s style stagflation in which savings, jobs, and above all retirement incomes become highly insecure. At that point we can reflect gloomily upon the second rate mathematicians hired by Wall Street and the second rate central bankers whose helicopters never assist the middle class or the poor.
Contrary to populist theory, it is fiat money, controlled by politicians and unaccountable central bankers, and not the deflationary but mechanistic Gold Standard, that is the true instrument of Wall Street.Link here.
A RUN ON WALL STREET FINANCE
The market week commenced with the fanciful notion that increased purchases by the GSEs would suffice to reliquefy the U.S. mortgage marketplace. The NYSE Financial Index proceeded to rally 7% before reality began to return. A tumultuous week of faltering international credit markets ended with the major global central banks injecting liquidity to the tune of $140 billion, including Federal Reserve mortgage-backed securities purchases of $38 billion. Friday it was reported that Fannie Mae sought permission for asset growth of a “moderate” increase in the range of 10% – a $70 billion or so drop in the bucket.
The GSEs will certainly not be bailing out the global credit system. Instead, the question has become how successful global central bankers will be in restoring confidence in a system that so has so abruptly begun coming apart at the seams. At this point, I will assume that global central bankers have come to accept that only their aggressive interventions offer the hope of a liquidity backstop sufficient to bolster fading confidence and stem a modern-day run on “Wall Street Finance”.
The risk market contagion that erupted in U.S. subprime mortgages has now fully engulfed the heart of “structured finance” – the CDO marketplace, asset-backed securities, the “repo” market, credit derivatives, “structured products”, and even the perceived pristine “money” market fund complex. The Financial Times quoted Marc Ostwald, fixed income strategist at Insinger de Beaufort: “There is huge pressure on money rates due to an apparent sense of mistrust. ... [V]ery few institutions appear willing to lend. If you kill off the inter-bank market and the asset-backed commercial paper market has effectively collapsed, then we look to be heading for a serious liquidity crunch.”
Central banks do retain significant potential firepower to buttress marketplace liquidity in the near-term. Yet the ongoing impact such interventions will have in restoring trust in market pricing, securities ratings, sophisticated model-based and leveraged trading strategies, counterparty risk, general risk management/hedging capabilities, and liquidity in Wall Street’s newfangled “structured” products is very much an open question. It is my view that some crucial financial myths have been thoroughly DisCredited.
In general, a market’s belief that credit is as attractive (holds similar attributes) as “money” plays a decisive role in fostering credit expansion. Over time, as the perception of moneyness is applied to expanding types and quantities of credit instruments, a full-fledged credit bubble takes hold. And, as we have witnessed, the longer credit excesses inflate asset prices, corporate earnings, and household incomes, the more seductive the myth that the underlying credit instruments are increasingly safe and liquid.
It takes years (decades?) and, importantly, the successful perseverance through at least a few close calls, for the “perception of moneyness” to become fully embedded in the structure of the credit system. Emboldened market participants eventually come to believe that that nothing can seriously interrupt the boom. Each near-crisis surmounted leads to only greater confidence in the underlying credit system and the capacity for the authorities to sustain the expansion – each period of greater excess layers more dangerous layers of risk on top of an increasingly fragile pyramid of risk.
I previously discussed the previous (unsung) hero role the GSEs played in multiple near financial crises going back to 1994. Whether they acted in concert or not, timely Fed rate cuts coupled with huge GSE market purchase operations provided an epic market support mechanism throughout a period of unprecedented Wall Street innovation and enlargement. Importantly, over time the market perceived that liquidity could be taken for granted under virtually all circumstances. Clearly, any “AAA” security would remain highly liquid – even during those occasional (and brief) bouts of market turbulence. “Triple A“ came to connote “money” – an instrument that would always entice a buyer at a fair market price. Better yet, often such instruments even increased in value during market tumult. It certainly did not hurt that GSE debt dominated the entire “AAA” market. And as the leveraged speculators repeatedly took full advantage – certainly in 1994, 1998, 1999 and 2000 – the GSEs were more than happy to pay top dollar or more for MBS, mortgages, and other debt instruments any time the progressively more over-leveraged markets lurched toward de-leveraging and illiquidity.
Administrations, Congresses, and the Fed took no issue with the marketplace’s assumed implied government backing of GSE debt, allowing the GSEs for years to luxuriate in their unlimited access to market-based borrowings. Indeed, GSE debt enjoyed the extraordinary status of being completely immune to market liquidity concerns. The GSEs could borrow as much as they wanted – and buy as much MBSs and as many debt instruments in the marketplace as they (and the market!) desired. I cannot stress too strongly how this profoundly distorted the markets’ perception of pricing and liquidity risk for agency debt as well as for the markets overall – and for years nurtured today’s unfolding financial crisis.
Why am I rehashing the sordid history of GSE/Fed market interventions? I am convinced they played the key role in the market’s momentous misperception that “AAA” stood for “Always And Anytime liquid”. This liquidity had very much to do with the extraordinary mechanism whereby, during periods of financial stress, eager buyers of GSE debt (especially foreign buyers) would provide the GSEs unlimited wherewithal to provide a liquidity backstop in MBS, mortgage, and mortgage company debt instruments. And, let there be no doubt, the sophisticated leveraged speculating community took complete advantage of this extraordinary liquidity backdrop. I really believe that if there had been no extended GSE boom – there would have been no mortgage finance bubble, no Wall Street “structured finance” bubble, no derivatives bubble, and no protracted economic consumption-based U.S. economic boom. Unavoidable liquidity crisis would have nipped all in the bud some years ago.
Well, the world of finance subtly changed with the revelation of the GSEs’ (inevitable) abuse of phenomenal financial power. Issuance of GSE debt and Agency MBS stalled abruptly in 2004. Yet, by that time, mortgage finance bubble dynamics were in full force. After all, inflationary biases had taken firm hold in real estate markets across the country and, at least as signficant, throughout the expansive Wall Street mortgage finance apparatus. Indeed, the Street did not so much as miss a beat with the hamstrung GSEs. An increasingly assertive Wall Street was quite keen to more than fill the GSE void with its own brand of top-rated “structured finance”. And flood it they did.
The upshot were bubbling markets for ARMs, jumbo, Alt-A, “teaser”, “exotic”, and scores of subprime mortgages – the majority finding homes in the mushrooming market for Wall Street CDOs and other “structured products”. A protracted mortgage boom and inflated home prices provided a history of minimal credit losses, emboldening those rating mortgage-related securities as well as those happy to take leveraged positions in these perceived money-like instruments (including proliferating hedge funds, mortgage REITs, Wall Street trading proprietary trading operations, etc.). While the GSEs were left to spend billions sorting through their accounting mess, the various bubbles they were instrumental in nurturing grew to unfathomable dimensions. This mortgage debt explosion dispersed “top-rated” U.S. debt securities throughout the U.S. and global financial systems. This Wall Street alchemy worked so marvelously the industry moved immediately to do the same for risky acquisition-related finance and the unfolding global M&A bubble.
Returning back to the subtle change beginning back in 2004, the character of risk associated with new MBS issuance deteriorated markedly. While the “AAA” status remained constant, the non-GSE “private-label” variety of MBS/ABS were associated with increasingly risky underlying mortgages. The insatiable appetite for these relatively higher-yielding securities to satisfy the booming demand for CDOs and other structured products was sufficient to deaden any market sensitivity to the reality that the GSE liquidity backstop had been slammed shut. GSE balance sheets were no longer in a position to balloon on demand. The marketplace might have been conditioned to believe liquidity risk had not changed – but it had and profoundly.
From the spectacular subprime implosion to last week’s rapidly unfolding global liquidity crisis, a clearer picture is emerging: It is one of a momentous reversal in the liquidity backdrop. No longer does a reversal in speculator leverage conveniently flow onto GSE balance sheets, setting the stage (with Fed rate cuts) for an only more egregious expansion of credit and speculative excess. Instead, de-leveraging these days has quickly incited contagious marketplace illiquidity and a highly disruptive reversal of speculative flows from mortgage-related instruments, along with the very real risk of a mortgage credit collapse and financial markets liquidity dislocation.
It is popular to explain market gyrations as a “repricing” of risk. Other comments suggest that this is only a “short-term credit crunch” and that “this is a liquidity issue not a solvency issue.” This is much, much more serious. Key facets of “contemporary finance” are on the line. The entire process of Wall Street credit and risk intermediation is today in jeopardy.
There are literally $trillions of impaired debt instruments – previously “top-rated” securities that will never live up to their (fallacious) billing. And after a spectacular multi-year issuance boom, they are everywhere – especially in places appropriate for only the most “money-like” instruments. The perceived safest and most liquid securities found homes in various types of “money market” funds and other perceived low-risk investment vehicles. The bottom line is that these securities were misconceived as “money-like” from day one, and the marketplace has shifted to the recognition that they are instead highly risky and inappropriate for most investment vehicles, as well as for leveraged strategies. This radical change in market perceptions is wreaking bloody havoc on the untested credit derivatives marketplace.
Global central banks can somewhat cushion the de-leveraging process, but I doubt they can do much more than slow the flight from risky credit instruments and “investment” vehicles. Importantly, perilous market misperceptions with respect to risk and liquidity have been exposed. Speculative de-leveraging is unmasking serious flaws in various assumptions (including liquidity and market correlations) used by “black box” models in leveraged strategies across various securities markets. Risk management strategies are failing. The bloom is off the rose and a tidal wave of hedge fund withdrawals – and further de-leveraging – cannot be ruled out.
The major international banks have been key players in U.S. structured finance. This might very well be the epicenter of the current liquidity crisis, and they will surely vow to avoid such exposure to U.S. credit risk going forward. The highly leveraged Wall Street firms will struggle to rein in risk on myriad fronts and likely be forced to fight mightily for survival. And for how long the American public can hold its nerve is a major question. They have been conditioned to believe that their holdings in the stock, bond, and “money” market are safe and secure. And the longer central bank interventions sustain unsustainably inflated asset markets, the greater the opportunity for the speculator community to “distribute” their holdings to the unsuspecting public.
As much as I recognize the traditional role of central banks as liquidity providers of last resort, I just sense that being forced to move this early – with global stock markets at near record highs – provides confirmation of the acute fragility of the global credit system. Such moves would appear to risk further destabilizing already highly unstable global markets, especially currency markets. This does look to me as a run on Wall Street Finance – and an absolute mess.Link here (scroll down).
PLUNGE PROTECTION TEAM WORKING OVERTIME?
“Imagination is more important than knowledge,” the brilliant Albert Einstein used to say. Imagine for just a moment, that the Dow Jones Industrials has become a key instrument of national economic policy, and that by “actively managing” its direction, the government could impact the wealth of tens of millions of U.S. households, and by extension, influence consumer confidence and spending.
Since the appointment of Henry Paulson to the helm at the U.S. Treasury, the U.S. stock market has always found a way to defy the law of gravity. During Paulson’s short reign, the Dow Jones Industrials (DJI-30) broke an 80-year old record for the longest streak of gains with only 3 declining days in between. During the first 7 months of his tenure, the S&P 500 did not decline by 2%, the second longest-period without a 2% correction since 1964.
The market savvy Treasury chief, who built a $730 million fortune at Goldman Sachs, is also the chairman of the Working Group on Financial Markets, commonly known as the Plunge Protection Team (PPT), created by Ronald Reagan to prevent a repeat of the Wall Street meltdown in October 1987. The PPT is empowered to intervene in stock index futures and the foreign currency markets in the event of a crash. Paulson and his PPT are dealing with another tough challenge, trying to extend the S&P 500’s all-time record for avoiding a 10% correction. It has been 52-months since the S&P 500’s last slide of 10% or more, which took place from January 14 to March 11, 2003, when it lost 14%. Since then, the benchmark index has more than doubled without a similar drop.
Federal Reserve chief Ben “Helicopter” Bernanke is the U.S. Treasury chief’s right hand man, a key player controlling the U.S. money supply. Since Paulsen’s confirmation in July 2006, the broad M3 money supply has expanded at a 13% annualized clip, its fastest in 30-years, in a brazen effort to inflate the U.S. stock markets, and keep the cost of borrowing low for corporate takeover artists.
The PPT’s strategy is to offset weakness in the U.S. housing market with increased household wealth in the stock market, in order to avoid a recession. However, the weakness in housing has gone on longer and deeper than the PPT would like. The escalating foreclosure rate on U.S. homes has badly shaken the $2 trillion subprime mortgage market, and the riskiest BBB- segment has lost 65% of its market value. The sudden aversion for risk spilled over into the high-yield junk bond market, where yields jumped 120 basis points, putting speculators on edge about the outlook for corporate takeovers and share buybacks, the two key catalysts of the market’s rally to record highs. The U.S. junk bond market lost another source of liquidity, as the “yen carry” trade started to unwind, after the dollar tumbled from 124-yen in June to as low as 118-yen.
The PPT cannot afford to sit back and watch both the U.S. housing market and the stock market sinking at the same time. That might spell the dreaded “R” word – recession. Recognizing the huge risks to the U.S. economy, President Bush called for a special meeting of his economic advisors on July 27th, to discuss the stock market, which had plunged as much as 456 points the previous day. Did Bush give the PPT the green light to intervene in the marketplace to prevent a stock market crash on July 27th? After another volatile trading session on July 31st, when the Dow Jones Industrials gyrated within a 300-point range, from its early morning high of 13,500 to close sharply lower at its worst level at 13,185, PPT skeptics were asking, “Where is the mythical PPT now, with the stock market is teetering on the verge of collapse?”
But at around 3:20 pm EST on August 1st, the DJI-30 began to move up strongly and without hesitation. By the closing bell at 4:00 pm, the DJI-30 had skyrocketed by 230-points above its lows, to close 150-points higher on the day. Did the PPT intervene to prevent the DJI-30 and S&P 500 from closing below key technical support levels? However, PPT skeptics could argue that the August 1st DJI-30 surge was a delayed reaction to an earlier $2.50 per barrel plunge in crude oil. U.S. Energy czar Samuel Bodman was “jawboning” OPEC, and publicly called on the oil cartel to open its spigots wider, to cap the price of oil, and move the U.S. economy away from the danger zone. Also in the background, the U.S. dollar was building a “triple bottom” on the hourly charts at ¥118.40, which meant the “yen carry” trade was down but not out. The late surge in the DJI-30 was enough to persuade currency traders to bid the dollar to ¥119, which in turn, was enough to scare over zealous DJI-30 bears out of short futures positions, and pushed the stock market higher.
The following day, the DJI-30 held onto its late 230 point advance, see-sawing in a tight sideways range. Not knowing who delivered the late knock-out punch on August 1st, several short sellers folded their cards in the final half-hour, lifting the DJI-30 by 100-points to the 13,500 area. Yet during the trading session, the strength of the DJI-30 could not mask the underlying erosion in Wall Street power brokers, such as kingpin Goldman Sachs. However, the PPT would not stand idle and allow the panic swirling around the Wall Street power brokers to turn into a crisis.
On the morning of August 3rd, the PPT was faced with a renewed assault on the stock market, when the dollar plunged ¥1 to as low as ¥118.20 in the first hour of New York trading, following a weak U.S. jobs report in July. Traders reacted more severely to the private ISM Service sector index, which fell 8% in July, and tracks 85% of the U.S. economy. PPT spin-meisters began twirling the data, but then dire comments by Bear Stearns CFO Sam Molinaro during the afternoon unraveled the PPT’s hard work. “The fixed income market environment we”ve seen in the last eight weeks has been pretty extreme, and is comparable to market events that include the debt crisis of the late 1990’s,” he said. Molinaro’s confession left the DJI-30 in a shambles with a 281 point loss on August 3rd, closing below horizontal support at the 13,250 level, and knocked the S&P 500 below its 200-day moving average. ...
On August 8th, the DJI-30 was humming on all cylinders, up 550 points above its August 6th low, reaching 13,700, before word spread that Bush was holding a important meeting with PPT chief Paulson, amid talk that China was dumping U.S. bonds, in retaliation to U.S. sanctions aimed at the yuan. The DJI-30 plunged 200-points over the next hour. Soon after remarks by Bush and Paulson, the DJI-30 soared 150-points, “micromanaging” the market on every significant pullback or downturn. Nowadays, “investing” in the stock market seems like a crap shoot, rolling the dice on the next piece of “hot news” to roll across the computer screen.
Is the “Plunge Protection Team” myth or reality?
Is the legendary PPT just a myth, conjured up by a bunch of conspiratorial nuts? Former president Clinton advisor, George Stephanopoulos told Good Morning America on September 17, 2001, “There are various efforts going on in public and behind the scenes by the Fed and other government officials to guard against a free-fall in the market, what is called the ‘Plunge Protection Team’. ... They acted more formally in 1998, during the Long term Capital Crisis, and propped up the currency markets. And, they have plans in place if the markets start to fall.”
On August 8th, 2007, President Bush hinted at government intervention in the U.S. stock market. “Treasury secretary Paulson and his advisors are paying close attention, as the market begins to readjust its assessment of risks and are watchful for any downturn,” he said. The big question is whether Paulson and Fed chief Bernanke are pursuing a more active interventionist policy than what was originally mandated for the PPT? The turnover of interest rate, currency and stock index derivatives rose 24% to $533 trillion in the first quarter, and that is a big time bomb that can blow-up at anytime. It requires constant surveillance and “vigilance” over the world’s greatest casinos. Warren Buffett calls derivatives “"weapons of mass destruction.”
If correct, then the PPT is “watching the markets closely,” (Japanese code words for intervention) and Paulson and Bernanke aim to prevent a 10% correction at all costs. Indeed, the daily drumbeat of “jawboning” and brainwashing by the PPT, is borrowed by the playbook of Japan’s financial warlords, who are masters of manipulation in the Tokyo money markets. Yet, daily jawboning by the PPT, including president Bush, is starting to sound a certain note of desperation and anguish.
There are glaring signals in the marketplace that indicate when the PPT appears to be intervening in stock index futures. It is helpful to know when bargain hunting rallies are conducted by bona fide investors, or PPT intervention. If you expand your imagination, as Einstein suggests, and accept the notion that the PPT is “managing the markets”, you might become more successful in trading.Link here.
2000 FLASHBACK: HOW SHORT-TERM CHARTS REVEAL LONG-TERM TRENDS
When volatility reaches the extremes we have recently seen, the daily ups and downs can too easily overshadow what is next in the major indexes. It always helps to take a look at the bigger picture. A “long-term look” often begins with a short-term chart. Here is a short-term chart with about three weeks of action showing the volatility we have all seen in the markets. Now, compare that chart to this one of the 3-week period in the Nasdaq in March 2000.
That 2002 Nasdaq rally looked like the start of a major rally phase in the market. Not that anyone could forget what began in March 2000, but here is a visual reminder in chart, illustrating exactly what happened after that rally. An even bigger decline.
Can all charts be compared in this way? No. But sometimes, the right comparison gives you the right idea about the unfolding long-term trend. Steve Hochberg said in Short Term Update, “Yet as the (last) chart shows, in fact [big Nasdaq rally] was a deep wave two upward retracement (92%!), one that occurred at the forefront of a decline that erased 78% off the value of this major market index. When the trend changes, it changes and rallies become countertrend and very often sharp in nature. That is what bear market rallies are. But they all ‘fail’ and lead to more selling pressure.”
The similarities do not end with the Nasdaq. You will find a similar pattern in the Dow and other markets.Link here.
YESTERDAY’S GOOD IDEAS
After American Home Mortgage Investment Corp. postponed their dividend, but before they filed for bankruptcy, a Wall Street analyst gave his candid assessment of the REIT to CNNMoney.com. “Income-oriented investors should probably look elsewhere until further notice.” Since REITs are designed to flow income earned from real estate or mortgages to the investor, the advice was sound, particularly since there is less chance of American Home Mortgage paying dividends than Lindsey Lohan staying home Friday night to play Scrabble. Late advice, but sound.
Still, even when an analyst who covers REITs uses it, the phrase “income-oriented investor” has a condescending tone to it. It is as if anyone who tries (in vain) to find a company’s dividend yield on a financial website is a less evolved form of Investment Being. “Oh, I know exactly what you mean. I had a cousin from West Virginia who was an Income Oriented Investor,” people say. Taken more literally, Wall Street types see the “income-oriented” investor as a hopelessly short-sighted retiree who could not buy a TV Guide without help from the paltry income leaking from his growth-less portfolio.
Yet, the real income-oriented investor is not to be pitied, but admired. This is the investor who, over the years, put together a portfolio of dividend paying stocks while his golfing buddies were day trading. He does not need a high yield today because he bought a growing dividend stream yesterday.
A person also has to wonder just how income oriented these so called income-oriented investors really are. REITs roared like growth stocks for years before crashing like growth stocks that glitched. Lots of REIT investors were watching the charts, how many were checking their dividend’s sustainability. More than seven?
But who can blame investors for not extrapolating dividends and comparing them to today’s stock prices? For 25 years it has been more fun to look at the chart. Or when there was time to do a little research, take next year’s earnings and multiply them by next year’s PE, which somehow is always higher than today’s. Right?
Speaking of fighting the last war, earlier this year the Texas Teachers Retirement System decided to allocate 29% of its assets to alternative investments. These alternatives include hedge funds, private equity vehicles and other non-traditional entities, including a $100 million bet on Las Vegas casino development. Recently, the giant retirement fund had less than 6% of its assets steered that direction. Today the fund has a new appreciation for the non-traditional.
Texas Pension Review Board chairman and seasoned investor Shad Rowe thinks the fund may be going too far too fast. “It might be more prudent for them to go a little slower,” he told reporters in response to questions regarding the plunge into alternative waters. But the new chief investment officer of the fund, a longtime fan of the alternative investment class, told a Wall Street Journal reporter than he expects the retirement fund to produce higher returns with the same level of risk.
Teachers banking on fully funded retirement might have the following comments and questions: (a) More return and less risk? That is what they all say. (b) What happens if now happens? (c) Tell me again how am I taking less risk? (d) If Goldman Sachs’s absolute return strategy is taking on water, how are your guys doing? (e) Can we wait until hedge fund managers get in a bidding war for assets? You know, 1 and 5 instead of 2 and 20?
Who knows, maybe the new Chief Investment Officer will pick the right hedge funds and the right private equity players for retired teachers. After all, he has every reason to do his best. Because if he is wrong, he will be heading up another investment firm somewhere else.Link here.
“SAFE” MORTGAGES PROVED TO BE THE ULTIMATE RISK
It was not different this time either, was it? Wall Street’s promise that pools of subprime mortgages would shower high yields on investors without the commensurate risk proved as nonsensical as the 1990s’ pitch that dot-com companies thrived on clicks, not profits. Even credit-rating companies like Standard & Poor’s and Moody’s bought the idea that a few defaults of mortgages given to financially shaky home buyers would not noticeably hurt overall returns.
The reality is an entire market in default. And the mess threatens to do for the credit markets what the collapse of dot-com shares did for the stock market in the three years beginning in 2000. Securities based on subprime mortgages and other loans turned out to be the ultimate risk: They cannot be traded and their value is difficult if not impossible to calculate. BNP Paribas SA, France’s biggest bank, last week stopped withdrawals from three investment funds with subprime mortgage investments because it could not value them properly. At least the bank’s customers can still hope. Two Bear Stearns Cos. funds that put money in subprime mortgages are headed for liquidation.
Investors continue to worry about how much other banks and investment firms may be exposed to high-risk mortgages. A S&P index for seven Wall Street companies has declined 22% since June 13. Bear Stearns shares, included in the index, have plunged 29% in that time. The concern has spread to the entire stock market though not to the same degree. The S&P 500 has dropped 8.1% since its record on July 19.
Central banks in the U.S., the EU and Japan pumped $290 billion into the banking system last Thursday and Friday trying to make sure that the failure of high-risk mortgage securities would not lead to financial distress in other markets. While that may prevent panic, the low interest rates that led to excesses like subprime mortgages and rampant LBOs are gone. In May, LBO maven Henry Kravis boasted about the “golden age” of private-equity firms. Monday, KKR said the jump in borrowing costs might hurt the performance of its LBO funds. It is not improbable that KKR will postpone its planned IPO.
Blackstone Group LP, another big buyout firm, last week said it had raised a $22 billion fund for takeovers. Since Blackstone will need many times that amount in borrowings to buy more companies, it may be a while before that fund can be fully invested. Blackstone stock has declined to $24.57 since its public offering at $31 in June.
Fewer takeovers might be bad for stock prices. The promise of even poorly performing companies being bought at a premium has bolstered share prices for months. Higher interest rates also could put a dent in stock buybacks, which have put a floor under prices. Many companies actually borrow money to buy their stock – a questionable endeavor that would become more problematic if the cost of doing it rises. As they usually do when markets implode, many people are buying U.S. Treasury securities, considered the safest investment around. There are still no sure-fire investments, however. A significant increase in interest rates stemming from the fallout in subprime mortgages would push Treasury prices down too.Link here.
BASIS CAPITAL TELLS INVESTORS LOSS MAY EXCEED 80%
Basis Capital Fund Management Ltd. told investors that losses at one of its hedge funds may exceed 80% as the U.S. subprime mortgage rout prompted creditors to force the Sydney-based company to sell assets. Basis Capital is unable to “accurately estimate” the value of units in its Yield Fund, the hedge fund said in a letter sent to investors. The losses have worsened since a month ago, when it said the fund may decline more than 50%. The firm managed $1 billion in March.
Mitsubishi UFJ Financial Group, Japan’s largest bank, also reported losses sparked by the subprime crisis. Asian stocks slumped to a 3-month low on concern that falling credit markets may trigger a wider slowdown in economic growth. “The situation in global structured credit markets remains fluid and uncertain,” Basis said in the letter. The firm hired Blackstone Group LP last month to negotiate with creditors to prevent a fire sale of its assets after Bear Stearns Cos. was forced to liquidate hedge funds.
Basis Capital’s financiers have increased margin requirements “as a result of a global market-wide increase in risk aversion and a general desire to reduce their exposure to these markets,” the letter said. The hedge funds ran into trouble by investing in the unrated, riskiest portions of collateralized debt obligations and then leveraging the investment. The portions, also known by bankers as “toxic waste”, are first in line for any losses when borrowers fall short on mortgage payments. Delinquencies on U.S. subprime mortgages, or home loans to people with poor credit, surged to a 10-year high this year after borrowing costs rose.Link here.
Goldman fund cuts fees to woo investors after loss.
Goldman Sachs waived fees to draw investors to its Global Equity Opportunities hedge fund after stock-market losses wiped out $1.4 billion of assets this month, according to a person with direct knowledge of the terms. New participants will not pay the 2% management charge and Goldman will cut its performance fee in half, said the person, who declined to be named because the information is private. The New York-based firm and investors including billionaire Maurice “Hank” Greenberg agreed to put $3 billion in the fund earlier this week. Goldman spokesman Lucas van Praag confirmed the terms and declined to comment further.
Goldman, the world’s most profitable securities firm and 2nd-largest hedge fund manager, needed capital after stock declines worldwide confounded Global Equity’s computer-driven bets and threatened to spur withdrawals. The so-called quantitative fund lost 28% of its value this month. Other quant funds, including AQR Capital Management LLC and Highbridge Capital Management LLC, also suffered declines.
Goldman invested $2 billion of its own money in the fund, which had $3.6 billion in assets after last week’s tailspin. Existing stakeholders can get the same revised terms on any money they commit by August 17, the deadline for redemption notices this month. Goldman plans to reduce its own contribution based on the amount that current investors add to the fund. Goldman CFO David Viniar said that the new investment was not a “rescue” for Global Equity. Instead, the firm and the fund’s new backers were taking advantage of an “investment opportunity”.Link here.
By now, you may have seen Jim “Mad Money” Cramer’s tirade on Monday, August 6, against the Federal Reserve System’s Open Market Committee (FOMC) for not lowering interest rates. Because of YouTube, Cramer’s performance is all over the web. I have never seen anything quite like it. Screaming, calling them idiots, saying that people he has been in the investment business with for 25 years are about to go bankrupt ... this was unique.
Cramer is almost always bullish on stocks. He tells millions of CNBC viewers that the stock market is going to keep moving up. I have never heard of an instance when he has said “sell your index funds now and wait,” let alone “sell short.” Yet on August 6, he got in front of the camera and started screaming.
Is he right? Are the people he has worked with for 25 years now facing financial Armageddon? Which sectors are they in? It sure would be helpful if Cramer would give his viewers a few hints at exactly which kinds of ventures are at risk of closing their doors.
What is the problem?
Cramer seems unaware of the nature of the problem facing the Fed. Beginning in 1987, Greenspan’s Fed expanded money in order to overcome downward movement in the stock market. This began within days of his accession to the chairmanship, when the Dow fell over 500 points in one day – over 20% – accompanied by comparable declines in stock markets around the world. This was also his solution to the 1990 recession. For a decade thereafter, the Fed expanded money. This created the upward move in stocks. It also led to the housing bubble. How? By keeping short-term interest rates low, the Fed encouraged businesses to expand and consumers to borrow and spend. The consumers were employees. The economy grew. So, they moved up to nicer homes.
Beginning in mid-2000, the Fed pushed the Federal Funds rate from 6.5% to 1% over a period of three years. Nothing like this had taken place since the Great Depression. To make overnight money available at 1% was like waving a red flag in front of a bull. The Dow still fell in 2001, and the Nasdaq collapsed. It took until 2003 for the reversal to take place. Today, Bernanke’s Fed is keeping the monetary base growing at about 2% per annum, which is low. Month after month, the Fed does not announce a lowering of the Fed Funds target, which stays at 5.25% – lower than in 2000.
Short-term T-bills pay about 4.6% (5% when Cramer launched his tantrum). With price inflation (Median CPI) at maybe 2.1% per annum, the real rate of return for T-bill investors is 2.5% per annum. On this, they will pay income taxes of maybe 30%. That is a real rate of return of 1.4% (1.75% when he threw his tantrum). Wow! Yet Cramer wants the Fed to lower the Fed Funds target rate. That anyone should get a real rate of return of 1.75% a year by purchasing the debt of the U.S. government appalls him. He goes on national TV to scream that the Fed’s willingness to accept this proves that Bernanke is an academic moron.
The Chinese threat.
Meanwhile, there is a move in Congress to hike tariffs against Chinese imports. In response, a Chinese official warned this week that China in retaliation would start selling T-bills, thereby driving up U.S. interest rates. In other words, China is threatening to adopt the strategy that works best in games requiring cooperation – tit for tat. The stock market ignored this warning. It rose.
Think of Cramer’s tantrum from the point of view of a central bank which holds hundreds of billions of dollars in U.S. Treasury debt. If the Fed were to lower the Fed Funds rate, China will suffer a loss of income. It holds debt, not equity. This action would tell central banks: “Your interests will be sacrificed to the interests of Jim Cramer’s buddies of 25 years, who misforecast the market and are now in dire straits.”
Investors think the Chinese are bluffing. They may be. They have pursued a policy of modern mercantilism, exporting goods and buying Treasury debt with newly created yuan in order to hold down the value of the yuan and sell more goods abroad. But protectionists in Congress are upset with this policy. They want to pursue mercantilism, too. They want U.S. exporting firms to be subsidized by government policy. So, they threaten to impose tariffs on Chinese goods.
On the one hand, the Chinese central bank is subsidizing the U.S. Treasury by buying its debt. Congress loves the effect of these low rates: economic investment, rising consumer debt, and a rising stock market.
On the other hand, Congressional mercantilists now propose to penalize the Chinese export sector for the exchange rate effect of the central bank’s policy of subsidizing the U.S. Treasury. A Chinese official says, “You don’t like our subsidy? OK, we will end it.” Investors call this a bluff. Why do they think this is a bluff? Because the U.S. economy would contract, and U.S. consumers would buy fewer Chinese goods. This is an accurate assessment. But undergirding this assessment is an assumption: “The Chinese central bank is trapped by its own policy of mercantilism through monetary debasement. It dares not stop buying T-bills, no matter what Congress does to restrict Chinese imports.”
In the short run, the Chinese central bank does have a huge problem. If it ceases buying U.S. Treasury debt, short-term U.S. interest rates will rise. But the People’s Bank of China can then buy Chinese government debt instead. This will lower short-term interest rates in China. Chinese industries that export to America will suffer losses, but companies selling to Chinese consumers will be subsidized. This will stimulate economic expansion in China via an alternative mechanism. The main economic problem is the subsidy itself, not who gets it.
The economic boom created by monetary expansion in China is artificial. It will end either in the destruction of the yuan through mass inflation (the crack-up boom) or in a Chinese recession. But this is true whether the central bank buys U.S. Treasury debt or Chinese Treasury debt. China’s central bank has been willing to load up on Treasury debt that pays low interest rates. The quid pro quo is free trade. The Chinese central bank is subsidizing China’s export sector by way of subsidizing the U.S. Treasury. If Congress changes the rules and blocks Chinese imports, then the Chinese can find a market which will not impose tariffs. That market is China’s domestic market.
It is not the FOMC which is following idiotic policies. It is the protectionists in Congress. These people expect to block imports from China, yet they also expect the Chinese central bank to keep buying and holding U.S. Treasury debt which it purchased in order to stimulate Chinese exports to America. They think the U.S. holds all the cards in this high-stakes game. But it is the Chinese who are exporting wealth, not the U.S. China is running the $200+ billion dollar annual trade surpluses with the U.S. The U.S. sells official promises to pay. China sells products.
In the long run, it is easier to sell products than it is to sell government promises to pay in a currency which the government’s agent controls. It is also more expensive to manufacture goods than promises to pay. Manufacturers in the U.S. have found it too expensive to compete with the Chinese. These two facts point to a day of judgment. “We have decided to purchase no more T-bills.”
Cramer will go ballistic, of course. He will lash out at the idiots who run the People’s Bank of China, who are threatening the livelihood of his buddies. But the directors of China’s central bank will not notice. They do not watch CNBC.
Which bubble should the Fed pop?
Cramer thinks that the Fed should lower the Fed Funds target rate. The FED cannot do this at zero cost. So, it is a matter of who takes the hit: Cramer’s buddies or the mortgage market. If the Fed lowers rates by creating more fiat money this will send a signal to investors: “Inflation ahead.” Rational investors will then refuse to offer to invest in 30-year T-bonds at today’s low rate, around 5%. They will demand a higher rate of return and force up long-term interest rates. The mortgage market will match every increase in the T-bond rate. So, what Cramer is calling for will have negative effects on the housing market.
The housing market has been a bubble. This bubble is ending nationally. We see this in the 40% to 50% decline in the share prices of home builders. In the midst of a crisis in the mortgage lending markets, rising mortgage rates would be another sledgehammer blow. Yet this is what Cramer’s recommended policy would produce. Can you see why the FOMC decided to leave the Fed Funds rate alone?
Cramer and his cronies are investors in the stock market. He is famous as a perma-bull regarding the stock market. He has staked his reputation on a rising stock market. Rising short-term rates threaten the stock market, given the bubble created by the Greenspan’s Fed. But Greenspan’s Fed also stimulated the housing bubble by persuading buyers that the economy would boom forever. Buyers were confident that the economic boom was permanent. Now the Fed faces a dilemma.
We are in a transition phase. The Fed has slowed down the expansion of the monetary base, and there has been no crash. The economy is still expanding. The stock market has not crashed – just dropped. The housing bubble has not popped in most markets, just slowed. So far, so good.
But is Cramer correct?
Yes. He has diagnosed the symptoms correctly. He just does not understand the solution. It is not just his buddies who are threatened. It is the entire capital structure of the U.S. economy. The fiat money policies of the Fed since the capitulation of Paul Volcker on August 13–15, 1982, reversed a tight-money policy that would have let the economy stabilize with much less monetary inflation. But the Mexican government 25 years ago launched a game of chicken. It threatened to default on its debt. It also threatened to nationalize all foreign banks in the country. Volcker blinked. So did all the other central bankers, who were meeting together in Canada that weekend. (Nice timing, Mexico.)
Greenspan followed in Volcker’s post-1982 footsteps. Bernanke is trying to call to a halt a 25-year policy of monetary expansion. This means that he is threatening the capital allocation decisions of a generation of investors who do not know what a good, old-fashioned recession is.
Cramer talks about his buddies of 25 years. Well, these guys grew up in an era of monetary expansion. They came to maturity in an era of inflation. Now Bernanke is trying to end this era. At some price, he can do this. Any central bank can. But the economic price is high. The politicians will not let the central bank force on the voting public the full costs of reallocating decades of capital allocation, especially that supreme allocation: the investors’ expectation of Fed-subsidized interest rates.
Cramer’s buddies are feeling the pain first. They have been hooked on fiat money all of their lives, as have we all. The Fed has been the pusher. Now, unlike dealers in the past, Bernanke is trying to put his clientele on methadone. Cramer’s buddies are suffering withdrawal symptoms. The rush is gone. The pain is increasing. Cramer’s tirade had a resemblance to Frank Sinatra’s performance in The Man With the Golden Arm, when he stopped taking heroin. Withdrawal is no doubt an excruciating experience.
Cramer’s buddies will not be alone in their pain if the Fed sticks to its present program. The bust phase of the boom-bust cycle will induce a lot of pain. Investors who have assumed that the Fed will always be a lender of last resort will find that their investment decisions are unraveling. This is why, in the long run, Congress will start doing a passable imitation of Cramer’s tirade. The Fed will eventually knuckle under. But that will take time. It may take a year. In the meantime, the withdrawal symptoms will spread.
Watching Cramer reminded me of a child’s tantrum. “I want it, I want it, I want it!” Some parents surrender early. Others hold out longer. But when it comes to central banks, they all eventually give in. “Yes, snookums, daddy will buy it for you. Please stop crying. Everything will be OK.”
Snookums knows he will win the contest. There is more than one kid in this family. They can gang up on the parents. When the tantrum spreads to all the siblings, the parents invariably capitulate. The best we can hope for as investors is that we will not lose half our capital in the interim phase, when only a few of the kids are rolling on the floor and vowing to hold their breath until they turn blue. The parent is holding out for now.
There will be more pain. There will be more tantrums. There will be more inflation. Officially, the FED is still fighting inflation. Its official position is “No, you can’t have it. You must learn to control yourself. Bad behavior is not rewarded.” Yes, it is. Always. The dollar is down by 95% since 1913.
But, during the brief periods of parental authority, such as 1928–29 and 1980–82, those who expect the Fed to capitulate may experience setbacks. Sometimes, the Fed holds out longer than investors expect. Capital is then reallocated. Snookums screams louder. Cramer’s tantrum is a foretaste of tantrums to come.Link here.
COUNTRYWIDE FALLS AS MERRILL CITES BANKRUPTCY PROSPECT
Countrywide Financial, the biggest U.S. mortgage lender, fell for the fifth consecutive day on the New York Stock Exchange after Merrill Lynch raised the possibility of bankruptcy. “Effective insolvency” would result should creditors force Countrywide to sell assets at depressed prices or investors lose confidence in its ability to raise cash, Kenneth Bruce, a Merrill analyst in San Francisco, said in a research note.
Shareholders should not “understate the importance of liquidity,” Bruce wrote. “If liquidations occur in a weak market, then it is possible for CFC to go bankrupt,” said Bruce, who downgraded Countrywide to “sell” from “buy”.
Countrywide’s shares have lost almost half their value this year on concern a credit crunch in the mortgage industry will erode profit at the California-based company. Bankers have curtailed lending to mortgage providers and demanded more collateral, forcing more than 70 companies to seek buyers or shut since the start of last year. Countrywide dropped to $22.47, the lowest level in almost four years, in New York Stock Exchange composite trading.
Last week, Countrywide said it had access to about $187 billion in credit. CEO Angelo Mozilo assured investors that the company has enough cash to cope with the market turmoil, and said it may even benefit as competitors are forced out of business. “We continue to think the company can survive a period of secondary market instability,” Bruce said in his note. “However, the steps that it would take to preserve shareholder value would be expensive, likely leading to further share price declines from here.”
Bruce said in his report that the “severe contraction” in liquidity is surfacing in almost every type of asset. He cited Coventree Inc., the Canadian investment bank that this week sought emergency funding after investors declined to buy its debt. The company later said it found buyers for C$600 million (US$557 million) of the securities. Coventree’s problem may spread to the U.S., Bruce said. “We hesitate to use the word contagion, but this market is feeling awfully similar to the fall of 1998,” he said, referring to the market crisis that resulted from Russia’s debt default and the collapse of hedge fund Long-Term Capital Management LP.Link here.
AT MORTGAGE BANKS, “GOING CONCERNS”, GOING, GONE
You think your job is tough? Think about the poor schlimazels from Deloitte & Touche LLP who blessed the books at American Home Mortgage Investment, mere months before it went belly up. The Deloitte accountants faced a crucial decision as they finished their audit work in March. Deloitte could resign and walk away. The firm could qualify its audit opinion by saying there was “substantial doubt” about American Home’s ability to continue as a “going concern” through the end of the year – as many short sellers already had concluded. Or it could give the company a clean opinion, expressing no doubt, which is what Deloitte did.
Five months later, American Home filed for Chapter 11 bankruptcy-court protection, still brandishing Deloitte’s clean audit-opinion letter. There is a reason why you do not see auditors pursuing second careers as tarot-card readers. They would not be very good at it. Yet every time an accounting firm renders an opinion on a client’s financial statements, the auditing standards say it must evaluate the company’s ability to continue as a going concern, and warn the public if it concludes there is “substantial” doubt, a term the rules do not define. The home-mortgage industry’s growing casualty list is a reminder: They are not very good at that either.
You almost have to feel sorry for the Deloitte accountants who drew this thankless task. While in hindsight it looks like they made a bad call, they also were in a pickle. Tucked inside American Home’s credit-facility agreement was a clause that said the company would be in default with lenders if its auditor tagged it with the dreaded going-concern language.
For the accountants, if they thought for even a second about this, it must have felt like staring into a house of mirrors. Had they made what proved to be the right call, they probably would have inflicted a mortal wound on American Home. Then again, looking back, a self-fulfilling prophecy would have spared investors from the company’s April 30 public offering of 4 million shares at $23.75 each, the prospectus for which incorporated Deloitte’s audit opinion. American Home’s shares closed yesterday at 22 cents.
Financial statements depend heavily on auditors’ judgments about a company’s forecasts. Look at almost any balance sheet, and the asset and liability values hinge on the company’s ability to remain in business. Those numbers would look far different if the company were preparing for liquidation, with holdings listed at fire-sale prices. That is why going-concern evaluations by outside auditors are a necessity. Auditors may not be particularly skilled at making them. When they do bark, though, you can bet shareholders will skedaddle, because then it is clear the problems lack plausible deniability.
Back in April 2002, after the dot-com bubble burst, a Bloomberg study found that, in 54% of the largest 673 bankruptcies at public corporations since 1996, the outside auditors provided no going-concern warnings in their annual audit letters during the months preceding the bankruptcies. Smaller companies got bit much more frequently. The 50 largest companies that filed for bankruptcy protection received going- concern cautions only 24% of the time. The auditors at today’s troubled mortgage companies are faring about as badly.
One group of accountants is thinking of ways to keep shareholders better apprised. The Financial Accounting Standards Board (FASB) is working on a proposal that for the first time would place the burden of performing going-concern evaluations – and warning investors – squarely on companies’ management. While executives surely would suffer from bias, and some would be bent on deceit, at least the people with the primary responsibility for making these calls would be the ones who supposedly know their companies best.Link here.
DON’T GET KICKED OUT OF THE LAP OF LUXURY
Wal-Mart and Home Depot told the world that their customers were hurting for cash and credit, so they would have to cut back their earnings forecasts. Wal-Mart’s CEO said that, “U.S. consumers continue to be under difficult pressure economically. It is no secret that many customers are running out of money toward the end of the month.”
But those are just the little guys, right? The biggest and wealthiest of them all must be doing all right. Those are the folks who think that paying $600 for a pair of high-end, designer shoes is just so déclassé. Nothing less than $1,000 for a pair of stilettos, say the A-list consumers, according to a recent AP story about rising prices for luxury goods.
How can you invest in the companies that cater to these luxury-loving types? Perhaps by tracking one of six luxury indexes that have sprung up this year, brought to you by financial types who suggest that investors can get rich by investing in what the rich buy. The first luxury index to come on line was created in early 2007 for BNP Paribas SA, the same French bank that has been in the news lately for freezing three of its investment funds that were hit by losses in subprime mortgages. The World Luxury Index includes 20 companies that purvey high-end goods, such as Porsche AG, Burberry Group PLC, LVMH Moet Hennessy Louis Vuitton SA, and Bang & Olufsen A/S. (And if you have to ask, then you can’t afford it.)
With so many luxury indexes abounding, Bloomberg has the perfect analogy: “Luxury-goods companies are starting to look like Internet stocks did in the 1990s, if only because indexes designed to track them are proliferating.” So, what does it mean when the exclusive becomes popular? If you are a contrarian, you know that it is a sign of a change-about-to-come. And that is exactly how our market analysts see it here at Elliott Wave International. In the latest Elliott Wave Financial Forecast, Steve Hochberg and Pete Kendall point out that previous financial manias, such as the Tulip Mania in 1637 and the stock mania in 1929, also led to what they call a “furious demand for extravagant luxuries.”
Are you tempted to find the nearest exchange-traded fund to invest in a luxury index? Then, pause a moment to read this excerpt from The Elliott Wave Financial Forecast: “The boom in luxury goods is no secret. But the latest surge carries extravagance to the outer limits of human imagination. There is a potentially critical reversal in the luxury-goods stock index ... Our contention is that the final extravagant burst of luxury spending is tied most prominently to the bonuses, commissions and trading profits of financial types, and it should dissipate quickly as some of Wall Street’s all-time great schemes unravel.”
In other words, now might not be the best time to get comfortable sitting in the lap of the luxury indexes.Link here.
STEP RIGHT UP AND WATCH “THE AMAZING DISAPPEARING MONEY”
Friends who know that I work for Bob Prechter’s firm always ask me questions about the markets. Yesterday I went to a small dinner party with my high school friend, and after a few drinks and appetizers the conversation quickly turned to subprime mortgages and the turmoil in stocks. I would not even bring this up – because who does not talk about the “credit crunch” these days – but did I mention that my friend is Russian and the dinner party was in his home in suburban Moscow?
The credit contraction that reportedly started because of the troubles with the U.S. subprime mortgages, the “junk bonds” of the real estate world, is marching around the globe. Even in far-away places like Russia – which seems insulated against cash flow problems by its vast oil and gas proceeds – the liquidity crunch is the talk of the town. People are worried.
And they should be. Just like the Dow, Russia’s RTS stock index has lost a big chunk of its value in recent weeks. So have other European stock indexes. Deutsche Welle reports that in Germany, some “banks are still looking vulnerable ... as reports broke of another U.S. building society with connections to Germany filing for bankruptcy.”
What “connection”, you ask? Turns out that Deutsche Bank and Commerzbank, two of Germany’s biggest financial powerhouses, “are among the creditors of HomeBanc Corp.” Now that HomeBanc has filed for bankruptcy, German financiers are worried if they will ever see any of the $4.9 billion HomeBanc had as “debts” on its books. These banks are just two of several German financial institutions with ties to the U.S. mortgage market. Maybe I am naive about the workings of the modern financial system, but is it not insane that mortgages that you and I get from our American lenders could very well be funded by German investors?
To stop the pool of available credit in the system from shrinking further, central banks are “injecting emergency funds” into the market – to the tune of $300 billion, so far. The question is, will it help save the stock market from a full-blown crash? Opinions on that are divided, and we do not have a crystal ball. But we do believe that the underlying dynamic of the current credit contraction is faltering investor confidence – a psychological phenomenon, not a financial one.
Last week, our European editor told readers of his European Short Term Update that the volatility index for the DAX, Europe’s benchmark stock index, “has recently soared to 3 standard deviations above its 60-day average,” which, based on prior data, could be a bullish technical sign. Even so, “equity investors are more afraid now than they have been in years,” says Tom. And “fearful investors sometimes decide to sell everything regardless of value and move to cash or bonds.”Link here.
Has the market looked “rational” and “efficient” to you?
“Market trends” are an obviously popular topic with investors, and for good reason. Nobody wants to be behind the trend, much less caught on the wrong side. But let us think instead about trends of another kind, namely the psychology of investors themselves – because that is what makes prices go up and down. Note that we do not mean some sort of mood shift among a few people, but rather a true collective psychology that includes most market part. They describe models that are “rational” and “efficient”, where prices move toward “equilibrium”. At the risk of over-simplifying, they think stocks are priced in the same way as a loaf of bread or a pair of shoes.
We say that is mistaken. And rather than provide a detailed explanation of why, we suggest that you join us in asking this question: Has the stock market been “rational” and “efficient” during the past month? We both know the answer.Link here.
CAN THE FED SAVE THE FINANCIAL DAY?
Over the past month, a violent credit and housing downdraft has pushed the hot air balloon of the U.S. economy into dangerously low territory. And, according to the mainstream “experts”, the only one pilot who can lift the airship back to safer skies is the Federal Reserve – through interest rate adjustments and cash infusions. But the way we see it, interest rate cuts will not make a lick of difference in stimulating the consumer to spend, the creditor to lend, or the corporation to borrow. Bob Prechter’s Conquer the Crash describes the “monetary strategy” of lowering the Federal Funds Rate to be as effective as “pushing on a string.”
Take, for example, the fact that during the period between 1984 and 1992, the Federal Reserve slashed rates from 11.75% to 3%. But if you look at several events along the way, here is some of what those cuts did not prevent: (1) The worst stock one-day crash since the Great Depression (in October 1987). (2) Record-high unemployment, a debilitating savings and loans crisis, slow GDP, and economic recession. Similarly, Fed rate cuts in 2000-2002 (6.5% to 1.25%) proved impotent against the longest stock market decline since the Great Depression, the tech-bubble bursting, and a brief economic recession. (Please Note: From June 2004 to June 2006, the Central Bank raised rates from 1% to 5.25%, an equally futile effort to tighten the spigot of easy money and remove the froth from the bubbling housing market before it burst.)
Now for the second crash-saving tool in the Fed’s arsenal: the August 10 $38 billion cash infusion, the largest single-day injection in six years. (Additional infusions since then bring the total “repo” to $64 billion and counting). “Fed races to the rescue,” exclaims one popular news site. “The intervention of the Central Bank to pump liquidity into the worlds financial systems calms markets torn by worries about evaporating credit.”
News Flash: The Fed is not a cash factory. It is a bank. Meaning, the Central Bank is not in the driver’s seat. Here again, Conquer The Crash explains: “The problems that the Fed faces are due to the fact that the world is not so much awash with cash, as it is awash with credit. The Fed’s purported “control” of borrowing and lending ultimately depends upon an accommodating market psychology. ...”
In this case, the psychology is one in which debt investors decide they want to keep (and not sell) the large quantities of bonds they are holding. As for the $34 billion infusion, the Fed accepted the very same mortgage-backed securities as collateral that no financial institution in its right mind will touch. My suggestion is to reread Chapter 13 of Conquer The Crash, because it is extremely relevant to the current investment and economic situation and provides great insight into the Fed’s machinations.Link here.
REAL ESTATE AND ASSET DEFLATION: BALLGAME OVER
When those of us at Ponder This started writing about “the coming asset deflation” in May of 2005, my, my, did our mailboxes fill up with, “Boy, are you ever wrong. The Fed will make sure these bubbles go on forever, stupid!” emails. Still, we had our small, rather quaint following of “fans”.
And a motley group we were indeed! As we developed our argument and saw our stuff get increasingly picked up by financial websites around the world, our “real estate deflation/credit contraction/liquidity crunch will sink all boats” theme took hold and the overwhelming majority of respondents began moving into our camp. Now we receive a stream of emails from readers demanding an update, wanting to know where things will go from here, and/or trumpeting their decisions to get out of (name almost any asset class) while the gettin’ was good. Most now think that asset deflation has taken hold. In two years’ time, the worm has certainly turned. That is probably because, um, for the record ... we were right.
May of 2005 happened to be the absolute peak of the real estate market, give or take a 60 day escrow or so. And that Big Kahuna is now moving relentlessly through American markets, one neighborhood at a time.
If not for our idiot Fed’s sponsored-borrowing/lending orgy (1% discount rates do have a way of getting people to run around naked and drunk), our post-“NASDAQ Crash” shakeout would have been painful, yes, but relatively short-lived. Instead, by carelessly adding real estate and credit bubbles to the mix, the Greenspan Outcome is going to be much more devastating and possibly decades long. Meanwhile, despite the massive liquidity pumped into the system by Alan Greenspan’s Merry Men, the NASDAQ barely made it back to 50% of peak 2000 value.
Now that the credit contraction/dislocation is making headlines, hedge funds and mortgage-backed securities markets are getting caught with their pants down, and the subprime meltdown is moving into Alt-A and even prime mortgage markets, our call for a credit collapse and liquidity crunch is right on schedule. It is no longer a question of “when”. You are seeing it take place now, right before your very eyes. Credit markets worldwide are seizing up and major financial institutions around the world could soon be going bankrupt.
The credit market meltdown has already dampened buying psychology, and remaining, unaware, knuckleheaded buyers are finding purchase loans ever-more-difficult to come by as lenders clamp down. If you stayed in the investment real estate game, you have already lost money from peak values and it is only going to get worse. Properties placed on the market tomorrow will likely languish and buyers will demand discounts of as much as 20% versus prices achievable just a few short months ago.
The Homebuilders Index began its retreat in July of 2005 and it has essentially crashed at this point. Huge quarterly profits have turned into massive quarterly losses in one year’s time. We are supposed to believe that median prices are down 0.6% year over year! Look for a “real estate crash” – a sudden 20-30% drop in home values across-the-board by late 2008. And, unfortunately, that will not be the end of the decline. It is truly a perfect storm for real estate, with credit market dislocations, mortgage-backed securities disruptions, tightening lending standards, too much consumer debt, too little consumer savings, zero pent-up demand, rampant foreclosures, excess homebuilder inventory and the unfolding coup de grace – severely damaged buying psychology. As the crisis takes full hold, it will soon be broadly accepted that “real estate is a bad investment.” We expect the asset class to fall completely out of favor, possibly for a generation.
Do not sit around waiting for a miracle from the Fed or for asset values to bounce back. We have barely begun the asset deflationary spiral led by real estate’s pratfall, along with the stock market and commodities, including the precious metals. You will be able to buy these assets later on for less money if you safely set aside as much cash as possible now. If you have leveraged anything, it is time to de-leverage now!
Market cheerleaders will tell you that “the economy is fine, employment is high, interest rates and inflation are low, earnings are up, it’s only a correction” and so forth. But as real estate and asset deflation spreads like a disease, all lagging economic positives will quickly turn negative. Stop looking back. It is time to look forward and play some serious defense. It is all about financial survival at this point. Remember, those cheerleaders do not give a whit about you and they will not be there to help when you lose your assets.Link here.
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