The Market Ticker

Where have we been?

You know the story by now, but let's recap.

In the early 2000s Greenspan cut the Fed Funds rate to 1% to try to prevent a recession on the back of the tech implosion and subsequent 9/11 attacks. This caused money to have an effective negative interest rate (interest rate less than inflation rate) which meant that the proper strategy was to borrow as much as was humanly possible, since you could profit simply from the 'positive carry' of simply matching the inflation rate in your assets.

This also forced money out of money markets and cash and into "investments", because there was literally a zero (or close to it!) return on savings. Of course inflation wasn't zero, so there was no point to CDs or other such money investments - you would simply lose your ass.

Since the stock market was "unsafe" (we just had the tech stocks implode and drag everything down) the money went into real estate.

Prices soared, making them unaffordable. In response to that, and the money market situation where there was no money to be made in "safe" securities, Wall Street "came to the rescue" by packaging up mortgages into what amount to bonds, slicing and dicing them and offering them out to investors.

Of course good credit risks were getting nice mortgage rates. That didn't earn enough on the paper either (once fees and costs got taken out) to be worth it, so Wall Street massaged the game by essentially throwing away credit qualification and replaced it with alchemy - a belief that "house prices always go up, therefore the collateral will bail us out from any bad loans" and "we can take crap paper and by allocating the equity to some piece of it, we can make 90% of it AAA credit and the rest junk".

Now that gave you acceptable returns.

Unfortunately, when Wall Street threw away the credit qualification book they doomed the scheme to failure, because the real deal was always about affordability of houses, not finance rates.

So houses went to 5x annual income (on average), which is only double the long term sustainable rate. All that "liquidity" sloshing around stuffed an "LBO PUT" under the market (short a shitty stock, tomorrow they become a buyout candidate and you lose your ass!) which meant that crap companies couldn't be shorted into the ground, as they should be. The result? 30% price appreciation in all the major worldwide stock indices.

Now the "last sucker" has run out of money, and suddenly, "do you have a pulse?" doesn't look like such a great way to qualify creditworthiness.

The bad news is that we sold that crap paper off all over the world. Asia has a bunch of it, Europe has a bunch of it, and of course we have a bunch of it. Its everywhere - in pension funds, endowments, even money markets! Places where it never should have been but was because it was allegedly "AAA" credit quality.

So - what happens now?

First, on a purely technical level the equity markets have been saved twice in the last week (Thursday and Friday) from what were certain outright crashes. Really. How? With huge liquidity injections by the various Central Banks, including our Fed.

But these injections do not solve the problem, which is, quite succinctly, that there is all this crap paper around but nobody is willing to value it at zero when it comes back "no bid", nor are they willing to take the bids they DO get when there are some!

Ultimately asset prices must return to historical norms. In the US, this means houses. They will fall to 2.5-3x annual income, on average. There is no way around it. That fall will cause severe pain that will spread around the globe, literally, as the paper behind those inflated prices will get marked down commensurately, with many pieces of that paper being worth nothing at all.

In particular those who are holding paper based on "negative amortization" capitalized interest are in real trouble. Likely critical trouble. That paper is in fact worth nothing, and this realization will come out in the next few weeks and months.

The Housing Market in the US is doomed for at least the next two years and perhaps longer. Builders are all likely to trade in the single digits and a number of them will go bankrupt.

The SEC is finally getting on the case, coming after some of the investment banks and wondering if they're valuing THEIR asset-based securities (e.g. mortgage-backed bonds) equally with those held by their customers. I bet the answer is "no", and when that is resolved, which will happen, you will see MAJOR losses taken at these institutions.

The LBO "PUT" is basically gone.

And the consumer can no longer refi out of a bad loan when they are underwater on their house, nor can they spend money they can "grab" from their home equity when it is no longer appreciating.

So what does this all mean?

In the short term - meaning next week - we will see if the liquidity issues remain and what explosions, if any, occur in the next few days. If the liquidity injections continue and/or there is a major detonation somewhere in the financial markets, we are likely to see an immediate and violent selloff in the equity markets.

There will be a tremendous desire to see that not materialize. Right now the amount of money that will be lost by option market-makers is tremendous and a big sell-off could make some of those losses catastrophic. As a result there will be serious efforts made to unwind risk which could move markets in either direction - but with a bias towards the downside.

In the intermediate term (next few weeks) I expect the equity markets to confirm a new primary downtrend. This requires confirmation between the Dow Industrials and Transports, Nasdaq Composite and NDX, and primary trendline support violations that are decisive. We are not there at this point. More to the point, if we do not get this, shorting the entire market on other than a short-term (e.g. daytrading, etc) basis is a high-wire act!

In the longer term (months towards Christmas) I simply do not see how we avoid a recession. Consumer credit has shifted largely to credit cards, which have tremendous interest payment requirements compared to HELOCs and MEWs. This saps money from the consumer's budget and forces it to go to the issuer of the card rather than be spent in the marketplace. I first identified this trend with the first quarter earnings reports and it has accelerated since then. In the coming months we are likely to see even worse retail sales reports, culminating in a negative GDP number in the 4th Quarter. Equity prices should start to react to this coming reality sometime in September or October.

Once this is recognized as the risk of a global recession then we should see rate cuts, and bonds will rally hard. But this is not a "today" scenario - a rate cut NOW would indicate pure desperation and would likely provoke the very market crash that the Fed is trying to avoid!

So in the short term I expect equity prices to reflect the jittery nature of the credit markets, with a potential for an outright crash at any time if a debt bomb goes off in the wrong place.

In the longer term (coming months) we should see a decline in the indices of approximately 30% when the recession that we will be facing becomes obvious and impossible to ignore. This decline could be much worse, perhaps down to 2003 levels, if the debt bombs go off in the wrong places PLUS we get the expected recession.

So where do I see the biggest risks and how am I trading this?

1. You do not want to be anywhere near bonds that are not US Treasuries and/or (maybe) Municipals. Period. If you have a money market or other "credit based" investment, you need to check right now what it actually holds, and if you see "asset backed" or "mortgage securities" or anything else like that in there, GET OUT.
2. Equities are very risky at this time. If the economy does go into recession we are likely to see a 30-35% decline in equity prices - the historical average for recessions! For obvious reasons losing 30-35% of your money is a terrifying scenario for most people.
3. Emerging markets are potentially even worse. These have outperformed over the last couple of years, but many of these indices are trading in what can only be described as a "parabolic blowoff top" sort of formation. Most of these formations have now broken trendline support to the downside, meaning that if you're not out yet, you damn well better GET OUT NOW.
4. Stay away from metals at this time! While precious metals are a good global instability risk there are a lot of institutions who hold them (and the companies associated with them) as assets. In a margin-call shitstorm these positions will be sold, driving down the price of these assets for at least a short while. There is likely to be a sweet spot coming, however, where buying metals as a trade will make sense. Holding some as a diversification strategy may be ok, even here, but I wouldn't take new positions now in either gold or silver (or their miners.)
5. Cash is King! IF this mess is mismanaged we could easily get a deflationary spiral. In that case cash is great because it buys more over time instead of less! If we start to see signs of serious inflation then obviously you need to figure out how to earn more than the inflation rate (or you lose purchasing power over time.) There is nothing wrong with short-term government paper (less than 3 year duration) at present; just be prepared to bail on that too if for some reason it becomes necessary (e.g. the Chinese actually start dumping their foreign reserve holdings as they threatened recently!)
6. Shorting specific stocks or sectors here looks attractive to me. Shorting the entire market is a high wire act at the present time because the primary trend has not yet confirmed as downward. However, if it does......

As always, your mileage may vary and so may your results. Do your own investigation - its important to have your own thesis for whatever decisions you make.

After all, its your cash, right?