Wednesday, December 30, 2009

Tick Tock

Not much to post of late. I'm summoning my energies for a series of articles reviewing the past and looking toward the future. I always look forward to these articles. They allow me opportunity to clear away the poor analysis and build upon the good.

In the meantime, let me entertain you with a poem, courtesy of the Financial Times' deputy editor Martin Dickson. If nothing else, the appearance of this now, after such massive recoveries in asset markets confirms the Socionomic/Elliott Wave thesis of a secular bear market in social mood. A secular bull market - like that during the S&L crisis or LTCM - is typically quick to forgive bankers for losses they have incurred to all. A year after the carnage and it seems that antagonism toward the finance industrial complex grows more rabid by the day. As it should. Pass this on to your friends.

The Bankers Who Wouldn't Say Sorry; A Cautionary Tale

(With apologies to Hilaire Belloc)

There was a time when naughty boys
Would have to forfeit all their toys,
And go to bed without their food
To force a new, repentant mood
Upon the wretched little toads,
Who flouted our great social codes.

Nor was blind arrogance a trait
That parents liked to inculcate.
They had regard for social graces:
Not for their offsprings’ haughty faces.
A beastly child engaged in folly
Would surely have to say: “I’m sorry!”

But now we live in debased times,
Sans punishment to fit our crimes
Our moral compass has got lost,
Or on the rubbish heap been tossed.
As in this cautionary tale of bankers,
Who came to look like social cankers.

You will all know the basic story,
In all its venal details, gory.
Of how a bunch of peerless clowns
Despite degrees – from Yale to Brown –
Behaved like schoolboys in the lab,
When teacher’s gone to smoke a fag.

Exuberant beyond all reason
(For this or any other season)
Fired up by dreams of starter castles,
Sardinian yachts and vineyard parcels,
They built themselves a strange device –
A ticking bomb, to be precise.

The trouble was they did not know,
It was a bomb ’twas ticking so.
They thought it merely marked the beat
That called them to stay on their feet
And dance away – to really bop –
To music that would never stop.

At last the bomb it ticked no more.
Instead it gave a mighty roar
Like some avenging finance demon,
And destroyed RBS and Lehman.
That made the bankers wail and yelp,
And rush to teacher for some help.

Faced with the imminent demise
Of all world banks of any size,
And thus of global finance too,
The state bailed out this sorry crew.
But were they grateful? Not a jot,
This arrogant and greedy lot.

“It wasn’t us,” was their refrain.
The regulators are to blame.
They failed to prick our growing bubble.
They are the cause of all this trouble!
And China too, and central bankers,
Who failed to give us decent anchors.

“And while we’re at it, let’s include
Those nasty hedge funds, brash and crude,
We may have lent them stock to play,
But not to short poor banks at bay.
We’re sad events turned out this way
But not to blame; nothing to pay.”

Their minds so tainted by success,
They could not see their gross excess
Had played a very major role
In this colossal world own-goal.
Amnesia can be a sickness,
But this denoted arrant thickness.

Their attitudes were so repulsive
The public backlash grew convulsive,
And dimly seeing that their wages
Just might be threatened by these rages,
Self-interest prompted some to say
“We’re sorry” – in a muted way.

But actions more than words do speak
And their repentance was skin-deep,
Just like the artful crocodile
Shedding fake tears beside the Nile.
(And while we’re thinking of the zoo,
A vampire squid swims into view.)

“It’s plain,” they said, “we do not need
Tough regulation. Do not heed
The cries of all those sad dimwits
Who want to break us into bits.
Our little hiccup now has passed.
Back to the gravy train – and fast!

“To moral hazard give no thought!
We see no need to get distraught.
Please rest assured God’s work we’re doing
(It’s merely taxpayers we’re screwing.)
The Lord to us has sent a sign:
Monopoly profits are just fine.”

How could these people fail to see,
Their debt to all society?
The short answer must surely be
A banker’s mind is conscience-free.
They grab the profits of risk-taking,
Leave us the losses that they’re making.

The politicians fumed and fussed,
But they were well and truly stuffed:
The banking system had to work
Or jobless men might go berserk,
Victims of a growth disjunction
Piled upon finance malfunction.

In short, the banks – still big and burly –
Had got them by the short and curlies.
So their response was rather vapid,
And not decisive, hardly rapid.
Bankers returned to their old ways,
Assured a life of Christmas days.

Too big to fail, too hard to tame,
They returned to their former game:
Taking risks of insane folly,
To stuff their pockets full of lolly,
Untroubled, with the certainty
Of a taxpayers’ guarantee.

It would be good to end this story
In a nice blaze of moral glory,
Like Hilaire Belloc’s clever tales
Where evil-doing always fails.
Alas, the only moral here
Is bankers just themselves hold dear.

But there’s a price we all will pay
If politicians won’t display
A little courage and crack down
Upon these unsafe, grasping clowns:
Another bomb is being built,
By bankers with no sense of guilt.

It’s ticking now, will louder tick
Unless we stop it, fast and quick.
For mark my words, believe this rhyme,
It will go off in five years’ time.
You’ll hear no end of sturm and drang.
When it explodes with a loud BANG!


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Thursday, December 24, 2009

Happy Holidays

I'm taking a much needed few days off over the holidays. Thus, there will be no weekend commentary this week.

I'll be doing some in depth posting over the next few weeks, so stay tuned!

Let me wish my readers a happy and safe holiday season.

Best,

Matt


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sunday, December 20, 2009

Technical Update 49.09/European Woes

Another week of gains for the US dollar was met with general indifference from equities around the world. Commodities also turned their cheeks to the currency market action, reminding us that correlations long-adhered to can break. Last week we were expecting a bit of a retrace in the dollar index and commodities which would allow for equities to put in new highs. That is still my working assumption. Yet with option expiry hangover, combined with 2 weeks of very low volume upcoming, I suppose anything is possible.

The weakness in the Euro is being blamed on sovereign concerns around the periphery of the EMU (European Monetary Union). Specifically, Greece, Ireland, Spain, Portugal, and Italy are the focus of most observers. But bear in mind that these issues are not somehow "unforeseen" as most imply with their surprise. Greece did not accumulate a 12.4% budget deficit overnight. Nor did Italy find itself with a total debt 1.14x its GDP. These have been very long-term problems. I, as well as many others, have been pounding the table with the untenability of this situation for a long time. And I ruminated back in the spring that the next round of this crisis would originate in Europe.

Social mood may have turned with the recent attention to these long-standing problems. And we know the kind of contagion that will result should this escalate. Let us not forget the issues facing Ukraine, Hungary, Romania and the Baltics. All major european financial institutions have exposure to these toxic emerging markets in addition to their hidden exposure to US subprime CDOs.

Below is a table from STRATFOR that details each Eurozone country and their debt burdens. Remember that the Maastricht Treaty forbids any country from surpassing a deficit of 3% of their GDP. Nearly every nation has completely ignored this. Germany's supposed new "conservative" coalition threw in the towel this week, suggesting they would escalate their deficit spending. If nothing else, this proves the uselessness of international regulations. When push comes to shove, any nation will look after their own asses first. It is this mentality that will, in my opinion, eventually lead to the breakup of the EU and the dissolution of the EMU. This process may have begun already. Or it may be dragged on for a decade or more longer. But the endgame is already written. A Euro will eventually be worth less than the "lowly" US dollar.



I recommend readers monitor CDS spreads closely as an indicator of the seriousness of these problems. Over a week ago, when stories started breaking about Greece's problems after a Fitch downgrade, their CDS premiums shot up to 232. Since then, Greek officials have said there is "no possibility" of EMU withdrawal or sovereign default. Yet, the assurances have not seemed to gain traction. Greek CDS now stand at 279. Intraday top movers in CDS premiums can be found at CMA Market Data.

Below is a chart of the Euro's performance. This makes 3 weeks straight of declines and essentially wipes out any of its gains from the previous 3 months. What's done can be undone in short order. Equity speculators should take note.



I am also including a number of charts from eastern European currencies relative to the Euro. Last winter, some of these currencies began blowing out. But assurances from the IMF managed to ease the fears - for a time. At issue are loans made in these countries (Latvia, Poland, Czech Republic, Hungary, Bulgaria, Romania, Ukraine, Russia) but denominated in other currencies (primarily the Euro, Swiss Franc and US Dollar). The availability of loans at very low interest rates; prospects of continuance in the decade long appreciation of local currencies; and eventual induction into the EMU were the primary forces driving asset bubbles in these countries. When the bubbles popped along with asset bubbles all over the world in 2008, their central banks began printing money to "stimulate" their economies. This had the effect of depreciating the local currencies and thus increasing the debt burdens of those who borrowed in foreign currencies. Default prospects increased, jeopardizing the solvency of their western lenders. This is where the IMF stepped in and gave some very vague guarantees with some very unknown preconditions. Most likely they instructed the eastern central banks to stop printing and told their finance ministries to instead introduce austerity measures. I wonder how long populist oppositions will stand for the rising unemployment that goes along with this? At what point will they simply say, "to hell with the western bank's losses, we default." Or, "to hell with the EU and the Euro, we're inflating our way out!" Either way, losses will eventually be realized on these malinvestments.

Hungarian Forint/Euro:


Polish Zloty/Euro:


Russian Ruble/Euro:


Ukrainian Hryvnia/Euro:


There are also potential issues in Bulgaria and Latvia, where currencies are pegged to the Euro. They were both scheduled to enter the EMU by 2012, but that now seems unlikely. If they decide to forego entrance, their pegs break and any loans made are essentially wiped out.

Ambrose Evans-Pritchard has another Euro-skeptic piece detailing the unsustainable nature of these austerity measures in southern Europe. Enduring deflation is the natural way out of things for the US, UK, Canada and essentially any country whose debts are largely domestically originated. But when this path is dictated by foreigners who got you into the problem in the first place, I can see how the political impossibility would lead to its failure.



Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Monday, December 14, 2009

Response to Robert Murphy

Robert Murphy of the Mises Institute had a good article out this morning titled, "A Case For The Inflation Camp." He talks about why he expects consumer prices to continue to rise. I recommend my readers have a glance over this.

As my readers know, I have a different take on matters. Below is the brief response I left in the comments section of Murphy's post. Feel free to weigh in with your own take.

The primary arguments in favour of deflation look less at consumer prices and more at asset prices, bank lending, debt/income or debt servicing ratios, demographics and social revulsion of excesses.

Many things can contribute to consumer price changes. This year we had a very large drop in inventories and capacity utilization which eased downward pricing pressures significantly in spite of falling consumer demand and reduced credit availability. We also had commodity prices rising from leveraged speculative bets by hedge funds.

The first two are like bullets in a six shooter. They can only be used once. I suppose the commodity speculation could be considered the very early beginnings of a "crack-up-boom," but other than gold, there seems to be little panic buying in the more "emotional" of these commodities (grains, energy). And it is precisely this fear (OMG, I might not be able to feed my family, "I'll take 10 sacks of rice!") that characterizes the CuB.

Until I see that kind of fear and still no willingness to quash it from central bankers, speculation of runaway inflation is premature.

One thing we can likely all agree on is that deflation "should" happen. We have too much debt and asset prices are too high to be supported by our incomes. And the easiest solution to this problem for those without access to a printing press (small businesses and consumers) is deleveraging. Considering they compose the largest sectors of the economy, their actions will determine the overall outcome.



Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sunday, December 13, 2009

Technical Update 48.09

Most major stock indices were flat around the world last week, even as the US dollar continued its push higher and commodities sold off significantly. The followthrough on the US dollar was something we were looking for last week as a key to the topping process we have been tracking for months. It has traced out a very nice looking 5 waves up (the Euro has done the inverse) and should now retrace that move in 3 waves down.

The blue chip stock indices have been the most resilient over the past few months as the FIRE sector (Financials, Insurance, Real Estate) has lagged behind considerably. It was a credit based bubble that popped in 2008 and it has been a credit based recovery. To me, this suggests that the overall structure of the economy has not changed. Therefore, weakness in these areas, much like during the 2007 rally, should be considered a leading indicator for the overall market. I am expecting the major indices to make marginal new highs next week, as the US dollar retraces but fails to make a new low. This should be the final non-confirmation prior to embarking on a monumental decline. This likely sounds like a broken record by now. We've been monitoring this process for months. Bears are now, to be sure, tired of waiting. I know I am. But to keep things in context: after a 53% rally in 6 months, the S&P 500 has rallied only 8% in the 4 months from August to the present.

The past few weeks have seen painstakingly quiet markets, reminiscent of John Kenneth Galbraith's account of the 1930 rally which he described, "as placid as a produce market." Despite the historical context of nearly all major bear markets retesting their lows to some degree, I have been able to find few market analysts/pundits willing to entertain that possibility. The idea of going back to where we came from is as preposterous to most now than dropping below Dow 10,000 was to most in 2007. Sure, many are expecting a correction, but little more than 10-20%. This is an incredible amount of confidence considering we have rallied more than 65% in just 10 months. I'd wager a guess that this is unprecedented confidence. Below is the Bull/Bear ratio, as determined by the Investors Intelligence survey.



The S&P 500 has traded within a 3.5% range over the past 5 weeks.



Crude oil has an opportunity to extend to the downside. Any continuation below Thursday's low substantially damages this chart.



As previously mentioned, the Euro has put in its most significant decline since June. A fairly swift retrace back up to 148-149 should occur prior to a resumption of the downward trend.



Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Wednesday, December 9, 2009

Sovereign Default Risk Puts Floor Under US Dollar

Note to readers: The following post originally appeared at Examiner.com. I have recently taken a position as their Canadian Economy writer. I will still be contributing to Futronomics, but some of the articles will be cross-posted. You will notice a difference in the style of writing in such articles, but I pledge to stay true to the spirit of my work to date. Naturally, the work will be a little more "Canada centric," but most will still have relevance for my American readers. Feel free to visit my Examiner page often and subscribe to my posts if you wish. I am paid minimally based on article views, subscribers and comments. However, this is more of a resume boosting endeavor, so we will see how it goes...

When Dubai World, the state backed infrastructure company, warned of its inability to meet obligations without assistance two weeks ago, some analysts noted that it had the potential to spark fears of other susceptible nations to do the same.

This week, markets have been tentative after rating agencies confirmed those fears with downgrades in Europe.

Greece, widely known to be the weakest among major EU economies, was the first to be given a downgrade by Fitch. Its rating was slashed to BBB+ and reiterated that further cuts may be in the offing. Standard and Poor's also expressed heightened caution a day earlier, stating that they have a "negative" outlook on the future direction of ratings. Ratings were also lowered on Greek commercial bank debt.

Ratings downgrades are considered significant events because certain investment institutions (such as pension funds) are only allowed to invest in debt that is considered investment grade. A downgrade could force selling of government bonds, pushing interest rates up and exacerbating the problems.

Fitch noted that the historical record of fiscal management in Greece had been poor and that they are, "not convinced that the substantive pension reform and other measures necessary to contain public spending pressures and broaden the tax base will be sufficiently strong to materially reduce debt."

Credit default swap contracts (the cost to insure against default) on Greek sovereign debt has risen substantially over the past two days to 232 basis points.

Spanish sovereign debt risk also rose, as Standard and Poor's put the nation on "watch negative."

Fears of greater contagion have put higher risk premiums on almost every European nation. As a result, the euro has fallen by 3% against the US dollar in the last week. Over the past few years, the US dollar has strengthened when risk aversion increases. The reaction could prove detrimental to other currencies like the Canadian and Australian dollars, which have also benefited from risk seeking investors borrowing money in the US and taking it abroad.

Willem Buiter, professor at the London School of Economics, and incoming economist with Citigroup, suggested that a bailout by the European Union may be a last-resort option at some point for Greece. But certain German officials have warned against this, asserting that it could set precedents for other EU members such as Ireland, Italy, Spain, and Portugal to expect the same.

Watch a Bloomberg interview with Buiter below. Interested parties can follow daily CDS movements here.



Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Saturday, December 5, 2009

Technical Update 47.09

Most indices posted large gains on the week, with previously underperforming groups (Semis, Small Caps, Transports, Utilities, Asia) taking the baton from the previous outperformers (like the Dow). Sector rotation is a signal of market strength and should not be ignored by market bears. Many of the negative divergences we have been tracking for months disappeared this week, showing a lack of ability for bears to capitalize on weakness.

There were, however, a few signals on Friday that may prove to be important for the bearish case. Nonfam payroll data was released, which beat expectations by a large margin. But after a short spike higher on the open, markets sold off for much of the rest of the day. This again proves my oft cited opinion that it is not the news that matters, but rather the reaction to it that we must give heed to.

The US Dollar was the big story on Friday, however. It posted its biggest gain in many months as the Euro and the Japanese Yen especially put in major reversals. It is my belief that the direction of the dollar holds more sway on equity markets than anything equity specific (carry trade), so it is not necessarily "cognitive dissonance in action" to ignore the many positive price movements in equities in favour of the evidence being displayed in the currency markets.



There's a lot to like in the chart above. It has decisively broken its down sloping trendline from March after briefly poking through 3 times in November. The RSI has, as pointed out over the past few weeks, displayed improving readings as the dollar has slowly drifted lower. It now pushes past the 50 barrier convincingly, which has proven to be the high water mark of the latest decline.



The weekly also displays some interesting signals. The MACD has crossed into positive territory along with the histogram. And stochastics are also looking bullish. The decline has been an 81% retrace of the previous advance, which, from an Elliott wave perspective, is not uncommon for a "wave 2" correction. This would imply sharply higher prices in a 3rd wave higher, which would greatly surpass the previous levels. Elliott waves are not always a useful tool, but when their patterns are as compelling as they are right now for the currency markets, extra attention is definitely warranted. Also of importance to the bullish outlook on the dollar is the current extreme sentiment against it, despite the fact that it is above where it was 18 months ago.



In fact, looking at the monthly chart, the extreme bearishness against the dollar looks even more unwarranted. It only sits a few percentage points below where it was in the early 90's. I'm fairly certain that if a survey of laymen were done and asked, "where is the USD relative to 17 years ago," the answers would be far lower, based on the steady barrage of "dollar doom" media coverage. I was recently forwarded an article where an interviewee responded with this intellectual gem:
As far as the "short dollar trade being too crowded," I'd dismiss it as nothing more than Nazi-style propaganda with no basis at all, only an underlying motive of trying to scare people out of their gold and silver positions so that the "bad guys" can take it from them.

I nearly hit the floor in hysterics.

As the near inverse of the dollar index, the euro also posted a large reversal day. The 50 day EMA remains as a barrier to lower prices, holding on all previous declines since the spring.



The Japanese Yen also had a sizable loss on Friday, giving up most of its previous gains of the past few months. Something looks like it went KABOOM here, and it would not surprise me at all to hear of hedge funds caught offside, betting against continuing correlations.



As always, followthrough will be the key to the importance of Friday's reversal. Over the past few months, we have documented dozens of opportunities like this for currencies, commodities and equities to change course. And in an almost comical ineptness, they have failed every time. We will know early this week, whether this is just another head-fake or the early stages of a resumption in trends that began 18 months ago.

Have a great week!

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Wednesday, December 2, 2009

Dubai Podcast and Comments

Michael Surkan of the Optimistic Bear again invited me on his radio show to discuss the ongoing issue with Dubai and its potential knock-on effects around the world. As I mentioned in my technical update on the weekend, this issue itself is not likely large or relevant enough to cause a global bout of deleveraging. But it may contribute to a loss in the prevailing optimistic tone toward the ability of some sovereigns to make good on their debts. The assumption is that any sovereign in trouble will be bailed out or assisted by another sovereign, the IMF, etc.

But this may be a premature assumption. Explicitly guaranteeing the debts of other sovereigns may increase the perception of systemic instability. German finance minister Peer Steinbrueck learned this last year when he blurted something about not allowing any Euro member to go belly up. He later backed away from that statement, surely after being made aware of the implications: if Germany were to guarantee the debts of all euro nations, they themselves would be perceived as ultra high risk. Abu Dhabi is certainly aware of this potential issue, hence their reluctance to immediately back Dubai.

The next assumption is that many heavily indebted sovereigns will attempt to pay off their debts through traditional measures (tax revenues, inflation, austerity, etc). Many times these measures are not politically possible. So strategic default starts to become a legitimate way out. Once this begins, it is difficult to stop in its tracks. Nobody wants to be stuck paying interest on debts while their competitors operate debt-free. Eventually, this will happen. New political parties will be elected and will view the debt burdens as "obligations of previous regimes."

Right now they continue to play extend and pretend. Extend the duration of obligations and pretend that assets are worth more than they really are. That will work only so long as it appears beneficial for everybody involved (ie. rising stock market). Soon, the sheer mathematics overrun the ability to continue this. As Steve Keen put it so well recently, and as Karl Denninger continually posits, the world's debt burden relative to our productive output is too high and is only poised to rise. And the percentage of our incomes required to service this debt is also too high. This has a corrosive effect on our ability to invest in productive capacity which lessens the other side of the ledger (output). All of the above puts upward pressure on risk premiums (ie. interest rates), which self-perpetuates the worsening servicing ratios.

This is the "Minsky moment" we experienced briefly last year. Confidence was high that it could be prevented. We are now in the process of testing that theory. In my opinion it will fail and another Minsky moment will soon occur - this time with dramatically less confidence in the ability of central bankers to postpone its effects, and less political capital to act as they did before.

Listen to the podcast below (run time about 20 mins).



As always, comments are appreciated.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sunday, November 29, 2009

Technical Update 46.09

A holiday shortened week and some wild swings toward the end were not enough to move the major indices very far from the unchanged mark. On a weekly basis they closed flat in North America and Europe, although Asian markets finished considerably lower.

The inability of Dubai World to repay its debts is what gets the blame for the late week selloff. But I am more inclined to believe it was simply jumpy speculators, fearful of losing their gains before the end of the year. Whether or not this event proves to be of any longer term importance largely depends on market participants' willingness to see that Dubai is not alone.

In fact, Dubai is a relatively small shoe among those waiting to be dropped. Excessive debt levels are everywhere. In many cases debt levels and leverage are higher than they were prior to the 2008 credit crisis. The only thing that has changed is sentiment. Popular sentiment is that governments will bailout banks that get in too much trouble; that large companies will be assisted in rolling over their debts; that overleveraged companies will be able to "earn" their way out of their problems in a recovering economy; and that increasing debt servicing burdens do not pose as barriers to any of the above.

As soon as perception is changed, the deleveraging of 2008 will continue anew. None of the problems were actually dealt with expediently. They were merely swept under the rug - given "lifelines." But those lifelines expire. So when the sheer mathematics of the situation meet the expiring lifelines that were given in the panic of 2008 and early 2009, the result will be unsurprising. (Abu Dhabi gave a similar "lifeline" to Dubai last year)

Dubai could serve as a stark reminder of this reality. Or it could be again rolled over and swept under the rug for another year. We've seen warning shots like this before. Remember back to June of 2007, when two Bear Stearns hedge funds blew up. This was quickly made to disappear while stocks continued higher for a few more weeks. Then another big shock in August. And again new highs for stocks into October. Thus, I would avoid taking this recent event as the long awaited "catalyst" for a move lower. I would instead watch for signals of contagion in credit markets. Are CDS spreads blowing out on other sovereigns early this week? Greece, Ireland, Spain, Italy, Mexico, Pakistan, Latvia, Saudi Arabia and numerous eastern European nations should be given extra attention this week.

Unless credit contagion is plainly visible early next week, I would be wary of a short covering rally that takes us to immediate new highs. But if nothing else, this recent incident has given us confirmation to the existence of a massive US Dollar carry trade. On Thursday night, the US Dollar spiked higher as speculators got spooked. Nothing else was spared. Gold was down $60. S&P futures were down more than 40 points. Oil dropped $5. And the phenomenon was worldwide.

Considering this is a technical update, I'll post a few charts before closing out.

First up is a chart of sentiment. It is the Investor's Intelligence bull:bear ratio. As you can see, the percentage of bulls relative to bears has reached a new extreme for the rally. This is typically a contrary indicator. (note: numbers are as of Nov 23rd)



Last week, I pointed out that the BKX (Bank Index) was underperforming and was poised to make a large move. It again underperformed this week. Below is an hourly chart of the past 3 months. Below its November lows, things start to get ugly for this index. Signs of credit stress should show themselves in this index first. Falling share prices in the banks will beget talks of more writedowns (not to mention coming accounting changes at end of year). And more writedowns will beget talks of further government assistance. The mere mention of this will absolutely crush improving social mood. And I don't believe further assistance will be politically possible. The big banks remain insolvent. That is the way they will inevitably end up. Attempts to paper over this reality appear to be unravelling.



I mentioned the Aussie Dollar last week as a carry currency. It weakened further this week. But the New Zealand dollar, while considerably less liquid, is also one to watch for signs of tense carry traders vacating their positions. It got creamed on Friday and is deserving of some attention in the event of followthrough.



Japanese banks are some of the most susceptible to falling asset prices. And they still have not worked through the bad debts racked up in the 80s. The Japanese Nikkei has been falling while the Yen rises to new highs. This is extremely painful to Japanese exporters and there are serious cracks between the new Japanese government and the central bank. Something could crack here too.



Have a great week!


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Thursday, November 26, 2009

Canadian Real Estate Goes Wacky

Consider me one of those that never expected the Canadian RE market to rebound after property values began to sink in 2008. But as we have been reminded by numerous bubbles over the years, parabolic blowoffs can last a lot longer than most imagine. Such is the case in Canada's two primary urban markets, Vancouver and Toronto. A concoction of factors has contributed to rapidly rising prices and euphoric expectations about the future.

Of course, when one has messages like the following being printed by newspapers almost daily, it should be no surprise that Canadians have been duped into believing the unbelievable:
“People are re-entering the market – they have the confidence to take advantage of bargain-basement prices. There's been a release of pent-up demand, and that has a long time to play out. Prices have gone as low as they are going to go.”

The above statement came from Gregory Klump, Chief Economist of the Canadian Real Estate Association. Astute readers may equate those statements with those of David Lereah who held the same position with the National Real Estate Association in the US. Lereah later admitted that his analysis was greatly compromised by the position he held - or in not so nice terms, he was a paid shill for the housing industry in the US. Regardless of this unsurprising revelation, the media here in Canada have no problem quoting Gregory Klump as if he were a legitimate expert worth listening to.

But the parallels don't end there for media treatment of the Canadian and American housing bubbles. Time magazine infamously called the top of the real estate market with their magazine cover titled, "Home $weet Home: Why We're Gaga Over Real Estate."



That was June of 2005 - what later was revealed as the top of the national bubble. It continued in some areas thereafter, but the writing was on the wall. In early November, an eerily similar picture arrived on my doorstep in the local Vancouver paper The Georgia Straight.



Intrigued and terrified I proceeded toward page 19, where the feature article lay. Along the way, I was inundated with full page ads for condo developments and just as many for luxury furnishing. The story started out documenting a 24 year old Indo-Canadian pharmacist's experience in buying his first condo. That was fine. But four paragraphs in, journalistic integrity took a back seat to complete fluff. Quoting the pharmacist:
"One of my friends who I used to live with in university, he's like, 'I feel since you bought your place, you've matured. You've completely changed in the way that you are. Before, we used to live the student lifestyle. Now, you're always cleaning your place. You have plants. You look after them. You've even got a cat now. It's like you're an adult.'"

Pass me a bucket. This reminds me of the disgusting marketing tactics used by penis enlargement pill pushers.

But that isn't all. The article goes on, defining the term "puff piece," quoting the most prominent figures in the local real estate market. First up was Cameron McNeill, real estate marketer:

...McNeill, whose company sold more than a billion dollars worth of real estate in the hot housing market of 2007, told the Straight by phone that he thinks the Olympics will keep a spotlight on Vancouver and magnify positive fundamental factors driving demand. According to him, those factors include low interest rates, a shortage of downtown land, good provincial government stewardship of the economy, and a safe investment climate.

McNeill added that it doesn't make sense to compare Vancouver-which has broad international appeal-to other Winter Games host cities. "Who wants to live in Salt Lake City?" he asked. "Lillehammer? I didn't know that town existed until the Olympics happened."

"I think the Olympics creates a euphoria, he stated. "But honestly, I don't think prices are going to spike preceding or post-Olympics significantly. I believe the real benefit of the Olympics is going to come in one, two, three, four years down the road."

Prices rose uncontrollably as soon as the Olympics were announced. It is something that has contributed to Vancouver becoming the most unaffordable city to live in in the Anglosphere with exception of some coastal paradises in northeast Australia (based on price-income ratios). McNeill also speaks of the oft-cited "land shortage." There is no land shortage - not even in downtown Vancouver. Where more square footage is required, we can build skyward, like any other city. There are blocks upon blocks of tired old buildings just waiting to be bulldozed and redeveloped. The map below is downtown Vancouver. Outlined in red is a huge chunk of largely underutilized land. Light industrial warehouses consume most of it. Century old rail yards take up much of the rest. Limited creativity is needed to see how existing land can be converted for other purposes.



Next up was Bob Rennie, another real estate marketer. Naturally, he echoed McNeill's sentiments:
..."It's after the Olympics that we're going to see the impact on real estate." ... "I don't believe that anyone ran back to Turin or Lillehammer or Salt Lake City... to buy a secondary residence or to move the family to safety or to move some money to safety. Vancouver is on the map. We're a world city. We're a brand."

The above statements will come across to most readers as unparalleled in arrogance. In fact, it is common sentiment here in Vancouver. This is best reflected by the Provincial Government's recent change in our provincial slogan from "Beautiful British Columbia" to "British Columbia: The Best Place On Earth." This, along with the above statements from Rennie and McNeill articulate perfectly the peak social mood this city is in. Despite 24 hour rain and eternal darkness for at least 6 months of the year, these folks can't see why anyone would choose to live elsewhere. Completely lost on them is that nearly everybody in the world is somehow passionate about where they are from, just like they are.

Don't get me wrong. Vancouver is a beautiful city. After traveling to over 20 countries in 5 continents, people ask me where my favourite place is. I answer "home." But while the combination of mountains and the ocean is my idea of paradise, I realize it may not be for others. There may be some wealthy visitors coming for the Olympics, but to contend that enough of them are going to want to buy houses to make an appreciable and lasting impact on the market is disingenuous. They will come and spend money. A tiny fraction will actually buy property, something which the market has already priced in.

But the opposite is also liable to occur. A wave of investors that have been holding supply off the market in anticipation of this event could flood the market just before the games, driving prices down and causing panic in those depending on a bonanza. Keep in mind that prices are still down in an 18 month period. This was not in the plans of investors who assumed prices would rise all the way up to the games. Now that this hasn't happened, industry promoters suggest prices will rise after the games.

The article goes on to quote more of these promoters, continually offering only one side of the story. It is never mentioned that even with mortgage rates at all-time lows, most borrowers are spending in excess of 40% of their incomes on minimum mortgage payments. And it is never mentioned that it requires up to 9 times the average household income to purchase a home in many parts of Vancouver (depending on how income is counted). There is only one explanation for statistics like these, many standard deviations from their historical norms. And it is the same explanation almost anytime we see prices divorced from their fundamental values.

Credit Expansion Fuels The Bubble

Like all other bubbles, the major contributing factor to this one is easy credit availability. In order to protect the Canadian manufacturing industry from a rapidly rising currency, the Bank of Canada has recklessly slashed benchmark interest rates to 0.25% and has left them there.

But the real driver of credit expansion can be traced back to the CMHC - the Canadian Mortgage and Housing Corporation. This is a government owned corporation which offers mortgage insurance and buys securitized mortgages in order to keep interest rates low and allow more Canadians to "afford" a home. From the CMHC's website:
CMHC plays a significant role in sustaining a healthy housing market and supporting access to low-cost mortgage financing. Generations of first time homebuyers who have limited down payments have been able to obtain mortgages at rates comparable to those with higher down payments due to our mortgage loan insurance products.

This has been the great enabler. And very much like their cousins Fannie, Freddie and the FHA down south, their very existence serves to accomplish precisely the opposite of what they intend - to make homeownership more affordable. They artificially stimulate demand, pushing up prices in the process. This fuels the notion that prices always rise, causing fearful prospective buyers to make poor economic decisions.

A revealing article was brought to my attention that confirms what we already knew. The CMHC along with the Conservative government were fueling a bubble in order to prevent the housing market from correcting to its natural level. More than $100 Billion in mortgages had already been guaranteed by the federal government, guarantees that would quickly turn into losses should prices fall considerably. Naturally, the solution was to make the problem even bigger. Guarantee even more mortgages, fix prices higher, and hope it all blows over. Murray Dobbin writes:
The facts are that over 90 per cent of existing mortgages in Canada are “securitized” -- that’s the practice of pooling mortgages (or other assets) and then issuing new securities backed by the pool -- MBSs, or Mortgage Backed Securities. That’s what happened with the sub-prime mortgages in the U.S. which (because the whole pool was so diversified) received triple A ratings by the rating agencies. Losses around the world amounted to hundred of billions of dollars.

Credit is still tight in the U.S. because no private investor has the stomach for such risky MBSs. That’s because those losses were private and not back-stopped by any government. In Canada, mortgages have been securitized for years. The Canadian-issued securitizations are called National Housing Act, Mortgage-Backed Securities. Unlike the failed U.S. pools, says Lepoidevin, “In order to find buyers for securitized mortgage pools, the Government of Canada has put guarantees on them” by directing CMHC to guarantee all Canadian mortgages.
...
By the end of 2007 there were $138 billion in NHA securitized pools outstanding and guaranteed by CMHC -- 17.8 per cent of all outstanding mortgages. By June 30, 2009, that figure was $290 billion, a figure Lepoidevin says “…exceeds the total value of mortgages offered by CMHC in its 57 years of existence!” CMHC’s stated goal was to guarantee $340 billion by the end of this year and is on track to reach $500 billion by the end of 2010. Total mortgage credit in Canada will grow by 12-14 per cent of GDP in 2009.

In an effort to prop up the real estate market in 2008 (when affordability nosedived) the Harper government directed the CMHC to approve as many high-risk borrowers as possible and to keep credit flowing. CMHC described these risky loans as “…high ratio homeowner units approved to address less-served markets and/or to serve specific government priorities.” The approval rate for these risky loans went from 33 per cent in 2007 to 42 per cent in 2008. By mid-2007 average equity as a share of home value was down to 6 per cent -- from 48 per cent in 2003. At the peak of the U.S. housing bubble, just before it burst, house prices were five times the average American income; in Canada today that ratio is 7.4:1 almost 50 per cent higher.

This high-risk policy actually prevents the natural playing out of the recession -- that is, the purging of the excesses of the previous boom period. CMHC’s easy-money resulted in a 9.3 per cent increase in Canadian household debt between June 2008 and June 2009.

Even bank economists admit to being concerned about a housing bubble. In a September research note, Scotiabank economists Derek Holt and Karen Cordes said, “…lenders have been scrambling to get enough product to put into the federal government’s Insured Mortgage Purchase Program over the months, and that may have translated into excessively generous financing terms.” Holt suggested that in two or three years -- or whenever the Bank of Canada increases interest rates -- many of these mortgages would be at risk.

The banks themselves have taken on virtually no new risk. According to CMHC numbers in the two years from the beginning of 2007 to January 2009 Canadian banks increased their total mortgage credit outstanding by only 0.01 per cent. Fully 90.5 per cent of all growth in total Canadian mortgage credit outstanding since 2007 has been accounted for by Mortgage Backed Securities. Of course, the banks have no interest in saying no if you have qualified for a securitized CMHC loan -- because they bear no risk if you default.

If that sounds like sub-prime mortgages, it should. Sub prime is any loan below prime. If a bank refuses you a loan, and CMHC gives you one, the loan is sub-prime. As Lepoidevin says in his warning letter, “Every single U.S. lender specializing in sub-prime has gone bankrupt. The largest sub-prime lender in the world is now the Canadian government.”

Hundreds of billions in government backed guarantees are driving prices to unsustainable levels in Canada. Like all other interventions into the market process, this too will fail. Instead of being on the hook for manageable losses, realizing that mistake and doing away with the CMHC, Prime Minister Harper and Finance Minister Flaherty have tripled the size of the problem, making its inevitable failure as systemically dangerous for Canada's financial system.

Unsubstantiated claims by industry hucksters of "pent-up demand" and foreigner buying sprees suggest prices will forever rise into the sunset. Common sense and a little bit of digging indicate otherwise.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Saturday, November 21, 2009

Technical Update 45.09

The S&P 500 is up a little over 7% since early August. It certainly feels like more. The last 4.5 months have been trying for market bears, sucking out volatility premium and refusing to respond to typical measures of extreme market sentiment. The major indices have again reached a point where they can capitalize on the visibly "weak hands" that are propping up the advance.

Judging from the sentiment on the various "bear blogs" I visit, it seems that most are now unconvinced that a top has been reached. These same venues were all quick to jump on previous declines and tops were called confidently. Now, however, with five distinct selloffs that ultimately failed, bears are more apprehensive. This is typical behaviour and indicative of the market taking the "path of maximum frustration." It seems that it is systematically trying to stretch and squeeze bears as much as possible, making as many as possible insolvent in the process.

But despite the seeming lack of conviction among the bearish camp, progressively more and more evidence is piling up in their favour. Every subsequent leg of this advance has been weaker than the previous and the most recent 3 day decline holds even more potential than was evident in mid-October. See the S&P 500 chart below with the VIX (volatility index) overlaid. It has registered a positive divergence relative to the index. RSI and MACD have each registered progressively weaker readings. And we can also see that volume has steadily declined throughout the course of the decline. These are all classic signals of a bear market rally losing steam.



Also of importance is the non confirmation among secondary indices. The Dow, S&P, Nasdaq, FTSE and Wilshire 5000 have each exceeded their October highs. Every other major index has failed to do so. As I wrote two weeks ago:

Tops are a process, while bottoms are an event. And this topping process appears to be no different. Especially bearish would be for certain indices (like the Dow) to make a marginal new high early next week, while the others fail to confirm. The bearish divergences noted in these pages two weeks ago would become even more pronounced.

This is exactly what has happened. So the appropriate stance would be to become MORE bearish given these developments. But that is not the way sentiment typically works. The emotional "pain" that one experiences being proven repeatedly wrong disables the ability to view market action for what it is. The same was true for bottom callers throughout 2008. By the time they were vindicated, few had the conviction to capitalize.

Below is the banking index. The academic consensus is that banks have recovered immensely since the panic lows of last winter. Naturally, they should be making immense profits with their interest spreads the way they are. But share price action tells a different story. They have been the weakest sector since the early spring rally, and the weakest sector over the past month. Could the market be telling us something different via the underperformance in this key sector? Could the balance sheet issues I have been raising for years continue to weigh on share prices? Or worse, is it possible that as many have alluded to continuously that most if not all of the world's major financial institutions are technically insolvent?

Do note the convergence of the moving averages on the chart below. Typically, when this occurs, a large move in one direction or another is imminent.



The terrible performance of small cap stocks should be worrying for bulls. In a healthy advance, small caps typically outperform larger cap stocks as smaller companies are more leveraged to prospects of future growth. With big cap names like IBM, MCD and JNJ leading the way with small companies lagging way behind, the hesitancy of bulls in this recent rally becomes easily apparent. Big name money managers have been distributing their shares of small companies to retail holders while they accumulate shares of safer names. We've seen this game before, and we know how it ends.



This can also be illustrated by the relatively few stocks that made new 52 week highs in November compared to those that did in October. Plotted on the chart below and smoothed as a 10 day moving average, the weakness be seen clear as day.



On the currency front, we see similar divergences. The Canadian dollar has backtested its rising trendline and turned back down. This is textbook Elliott Wave behaviour, with the break of the trendline being wave 1 and the retest of the underside being a wave two. So long as the trendline is not regained, the bearish case remains intact.



A similar case can be made for other currencies that have benefited the most from the US Dollar Carry Trade. Most notably the Aussie and Kiwi Dollars, the Brazilian Real and to a lesser extent the Euro. They are all in rather precarious positions, and a technical breach of very obvious support levels will most likely illicit further selling and an unwinding of these speculative positions.

But all of these currencies are moving inversely to the US Dollar Index - whether they are part of the index or not. So it is the big kahuna. And when it breaks above, we can be assured that the rest will break below in sympathy. Below is a chart of the US Dollar. Most notable is the trendline dating back to early March. It has been briefly exceeded twice this month (Nov 3rd and last Friday) but failed to close past that mark. Also of note is a parallel trend channel dating back to June. The upper band of this channel correlates roughly with that Nov 3rd high, giving us a fairly good idea of where resistance resides. 76.81 is the number to beat. If we get two consecutive closes above that number, I'd have a high degree of confidence to call the bottom for the dollar. A spectacular advance would be the result.



That's all for now.

Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Friday, November 20, 2009

Steve Keen Speech

Steve Keen, the Australian economist, gave a brilliant 30 minute speech last week that can be watched in its entirety below.

We are in agreement that debt levels have likely peaked relative to economic activity and that the likely course forward is an unwinding of this debt back to historical norms. I discussed this at length in my last post, "Missing the Forest for the Trees."

edit: the embedded video led to a repetitiously agonizing 16 second trailer for Michael Moore's "Capitalism: A Love Story." The actual speech can be found at the following link:

Full Speech Here

Although Professor Keen and I would likely agree on more than we would disagree, I have doubts that he would endorse the solutions I proposed in that post. He does not believe, it seems, in the benefits of mutual voluntary exchange, instead electing to cling to the absurd Marxist notion of 'capitalist exploitation' over susceptibly 'irrational' actors. To this extent, he is dead wrong. Keen fails to understand the difference between the neoclassical "rational expectations" thesis (that underpins the EMH) and the more Austrian "rational action." Rational expectations, we would agree, are impossible. To be able to foresee exactly how any action will result, one must operate with perfect information, or in other words, omniscience. This is absurd. No individual or group of individuals can make a claim to this ability - government central planners especially. But rational action is something else completely.

Rational action implies that at the time of decision making the actor will always elect something that he/she believes to be beneficial. Otherwise, no action would be taken. For example, if I were sitting on my couch feeling hungry, I may find the idea of expending energy and money to walk around the corner for a hamburger. Upon my completion of this task, whether I found the result of my action satisfying or not, my thought process was rational. It could have been insufficient and given me a tummy ache. I would then have experienced loss on this transaction. But my action was still rational. Rational action can lead to either profit or loss - two necessary potential outcomes for any action.

It seems that modern economics has been consumed by a utopian desire to eliminate "loss" from the realm of possible outcomes in voluntary exchange. To do this, the central planners seek to minimize our ability to engage in voluntary exchange, making more and more exchange involuntary. The justification for this is that people suffer from irrationality and require decisions to be made for them.

No greater folly has poisoned the minds of humankind.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Wednesday, November 18, 2009

Missing The Forest For The Trees

With the 65% rally in stock indices, the idea of actual reform of the financial system seems to have been put aside from serious consideration. Law and policy makers are instead holding out in hopes that 2008 was all just a bad dream, a rogue wave that nobody could have expected, or some sort of other metaphorical platitude designed to distract us from the reality of what happened.

Senator Chris Dodd introduced a bill that supposedly will reign in the financial industry. The bill would have been worth reading, and perhaps even worthy of taking seriously were it not over 1100 pages long. The length of the bill tells me everything I need to know - it is filled with loopholes, concessions, and incentives to ensure that any meaningful change can be interpreted away by the best cunning team of lawyers freshly printed money can buy.

Karl Denninger has a pretty good takedown of the bill. That's not to say it's all bad. But the instances of actual reform (like eliminating regulatory arbitrage) will be outweighed by the damage inflicted by the perception of stability being falsely instilled in the minds of all market participants (ie. everyone). This is the single biggest problem I have with regulation. Lawmakers dance around pronouncing how safe and secure everything is, typically exaggerating such stability to make themselves look better, and people take their word (even if they know otherwise), knowing that it is someone else's ass on the line should all go awry. "Moral Hazard" in other words.

Ron Paul's "Audit the Fed" bill (HR 1207) is also under attack from partisans of the status quo. Mel Watt, a congressman from Bank of America's district, has put forward an amendment to the bill that essentially kills it dead. In politics, apparently you don't have to vote against anything. You simply water down what you don't like to the point of making it meaningless. This way you end up with thousands of pages of laws that cancel each other out, confusing everybody except the aforementioned lawyers who's jobs rely on said confusion. Somehow I don't think this is what was in the minds of those who crafted our systems of government, but I digress.

The point is, despite all sorts of cage rattling, nothing is actually being done. And there is mounting evidence that the opposite is happening: the institutions primarily responsible for the crisis have been given the keys to the city with the hopes that they rescue the system on their own accord. Good luck with that.

But as I implied earlier, doing nothing would be a better outcome than creating the perception of doing something while in fact doing nothing. That way, at least people would remain skeptical of the entire framework and reject its further expansion, thus reducing the potential damage.

But can we really expect anything that will actually have a stabilizing effect to be done given that almost nobody understands what caused the crisis in the first place? Obviously not. If you start with faulty assumptions, your analysis is bound to have faulty conclusions. Right now the assumptions are that:

- Banks were always well capitalized - it was just a lack of confidence that put them in jeopardy - and now that confidence is restored, everything will be fine.
- The lack of confidence caused people to save money - thus dampening consumption from its "normal levels" - and with enough "stimulus" there will be a disincentive to save, spurring consumption and helping boost GDP
- There was not enough regulation - new derivatives and bank activities managed to circumvent existing regulations - and with bigger or newer regulations these activities will be brought under control
- Pay incentives for financial executives encouraged unnecessary risk taking - changing the incentive structures for executives will help eliminate excessive risk
- The lack of a resolution authority was the reason why more big banks did not fail - the creation of such an authority will ensure systemic risk is limited
- The present financial system serves a social purpose by providing access to credit which encourages growth and prosperity

All of these assumptions are false. And there are many others. The decisions being made now are based on these assumptions, and therefore their chance of success remains zero. Just as the avoidance of crisis was in 2007.

What are the real problems?

The problems noted above and their accompanying "solutions" have one thing in common: they disregard debt (credit) as any sort of problem. This should come as no surprise, because those who put forward their interpretation of the issues and those who seek to legislate solutions to them nearly all subscribe to economic ideologies that dismiss credit growth as potentially destabilizing for an economy.

But credit growth is the central problem. And the inability for credit to grow further is what caused the crisis. Again, this was a mathematical certainty to occur at some point. One needs only a calculator and 6th grade math to reach that conclusion. When credit growth is compounded at annual rates between 6-15%, it does not take long for the parabolic advance to reach a breaking point. We reached that breaking point when our debt servicing to income ratio began to rise faster than our incomes and the equity in our primary assets (homes). Credit expansion slowed and asset prices, which had already priced-in years of future credit expansion began to be re-priced to levels more in line with our incomes.

Credit is the central cause of the crisis - the disease (if we are to characteristically resort to medical metaphors). The symptoms of the disease are many, a few of which are listed above. By addressing the symptoms we will not reach a paradigm of increased stability over the current system. It will be inherently unstable. Such has been the case for a century. And something that post-Keynesians like Hyman Minsky and many Austrian economists have been arguing for about as long. The only question revolves around what the "redline" is. What level of debt can be sustained by an economy? Of course, this depends on many factors: interest rates, income growth, productivity, etc. Because it is unknown at what level of debt an economy begins to "choke," we cannot say with 100% certainty that it has been reached. But we can make an educated guess, based on the events of last year, that we crossed that level.

Below is a chart of total public and private debt outstanding in the US. As you can see, total debt is now 4x the size of the entire economy - far more if one factors in unfunded future obligations or if one considers the guarantees issued for suspect financial instruments. (chart courtesy Market Ticker).



Economy bulls believe one of two things:
(1) Debt doesn't matter and this could continue rising for decades, or
(2) We can grow our way out of the problem via productivity advancements and income growth (I'm still yet to find anyone that feels this to be likely).

I have my eyes and ears peeled for any signs of (2), but I just don't see the necessary actions taking place to allow for this (deployment of savings on CapEx by businesses, competitive wages, proper demographic influences, etc). To the contrary. This economic "rebound" is not being led by productive deployments of capital, rather asset price speculation. This is the same reason that led me to believe that the '03-'07 expansion was mostly illegitimate. I was correct then, and I have no reason to believe my analysis was wrong and I just got lucky. The crash in asset values and seizure in credit that I hypothesized would be the result of an illegitimate expansion, happened - only more violently than I thought likely.

As I mentioned above, (1) is false and rooted in fallacious economic theory (Keynesian and Monetarist). While I suppose a temporary expansion of debt levels is possible (so long as interest rates remain low or continue falling, debt servicing ratios don't rise much), my intuition is that the max level was reached in 2008 and there will be neither demand nor supply of credit to allow for further expansion.

The combined factors above lead me to believe that we are on the cusp of another credit seizure and collapse in asset prices for the same reasons it happened last time. Such a collapse is unavoidable. The solution is to let it happen in an orderly fashion, in accordance with the law, and most importantly, with a viable framework for what a replacement financial system will look like once the unwinding is complete.

Discussion on what this system should look like need to begin immediately. If it is not in place prior to the unwinding of the current system, the unwinding runs the risk of being disorderly and vulnerable to being accompanied by the nasty side effects of such a disorderly collapse (ie. starvation, rioting, lawlessness, war, etc).

Simple Proposal For A Sound Financial System

Primarily, it needs to be acknowledged that unbacked credit expansion serves only the needs of a select few (the issuers) at the expense of everyone else. A future system shall make the extension of said unbacked credit a criminal offense. No new laws are required for this. Most western judicial systems have laws against counterfeiting, misappropriation and misrepresentation. As they are written, they need only be applied to the financial system as they are to any other person or industry. Lending anything that one doesn't already possess is a violation of all three laws.

With this one simple interpretive adjustment in the application of our current laws, we can eliminate nearly every adverse symptom of our modern day economies (failure is not an adverse symptom, thus cannot be eliminated). In order to facilitate the above and to structre our financial system in a manner consistent with the law, the following would also prove necessary:

1) Convert all credit obligations for common equity
2) Liquidate the remaining debts that are not backed by existing equity
3) Eliminate legal tender laws
4) Financial institutions will elect to become one of three types of institutions:
i) Depository Institutions - The banks take deposits for safekeeping of a predetermined measure of deposit (dollars, gold, oil, wheat, land, whatever is accepted by the market) and facilitate electronic or physical transactions between like institutions. A fee is charged to depositors for these services.
ii) Lending Intermediaries - These institutions facilitate the matching of lenders and borrowers. A rate of exchange is settled by the two parties at the prevailing market rate. Should the borrower default, the lender experiences loss. The intermediary is responsible for the collection of regular payments and collateral in the event of default. A fee is charged for these services. No risk is ever taken by the intermediary.
iii) Investment Firms - These firms pool capital on behalf of willing investors and use it to speculate or invest on whatever they choose. Returns are based on entrepreneurial intelligence rather than who can take the most risk with borrowed money.
5) Eliminate regulatory redundancies (eg. capital ratios)

There is no social benefit in large, multi-purpose, ultra-leveraged financial institutions. Economies of scale in banking are typically left at municipal lines. Furthermore, our relatively new means of electronic transactions drastically reduces our need for indirect exchange (the use of money). Small transactions can easily be achieved with specie and dollars need only be retained as a unit of account. "Capital" will always be something tangible and the abolition of legal tender laws will encourage the monetization of more types of capital (primarily, the most irregular of commodities).

These changes are not an effort to tame or eliminate the business cycle. Not a "utopia." But it must be acknowledged that much of the business cycle we currently experience is due to the expansion of unbacked credit. Other business cycles will persist based on demographic, social and environmentally driven changes in values (among other factors). These cycles will most often be mild, but sometimes severe. But under the system outlined above, they need never be systemically jeopardizing. Success and failure should be embraced as equal sides of a smoothly functioning economy, neither embraced nor scorned. Yet failure that does occur will be on account of poor entrepreneurial judgement, rather than as result of others' excessive risk taking and systemic collapse.

I challenge the reader to explain coherently how our current financial system serves any greater social function than what I have briefly outlined here. And I furthermore request the reader to address the morality and logic of a financial system so complex as to be incoherent to the average person, while such a simple alternative presents itself.

If anyone has any details to add, I encourage you to do so in the comments section. I was purposely vague on certain areas of my "solution" so as to elicit further discussion.


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

Sunday, November 15, 2009

Technical Update 44.09

Major averages again failed to confirm their numerous bearish divergences with increasing selling pressure. The modest declines were not enough to instill a significant amount of fear in traders and dip buyers took advantage of the indecisiveness. Again, we turn to my list of factors that I feel will be sufficient to turn the tides. Some were achieved in the previous decline but not all. We will again have to endure higher prices and monitor continuing divergences prior to incurring more definitive sell signals.

1. Consecutive daily declines of 2.5% or more. This hasn't happened since the rally began (if so, only marginally).
2. Weaker internals than previously displayed during the rally via 10 day moving averages of a) put/call ratio b) advance/decline issues c) advance/decline volume.
3. A considerable increase in the US Dollar Index. A crossover of the 20 day EMA over the 50 day EMA is something that has not yet occurred since early April.
4. Divergence between major indices. Dow, S&P, Nasdaq, Transports, Banks. We should see significant divergence between some of these indices at a major top. There have been divergences present at various points, but they have quickly resolved themselves. Specifically, I am looking for underperformance in the transports, banks and/or the nasdaq.
5. A complete Elliott Wave '5' down on more than an intraday basis.


While it may feel like prices will inevitably rise higher, and perhaps in a final parabolic manner, it should be noted that among the divergences present at both the September and October highs, those same divergences are persisting and even more pronounced at this time. While the Dow has powered higher, only the S&P, NDX and FTSE indices have confirmed that new high in November - and each of those three have only managed it by a few measly points. For a technician that follows the Elliott Wave Principle, this is problematic. A recovery high after an initial decline (ie. a '2 wave'), cannot exceed the beginning of wave 1. This forces the technician to interpret the various indices differently until they confirm. And while there is nothing wrong with doing this, my experience is that when there are so many equally valid interpretations of the price structure it is best to focus on other technical measures until the pattern reveals itself more clearly.

So while there remains possibilities from an Elliott standpoint to continue higher, more conventional technical analysis still argues for lower prices. Significant RSI and MACD divergences as well as pathetically low volume should be warning signs to those of bullish inclination.



One index that does appear to be divergent with the US Dollar Carry Trade is Shanghai. As much as this differs with my overall take on China's dependence on US exports, the technical pattern is very compelling. The Shanghai market appears to have put in an impulse 5 wave pattern into the summer, and a one month correction thereafter. If this holds, the best outlook for the future is that Shanghai has put in two consecutive 1-2, 1-2 legs higher, setting up for a 3rd of a 3rd of a 3rd. In Elliott Wave terms, this is a holy grail setup and argues for MUCH higher prices. A drop below 2900 would invalidate this thesis, creating a somewhat low risk entry on the long side. Sometimes the technical patterns that do not jive with one's fundamental biases are the best trades. Mindful of this, I have taken some long side exposure in FXI as a hedge to my S&P puts.



Good luck this week!


Disclaimer: The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.

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