Technical Update 33.09

The probabilities have materially shifted in favour of a lasting market top. Of the 2-3 dozen market indicators I follow, all but a few are consistent with this hypothesis. If you would have asked me in April what I thought would coincide with a bear market rally top, I likely would have answered the following:

- extreme bullish readings from sentiment indicators (DSI, AAII, Investors Intelligence, bullish percent index)
- bullish proclamations from prominent analysts, investors, economists, central bankers and politicians
- media embracement of "a new bull market" via magazine covers and daily cheerleading
- persistently weak economic fundamentals inclusive of deteriorating credit conditions and banking failures
- negative divergences in the currency, commodity and bond markets
- negative divergences in momentum indicators (ie. RSI, MACD, Stochastics, etc)
- declining volume throughout the rally
- decreasing volatility
- countable Elliott Wave corrective patterns
- DeMark sell signals
- Dow Theory non confirmation

Among the above, nearly all conditions have been met. It would be wise to keep an eye on the few that have not yet been met.

- The Dow Theory, by many interpretations, has recorded a buy signal. Some interpret it differently, however.
- DeMark sell signals will record if we have a close below the close 4 bars earlier with followthrough on the next open (any close next week below S&P 1025 should do the trick).
- Elliott wave count could be suggestive of higher prices (I'll cover this more below)
- Although volatility is declining, options traders are overwhelmingly betting on higher volatility (declining prices) in September and October.

For volatility, it is important to note that when looking at the VIX, one is looking at option premiums for 1 month in advance. The VXV, however, measures volatility 3 months forward. The VXV is trading at quite the premium to the VIX. Additionally, historical (realized) volatility has been quite tame. And there has yet to be any "capitulation" in the premiums being charged. In fact, the spread between implied and realized volatility is at multi year highs. This may be something to keep your eye on for the following week, which happens to be the week before a long weekend (monday the 7th) and typically of very low volume.

It is worth pointing out, however, that back in October and November, when volatility was at very extreme readings, the VXV (3 month) was trading at a discount to the VIX (1 month). This proved to be correct as volatility was indeed more muted over the following months. There is no reason (other than contrarianism) that the same cannot prove to be true today with higher volatility being priced in. See chart below:



What is ambiguous about the Elliott Wave pattern (skip this if you don't understand Elliott) is the labeling of the final wave C of (Y). Since the March low, either a "zigzag" or "double zigzag" appeared to be playing out. The highs around 940 in early June marked the first zigzag, however there were not enough other factors (like those mentioned above) for this to mark a high, and a double appeared to be the most likely scenario. So from the 869 low to about 1018, we had an A wave, followed by a B wave retracement to 979 and a subsequent 5 wave rally to Friday's opening high of 1039.47. What is still up in the air is whether the recent 5 wave rally is simply wave (1) of a bigger rally past 1100 or not. I do not think this is the case, but it remains a possibility. Should a strong rally blow past 1050, this would likely become the higher probability scenario. If prices were to rise moderately early next week, we may be witnessing an "ending diagonal" that would terminate itself around 1050.

The chart below is courtesy of Daneric's Elliot Wave Blog.



As I mentioned earlier, the dollar and many commodities have failed to confirm the move higher in equities. Treasury yields, additionally, are well off their lows. If stocks are ready to push higher, these divergences need to disappear.



Lastly, I want to revisit something I was following a few months ago.

One should always be wary of an irrational market to persist longer than initially believed possible. And it should also be mentioned that corrective waves have a tendency to last a minimum of 1/3 the duration of the preceding secular trend. Marking the beginning of the trend as Oct of 2007, the first wave lower was 17 months in duration, meaning that this corrective rally should last at least into the end of the summer. Sharp pullbacks, however, can easily interrupt this path. And that is my primary expectation - that we see a sharp pullback of 10-20% in the near term, followed by a late summer challenge of, and perhaps exceeding of, the recent highs (S&P 956).

We did get our pullback (it was rather dull, though) into July of about 10%. And we did exceed the June highs of 956 (by quite a bit). We have also passed the 1/3 retracement in terms of time. This rally has lasted 25 weeks compared to the decline that lasted 61 (40.9%). Measured in constant dollar terms and using May '08 as the high, our 42 week decline will be contrasted with a near perfect Fibonacci 61.8% retracement next week. Something to think about... or not.

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.

In Transfer

Apologies for the lack of content of late. I'm in transfer mode right now. New apartment. New website coming. Starting up some side projects. And repositioning my trading account for a potential top.

In the meantime, I have made my Google Reader favourites available for all to see. I scan through over 100 blog posts and newspaper articles on any given day (as I get faster and more efficient at doing this, it seems, the list grows). I will flag the ones that I think are most important and they will show up on the right hand portion of this page under "Recommended Reading." I won't necessarily be in agreement with everything posted there. But if it is presenting an interesting contrary opinion and is relevant, I may give it a nod.

This will likely be a larger part of the new website where I will refrain from posting more than a weekly missive on technical and fundamental issues.



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.

Transparency 1 - Federal Reserve 0

Score one for the good guys.

Aug. 24 (Bloomberg) -- The Federal Reserve must make public reports about recipients of emergency loans from U.S. taxpayers under programs created to address the financial crisis, a federal judge ruled.

This is a major victory in the battle against encroaching central bank power over the US economy. This also sets a major precedent in eventually allowing for a total audit of the Fed (perhaps making HR 1207 redundant).

I hope the judge has protection.


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.

On The Calculation Of GDP

Rolfe Winkler who writes one of the Reuters blogs - formerly of Option ARMageddon posted a really good quote from Bobby Kennedy circa 1968. It reminded me of something else I had read.

They both have to do with the absurdity of how we calculate our economy's progress - namely GDP (formerly known as GNP). Just as looking at someone's income bracket and trying to make a determination of how "happy" they are, it is a bit of a stretch to simply measure the amount of economic activity as if "activity" can simply be defined as one homogeneous unit. It cannot. Some activity is legitimate progress. Some activity shows progress now, but is only at the expense of a necessary future regression. Other activity is just plain damaging from the outset.

Unfortunately, making such determinations about the nature of economic activity is extremely subjective. It is so for the same reason that many people find living on an income of $20,000 very comfortable, while others cannot do without $200,000. Neoclassical economists try to label one as rational, and the other as irrational. This way they can eliminate the irrational from their models. By doing so, they allow their own subjective values to reflect themselves in the numbers that result from these models and the policies that are then recommended. They know of no other way. If these economists were forced to admit that they cannot even judge the total economic activity in a nation, they would be completely disposable. GDP calculations are used as the anchor for virtually all other economic models.

Kennedy's quote below highlights the social degradation that inevitably results from focusing on absolute numbers rather than the quality and independent nature of each input. It could have been said today - more than 40 years later - as increasing focus is put on financial innovation and accounting tricks to "meet the number," while we accumulate more and more long term debt and watch the manufacturing portion of our economies erode to an afterthought.

Too much and for too long, we seemed to have surrendered personal excellence and community values in the mere accumulation of material things. Our Gross National Product, now, is over $800 billion dollars a year, but that Gross National Product - if we judge the United States of America by that - that Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities. It counts Whitman’s rifle and Speck’s knife. And the television programs which glorify violence in order to sell toys to our children. Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile. And it can tell us everything about America except why we are proud that we are Americans.

-- Robert Francis Kennedy, speaking at the University of Kansas, Lawrence KS, 3/18/68

The quote reminded me of something I had read along the same lines by Lawrence Parks. Burn Your House, Boost The Economy:

As recently as 50 years ago, economists regarded the vitality of the economy as consonant with its ability to produce things people want (and would pay for). Today, the economy has been redefined into something called the Gross Domestic Product, or GDP. It measures all goods and services brought to market in a given year. But is it really an accurate measure of how well an economy is serving people's needs? Here are some outlandish ways the GDP can be boosted.

Things Kids Can Do. Get sick. Constant medical attention is good for the GDP. Medical costs account for 14 percent of it. Let's stay on the growth curve. Kids can also become juvenile delinquents. If they get arrested for heinous crimes, they go to jail, the expensiveness of which gives the economy a jolt.

Things Adults Can Do. Get a divorce. Legal costs, two houses, and all the things that go with two houses (furniture, kitchen supplies, pictures, etc.) are important components of the GDP. Divorces stimulate consumer demand.

Break something around the house, like a television, a dish, or a window. Replacing these increases the GDP and creates jobs.

Smash up the car. It will have to be fixed or replaced. The auto industry employs, directly and indirectly, one of every seven workers in the U.S., and they need the overtime.

For great results, burn down the house. Don't worry. If you handle it right, insurance will pay for it and the rebuilding will keep a lot of people busy for a while.

Quit your job as a scientist and become a taxi driver. Research and development is not included in the GDP, but money spent on taxicabs is.

Overeat, don't exercise, don't brush your teeth, do drugs, smoke, drink, and make yourself terribly sick. Get family members to do the same. Higher medical expenditures especially help the GDP move up, up, up.

Hire help to take care of the kids, and force your wife to get a job. This gives the economy a double boost. If your wife takes care of kids and cooks, this is not counted in the GDP. Hired help is. If she gets a paycheck too, that counts towards measuring economic growth.

Hire a lawyer and sue somebody. Lawyers' fees are directly added to GDP.

Things You Can Do With Your Neighbor. Riot and burn the neighborhood. The damage won't be subtracted from GDP. But rebuilding puts people to work and benefits the GDP.

Form a gang and commit crimes with a view to getting caught. The more people in jail, especially folks who would not otherwise have jobs, the better off the economy. Today, building and managing jails is one of the hot "growth" industries, to say nothing of the security business.

Things Businesses Can Do. Pollute. A giant oil spill would be great. Superfund sites expand the GDP.

Leverage up and build excess real estate, e.g., see-through buildings. They add to the GDP when they go up, but the waste is not subtracted when they are demolished. Similarly, companies can build excess plant capacity (as IBM did in the mid-to-late 1980s to the tune of $30 billion).

All of this counts toward GDP. Again, when companies are "downsized," nothing is subtracted from the GDP. It's similar in concept to the "roach motel": GDP counts the things going up, but not going down.

For Best Results, Get The Government Involved: Lobby your elected representatives to raise taxes and spend more money. Government spending on goods and services adds to the GDP and "creates" jobs.

Start a war. Preferably one far away where no Americans get killed. B-2 bombers, tanks, bullets,...all count in the GDP. Also, send Stinger missiles to liberation armies around the world. Maybe some of these missiles will be used to knock down airliners. Replacing them helps the economy, and, if lawyers get involved, there's a GDP bonus.

Target savers! People who save actually hurt the economy because they don't spend. If people spend their savings, then those purchases are added to the GDP. When they don't spend, the economy suffers. What can be done to discourage saving? First, tax the return on savings: a higher capital gains tax would be very helpful. Second, and best, debase the currency. By printing up more and more money, we can dilute the value of people's savings (especially their long-term savings such as their pension funds) surreptitiously stealing their savings for politicians to spend and thereby increase GDP.

Get Mother Nature On Your Side. Pray for a natural disaster: a hurricane, an earthquake, a big fire, a flood. Disasters give the GDP a tremendous life because of all the rebuilding that must take place.

If we do all these things, we'll have enough statistical growth to replace decades of economic stagnation. We may achieve double-digit rates. As for whether the economy is actually vibrant, we'll have to ask an economist who exercises more critical judgment than those who swear by GDP data.

I suppose GDP could register a positive reading for the 3rd quarter. Perhaps the 2nd is revised higher as well. But what exactly would that be telling us? What would it mean for the millions of newly unemployed workers who can't find jobs in anything close to their area of specialization? What would it mean for the heavily indebted who see no rise in their incomes as assumed when they chose their payment plans? The numbers, as always, will be completely meaningless for individuals who make their decisions based on their own unique situation, not some vague indefinable concept like "the average person."

Statistics like GDP, price changes (known as inflation), consumption, manufacturing, and wages all focus on "aggregate" numbers. They tell us nothing of what is occurring at the individual level. As such, they are useless for all practical purposes. We'd be better off without them - and the economists who propagate them.

Bobby Kennedy was a Democrat. It would be nice if some of his common sense could be resurrected today.

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.

Technical Update 32.09

Another week of rallies has put the major averages at new highs for the year. From where I sit, there is limited resistance between 1025 and 1075 on the S&P 500. However, large moves into options expiration Fridays have a tendency to reverse hard the following week (aka. hangover), so caution would be wise. Every step higher the market takes is part of the process I have been watching since late February when I wrote about the possibility of a multi-month rally. Each step of the way I have made observations of clues the market leaves as to it's eventual stopping point. Oftentimes, these observations have led to minor reactions in price, only to be met with further bids and higher prices. Such is still the case, and it demands respect. So while technical observations can prove correct temporarily, price is the ultimate arbiter. Right now the trend in price is up and that is the single most important factor.

I am half expecting a parabolic finish to this rally. Perhaps an enormous gap and run that fails and reverses just as hard as it came. The November-January rally finished like this with an "island" reversal. Perhaps this one will as well.

The last few weeks of August and into Labour Day are typically very quiet. So I would not be overly excited for a big move or a jump in volatility before this period passes.



Below are various measures of market internals. Most are at either multi year bullish extremes or are showing negative divergence relative to their strength earlier in the spring/summer. These are the types of readings one would expect to see prior to a major shift in the markets. But while they are "extreme," they can just as easily become "ridiculous."

The first chart is that of the Put/Call ratio. Lower readings are typically associated with more call buying and thus more bullishness. It is used as a contrary indicator. Friday's trading saw this ratio drop to 0.59, its lowest since late 2007 - when the market began a 20% decline into January of '08.



Next is a chart of the advance/decline ratio. It is calculated by subtracting the total amount of gainers by the total amount of losers on any given day. The blue line is the 50 day moving average of this number. We can see that as the market has been pushing higher in August, it has been doing so with less and less leadership.



Likewise, fewer and fewer stocks have been making new 52 week highs as we push higher - another hint of declining leadership.



The bullish percent index is the percentage of stocks in the "up" phase on their respective "point and figure" charts. Typically, any reading over 80 is thought to be a bullish extreme, while anything under 20 is overly bearish. Back in March, this index registered its lowest reading in the history of the data - since 1987. We are now sitting at the opposite extreme - the highest reading ever, just above 90%.



The following chart shows the percentage of stocks trading above their 50 day simple moving averages. Earlier in the spring, a greater percentage were accomplishing this feat than are now. This is indicative of potential exhaustion in previous market leaders.



Lastly, the NYSE closing TICK data is showing some negative divergence from its previous highs. Traders appear to be shying away from overnight risk. The blue line is a 10 day moving average of the reading.



It is not often that one finds such a synergy between the various market internals. When one does, the odds for a turn in the opposite direction are very high based on my previous experiences. However, being measures of market psychology, most are inclined to ignore them at precisely the time their messages should be heeded.

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.

CRE Blows Sky High

If Commercial Real Estate in the US blew off the face of the economy, would anybody notice? Apparently not.

The sector that most recognize as being responsible for the recession of the early 90's is collapsing at a pace greater than that of the residential meltdown that started in '06. While not as large in nominal terms, CRE tends to pack a bigger punch due to the larger size of the individual loans. They are concentrated in the small regional banks, where only a few loans could make up a great portion of the banks total loan book.

The chart below puts the price drop in perspective (courtesy Calculated Risk):



As usual, commercial lagged residential by about 18 months. But the rate of decline has been even more rapid, putting it at a similar total decline in about half the time taken for the residential market.

However, the Moody's CRE index may be a bit misleading due to the illiquidity in the commercial space and relative few transaction inputs. Actual price drops in some areas could be much greater or much smaller, depending on the individual market involved.

We were given a decent demonstration of this market bifurcation yesterday when Colonial Bank was taken over by BB&T after being shut down by the FDIC. BB&T made the actual value of Colonial's loan portfolio available - and the results are disconcerting. Colonial's total loan book was found to be worth only 63% of the marks being carried. The construction portion of the portfolio was found to be worth only 33% of their carried value. The table below is a comparison with other major bank mergers of the past year and a breakdown of asset markdowns:



The above information should not be understated. Bank portfolios are deteriorating even as the economy is supposedly recovering. So while GAAP accounting principles have been temporarily suspended, the losses are still there - and growing. In other words, the administration has lathered the pig with lipstick. But it is still snorting and rolling around in mud - thus not fooling anyone.

What should concern people most is that the FDIC has waited so long to halt operations at this insolvent bank. If capital ratios are allowed to become so impaired before any action is taken, one must ask, "how many others are in a similar position?" The fact that the FDIC Deposit Insurance Fund (DIF) has essentially run out of cash, leaving it with only a line of credit with Treasury is the probable explanation. And if this is the case, why has this line of credit not been tapped into by the FDIC? Could there be some undesirable strings attached for the FDIC, perhaps yielding more regulatory power to the Fed that is the sticking point? I touched upon this recently in Geithner Throws A Hissy-Fit Over Power Struggle.

We can ask questions and ruminate over the possibilities without end. But what is definitive is that the FDIC does not have the ability to absorb losses of any amount let alone loss rates in the 30% range. And the reality of the banking system appears to be showing through the "paper it over" solutions given in the past year.

This is going to get interesting. Stay tuned.


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.

Lynn: Deflation Theory Is Lemon We've All Been Sold

In one of the better Op-Ed pieces in a major financial publication I've seen in quite some time, Matthew Lynn attacks the common dogma that deflation is dangerous and evil while inflation remains a benevolent and kind friend to all.

This goes along well with my last article, Depression in the 21st Century, where I urged the abandonment of unnecessary fear in understanding what a deflationary depression would look like for various people.

Lynn concludes his article:

There are winners and losers, just as there are from most economic developments. The important point is that the people who lose are more powerful than the people who gain. That might explain why we hear about the dangers of deflation, and not about its advantages. It still doesn’t make them right.

There is no threat from deflation. It may even be desirable if it encourages a balance between saving and consumption, and discourages governments and banks from taking on debt.

If Lynn's conclusion sounds conspiratorial, it's because it is. "The money interest" as it used to be known will stop at no end to ensure that they are able to increase the supply of it at will. 180 years ago this meant attempting the assassination of Andrew Jackson - six times. Murray Rothbard's book, A History Of Money and Banking in the United States, is perhaps the best book to read for understanding these realities. It destroys popular misconceptions and attacks those originally responsible for their adoption into mainstream thought.

As an extension to Lynn's piece today, curious readers may wish to explore a more in depth piece discussing deflation and the misinformation that has typically been tied to it. To do so, I recommend Jorg Guido Hulsmann's monograph Deflation and Liberty, which can be read free in its entirety at that link.

It is high time to put an end to the culture of fear being propagated by central bankers and their minions in government. Neither deflation nor a general economic depression can be seen as an unquestionable evil. Both will reinstate discipline in our markets and provide justice for the responsible.


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.

Technical Update 31.09

The major averages failed to make any kind of significant pullback in price. Overbought conditions can work themselves off via either time or price - usually, but not always, a combination of both. It appears that the S&P is merely taking its time moving sideways prior to another thrust higher. The shorts appear to be getting frustrated as even bad news (retail sales, consumer confidence, bank failures) is happily bought. The bi-weekly short interest report shows short interest falling in the last two weeks of July, even as the market rallied - consistent with the short squeeze thesis.

As mentioned earlier this week, the markets tend to take "the path of maximum frustration" at major turns. It will be attempted to ensure that as few as possible are allowed to benefit from another leg down in the stock market. And notice how short interest is much lower than it was at this time last year.



It can also be seen that there remains higher levels of short interest in financials and consumer discretionary stocks. I suppose some may be speculating that back to school sales will be poor. A few positive reports on that front could accompany a final blowoff top and yet more short squeezes.



Below are the hourly charts of the S&P and Nasdaq. You can see the underperformance of the Naz, which typically signifies a fractured and unhealthy market. It should be watched closer than usual for signs of what's to come. Also note here the fairly moderate momentum indicators like Stochastics and RSI, while price remains within spitting distance of their respective highs.




Sticking with the Nasdaq theme for a moment, Jeff Cooper of Minyanville had a great chart showing numerous trendline intersections dating back to 2004. Cooper does a lot of very good time and price work in the school of W.D. Gann. He predicts that a topping process is in the works now and that September will prove troublesome.



China should also be watched for signs of rally exhaustion. A continued drop over there would leave North American markets hard pressed to justify many of their recovery-priced-in valuations.



There is support on the Euro around 140 and again at 138. A cluster of moving averages and trendlines hovers in these areas. Should it break, I'd have enough confidence to say the equity rally is over. Until then, I see it possible that we continue higher.



The same could be said for the British Pound and the Canadian Dollar.




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.

What Does Depression In The 21st Century Look Like?

There are many powerful misconceptions that need to be addressed about our past in order for us to gain a better understanding of the present. Looking back at the roots of "conservative" and "liberal" ideology would be one. Addressing the people and motives that were behind the creation of our current monetary system is another. But appreciating what the Great Depression was, what it meant and what it looked like is something that seems to be shrouded in hyperbole and sensationalism, giving the word "depression" such a mythological undertone as to almost make it meaningless.

When I suggest that we are in a "depression" now - or heading toward one - most dismiss the notion as "out of touch." "If we're in a depression, where's the dirty people riding on top of trains? Where's the people lining up for a day's work? How come when I go to Walmart, it's packed full of shoppers? Why does everyone still have a car?"

The above questions show an ungraceful ignorance of basic economic realities involving wealth, money, debt, productivity, education and many other components of an economy that naturally fluctuate - but even more so in times like now.

The mythology of the Great Depression likely started for most in school. I remember being taught about all of the daily necessities that people had to do without, the unemployment lines, food stamps, the dust bowl and the desperation it caused in eagerly joining up for the ensuing war. To get an idea of what children learn about the Great Depression today, one can take a look at Mrs. Winfield's Grade 6 Website.

I remember the same picture of Florence Owens Thompson being shown to me as representative of daily life in the 30's - as well as ones of bread lines and soup kitchens.



While not factually incorrect, summaries like Mrs. Winfield's are terribly misleading. Leaving out major causes leading up to the '29 crash and painting pictures of total destitution for nearly everybody.

It seems that today, the word "depression" is more representative of what happened in the 30's, rather than being representative of a general economic phenomenon. So when it is attempted to be applied to today's world it is dismissed as impossible. While the 30's repeating themselves verbatim is impossible. An economic depression is not.

I suppose another way of describing this misconception is through the mainstream lack of differentiation between money, credit and wealth in general. I've outlined my position as to credit being more important than the money supply in terms of the inflation/deflation question. So I will not dwell on that here. But another powerful misunderstanding seems to revolve around definitions of money and wealth.

It is assumed that if we were to have a depression, all of our wealth would disappear. Hyperbolic statements are made in the media that, "the doomsayers think we're going back to the stoneage." Being a stock market bear would probably qualify me as a "doomsayer," but to imply that a major correction in the stock market is equal to the loss of our technological advancement is just plain silly. Let's explore this further.

Wealth is cumulative in nature. Another word for it is capital. Essentially, it is something that is used to produce something else. In contrast consumer goods are things that capital can produce with various amounts of labour providing assistance. What is capital to some people may be consumer goods to others. For example, raw materials are capital goods for the toolmaker. Whereas the tools are capital goods for the homebuilder. And the home is a capital good for the landlord. The renter of the home consumes what it can produce - shelter.

So if a depression were to ensue thereafter, bankrupting all of the above, it does not follow that all of the capital goods disappear and become completely unproductive. They remain. And although their value may fall relative to whatever metric is commonly used, and while their ownership may be transfered, they are sill capital goods.

This may seem self-evident to many. But if arguments about the impossibility of depression are broken down, they violate these basic economic principles. Depression is a relative term. It is used to describe a dramatic drop in economic activity, a transfer of capital goods from the incompetent to the competent and typically a reduction in debt levels via bankruptcies.

People have become progressively wealthier over the last century. Those who nowadays are considered to be impoverished, have access to luxuries that only the wealthy elite did decades ago. This can be illustrated by the chart below which plots US GDP per person, adjusted for inflation since 1929. (courtesy Econompic Data)



It does not matter how bearish one is. Even a substantial decline in the above metric would only make people feel as "poor" as they felt in the 90s. Of course, the problem with dealing in aggregates is that some people are hit harder than others. But because the nature of a depression is to depress the values of capital goods and force liquidations of those who have made malinvestments, it is typically the already wealthy who are hit the hardest in relative terms. This happened in the 30's and will likely happen again - no matter how much it is resisted by central banks and politicians. Evidence of that can be seen below:


(note: the above chart only goes to 2006)

The wealth of all has a tendency to grow over time. But the wealth of the elite tends to grow even faster during highly inflationary periods - and decline during periods of deflation (remember: inflation/deflation are changes in the supply of money and credit, not prices).

Again, the point of this is to paint a realistic picture of what a deflationary depression would do to our wealth. We would still have all the technological advancements of the 20th century. We would still have all of the productive capacity used to provide it. We would still have an able workforce, etc, etc. It is true that there is a depreciative factor in all of these things, which is the basis for the immediate liquidationist argument - the faster this happens, the less depreciation is experienced while under incompetent management. But it is clear that the hyperbole of "living in caves" is baseless fear mongering. (Ironically, it is people like myself accused of doing the fear mongering). But I digress.

The final argument I would like to touch on that dispels the depression impossibility argument has to do with debt and its impact on economic activity. Because we live in a credit based monetary system, the influence that credit expansion has on GDP is sometimes quite substantial. It has the effect of pulling forward future demand to the present. That is, people who would normally need to save prior to consuming something can borrow money and instead do it sooner. Karl Denninger of the Market Ticker Blog had some good comments along these lines that I will more or less echo here, starting with the chart below of total private debt outstanding.



As the chart above shows, there was very little growth in credit relative to the size of the economy prior to 1981. For all intents and purposes, we can consider that most post war economic growth was legitimate. Since then, private debt outstanding has gone parabolic. In 1981, with the GDP around $3 Trillion, total private debt outstanding was around $4.5 Trillion. After Q1 of 2009, with GDP around $14 Trillion, total private debt outstanding sits around $50 Trillion - an increase of about $45 Trillion. The total cumulative GDP since '81 is $218 Trillion. 45/218 = ~20%.

20% of US economic growth since 1981 has been based on credit expansion. More of this occurred in the latter part than did earlier. Unfortunately, none of this includes the many trillions more of government debt - but that is unnecessary for this analysis. It is enough to consider just private debt (besides, it is spurious at best to conclude that government contributes any growth at all). Of course, it could be argued that we have made technological advancements that allow for a more efficient expansion of credit. To an extent I can see the validity of this. Having computers that are able to keep track of payment, credit records, collateral values and such is definitely less cost prohibitive than attempting to do so with paper record keeping. Lower costs in the provision of credit should enable confidence in a lower rate of interest to persist. But in the inverse it can be said that 2008 made that argument a pile of crap. The truth probably lies somewhere in between.

The implications of this should not be underestimated. If this credit is on the verge of collapse, a significant portion of economic activity, say between 15-25%, could go along with it. To most, this is apocalyptic. Hellfire and brimstone kind of stuff. But to anyone who read the above part of this article, it can be seen in a more realistic light. A drop in 15-25% of US GDP would bring the country back to it's level of activity around (gasp!) 2002-2005.

How much poorer would the average person feel if they were to be relegated to their standard of life 5 years ago? As mentioned before, "the average person" is a bit of a misnomer. There is no such thing. It would mean immediate poverty for people involved in some industries - and no change at all for others. Many would see their standard of living rise as many of their basic necessities would fall in price.

It seems to have been a bit romanticized among many bearish commentators about how a collapse in credit will force a return to frugality and away from conspicuous consumption. But it should be made clear that this frugality is a relative phenomenon. Regular people will not have to do without basic necessities like they did in the 30's. The massive productivity advancements since then have made these goods much more affordable while the accumulated capital we have makes them more plentiful. People will trade down in brands and therefore spend less overall. They will do without the unessentials that were previously only consumed because of easy credit. People will choose smaller dwellings and squeeze more into existing large ones. They will accept lower wages in exchange for fewer hours.

None of this will have an extreme depreciative effect on people's quality of life. We will not lose our existing infrastructure. Life goes on. For some easier than others. A depression in the 21st century is real and probable - if not inevitable.

It would just be nice if we could address our problems rationally without the fear campaign that seems to go along with it.


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.

Midweek Thoughts

I'll again point out some of the better material I have come across this week for the benefit of my readers.

"Andy Dufresne" at the Zero Hedge blog is telling people "Don't Be Bearish The Bonds, Seriously." He makes some good points that I have highlighted before. I believe that the savings rate will be above 15% before we see an actual recovery. The historical average is around 7%, but we visited levels at the low end never seen before earlier this decade (below 1%), and I believe the historical mean will be overshot on the upside as well. Where will all that money go? Toward government securities is the typical spot. Remember how it was seen as outrageous that the US debt was climbing from 7 to 8 trillion just a few years ago? People said that any more of that was going to cause inflation to skyrocket. And it never happened. Now we're at 13 trillion and people keep saying the same. Yields kept going lower as the demand for debt was seemingly insatiable. Some of that was absorbed by foreigners, which, it is true, will at some point stop buying. But that is a smaller percentage of the overall picture than is typically talked about.

People seem to be assuming that the asset allocation tendencies of savers and investors will remain the same as they have for the past 20 years. They assume that people are "underweight equities" but only by looking at 10 or 20 years of data. They forget that people used to allocate significant portions of their savings to government backed term deposits and treasuries. In other words, the past few decades are the anomaly, and the demand for government paper over the past few years is actually a reversion to the mean.

Of course, this is not the way it should be. Government shouldn't be allowed to go into debt at all. But this is the way it is. And as we see in Japan, an increasingly frugal and risk-averse citizen will provide ample demand for guaranteed ROI. The article below outlines this well.

Everybody loves to hate the bonds. “Confetti”, “certificates of confiscation”, “wall paper” are some recent terms used to describe them. I agree, it sounds like a loser's bet to give your money away to that “malfunctioning corporation called America” (Gordon Gekko, correct me if I am misquoting) for a measly 3.75% a year for 10 years. For 30 years the assumptions begin to sound even more ridiculous. But are they really? (Hint: check the 10-year return on an S&P 500 index fund, negative right?)

So why not short them?

We have a deflationary problem, which cannot be simply solved by printing. Let me elaborate. The original “printers” are not Bernanke & Co, but the Japanese, which pioneered quantitative easing in the late 1990s. From the CLSA 1Q review, which was available in the public domain earlier this year on their website for everyone to see:

Obama is sending increasingly explicit signals about the fiscal package he feels necessary to stimulate the US economy. He has also made it clear that he will not be dissuaded by a growing budget deficit. This was already US$436bn or 3.1% of GDP in the fiscal year that ended in September and as Figure 13 shows, net issuance of Treasuries exploded in September and October.



A successful Chinese fiscal stimulus implies a fall in the current account surplus. China’s forex reserve growth is therefore likely to slow further and with it official purchases of Treasuries. Despite this we would be long duration in the US bond market; for most of 2009 we expect 10-year yields to be well below 2%. [They have changed that forecast now given the green shoots, not taking the piss--AD]

Though foreign buying of Treasuries will shrink, US savers will more than make up the gap. The US private savings-investment imbalance is swinging towards savings as households cut discretionary spending and corporate investment falls. The visible expression of this will be the collapse in loan to deposit ratios as bank deposits take a disproportionate share of newly generated savings and ultra-tight lending attitudes and debt repayment shrink loan portfolios. This is not just specific to the US; expect loan to deposit ratios to shrink across all Anglo-Saxon economies.

There are two additional factors that also suggest lower yields. First debt issued to finance the purchase of distressed assets really amounts to a debt swap. The institutions that sell problem assets to the Treasury (or Fed) will be the buyers of the government debt that is necessary to fund the purchase. Second, as we note in Question 9, Bernanke has explicitly included outright purchases of Treasuries as one of the unconventional policies that he will pursue to expand the Fed’s balance sheet. Such outright purchases in Japan contributed to an historic low of 45bp for 10-year Japanese government bonds in June 2003 (Japan’s general government deficit was around 8% of GDP at the time):




The scale of Japanese outright debt purchases was not the only factor that generated sub-1% yields in Japan. The dip in yields came at the end of a long period of private sector deleveraging, sub-1% growth (in 2001 and 2002; 2003 saw GDP growth accelerate) and consumer price deflation. All are present in our US forecast for 2009 and 2010 also.

Now the Fed is winding down purchases of Treasuries, because it has averted the crisis (TBD I think). Even Roubini is praising Ben, only Nassim Taleb calls them as he sees them (h/t Nassim). Whatever you do, don't short the bonds by digging your heels in. An idiot that I worked for last year did it 5 times in a row and five times lost money. A bond short is OK for a (well-timed!) trade; the late Benet Sedacca nailed them back in December. But if you are looking for the short of the century, that one will have to wait for quite a few years, IMHO (JGBs on a longer scale presented below).

Also from Zero Hedge comes a study of Capital Expenditures (CapEx) by the S&P 500 companies. As I pointed out in my article "Digging Beyond Better Than Expected Earnings," we would need to see significant new investments in future productive goods and services in order to legitimately talk about recovery. This is how the structure of production works - even one based on credit. Costs fall, and the savings are used for reinvestment in new technologies that were previously uneconomic. As this is not happening, my intuition says that we are still in the early stage of liquidation/deleveraging phase and companies are waiting for costs to fall even further and therefore for risk to be reduced even lower before they spend their precious cash resources.

From "Tyler Durden": V-Shaped Revenue Recovery Combined With L-Shaped CapEx Growth

The chart below demonstrates two things: i) the revenue decline in the current quarter indicates no inflection point in revenue pick up, and ii) expectations are for a V-shaped recovery in revenue.



So the logical question is where will all this revenue come from? With massive excess capacity overflowing in the economy, pundits point to inventories, which will be "restocked" in order to increase sales for all these lean and mean companies that continue laying off workers even as the recession progresses. In other words, capex spending should already be picking up, as that is the primary driver of revenue increases down the line: indeed, a simple fact nobody likes to talk about. We shall get back to that in a second.

The other notable fact is that companies which have for the most part shut down the dividend spigot, and are virtually not paying any corporate taxes anymore (hey, if Goldman can get away with it, everyone will be pocketing those NOLs compliments of a horrendous 2008 for a long, long time). So cash should be higher? Presumably. And that cash should be going to paying for capex. At least that is the thinking if one wants to be bullish on revenue increases.

Zero Hedge decided to analyze quaterly revenue and capex trends among S&P 500 companies over the past year, and we also threw in a study of total and net debt, just to get a sense of what the capitalization of these "poised for a recovery" companies looks like.

Here are the results:




Not only has CapEx not been increasing, it continues plunging: both YoY and sequentially. In fact, S&P CapEx likely at maintenance levels on a revenue/capex basis: not one company is interested in investing in revenue growth projects. Which makes sense: if you have a horde of cash and no clue what your access to debt will be like, any IRR on new CapEx projects can be thrown out of the window before it is even started. Forget the revenue V-recovery: companies will be lucky to preserve revenues where they are, let alone grow them in the future. Alas, what the MSM forgets is that you need investment in expansion opportunities to grow the topline - SG&A trimming can only take you so far, and with decimated and unmotivated work forces, good luck growing organically in this oversupplied economy.

click the link above to read the rest of the article

Elsewhere, Michael Panzner believes we are About To Get Blindsided Again. The multi-trillion dollar mistake that was (and still is) Fannie Mae and Freddie Mac apparently did not teach any lessons. The FHA (Federal Home Administration) and Ginnie Mae (their partner), have been attempting to pick up the slack in "less than good" mortgage underwriting practices. While the private lenders have figured out that it is not so wise to give mortgages to people with very little skin in the game and suspect ability to pay, government based lenders are a little slow (as always) to adjust their practices. The result? Hundreds of billions of dollars in new loans that are, for all intents and purposes, subprime. You can put this in your folder of "problems to come" - if there's still room.

The article that Panzner points out is from the Wall Street Journal:

Ginnie Mae and FHA are becoming $1 trillion subprime guarantors.

Much to their dismay, Americans learned last year that they “owned” Fannie Mae and Freddie Mac. Well, meet their cousin, Ginnie Mae or the Government National Mortgage Association, which will soon join them as a trillion-dollar packager of subprime mortgages. Taxpayers own Ginnie too.

Only last week, Ginnie announced that it issued a monthly record of $43 billion in mortgage-backed securities in June. Ginnie Mae President Joseph Murin sounded almost giddy as he cheered this “phenomenal growth.” Ginnie Mae’s mortgage exposure is expected to top $1 trillion by the end of next year—or far more than double the dollar amount of 2007. (See the nearby table.) Earlier this summer, Reuters quoted Anthony Medici of the Housing Department’s Inspector General’s office as saying, “Who would have predicted that Ginnie Mae and Fannie Mae would have swapped positions” in loan volume?

Ginnie’s mission is to bundle, guarantee and then sell mortgages insured by the Federal Housing Administration, which is Uncle Sam’s home mortgage shop. Ginnie’s growth is a by-product of the FHA’s spectacular growth. The FHA now insures $560 billion of mortgages—quadruple the amount in 2006. Among the FHA, Ginnie, Fannie and Freddie, nearly nine of every 10 new mortgages in America now carry a federal taxpayer guarantee.

Herein lies the problem. The FHA’s standard insurance program today is notoriously lax. It backs low downpayment loans, to buyers who often have below-average to poor credit ratings, and with almost no oversight to protect against fraud. Sound familiar? This is called subprime lending—the same financial roulette that busted Fannie, Freddie and large mortgage houses like Countrywide Financial.

On June 18, HUD’s Inspector General issued a scathing report on the FHA’s lax insurance practices. It found that the FHA’s default rate has grown to 7%, which is about double the level considered safe and sound for lenders, and that 13% of these loans are delinquent by more than 30 days. The FHA’s reserve fund was found to have fallen in half, to 3% from 6.4% in 2007—meaning it now has a 33 to 1 leverage ratio, which is into Bear Stearns territory. The IG says the FHA may need a “Congressional appropriation intervention to make up the shortfall.”

The IG also fears that the recent “surge in FHA loans is likely to overtax the oversight resources of the FHA, making careful and comprehensive lender monitoring difficult.” And it warned that the growth in FHA mortgage volume could make the program “vulnerable to exploitation by fraud schemes . . . that undercut the integrity of the program.” The 19-page IG report includes a horror show of recent fraud cases.

If housing values continue to slide and 10% of FHA loans end up in default, taxpayers will be on the hook for another $50 to $60 billion of mortgage losses. Only last week, Taylor Bean, the FHA’s third largest mortgage originator in June with $17 billion in loans this year, announced it is terminating operations after the FHA barred the mortgage lender from participating in its insurance program. The feds alleged that Taylor Bean had “misrepresented” its relationship with an auditor and had “irregular transactions that raised concerns of fraud.”

Is anyone on Capitol Hill or the White House paying attention? Evidently not, because on both sides of Pennsylvania Avenue policy makers are busy giving the FHA even more business while easing its already loosy-goosy underwriting standards. A few weeks ago a House committee approved legislation to keep the FHA’s loan limit in high-income states like California at $729,750. We wonder how many first-time home buyers purchase a $725,000 home. The Members must have missed the IG’s warning that higher loan limits may mean “much greater losses by FHA” and will make fraudsters “much more attracted to the product.”

In the wake of the mortgage meltdown, most private lenders have reverted to the traditional down payment rule of 10% or 20%. Housing experts agree that a high down payment is the best protection against default and foreclosure because it means the owner has something to lose by walking away. Meanwhile, at the FHA, the down payment requirement remains a mere 3.5%. Other policies—such as allowing the buyer to finance closing costs and use the homebuyer tax credit to cover costs—can drive the down payment to below 2%.

Then there is the booming refinancing program that Congress has approved to move into the FHA hundreds of thousands of borrowers who can’t pay their mortgage, including many with subprime and other exotic loans. HUD just announced that starting this week the FHA will refinance troubled mortgages by reducing up to 30% of the principal under the Home Affordable Modification Program. This program is intended to reduce foreclosures, but someone has to pick up the multibillion-dollar cost of the 30% loan forgiveness. That will be taxpayers.

In some cases, these owners are so overdue in their payments, and housing prices have fallen so dramatically, that the borrowers have a negative 25% equity in the home and they are still eligible for an FHA refi. We also know from other government and private loan modification programs that a borrower who has defaulted on the mortgage once is at very high risk (25%-50%) of defaulting again.

All of which means that the FHA and Ginnie Mae could well be the next Fannie and Freddie. While Fan and Fred carried “implicit” federal guarantees, the FHA and Ginnie carry the explicit full faith and credit of the U.S. government.

We’ve long argued that Congress has a fiduciary duty to secure the safety and soundness of FHA through common sense reforms. Eliminate the 100% guarantee on FHA loans, so lenders have a greater financial incentive to insure the soundness of the loan; adopt the private sector convention of a 10% down payment, which would reduce foreclosures; and stop putting subprime loans that should have never been made in the first place on the federal balance sheet.

The housing lobby, which gets rich off FHA insurance, has long blocked these due-diligence reforms, saying there’s no threat to taxpayers. That’s what they also said about Fan and Fred—$400 billion ago.

And lastly, Jonothan Weil continues his good work for Bloomberg in his op-ed piece today: The Next Bubble To Burst Is Banks' Big Loan Values. For the life of me, I cannot figure out how people are surprised by this. It is a well known fact that banks have been massively overvaluing the assets on their books. Bank shares and optimism on the financial sector have been rising in spite of this information. Almost any analyst with credibility left knows full well that a good portion of the big banks are technically insolvent. But most economists provide economic recovery models that will eventually turn these books positive and therefore make it a non-issue. Their models suggest home prices will stop falling, unemployment will not exceed 11%, and that GDP will return to "trend growth" by the end of the year or sometime in 2010. As such, some of the assets currently showed as impaired will turn positive, and there will be very few new additions to the "loss" category. Take away these baseless assumptions about the future and it is plain as day that these banks are insolvent by a large margin.

Weil reports:

Aug. 13 (Bloomberg) -- It’s amazing what a little sunshine can accomplish.

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”

While disclosures of this sort aren’t new, their frequency is. This summer’s round of interim financial reports marked the first time U.S. companies had to publish the fair market values of all their financial instruments on a quarterly basis. Before, such disclosures had been required only annually under the Financial Accounting Standards Board’s rules.

The timing of the revelations is uncanny. Last month, in a move that has the banking lobby fuming, the FASB said it would proceed with a plan to expand the use of fair-value accounting for financial instruments. In short, all financial assets and most financial liabilities would have to be recorded at market values on the balance sheet each quarter, although not all fluctuations in their values would count in net income. A formal proposal could be released by year’s end.

Recognizing Loan Losses

The biggest change would be to the treatment of loans. The FASB’s current rules let lenders carry most of the loans on their books at historical cost, by labeling them as held-to- maturity or held-for-investment. Generally, this means loan losses get recognized only when management deems them probable, which may be long after they are foreseeable. Using fair-value accounting would speed up the recognition of loan losses, resulting in lower earnings and reduced book values.

While Regions may be an extreme example of inflated loan values, it’s not unique. Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said. The difference represented 58 percent of the company’s Tier 1 common equity, a measure of capital used by regulators that excludes preferred stock and many intangible assets, such as goodwill accumulated through acquisitions of other companies.

Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bank’s Tier 1 common equity, by comparison, was $47.1 billion.

Widening Gaps

The disparities in those banks’ loan values grew as the year progressed. Bank of America said the fair-value gap in its loans was $44.6 billion as of Dec. 31. Wells Fargo’s was just $14.2 billion at the end of 2008, less than half what it was six months later. At Regions, it had been $13.2 billion.

Other lenders with large divergences in their loan values included SunTrust Banks Inc. It showed a $13.6 billion gap as of June 30, which exceeded its $11.1 billion of Tier 1 common equity. KeyCorp said its loans were worth $8.6 billion less than their book value; its Tier 1 common was just $7.1 billion.

When a loan’s market value falls, it might be that the lender would charge higher borrowing costs for the same loan today. It also could be that outsiders perceive a greater chance of default than management is assuming. Perhaps the underlying collateral has collapsed in value, even if the borrower hasn’t missed a payment.

The trend in banks’ loan values is not uniform. Twelve of the 24 companies in the KBW Bank Index, including Citigroup Inc., said their loans’ fair values were within 1 percent of their carrying amounts, more or less. Citigroup said the fair value of its loans was $601.3 billion, just $1.3 billion less than their book value. The gap had been $18.2 billion at the end of 2008.

Covering Liabilities

History provides some lessons here. A common problem at savings-and-loans that failed during the 1980s was that they relied on short-term funding at market rates to finance their operations, which consisted mainly of issuing long-term, fixed- rate mortgages. When rates rose sharply, the thrifts fell in a trap where their assets weren’t generating sufficient returns to cover their liabilities.

The accounting rules also left open the opportunity for gains-trading, whereby companies post profits by selling their winners and keeping losers on the books at their old, inflated values. Had the thrifts been marking loans to market values on their balance sheets, their troubles would have been clearer to outsiders much sooner. (The FASB didn’t require annual fair- value footnote disclosures until 1993.)

Arbitrary Accounting

If nothing else, today’s fair-value gaps highlight the arbitrariness of book values and regulatory capital. Banks already have the option to carry loans at fair value under the accounting rules. For the vast majority of loans, most banks elect not to, on the grounds that they intend to keep them until maturity and hope the cash rolls in.

Consequently, the difference between being well capitalized and woefully undercapitalized may come down to nothing more than some highly paid chief executive’s state of mind.

Fair-value estimates in the short-term can be a poor indicator of an asset’s eventual worth, especially when markets aren’t functioning smoothly. The problem with relying on management’s intentions is that they may be even less reliable.

At least now we’re getting some real numbers, even if you have to dig through the footnotes to get them.

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.

Sobering Words From Bob Prechter

Robert Prechter of Elliott Wave International and the leading proponent of Socionomics (social mood determines events, rather than the other way around) has been, in my mind, one of the only analysts/pundits/economists out there who has legitimately called both the deflationary credit crisis and the ensuing rally that we are in now. His unique method tracks the stock market as a barometer of social mood which patterns itself in distinct formations representing fear and greed. Very few others are willing to subscribe to his theories and quite understandably so. They imply that human nature leaves us with very little to determine on our own. More accurately: the character of society and the economy are preordained, but the exact events that result are not.

Similar parallels can be drawn with generational theories put forward by Neil Howe and William Strauss and continued by John Xenakis. These suggest that generational archetypal characteristics are defined and develop based on the environment they have been raised in, which itself moves in predictable cycles making future socioeconomic shifts an inevitability.

The two separate theories are not entirely compatible, but they share more similarities than they do differences, the primary one being that there is very little any person, leader or government can do to alter the broad course of the future. Both theories can say, for example, that society in general is more likely to embrace a fanatical leader at certain times than others; that society in general is more likely to reject international cooperation, free trade, high taxes, social programs, etc at certain points in their cycles; that women in general will be more inclined to dress and act conservatively, bear children, etc after experiencing certain types of events earlier in their lives. Neither theory can say, however, what they will wear, or what level of taxation will be acceptable, or what kind of fanatical leader will be embraced.

I subscribe to both of these theories because they appear to have a far better record in predicting broad changes in the economy, and therefore make investing decisions much easier. I admit that they are disturbing in a way. As a person who has studied economics at a theoretical level, and believe that certain policies and social structures will prove to be more beneficial than others, it is difficult to reconcile that no matter what path we choose to take, there will always be social and economic cycles and the undesirable consequences inherent in them. Then again, I remember a wise man advising that the ability to hold two opposing views simultaneously is somehow virtuous. But I digress...

The reason I believe that Prechter has been nailing the tops and bottoms of the last few years is because of his contrary position as to the causal nature of social and economic events. That's not to say he can't be wrong. He has, in fact, been very wrong in the past, thinking that the '87 crash was going to mark the same kind of top he thinks we have made in '07. But to me, an extra 20 years of experience and time to further develop his method makes his opinion more worth listening to, not less. He does not seem to make media appearances discussing his directional calls unless the wave pattern is very compelling.

This week he made an appearance on Yahoo's Tech Ticker. The four short videos can be found below in no particular order (thanks to reader Mike for the heads up):









Prechter does hedge with the "corrective waves are complex" line, so I would be cautious to start shorting anything very aggressively. The markets seem to be hitting their maximum upside targets before retracing to their minimum targets, which is still a sign of strength and deserving of respect. Bob mentions extremely positive sentiment on equities (93% bulls) which, of course, could turn into 95% or 98% just as easily with another final rally toward S&P 1100/Dow 10000.

Prechter would say that the purpose of this rally is to "convince as many people as possible that the worst is over." John Xenakis has something he calls "The Principle of Maximum Ruin," where the most people possible are made to suffer the greatest losses possible. And as a trader/investor, I am most definitely familiar with "The Path of Maximum Frustration," where markets will tend to go just far enough to convince you that you've erred before turning around.

We saw this kind of activity from 2005-2007, when real estate had already rolled over, subprime mortgages were blowing up and debts were mounting even higher. All the while the market continued to march higher and all everybody cared about was the next big merger, or how many decades the cinderella economy/great moderation would last. In August of 2007, everything the bears had been talking about for decades started to matter and the markets dropped - only to frustrate as many of them (myself included) to the furthest extent possibe by rallying to new highs 3 months later.

We also saw the same type of activity in late 2008. With the market dropping more than 50% and then rebounding over 27%, the bulls were celebrating a successful recovery and analogies to 1987 were flying all over the place. Months later, the markets collapsed again, methodically eliminating any bullish sentiment before embarking on the largest rally over a 5 month period in 8 decades. The same pattern is at work. But there are limited ways to gauge the extent without the benefit of hindsight.

Because I do believe in the "corrective" nature of this rally, it has always been a very risky proposition for me to justify much long side exposure. It is difficult to see it continue higher without participating much. I bought some November calls in AIG a few weeks ago which appears to be working (that can change fast with such volatility), and I am still holding my LEAP puts on the S&P. Mastering the emotions of such volatile times is no easy proposition, which is why I think both Socionomic and Generational patterns are more important than ever. They seem to provide the only believable explanation of such volatility and are, in my opinion, very likely to be proven correct over the coming years.

I don't often "do" advice in this space, but I think caution is the best course at this time. Pressing short side bets could prove disastrous if done too soon. And chasing the long side can eat into precious capital when inevitably done right at the top.


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