Monthly Archives: August 2009

The “other side” of the deflation trade

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Graphite here. I remain an ardent deflationist and continue to see strong risks of a continued collapse in asset values in world real estate and equity markets. That said, one key practice in speculation, no matter how strong one’s conviction in a particular trade, is to understand the other side of that trade and how the market could move against your position.

This can sometimes present a challenge for deflationists because so much of the opposing camp is composed of die-hard Panglossian buy-and-holders betting on a V-shaped recovery, rounded out with a few gold bugs who present little or no argument other than that the Bernanke Fed will embark on a suicidal campaign of massive money printing.

Although Marc Faber has issued calls for hyperinflation before, the discussion in the video below represents a much more measured discussion of a serious alternative to the near-term bearish case for stocks and the economy:

“My sense is that — here I’m talking about the economy — that the economy, near term, can recover, and maybe the recovery will be somewhat lengthier than expected a crack-up boom, because the first stimulus package in the U.S. probably will be followed by a second one, and money printing will lead to even more money printing next year. So it can last, say, 12 to 18 months, and then we will get another set of problems ….”

Faber goes on to recommend buying financial stocks, on the expectation that the banks will continue to get free money from the government and parlay that largess into significant profits. His long-term view remains as bearish as ever, but he presents an important alternative perspective on how soon the economic calamity will arrive and what form it will take.

That said, I think Faber is wrong that the market will continue to enthusiastically take up the Fed’s offers of liquidity and use them to fuel speculation for very much longer. No one is laboring under the delusion that the garbage stocks like AIG, FNM, and FRE which have led this last leg upward are worth anything more than zero — and while from a contrarian perspective that could indicate that there is room remaining for investors to develop an even more desperate belief in a new bull market, I think it is much more likely a manifestation of the new trend toward skepticism which will come to permeate the entire market as the bear runs its course.

Whatever your perspective, it’s always fun to see Marc Faber’s characteristic chuckle at the suggestion that our wise overseers will competently steer us through the crisis.

That should about do it.

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We haven’t seen this kind of bullishness on stocks since 2007. Pullbacks at every degree since the March lows have been shallow.  Volume and implied volatility have dwindled, and this month the put/call ratio has plunged while trader sentiment surveys have shot through the roof and levitated for three weeks. Tim Knight noted today that he had never seen the comment board on his blog so bullish, and those are hard-core bears. Dollar bearishness remains very high, while new lows have not been forthcoming. Treasury bonds are firm, having rallied off extremely low sentiment. China’s wave 2 bubble has apparently started to burst. Mortgage delinquencies and foreclosures are rising. The FDIC just became technically bankrupt. Bernanke is basking in his “success.”

Any further gains are going to be borrowed at steep interest, and we shouldn’t have to wait much longer for some fireworks.

Here’s the 5-day put/call vs. the S&P:

Indexindicators.com

Here’s the 20-day average and 3-year view:

That great economist, Ben S. Bernanke

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For your amusement, here’s Bernanke a couple of years ago doing his best to downplay our problems:

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To the dismay of many a fair-minded observer, Bernanke the Fool has been nominated for another term as Fed chairman. My comment is, so long as there is a Fed, who cares who runs it? The chairman, like the US President, is nothing but a figurehead. He provides lip service for policies that exclusively benefit the cartel of big banks.  Thus it has been since the Morgan, Schiff, Warburg and Rockefeller syndicates conspired in 1913 to draft the Federal Reserve Act and ram it through Congress two days before Christmas.

I’m a little bit surprised that Bernanke was nominated again, since there is such low public opinion towards him and his employer. I thought that he might be thrown to the dogs to satisfy the public’s urge for ‘change,’ but I guess the logic is that by keeping him on they can better preserve the fiction that the Fed saved the world. He is also very lucky that the nomination schedule coincided with the likely peak in Wave 2 sentiment (2nd waves are characterized by the near consensus that the old trend is back to stay, in this case, the Great American Bull Market).

Along the same line, I’m also surprised that the campaign to audit the Fed hasn’t found more support from the White House, since it would be the perfect PR opportunity for them to pretend that they were independent of the bankers. I half expect to see the audit happen, with the results decided in advance of course, something akin to past Congressional “investigations.” Maybe they will have to do something like this once mood sours again with the next wave of foreclosures, bank failures and panic selling in the markets.

The real campaign should be to end the Fed, not audit it. We already know what it does, and they are actually surprisingly transparent for such a sinister institution. It’s all right there on their website.

In praise of bank runs, the only regulator we need

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Graphite here. Mike has asked me to join up as a guest blogger, and since I’ve always loved the spirited mix of finance, politics, and righteous anger of The Sovereign Speculator, I’m happy to come aboard.

If you needed another sign that this deflationary crash is just getting started, take a look at this blog post over at The Baseline Scenario. It’s stunning that in August 2009, with the FDIC in a state of de facto bankruptcy, anyone can write “the FDIC works” with a straight face. Just because it’s not the kind of horrible fascist “solution” that the current pack of knaves in Washington would pursue, doesn’t mean it’s some kind of brilliant idea.

The FDIC’s explicit purpose is to bail out imprudent depositors at the expense of prudent ones. If it wasn’t for the FDIC, all those people strutting into Corus’s Chicago branches to put their money in CDs yielding 0.25% more than the competition might have been just a little bit more concerned that it was going to fund condo development projects in Florida. Instead, they got a free lunch — why look at where your money’s going when Uncle Sucker (sorry, Sam) gets to eat the losses?

The idea that the FDIC “self funds” out of the banking system is nothing but a polite fiction. It has nearly always had to rely on taxpayer bailouts when resolving banking crises. Meanwhile, the banks that stayed prudent, made reasonable loans, and kept their reserve deposits in more liquid holdings are being slammed with huge assessments and fees, which are preventing them from recapitalizing themselves or offering better rates to their customers — in effect, spreading the stress and weakness of America’s worst banks to its best ones.

Yeah, this is a great solution to the problem of bank runs. Let’s see what happens when we really do get a full banking panic and the FDIC needs to go draw on its $500 billion line of credit with the Treasury. If you think that story ends with American depositors happily riding off into the sunset with their cash, I’d love to have some of whatever you’re smoking.

People talk about bank runs as though they’re some kind of unmitigated evil, just because some people lose money. As a matter of fact, they impose discipline and order on both banks and depositors, and ensure that the banking system as a whole remains diverse and resilient to major shocks. The moral hazard created by the FDIC was one of the most important drivers of the concentration of deposits at a few mega-banks, which (all carping about the “unregulated shadow banking system” notwithstanding) were the primary source of the awful lending binge which precipitated the credit crisis.

Look for a bottom after people finally start to dismiss, ignore, and ridicule the FDIC and its absurd apologists.

Summer school

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There are still a lot of people out there who didn’t absorb last year’s course on the credit cycle, particularly the chapter on inflation and deflation. To remedy this gap in your elementary economic education, before buying resource stocks or saying that any market will go to the moon on Fed-powered rockets, you are required to read this refresher by Mish Shedlock. An except is below:

…there are practical as well as real constraints on what the Fed can and will do. Nearly everyone ignores those constraints in their analysis.

Congress in theory and practice can give away money. Indeed, Congress even does that to a certain extent. Extensions to unemployment insurance, increases in food stamps, and cash for clunkers are prime examples.

However, those are a drop in the bucket compared to the total amount of credit that is blowing up. Take a look at the charts in Fiat World Mathematical Model if you need proof.

The key point is it is the difference between Fed printing and the destruction of credit that matters! As long as credit marked to market blows up faster than handouts and monetary printing increase we will be in deflation. Deflation will not last forever, but it can last a lot longer than most think.

Also ponder this missive from the dean of Deflation U, Robert Prechter:

“The Fed’s balance sheet ballooned from $900 billion just five months ago to more than $2 trillion, by buying outright, or swapping the pristine credit of U.S. Treasury debt for the questionable paper held by troubled banks, brokerages and insurance companies. One of the marketplace’s most strongly held beliefs is that the U.S. dollar is on the verge of an imminent collapse and gold is set to soar because of the Fed’s historic and irresponsible balance sheet expansion… We agree about the irresponsible part, but not about the near-term direction of the dollar and gold. Our forecast is being borne out by the dollar, which has soared straight through the Fed’s most aggressive expansion to date. Just as Conquer the Crash forecasted, the Fed is fighting deflation but, as the book says, ‘Deflation will win, at least initially.’ The reason is that there are way more debt dollars than cash dollars, with about $52 trillion currently in total market credit. As this enormous mountain of debt implodes, it is swamping all efforts to inflate. Of course, the Fed has explicitly stated that it will keep trying. Its initial effort was akin to trying to fill Lake Superior with a garden hose. But $2 trillion still won’t do the trick of stemming a contracting pool of $52 trillion. The only real effect is that taxpayers get hosed. Obviously not all of the $52 trillion is compromised debt, but the collateral underlying this mammoth pool of IOUs is decreasing in value, placing downward pricing pressure on the value of related debt, which won’t show up in the Federal Reserve figures for many months. A reduction in the aggregate value of dollar-denominated debt is deflation, which is now occurring. Eventually the value of credit will contract to a point where it can be sustained by new production. At that point, the U.S. dollar may indeed collapse, as gold soars under the weight of the Fed’s bailout machinations. But deflation must run its course first. In our opinion, it has a long way to go…”

Also consider an oldie from yours truly  (Some Basic Points on Inflation and Deflation):

#1 The business cycle is the credit cycle.

#2 Inflation is a net increase in money and credit, not just prices (mainstream opinion) and not just money (common misconception among contrarians).

#3 Deflation is a net decrease in money and credit.

#4 There cannot be both inflation and deflation at once.

#5 The central bank and the government bring about inflation by absolving banks of the responsibility for their actions. 9:1 fractional reserve lending would not be rewarded in a free market devoid of FDIC insurance and a central bank to print the money to pay for it and other bailouts for bankers.

#6 Price increases themselves are not inflation. If you have a fixed expense budget and your grocery and energy bill goes from $500 to $700, you must cut back $200 somewhere else (for instance, many are deciding to forgo eating out).

For points 7-11, click here

Also see, Why Bailouts will Not Stop the Depression

Still rolling over?

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At the moment, everything is still up in the air, so to speak. The rollover into the sub-950 range is still on the table, since a bounce like the last 24 hours on weak internals (such as an advance:decline ratio of well under 2:1) should surprise no one. Despite the lack of oomph here, it is still possible we drift to new highs. I’m sticking with a bearish stance until we see some more strength and breadth on the upside. A sharp drop to fresh lows in late US trading today or tomorrow would not surprise me, and this chart provides a nice stop in case that does not pan out:

Interactive Brokers

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Meanwhile, the zig-zag action in the dollar since Monday looks corrective, maybe a wave 2. Sentiment remains highly bearish on the dollar in the face of a pretty sharp rally. Silver completed a brutal $1.70 drop over 5 days, but everyone still loves it. Oil is conspicuously not making new highs here with that storm out there. Nice short set-up there, since you’ve got a ready-made stop just above these levels.

Copper also seems to be losing its mojo, and is potentially on the verge of a very sharp fall after this sideways correction. Also a nice stop there. Did you read about how pig farmers and other Chinese are taking out bank loans to stockpile tons of the stuff? Now if that isn’t a productive use of credit, I don’t know what is.

Credit spreads (junk vs. quality and corporate vs. Treasury) continued to widen yesterday, further undercutting the integrity of the bounce in equities.

What should worry the bears a bit is the oversold condition in Chinese equities, down 20% from their peak a few weeks ago. But then India’s bubble is just as big and they’ve not dropped nearly as much.

Safest route here is to short with a tight stop or sit in cash. Longs are just tempting fate.

Hugh Hendry walks around China

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Hendry is the founder of Eclectica Asset Management.

“Who is going to pay the debt that that building is resting on? …A building with no tennants. Half a billion dollars of someone else’s liabilities.”

“…very expensive, empty building where the developer went bust.”

“I haven’t seen any sign of a manufacturing base anywhere close to here.”

Barf O’Rama

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Bloomberg’s Tom “Tuxedo & Bowtie” Keene recently provided a 10-minute forum for Abby Joseph Cohen, Senior Investment Strategist at Goldman, to drone on about how the “recession is ending right now,”  “consumer growth will be increasing,” and how she expects “profit growth,” etc, etc.

There was no mention of Ms. Cohen’s 1600+ call for the S&P made in early 2008, nor of course her continuous bottom calling in the wake of the dot-com bubble that she helped promote. No mention of P/E ratios, dividend yields, book values, debt loads, nothing. Just an opportunity for her to lecture the audience about the importance of longer term investment horizons. Mr. Keene even asked for questions from the audience and surely ignored a few from skeptics: we just love to have you on the show, he said, but “boy do we get the hate mail.” You don’t say! Why GS still keeps this dog in the house is beyond me.

Now, I know all you Prechter skeptics out there will come out and say I’m using a double standard, but that is not the case. This Goldman “strategist” offers her advice explicitly to retail investors, and continually urges them to buy the stock market, no matter what. She has never said anything else. Mr. Prechter’s services are intended for more sophisticated speculators and institutions, and he has shied away from offering advice to amateurs, other than admonishing them to stay in “the safest cash equivalents” ever since the bubble got rolling. Taking this advice would have saved most people lot of money and heartache over the last 10 years (admittedly, overeager shorts included).

Furthermore, when you read Prechter, you always learn something. Market history, valuations, and the mechanics of money and credit are explained with facts and figures. You can judge them for yourself. Cohen can’t be bothered to mention a single number, other than her expectations for 3% GDP growth. This interview, meant for everyday people driving to work in the morning, reflects absolutely reprehensible behavior from both Goldman and Bloomberg.

Line in the sand

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S&P 500 e-mini futures, including overnight trading, 1-month view, 1-hour bar:

Interactive Brokers

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The story here is that nothing is confirmed yet. The megaphone pattern (expanding upward wedge) hasn’t been busted, so we could still make a new high here, though the strength of such an advance should be weak. Each leg up for the past several weeks has sported weaker internals, such as a lower advance/decline ratio.

Based on internals, sentiment indictors and the action in other asset classes, I think the top was made about 10 days ago, but you never know. Don’t get caught in a bear trap.

By the way, this is what a busted megaphone looks like (Eurostoxx 50, 1 month chart):

Storm rolling in from the East

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Bloomberg.com

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Mainland China was hit the hardest, down 6% today and 12% in a week:

Yahoo!

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The deflation trade is on again. Commodities are down, bonds are up big, and the dollar and yen are up. Here are those two scripts vs. the euro, pound and Aussie:

Yahoo!

Funny how you can’t tell the difference between the euro/yen, Aussie/yen, pound/dollar, euro/dollar and Aussie/dollar. Throw some global stock indexes and Treasury bond yields in there and they’d blend right in, too, and probably even gold and a commodity index.