|
Today's Market WrapUp 09.04.2007 Mon Tue Wed Thu Fri Barbera Archive The Lull and the
Great Inflation-Deflation Debate Stocks continue a post sell-off recovery pattern, with liquidity flows helping to restore more normalized conditions in many areas of the capital markets. Over the last few days, energy prices have moved higher, the Dollar marginally higher, Metals higher, and Bond prices slightly lower. The ‘feel’ of the current market is that of a ‘lull,’ a quiet time, an “Intermission” in the still unfolding multi-act play that is the Credit Contraction of 2007. To be sure, we know it is not over, not by a long shot. Sometimes, at points in time like this, it is very easy to extrapolate the short term stability associated with a temporary lull into a more giddy feeling that everything may soon be over, with things ending up to work out “just fine.” The Muddle Through Mind Set grows during periods of relative calm with active players quickly wondering, “Perhaps the stock market is a good buy after all?”, “Perhaps the DJIA will go back and hit new all time highs?" And “Perhaps it is time to make the plunge back into stocks, or maybe into metals?” Perhaps it is time to do something -- to react to this relative calm -- to re-allocate portfolios in some new fashion to take advantage of this perceived unique window in time. As a fairly active trader myself, I hate periods of time like this, these lulls. It is the conflict of the daily action that entices one to trade, and the larger trend where there is sure to be another shoe to drop. To the impetuous trader, the lull is a time of ‘hope restored’ holding out the promise of a quick return to the days of easy profits; “Come’on, get back in the water, take the plunge, do something" -- beckons the lull. Yet, at times like this, we often find that real patience is the greatest investment asset. To remain idle and watchful is often the most difficult path. Conversely, while it is easy and always “feels good” to leap onto the latest three day trend, taking comfort that things are on the mend, usually periods like this tend to resolve themselves with abrupt psychological changes, a pre-opening event, an overnight catalyst, a mid session disappointment, something unexpected that ends up kick starting the next round of downside trouble. What could that event be? While your guess is probably as good as mine, perhaps the Fed will not move as rapidly as Wall Street hopes to lower interest rates on Sept 18th. An autonomous Fed, seeking more independence from its Wall Street lap dogs, departing from the Fed Funds Futures Expectations and the days of rapid “Greenspanian” mollification, -- what a headache that would be in the making. A market rallying into that time frame and then selling off amid disappointment thereafter -- that could be the beginning of the next serious move lower. Intuitively, I believe we are in a period of great hidden danger, and one of great hidden risk. How so? Well, just look at the Bond Funds for a moment.
We know that at a very core level, the fundamental problems of bad CDO’s burdened with now junk quality Sub-prime, ALT’A and even some Prime Mortgages are still deeply in the red. Certainly, CDO and Sub-Prime pricing remains a disaster. Further, we know that CDO’s are synthetic products made by banks, and priced by banks. CDO’s have no formal market price and change hands in a primarily over-the-counter market. Over the last few weeks, many of these toxic-waste CDO’s have had their pricing frozen, with investors-funds unable to redeem their purchases. Across Wall Street, frozen pricing has allowed banks and brokers time to maintain the former valuation of there CDO holdings, and valuable time during which other assets can be sold in order to raise cash. Presently, the amount of CDO’s outstanding is estimated near One Trillion dollars. If a substantial portion of that One Trillion dollars is now approaching a mark to market phase, then upcoming write-downs in asset pricing could send shock waves through many markets in the weeks and months ahead.
To this point, credit spreads have, in many cases, not eased one bit. This hints that the underlying distrust and lack of confidence seen at the heart of the credit contraction remains. Without question, the underlying distrust harkens back to the kind of deals that were taking place in credit markets only a few months ago. In many cases, lending took place amid a very poor climate of thinly priced credit risk, non-existent escape clauses, interest only teaser rates, and negative amortization clauses. In the days ahead, credit agencies will be forced to downgrade much of this toxic debt, which when re-priced will both negatively impact future availability of credit, while simultaneously forcing current asset holders to disgorge these securities once these fall below minimum credit worthy standards. Because so many of these structured products have been securitized across the entire financial system, we today face the prospect of an interlinking spider web, wherein asset market write downs at SIV’s (Short Term Investment Vehicles), Pension Funds, Mutual Funds, Banks, Hedge Funds, Brokerage Firms, and Money Market Funds can quickly impact counter-party values. In coming weeks and months, the further downside price action in housing prices is also likely to affect loan collateral values, opening up a broad array of things that can go wrong in the CDO, CMO, and CLO crowd. And then of course, there is the US Consumer, who in recent years was content to use housing inflation as a surrogate for a traditional pool of savings. Not only will housing deflation now impact disposable income spending patterns, the downside of Mortgage Equity Withdrawal (MEW), but in some cases, where debt abuse was extreme, Home Equity Loans (HELOC) will also become a burden, especially with so much of the financial economy now handing out pink slips. Already leading Credit Card companies are reluctantly acknowledging a build up in late payments, always a reliable indicator for recession.
Above: the 2-year, 5-year Curve (top) is steepening, a sure fire indication of a slowing economy to be followed as it always has been, by surging increases in Initial Claims (lower clip). The Financial Economy is increasing lay offs by the day, and this, along with Housing, has been the great job creator for the US Economy these last few years. We know there are those who say the Fed will print money and bail out the system, and while it may seem as though the Fed has unlimited power, in truth, the present situation is one in which the Fed will very likely remain quite the hostage to outside variables. Chief among these outside variables is the potential tidal wave of external foreign debts that could find its way back home to the USA, and in so doing, demolish the purchasing power of the US Dollar. We are on guard, as the consensus view probably needs a major re-think at the current time. In our view, not only is the US Economy now heading into a recession (see Fords latest report on Auto Sales), but in this instance, the signs of weakening economic armor will likely result in higher, not lower, long term rates.
|
