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Today's Market WrapUp 09.30.2008 Mon Tue Wed Thu Fri Barbera Archive Financial Upheaval & the Ring of Fire For the last two weeks most Americans have been mesmerized by the financial train wreck unfolding before our very eyes. We have witnessed major banks like Wachovia, Washington Mutual and other (FNM, FRE, AIG, Lehman, Merrill Lynch) financial institutions collapsing on a nearly day-to-day basis. We have watched in hope that somehow Washington could ride to the rescue and help slow down the pace of this collapse, possibly limiting its impact on those of us who are forced to work hard and who have no golden parachute “downside protection” should we fail in our daily work. In retrospect, it is abundantly clear that the initial Paulson bill was a disaster -- that it did not have much chance at success even if rapidly passed. Importantly, there has been for most of us, a set of dual concerns at work during this time. On the one hand, there is the ideological concern to see something unfold that is “right for the country” and aids the broad markets. On the other hand, there is a second set of concerns, which is often more personal, the “what do I do with my money, and how is this going to affect me” aspect of the current crisis. On that second level, most of us do not want to see markets move lower as happened yesterday, as valuable capital is being destroyed. Just yesterday, a staggering 1.2 Trillion dollars was lost -– granted, on paper -- but still the number speaks to the potentially enormous impact these types of swings can have, and the kind of dramatic upheaval which has been unleashed. In last week's column, we recounted our long standing advice to raise cash and move to the sidelines, to seek self preservation, away from the volatility of capital markets. So often in the past, we hear investment advisors speak of “investing for the long term” and that over time things always come back. That may yet be true, but that advice does not address the human aspect of investing, which is the frailty of human nature. As a hedge fund manager myself, I have experienced my portion of tough times when managing investment portfolios. It is the kind of pressure that mounts –- sometimes by the hour, steadily wearing on the nerves -- slowly and relentlessly eating away at you from within. The pressure can go on day-after-day, week-after-week. Anyone who ever said ‘investing’ was easy simply does not know what they are talking about. It is ‘war’ without bullets, but a kind of mental war, nevertheless. For investment professionals, we are trained at managing risk, and in making the kind of tough decisions which facilitate more rapid portfolio recovery. In any war, there are many battles, and in many battles, the home team can be tactically outflanked. In any battle, a good commander needs to know precisely when to fall back, and there is always a time to fall back. Yet for the average investor, he is indoctrinated into a more passive approach -- ‘forget about what is happening now, and look forward to a better day down the line’ -– he is told. Yet, if John Q Public sees his portfolio sinking day-after-day, week-after-week, and perhaps month-after-month, we have to ask out loud, "Is he really going to have the intestinal fortitude to stick with a dollar cost averaging strategy and keep “pouring in” what must soon look like more 'good money after bad'? -- How long will it be before his resolve is worn down, before his psychology is crushed by the weight of crumbling markets?" In my view, that is a question that most investors really need to assess, and this is one of those last good moments to make the all important ‘gut check.” Does what is happening now really seem to justify you keeping your hard earned capital actively involved in these collapsing markets? Of course, ‘age’ can be a factor, and perhaps for those in their 20’s the time horizon is not an issue. However, for most of the rest of us, one has to stop and ponder the imponderables. Ask what happens if the recession causes YOU to lose your job at an inopportune moment? What if this is the start of a second Great Depression? Then what? The answer for most is that if a job is lost, then all of a sudden that pool of investment capital which was being ‘dollar cost averaged’ and held aside ‘for the long term’ -- well, that capital is immediately liquidated and becomes the new day-to-day living capital. At that point, losses are realized, a bad taste for investing is cast, and who knows how long it will be before that investor returns to the capital markets. Risk control and a Stop Loss mentality would have avoided this outcome. The myth that is never debunked is that in each economic cycle there is a time and a place for investment managers to hold onto CASH. There is a time and a place where CASH is NOT TRASH, and where investment managers should be paid to hold onto cash and preserve capital. In fact, I would argue in the most passionate possible terms, that it is at times like that, where investment managers truly establish their value. Capital preserved in a crash is capital available to invest when real bargains are on the table when the long nightmare finally comes to an end. Over the years, the words “market timing” have been disparaged and berated by those supposedly in the know, bashing technical analysis with unending arrogance. Yet, a quick example in the chart below, which shows the DJIA over the last century with its 20 month moving average. On the bottom clip is the cumulative equity track of the DJIA “with switching” (using the 20 Month MA) and without switching (using just a buy and hold), see lower line. Now, which one would you rather own? Which one would have been easier on your nerves, and which one would have simplified the investment process and preserved capital? Enough said.
Above: Top clip, the DJIA with 20 Month MA. Below: Upper line, DJIA equity with switching, and avoiding the big declines, and lower line: Buy and Hold – riding through and hopefully without developing a serious drinking problem, holding on for the long term – which one works better for you? In summary, we digress to this subject to address the concerns of those who are confused and wondering, what should I do? To be clear, situations like this demand -– they (pounding the table) DEMAND, -- that investors manage their risk! Preservation of capital is key, and with the temperature in capital markets now at a boiling point, those investors who proclaim they are dyed in the wool “long term investor types” had better be sure because these markets are very likely to keep on testing their mettle for some time to come. In my view, this crisis is, at present, most likely in the second or third inning and no further than that. Maybe only the second inning. Is this the beginning of a Great Depression? In my view, the answer is quite possibly, yes. The economic contraction now underway represents a global collapse on a scale only seen in the 1930’s. For most, the economic landscape a year from now, will bear few similarities to the care free days we now enjoy. This is a matter of economics and to a very large degree, an extended collapse has already been baked into the cake via the years of gross excess that embodied the recent historic boom. The present monetary system could now be in the process of dying, and its death process could be long and drawn out, eventually yielding to an entirely new monetary regime. The mechanism by which this could unfold is very likely to be inflationary, notwithstanding the feelings by many that at the moment, profound deflationary impulses are at work. The key in understanding the final outcome however, lies in the behavior seen in recent weeks. At the core, we have no argument with the deflationary bears who point to a debt bubble and the emergence of a super powerful systemic credit crunch. Yet, the Achilles heal in the deflationary argument has been revealed for all to see in the action of Fannie Mae, Freddie Mac and AIG -- not to mention the Paulson Plan. In all cases, the operative procedure at work is the transfer of previously accumulated bad debts to the government balance sheet, with the government rolling up its sleeves to begin the monetization process. Bernanke Helicopters at the ready! Bad Debts will be socialized and the pain shared amongst the broad population. Savers will be decimated as systematically undercutting the purchasing power of fiat money is by far and away the path of least resistance. This is the rule of centuries. Just look at how congress has been jockeying back and forth, party-to-party, in an attempt to shift blame, point fingers, and assume a false mantle of leadership. This is Brazil, Argentina, Mexico of the 1980’s exported worldwide. Any questions? Understand, what you have just seen is but a preview of coming attractions. As I see it, those sending up a great big ‘whoop-dee-doo’ about the markets bounce back in today’s session are likely simply deluding themselves once again. Yes, equity markets rallied, but are already likely now pricing in the positive aspects of the next congressional bill. Within a few weeks, if not less, the focus will once again shift back to earnings, and on that front the news will not be good. Thus, while the manic nature of these markets means they can be prone to overshooting during short periods of time, I would not be surprised to see the market ‘sell the news’ in the next few days, if and when our beloved leaders finally get a new bill passed. However, in all of the endless political discussion of the last 10 days, there has been one aspect of what is likely “real truth” that has been unveiled to the American public. Namely, the vast discussion surrounding ‘downside risk’ to the broad economy, the "if something is not done, things will get worse" conversations. In our view, chances are these downside risks are already deeply embedded, as it appears the nation's credit markets have gone into a heart attack seizure. This seizure is not going away any time soon, as at the moment there exists no clear mechanism to concrete price discovery and no clear path to figuring out where bad debts are concentrated. In the charts below, we highlight the economy’s beating heart, which is the commercial paper market where quality spreads versus Treasury Bills have been widening out on the upside at an alarming rate. In seeking to work with the tools at our disposal, we also break the Quality Spreads into two categories. The first chart is the 90-day Commerical Paper spread for Financials versus T-Bills, and the second Spread is Non-Financials versus T-Bills. To the left side of the charts, we see three distinct spikes in 1998, 1999 and 2000 which attended the LTCM Crisis, the 9/11 crisis, and the Worldcom/Enron Crisis. To the right, we see the upside explosion in quality spreads that have attended the current crisis. Importantly, while we cannot be sure, I believe that the second chart is a bit disingenuous. It shows a dramatic spike in the spread on non-financial commercial paper versus treasuries.
In truth, we strongly suspect that this huge spike to the upside is being created by industrial companies who are really banks being included in the data series. Case in point, General Motors and Ford Motor, both of which are industrial credits, but who are really major banks. In both cases, there is huge evidence of massive distress dead ahead. In both cases, the ship of state has just smashed into a titanic sized underwater iceberg, with multiple compartments now taking on water as a CDS meltdown could unfold at any time. At a conference in Atlanta last week, I asked a distinguished panel of credit market experts their view of the CDS market. The answer: it’s a mess, and no one is sure how to unwind these derivative contracts. Ultimately, simply doing damage control on a CDS implosion will be inflationary on a scale perhaps never imagined. For those whose eye might be wandering and transfixed on the banks who are called banks, let us momentarily redirect your attention to the ‘non-bank-banks.' Since last week shares of GMAC LLC (GMA) have fallen another 26%. Just what will happen should GMAC collapse? Would this be another ‘too big to fail’ entity, or could this, along with Ford and Rescap, be the catalyst for the next round of CDS related problems?
In the chart below, with the gracious help of Chris Puplava, we update the trend for the Credit Default Swaps on GMAC and Rescap. At values of 5,834% (Rescap), 4615.10% (GMAC) and Ford Motor Credit (2527%) these are comparable to the kind of spike values seen at WaMu just before its demise (6055%). The ripple effect from these players could easily unleash a tidal wave of problems for other issuers including GE Capital, CIT Group, Sears Acceptance, Textron Financial, International Lease and others. For GM, the yield to maturity for its bonds set to mature in 2015 is now recording a yield of 21.81%, while for Ford bonds maturing in 2018, the yield to maturity is at 23.94%. These are urgent signs of extreme distress, and with cash flow in the process of moving into a steep decline courtesy of the building recession, it would seem that a pair of large Chapter 11 filings is dead ahead. Can anyone even begin to imagine the political wrangling that will attend the demise of American auto companies? To be sure, the problems attending this credit cycle are a long, long way from over.
In pondering the possible remedies, I thought that Axel Merk did a great job getting to the heart of the matter in his recent comments on Financial Sense. These focused on recapitalizing the balance sheets of mortally wounded financial institutions so that they can resume basic lending activities. Combined with an increase in the FDIC Insurance which Jim Kramer has been calling for, and a temporary suspension of the FASB Mark-to-Market Accounting Rules, these steps could begin to unwind some, some of the underlying problems. For the stock market, hopes were running high today on both aspects of a potential new bill, one that might better address the FASB problem, and one that could include bolstered FDIC insurance. These remedies would make a better bill, would still likely not affect the overall trajectory of the economy, which appears to be accelerating into a steeper economic contraction. Looking back at early 2007, we first forecast a steep recession in these pages, with only a few other voices commenting (Puplava, Shiff, Roubini, Kasriel, Pretti) to that affect at that time. As things have progressed, the deepening economic contraction will translate into much lower revenues for both cities and states, where job cut backs are likely to mount. We can see the evidence and forecast for more unemployment in the charts of falling municipal bonds and indices like the Nuveen Muni Index, and the action of closed end funds like those managed by PIMCO.
No wonder Bill Gross is ready to do ‘pro-bono’ work, for as long as the credit market arteries are constricted, the outlook for severely contracted credit is bad news for credit dependent Muni bond investors. Absent the burden landing on the back of Joe Six-pack, the “financial tsunami” (to quote Gross) will be bearing down on Newport Beach. As things march forward, investors should understand that more government involvement in these problems will likely over time begin to force this problem into the currency markets. We already see signs of early credit market deterioration taking place in the shape of the CDS rates for the US Government, which, while still very low, has nevertheless been widening out at a steady clip in recent weeks providing shades of things to come.
Against this backdrop we would reiterate that for the majority of most investors, the operative rule of the moment should be to avoid this declining vortex, this hotly burning ‘ring of fire.’ Lighten up, and raise cash. Use rallies as opportunities to sell into strength. The state of the economy is NOT secure, and as a result, this is the only recipe for self-preservation in the kind of powerful bear market that now prevails. Stocks ended the day up sharply and recovering a large portion of Monday’s losses. End of quarter ‘window dressing’ was almost certainly a factor with funds looking to put the best spin on what has otherwise been a dismal quarter. For the DJIA, the index surged by 489.04 index points or 4.72% to close at 10.854.49, while the S&P 500 gained 58.32 index points to end at 1164.74, a gain of 5.27%. The NASDAQ ended higher by 102.68 index points or 5.18% to finish at a close of 2086.41. And 10 Year Bond yields ended up .20 basis points at 3.83%, an astounding surge of 5.51%. Gold ended lower by $17.00 at a close of $877.40. That’s all for now, Frank Barbera Copyright © 2008 All rights reserved. CONTACT
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