THE HUNT FOR INFLECTIONS
by Brady Willett
FallStreet.com
October 30, 2007

The GM and Ford debt downgrades in 2006, the Amaranth blowup, the mini-market crash in China in March 2007, and the subprime debacle/credit crunch that started in July. The common theme following these and other events was that the U.S. equity markets quickly rebounded following a brief period of heightened investor fear.

Along with the buy-the-dips theme in U.S. equities, other asset classes have proven equally resilient to short-term shocks.  For example, since crude oil first topped $60/barrel in 2005 and the price of copper quickly doubled in late 2005-early 2006, calls for a commodities-‘bubble’-blowup have repeatedly arrived during every price correction.  But commodities prices, and in particular crude oil at $90+ barrel today, continue to increase, with the CRB index currently sitting near record highs.

The obvious danger following many years of financial market ‘resiliency’ is that investors have become complacent; that investment decisions supposedly based on realistic assumptions of future returns are instead being composed by a myopic glance at the historical ledger.  To wit, is it realistic to surmise that developed nations that previously benefited from housing prices essentially doubling from 2000-2005 will be able to grow as smoothly with those same housing prices poised to decline? Moreover, is it rational to watch emerging markets go from being ignored by the global investing community to cherished and in many cases comparatively overvalued (to developed nations) and still expect spectacular EM gains in the future? Finally, is it wise to gaze at the slow-motion breakdown of the world’s largest economy and still remain super bullish on commodities?

Suffice to say, as an increasing amount of seemingly intractable macro gambles get played out across the financial spectrum drawing conclusions about potential inflection points for asset prices and economic activity becomes exceptionally difficult. Even so, it is highly doubtful that sublime madness has transcended historical precedent and rendered recessions and bear markets obsolete.  In other words, while Mr. Inflection is unlikely to shimmy down your chimney and hand you a check for being a good market seer, that shouldn’t deter the investor from asking when, not if, the good times will end, and what contrarian opportunities will inevitably arise.

“The central question now is whether the global economy is at an inflection point.” IMF’s Rato

A central question that while untimely, has been a prudent one to ask for more than two years…

Questioning Blissful Ignorance

Few analysts and money managers focus on the fact that the U.S. economy and financial markets continue to underperform most of the world.  Rather, apparently all that matters today is that stock prices are rising.

“It is astonishing to me that the subprime-/housing-induced inflection point in credit, from credit expansion to credit contraction, continues to be ignored by market and economic bulls.”  Kaas

Astonishing or not, the U.S. has proven capable of functioning somewhat happily with its debt quagmire and credit addiction by weakening its currency from a position of strength. Is the world being conned (forced?) into playing the ever weakening U.S. dollar hegemony game?  Can U.S. policy makers and investors alike continue down their current paths without stoking inflationary pressures? Is it really rational to conclude that the Fed can adroitly contain a deep recession in the housing market, that corporations can continue their hot earnings streak, and that the U.S. consumer can continue to borrow their way to prosperity?

Answers That Haunt

The bullish story maintains that equity gains will nullify the wealth destruction in real estate, corporations will benefit from the weaker U.S. dollar, and the U.S. consumer will continue to spend thus defying the slow down odds. Combine these outlooks with years of ‘resiliency’ in the financial markets and global economy and the rosy conclusion is that ‘rationality’ is overrated.

Unfortunately it is this optimism-resiliency-optimism loop that could prove both dangerous and irrational.  Thanks to recent financial market gyrations - movements that are actually being applauded by many economic/market bulls - it is not inconceivable today to imagine a world breaking free of U.S. dollar hegemony; a world that moves into newly emerged markets during times of crisis rather than into U.S. based assets.  Given the U.S.’s recent dependence on foreign capital, asset bubbles, and financial market premiums to sustain economic growth, it is wholly irrational to cheer underperformance of the U.S. economy and financial markets as this trend threatens to rob the U.S. of its ultra-important safe haven status.  Quite frankly, as the U.S. Fed acts alone in desperately cutting interest rates equity investors should be concerned that something is serious amiss.

Instead investors and analysts bask in the U.S.’s resilience; they yell for bailouts and cheer larger than expected write-downs, while at the same time incessantly speculating on housing/financial stock bottoms. This eerie confidence doesn’t appear to be in reaction to the deteriorating fundamentals, but born from years of conditioning.

Conclusions

With an estimated $2+Trillion of capital being deployed with unknown amounts of leverage by hedge funds, sovereign wealth funds entering the financial market fray, and individuals increasingly apt to make adventurous capital decisions from both an asset class and geographical perspective, identifying the exact spark that ignites lasting damage to bullish investor sentiment is difficult to do.  Quite frankly, in today’s new age of resilience the expected oscillations between investor complacency and fear have been permanently modified, or so we have been led to believe.

Before accepting any new investment order, it is worth recalling that although the U.S. stock market mania started to crater in 2000 and the U.S. recession arrived in 2001, it was not until 2002 when the majority of ticker chasers finally gave up and pulled money out of U.S. mutual funds en masse. A similar outcome may well be in the cards today, with the so called ‘inflection point’ for the U.S. economy arriving well before average investor dramatically alters their investment approach.

As for when Mr. Inflection will enter the building, not withstanding the seemingly intractable gambles being played across the financial markets today, there is ample evidence to suggest that this moment already arrived for the global economy in July 2007. The delayed response by investors to Mr. Inflection’s arrival isn’t necessarily anti-archetype, but a product of resiliency conditioning.

© 2007 Brady Willett
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