US MARKETS

Last week’s credit creation figures continued their assent along with ever growing money supply. Banking, Wall Street, hedge funds and corporate America continue to employ this deluge. The entire future of the American and world economy lies in the hands of the Fed, other central banks and their wanton, unregulated, creation of liquidity and derivatives. The resultant speculation and enormous leverage are already at extremes so that the boom won’t falter. We know the western central banks cannot stop what they are doing, because if they do the system will collapse.

Wall Street will keep doing what it is doing because the financial rewards are enormous. The attitude is when it collapses, it collapses. They will employ and enjoy the tidal wave of credit and use ever-greater leverage in their derivative and arbitrage operations. We expect that the divide between economic output and progress and the financial bubble of massive credit will widen. Junk is the name of the game. IPO’s, M&A, corporate debt issuance, junk derivative insurance, credit derivatives and leveraged lending that knows no end. There simply are no rules anymore. The seas of liquidity are calm. The players believe there will never we another storm again. We have news for them; they are living in a world of false hope and security. It is impossible for liquidity to continue to build indefinitely. Sooner or later the retrograde process has to begin and the central banks are well aware of this. In addition, the very notion that derivatives reduce market risk and volatility can only be conceived in a state of dementia. There is no guarantee that excess liquidity will go on forever and this is what derivative and computer based dynamic hedging strategies are all about. The players believe the system will always be in place, no shocks, no fear of unforeseeable disruptions to upset their formulas of probability. We all know as well that foreigners and foreign central banks will not buy our depreciating, fiat currency forever. The unfavorable environment is out there and it will reappear. That is when the game changes. Occasionally you get isolated incidents of trouble, but sooner or later, due to the connectivity of the credit and derivatives market, you will have a rush, a world of problems. This is how the downside begins and once it is underway it has a way of being unstoppable. Just because risk is perceived as minimal doesn’t mean it is minimal, even if the crowd believe it. You cannot make a pig out of a sow’s ear. Just because credit driven demand is insatiable does not mean junk has become investment quality. Just look at today’s spreads between junk and investment quality paper. Subprime mortgage securities are being treated in the same way. Like it was normal and acceptable to accept such risks. Structured finance is a very dangerous game and the illusion of soundness is just that illusion, which eventually leads to delusion.

In order for this lunatic market to function what was once madness is now normal. In order to keep the credit bubble going everyone has to accept what once were considered specious assumptions. What they fail to see is that the entire system is suspect due to interdependency. One major link breaks and the game is over. That is why in time markets will question the premise on which today’s markets have been built. Then there is the untoward event that bolts out of the blue, that no one expects happens, and the house comes tumbling down. Speculative dynamics do not live in a world of their own, they are interconnected and again therein lies the credit bubble’s weakness. Coordinated central bank intervention cannot hold back the tide of reality forever. This past week we again witnessed massive market intervention by central banks. There efforts only last for a little while and each time that they altered the normal flow of events it gets more expensive. This recent foray we estimate cost $5 to $10 trillion to coordinate. You cannot afford that month after month. We are asked when will this liquidity driven speculation end. The answer is when that untoward event occurs or the borrowers see little hope for reasonable profit and back off from the markets and thereby use less or little of the liquidity. The system cannot survive without the perpetual speculation. The unwinding will destroy the system.

There is no chance the Fed will ease by cutting interest rates. It would be suicidal. They have to play the game out to the end. They have little choice but to perpetually increase money and credit. Interest rates should remain unchanged. That allows slow deterioration of the housing market, the economy and the dollar. The other side of the equation is higher prices for gold, silver and commodities.

The stock market is only selling 6% higher then it was at its peak in March of 2000. That is an average gain of only 1% per year as the S&P 100 and 500 are well below their peaks as is Nasdaq. In fact, the latter has only recovered 36% of its 2000 high. Remember it did fall 79% in two years. On a long-term basis we are leading up to phase two of the biggest bear market in history.

If you haven’t noticed there hasn’t been a correction since last summer and we believe that is the result of market manipulation by the Fed and the Working Group on Financial Markets. No normal market acts in such a manner. In part the market is dominated by hedge funds, which are similar to the pool operators of the late 1920s, only today some of them work in conjunction with major brokerage houses that are working with the Fed. The problem is that in the end it is the American consumer who will eventually force the market downward, irrespective of manipulation. All the claptrap about Asia assuming the role of the US economy is just that, foolishness They export 75% of their production to the US and western Europe. We also believe the era of free trade and globalization is nearing its end. That means grave problems for transnational corporations and countries like China that have banking, employment and demographic problems. The Dow 30, all of which are international conglomerates, will see their bottom lines quickly shrink and that will be followed by lower stock prices to the consternation of hedge funds and elitists. Those who retire in the next generation, if today’s attitudes hold, will do so with no savings, pensions, Social Security or Medicare. The future for blue chip stocks is questionable and that is borne out by their being overpriced. That is why their top executives are selling off their stock. Yes, large corporations have lots of cash, but if earnings fall, they still have long-term debt, pensions and health care to deal with.

The Chinese, the biggest buyers of Treasuries and Agencies as well as corporate securities and mortgages know full well M3 has increased 7% annually since 1959. That 2.9% return they’ve been getting on Treasury debt isn’t cutting it with inflation over 10% and many other dollar sellers in the market. Fed rates should really be 10%, not 5-1/4%. That is another reason we do not see lower interest rates.

Instead of having $300 billion in savings that homeowners had in 1990, they are now $1.3 trillion in debt. As borrowing becomes unsustainable, consumption declines as it is presently in a recession and due to the size of the debt a depression ensues. House prices have and will continue to decline. It is not hard to figure out where the economy is headed as housing related businesses fall into recession. Do not forget those businesses provided 57% of the growth over the past six years. We are assured over and over by our media, the Fed, CNBC, the government and corporate America that all will go well and, of course, that is lies and more lies.

We are one-third of the way through the residential housing construction decline, but only 20% through the housing price decline. As you can see we have two to three years to go before housing hits bottom.

We just love being contrarians. Analysts surveyed by Barron’s all believe the S&P 500 will appreciate in 2007 at least 10%. That truly tells us the market is headed down. Another indicator is that the yield differential between Treasuries and junk bonds is only 3%, not the normal 8-1/2%. In fact in the 1980s, it went as high as 15%. If you want a nice spread buy Treasuries and short junk bonds.

We have had eight straight months of an inverted yield curve. We do not hear a mention of that in the financial media. It has assisted in bringing on inflation in 9 of the last 10 corrections. It is like ‘don’t bother me with the facts’. In all of the past inversions the Fed has sharply cut money supply. This time they cannot. Day by day they exacerbate the problem by feeding more money and credit into the system to fend off the inevitable. That means stagflation, inflation and stagnation.

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It’s a long way down from 9% growth in the first quarter of 2006 to an estimated 2.5% in the fourth quarter. This has happened five times in 20 years and in four of those periods there was a recession. The drop from the first quarter to the third and fourth quarters was the most abrupt in 25 years. In addition, like most all figures emanating from the Labor and Commerce Departments, they are bogus having been hedonically adjusted. We know all adjustments are in favor of government or general economic performance, thus, we can just imagine what the real numbers look like. It is of no consequence to government and Wall Street that the official figures are hypothetical and has little to do with reality. The official projection for GDP growth in 2007 is 3% and government will find a way to produce such a figure, when in reality that figure is probably going to be 1-1/2%. This is our government’s ‘let them eat cake’ attitude. Incidentally, that 3% growth would be the lowest in 50 years. On top of this we are being told inflation will be 1-1/2%, down from the current official 3.4%. The real figure is over 10%.

The real determinant is net purchasing power for consumers after real inflation and for the coming year that doesn’t look very promising. Even if the consumer played catch-up in wages they are still a net 6% loser and the higher wages that make up 70% of corporate costs, mean lower profits or higher inflation or a combination of both. Corporations have squeezed out all the productivity they could over the past six years and they will struggle to achieve 2-1/2%, the long-term norm. As a result interest rates would normally rise, but because the Fed and others have created a sea of money and credit, investors have to have someplace safe to put their money, and that is into Treasuries. That has abnormally driven Treasury prices higher and yields lower. That is also part of the reason the stock market has moved up 15% over the past four months. Understanding this you can see how critical it is for the Fed to continue to flood the economy with money and credit. The flipside is higher inflation again robs the consumer of purchasing power. Inflation pushes all other economic factors into the background that is why government and Wall Street lies about it and suppresses gold, silver and oil prices. The gold and silver reflect inflation and oil increases or decreases inflation. Inflation is the paramount factor that remains with the passage of time.

The inverted yield curve has been in place for 8 months and as in the past the rate of GDP growth has dropped sharply. That is borne out by the level of consumer spending in November being 2.3% officially, down sharply from 5.2% in the third quarter and 6.7% in the second quarter as we predicted in February. All those “experts” who poo pooded the predictive qualities of the inverted yield curve because we were in another “Goldilocks era” had best pay attention. The gap between the 2-year Treasuries and the 10’s is 14BPS, which is the widest in 8 months. Normally yields would slip lower, but we see the 2’s yield moving higher due to interest rate pressure from the ECB and the Bank of England, which in time will pull the yield on the 10’s higher as well.  

We expect the household debt service ratio, at 14.5% of disposable income, to rise with the severe increases in ARMs interest rates and that means less disposable consumer spending. Home equity extraction after having peaked in 2005 at $869 billion and was $380 billion in the recent third quarter is very likely to diminish in 2007.

Durable goods purchases in 2007 will fall. Last year home purchases fell 8.1%, in 2007 they should fall at least 15%, as a major economic downturn appears. If interest rates remain at 5-1/4%, the economy will deteriorate at a moderate rate and the dollar will fall at a moderate rate. Higher interest rates would allow the dollar to hold above 78.33 to 80 on the dollar index, lower interest rates would help the economy, but the dollar would collapse.

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-- Posted Wednesday, 10 January 2007 | Digg This Article