Tuesday, August 14, 2007

8/14 Speculators Take Global Economy Hostage, Central Bankers’ Liquidity Concession, With Nothing in Return, Interest Cuts Next?—Part 1

August 14 (Econotech FHPN) – This is the first of a two-part article, which I have broken up due to length. I will post the second part in the next day or two, please look for Part 2, hopefully on the sites you visit that very kindly post or link to my articles, or on my web site link. This first part is under 6,000 words, the second under 4,000. Thanks. -- econotech

Please NOTE well: All bold emphases added in the many quotes from mainstream media throughout this article are by me, NOT in the original. Btw, if I've seemed to put bold emphases on too many superlatives, it's simply to try to accurately convey the highly unusual environment financial markets are currently in. -- econotech

“The calmer tone in global markets yesterday will encourage Federal Reserve policymakers to believe they are striking the right balance in response to credit market upheavals: stepping up liquidity support aggressively when needed, but holding fire on interest rates. But with further credit bombshells likely, there is every possibility that the coming days will see renewed turmoil and fresh pressure on the U.S. central bank to cut rates.” FT, Aug 14, “Fed weighs economic impact of market turmoil,” Krishna Guha

“Central banks worldwide have injected at least $323.3 billion in the past 48 hours …the Fed said in a statement that amounted to a promise to do whatever was necessary to keep markets from seizing up. Such statements from the Fed are unusual, with the last having come after the September 11, 2001, terror attacks, and reflect the seriousness that policy-makers view the current disorder in markets. Before the September 11 attacks, the Fed had not offered reassurance on its willingness to provide liquidity since October 20, 1987 -- the day after Black Monday.” Reuters, Aug 10

“in times of crisis it [the central bank] should provide unlimited amounts of liquidity to ensure the smooth functioning of the payment system … When, as happened last week, they dump large amounts of liquidity in the system, they also allow banks that did foolish things to get off the hook. And many banks did foolish things … More drastic reforms will be necessary. Banks have increasingly been involved in activities outside the supervisory and regulatory framework. They have done so by offloading part of their riskier activities to hedge funds. Banks that engage in such activities should not expect to enjoy the automatic insurance provided by central banks without accepting that there is a price to pay for this. The price is that these hedge fund activities are brought back into the same framework of supervision and regulation as the other banking activities. This will not be easy, because it involves a difficult exercise of international co-operation.” FT, Aug 13, op-ed, “Banking bail-out sows seeds of future crises,” Paul de Grauwe

Among today's big fears: that commercial and investment banks, thinking they have used derivatives to lay off the risk of defaults, will discover they effectively bought insurance from hedge funds whose financial survival depends on credit from those same commercial and investment banks; that big firms are exposed to troubled markets in ways they don't realize or haven't disclosed; or that players with heavy borrowing will have to dump their holdings and make everything worse … Some Fed officials worry a rate cut now might suggest the bank is focused on the markets rather than on the economy. Others see a growing economic justification for easing. Some analysts suspect Mr. Bernanke, who has been in office for 18 months, will be reluctant to cut rates in order to expunge belief in the "Greenspan put" -- Wall Street's term for the perceived readiness of his predecessor to cut rates and bail investors out of bad decisions.” WSJ, Aug 13, front page article, Greg Ip, Deborah Solomon and David Wessel

the Great Unwind of the global credit pyramid still has further to go … there's a 21st century version of a run on the bank, and the central banks have had to step in to do their prime duty of supplying liquidity when the market won't [the conventional view—econotech] … well before the real economy feels much impact from the current financial dislocations.” Barron’s Online, Aug 9, “Even After $1 Trillion Goes Poof, It Ain’t Over,” Randall W. Forsyth

All cosy assumptions have suddenly been called into question …Central banks should only bail out traders who made bad bets if the financial infrastructure is truly in danger [still a conventional view—econotech] …[the Fed] offering funds to banks and saying it would accept mortgage bonds as collateral. This step is more extreme than first appears. The Fed used public money to take risk, in the form of high-quality, but stricken mortgage securities off banks’ hands – at least for the short term,” FT, Aug 10, “Financial plumber must stem the panic,” John Authers

“the question haunting the markets yesterday … is what on earth has triggered this sudden €94.8bn [ECB liquidity injection] move? One explanation - and the one alarming many traders - is that there is something truly nasty lurking out there in relation to credit losses that only the ECB knows about. If so, let us all pray that it does not involve any of the big dealer banks. However, another explanation - and let us hope this is the correct one [prayer and hope are not the most effective solutions—econotech] - is that the ECB is engaged in a subtle war of psychology with the commercial paper market.” FT, Aug 10, “Has the bank seen something nasty on the horizon?” Gillian Tett

“What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up … This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults … And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them … when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults … Let’s hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn’t count on it." [Dr. Krugman is a great economist, but hope is not a strategy—econotech] NYT op-ed, Aug 10, “Very Scary Things,” Paul Krugman

Friday’s action by the Fed marked the abandonment of its “business as usual” stance. It told dealers it would re-enter the market as often as necessary, and – in a highly unusual move – accepted high-quality mortgage-backed securities as collateral for the entire $38bn of funds. This amounts to the most extensive liquidity support operation undertaken by the US central bank since the 9/11 terrorist attacks and follows similar steps by the European Central Bank and Japanese central bank in the past two days.” FT, Aug 11, front page lead article

“The level of funds markedly exceeded the ECB's only previous major intervention - on the day after 9/11 when it lent €69bn followed by €40bn over subsequent days. Even more striking was its one-day pledge to meet 100 per cent of all funding requests from financial institutions … The ECB did not offer any detailed explanation for its move, which caught markets by surprise” FT, Aug 10

“Fallout from the intensifying credit crisis stretched from a French bank to the largest home-mortgage lender in the U.S., triggering unusual central-bank interventions and driving the Dow Jones Industrial Average to its second-worst drop this year. The troubles demonstrated both the global reach of the crisis and its impact on a widening circle of markets and companies.” WSJ, Aug 10, front-page article

“Federal Reserve Chairman Ben S. Bernanke was wrong. So were U.S. Treasury Secretary Henry Paulson and Merrill Lynch & Co. Chief Executive Officer Stanley O'Neal. The subprime mortgage industry's problems were contained, they all said. It turns out that the turmoil was contagious.” Bloomberg, Aug 10, “Bernanke Was Wrong: Subprime Contagion Is Spreading,” Bob Ivry

“"Like everyone else, [central banks] face uncertainty about the future (most of which is shared uncertainty), but, unlike almost anyone else, they must maintain an aura of wisdom, of being in control, almost as if they did know (a lot) more about the future than the rest of us," writes Ethan Harris, chief economist at Lehman Brothers. "They do not."”, thestreet.com, Aug 10, “Bernanke’s Bind: No Easy Answers,” Liz Rappoport

Financial Markets’ and Officials’ Panicky Fear of Lurking “Unknown Unknowns” and “Black Swans”

The title of my last article on July 26 link, “Speculators’ Liquidity-Leverage Russian Roulette with Economy” may have seemed a little over the top to some at the time, that is, before this past Thursday and Friday, Aug 9-10. As of Aug 14, the day this new article is being posted, that may no longer seem to be case for the title of that article and this one.

During that 48-hour period at the end of last week, global central bankers injected around $300 billion of liquidity into the banking system, promising unlimited short-term funds, even taking mortgage-backed securities as collateral, extremely unusual moves that evidently only have had two precedents, 9/11 and the Oct 1987 crash, when the U.S. market fell more than 20% in a single day.

So, why did the central bankers concede to speculators’ pressure, yet again? (I believe that using "speculators'", at huge financial institutions, is a more accurate and realistic way of putting it than the much more common euphemism, "market pressure.")

If you consider that the rampant fear and surprisingly drastic actions occurred, even though global financial markets haven’t even begun to really crash, yet, let alone a recession begin to take hold, then isn’t that some indication of the seriousness, potentially, of what may really be at stake, right now?

Like Dr. de Grauwe, a well-regarded international economist whom I quote above, I have no problem with central banks basically “doing their duty,” so to speak, by providing liquidity to try to keep the global financial system from freezing up or melting down, pick your metaphor.

To not do so would be irresponsible to the global economy and populations that rely upon a smoothly functioning financial system for their essential daily and future well-being.

But as Dr. de Grauwe's above quote somewhat suggests, there needs to be a significant cost to the global speculators of the recent largesse from central bankers, who, in principle, are very high public servants who have been trusted with the awesome responsibility of nations' money supply and credit, most especially in this age of fiat currencies.

And that cost to the speculators is to rein in, ASAP, their ridiculous speculative, selfish antics that are now putting the global economy, and the well-being of billions of innocent people, at risk, yet once again (as Asia, with nearly 4 billion people, fully knows from its earlier run-in with the global speculators in the so-called Asian financial crisis of 1997-98, known in Asia as the IMF crisis).

Very powerful speculators have gained the privilege of stewardship of the global monetary/financial system. So be it, that’s current reality. But that reality needs to be changed, as the current credit market dislocations have made clear, yet again.

The global financial system is in another mess, yet again, simply because global speculators, yet again, pushed their search for high yields and excess returns way too far, and because global monetary officials, yet again, facilitated it with E-Z money and allowing them to run amuck.

(Recall the many previous speculators’ bubbles, and then remember the old saying, “fool me once, shame on you, fool me twice, shame on me.”)

Most importantly, it NEVER had to come to the current situation in the first place. It did, yet again, due to a very basic, ancient human foibles, excessive power, greed, hubris--the global speculators’ simply never know when enough is enough, rather they always want more, more, more, with a take no prisoners attitude to get it.

(Exhibit A is the Citigroup CEO quote about dancing to the liquidity beat with which I led off my July 26 article link. Exhibit B is Jim Cramer’s now infamous tirade on national tv berating Fed governors on behalf of his Wall Street contacts, which I take up later in part two of this article.)

Given such poor performance on the part of both global speculators and monetary officials--and I hope it should be clear by now on my web site link that, while so many seem to focus so much of their ire just on the latter, both are to blame, the structured credit-addicted (CDO's, CLO's, etc) prime culprits and huge beneficiaries of the current system are the global speculators, monetary officials are their "enablers," justifiably held accountable for not living up to their public responsibilities--one of their speculative own might adolescently say on tv, “You’re fired!”

With the global economy still in good shape, perhaps we should be more tolerant than that, for now, since many of them really are extremely talented and/or powerful, who perhaps may still surprise and do great good in better allocating global capital, if provided with the right economic incentives, ones that encourage innovation and production, not absurdly excessive, destabilizing speculation.

So for now, let’s as adults, say to them, shape up, or ship out.

Because we don’t want nor need you, if you can’t control your adolescent absurdly excessive “risk-taking” behavior, which repeatedly puts the global financial system and economy at completely unacceptable risk, mainly for your own selfish gain. More on this later.

My Investment Suggestion Continues to be Hedge Until If/When See Some All Clear Signs

Turning to my investment suggestion, as I’ve said in my June 21 link and July 26 link articles, I continue to believe that it is best to be hedged, however and as much as each individual prefers, since the basic investment problem continues to simply remain that no one knows how bad things might get, as was clearly demonstrated, yet again, the past week.

Practically, as I will show in a few charts later in this article, equity markets have greatly increased in volatility, but they have NOT yet corrected significantly, this has not even been a normal correction, by historical standards, so far.

So, investors are currently being offered the worst possible combination, very significant risks from increasing volatility, which is still on average below the average level of the late 1990s, but with nowhere near low enough prices to compensate for such risk.

To make that currently unfavorable reward-risk ratio better, either equity prices need to decline significantly further, and/or volatility needs to significantly dampen down.

Or a new bubble, tech redux (watch the price action of a few leading tech stocks for clues), energy (an obvious secular uptrend) or some others, needs to emerge to justify current valuations and volatility, which at the moment seems unlikely.

One of the more glaring anomalies in global financial markets has been the continuing huge disconnect, over many months now, between the increasing turbulence in the credit markets and the so far modest correction in the equity markets. One is wrong.

The flight-to-quality 40 bp decline in 10-year bond yields over the past month has helped equity valuation models.

As noted in my July 26 article link, on June 30 I sent out an e-mail saying, “I now feel that there is greater than a 50% chance of a significant correction in the stock market in the 3rd qtr. By significant, I mean at least 5-10%, but it could be much more.”

Given how fear already has swept through the global credit markets last week, clearly the probability of the more worse case scenarios is now higher at the moment.

Most mainstream pundits and mainstream media, as good as its coverage of the unfolding credit crises consistently has been for months (I am very grateful for the hard work of many mainstream journalists and columnists, reflected in the large number of quotes in this article), have yet to really emphasize critical potential risks.

One significant exception continues to be noted global portfolio manager Dr. Marc Faber, who is on Barron’s semi-annual roundtable, and who expertly talks about the U.S. entering a recession and bear market in the upcoming months in these two Bloomberg interviews on Aug 13 link and Aug 10 link, both of which I STRONGLY urge readers to listen to.

For those who have the time, I also highly recommend this considerably longer Bloomberg interview with Dr. Nouriel Roubini on Aug 14 link (and Roubini's and Setser's blogs at their rgemonitor.com, also recommended in my last article).

But before discussing very serious potential market and economic risks in the next section, let me close this section with the most basic, if seemingly utopian, message of my web site link, whose tag line is “Finance Innovators, not Speculators”:

If global leaders and people use the current unfolding financial markets’ situation to summon their wisdom and courage to try to just “think the unthinkable,” starting with how to change an increasingly dysfunctional global financial/monetary system, also how to restructure taxes to promote productive economic activity rather than rampant speculation based on uneconomical paper capital gains, remove onerous business restrictions (starting with SOX), reform education, fix the health care mess, etc. …

then the ongoing awesome changes in the global real economy and all areas of science and technology should, without doubt, create an unprecedented era of world peace, just prosperity, creativity, artistic beauty, far surpassing any civilization in human history (and fairly dealing with issues such as global warming, energy, water, demographics, health, etc.).

Why This Time Potentially Could Be Much Worse than LTCM Oct 1998

“Today's turmoil is creating obvious comparisons to 1998. Then, a financial crisis at first crippled emerging Asian economies without threatening the U.S. or other Western economies. But when Russia devalued its currency and defaulted on foreign debts in August, it sent a shock wave through global markets ... hedge fund Long Term Capital Management imploded. Trading in numerous markets came to a near halt. The New York Fed organized a rescue of LTCM, and the Fed cut interest rates by three-quarters of a percentage point between late September and mid-November. The U.S. escaped recession. Whether today's credit crisis looks as bad is a subject of intense dispute. "In 1998, a lot of big boys were really scared," said a former government official and veteran of '98. "Right now a lot of the big boys are saying, 'How can I profit from this?' That feels a little different … But comparisons are difficult. The greatest stresses today are in markets that were far less important in 1998. Their evolution since then has made it much harder for regulators or Wall Street CEOs to know precisely where the risks lurk.” WSJ, Aug 13, front-page article, Greg Ip, Deborah Solomon and David Wessel

“Each time the buy-out funds checked in with Morgan Stanley, Cadbury's adviser, the bank ratcheted up the interest rate on the debt package, according to people close to the matter. For the private equity titans, this unusual behaviour was a confirmation of their worst fears: the world had fundamentally changed, and not in their favour … That moment could be etched into the memory of buy-out executives for years to come. Just days after Chuck Prince, Citigroup's chief executive, had confidently proclaimed that he was "still dancing" to the tune of the buy-out boom, the music stopped and the self-proclaimed "golden age" of private equity came to an end. Indeed, since the end of July, discussions about large private equity takeovers have virtually ground to a halt, say Wall Street bankers.” FT, Aug 14, “Not dancing anymore. How the music stopped for buy-out buccaneers,” James Politi and Francesco Guerrera

“Blackstone has warned of a slowdown in large private equity takeovers due to the upheaval in credit markets. But the US buy-out group said the new environment could help boost returns over the long term. Tony James, Blackstone president, said that the meltdown in the financing markets for risky debt would in the short term hit performance by reducing fees and delaying asset sales … Mr James suggested that in the changed environment Blackstone would be pursuing different kinds of transactions - smaller buy-outs, public equity investments, and buying debt of pending deals at a discount.” FT, Aug 14

“Blackstone Group LP, manager of the world's largest private-equity fund, said second-quarter earnings more than tripled as revenue at its four main units increased during a record year for leveraged buyouts.” Bloomberg, Aug 13

“Wal-Mart Stores Inc., the world's largest retailer, said second-quarter profit rose less than analysts anticipated and lowered its earnings forecast … ``U.S. consumers continue to be under difficult pressure economically,'' [CEO] Scott said on the call. ``It is no secret that many customers are running out of money toward the end of the month.” Consumer spending, which makes up about 70 percent of the economy, slowed to a 1.3 percent annual growth rate in the second quarter, the weakest since 2005.” Bloomberg, Aug 14

“[Wal-Mart CEO] Mr. Scott said. "The paycheck cycle is, in fact, more pronounced now than it ever has been."” WSJ, Aug 14

Home Depot on Tuesday reported weak second-quarter earnings, confirming its earlier outlook, and said it expected grim market conditions to continue into 2008 … Sales in stores that were open for at least a year fell by 5.2 per cent. The worst depression in the housing market in 16 years continues to present a “tough selling environment” for the home improvement retailer, chairman and chief executive Frank Blake said. “We believe the housing and home improvement markets will remain soft into 2008.”” FT, Aug 14

“The lending landscape has changed dramatically … Even if months of absurdly easy credit are simply giving way to a more realistic but stable view of risk, clearing the backlog will take time … Demoralising subprime-related headlines are also likely to recur as disclosures of real or paper losses at investment funds and banks dribble out over the coming months … If buy-out firms cannot borrow as aggressively they will pay less for public companies, eroding the premium built into stock prices. Meanwhile, if companies find borrowing tougher, they will indulge in fewer share buy-backs and special dividends, further disappointing equity investors. Tougher lending criteria could also force more of them into bankruptcy. Decent global economic growth could help offset much of this. However, a serious credit crunch could crimp growth by squeezing commercial activity.” FT, Aug 12, “Investor should prepare for more of the same at best,” Tony Jackson

U.S. banks increasingly tightened loan conditions on sub-prime and non-traditional mortgages in recent months and became more cautious about prime mortgages, syndicated loans and commercial real estate, according to a survey by the Federal Reserve … The survey was conducted just before the global credit crunch intensified.” FT, Aug 14

“UBS AG, Europe's largest bank, fell to the lowest in a year on the Zurich exchange after acknowledging that ``turbulent'' markets may reduce profit for the rest of the year.” … UBS has overtaken Morgan Stanley as this year's top underwriter of share sales, according to data compiled by Bloomberg.” Bloomberg, Aug 14

The 14 percent rally in Chinese stocks in the past two weeks has created some of the largest companies in the world by market capitalization and defied a global rout that wiped more than $3.3 trillion from equities worldwide. The gains helped Industrial & Commercial Bank of China Ltd. attain a market value that exceeds all but two U.S. companies … ICBC's Shanghai-listed shares trade at 39 times reported earnings, almost four times Citigroup's multiple of 11. Shares in China's CSI 300 Index trade at 50 times profit, while those in the Standard & Poor's 500 Index trade at 17 times … The CSI 300 has more than tripled in the past year … Trading by individual investors accounts for about 60 percent of market volume … Investors in China have opened about 33 million brokerage accounts already this year, more than six times the total for 2006. Daily turnover on the nation's two stock markets soared more than fivefold.” Bloomberg, Aug 14, “China’s Stocks, World’s Costliest, Defy Global Slump,” Darren Boey and Zhang Shidong

“What makes China's worst inflation scare in a decade doubly dangerous is its deceptively harmless appearance. Many analysts are inclined to write it off as a temporary food shortage, when it actually stems from a serious money glut. The annual inflation rate zoomed to 5.6 percent last month, the highest in more than 10 years … Just as loose global monetary conditions have caused energy prices to run away in recent years, surplus liquidity in China -- the deluge of money entering the country through its record trade surplus -- is now showing up in food costs, which account for a third of the Chinese consumption basket … money supply, which grew 18.5 percent in July, the fastest pace in more than a year.” Bloomberg, Aug 14, “Blame Money, Not Pigs, for China’s Price Scare,” Andy Mukherjee

The spurt in inflation comes at a sensitive time in China’s political calendar, ahead of the five-yearly Communist party congress in October, when stability is at a premium. Outbreaks of inflation have triggered political upheaval in the past.” FT, Aug 14

Final reckoning only days away for Musharraf. Time is running out for Pakistan’s president to secure his political future and avoid a constitutional crisis,” FT, Aug 14

Poland’s ruling coalition crumbles,” FT, Aug 14

So, why could this get a lot worse than LTCM in Oct 1998?

Back then the Fed could arrange a Wall Street bailout of one hedge fund, a very easily identifiable locus of risk, and Greenspan could quickly cut rates three times (thereby re-affirming the infamous “Greenspan put,” perhaps soon to be called the Bernanke-Trichet put, once again creating even more “moral hazard,” i.e. speculators are assured that, heads I win, tails I still win, hence you lose.)

The current situation is NOT comparable, and is, potentially, far worse. And the prospect of a global financial meltdown, as bad and unfortunate as that would be, potentially might just be the tip of the iceberg.

That’s because, very unfortunately, the underlying strength of the basic financial and economic structure of the U.S., in particular, is now far weaker than in the late 1990s, yet very few in positions of power yet want to admit to it (through sheer denial, almost all of the American elite, who should know better by now, still maintain that the U.S. remains the omnipotent, ubiquitous sole superpower, for those interested in this issue, see my 17,000 word Oct 27, 2006 article link, "Global Strategic Bargain: Positive Reality Therapy for America's Critical "States of Denial"").

This situation has been reversed in “emerging markets,” which are in far better shape now than back then, though that probably will NOT protect them from a global financial meltdown, as Marc Faber notes in the two video links in the section just above, should it occur.

In the late 1990s tech bubble, financial market problems were concentrated in usually risk-averse, unleveraged mutual funds then uncharacteristically gobbling up obscenely over-priced IPO’s, and economic problems in capital spending in the corporate sector, which suffered a sharp downturn in the 2001-02 recession, while consumer spending growth did not go negative.

Now, as the mainstream media likes to point out, the corporate sector has record high profit margins and still good earnings growth (up over 10% in the second quarter, which would be normal at a cyclical peak), and huge amounts of cash (according to Goldman, non-financials in the S&P 500 have $800 billion in cash, 10% of their assets), which it seems to have no better productive use for than economically dubious m&a and stock buybacks, both of which will likely recede from their record levels.

In the current situation, potentially severe problems are now dangerously concentrated, though globally dispersed, in the banking and highly leveraged speculative finance sectors, i.e. hedge and private equity funds and commercial and i-banks, all now much larger, increasingly indistinguishable, and financially cancerous, and in the consumer sector, which has been heavily dependent on its real estate asset “paper wealth effect,” due to the stagnation of real incomes in the 2000s.

Households did accumulate enormous "paper wealth" in the 2000s, but much of that is concentrated in the upper percentiles, especially at the very top, the huge winners in the current system, much of their winnings coming from lightly taxed speculative capital gains. For average income/wealth households, with real estate prices now declining, and real-world prices rising, consumer spending has been under pressure.

Additional factors usually neglected by the mainstream media that are critically different than in LTCM Oct 1998 and the late 1990s tech bubble include the following: the U.S. has a far larger current account deficit and external debt; a very weak dollar; a budget deficit dependent on cyclically high corporate profits and especially huge capital gains, both of which may peak; high energy, food, health care and other prices; worrisome slowing productivity (the rapid rise in productivity in the late 1990s was the underlying basis of the tech bubble); and just around the corner, huge unfunded pension/health care liabilities.

In addition, much of the world thinks that the U.S.is currently losing two wars and U.S. global standing is very low, as repeatedly shown in polls.

In fact, there has been a dramatic shift in relative economic strength between 1997-98 and now. Back then, Asian nations had current account deficits and currencies under attack.

Asians, now holders of trillions of depreciating U.S. dollars (left click on chart to enlarge, courtesy of St. Louis Fed) do not fondly remember U.S. actions protecting American speculators at the expense of Asian living standards in the 1997-98 so-called Asian financial crisis, which some Asians call the IMF crisis and identify with the U.S.

In addition, obviously the global geopolitical situation today is also far worse than in LTCM Oct 1998, not only Iraq and Afghanistan, but also very worrisome in Pakistan, a nuclear power, Iran and elsewhere.

All these potentially destabilizing factors, which especially when taken together are far worse than during LTCM Oct 1998, if for no other reason than they now are now afflicting the U.S., not the more peripheral "emerging markets" as back then, are usually being ignored right now by both financial markets and the mainstream.

But without being alarmist, for most countries, all these factors taken together usually would be the symptoms of an upcoming major financial/economic/political crisis.

Since the dollar is still the world’s major reserve currency and the U.S. is by far the dominant military power, that very unfortunate potential outcome has been continually avoided, to the puzzlement of many mainstream economists and other academics, as the rest of the world continues to finance, for now, America’s spending spree, both consumer and military.

(I won't go into here the esoterics of financial, not physical, "dark matter" and what economists affiliated with Deutsche Bank cleverly but inaccurately labeled Bretton Woods II back in 2003.)

The Big Positive Difference This Time

Perhaps the main reason, or rationalization, for sweeping the potential very large risks under the rug, at the moment, is the one very obvious, extremely huge positive that many others, and myself on my web site link, have consistently noted, namely extremely strong global economic growth, especially in Asia.

My ultra-simplistic working assumption has been that the U.S. real estate and lbo bubbles were so absurd and so huge, i.e., that it was economically impossible for the Fed to give away essentially free money (negative real interest rates) for so long without creating huge potential problems, therefore that the subsequent credit market problems must be quite large, hence the subsequent pain probably has significantly further to go. Kudos and thanks to others who have analyzed this far more thoroughly than I have, and it is now almost consensus opinion.

But, on the other hand, as I’ve also repeatedly said, we've also never lived in an era where so much of the world is now in the market economy, and I believe the ongoing long-term positive benefits of that truly historical change are likely to be continually underestimated also, especially by those in the west.

Real estate and credit market problems have become major daily news in the U.S. The huge positive gains from a market economy in China, India, and elsewhere seem quite remote to the very busy daily lives of most Americans, but these gains continue, day in and day out, rapidly, cumulatively greatly improving the lives of hundreds of millions of people over time.

Asian growth obviously has continued to be extremely strong, even as the U.S. has slowed. E.g. the IMF recently raised its forecast of global growth in 2007 from 4.9% to 5.2%, even while it cut its forecast for the U.S. Whether or not that will continue to be the case if the U.S. goes into an actual recession is still an open question in my mind.

China, which grew 11.9% in the second quarter, will contribute more to global growth this year than the U.S. On the negative side, China’s consumer prices have just increased 5.6% in July, well above estimates of 4.6% and the highest rate in more than ten years, from 4.4% in June.

Regardless of the strength of Asian economic growth, a global flight from risk will most likely have a strong negative impact on emerging stock markets, which like others has continued to hold up remarkably well so far and thus remain over-extended and overbought on a long-term basis, as I’ve shown in charts several times in the past month or two.

China’s mainland stock markets of course continue to seem to be in a world of their own, extremely over-extended, and thus remain another potential source of global financial risk and instability.

Financial Markets’ Sharply Higher Volatility without Low Enough Prices to Attract Buyers

I will break the main flow of this article with this section, to briefly show a few key charts.

Note well, this article is posted Tues, Aug 14, the charts in this section were from e-mails sent out last week, Aug 6-10, I did not have time to update them for this article, but I believe the points they illustrate hopefully are still valid.

Left click on the charts to enlarge.

This 5-year weekly chart of the S&P 500 (as of Friday, Aug 10) shows that so far the correction has NOT been very severe, though it has broken the uptrend from July 2006 (purple line).

In the short-term, the S&P 500 is oversold, shown in the bottom indicator, "stochastic momentum index," and thus "normally" due for a bounce, though the current financial environment is obviously no longer normal.

Longer-term, this correction would have further to go just to get down well into the bottom of the regression channels, the parallel lines (the red one is 2 std dev from the middle regression line), bringing the "true strength index" trend indicator down to 0 or below.

Going down toward the bottom of the regression channels would create real equity market fear and concern, and perhaps at some point more Fed intervention to try to trigger a massive short-covering rally (something Greenspan did with the LTCM crisis in Oct 1998, but which led to all sorts of "moral hazard" problems later).

More so than the S&P 500, most world stock market indexes were so far above-trend and overbought at the peak on July 19, that even a normal modest correction has not brought them down to very attractive entry points so far. I have shown these charts, especially of EEM, the emerging markets etf, a number of times in previous articles on my web site link, so will not do so here.

Greatly compounding the practical investment problems (as Goldman's and other "quant" funds can well attest to) has been the surge in volatility. As shown in this chart (from Tues, Aug 7), VIX (black line), the widely followed S&P volatility index, has been trending sharply upward, and is now significantly higher than it was at the previous peak in May-June 2006.

Yet for the etfs shown, EEM emerging markets (red) and QQQQ Nasdaq 100 (blue), the percentage price declines in that earlier 2006 correction were significantly larger than they have been now.

In other words, to repeat what I said earlier, equity investors are now facing the worst combination of greatly increased volatility without low enough prices to make the added volatility risk worth taking.

This next chart (from Mon, Aug 6) shows the percent change in three etfs, XHB (black) homebuilder, SPY(blue) S&P 500, and QQQQ (red) Nasdaq 100.

The main point of this chart is that all three were highly correlated up until Feb 2007. Since then, until the past few weeks, SPY and QQQQ ignored the increasing troubles in the real estate sector so clearly reflected in the rapidly declining price of XHB.

Finally, this last chart (from Wed, Aug 8), shows the normal "retracement" bounce of XLF, the financial sector etf, during the seemingly highly manipulated rally Mon-Tues, Aug 6-7. of last week (such as floating rumors of FNM and FRE buying subprime mortgages, similar to the July 12 rally that hyped Wal-Mart sales a day before weak consumer spending was reported), which failed Wed, Aug 8 afternoon, leading to the sharp decline Thurs, Aug 9, when the central bankers threw open their liqudity spigots.

Thanks very much for reading such a long article, I greatly appreciate it. Part 2 to follow in a day or two. -- econotech

Thursday, July 26, 2007

7/26 Speculators' Liquidity-Leverage Russian Roulette with Economy; Real Cap Gains Tax Scandal

July 26 (Econotech FHPN) --

"The point is that these innovations have externalities for the entire financial system that are hard to measure but dominate their apparent value. Rather than adding complexity and then trying to manage its consequences with regulation, we should rein in the sources of complexity at the outset. Linked to the need to reduce market complexity is the need to relax tight coupling … A less disruptive course of action is to reduce the amount of leverage that comes as a result of liquidity, since this is ultimately the culprit that high liquidity and speed of execution breeds. The externalities to high leverage are greater than they appear, because on most days everything runs smoothly. But as we have seen time and again, in the instances where it really matters the liquidity that is supposed to justify the leverage will disappear with a resulting spiral into crisis. Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets." Richard Bookstaber, "A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation," 2007, Wiley, pg 260. [bold emphasis added by econotech]

"Chuck Prince yesterday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, declaring that Citigroup was "still dancing". The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity at the moment it would not be disrupted by the turmoil in the US subprime mortgage market. He also denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back, in spite of problems with some financings. "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing" … "The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be.” … "At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don't think we're at that point."” FT, July 10, front page [bold emphasis added by econotech]

This article is mainly about whether to practically deal with an increasingly risky current investment environment, via hedging, as a follow-up on previous articles.

The Bookstaber quote above addresses the far larger issue of the safety of the current financial system, and what could be done to increase it. I strongly recommend the new one-hour interview with Bookstaber at financialsense.com link. Dr. Bookstaber's (MIT economics Ph.D.) practical knowledge of derivatives and credit markets has been earned since the early 1980s as a "financial engineer" and "quant" at Morgan Stanley, Salomon Bros, and a hedge fund.

As for the above quote from Citigroup's CEO Prince, I will comment in the next to last section of this article on his "it's not my fault, the liquidity made me do it" rationalization for continuing the credit bubble. For now, I will just ask, is the almost adolescent yet high-stakes game of liquidity-leverage Russian roulette or chicken, or musical chairs to adapt Prince's dance metaphor, any way to finance a modern global economy, who do you think benefits from doing so, and who will lose if/when the music stops?

If you've seen this movie before, it might feel like watching a car wreck in seeming slow motion, you cringe, but can't stop it from happening. But you can, the current rules of finance are not the same as the immutable laws of physics. E.g., capital gains taxes which encourage the ongoing orgy of speculation can be changed, as I discuss in the third from last section. The last section talks about my web site's link new tag line, "FINANCE INNOVATORS, NOT SPECULATORS, For Just Global Development, To Restore America's Purpose and Values."

What to Do If/When Liquidity-Leverage Music Winds Down

With a sell-off in U.S. stock markets July 24, I would like to give an update today (July 26) to my June 21 article, “”Goldilocks” 65 Basis Pts Higher” link, specifically the last section titled “If and When to Hedge?” where I wrote:

"As I've tried to imply earlier in this article and in recent previous ones, while I have consistently presented "the long-term uptrend is your friend" view on my web site since the middle of the sharp global sell-off May-June 2006 (starting with my June 2, 2006 article link), now might be one of those times to consider incurring the costs of hedging your bets, in some way to some extent, depending on your preferences. Again, in terms of timing a hedge strategy, July, like most first months of each quarter, tends to be seasonally stronger, after negative earnings news comes out in the previous month."

I have not given specific investment suggestions on my web site link, that is NOT its intent nor purpose. But by hedge, I meant exactly that, hedge, perhaps with puts, or however else one is most comfortable (including simply raising cash, lowering beta, using stop losses, buying precious metals, etc). Or, perhaps even easier, consider using calls (similar to going long both securities and puts), to limit downside risk and avoid the difficult task of trying to match-up hedges with longs (rising volatility is making the use of options more costly).

I tried to be a little more specific in a private e-mail distribution on June 30:

“To get right to the bottom line, I now feel that there is greater than a 50% chance of a significant correction in the stock market in the 3rd qtr. By significant, I mean at least 5-10%, but it could be much more … for the very little that it's worth, my guess is that the stock market might be okay through around July 20, as money continues to flow into large cap and tech stocks during the upcoming 2nd qtr earnings season. Then I think the period of maximum risk begins, from around July 20 thru to about Oct 10.”

Will July 20 mentioned above turn out to be a, or even "the," top? It simply doesn't matter, it was just a sheer guess. So far, July 19 has been the closing high in the S&P 500, and money did flow into tech and large cap stocks during the July earnings season, producing a rally stronger than I expected (I had previously written of this shift into large caps and tech a couple of times, e.g. on May 31 "Brief Update" link).

Regardless, do I still have the same concern about a significant market correction in the third quarter? Yes, I would again suggest that investors consider hedging to protect their gains. I discuss a couple of caveats in later sections.

Btw, I simply can NOT suggest such actions as going net short on my web site, so please don't read anything into my failure to do so, should the 2002-07 bull market look like it is sharply correcting.

How Far Will Credit Market Problems Go?

The basic investment problem that I've highlighted before remains that no one really knows how far the very obvious excesses that have been concentrated in the credit markets in the 2002-07 bull market are going to play out.

But so far all the news has been bad, and it keeps getting worse day after day, with the subprime woes spilling over into higher rated mortgage securities, and into the absurd economic misallocations of the lbo and m&a deals, which finally belatedly are having some difficulty getting funded in the capital markets.

Under these circumstances, it is simply financially prudent to try to protect one's investments as best as possible.

However, until just the past few days, there has been a huge disconnect between what is going on in the credit and equity markets, with the latter seemingly almost willfully and deliberately ignorant of the problems in the former.

This is even more true of rising geopolitical risks, not only in Iraq, but especially in Pakistan, Afghanistan, Iran, and elsewhere, which global financial markets continue to almost completely ignore, other than through the price of oil and precious metals.

Unfortunately, as I’ve written several times already, e.g. on June 7 link and June 21 link, even most professional equity investors are woefully in the dark on the day-to-day working reality of credit, derivatives and structured finance markets, which are deliberately very non-transparent, even to government regulators, to their unease.

(Btw, I was tempted to post extensive quotes on these credit market issues, I have a 16,000 word file on them just from the past month alone, but I simply don’t have the time to do news summaries on my web site.

I would STRONGLY recommend that any equity investor interested in following credit market issues, which are particularly critical right now, regularly read Bloomberg at http://www.bloomberg.com/ and subscribe to the Financial Times, which are very good news sources on them. Randall Forsyth at Barron's Online has also been doing a good job lately covering credit market issues. Nouriel Roubini's and Brad Setser's blogs at rgemonitor.com have done a good job on the first half economic weakness. There are also others certainly worth following especially right now, see my links list.)

Precious Metals, Dollar, Oil Indicate Increasing Desperation to Contain Credit Market Damage

The recent action of the dollar, precious metals and oil, along with the ongoing very rapid expansion of key monetary aggregates globally, seem to indicate that the financial powers that be are becoming increasingly desperate in their efforts to contain the damage in the credit markets.

Suffice to say, every investor should be very aware that precious metals, the dollar and oil are at critical levels, decisive breaking of which would reflect increasing major risks in the global economic/financial environment, so please continue to follow these markets very carefully.

Btw, Bernanke's recent speech about "anchoring" inflation expectations seems rather futile in a world in which the major reserve currency, the dollar, isn't anchored to anything real. One look at charts of the dollar index against major currencies from 1973 to the present (see chart below, left click once to enlarge, courtesy of St. Louis Federal Reserve) and gold would seem to indicate that. Again, is this any way to run a global monetary system, for lack of a better term?

I do not have more to say for now about gold, the dollar, and energy, especially oil, markets which are extensively covered by others more knowledgeable than myself on these issues, including on the sites that kindly repost my articles and I have listed in my links section, so I will defer to them on these topics for the moment. But deferring does not mean minimizing the importance of these issues.

Equity Market's Suspect July Rally

In the equity markets, particularly suspect in the July rally was the seemingly manipulated short-covering strong gain, on relatively light volume, on Thurs, July 12, early in the day attributed to better-than-expected same-store sales from Wal-Mart, and a large m&a deal, Rio Tinto’s takeover of Alcan.

Needless to say, yet another mega-deal was hardly new news in a record-breaking year for m&a, nor is consumers’ dealing with rising energy and food costs trying to stretch their budget by shopping at discount stores necessarily good news.

In fact, the very next day, Friday the 13th, came a report of very weak consumer spending in June, yet of course in the bull market media frenzy that did not reverse the previous day’s gains. Lost in the mass media hype is that most of the increase in second-quarter GDP will be from a large inventory swing, secondarily from the external account, with consumer spending still expected to be below trend.

As for the other most common rationalization for the July rally, earnings so far have been coming in up about 8%, again better than the reduced expectations, again same old game. This seemed to be enough to spur a small tech-bubble redux, with lower but still nose-bleed p/e's in a few crowd favorites such as RIMM, AAPL, and AMZN that I've previously mentioned in another article.

It's Not Only About Your Father's S&P, Dow and Nasdaq Anymore

My first caveat regarding a significant market correction in the third quarter is that, while the S&P 500 is usually the benchmark index for American investors, it is far from the leading one in the 2002-07 bull market.

As I've said before, that prize goes to emerging markets, which are up 4 times as much as the S&P, and equities and commodities in energy, materials, precious metals, etc.

All these markets play off the same theme of strong global economic growth (with precious metals also reflecting other issues) that has been unprecedented in history, in terms of speed, scale and scope. As a result, U.S. financial markets are no longer as dominant as they once were.

So, in trying to determine the trends and risks of global financial markets, we need to look at other leading markets, not just the large cap U.S. S&P 500, Dow Industrials and Transports, Nasdaq 100, etc. (on which many excellent traditional technical analysts still seem fixated).

EEM, the emerging market etf, and OIH, the oil service etf, are still in strong long-term uptrends. But, as I've been writing for the past few months on my web site link , these uptrends are extremely over-extended at the current time, and thus susceptible to sharp declines.

E.g., here is a 4-year daily chart of EEM that I've shown before, courtesy of prophet.net (left click to enlarge), indicating that it has just started to pull back from being 2 standard deviations above its linear regression trendline, it is currently down nearly -6% intraday today (July 26), while EFA, the developed markets etf, is down -3.6% mid-day.

(I didn't use a log vertical scale since this greatly curves the regression lines, so EEM's current strength is somewhat visually exaggerated compared with earlier due to the linear scale, e.g., its recent 10 point move from 130 to 140 is far less in percent terms than the earlier 10 point move from 40 to 50 four years ago).

Let me be crystal clear that looking at these other leading markets is NOT meant to minimize the importance of developments in the U.S.--everything is connected nowadays, both in the real world and the financial one.

As I've indicated before link, up until the past few days, huge credit market risks have been counter-balanced to some extent by huge real global economic growth, though that balance is rapidly turning into global risk aversion.

E.g., China grew 12% in the 2nd quarter (China's mainland stock markets have just come back to their previous highs, and are very highly valued and frothy). The world has never seen anything like this growth before, again in terms of speed, scale and scope, though it of course has seen many previous examples of excess speculation.

Why I Try to Stay Aligned with the Long-term Trends, Except When They Change :-)

As for my second caveat regarding the prospects of a significant market pullback in the third quarter, as my phrase “the long term uptrend is your friend” above clearly implies, I do not place too much faith in trying to forecast, or guess, critical turnings points in financial markets, for various reasons that I’ve described elsewhere on my web site.

Suffice to say here that the economic/financial environment has changed so much in the past decade that I have great difficulty extrapolating prior experience, statistical patterns, rules-of-thumbs, theories, hypotheses, sheer guesses, etc.

(The Bank for International Settlements says something similar in its recent "Annual Report": “the combination of developments is so extraordinary that it must raise questions about the source and, closely related, the sustainability of all this good fortune. A variety of hypotheses have been suggested to explain subsets of these phenomena, but each falls short of explaining them all.”)

Given that, I am content with trying to merely recognize major trend changes early enough as they happen to matter. For most individual investors, that is more than good enough. Larger, slower institutions must invest on the basis of their forecast.

(Btw, on the efficacy of forecasting financial markets, I recommend the views of portfolio manager and economics Ph.D. John Hussman. I would especially note his July 16 “Weekly Market Comment,” “A Who’s Who of Awful Times to Invest,” link which does an excellent job indicating the risks of this type of market environment.)

A Real Capital Gains Tax Scandal

Recently there has been a little political concern raised over very low taxation of the huge gains of private equity fund owners, though their lobbyists quickly quashed it. The issue raised was whether their gains should be taxed as capital gains or income.

Of course it should be the latter, but that misses the key point. The very low capital gains tax rate has not done what it was sold to do, i.e. increase investment in productive economic activity, that investment has been low by historical standards in this economic cycle.

Rather, low capital gains taxes, including real estate, have clearly done what they could be expected to do, produce enormous speculative financial capital gains, mainly for the benefit of the ultra-wealthy. That is what the U.S. tax and monetary systems and economy are geared toward doing.

Obviously capital gains that reflect expected real future cash flows from expected real future economic activity should be strongly encouraged and very lightly taxed (and onerous regulations removed, starting with Sarbanes-Oxley, I felt strongly enough about this to post "Sarbox counterproductive" twice, on March 8, 2006 link and April 10, 2006 link.)

The same is true, probably even more so, for real income, which also should be taxed at very low rates, because real income must come from the production and sale of real goods and services.

Whereas, in contrast, capital gains can often be manufactured out of pure Wall Street financial fantasies and speculation, purely in fanciful spreadsheet projections and the click of an electronic trade in cyberspace.

Today, much capital gains, again most especially of the ultra-wealthy, are from mere paper shuffling of assets and virtually unlimited credit creation, with very little, if any, link to real productive economic activity.

(Btw, mainstream economists don't seem to be willing to look at these financial speculative capital gains as probably the main source of growing income and wealth inequality in the U.S., instead focusing on differences in education which doesn't explain the rising disparity in favor of those at the very, very top vs other very well-educated people.)

I think any honest person who has ever worked in a hedge or private equity fund or i-bank would know how completely economically absurd many of their deals really are, and the fact that they are driven by pure greed, plain and simple. This is not how markets' "invisible hand" is supposed to work. Most mainstream economists, especially academic ones who haven't worked in speculative markets, just don’t seem to know this, much less the politicians.

Paul Krugman, an honest and extremely capable mainstream economist (e.g. a 1991 winner of the highly prestigious John Bates Clark Medal), came close to hitting the capital gains tax nail on the head in a recent NYT column on this issue:

“There's a larger question one could ask: should we even be giving preferential tax treatment to true capital gains? I'd say no, because there's very little evidence that taxing capital gains as ordinary income would actually hurt the economy. Meanwhile, the low tax rate on capital gains is one main reason the truly rich often pay lower tax rates than the middle class. A couple of weeks ago, Warren Buffett pointed out that he pays an average federal income tax rate of 17.7 percent, while his receptionist pays about 30 percent. But even those who disagree with me on the larger point, who think the special treatment of capital gains is justified, should be able to agree that treating the income of fund managers differently from the way we treat the income of everyone else who works for a living makes no sense. And that's why it's very disheartening to read that prominent Democratic senators are taking seriously the claims of fund managers that making them pay taxes like regular people would discourage risk-taking.” NYT, July 13, Paul Krugman, op-ed, “An Unjustified Privilege” [bold emphasis added by econotech]

But even Dr. Krugman, who has been extremely outspoken in going after the U.S. political elite on Iraq and other issues, so far has been unwilling to do the same with its speculative financial elite. In general, most well-meaning and very capable economists still show great deference to the financial, as opposed to political, elite

What Citigroup's CEO Didn't Say

While Krugman at least honestly raises the critical capital gains tax issue, compare this with the quote from Citigroup's CEO at the front of this article.

Citigroup’s Prince failed to make two critical points, first that the global hyper-speculators are dancing to music of their own making, to use his metaphor, through their infinite credit creation schemes. I.e, liquidity is not some external, exogenous, force of nature, it’s created by the global hyper-speculators’ own daily decisions and actions.

The second, even more critical point, that Prince obviously won’t say is that this liquidity-driven global financial system is mainly intended to benefit its mega players, and is a completely economically absurd way to allocate savings and capital in a global economy.

Again, what this monetary/financial regime, for lack of a better word, is very good at is creating capital gains out of thin air, which mainly accrue to the ultra-wealthy, hence the unending stream of absurd deals that do just that.

What this economic regime isn’t very good at right now is rationally allocating investments that actually produce significant gains in real income, again which should have very little if any tax, by meeting the real needs of the vast majority of the world’s population, not the Madison Ave.-induced fantasies of a tiny, increasingly superficial ultra-elite.

Sooner or later, this massive global mis-allocation of capital for the benefit of a very small group of global hyper-speculators will change, hopefully positively, but if not, then with negative consequences.

That has always been the case throughout history, when an entrenched elite doesn’t do the right thing, bad things invariably follow in reaction, in terms of conflicts and ideologies, which the elite then use to rally people against.

Let’s hope history doesn’t sorrily repeat itself yet again.

The Meaning of My New Tag Line: "FINANCE INNOVATORS, NOT SPECULATORS, For Just Global Development, To Restore America's Purpose and Values"

I've shortened the tag line on my web site link, still keeping the capitalized main theme, it now reads, "FINANCE INNOVATORS, NOT SPECULATORS, For Just Global Development, To Restore America's Purpose and Values"

This reflects my belief that the leading front in global history is the amazing economic development going on in many parts of the globe, while the U.S. government is bogged down in a debilitating, in many ways, rear-guard battle in the war in Iraq. (I view global history in terms of the leading nations moving forward human progress and global development, or unfortunately not, in any given era.)

I believe it’s very unfortunate that the U.S., and many Americans, seems so pre-occupied with other things, including a huge capital gains fueled consumption binge of unprecedented proportions among its elites, to not have time to truly understand and appreciate the march of global progress in many parts of the world right now, which the U.S. previously had led for much of the past century, resulting in its much higher former global standing.

I also believe that the current U.S. failure to provide such global leadership, especially the U.S. financial elite’s focus on its own ill-gotten speculative gains, has greatly eroded America’s historical purpose and values. (For some suggested changes in U.S. policies, please see my Oct 27, 2006 article, "Global Strategic Bargain: Positive Reality Therapy for America's Critical "States of Denial,"" link.)

As for the U.S. tech elite, it's nice that Apple is selling a lot of iPods, iPhones, and Mac's, Amazon a lot of stuff, and Google a lot of ads. But Steve Jobs, the once hip computer revolutionary, and Silicon Valley, the once awesome center of American innovation, have increasingly gone the way of Madison Avenue and Hollywood (though Yahoo recently switching CEO's was a small step in the other direction).

Hopefully the U.S., and its tech elite (I have little hope for the financial elite, perhaps those around the Rubin/Summers wing of the Democratic Party in the Hamilton Project will belatedly surprise me) will once again rejoin the global march of progress. If so, the U.S. might begin by once again starting to pay its way, instead of sucking in the world's savings much needed for economic development elsewhere.

After more than three decades of the U.S. becoming the world's credit junkie, to start to change would require difficult but nevertheless doable reforms in the world monetary and financial regime, again for want of a better word. It would be much easier to make the much-needed global economic adjustments while things are still going relatively well.

But with the speculative finance elite dominating the U.S. economy, and the leading candidates of both parties seemingly in their hip pockets (with Clinton and Obama particularly good at getting money from hedge and private equity funds, i-banks and Hollywood), I personally don't have much optimism about that occurring any time soon. I hope I'm wrong.

Thursday, June 28, 2007

6/28 Global Financial Markets' Bipolar Disorder Even Greater than Usual

June 28 (Econotech FHPN)--Is it just me, or do global financial markets currently seem to have even greater bipolar disorder than usual?

The past few months I have been increasingly highlighting global financial markets' risks, while also noting more recently that momentum investors have been shifting into U.S. large cap and tech stocks, which in general have been laggards in the 2002-07 cycle.

Exhibits A and B just from today, compare these two stories below. First the lead story on Yahoo!Finance this afternoon; before the price rise, RIMM's trailing p/e was already 50, according to Yahoo!Finance:

"Research in Motion's 1Q Earnings Jump
Thursday June 28, 5:06 pm ET
By Rob Gillies, Associated Press Writer
Research in Motion Says 1Q Earnings Grew 73 Percent on Increased Sales; Shares Soar 14 Percent

NEW YORK (AP) -- Shares of Research In Motion surged more than 14 percent in after-hours trading Thursday after the BlackBerry maker said its first-quarter earnings grew 73 percent on increased sales and subscriber additions."

Now second, the lead front page story in this morning's "Financial Times," one of the world's most authoritative financial news sources:

"Axed deals reflect concerns over credit
By Lina Saigol and Joanna Chung in London and Richard Beales in New York
Published: June 28 2007 03:00

Companies are pulling financing deals across the globe, in one of the clearest signs yet that investors' worries about rising interest rates and US subprime mortgages could be infecting other areas of the credit world and driving up the cost of corporate borrowing ... The bonds and loan deals were pulled after investors refused to buy them under the proposed terms, demanding higher premiums and more protection. Stephen Green, chairman of HSBC, yesterday ... In an interview with the Financial Times, he said he was "worried by the degree of leverage in some big ticket transactions nowadays" and felt that "something is going to end in tears". He also warned that losses could be higher because the parcelling out of risk to so many parties across the financial system could make it more difficult to arrange a rescue - a comment that highlighted widespread and growing unease among senior banking executives ... Many investors are now reassessing risk, which could force up the cost of doing deals and cause a sharp slowdown in private equity activity. Investors appear to be rejecting deals involving the riskiest structures ... Amitabh Arora, New York-based head of interest rate strategies at Lehman Brothers, said: "The bigger risk now is that it calls into question CDOs as a financing vehicle in the corporate credit market.""

Tuesday, June 26, 2007

6/26 Emerging Markets Volatility, Regional Banks Negative Alpha Just Two More Warning Signs

June 26 (Econotech FHPN)--Due to my ongoing concerns about the global financial markets at the current time, I've been posting more frequently the past month than I feel comfortable doing. I hope that I am not becoming too short-term oriented as a result.

Emerging markets have been a clear focus of public equity market speculation in the 2002-07 cycle (there's much larger speculation in private equity, structured finance and derivative markets). In this respect, EEM, MSCI emerging market etf, is the QQQQ, Nasdaq 100, of this cycle.

Perhaps with the critical difference that EEM's p/e is now actually over an order of magnitude lower than Nasdaq's in March 2000 (I know that seems difficult to believe in retrospect, especially given how "efficient" developed financial markets' are claimed to be).

I showed in my last June 21 article (“”Goldilocks” 65 Basis Pts Higher," link) that EEM is now 2 standard deviations over its 4-year linear regression trend. Much shorter-term, over the past month since May 23, EEM has started to exhibit greater volatility.

You can see that on the attached 60-day, 60 min chart, courtesy of prophet.net (left click once to enlarge).

Before May 23, EEM prices hugged the center green regression line. After May 23, these prices have been yo-yo-ing up and down. You also can see the same thing in the "true strength index" panel, with the greater oscillations around the 0 line.

To me, this chart is an early warning sign, for the following reason. Over this short-term period, reward, in this case the rate of price change, essentially the slope of the regression line, hasn't changed. Yet risk, indicated by the greater volatility (larger standard deviation of prices), is increasing.

So, EEM most recently is generating the same return, but now at higher risk. I.e., risk-adjusted return is going down, especially when you add in the additional factor of the higher hurdle of rising l-t interest rates.

Perhaps this declining risk-adjusted return may seem a somewhat subtle change if one is mainly focused on return. But I believe that when a market starts giving the same return for higher risk, it's time to start taking notice.

To be crystal clear, I am NOT predicting here imminent meaningful declines in the emerging markets, though I think the risks of that have been increasing. E.g, perhaps July might have its typical seasonal bounce, with declines to then follow.

But to continue the analogy from my June 7 article (“Equity Markets Flying Without Instruments Into a Non-Linear Storm”, link), I do think there are subsurface cracks in the ice.

In that article, I showed a chart of XBD, the broker-dealer index, with a negative alpha (risk-adjusted return) since July 2006, saying that didn't seem like a good sign for a global financial economy seemingly run for and by the Goldman Sachs’ and Blackstones’ of the world.

I-bank stocks have been weaker since I posted that due to concerns about the Bear Stearns hedge fund situation (see my June 21 ""Goldilocks"" article link).

Here is a 4-year weekly chart of another financial sector, RKH, regional bank etf, courtesy of prophet.net (left click one to enlarge).

Similar to XBD, RKH’s alpha is negative, in the latter case at the lowest level of the past four years.

It’s a little difficult to see, but RKH is now below its 40-week moving average (purple line) and right near the bottom (2 std deviations) of its linear regression channel. Both served as support in Oct 2005, failure to do so again would be significant this time.

So the signs, “Warning Thin Ice,” continue to add up. Perhaps the darkest hour is just before dawn. Wall Street is probably hoping for the usual first month of the quarter bounce in July during earnings reporting season.

But perhaps these increasing warning signs mean there may be more darkness to come. That’s why I’ve recently suggested considering hedging one’s bets in the most appropriate manner for each investor.

I think most people naturally would prefer not to hear such warnings and suggestions, and I'd prefer not to give them. But no one likes losing money either, so perhaps, at selected times, it may be worth running the risk to one's credibility by making them.