Thursday, December 4, 2008

The Edge of The Abyss

Taking a step back from the nuisance and noise of the present day, one can fully appreciate the arc of violent dislocations transpiring across the global financial system. Over the course of the last decade, the world has experienced exogenous shock after shock; the Asian Financial Crisis (1997), the Russian Financial Crisis (1998), the Technology Bubble (2000), Enron and Worldcom (2002), the Housing Bubble (2006), the Credit Bubble (2007), the Emerging Markets and Commodities Bubble (2008) and coming to theaters near you, the Bond Bubble (2009). From the perspective of a former geologist, these were the initial tremors of friction.

Make no mistake about it, the financial markets are the dog, the political fall-out and massive global instability that arises after economies and governments collapse is the tail. I believe Nassim Taleb was correct in describing the present as perhaps the most dangerous episode in American history since the Revolution. 

The kinetic energy of these crises has always been maintained within the system. Each time a monetary policy or fiscal policy official tells the public the problem has been contained; it mutates, changes shape and shows up somewhere else. Nothing is resolved and no maladies are purged from the system. It is just like a doctor treating the symptoms, but never isolating the cause. Worse yet, the doctor seems to always prescribe steroids for these ailments, further masking the cause and pushing down the road the inevitable collapse of the patient.

As a cynical observer of these events, the present culmination of disruptive forces within the financial system is nothing less than poetic. Whether it is our current President's complete lack of political capital to affect any necessary change or Henry Paulson's impotence and maleficence to Treasury's (aka Goldman Sachs) role within the meltdown, the crisis has reached critical mass and will begin to act disorderly, or more succinctly, chaotic. Despite the tremendous volatility and downward pressures upon the system, the markets overall have been orderly and methodical. I believe we are about to cross that threshold.

Milton Friedman once said that he did not believe the Euro would survive it's first crisis. It appears that the crisis has arrived.

"The euro is going to be a big source of problems, not a source of help. The euro has no precedent. To the best of my knowledge, there has never been a monetary union, putting out a fiat currency, composed of independent states.

There have been unions based on gold or silver, but not on fiat money—money tempted to inflate—put out by politically independent entities...

Inflation is a monetary phenomenon. It is made by or stopped by the central bank. There has been no similar period in history like the last 15 years in which you’ve had little fluctuation in the price level. No matter what else happens, this will maintain as long as the US Federal Reserve maintains strict monetary policy and control of the money supply.

The same thing is true in Europe. The ECB (European Central Bank) has held down the rate of monetary growth. So there have been stable prices. The pressures in Europe, however, will be much stronger than in the US. The main pressure is to print money and be more expansive in order to promote employment.

What the ECB does really depends on whether Germany and France and Italy will back it. Italy may well be the main problem...

In this sense, the euro is good for Europe. But only if there is flexibility all around. The problem is that, in a world of floating exchange rates, as Italy was before the euro, if one country is subjected to a shock which requires it to cut wages, it cannot do so with a modern kind of control and regulation system. It is much easier to do it by letting the exchange rate change. Only one price has to change, instead of many.

But now, in the euro, that option is taken away. The only alternative if a state has to adjust to a shock is to let internal prices vary. It has to let wages go down, if necessary." - Milton Freidman 2006
Below is an article from the UK Telegraph that neatly sums up the gauntlet of moving parts now unfolding across the Atlantic. I would urge you to read the entire article. Anyone expecting (the Fed and ironically Jim Rogers) the US dollar to weaken and resume its decline will be greatly disappointed, or as the Telegraph puts it, "America is the staid old lady in this drama."

By Ambrose Evans-Pritchard
Last Updated: 10:52AM GMT 26 Oct 2008

The financial crisis spreading like wildfire across the former Soviet bloc threatens to set off a second and more dangerous banking crisis in Western Europe, tipping the whole Continent into a fully-fledged economic slump. Currency pegs are being tested to destruction on the fringes of Europe’s monetary union in a traumatic upheaval that recalls the collapse of the Exchange Rate Mechanism in 1992. “This is the biggest currency crisis the world has ever seen,” said Neil Mellor, a strategist at Bank of New York Mellon. Experts fear the mayhem may soon trigger a chain reaction within the eurozone itself. The risk is a surge in capital flight from Austria – the country, as it happens, that set off the global banking collapse of May 1931 when Credit-Anstalt went down – and from a string of Club Med countries that rely on foreign funding to cover huge current account deficits.

The latest data from the Bank for International Settlements shows that Western European banks hold almost all the exposure to the emerging market bubble, now busting with spectacular effect. They account for three-quarters of the total $4.7 trillion £2.96 trillion) in cross-border bank loans to Eastern Europe, Latin America and emerging Asia extended during the global credit boom – a sum that vastly exceeds the scale of both the US sub-prime and Alt-A debacles.

Europe has already had its first foretaste of what this may mean. Iceland’s demise has left them nursing likely losses of $74bn (£47bn). The Germans have lost $22bn. Stephen Jen, currency chief at Morgan Stanley, says the emerging market crash is a vastly underestimated risk. It threatens to become “the second epicentre of the global financial crisis”, this time unfolding in Europe rather than America. Austria’s bank exposure to emerging markets is equal to 85pc of GDP – with a heavy concentration in Hungary, Ukraine, and Serbia – all now queuing up (with Belarus) for rescue packages from the International Monetary Fund. Exposure is 50pc of GDP for Switzerland, 25pc for Sweden, 24pc for the UK, and 23pc for Spain. The US figure is just 4pc. America is the staid old lady in this drama.

Amazingly, Spanish banks alone have lent $316bn to Latin America, almost twice the lending by all US banks combined ($172bn) to what was once the US backyard. Hence the growing doubts about the health of Spain’s financial system – already under stress from its own property crash – as Argentina spirals towards another default, and Brazil’s currency, bonds and stocks all go into freefall.

Broadly speaking, the US and Japan sat out the emerging market credit boom. The lending spree has been a European play – often using dollar balance sheets, adding another ugly twist as global “deleveraging” causes the dollar to rocket. Nowhere has this been more extreme than in the ex-Soviet bloc.

The region has borrowed $1.6 trillion in dollars, euros, and Swiss francs. A few dare-devil homeowners in Hungary and Latvia took out mortgages in Japanese yen. They have just suffered a 40pc rise in their debt since July. Nobody warned them what happens when the Japanese carry trade goes into brutal reverse, as it does when the cycle turns.
The IMF’s experts drafted a report two years ago – Asia 1996 and Eastern Europe 2006 – Déjà vu all over again? – warning that the region exhibited the most dangerous excesses in the world. Inexplicably, the text was never published, though underground copies circulated. Little was done to cool credit growth, or to halt the fatal reliance on foreign capital. Last week, the silent authors had their moment of vindication as Eastern Europe went haywire. Hungary stunned the markets by raising rates 3pc to 11.5pc in a last-ditch attempt to defend the forint’s currency peg in the ERM.

It is just blood in the water for hedge funds sharks, eyeing a long line of currency kills. “The economy is not strong enough to take it, so you know it is unsustainable,” said Simon Derrick, currency strategist at the Bank of New York Mellon. Romania raised its overnight lending to 900pc to stem capital flight, recalling the near-crazed gestures by Scandinavia’s central banks in the final days of the 1992 ERM crisis – political moves that turned the Nordic banking crisis into a disaster.

Russia too is in the eye of the storm, despite its energy wealth – or because of it. The cost of insuring Russian sovereign debt through credit default swaps (CDS) surged to 1,200 basis points last week, higher than Iceland’s debt before Götterdammerung struck Reykjavik. The markets no longer believe that the spending structure of the Russian state is viable as oil threatens to plunge below $60 a barrel. The foreign debt of the oligarchs ($530bn) has surpassed the country’s foreign reserves. Some $47bn has to be repaid over the next two months.

Traders are paying close attention as contagion moves from the periphery of the eurozone into the core. They are tracking the yield spreads between Italian and German 10-year bonds, the stress barometer of monetary union. The spreads reached a post-EMU high of 93 last week. Nobody knows where the snapping point is, but anything above 100 would be viewed as a red alarm. The market took careful note on Friday that Portugal’s biggest banks, Millenium, BPI, and Banco Espirito Santo are preparing to take up the state’s emergency credit guarantees.
Hans Redeker, currency chief at BNP Paribas, says there is an imminent danger that East Europe’s currency pegs will be smashed unless the EU authorities wake up to the full gravity of the threat, and that in turn will trigger a dangerous crisis for EMU itself.

“The system is paralysed, and it is starting to look like Black Wednesday in 1992. I’m afraid this is going to have a very deflationary effect on the economy of Western Europe. It is almost guaranteed that euroland money supply is about to implode,” he said.

A grain of comfort for British readers: UK banks have almost no exposure to the ex-Communist bloc, except in Poland – one of the less vulnerable states. 
The threat to Britain lies in emerging Asia, where banks have lent $329bn, almost as much as the Americans and Japanese combined. Whether you realise it or not, your pension fund is sunk in Vietnamese bonds and loans to Indian steel magnates. Didn’t they tell you?

So what to expect over the coming year? Pretty much every major financial crisis that the world has experienced in chapters over the last decade rolled into one giant cannoli. Deflation has arrived. Can the world digest it?

Wednesday, December 3, 2008

The Thomas Friedman Top

It's easy for us to pick apart recent history and say all the information was there; tight credit spreads, an LBO buyout binge, a housing bubble, a commodities bubble, Goldman Sachs and Thomas L. Friedman. 

Yes, Thomas L. Friedman.

From Wikipedia:

"In the book, Friedman recounts a journey to Bangalore, India, when he realized globalization has changed core economic concepts. He suggests the world is "flat" in the sense that globalization has leveled the competitive playing fields between industrial and emerging market countries."

Could there be a more appropriate illustration of Friedman's captive audience or should we say the choir of advertising executives posing as free-market capitalist?

The World is Flat by Thomas Friedman Wins Financial Times and Goldman Sachs Business Book of the Year Award
November 22, 2005

Lionel Barber, editor, Financial Times said: 'We've had a wonderful set of entries for this prestigious prize. Thomas Friedman is a worthy winner. His book is compelling, hugely enjoyable and relevant to the most pressing issue on the minds of politicians and business people around the world.'

Lloyd C Blankfein, President and Chief Operating Officer, Goldman Sachs, said:

'Thomas Friedman has identified the most important economic and political theme of the early 21st century and has provided us with the vocabulary for debating its merits and challenges.'

Speaking from Washington DC, Thomas Friedman commented:

'I'm absolutely thrilled and honoured to be the first recipient of the Financial Times-Goldman Sachs business book award. I'm thrilled and honoured because these are two such classy organizations, who take business and business reporting seriously. I'm thrilled and honoured because the judges who made this award are such an esteemed group. And I'm thrilled and honoured because I think this Financial Times -Goldman Sachs award for business-financial writing is going to become a much sought-after prize, as more and more writers and publishers get to know about it in coming years. I'm sorry that my crazy travel schedule - I've been between Beijing and Jerusalem in the past few weeks - did not allow me to be in London.'

Where have I heard such confidence and illuminating insight before? Perhaps Alan Greenspan, circa 2004?

"Overall, the household sector seems to be in good shape," "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."
It appears Friedman was as prescient to the strengths of globalization as Greenspan was to housing or more or less everything.

Fast forward a few years and here we are. The chart to the left illustrates just how bubblicious the concept of globalization became. From the ever worthy fellows at the Bespoke Investment Group:

"Just as it’s been a Black October for the equity markets, it’s been even worse for global commerce. The Baltic Dry Index, which is often cited as a barometer for global shipping rates, is now down fourteen days in a row and has declined on all but one day in October, with a month to date fall of 64.3%. Since its peak reading of 11,793 in May, the index is now down by 90.3%.

As shown, the Baltic Dry Index had a meteoric run since the start of the decade, as it became one of the key symbols of the ‘globalization’ trade. Many argued that globalization would work its way into every aspect of the economy, with some health care companies in the US even going so far as to send their patients to emerging countries for surgical procedures. Judging by the recent performance of the Baltic Dry Index as well as global currency markets, however, it now appears that like any ‘new thing,’ the globalization trade went too far. In fact, when compared to the bursting of prior bubbles, the decline in the Baltic Dry Index from its peak is greater than every single one."

One last excerpt from the book quoting Bill Gates. I can't dispute the man's genius, but I think he may have gotten a bit carried away here. Kind of like when he was CEO for a bit too long.
"Bill Gates explains the meaning of this transformation best. Thirty years ago, he tells Friedman, if you had to choose between being born a genius in Mumbai or Shanghai and an average person in Poughkeepsie, you would have chosen Poughkeepsie because your chances of living a prosperous and fulfilled life were much greater there. ''Now,'' Gates says, ''I would rather be a genius born in China than an average guy born in Poughkeepsie.'' - The World Is Flat

I'm not sure the people in Mumbai or Shanghai will feel the same way in the next decade. Just like the markets, they revert to the mean.

Going Lower

As Dennis Gartman often notes, a good trader "Trades like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand." Dogma is a dangerous attitude to front in markets such as these.

With that said, I believe as traders we need to move even further out on the continuum of risk and frankly those that have been dogmatic (towards the downside) have been consistently rewarded. That paradigm will change for sure, but guessing that inflection point will be tremendously difficult. Based on my proprietary research, I believe the odds are growing that between now and the end of January the market will move another leg down, perhaps into the mid 600's on the S&P.
Some things I am looking at:

- The damage sustained to the BKX;

- The expanding gold/silver ratio;

- Weakness in the Euro, strength in the Dollar;

The velocity of these moves, both up and down, have sustained the dominant trend lower. Until the market can break out to the upside and consolidate in a narrow range, there will be no traction. These markets are hollow right now. Just look at SAP Capital or Picken's hedge fund. They are almost completely in cash and waiting. Perhaps you should too!

Monday, December 1, 2008

Oversold is a Relative Phrase

We are currently experiencing the practical application of the old adage "Markets can stay irrational, longer than you can stay solvent". Or perhaps today's version, "Markets can get oversold and remain oversold longer than you can remain solvent." Many of the traders in the past year have received a crash course in this axiom. Their guidposts that they follow on a daily and weekly basis have become the Bonneville salt flats. Wide open, barren, desolate, hard and fast if you find momentum.

I think traders looking for a sustained rally here may be asking for too much. Isn't everyone from Barton Biggs to Marc Faber waiting for that? Granted Barton Biggs has been saying that for no less than a year and a half, I firmly believe that on a longer term trading horizon (weeks and months) the carnage in the financial sector (BKX) foreshadows considerable downside to the overall market. The fact that this is a financial crisis of the likes there are few comparisons, and that the financials constitute the single largest (~16%) percentage of the S&P 500, it should be no surprise that the 2002 lows will be substantially violated; and I am not talking about 741 verses 768. We are talking about a possible 40% decline from the lows.

And for those of you glancing at the shocking depths of these rsi readings on the S&P 500 and speculating that the only move from here is up, check no further than the BKX chart. It has been in the red-zone (<30) for more or less a year. Comparatively, the S&P has only been in the red-zone since October.


The rapid deterioration of the equity markets this morning smells like something more than a retracement of recent gains. Furthermore, the gold silver ratio that has been an excellent forward looking barometer of risk seems to be pointing towards another spell of liquidation and perhaps a lower, low. Maybe it is just another test of the recent lows, or perhaps not.

For certain, weak hands are selling today. If we get down to 800 or slightly lower, we will see what mettle this rally holds.