In the short term, eg the next couple years, there are several minefields that are sitting out there, any one of which could explode – these are the reasons I am bearish about the current market in the short-med term.
Sub-prime – the hot issue at the moment (US banks have to mark their assets to market by Sep 30 leaving the reporting to be done in October, obviously a time of seasonal lows for the market – how much did they lose, I’m tipping more than 200pts worth of decline from the All Ords high). Nowhere near finished with yet. It will just take a couple bad numbers or a bank falling over in the US to set off another plummet, and this one will be more severe.
Unwinding of the yen carry trade caused by a rise in Japanese interest rates – if this happens, our market (including the entire smorgasboard of well undervalued resource stocks) will be smashed across the board as all the funds borrowed in Yen are paid back via assets sales in high yielding currencies (ie ours) – we saw this start to happen in the recent correction, and their was a flight to – of all things – the “safety” of the USD and away from our currency.
Higher oil prices – it is now widely accepted that the world has reached or is about to reach peak oil, the evidence is already out there (Exxon reported a decline in production of 10% recently) and with the global growth in population coupled with the Chinese just recently reaching the critical point (around US$3000) where their average income leads to skyrocketing demand for oil guzzling goods, there is no hope of keeping up. Ie much higher oil prices are a near certainty in the medium term. How will the world economy deal with US$100 oil? And what incentive do OPEC have to increase their production if they know they are running out?
The imminent collapse of the USD, the world’s “reserve currency”, of which more is literally printed every time we have a “crisis”. http://www.fxstreet.com/rates-charts/usdollar-index/ The market is already saying the Fed will drop rates there 25-50 bp. Take a look at that USDX chart. 80 is the all time low for the USD against a basket of other currencies. When that support collapses (and the Fed will throw everything at it), consider what will happen when China and all the other countries the US owes money to start selling off all their trillions of dollars in US Assets. The Chinese have already hinted at doing this recently if the US refuse to remove a few tariffs. It could happen suddenly or they could do it slowly – either way, the USD is f%@ked as surely as the Baht was in the Asian currency crisis, it’s only a matter of time. The Chinese could win a war against the US in a heartbeat by collapsing the USD. They have already started diversifying away from US assets too in the form of setting up a gigantic Investment Fund (probably designed to acquire resources).
The state of the economies of the US and Europe – these are the countries that do the importing from China et al. Their economies are both in shocking shape.
Of course, we could somehow sail through all of the above unscathed. And the stockmarket could just continue on its way. But what are the probabilities?
I still believe in a long term commodity bull market despite these problems, and in the next few years there will be dramatically higher energy prices (oil, gas, uranium) and commodity prices despite this, simply supported by a growth in the global population (BRIC), declining oil reserves (and a lack of new finds), although base metals prices may be more mixed. In the first instance though, as one or any of the above minefields explode, the commodity stocks will be the baby thrown out with the bathwater. Also after the blood on the streets has dried up (love that imagery) gold stocks – and for this read my favourite insanely cheap gold spec PGM – are going to outperform dramatically as the world gravitates back towards gold for a new reserve currency.
The market may keep rallying for another couple weeks – bear in mind though the recent rally has been on light volume. Personally I think this is a sucker rally, but who knows – I don’t proclaim to be able to pick day to day moves any more than the next person. It’s just a matter of having stop losses in any long positions.
Anyways, on that uplifting note, have a read of the below uplifting articles.
Brace yourself for the insolvency crunch
by Ambrose Evans-Pritchard on 23 Aug 2007
The liquidity crunch is not yet over: the insolvency crunch has hardly begun.
Yes, investors are jumping back into the stock markets, hoping this is just another routine shake-out - much like February 2007, or May 2006 - before the rally resumes. The `buy-on-dips’ orthodoxy dies hard.
And yes, speculators have renewed their leveraged bets on the yen and Swiss franc carry trades, borrowing cheap in Tokyo and Zurich to play global assets. The core belief is that nothing has really changed, that the world economy is still in rude good health.
Be very careful. Interest rates in Europe and Asia are that much higher now, with delayed effects starting to bite hard. Japan’s economy has stalled to 0.1pc growth in Q2; the euro-zone has slowed to 0.3pc; and China’s refusal to import (by currency manipulation) makes it a drain on world demand. Above all, the credit bubble that perpetuated the rally of the last eighteen months beyond its natural life has definitively burst.
Credit spreads on the iTraxx Crossover (a good barometer of corporate bonds) have ballooned 180 basis points since February. The cost of borrowing for most firms in Europe and North America has jumped from circa 6.5pc to 8.3pc, if they can get it.
Many cannot. Germany’s Chamber of Industry told me yesterday that it had been flooded with distress calls from family Mittlestand firms unable to roll over credit lines. In Canada and Australia, junior mining finance has dried up almost entirely.
Global junk bond issuance has been frozen for two months. Fresh sales of collateralized debt obligations – the CDOs of subprime notoriety: a $1 trillion sold last year - have all but stopped. Banks have yet to off-load $300bn of debt from leveraged buy-out deals, forcing them to keep the liabilities on their books. They are all snake-bitten now.
The private equity buy-out premium – which pushed up the price/earnings ratio on the MSCI-600 of “median” stocks to a record high of 20 in May - has vanished. The P/E ratios on the DOW 30 big stocks are much lower – because they are too big even for the big cat predators, KKR and Carlysle – but they are not low, given the late stage of the cycle. In reality, an earnings bubble and ultra-cheap credit have flattered profits.
So no, the world has changed, dramatically. Whether this means a protracted global downturn and a “profits recession” depends on how quickly the central banks choose to respond, and how far they are willing to go.
Ben Bernanke is looking hawkish to me, given the shock of what happened on Monday when yields on 3-month US Treasury notes plunged at the fastest pace ever recorded, a panic flight to safety that no living trader had ever seen before.
Why? Because trust had collapsed to such a degree that players with a lot of cash no longer believed it safe to leave wealth in bank accounts, or the money market funds of brokerage companies - (exposed as they are to short-term commercial paper and subprime CDOs). This did not occur after 9/11, or in the heat of the October 1987 crash. Nor did was there such a banking panic in October 1929. (it hit in August 1931). If you think this is of no importance, or that this will pass swiftly, you have a strong nerve.
“When you have a run on the money markets like this, it is bound to spill over into the real economy,” said Albert Edwards, global strategist at Dresdner Kleinwort.
“We already thought there was a 40pc chance of a US recession before all this happened, but the risks are now much higher and don’t forget that rates on adjustable mortgages will keep rising until a peak next March, so the maximum pain will be in the second and third quarters of 2008,” he said
“There will be large bankruptcies, and liquidity is not going to help because too many people bet the farm at the top of the cycle, and they’re now insolvent. A lot more bodies are going to be floating to the surface before this is over,” he said.
The belief that Europe would somehow be insulated has been tested over the last two weeks. Two German banks have required bail-outs on subprime bets – Sachsen LB for Eu 17.3bn, IKB for Eu 8.1bn.
Alexander Stuhlmann, boss of WestLB, confessed that the German banking system was in a "not uncritical situation". Jochen Sanio, head of the German regulator BaFin, said a few days earlier that the country faced the worst banking crisis 1931.
Hence the continued actions of the European Central Bank, which has quietly injected 85bn euros in extra liquidity so far this week, almost as much as it did on the first day of emergency stimulus in early August.
“Banks are still thirsty for credit, and the spreads have been amazing. This is not business as usual at all,” said Julian Callow, chief Eurozone economist for Barclays Capital and an expert in the arcane field of central bank operations. (He used to work for the Bank of England.)
To clarify: the ECB allotted an extra Eu 45bn extra through a `weekly refi’ on Tuesday; and then Eu 40bn in a 3-month offer on Wednesday to stop the short-term commercial paper market seizing up.
What we know is that 146 banks bid for loans on Wednesday, some clearly in such distress that they were willing to pay up to 5pc interest – a full 1pc above the ECB’s benchmark rate.
Just like the dotcom bust: when the US sneezes, Europe catches… you know the rest.
In a warped sense, one has to admire the cool way that Americans – who save nothing, in aggregate – tapped into the vast savings pool of thrifty Germans to finance their speculative excesses, and then left the creditors holding a chunk of the subprime losses.
Was it sharp practice, in the same way that foreigners were recruited by Lloyds of London in 1986 and 1987 – before the impending asbestos losses were known – and place like cannon fodder on “spiral syndicates” to absorb crippling losses? (Lloyds denies this occurred).
I am endebted to Randall W.Forsyth from Barron’s for this delicious quote from a hedge-fund operator, recounting with disgust what happened this time in a letter to clients.
"'Real money' (U.S. insurance companies, pension funds, etc.) accounts had stopped purchasing mezzanine tranches of U.S. subprime debt in late 2003 and [Wall Street] needed a mechanism that could enable them to 'mark up' these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!!
"These CDOs were the only way to get rid of the riskiest tranches of subprime debt. Interestingly enough, these buyers (mainland Chinese banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, U.K. banks) possess the 'excess' pools of liquidity around the globe. These pools are basically derived from two sources: 1) massive trade surpluses with the U.S. in U.S. dollars, 2) petrodollar recyclers. These two pools of excess capital are U.S. dollar-denominated and have had a virtually insatiable demand for U.S. dollar-denominated debt . . . until now.
Shameless.
THE LIQUIDITY CRISIS OF 2007 A Question and Answer Survival Guide by Atash Hagmahani & Andy Sutton My2CentsOnline.com August 24, 2007
Is the current stock market correction a healthy correction, or the start of a bear market?
It's hard to say, because of the mysterious and counterintuitive way that US stock markets tend to recover in the late hours of trading, after stock markets around the world were plunging the rest of the day. There is clearly not the high degree of transparency that small to medium investors need to make sound investing decisions. Perhaps one of the biggest misconceptions with regards to the stock market is that securities are priced fairly. To a large extent, markets run on emotion, and therefore, are inefficient. Today significant portions of the markets are run by computer models and therefore are perceived to be perfect. However, the computer software is only as good as the person writing it. The software often carries the biases and perceptions of the programmer. Instead of trying to predict the future of what the stock market will do, ask yourself if you can think of more rational and more productive ways to make money than trying to buy electronic tokens from each other and later sell them to each other at higher prices.
What caused this recent crisis to happen?
The stock market volatility is being caused by lower-than-usual amounts of ready cash, or in other words, a liquidity crisis. Liquidity means that enough cash is available for assets to trade hands without the sellers taking a significant loss. Liquidity is what the world's financial network is lacking at the moment.
The liquidity crisis happened because of questions regarding the value of several types of securities, which in turn had been used as collateral for outstanding loans. One of the securities in question is the CDO, or Collateralized Debt Obligation. What happens is that investment banks sell interests in a pool of mortgages. The value of the underlying bonds is derived from the expected future cash flow from the mortgages that make up the bond. When these bonds were packaged together, a certain percentage of the underlying mortgages were expected to default and end up in foreclosure. The pool of mortgages was divided up into groups called tranches; each tranche corresponded to different levels of risk and reward. The highest rated tranches had the highest priority for repayment of principal, and the lowest interest rate offered, while the lowest-rated tranches had the lowest priority for repayment of principal but the highest rate of interest offered. However, what we have seen is default and foreclosure rates higher than those assumed. These additional defaults and foreclosures have reduced the future cash flows. Once that happens, it becomes inherently obvious that the bonds are no longer worth the price on the books.
The main problem with this scenario is that some of the mortgages should never have been made in the first place. The reason that they were is because in a fiat money system where credit can be created on demand, investors armed with limitless supplies of borrowed money will tend to bid returns on investment down to absurd levels. Eventually lenders become desperate for new borrowers, and will make irresponsible loans, and then try to sell interests in these to someone else as quickly as possible. The high-risk tranches are popularly known as toxic waste.
They were able to find suckers to buy interests in these loans because major Wall Street credit rating companies were giving investment-grade ratings to high-risk tranches.
Have there been any liquidity crises in the past?
Yes, many. Ironically, one of them, the Banker's Panic of 1907, was the excuse given to create the Federal Reserve. The operations of the Federal Reserve were supposed to prevent such things from happening.
In the case of the panic of 1907, the stock market crashed twice, there was a recession, and there was a run on the banks.
Doesn't FDIC insurance mean that bank deposits are safe now?
FDIC insurance isn't really insurance, it's a pool of money to be used to buy up enough bad loans off the failed bank's books to make it attractive to a potential buyer. It's not used to pay back the depositors.
It only works when bank failures are isolated events, and will not work in a systemic crisis.
The purpose of FDIC insurance is not to really guarantee the safety of the banking system, but to prevent runs on banks by reassuring investors that their accounts are insured. Bank failures, however, are not really an insurable event.
What's different about the liquidity crisis this time?
The biggest difference is that in this case, the crisis is on a global scale due mostly to displaced dollars as a result of our persistent trade deficits. For years we have been importing more than exporting. This has resulted in many foreign countries ending up with a growing excess of US Dollars in their coffers. Instead of holding onto the cash, they invested in government bonds, agency debt, US stocks, and unfortunately, CDO’s. CDO’s were especially popular due to the high credit ratings coupled with attractive interest rates.
The market for US mortgages is over $9 trillion dollars. To put this in perspective, it is more than the entire indebtedness of the US government. US GDP is around $13 Trillion. The total supply of money in the US system (M3) is around $12 Trillion. So it is easy to see the enormity of the US mortgage market. Granted, many of those loans are prime loans, and the borrowers faithfully make their payments each month.
The biggest threat right now is that we are seeing this crisis coupled with a slowdown in the overall US Economy. As recently as 8/16, the Philadelphia Fed Survey indicated that overall business conditions in the Northeast are at a stall. Retail sales are slowing down, and if you consider that the numbers reported are actual dollars, not units sold, retail sales are flat to negative already.
What has the Federal Reserve done in response to the crisis?
The Federal Reserve conducted several repo operations in which they injected billions of dollars into the banking system. Repos are temporary swaps of collateral for cash. The Fed found that because only quality collateral is used in repost that banks were using the repos to get liquid, then holding the cash. This was done as a defense against further liquidity crunches. The only problem with the repos is that the institutions that really needed the loans couldn’t get them because they lacked quality collateral. Once this became evident, the Fed switched to the Discount Window method.
Quoting from their own press release:
To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets…
In other words, the Federal Reserve lowered the interest rate at its discount window, will accept the toxic waste as collateral (they have no reason not to, since the credit they use to buy the collateral isn't real money that they had to work for), and are encouraging banks to get loans from them.
Will lowering the interest rate at the Fed's discount window solve the problem?
No. The discount window is still a higher rate than the federal funds rate, so the only banks that have an incentive to apply to the federal reserve for loans are those banks that are being turned away from other banks. This smacks of desperation, but it doesn't solve the problem of collateral that is worth significantly less value than it's on the books for. If the central banks just keep rolling the loans over and over again, first of all that creates moral hazard (an incentive to do the wrong thing), and second, it amounts to monetizing worthless debt, or in other words, it causes inflation and lack of confidence in the currency.
On top of this hazard, the Fed is going to be faced with the reality of a recession in the near future. Monetizing junk mortgages and cutting rates at the same time to spur the economy is likely to trigger a sell-off of the dollar. The dollar seems to have 9 lives, but it is difficult to imagine a scenario in which the above conditions occur and the dollar doesn’t fall.
If lowering the interest rate on the discount window won't solve the problem, then why is the Federal Reserve doing it?
Average people who read the mainstream media's reassurances that this will solve the problem are likely to believe them. So above all, this is a confidence game. The purpose is probably to keep average American and foreign investors in the stock, bond, and money markets so that favored corporations have more time to get out.
Letting banks that are in trouble apply for loans at the Fed's discount window allows the Fed to figure out who is in trouble, and it buys time. The real danger to this situation is that the bigger banks either try to smooth over or understate their exposure and risk and one (or more) end up going bust. If this were to happen, the financial system itself could collapse.
Is this something that I should be worried about?
It's impossible to predict the future with any accuracy. It's better to make preparations according to likelihoods and how much is at stake, and then worry less.
What are some possible risks associated with this crisis?
Many types of assets will become difficult to sell without a loss. Slow-moving assets such as real estate and small businesses will move slower than usual unless deeply discounted. Fast-moving assets such as stocks may plunge in value. Long-term bonds have inflation risk. Even inflation-indexed bonds have significant inflation risk because they are indexed to ridiculously low measures of price increases.
Money-market funds, that tend to contain uncollateralized debt, are not necessarily covered by the FDIC. Many of the higher-returning money market fund have also bought heavily into the subprime mortgage bonds. They did this to capture the higher yields. What they also captured was higher risk, risk that is not perceived to be present in money market funds.
The FDIC can't handle a systemic banking crisis or for that matter one really big bank failure.
What can I do to protect myself from possible consequences of this situation?
While we cannot make specific recommendations because of suitability requirements, some strategies used in situations like this are:
Keeping on hand, in cash, expense money calculated to last for a predetermined period of time Buying quantities of precious metal bullion coins to use as currency substitutes Buying precious metal collectible coins. During the crisis, these might fall in price, which is actually a good opportunity to buy them at a discount as a hedge against currency depreciation. If the crisis is too bad, however, then they will skyrocket in price against a collapsing currency. Decide what you can afford and how much you're willing to pay. History has shown our government’s predilection to confiscate bullion. So far, such has not been the case with numismatic (collectible) coins Selling US Dollar-based assets and converting the funds to cash or near-cash positions denominated in multiple foreign currencies, while avoiding money-market funds. Keeping printed statements from brokerage and other stock accounts on hand The mainstream media isn't discussing the crisis much anymore. How will I know when it's over?
The crisis is probably actually in its early phases! Public sentiment is usually wrong. Right now there is still too much optimism, as is typical of the early phases of a crisis. Think of the passengers on the Titanic who were casually chipping pieces of the iceberg off to cool their drinks. When the crisis actually bottoms out, there is likely to be a lot of leftover hand-wringing and despair. To stay better informed, read financial news sites such as this one.
The mainstream media is incredibly biased in this regard. Remember, the media outlets are owned by large companies with profit motives and an interest in keeping the status quo healthy. Many of these ‘economic experts’ seen on TV are nothing more than journalists.
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