Wednesday, August 20, 2008

Whats next

I wrote this August 20, 2008. It never made post status, but what has transpired since, it becomes an interesting read October 26, 2008

Meanwhile, back at bear chat, the debate rages about inflation and deflation, gold and silver shortages and all kinds of wacko stuff. But, what is really happening? I think it is everything contrary to what the news says, that we are actually deflating, that the dollar is getting stronger because there is not only a shortage of them to continue the rest of the world on its merry way, but that they are going to get even shorter in supply. The US political scene is really getting messy and whomever wins the next election is going to prolong this agony any way they can, because government draws its power out of agony and not out of prosperity. Here in the US, they just get us to rubber stamp that what they are doing is agreed to because we voted for it. None of us would vote and I don't because I never agree to what they are doing.

The biggest shoes are about to drop, FNM and FRE. They will either languish for awhile or they will agree to something with the US in return for dropping all suits and prosecutions. Thirdly, the US will at least figure out that FNM and FRE weren't all at fault and were only doing what HUD and Congress told them to do and throw them a bone. The third case would allow them to begin to transact business like they should have all along and shut down the loose lending standards that have been increasingly applied since 1995.

For those on the inflation side, no one has shown me how the big spending consumers are going to get the money to keep the party going. Inflation going forward depends on money or credit to keep the bust going big time. In the 1970's, people went out and hoarded stuff to get a jump on the next price increase. This time they just aren't buying what is going up any more than they have to. Why is clear, they don't have the money or the capacity to ask the boss for more money this time.

The wacko gold bug bears think the dollar is going to nothing. I give them some credit in foresight, but I don't believe we are at that point nor do I believe they are going to be young men when it occurs, as in under 70. The US is still the economic powerhouse of the world and most of the rest of the world merely acts as suppliers to the US economic machine. Today I saw a comparison with Japan, the 1930's and with Argentina, and the comparison was the US was mostly like Argentina. There is a lot to the world besides adding up money flows, as they happen for more reasons than one side getting rich and the other going broke. In the case of the US, its debt is dollars and the financial assets of the world are dollars, mostly by choice. As I have written before, the exporting countries to the US have been exporting for a purpose, namely to acquire dollars. Their machinery over there is geared to produce goods in exchange for dollars and thus if the US fails to purchase the production, their business models fail.

The comparison to Japan is really deep. In todays society, savings and debt are bedroom cousins of each other. I am not sure what savings is, but to say that according to statistics, the corporations in the US made record profits in comparison to the GDP, the highest since 1929. Debt in the US is well over 300% of GDP, yet we owe foreigners an amount in the area of 50% of GDP. The other roughly 300% came from somewhere. Someone saves that money to create the loan and the more saved, the more debt accumulated.

If I had to make a guess right now, we are going to a short period of inflation talk followed by some bankruptcies, followed by a collapse in consumer spending. Consumer spending crashes won't be pleasant for the developing world or for parts of Europe. It is the US consumer floating China, not the relending of money to the US that is floating the US consumer. The consumer stops spending and expanding the economies of Asia as soon as the US consumer has no more credit. Then the money supply implodes in on itself, causing a scramble for market share in a variety of world commodity producers. Those that are liquid and poised to pick up some bargains in commodities will make a lot of money, while those caught speculating long are going to be crushed by the debt deflation.

Here is the problem with calling for deflation. The current mess created by the bailout of the financial system under the guise of floating bad funds under the auspices of the international banking community, we have the appearance of run away prices. The big point here is that the dollar recyclers are also commodity consumers on a grand scale for the first time and rather than lend the money back, they went shopping. Thus the prices for commodities everywhere are being pushed by demand from areas not seen since the 1970's. The 1970's commodity price spirals were also created by the third world being loaned money at that time to consume, together with a large war, the launching of social programs in the US and the removal of gold backing from the dollar. Throw in the maturing of the baby boom generation born between 1945 and the early 1960's and we have a huge demand for everything. People don't remember deflation because deflation is something avoided at all costs and the ones that saw it are dead. The people that saw the last gas crunch are the ones running the money now and they recall that very well. Thus, we have dead people that remember the deflation and a huge generation that remembers the inflation. Thus, we will eventually move to fight inflation, not even having a clue as to what deflation is.

But, it is deflation that will win. Everyone scoffs at it and I am a contrarian and I believe it will happen. They won't lower prices until their warehouses are so piled with crap that their bankers are calling the loans if they don't liquidate. People don't know how to make money and they understand losing it even less. Once they start holding out for their money, they are going to find that debt is consuming money so fast that yesterdays rock bottom price is a sellers bonanza today. In many cases selling is going to mean bankruptcy and not selling is going to mean bankruptcy. We are already seeing this in the financial circles, as you can't sell your CDO's at this price so wait. Wait and you keep taking lower prices, as word gets out this stuff is mainly toxic. The car business is more than just gasoline, as the sales apparently started to dive last July, not after the price run up in gasoline. It is just that the automakers are all trying to sell what brung them, not what they can't make presently. We won't see that demand return when the price of gasoline falls because people just won't have the money this time around. It is one thing to wait around for a deal, but it is another to have your money or credit disappear in the meantime. There is going to be a lot of this.

The problem cannot be solved in the conventional sense that a normal recession happens. It can't be solved because it is a debt problem that must be wiped out in a liquidation. They don't wipe it out and either the economy drags into a long term down cycle or the deflation pressures are worse next time.

Monday, August 11, 2008

Now We Have Been Rescued-NOT!

I carry on a continual debate with other bears about whether we are in an inflationary environment or a deflationary one. It appears for the moment that we are hung between the two, but it is my contention we end up with deflation, at least until recovery starts anew. I will go into details what I mean later in this post.

The stock market bottomed again on July 15. I had been expecting a bottom because July always provides turns in markets or I should usually. In fact, if one would trade just 4 months, they would probably make more money than trying to force the markets for the entire year, the first months of quarters. Almost all the strong moves I have seen originated in January, April, July and October with April and July usually providing signals of direction. I won't go into details here because I don't have a load of statistics, merely observations. But, the point is that in bears, an up means a correction of a down move in July, in bulls an up means get on board, at least from what I have seen. A down in a bull means all hell is going to break loose and a big correction is ahead, ala 1987, 1997 and 1998 and to some extent 2000 to name a few. This correction looks like the ones we had in 2001 and 2002, where we had big falls into July, a strong rally for a month then a turn down. The true nature of the 2000-2002 bear was obscured by its aliabi, the 9/11 event, which was a smoke screen (A $30 billion event causes a recession and a $500 billion real loss is supposed to be a walk in the park? I will get to this later as well), but the bottom in July was taken out in August and we were headed strongly down when 9/11 hit. an

So I think this is a seasonal event that has appeared in the last 2 strong bear moves down and nothing but a bear correction. The bulls are rejoycing in some things, namely that the Fed won't have to raise interest rates because of the oil markets being in decline. There is too much reflection on the 1970's going on when in fact this is nothing like the 1970's. The 1970's were a period of strong worldwide demand colliding with a required change in the US money and strong generational demographics in the US coming into play. This one is a long and pure financial bubble, aka, 1914 to 1930. There is a world of difference.

The bulls are celebrating a strong reversal in the dollar as well. So they celebrate the fall in the dollar and then the rise in the dollar like both are Johnny on the spot to rescue them. There is the thought that the dollar is making oil go down and the thought that oil is making the dollar go up. I have to believe neither of them are true and that if anything, the dollar price in oil is a supporting feature of the dollar, not a depressing feature of it. The true culprit is liquidity and it might be liquidity in a lot of places.

Doug Noland, whose inflation outlook is much polar to mine, speculates that the pair trades on Wall Street are in a mess and that is what is causing the fall in commodities, the rally in the dollar and maybe the stock market rally as well. I give him an angle on this because I am still pretty naive to what the pair trades are at this time and I would venture Doug, being where he is has a clue. Truth be known, the banks could very well be running the markets against their customers to make some money of their own. What Wall Street and its financiers will do to their customers for money is as close to fraud and a violation of some kind of fudiciary duty as can be imagined, as they know where the players are most of the time. This means they know how much retail money is short in the stock market and can influence moves overnight by moving the market parameters and they know the pair trades, thus force the hands of the players to carry the trade in their favor. Plus they have all the free money anyone could imagine, as they only have to mark to market.

The bulls speculation is that the price of oil is the entire problem, that the subprime losses didn't really happen and that what did happen is easily absorbable. This is all bullish nonsense and those that spout it really can't believe it. There is a lot of difference between a $500 billion loss in the bond market and a $500 billion loss in the stock market. For one, the bonds are expected to be there, while it is accepted that stocks are play money. In public institutions few are based on stock in their portfolio that depend on it for their net worth. Most is in trusts and the vulnerable are the pension trusts which have been swept under the rug for years anyhow. Bonds, on the other hand, come out of the net worth of highly leveraged financial institutions and not only have to be recognized, but greatly impair the capacity of these institutions to make more loans. Stocks might have a wealth effect and in some cases force corporations to pay more attention to their pension liabilities, but bonds make companies go to zero and destroy the capacity for further financial growth. I don't believe most of these losses are temporary, as the companies taking them are having to make bargain basement deals for more capital and would otherwise find a legal way around imaginary losses. They aren't taking these losses to get ahead of the curve in other words, but only out of necessity. There are more to come.

I believe this is the real game behind the dollar rally, the decline in the price of oil and the decline in business in general. I also believe it will lead to deflation. I will introduce what I call my theory of pressure just to coin a phrase. I think it applies in all systems where you can deal with excess for awhile, but you can't deal with shortage for very long at all and shortage includes a reduction in the former excess. Thus if we are getting 12 units when we need 10, whether it be oil or money, we can play with that for awhile. Once the market pretends we have 12 units when we need 10, in money, we have inflation expectations and an accomodation that we are going to continue to need 12 units, we are going to price like we have 12 units and so on. But, let the market drop to 11 units and one might realize after awhile that Old Joe didn't have as much inventory last time and we are using just in time inventory systems so we have better stock up a little. On the other side, demand is falling for oil in the US. What does that mean? Even though the price is up, the pressure to acquire more oil has dropped and in fact, the inventories can be reduced by a factor of maybe 20 times the drop in demand, because that is how many days of inventory are being held. This is probably fallacious because so much of the inventory is used to fill the system and not really in surplus (ie in pipelines and other places). Thus mere changes in pressure, even if pressure is still in excess or in sufficient are enough to produce a swing in the opposite direction.

There is a lot of talk about there being too many dollars in the world. Are there? The oil markets have created a pile in the Middle East and in Russia. The export markets have created a pile in east Asia and even in South America in places. But, is the pile growing fast enough? The typical inflation bear seems to think it is growing so fast that in a matter of days the dollar is going to zero. But, ask the banker in London who is borrowing against a rising or high TED spread if there are enough dollars? He will probably tell you differently.

The point being that outside of OPEC, the flow of dollars has changed dramatically. In OPEC, we have seen the run in oil prices maybe come to an end and demand begin to drop so the flow may change there as well. The stated US trade deficit isn't rising despite massive increases in oil prices and the bill for oil. This means there is $200 billion of international income missing from the exporters to the US. There are other problems as well, namely massive losses in bank capital.

Though we may have a stock market crash, my idea here is that we are more likely going to have a long grind down. Bulls point to factors that have no real bearing on what is going to happen going forward and look back at a time when credit was easier, cheaper and more widespread than we will have going forward. They point to a bottom in housing that seems to never come and is threatened by further financial impairment in the GSE's and other sources of home financing. Mostly they point to a fall in oil prices, which were caused to start by the solution to the credit mess sought by banks and now are falling most likely due to even tighter funds. They look back at the amazing growth in China and think it will carry us through, when in fact the Chinese have in total assets about 25% of the GDP of the US and if they have to spend those, they are out of business.

I don't believe the real impact of the credit crunch is upon us yet. Using the unwritten theory of pressure, what we are seeing right now is the impact of diminished pressure. The banks wrote a hot check to cover their SIV's then after awhile the Fed covered it then the different wealth funds around the world took the money out of circulation by injecting capital into the banks. Thus we had a sudden blow up in pressure that probably peaked in March and now we are seeing the pressure diminish into May and probably level out now. The point of the leveling out only has to do with the stock market, which is enjoying a temporary increase in pressure due to less money being needed to trade the oil market. But, the supply of pressure creating money is declining and the stock market will only last so long.

In this vein, I think we are moving to a bear in all markets and the action to the upside is only due to the idea that most traders have lived their entire lives in asset inflation times and are continually trying to buy the bottom. Robert Prechter, someone that many try to discredit, said in his books that once the supercycle top was reached, the previous bull action would have been so long that the market would be bought all the way down. I see here that people are speculating in housing, despite the fact that the financing for housing has been impaired not only on a national level, but an international level as well. They have no clue that 75% of the demand for housing is based on financing and much of the rest of it is based on the idea that prices will go up. We are going to get a time where neither prevail, neither easily available financing or the expectation the price will go up. Existing home sales are still well above 4 million, which used to be the speculative peak of home sales, which tells me there is plenty of speculating going on.

Look what is going on in China. Now we have a dollar reversal and maybe it is short term and maybe it isn't, due to the level of interest rates worldwide and the use of dollars for banking liquidity worldwide. Hot money going into China with its high growth and appreciating currency (appreciating while inflation rages over there as they have overpaid for everything) is likely to reverse and it won't find a wide exit. The Shanghai was off 5% last night, a level that constitutes a crash over 1 day (the list of 5% down days in US history is pretty short) and this in itself might be a signal the door isn't too wide. The entire world is on the short dollar trade and the banks may have all speculators where they want them, as bankers might just want to take delivery on all these dollars.

As of right now, bears are cheering in the commodity markets and crying in the stock markets. But, the cash flow that was generated by commodities was an important factor in supporting the economys of the world, as it created the pressure in dollar assets to keep the supply of dollars sufficient. Some say the oil market went up because of a weak dollar, but it is all possible that the oil markets kept the supply of dollars on the international markets up, mainly because so many Americans had to put the purchase of gasoline on their credit cards. I doubt the US consumer is alone in this matter. Now with the peak in oil demand, oil prices, the incoming pressure of dollars is weakened and thus the supply pressure of dollars has declined or even turned negative.

I have been posting that the market would rally for a month, retrace 5/8th roughly of the decline since May and roll over. A month would be August 15. This has been the pattern going into and coming out of July in the past 2 bear market moves. The lone bullish exception was 1996, which in fact was a sideways market that took off out of a sudden decline in July and reversal. Thus the sideways, which bulls consider down market, turned up in July. This wasn't a sideways market, but a steady sell down. In fact, this wasn't a classic turn off the bottom as we have seen in the past. Past turns have made a 1000 points in a week, well beyond the moves we have seen so far.