Sentiment Extremes - Thinking Ahead

Posted by urbandigs

Wed Oct 14th, 2009 10:15 AM

A:I see that I didnt miss much while I was away when it comes to the outside world. Sentiment remains aggressively optimistic, the fed engineered bank recapitalization environment is powering bank earnings, gold is inching higher and just seems on a much higher path, uber liquidity is powering equities and other asset classes, and there is little action by the fed to pull away the punch bowl - Ben is clearly thinking inflate, inflate, inflate our way out of this debt deflationary episode. Can't fight the momentum and this move can last a lot longer than many believe. In my humble opinion, with a few quarters of great data ahead the biggest risk to the markets now is a suprise move by the fed to remove liquidity from the marketplace. When China announced they may constrain bank lending a few months ago, it was good for a 23% correction in just over 3 weeks. That right there is a glimpse of how markets can react when talk of removing the punch hits the headlines. For now, it remains Miller Time!

Jeff's piece in early August, "Here Comes the Long Hangover..But First a Few More Drinks", still seems especially relevant some 10 weeks later:

That attitude unfortunately seems to embody a relentless optimism that still lurks in the American psyche - one that I am not sure is justified, given the financial pickle we're in. I see this optimism in banks that are routinely reporting much higher non-performing assets, but raising their charge-offs much less than those increases. It seems that they think that when they get the properties back and sell them, they will end up being made whole. This thinking rests on the idea of a durable recovery that boosts rents and convinces buyers to lower the risk premium they are currently demanding to provide liquidity of any kind in this environment. It also embodies a belief that debt to bolster purchases of assets will be made available, by someone whose balance sheet hasn't blown up.

As I have discussed here recently ("Every Upturn Starts with Restocking") it's going to take quite a restocking effort to get back to a reasonable rate of economic activity despite the actual decline in consumer purchasing power. Not only that, as Greenspan pointed out in the interview, consumer purchasing power is highly variable, as the stock market has just re-instated some $3 trillion of consumer wealth that was previously taken away.

It is for this reason that I believe that we will see at least a couple of more quarters of strong economic rebound and one to two quarters of public companies surprising to the upside on earnings estimates. My guess is that the stock market will begin to figure out that the opposing forces at work in the economy will result in very slow GDP growth and a modest future outlook, sometime before year-end and markets will begin to adjust. I don't think it will look anything like the bear market we have just been through, but it could be the beginning of a multi-year period of ups and downs, like the 1970s or the last Japanese decade. But first let's party like it's 1998, just one more time.
We are in that period of time where earnings estimates are reflecting the uber stimulus (both fiscal & monetary), uber liquidity facilities, inventory restocking, and increase in confidence that comes with an increase in asset prices across the board. Stocks are a proxy for everything and fears of a second hit to the economy, whether it be CRE or Option Arm recasts or FHA bailouts, are not even getting a worthy glance right now. It seems to me that complacency is starting to set in and the upcoming data will likely reinforce these emotions further that its party time forever!

It was the punch bowl that contributed to getting us into this mess, it was the punch bowl that helped to get us out of the mess (eliminating systemic banking failure risks and fears of 2008 and early 2009), and I believe it will be the removal of the punch bowl that will trigger the unintended consequences to the mess we got into. First the fed will rein in the emergency credit facilities and lifelines, then the markets will force their hand and they will raise rates (with talk of it being premature of course compared to unemployment situation), then they may have to drain liquidity through permanent open market operations (years out) so that now idle excess reserves don't pour into the economic system, and finally, they may have to raise reserve requirements as part of regulatory reform so that this doesn't happen again.

None of this has happened yet, and rather, world markets are reacting to the most opposite environment today. I guess that is why they call them, unintended consequences. I really wonder when the markets may start to force the feds hand to remove liquidity from the system?

You see, the fed thinks they are king of the hill, lord of the manor right now. Markets are reacting and emotions/expectations have shifted. But that is when something unexpected happens. Maybe decreasing maturity debts will may make the treasury market get hairy:
"...the maturity of Treasury debts is decreasing, from 6 years in 2000 to 4 years today, and dropping towards 2 years. As Karl Denninger comments, this places Treasury in an untenable position: it has to roll over the whole deficit every four years PLUS tack on new debt to cover the deficit. Why would the maturities decrease? Maybe that is all our trading partners will take, since they are rolling out of the Dollar into the YE$ basket. By reducing their exposure to long-term Treasuries they better prepare to get out if the US Peso continues to fall.

When something cannot go on, it doesn’t."
We know higher rates are coming, what we don't know is when and how fierce the initial adjustment to yet another new world might be. You can't time these things. Perhaps it will be if/when commodities get silly again? How quickly we forget how we all felt in early to mid 2008 when commodities went berserk.


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