No One Here But Us Chickens

Posted by jeff

Wed Nov 25th, 2009 09:00 AM

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I know that on Thanksgiving day it is incredibly impolitic to turn the attention away from the season's favorite bird, but I want to interrupt your holiday mirth with a warning. Risks in world markets are rising and it is now time to contemplate positioning for what could be a coming "echo bust". While my contrary nature had me looking for a bottom in the markets all too early and I turned reluctantly bullish this summer (Bull Market Break Out On Tap?), I am now becoming quite nervous about stock market performance in 2010. I am usually early, and I have been a reluctant bull and scale seller of stocks throughout this bull market and more heavily as of late. But if I learned anything in my years as a portfolio manager it was never to argue vociferously with the markets once a trend change was confirmed, but also to start thinking about what could cause a trend change before it comes, in order to be "mentally prepared" for it. So it is in that spirit that I share with you today, what has been on my mind lately.

I have been operating under a scenario, which may or may not be correct, but so far appears to be reasonably predictive of what has taken place in the markets. The scenario is that we had a lending bubble worldwide which popped in 2006 to 2007, helped by worldwide increases in central bank lending rates. What the markets really didn't understand as the bust unfolded was how interlinked world markets were, how much leverage (often off balance sheet) was in the system, and how dependent on fragile links and counter-party solvency some widely used financial products were (think mortgage and bond insurance, CDOs etc.) Likewise we didn't appreciate how much of the worldwide growth in prior years had come from "mal-investment" and how unsustainable the U.S.'s dealer/addict relationship with China was. The stock market which didn't appear to be wildly over-valued (by 1987 standards) at the top, in retrospect was very expensive in light of how much of the prior cycle's growth was unsustainable in nature.

The final leg of the stock market crash produced very cheap valuations, and was brought on by visions of Armageddon in financial markets (money market funds going bust and commercial paper markets nearly shutting down). This was all topped off by a "CNN Effect" in October and November of last year, when people were literally cowering at home afraid to spend any money.

Since that fateful time, governments and central banks around the world have taken debt off of consumer, corporate and bank balance sheets and moved it to their own. This has relieved the liquidity crisis, prompted a scorching rally in debt and equity markets and allowing significant debt refinancing and equity raising. Under my scenario, the reversal of the "CNN Effect" would lead to better consumer and economic performance than expected and could fuel a larger rise than many might have expected. I think that performance is now largely in the past (remember that the stock market discounts about 6 months to a year in advance) and it is now time to contemplate a future with a lot more heavy lifting.

We all know the list of challenges that continue in front of us:

Unemployment above 10%, with little hope for a significant reversal from any growth sources that can currently be identified.

Continued over-supply in residential real estate and a backlog of foreclosed properties overhanging the market, threatening the modest price recovery and presenting potential for another downward spiral.

Commercial Real Estate price collapse - with prices now down to 2002 levels according to a recent study by Moody's.

Recently several factors are beginning to make me feel that imbalances are again getting to tipping points, where the tactical moves that have been made by governments around the world may soon be set to run out of gas, throwing us back into a maelstrom of reasessment of the sustainability of the current world economic order and the band aids and duct tape approach taken so far to ameliorating the crisis.

After bankrupting Fannie and Freddie in the real estate run-up, the government brought forward its last best agency to try to hold back the flood waters of the real estate collapse - the FHA. The FHA continued the unsafe practices which produced the real estate debacle, namely "no money down lending". Officially the FHA requires 3.5% down, but you can finance part of this and with the $8,000 new home buyer credit, your at essentially zero down...again. Now the FHA is heading into a tailspin.

The FDIC, which acts as the backstop for bank failures is beginning to be overwhelmed by the cavalcade of corpses it is presiding over. Soon the FIDC will also become a member of the un-dead.

Now there is no guarantee that these well known and predictable issues will result in disaster, and I am not calling for that, however, the markets are beginning to sniff out the problems with already over-levered governments dealing with any additional asset deflation.

Credit default swaps on Dubai's and Greece's debt are starting to widen.

We are seeing increasing action/worries about sovereign debt downgrades (here and here).

Gold has entered the one-way trade zone - it goes up when markets go up and people put on risk and it trades flat to up when markets go down and people shun risk. As Noah has opined here before the rally in Gold reflects a loss of confidence in fiat money and governmental efficacy in dealing with today's economic problems generally.

Warning bells are beginning to ring and it is best to pay them heed considering the "Less Worse nature of this bull market". The fiscal first quarter is a seasonally weak one for many companies. The consequent lack of a steady drumbeat of sequentially better corporate and economic performance data will be a big test for the markets. It will be interesting to see if the market can subsist on easy comp driven, strong year-to-year growth numbers alone.

Lastly as notable from the chart of the S&P 500 on the left here, the market is getting close to major resistance levels from the period prior to the post-Lehman collapse. This is a natural point for us to see the kind of churning action of the last few weeks. the question becomes, whether this will turn into a real correction, something we have seen little of in this monster rally, or whether it might even turn into something nastier. Many are already wedded to the idea of a Japanese style lost decade, I am not yet in that camp, believing that our destiny is still in the hands of our leaders. However, I believe that we are coming into a period of much greater skepticism about what has been achieved so far.....in terms of market action. So be careful out there and have a safe and happy Thanksgiving.