So there I was on Tuesday, pondering how far the absurdity of the rally would go and straightening out a few problems here and there for clients and what happens? The phone rings and it’s my friend The Bond Dude.
hadn’t heard from him for a while and what followed was about a 45-minute lecture on why my praise of Nobel Prize winner Joseph Stiglitz last week - remember Stiglitz is the guy saying that big banks were not really too big to fail, and that there were ways out of the present disaster in financial markets - was all wrong because I hadn’t considered the Federal Reserve’s Z-1 (Flow of Funds) Report.
Upon admitting I hadn’t read it since the December Z-1 report came out - it’s a quarterly - and why couldn’t my scolding be delayed until tomorrow when the next Z-1 comes out, TheBondDude launched into his scary explanation of why Stiglitz is wrong, and why the big banks really do have to be saved. Virtually no one understands this mess better than TBD…maybe even better than Ben Bernanke and Time Geithner, which is going a fair piece….so I paid close attention.
I’ll paraphrase best I can:
“The problem with the Stiglitz approach is that if you try to protect only the small depositors, you will have all that money (brokered CD’s and such) which is on deposit from other banks and big players to deal with. Say you’ve got major bank A and it is holding as part of its asset base certificates of deposits issued by bank C. You see what can happen? See what happens if the banks are allowed to fail? As soon as banks start to lose any confidence in one another’s paper, then you get something like the Herstatt effect where counterparties fail to perform and we get a Depression overnight.”
But Stiglitz, I argued, would do a better job of keeping Main Street’s money whole and the public wouldn’t be left holding the bag for the bankster’s bad behaviors and gambling addictions. But TBD persisted…and he insisted that there’s only one answer: Inflation, and just as fast as we can get it. If housing prices are down 20%, a bout of inflation would blow housing prices back up and fewer people would be ‘upside down’. “Would you miss a $1,500 payment on $100,000 of equity?”
That’s obviously what all the spending frenzy has been about in Washington - getting all that money borrowed and spent into the system. But TBD is not impressed.
‘Look: the problem is that what the government is doing now will work…but it won’t work until we are two or three years down the road…and by then, the whole country will be beggared.”
“We agree that the only way to fight incipient deflation is with a countermeasure of slightly greater inflation but all the spending coming out of Washington so far has been far to slow-acting to save us - 18-months at best. You saw what happened in the mortgage bonds last week?”
Since I don’t sit on a trading desk, and I’ve had the good sense to be parked in Treasuries, I had to answer “No.”
“Well, we had about a billion dollars worth of mortgage bonds come through and even though they were mostly option ARM’s, the yields were pushing 25%. Remember where they were the last time we talked?”
“Yeah…weren’t option ARM’s down around between 15 and 20 percent?”
“Exactly. And that was what, two months back? You see what’s happening? Things are getting worse, not better in the market.
I’ll give you and even more frightening example…let’s look at triple A commercial paper…uh…here’s an 8 1/2 at 196 over credit swaps…that works out to a 22% yield. 22% for triple A commercial, got it? And it gets worse as you go down the ratings… here’s a single A commercial for 48% yield.
You see how much worse things have gotten?”
Oh, boy, did I ever. “So the market rally on Tuesday isn’t real because if the single A commercial yield translates to a market P/E of what, for the hot money? A P/E of 2 maybe on the S&P 500?
“OMG, so we’d be looking at an S&P down around 200 and at those levels, we might really be back in breadlines and our 401(k)’s and even phat public pension funds would be toast…is that it?”
“You’re close. But in fairness, that single A 48% yield probably has some defaults priced in, so maybe after those, the market’s thinking the yield will be more like 33%.”
“But that still means a price/earnings ratio equivalent for the major stock indices around 3 in order to compete with the fixed income gang! I haven’t looked at the P/E of the Dow lately, but I’d bet it’s still north of 15 since everybody and their grandmother has been whacking earnings forecasts. Have we, like, passed the point of no return where it blows up into Depression 2.0 no matter what the policrats do?”
“Basically, unless they follow the plan I’ve laid out - and do so instantly, yes.
The only way to really fix this is for the President to declare a financial emergency and give mandate everyone in the whole country gets a 10% mandatory wage increase for all workers….
Of course, there would be hardship exceptions for businesses with a high labor component, so outfits like restaurants could lose money and bill the government for their losses and make a little dough. But we need money in the system yesterday to spin around from the developing deflation dynamics.”
“Hold it…Bond Dude…the last time you pitched me this idea a couple of months back it would only take a 5% mandatory wage hike. What happened?”
“Things have gotten worse. The fixed income yields are still climbing, as I explained, and thanks to government doing the wrong thing, the cost of saving the system keeps going up. Two months ago my solution would have cost maybe $100-150-billion - and it would have saved a pile of foreclosures because home prices would be stabilized and climbing again.
Since no one is paying attention and the interest clock is ticking, the cost has probably doubled to the $300 - $350-billion range. And it’s spreading into the primes now because banks aren’t lending, and with home values falling, the 5% of the prime pool that has to move every year for work reasons, can’t do so.
So here’s the hard part: what do you want? The alternatives are mandate 10% inflation now and that gets us further on the road to socialism on the one hand, or would you prefer to have the deflation dynamic build for another 18 to 24-months, have all those foreclosed homes picked up for pennies on the dollar and have a kind of New Landlord Feudalism on the other? Maybe those new Landlords will be Chinese repatriating some of their Treasuries, you think?”
Sadly, he’s probably right. If interbank holdings are large enough, then yes, maybe ‘too big to fail’ just might be true…
“And you know that would impact every bank, insurance company, and pension fund, which would then have to be made whole, too, right?
That’s the problem: Government’s doing something - it’s just the wrong something because it’s going to be too slow. We need inflation right now and without it, deflation is going to keep whacking us…”
“In spite of markets like today’s?”
“Yup.”
I then asked The Bond Dude why his helicopter and Gulfstream class friends haven’t sent him to DC to fix the problem. But I already knew the answer: Like me, he’s probably offended both sides of the political aisle to such an extent that they won’t return calls…even though more often than not, we turn out being right in the end.
—-
Having gotten thoroughly bummed out by that call, I dialed my friend Robin Landry who manages his client accounts from his office sensibly located in Shawnee Oklahoma, to see how his trip out to Vegas was last week and to ask him is this our long awaited rally catching fire?
“Probably not. This looks like it’s just Wave 4 of the 5th wave down which should still reach my target around 6,000 plus or minus a couple of couple points. The thing to watch as the next decline starts is if the breadth indicators get worse than they were in the preceding rally. If so, then even the 6,000 +/- 200 area will not hold.
The concern rises because some of the indicators that I use are not confirming that the wave that we’ve just had, before this rally, is really the third wave. Thus, leaving open the possibility that the market decline is extending itself to the downside.”
“So if that his how it unfolds, how soon would we be able to see it, and just how far down is do we go… I’m asking because the predictive linguistics guys are hinting that we may not see much of a rally this spring…and I’ve been watching since mid-December hoping to make a whole pile of money in gold and oil options in what should be a rally real quick, or to play some long-side stock index options…”
“If the indicators do show that the market is extending downward, then the possibility is that the rally from the November low of ‘08 to January ‘09 was not a fourth wave, but was in fact B wave or a wave 2, and we are already in the larger third wave down.
If that is the case, and by the way, even though I don’t think so — yet — but the concern is there due to some of the indicator readings — there really is no stopping point until the 4,300-4,400 line in my (Dow) work, and that would just be an area where we would get another bounce before working even lower from there.
The danger on the downside I believe is not understood by 99% of the investing public. There is still too much faith in the government’s ability to manage the economy and the stock market.
The psychological aspect that I believe is in charge here, of what we are going through right now, is that the average citizen has seen so much wealth destroyed that they are reverting back to using common sense in their day-to-day activities, i.e. buying only what they can afford and heaven forbid, starting to save money, instead of spending it. …the exact opposite of what the government is trying to tell you to do.
Thus the government policies, in my humble opinion, are doomed to fail and are like pushing on the proverbial string. Self-survival will cause people to do what’s best for them and not what the government wants them to do.”
So this morning, taking in all the inputs: Frank on the up-tick rule, The Bond Dude on competing yields for ‘hot money’ going into fixed incomes, and Landry’s system of analyzing markets which he’s been perfecting since 1976…it all smells like a little follow through at the open and a run this morning toward 6,979 plus or minus a Happy Meal, and then I’d expect another free-fall.
Or, we could go to 7,404 before free-falling again. But, it would take a day or two over 7,404 to convert Landry - or me for that matter - into believing the alternate wave count that would label the last week or two’s downside as a failed fifth and we are going into the long awaited (since mid-December) Fourth Wave.
If it turns out to be a failed fifth, I will have missed my ideal long side entry. But I don’t think so…at least not yet. So I will sit back and watch and wait; glad I’m not in the business of giving investment advice on your own there. Mid-session reversals, anyone?
For what it’s worth, Pacific Investment Management (PIMCO) has joined Warren Buffett and Dr. Doom Marc Faber is predicting an uptick for inflation.
But the problem is, like The Bond Dude explained, it’s probably too little inflation to keep us out of the soup lines. So for now, you might be praying for inflation and be pleased when you get it because it will keep your home price from collapsing and (if you’ve been paying attention) that garden I told you to plant this year will hedge you against higher food prices when inflation arrives and might even get you a little exercise for a change.
