AUTUMN MELT-DOWN
De-leveraging the System
"The Federal Reserve deliberately
leverages the system -- every cycle seems to get more brazen and dangerous. Fed
pump-and-dump operations resemble those of a boiler room penny stock operation
-- cram a bunch of leverage (excess credit in the Fed's case) into financial
markets, entice investors into excessive long positions in the targeted market
(penny stocks for boiler rooms, bonds and equities for those who follow the
Fed), push the bubble as far as it can go -- then watch from a distance (and
deny responsibility) when inevitably, it all goes up in smoke.
The Fed seems to do one of these pump-and-dump operations about every
four years. The last was the 2003 51/2% FED Funds drop to 45 year lows of 1%.
Previously was the 1999 Y2K credit expansion, which inflated the early 2000
Nasdaq bubble and led to the subsequent crash. The major one before that was
the 1992-93 credit expansion, which culminated in the 1994 global bond market
debaucle. The process of leveraging up the system sends out a signal -- go
forth and speculate. Buy stocks, bonds and houses, build buildings,
leverage up your holdings. Take no thought for tomorrow. We are in a NEW
PARADIGM. Swing for the fences. At some point, the leveraged Ponzi scheme collapses
-- either as a result of a Fed tightening -- or it simply topples from its own
dead weight of poor ill advised investments (malinvestments). Investment
Balloons like trees can’t grow to the
sky.
Both the Bond and stock Markets, the Real Estate and Commodity markets
as well as the Economy are approaching that point. Even though long term
interest have fallen and have only recently started to turn around since the
FED started tightening over a year ago,
it will undoubtly be too much Fed tightening that once again upsets the
apple cart. There used to be a rule “three
steps up and a stumble” well we just had our 10th rate increase and there is
increasing evidence of the beginning of involuntary de-leveraging. (The reason
that its taking more than three steps before the stumble is because up until
this week we were in negative interest rate territory) Remember Money created out of thin air is
not Real Capital. When a loan made out of thin air money is repaid it does not
go back to the original saver, it just disappears ( gets wiped off the books)
and the money supply shrinks.
1) Money supply growth has begun to slow
2) Banks are beginning to liquidate Treasuries. The
Fed has pumped banks full of Treasuries with its low interest rate policy --
and now it is dump time. The model forecast sees an ongoing liquidation of
Treasuries by banks.
3) Commercial lending has been going nowhere fast. The model sees no recovery in bank commercial
lending.
4) A slowdown in real estate lending. So far it is just the first signs of a
slowdown but common sense sees a much bigger real estate lending
slowdown ahead. The sub prime lenders should get hit first.
5) We are now witnessing the first significant decrease in refinancing
All this involuntary de-leveraging process should feed through into
weaker corporate results and economic statistics. Once the present seasonally
strong period for earnings and the economy is over, WATCH OUT BELOW. Just look at the weakness in the Banking
stocks which it is now spreading to the rest of the financial sector (GE etc.)
and especially the sub-prime sector.
So the process of leveraging up the system has run its course and the
involuntary de-leveraging is underway but
de-leveragings are not low-volatility events -- financial market dislocation is likely to begin sometime in the
third quarter or certainly no later than the first quarter of 2006. Ii is
likely. that the Manipulated Earnings reporting season is keeping a bid under
stocks for now, but the news should be mostly downhill from here. Reported
S&P500 earnings growth is at a 50 year highs-- But Comparisons should be
much harder from here on in… the profit cycle is probably topping.
Overvaluation is still a huge issue -- the S&P500 P/E ratio is still 1.5 to
2 standard deviations above its long term average. That may seem cheap (down
from 4 standard deviations in 2000), but the bubble era warped the concept of
value. John Templeton says to “buy at a point of maximum pessimism and sell at
a point of maximum optimism“. For the current cycle -- We are definitely at or
near an all time highs in Optimism. That's certainly a lot to stew over. But the
big point is that the monetary system itself is now contracting liquidity -- right
at the point when the majority feels the liquidity bubble can go on
indefinitely. This is how a liquidity bubble collapses under its own
weight. I’m afraid that I foresee a "market dislocation" in the third
quarter, which as you all know goes along with some of the things that I've
been writing about lately. When majority opinion is so well-entrenched on one
side, there is not room for everybody to exit gracefully.
Be wary of that Old Wall Street
Adage “DON”T FIGHT THE FED” Watch what is really happening, not what they are
saying.
Dr. Aubie Baltin CFA, NTA, CFP
Palm Beach Gardens, FL
561-840-9767
August 15, 2005