Bull or Bear – Let History Be The Guide

I recently published an article of stock market history at http://seekingalpha.com/article/90537-bull-or-bear-let-history-be-the-guide

Looking For the Next Bubble – Commodities?

I recently published this article discussing the recent behavior of commodity prices with a historical perspective:    http://seekingalpha.com/article/88827-looking-for-the-next-bubble-commodities?

The Top Five Financial Issues for the Coming Decades

With all the turmoil in investment markets, I have found it useful to try to estimate major financial issues that will influence the American economy over the next few years and several decades.  This will summarize my current findings ranked in order of total dollar value.  All of these problems need to be resolved for the future viability of our way of life.  I think it is obvious that if the biggest problem is not solved, what we do with the other four will be of little consequence.

Issue #5:  The estimated asset write-downs resulting from the 2007-2008 credit crisis.  The International Monetary Fund has estimated this to be $1.1 trillion.  Less than half of this has been realized to date.  The time frame for this to be totally realized is one to three years.  The potential for this estimate to be too high is limited to a couple hundred billion at the most.  The potential for this estimate to be too low depends on whether or not we see an extended downward spiral in home prices and the associated worsening of credit markets.  Worst case scenario is probably another $1 to $1.5 trillion, corresponding to defaults on 20% to 30% of home mortgages.

Issue #4:  U.S. national debt of $4.4 Trillion.  This figure is obtained from the “Long-tern Financial Outlook”, U.S. Government Accountability Office, Jan. 2008.  Government estimates envision a balanced budget by 2013.  If you believe this, I would like to sell you a well known bridge over the East River.  However, I will use that to project the national debt to grow to $5.9 Trillion in the next five years.  The probability that this is too high an estimate is extremely low.  The probability that the national debt will be larger than $5.9 Trillion in 2013 is very high.  Furthermore, I am skeptical that a balanced budget will be achieved, not only in five years, but even in 10 years.  The risk is high that the national debt will continue to grow through deficit spending for many years to come.  I do not have a rational way to estimate an upper limit for the national debt in five years or beyond.

Issue #3:  The unfunded liabilty of the Social Security System is estimated to be $6.7 Trillion (Government Accountability Office, Jan. 2008).  This number could be higher with inflation above the report estimate – approximately 3%.  The time frame for this figure is several decades.

Issue #2:  The unfunded liability of Medicare is estimated by the Government Accountability Office to be $34.1 Trillion.  Again, higher inflation could raise this estimate.  The time frame is several decades.

Issue #1:  The cost of imported oil.  Many sources have estimated the 2008 cost for imported oil to be approximately $800 Billion at an average price of $120 to $130 per barrel.  The estimate for the hidden cost of oil – added military expense, environmental expense, health care expense, infrastructure degradation, etc – was approximately $825 Billion per year in 2006.  See the following website for details on the hidden cost:                                                               .   www.setamericafree.org/saf_hiddencostofoil010507.pdf 

If we assume the 2006 hidden costs and the estimated 2008 purchase cost to be applicable for the next 30 years, the cost of importing oil over that time frame is approximately $48.7 Trillion.  The likelihood that this too high an estimate is extremely small.  To lower the cost not only does the price of oil have to stay at or below current levels, the amount of oil we import must stay at or below current levels and there must be no inflation for 30 years.  With that scenario, the present value of a cash flow of $1.6 Trillion per year is $45 Trillion at a discount rate of 5%.

It is much more likely that the annual cost for imported oil will rise from the $1.6 Trillion per year.  If the cost rises by 10% per year (probably too small a figure), the present value of the cash flows over 30 years is approximately $58 Trillion.  The cost of continuing current energy policy is somewhere between $45 Trillion (an unrealistic lower bound) and something larger than $58 Trillion.  Half of this money is paid to entities outside of our economy and can only return to us by purchase of our assets.  A lot of the hidden cost remains within our economy, but none contributes to higher productivity.  The hidden costs are basically maintenance expenses.

Can a Margin Call Instantaneously Double the National Debt?

Rumors abound that the U.S. government will, one way or another, step in to guarantee the debt held by Fannie Mae (FNM) and Freddie Mac (FRE), the mortgage underwriters for the country.  Why has this possibility arisen?  These mortgage corporations hold $3 trillion in mortgage paper.  This has been written with a leverage of 100+ to 1.  In otherwords, these corporations have put up about $30 million (stock holders equity) and borrowed about $2.97 trillion within the U.S. financial system (which includes international lenders) to buy the mortgage obligations.

This situation has resulted in what is comparable to a margin call.  When an investor buys stocks on margin, he puts up part of the purchase price and borrows the rest.  U.S. security laws have a margin requirement, a limit on the percentage of stock value that can be borrowed.  If the stock purchased on margin falls far enough below the purchase price, the percentage of stock value financed by the margin loan can rise above the maximum value permitted by law.  When this happens, the investor receives a margin call.  He must then immediately provide more cash or the position will be liquidated by the broker/dealer.

The situation with FRE and FNM is similar in concept to the margin call, but is different the details.  The conceptual similarity is that these corporations have bought mortgages, effectively, on margin.  Investors around the world have provided the money for the margin, which totals approximately $2.97 trillion.  Many of these mortgages have been written with loans at 80% to 100% of the purchase price.  Currently, the market value of some of these mortgaged properties have fallen as much as 20% or even more.  Thus some of these mortgages are “under water”, i.e. the balance owed by the homeowner is more than the current market value.  This produces a situation where the balance sheets for FRE and FNM should show negative net worth.  In other words, these corporations should be bankrupt.  Technically, they can not be proven bankrupt because there is no transparent market for the mortgages they own. The market value can only be estimated.  It should be obvious, however, that the value of each mortgage can not be more than the market value of the underlying property.  I compare the current situation to a margin call because it is possible that the market value of mortgaged homes has fallen by more than $30 billion (1%) plus the aggregated down payments.  Therefore the $2.97 trillion in borrowed money is probably backed by negative equity.  In other words, to adequately secure the debt, more capital must be raised or the debt must be sold to repay the lenders.  I refer to this as the FNM/FRE margin call.

What can happen now?   One possiblity is nothing.  This would be disaster for the reeling U.S. financial system.  It would effectively cause a collapse because no one would have the confidence to lend to a system that ignores its obligation to honor its debt.  This will not be allowed to happen.

Another possibility is that FNM and FRE would be provided access to the Fed discount window.  In other words, these corporations could obtain capital by putting up their mortgage paper to secure loans by the Fed.  This would solve the problem if the bottom is close in housing prices.  However, if housing prices were to continue to fall, this action would be like a bandaid on a severed limb.  A total decline in house prices of 30% to 40% could require as much as $900 billion to $1.2 trillion in Fed financing.  This is in excess of the money in circulation under the Fed.  In order to provide liquidity, the Fed would need to have the Treasury issue more debt in order to obtain the necessary money to keep the Fed window open.  Thus, the national debt would be increased.  There would be some offsetting assets (value of mortgaged properties).  The major problem, however, is capital, not liquidity.  Therefore, this use of the Fed discount window would be outside the stated purpose of the facility. 

Another possibility is the abolishment of FNM and FRE with the assets and liability assumed by the U.S. government.  Instantaneously the national debt would be increased from the current value (approximately $3 trillion) to a new level of approximately $6 trillion.  Unless our economy collapses, this increase in national debt is offset by approximately the same value in assets, the mortgaged properties.  The problem is that, absent the huge mortgage financing vehicle represented by FNM and FRE, home mortgage financing would be reduced to a very low level.  Absent the ability to obtain mortgages, buyers would not be able to buy homes.  The housing market would dry up and home values could easily fall precipitously.  In that event, the national debt would be permanently increased by the loss in home values.  Therefore, if this option is pursued it would be necessary for the government to operate the mortgage underwriting business that FNM and FRE have operated in order to hold down the potential escalation of the national debt.

Inaction is not a possible solution.  Some form of action will be taken by the government.  The best result will have a mortgage market continue in the future.  The best result will not be fractured if housing values drop another 20%.  Preserving equity for FNM and FRE stockholders should not be a primary objective of the government action.  It is most likely that government action will be to offer some form quarantee to FNM and FRE issued debt and to keep these corporate agencies operating, probably with more regulatory oversight.

The Fed Rides to the Rescue – Or Does It?

The Federal Reserve arranged rescue of Bear Stearns in March has been widely credited as having stabilized financial markets.  Stocks, especially financials, have performed very well since.  The ensuing celebration  has largely viewed these events as the Fed’s gift to the economy, and investors in particular.  Caution:  there is an old saying “Do not look a gift horse in the mouth.”  The meaning is that if someone is willing to gift you a horse there might be something wrong with it, such as a lack of teeth.  If that is the case the horse is doomed to starvation.

Let’s examine the Fed’s “gift horse”.  The Bear Stern rescue was accomplished by the Fed changing the way it serves the financial system.  One major change is that it opened the discount window for short term lending to investment banks.  Previously the window was available only to traditional (commercial) banks, although the expansion of many of these banks into the investment arena had blurred the distinction between commercial and investment banking.  For example, Bank of America, Wachovia and other super-regional banks have moved into some investment banking areas in the past several years.  Now, however, investment corporations such as JP Morgan and Goldman Sachs can arrange short term financing directly by the Fed.  This was not possible before March.

Another major change with the “gift horse” is the way the Fed allows the discount window to used.  Traditionally, the securities traded through the window were U.S. Treasuries.  These were the collateral used to secure the Fed loans to the banks.  Now the Fed is accepting collateralized debt obligations (CDOs), including mortgage backed securities, in exchange for U.S. Treasuries.  In other words, the toxic waste of the mortgage crisis is now being taken off the books of the investment banks and put on the books of the Federal Reserve.

Securities held by the Fed is what backs the value of the $818 billion of U.S. currency estimated to be in circulation.   Because approximately 20% of the securities backing the value of this $818 billion is now comprised of CDOs of unknown value, the future value of the dollar is at risk.  Of course, the value of the dollar is already down because of huge federal deficits and trade deficits.  The debasing of the securitization of the dollar just adds another layer of burden weighing down the value.

The dollar is a fiat currency.  This means it is a currency not backed by any hard physical assets, such as gold.  The dollar has been the reserve currency of the world for several decades.  However, since the end of the gold standard in 1972, the only backing of the dollar is “the full faith and credit of the U.S government”.  The agent of the U.S. government for maintaining faith and credit is the Federal Reserve Bank.  The securities held by the Fed are becoming increasingly suspect.  For a few months in the spring of 2008 the Fed has “rescued” a floundering U.S. financial system.  What will the consequences of this rescue be in the coming months and years?  It is unsettling that in the history of the world there has not been a previous fiat currency that has survived.  All historical fiat currencies have eventually collapsed to worthlessness.  It is true that some fiat currencies have survived for a long time.  An example is the currency of the Roman Empire, which survived for hundreds of years.  In more recent times, fiat survival has been much shorter.

The possible salvation for this gloomy scenario is that the CDOs will prove to have value and will be returned to the books of the investment banks.  In this case the securities held by the Fed will be restored to U.S. Treasuries.  After all, Fed loans are temporary and short-term.  The problem is that the value of the mortaged backed securities will not be worked out in the short term.  The work out of variable mortgage resets will not be substantially completed for 2-3 years.  The decline in the housing market (house values) may not be 50% complete.  The lower house values fall, the higher the mortage default rate.  So the question mark in the title will not be resolved for several years.  Ask again in 2011. 

Housing/Credit Mess

Here is the best summary of the current disaster that I have read:  http://www.moneymorning.com/2008/05/02/with-much-blood-letting-to-come-the-u.s.-housing-finance-system-needs-replacing

Open Letter to Ben Bernanke

On March 11 Keith Fitz-Gerald published an outstanding open letter to Federal Reserve Chairman Ben Bernanke.  The letter is reprinted here , with permission. 

This article was orginally posted at MoneyMorning.com. (link “moneymorning.com to the link below”)
http://www.moneymorning.com/2008/03/11/dear-ben-to-save-the-u.s.-economy-here-are-the-moves-you-need-to-make-now/ 

Dear Ben: To Save the U.S. Economy, Here Are the Moves You Need to Make Now

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map ReportLast Wednesday, U.S. Federal Reserve Chairman Ben S. Bernanke told the Senate Banking Committee something that’s becoming more evident by the day, “I don’t know how to fix it.”

Bernanke was actually referring to the mark-to-market accounting rules that may be forcing the banks to take bigger write-downs than are actually warranted. But in my mind, those valuation issues are at the heart of the subprime-mortgage and credit crises. So the fact that the head of our central bank has no idea how to address that very basic problem is incredibly unsettling.

You see, the global credit crisis isn’t just “a” crisis – it’s “the” crisis of our time. It’s so important that I offered my views in a letter to our central bank chief earlier this week. And now I share that letter with you.

Dear Dr. Bernanke, I’m sorry to hear that you don’t know what to do about the credit crisis. That must be terrifying to you. I can tell you, it is certainly that frightening to the hundreds of millions of Americans who have seen their homes plunge in value and who now are watching their investment portfolios get vaporized. Ben, you’re fighting the wrong battle and you have been since Day One, when you took over from your predecessor, Alan Greenspan. You’ve been printing money on the assumption that this action will stimulate demand. That’s great in theory, but it’s clearly not working. Here’s why. Every dollar you print devalues every other dollar in circulation. What’s more, each new dollar you print also stokes inflation, which is why Americans are feeling pinched right now. Forget the housing crisis or the consumer confidence statistics that you and elected leaders seem to be so focused on: These are the byproducts of the monetary problems I’m referring to – and aren’t the root cause. The credit crisis began because there was too much money available. Not having enough money has never been an issue. What is at issue – and what’s causing such pain in global markets at the moment – is that banks and other financial institutions will no longer lend to each other. Americans – and, indeed, consumers worldwide – are caught in the middle. That’s why they’re unhappy. Of course consumer confidence is at all time lows, housing is melting down and wages are stagnating. But, again, those are byproducts, and not causal factors. Here’s a five-step plan that I believe will help sort this out. It’s simple, but it’s decisive, and that’s what’s needed right now. Step 1:       Stop printing so much money. Take steps to restrict the monetary supply, including limiting how much “fantasy” currency the credit card companies can create. This is money that’s not backed by anything except the companies that created it. I’m sure you see the irony here, since it’s the companies that created the collateralized debt, the special-investment vehicles (SIVs) and other derivatives that caused the trillion-dollar problem roiling the markets right now. Step 2:       Create incentives for institutions to lend to each other, a strategy that includes raising interest rates. You could argue, as will many who read this, that this will stifle demand. I’ll concede that this might happen in the short run. But in the long term, this will provide a natural hedge that will selectively weed out those companies that shouldn’t have been in the game in the first place. Think of it as a form of “financial Darwinism” and, by all means, talk to Paul Volcker to get his perspective. Many people thought he would kill the economy in the early 1980s when he raised interest rates to the sky to kill inflation, but that didn’t happen. In fact, you could argue that he set the stage for one of the greatest bull markets in history. Step 3:       Stop socializing debt. The public treasury is not a proxy for handouts, so stop treating it as such. We do not need the current credit crisis fiasco turned into social debt that will burden our country and every American for countless generations in the future. The latest surveys reveal that up to 80% of Americans think the financial institutions that got us into this mess should be allowed to fail. So why are you pandering to the politicians who insist on bailing them out? Nobody will bail me out if I fail to make my debt payments anymore than they will assume your personal debts, either. The fruit picker in Southern California making $17,500 a year who reportedly “qualified” for a $700,000 adjustable-rate mortgage (ARM) should receive a “stupidity premium” on his next tax return and the mortgage representatives who handled and processed the paperwork should be prosecuted in criminal court for predatory lending – if not for “credit-rating homicide.” Step 4:      Let the free-markets work freely. Contrary to the “Chicago school of economics” free-market strategies that you and your entourage profess to employ, the markets really do want you to take active steps to fix this mess. Providing more money to stimulate demand presumes that the financial institutions handling it will be healthy enough to do so [or wise enough to deploy it properly - an assumption I find hard to agree with, at this point]. Since I can argue that these financial firms are neither healthy nor wise enough to do so, it’s probably a mistake for you to assume that the new money will rescue weak institutions that shouldn’t be in business in the first place. If a person is addicted to drugs, and then runs out of the cash they need to finance their habit, they go into withdrawal. You don’t solve that problem by giving them more cash, or more drugs. You do an intervention and send the poor person to rehab. Similarly, with an economy that has abused credit the way the United States has, you don’t address withdrawal [the U.S. credit crisis] by firing up the financial printing presses – which is tantamount to a federally sanctioned credit-line extension. Again, it’s time for an intervention that stops consumers from abusing credit. Step 5:       Tell the American people the truth. The Federal Reserve Act of 1913 requires the Fed to promote stable prices. You’ve got a once-in-a-generation opportunity to do so … and to make a difference. Let those idiots on Capitol Hill know that their actions are interfering with your ability to do your job. Point out to them what “Everyday Joes” already know, and what you know – that “the emperor has no clothes.” This is not a political issue for either party and you need to make that clear when you draw your line in the sand. This is a generational crisis. Every single one of us is responsible for the path ahead – but precious few folks besides you are in a position where they can truly make a difference. President John F. Kennedy once said that “the hottest places in Hell are reserved for those who in a period of moral crisis maintain their neutrality.” In other words, sir, don’t damn yourself. In closing, people do not write books about Captains of Industry who don’t know how to take charge any more than they will write about Fed chairmen who have no clue about how to fix things. But history does look back favorably on decisive leaders who act with conviction. You have the chance to play that role right now – regardless of who’s in the White House. And I urge you to grab that chance. Best regards, Keith Fitz-Gerald Investment Director Money Morning

Can Bush Save the Dollar?

By Prof. Menzie Chin, University of Wisconsin

Author Bio and PiedmontHudson notes are at the end of this very interesting article which shows just how deep a hole the dollar is in.

T
Figure 1: Log real trade weighted value of dollar against a broad basket of currencies (blue) and against major currencies (red).

Why the Fed Can’t Save the Market

While it is probably not a primary objective of the Federal Reserve to boost stock prices, the investment community seems to hold the view that current Fed activities can influence equity prices in the near future much more than it is reasonable to expect.

Historically, falling Fed rates have preceeded, on average, rising stock prices.  The time periods of rising prices are experienced for many months (and even years) after the first rate cut.  However, there are times when the delay from the first rate cut to rising stock prices is very long.  The most recent example is the current bull market which just ended.  It started in the fourth quarter of 2002, well over a year after the Fed started cutting rates.

The latest three day bounce in the stock market is not likely to last.  This week the Fed meets and the futures markets have priced in the expectation of an additional 50 basis point (0.50%) discount rate cut.  What will actually happen is up in the air, in my opinion.  The Fed is really on the spot.  I have a most likely market response scenario for each potential Fed action:

1.  The Fed raises rates this week.  I believe this is an impossiblity.

2.  The Fed takes no action this week.  The market will sell off sharply with much handwringing over an unresponsive Fed being “behind the curve”.

3.  The Fed lowers by 25 basis points.  The market will sell off, but probably not as sharply as in 2.  There will be the same handwringing as in 2.

4.  The Fed lowers by 50 basis points.  This is what is expected by bond traders.  In my opinion, the probability is 50/50 (pardon the pun) or less.  If this happens the market may have a short rally (possibly only minutes) and then start drifting lower again.  The investor psychology will be dominated by a fear that maybe things are even worse than they thought because the Fed has cut the discount rate by 1.25% in a week’s time.

5.  The Fed lowers by 75 basis points.  This is quite unlikely, in my opinion.  If it were to happen, the response would be similar to 4. for the same reasons.

6.  The Fed lowers by more than 75 basis points.  I believe this is impossible.

My view is that whatever the Fed does this week will produce little benefit for stocks.  We still have the weight of unwinding all the complex financial derivatives that were developed over the past five years.  We still have the uncertainty of what the balance sheets really are for the major banks.  We still have a slowing GDP growth rate – some think it may already be negative.  We still have consumers squeezed by record credit card debt, rising variable rate mortgage contracts, falling home values and concerns about keeping their jobs.  With consumer spending accounting for 2/3 of our GDP, our economy is struggling.  Stocks will not put in a bottom until there is hope that all these negative factors will turn up within 3-6 months.  We are not there yet and may not be until late this year.

Market Update

We are at a critical juncture in the state of the market.  A classical “Head and Shoulders” pattern has been traced by the three major market indices since 3/13/2007.  All that remains to complete what could be a market top signal for the S&P 500 is a close below 1406.70, the close on 8/15/2007.  A retest of that low on 11/26/2007 produced a close at 1407.22.  The close yesterday (1/4/2008) was 1411.63!

If the S&P 500 has a closing price below 1406.70 in the next several days, we have a bear market signal.  How do we know if a bear market is actually going to occur?  My benchmark to confirm a bear market is a close for the S&P 500 below 1370.60, which was the intraday low reached during trading on 8/16/2007.

If the current situation is simply another (successful) retest of the 8/15 low, the coming week will see a market rally of a few percent.  I do not feel a successful retest can be proclaimed unless the S&P 500 ends the coming week above 1450.  A smaller advance must be viewed with suspicion and judgement reserved.

In August, the recovery from the lows of 8/15 and 8/16 saw the S&P close at 1411.27 on 8/16 and 1445.94 on 8/17.  By Tuesday 8/21 the market closed above 1450.  The high in October (the “Head” of the chart) was a close of 1565.15 on 10/9 and an intraday high during trading on 10/11 of 1576.09.

At the end of November, the S&P 500 reached an intraday low of 1406.10 and closed at 1407.22.  Two days later it closed well above 1450.

The software for this Blog does not allow me to import my Excel chart showing the plot of the “Head and Shoulders” pattern.  If you would like me to e-mail it to you, please contact me at jlounsbury59@hotmail.com .

This discussion has been on purely technical observations, not economic analysis.  What makes me especially watchful at this time is the confluence of a “perfect storm” on the economic side.  We have a credit crisis, world-wide, still of unkown proportions.  The US consumer, responsible for 2/3 of our economy, is extremely over-extended by falling home equity, record mortgage and credit card debt, high fuel prices (which may well rise further in the coming weeks) and rising unemployment.  One important indicator is help-wanted advertising, which has fallen to lows not seen for more than thirty years.  The possiblity of a recession has increased markedly in the past few months.  Stocks generally do poorly going into a recession.  The bright side is that they start doing very well once we actually are in recession.

How to deal with this?  Be careful in making any new investments while this scenario is playing out.  Trim positions that have had large run-ups in 2007.  If you use stop loss orders to limit risk, tighten (raise) the stops.  If you want to try some short term trading, look at ETFs that short various indices or sectors.  Examples are SDS (200% short the S&P 500), QID (200% short the NASDAQ Composite), SRS (200% short the US Housing Index), SKF (200% short financials) and FXP (200% short the Shanghai Index).  Note: Loss control is critical in using these highly leveraged, very volatile ETFs.