The End of Extend & Pretend?

November 27, 2010

The S&P500 dropped 0.9% in a holiday shortened week.  Volume was light, but it had less meaning due to the shorter week.  Interestingly, and ominously, the VIX (or fear) index spiked over 23% in a sign of possible turmoil hidden beneath the surface.  It seems like many traders suddenly decided to take out an insurance policy to protect against downside price movements.

The macro data were mixed to weak.  Although the second estimate of the third quarter GDP growth was slightly better than expected (at 2.5%), more than half of that growth came from inventory builds, builds that are clearly unsustainable.  Housing, already showing signs of deteriorating months ago, is dropping like a rock.  Existing home sales fell in October; they were expected to be flat.  New home sales plunged; they were expected to rise.  Personal spending rose less than expected; personal income did slightly better than expected.  Durable goods orders collapsed; economists estimated that they would be flat.  Initial jobless claims improved to 407,000, BUT only because the government twisted the number higher with a huge seasonal adjustment; without this adjustment, claims would have risen. 

Technically, the S&P has formed a downward sloping channel on the daily charts.  And many of the momentum, oscillator, and breadth indicators are pointing to more downside potential.  The weekly charts are painting a possible double top formation where the first top peaked in April and the latest one in early November.  If the S&P drops meaningfully over the next two weeks, then the weekly charts would turn decisively bearish.

It looks like the global policy of extend and pretend may be finally ending.  The policy, in a nutshell, is one where private bank losses–with the help and cooperation of national governments–are hidden from public view.  The hope is that if banks delay the recognition of their old losses, they could earn their way out with current profits, profits often subsidized by central bank support.  The goal is to protect the capital structure of the banks, specifically the debt holders;  senior debt holders (often the largest source of bank funding, next to depositors) have yet to take any major losses virtually anywhere in the world during this Great Recession.

Japan has been struggling with this policy for over 20 years.  It’s still not out of the woods today.

The US adopted the same approach in 2008 when the banking system began to implode.  Over two years later, the US banks are still stuck with this policy, with most of the losses still hidden on the too-big-to-fail bank balance sheets.

So where is the change in policy coming from?

Europe, and specifically Germany.  The Eurozone nations, specifically the PIIGS, are slowly but surely falling like dominos.  Greece fell in May.  Ireland is falling today.  Portugal and Spain–judging by their sovereign debt yields and CDS rates–are soon to follow. 

The key, or the trigger, is an announcement by Angela Merkel of Germany, that Germany will not be able to continue supporting the wounded PIIGS much longer UNLESS the senior debt holders of the banks that lent funds to the PIIGS also share in the pain.  In other words, Merkel and Germany are hinting that the taxpayers of the Eurozone nations should not ALONE continue to bail out the banking sector, the very same banking sector that made the risky loans in the first place, and specifically, the senior bond holders (to the banking sector) who–unlike depositors–fully understood that they invested with the expectation that they were incurring a risk of loss.

This would change everything.

Up till now, the global credit markets have been operating under the assumption that the banksters–who’ve so far successfully controlled the politicians–would NOT have to suffer by taking losses on most of their debt investments. 

But what Merkel is saying–even if she really wanted to make the banksters whole–is that she and her political leadership are at risk of a popular (and in Germany’s case, constitutional) revolt.  She may not be able to force the German taxpayers to further protect the European banksters.

And the same thing is happening in Ireland.  There is a strong chance that the people will reject the European so-called bailout.  Iceland did so about a year ago, but Iceland was not on the Euro.

What does this mean?  The shock effect to the capital markets could be devastating.  In essence, the markets would be staring a hundreds of billions of dollars in losses.  But more importantly, the markets would lose confidence, confidence that the world’s governments and their taxpayers would always be there to protect them against major losses.

To put this into context, the psychological effect could be larger than the shock from the Lehman Brothers collapse.

In fact, it could be ten times larger.

European Collapse….Around the Corner?

November 21, 2010

The S&P500 was unchanged for the week, and would have finished lower if not for a surge in the final 30 minutes of trading on Friday.  Volume for the week was light.  The VIX index dropped.  Complacency grew as the Fed’s now explicit put option is being factored into stock buying analysis–why buy put options when the Fed will do it for you?

The macro data continue to paint a picture of a struggling economy, despite the fact that the recession has been officially declared to be over.  Producer prices were lower than expected–both headline and core.  The same thing happened with Consumer prices.  But a major question remains:  how accurate are these figures when the government has a strong interest in keeping them suppressed.  Housing starts were much weaker than expected.  Initial jobless claims are still stuck in the mid-400 thousand range; not where they need to be for a true recovery.  The Empire State survey was much worse than expected; the Philly Fed survey was much better.

Technically, the S&P is struggling to bounce back from its prior week drop.  Momentum is still weakening and pointing to more downside risk.  The bullish percentage is slipping.  And several indicators of the market’s breadth (eg. advance/decline ratio) are also weakening.   Just as in late April and early May of this year, the equity markets are not standing on firm ground; it wouldn’t take much to cause a stampede out the door.

And the crisis in Ireland could possible lead to that stampede.  But not in a direct way.

Like Greece, Ireland is about to be “saved” by the EU and the IMF.  The problem with being saved this way can be described by comparing the Eurozone nations to a group of mountain climbers who are all tethered together for mutual protection.  If one climber, out of say ten, falls off the edge of a cliff, the remaining nine climbers can confidently prevent the fallen climber from plunging to his death, even if the climber is only suspended by the tether and dangling in mid-air.  That first climber was Greece, and he fell in May.  Ireland will be the second hiker to fall.  But now only eight climbers will remain to keep the two fallen climbers alive.

Soon after Ireland falls, Portugal looks like it will also fall off.  Then only seven climbers will be expected to “save” the fallen three.

Soon a tipping point will approach.  If Spain falls after Portugal, then the remaining climbers may not be able to keep the fallen nations suspended without getting dragged off the cliff’s edge themselves.  Spain has far more debt to be refinanced than the first three nations, and there will be fewer strong nations left to do so.

Finally, even if by some miracle Spain’s fall does not cause the remaining climbers to collapse, then the odds are high that Italy (which has even more public debt than Spain) will certainly do the trick.

If or when Spain (and Italy) falls, one of two things will happen.  Either the Eurozone will blow up, right then and there, or the remaining strong states (led by Germany) will cut the tether and causing the fallen nations to fend for themselves while the remaining states circle the wagons and defend their own banking systems from the tsunami of credit losses that they’ll incur as the PIIGS implode. 

Either way, the Eurozone is doomed.  The bottom line is that there is way too much debt in the PIIGS nations (relative to their GDP’s) and there isn’t enough money in the system to bail everyone out.

So there will be pain, severe pain, and the question will be:  how does this pain get distributed between the creditors and the taxpayers, and when does this start?

And this isn’t even the bad news.  What truly scary is that the same debt problem is building in the US, the UK, Japan and even China.   In fact, much of the developed world (far more than 50% of global GDP) will face this very same nightmare. 

Tick, tock….


America, the Land of the Fraud

November 13, 2010

The S&P500 finally slipped a bit last week, falling 2.2%.  The VIX index shot up almost 13%, but it is still closer to its long-term lows, rather than its highs.   This suggests that there’s a lot more room for fear to enter the stock market party, IF the Fed’s perceived support of the stock market doesn’t succeed in keeping the fear at bay.  Trade volume was average, also suggesting that the selling wasn’t panic driven, in which case volume would have soared.

There wasn’t a lot of macro news last week.  Our trade deficit was still hugely negative, although slightly better than expected.  Initial jobless claims still hovered near the mid 400 thousand level, a level that’s NOT associated with net job growth.  Consumer sentiment, a warped survey due to the impact of the low interest rates (which have been openly manipulated down by the Fed), was slightly better than expected, but still at dismally low levels.

Technically, the S&P is still very overbought on the daily charts.  Last week’s sell-off broke several technical support levels, but not decisively so.  What’s interesting, and unexpected, was that the sell-off happened as the Fed began its second money printing operation.  If the “sell on the news” didn’t happen when QE2 was formally announced, maybe it will happen when QE2 gets underway and traders have no more government-led price support programs to look forward to.

Author Charles Hugh Smith, recently posted and essay titled: Fraud and Complicity Are Now the Lifeblood of the Status Quo.

In it, he asserts that the status quo would collapse if the systemic fraud and complicity were banished.  Instead of being acts of evil conspirators, fraud has become the foundation of the US economy and its financial system.

So today, the entire status quo is entirely dependent on fraud for its very survival.  The status quo would implode if fraud and complicity were withdrawn suddenly from our system.

How so?  Charles Hugh Smith presents a list of evidence:

1. The mortgage is riddled with fraud and misrepresentation.  It’s so toxic, that nobody is will to touch this market except the federal government, through Fannie, Freddie and FHA.

2. The foreclosure crisis reveals a Banana Republic system of law, where the big banks and Wall Street can do no wrong, but Main Street can. 

3. Housing and commercial real estate is still in a coma; organic demand has not returned.  Were the government to pull out of the mortgage market, prices would instantly collapse.

4. Wall Street and the big banks epitomize control fraud, where winning decisions result in huge bonuses, but losing bets are paid off by the taxpayers, so that the huge bonuses can continue flowing to the banksters.

5. The stock market is constantly propped up by the Federal Reserve and other financial elites.  Recently, the Fed (in a WaPo Op-Ed) has made explicit its desire for stock prices to rise, even as high frequency trading and other cheating programs make the markets vulnerable to total collapse (as these schemes take money away from Main Street investors).

6. Corporate accounting is a farce.  When Congress forced the accounting standards board to approve mark to model accounting in early 2009, the integrity of the financial statements from the entire financial sector is in serious doubt.  Many, if not all, the too-big-to-fail banks are effectively bankrupt, but the new accounting gimmicks allow the banks to hide this truth from the investing public.

7. The US political system has been bought and paid for by the financial elites.  With its seemingly limitless campaign contributions, the monied interests have hijacked the political system to further enable their looting of the public and the taxpayer.

Charles Hugh Smith argues that when a system becomes dependent on fraud and misrepresentation of risk for “business as usual”, then all that is required of the complicit is to “dot the i’s” and fill out the report, court order, balance sheet, act of Congress, just like everyone else does.

In this way, asserts Hugh Smith, financial evil becomes commonplace.

Yes is has, Charles, yes it has.

QE2: Impact at Home and Abroad

November 6, 2010

The Fed has saved the day….and the stock market….shoving up the S&P500 by 3.6% last week.  Not only did the Fed deliver on the highly expected quantitative easing, but Ben Bernanke came out of the closet and admitted–in a Washington Post Op-Ed–that one of the Fed’s goals is to boost stock prices.  The VIX fell, but interestingly not back down to the lows last seen in April before the Greek sovereign debt crisis exploded. 

And now, everyone’s jumping into the risk pool, buying everything in sight.  The last time this happened was immediately after the credit crunch materialized in August 2007.  The Fed leaped into action, slashing rates and the stock market soared to new highs in late October of that year.  Then reality set in, but later in 2008. 

The economic data, as if they matter anymore, continue to paint a picture of a struggling economy.  Personal income and spending both sorely disappointed.  ISM manufacturing came in better than expected; ISM services met expectations.  Initial jobless claims were much worse than expected, at 457,000.  Pending home sales fell; they were expected to rise.  Non-farm payrolls were, at first glance, better than expected, at 151,000.  But the birth/death model magically conjured up 61,000.   The unemployment rate rose slightly from 9.58% to 9.64%, and the broader measure (U-6) remained at an elevated 17.0%.  Beneath the surface, other data pointed to problems with employment.  The household survey reported that 330,000 jobs were LOST in October.  The labor force participation rate and the employment population ratio both fell to near cycle lows; if employment was genuinely improving, both of these figures would be rising.  And the number of folks unemployed for more than 26 weeks also rose to 6.21 million, up from 6.12 million in September.

The impact of QE at home and abroad could turn out to be very damaging.  This impact would show up in the numbers later, perhaps early 2011.  But show up, it will.

At home, Karl Denninger, explains in simple terms how Mr. Bernanke’s money printing will backfire, resulting in a “downward-spiraling economic disaster”.

Mr. Denninger describes QE as a hidden tax on consumers and businesses.  By debasing the dollar, major globally priced inputs (mainly oil, raw materials and food) will soar in price.  This is already happening.   Higher food and energy costs result in lower disposable income for consumers, AND lower hiring and wage increases for businesses (who’ll cut labor costs to offset the higher material and energy costs).  In turn, this will lead to higher costs for government social programs, because poorer consumers will turn to the government for more benefits–unemployment, food stamps, Medicaid, etc.  But with lower income tax revenues from the poorer and fewer wage earners, the government will need to borrow more from the bond markets.  And since the bond markets will not lend to the government at today’s paltry interest rates, the Fed will be forced to do “even more QE to ‘spur employment and increase asset prices'”.

Voila, the Fed is trapped.  It created this death spiral.  It has sucked the US government and economy into it, and there is no way out….without a lot of damage and pain.

Abroad, the reactions are pouring in, and they’re all nasty.  China’s central bankers have attacked QE and currency manipulation and utter hypocrisy by the US which has been attacking China for manipulating IT’S currency.   Xia Bin, a long-standing adviser to China’s Central Bank, called the blatant printing of dollars as “the biggest risk” to the global economy.  “As long as the world exercises no restraint in issuing dollars then the occurrence of another crisis is inevitable, as some wise Westerners have lamented”.

Germany’s finance minister,  Wolfgang Schäuble, lashed out by saying so “With all due respect, US policy is clueless”.

Guido Mantega, Brazil’s highly respected finance minister, attacked QE by remarking that “it does no good at all to just throw dollars from a helicopter.”

What’s next?  At first, inflation in daily goods and services, food shortages, and spiking energy costs.  Then currency wars could easily escalate to trade wars, as these angry economic powers say “no mas” to the Fed and the Treasury.  Sadly, the ultimate outcome, as populations around the world begin to riot, will probably be a hot war, or two.

We’ve seen this movie before.  It was filmed in the 1930’s.