Tuesday, February 16, 2010

2010: Financial Judgment Day

Housing, Gold, Stocks, Interest Rates, Currency - An Intermediate Outlook.

Last month, the Institute For Economic Reality held a discussion on why the current fascination with commodities, especially gold, is a game that is about to turn. Since then, we have seen the stock market peak on January 19th, and then take a turn for the worse. While this was knowable, it is very difficult to determine the time frame for such a peak.

The high octane flim-flam rally that has occurred since March of 2009 has shown to be hollow, as the most basic indicator in technical analysis, showed the rally was inversely correlated with volume. As prices rose, fewer and fewer people could, or were willing, to participate. This smelled of the large zombie banks in New York throwing stocks back and forth to one another in an attempt to sucker in the remaining dumb money. It appeared to work at first, but people appeared not to be fooled. It's tough to speculate in stock wreckage when you have lost much of what you have saved over your life, and your Bainbridgeislanddreamhome is 35-40% below what it was at the peak of the stock market. Speculation is done with money you can afford to lose. Your survival stash isn't something you are going to throw at an enterprise that is less predictable, and has a higher risk/ROI ratio than a roulette wheel.

At the Institute For Economic Reality, we are always trying to push back the frontiers of economic cluelessness in an effort to improve our community. When you have one of the largest contributors to Congressional campaigns constantly dumbing down the population with mindless twaddle such as "real estate always goes up" and "buy now or be priced out forever," someone has to offer an alternative view.

For the past year, we have seen the dollar tank, while everything else has rallied. This would include gold, stocks, other currencies, and bonds. Even Bainbridgeislanddreamhomes managed to perform about 30% above what they would have, had it not been for the epic manipulation by every financial power on the planet to keep them above water. With all that, they still dropped in price. Imagine what it would have been without the manipulation...

Over the President's Day weekend, a discussion was held at the Senior Fellowship level of the IER between the Worldwide Headquarters in Poulsbo, and the currency trading division in Seattle. The subject matter was the intermediate term movements of the macro markets and the most strategic way to capture the movement of the various markets. Normally, the IER does not discuss trading strategies, and the following discussion is not to be construed as trading advice, but an intellectual exercise and explanation of where we find ourselves in the economic morass foisted upon us by the economic illiterate that traffic in such matters.

The IER Chairman asked that the senior fellows discuss how the recent drop in the equity markets is a short term phenomenon and a counter rally will occur and challenge the recent January high. Traditionally, the first drop off the high in the equity markets sucks in the shorts with mindless abandon, and then a squeeze ensues where the shorts pull the ejection handles to avoid getting killed. This happens over and over during the bear market rally, and eventually the short squeeze FAILS to take out the previous high, creating a "double top," or "failing rally," and then both the shorts and longs bail on their positions, sending the markets into the tank. Witness the second half of 2007, or early 2000 as recent examples.

The IER's senior fellow in the currency division did manage to grab most of the dollar rally/euro swoon in the past few weeks, but has since reversed the position to capture the rise of the euro and drop in the dollar. Why? The (Powers That Be - PTB) will not allow Greece to drop everything they have worked for over the past two years and will commit all their resources to keep the fraud functioning. This will cause the shorts in the euro to cover and sell the dollar in the process to cover that short. However, this will likely cause the PTB to spend everything they have to keep the Greeks in the lamb, gyros and Ouzo they have come to expect. That works right up to the point where the Germans run short of patience and money to bail out Portugal, Spain, Italy, Ireland, and the Greeks. Since it is no longer fashionable for the Germans to invade every time they get pissed off, they will resort to withdrawing liquidity.

Why now? What is different now than a year ago? The US debt.

Over the past year, when we have had an international funding crisis (Dubai and Portugal), "mystery money" has magically appeared and buoyed the US debt market, especially US Treasuries. Had it not been for this "mystery money," US bond auctions would have failed to the point where rates would have to rise to fund the auction. The "mystery money" has shown up at the most opportune times to prevent this, BUT other damage has occurred. The IER believes this to be related, and is strong evidence that the perception of global liquidity is a mirage (hat tip to IER's North Texas Adjunct Fellow). Given the Bacchanalia happening in the halls of Congress regarding their spending, the dry patches in the worldwide liquidity pool will become larger, more frequent, and more persistent. The PTB will have to decide which debt debacle will kill them first - the US, or the rest of the world. They know it is the US.

If it aligns with the technical analysis, this would cause a failing rally in relation to the January high. If we take out the January high with elan, this view needs to be broomed and we re-rack and try again. Mulligans are allowed in macro-economic financial analysis.

Looking back to 2008, specifically July-October, we see a pattern that has all the elements of repeating, but on a MUCH larger scale. Here is the IER's take on that time frame.

The markets are made by traders of varying competence. The major markets are currency, debt, equity and commodities, and that is essentially the pecking order sorted according to intellectual firepower. Currency traders have to be right, or they are dead. The leverage they use is the equivalent of playing with high voltage. Know what you are doing, or you get planted the next day. The bond traders need to understand what the currency traders are doing and how the interest rate complex moves, since liquidity is a major player in setting interest rates.

Next up, we have the guys that spent their college years perfecting the beer bong, and think CNBC is actual news - the equity traders. The trade isn't so much on what the underlying company is doing, but the perceptions on how other traders believe traders will view how the stock will trade with traders expectations of what future traders will think. In other words, they are playing a game of finding the "greater fool." What skill they do posses, is largely confined to convincing the general public that stocks are a good buy, "and always go up." (where have we heard that before???)

Finally, we have the commodity traders. These folks are truly the last to know, and the first to get run over. These guys are the ones at the poker table wondering who the mark is.

This is also the order of liquidity, as currency is the most liquid, and commods are the least. This phenomenon lends itself to be an inverse indicator of the ability to manipulate the price.

In the summer of 2008, we had an interesting destruction in the market place. In late July, oil peaked in the high $140s and then was taken out into the alley and shot, but equity continued to run right into August. That's when equity had a local peak. In September, bonds came into the killing zone in such a fashion that Paulson and Bernanke called Pelosi and her crew into a room and told them that absent a $700B tribute, the bond market was going to detonate. The dollar had it's relative peak in October.

See a pattern?

We, at the IER, believe this pattern will repeat in 2010. Here is the blow-by-blow of how it will likely go down.

Equity peaked in January 2010, and then rolled over as European financial stress, as well as political instability (from the banker's perspective) hits the market. The dollar starts to get squeezed (rising in price from being freakishly oversold), taking commods down.

Greece gets bailed out by someone, causing the euro to rise and the dollar to get sold. Commods rise, as well as stocks and other currencies as related to the dollar. Given the manipulated interest rates, the dollar resumes as the major funding mechanism for the worldwide "carry trade" causing it to be inverse to every other store of value on the planet. Traders see this weakness and pile on - shorting the dollar to fund speculative purchases in equity and commodities.

These carry traders are both long commodities/stocks/currencies and short the dollar, which works very well, right up to the point it doesn't. Keep this in mind, as this is EXACTLY what happened with the yen in 2008, but the yen wasn't the world's reserve currency - the Yankee Lira is.

If anything, anything at all, goes haywire, fear (risk) will hit the market place with little notice. This market place is short dollars, and long everything else. The US dollar will be at low interest rates, signifying anticipation of little or no risk going forward, which means complacency has set in and the trade is lopsided.

-Iran could do something stupid.
-China or Japan could try to raise funds by selling US denominated debt (raising dollars).
-Congress could go completely around the bend with its spending. Al-Queida could uncork another one (US.gov told everyone that we are going to get hit in the first half of 2010).
-Europe could blow up.
-Australia could go down the pipe (clockwise).

Anyway...something is going to happen, and the PTB have already shot their wad on Greece and US Treasury auctions (the last 30yr was a failure). When that happens, the dollar, being the world's reserve currency and home to over half of worldwide defense spending and 6000 nuclear warheads, to say nothing of the world's largest economy, third largest population, and despite recent activity, one of the most stable legal systems in history, gets bought out of fear.

We get a short squeeze of cosmic proportions, setting off cascading margin calls as both dollar shorts and commod/equity/currency longs get sent to market in a panic to close out positions. If this happens in proximity to the January high in the stock market, we get a "failing rally/double top," and the "all in short" signal goes out. The rapidity of this will be unprecedented, as anyone offside on this trade (the bulk of the banks in the US and Europe) will exsanguinate in seconds.

Remember, the trade is lopsided and that ALWAYS, without exception, is a prelude to the herd getting slaughtered en masse.

The dollar rises, and everything else gets crushed. Commodities will go first, just like they did in 2008 when the yen got covered. Stocks go next as money that rotated from the commodity market runs dry. Finally, all the shenanigans in the bond market stop as Bernanke moves to save The FED. The accounting gimmicks won't save him this time, as the world finally realizes the money is gone, and has been for some time. He, and his criminal banking cabal use the chaos in the equity markets to get the last pop out of bonds, and then the floor disappears from them.

Everyone dials 1-800-GET-ME-OUT, as the fear is real because we just saw a top and failed to extend it. Failure is fresh in everyone's mind.

We don't need to spill a lot of electrons on how Bainbridgeislanddreamhomes will fair in this bloodletting. They will be on the killing floor, covered with the gore from the bond, stock, and commodity markets. Interest rates will pop hard, without relenting, as money is evaporating all over the globe, at the same time everyone is trying to cover their dollar shorts. Stock charts will look like Moses turned Yosemite Falls into blood, with large, long red candles going straight down, destroying confidence and killing off one leg of the triad of Boomer retirements. Gold, silver, oil, grains, copper, etc all get sold into a worldwide economy in serious retreat. We are looking at $20 oil, $300 gold, $4 silver, and $150K Bainbridgeislanddreamhomes. Given that credit will be temporarily frozen solid, those prices are optimistic.

While currency, bond and stock markets are obvious determinants to the Bainbridgeislanddreamhome market, the commodity market isn't as obvious. Certainly, owner-occupied homes are not going to get margin called, but all the bank REO inventory will, sending prices straight down. Your Bainbridgeislanddreamhome is a place to drink white wine, park your Prius or Nisssan LEAF, and display Obama '08 yard signs. To the bank, it is an entry on a ledger, and nothing more.

That's how we see the debacle unfolding. These are merely predictions, and your mileage may differ. The IER is not a registered investment advisory institution, and this is NOT trading advice. This is nothing more than putting real world landmarks on our current situation in an attempt to educate the inquiring public about the status of our financial landscape.

The IER is largely flat, as we await the failing rally in stocks. Once we see a definite break in commodities (oil and gold will be the best to watch, but silver may very well presage both to the down side, as it is an industrial metal as well as a numismatic metal), attention will turn to the stock market double top. If it fails, it confirms the commodity break, the shorts go out on the SPY, QQQQ, banks and Cramer's famous "Four Horsemen." (AMZN, GOOG, AAPL, and RIMM - BTW, the "Four Horsemen" in the Bible are apocalyptic in origin, so take that for what it is worth). Speaking of Cramer, if he is chirping about new highs in close proximity to the January high, that is about as close to "short with impunity" indicator that there is. If Goldman Sachs is offside (and I doubt it, as they are the ones moving the markets), that will be the kind of short that will land you at the Adventurer's Club sipping brandy and smoking a stogy with Commander McBragg as the ballsiest move in 4 generations. McBragg will be speechless because this is your world, the rest of us are simply passing through...quite.

Dollar long-calls as well as puts on foreign currencies should pay huge, as premiums on the trade will be next to nothing when the double top is made. Remember, everything is a dollar denominated asset, including foreign currencies. That's what "reserve currency" means in practical terms.

Stay solvent. Stay nimble. Stay skeptical.

Ernst Stavro Bloviator
Senior Fellow, IER


Anonymous said...

So what do you suggest?

I have a $100K job, $90K left on a mortgage (my only debt) that has another 8 years to go, and modest (about $400K) savings including retirement...most of which is in stocks.

I'm not greedy. I just want to survive.

Should I pay down my mortgage a bit more aggressively while I still have a job?

From what you say, it doesn't seem like even bonds will be a safe harbor.

Eleua said...

The IER doesn't give specific advice, but is glad to use the example you give to enhance the present discussion.

First off, valuing survival over greed is a fantastic long-term strategy. You will go a long way in this environment with that mentality. After all, when risk is coming into the investment calculus, return OF capital is much more important than return ON capital.

Your $400K savings includes much of your capital at high risk, since you are heavily exposed to stocks, which are massively overvalued (generically speaking). Risk is going to come into every portfolio in the world and that will make multiples contract to the point where YIELD has to be competitive with similarly risk-exposed YIELD in bonds, which are also way overvalued. As bond yields go from sub-5 to double digit, stock yields will have to compete, especially in an environment where zany liquidity programs and policies will not goose stocks like they did in the past quarter century. These stock yields need to develop in the face of a shrinking global economy.

The IER is looking at these phenomena, as well as technical analysis in the major stock charts and forecasting a DJIA and SPX sporting a "2" handle for both. It might take some time, but we will get there. We went from 15K to 7K in 18months, and that was WITH manipulation to keep prices high.

Stocks = dead money.

Bonds are where the financial authorities are targeting their efforts, and the manipulation is to keep bond prices high, and yields low. This keeps asset prices high, which are the basis of the financial economy the American public has foolishly bought into, in lieu of a genuine manufacturing based economy.

Eleua said...

Part 2:

Paying down a mortgage is tough to discuss, because there are so many life choice factors involved, and they vary from person to person.

In general, if you just bought your Bainbridgeislanddreamhome, now is the time to hit the exits and take your lumps. Losing $100K is preferable to losing everything you have. Granted, if you are already underwater, you should consult a competent barrister to determine how you can shift the bulk of the damage aimed at your balance sheet to your banker's balance sheet. It is money well spent. He would also advise you not to take your real estate agent's knees out with a fungo bat, even if they deserve it for telling you that your house is special and a great "investment."

If you have been in your house for 20 years, and have only a few left, you obviously have a lot sunk into the home. You need to decide if your home is one that you will keep, no matter what, or if you want to sell it anyway, and move to Shady Acres.

If you want to go straight from your home to the funeral home, you need to protect your asset. Now is not the time to lose it. You need to pop open your spreadsheet and cash flow this thing. Your stock portfolio is poised for a cataclysmic drop, but so is your home price, and perhaps your income stream. What payments you are making at this stage of the game go primarily toward principal reduction, so the interest write-off is not as generous as it once was. At $100K, your standard deduction eats up the bulk of it, so the amount you save by itemizing shrinks every year. Eliminating interest payments is a nice way to go, because all that monthly payment now accrues to your savings.

I am a firm believer in debt-free living. Waking up knowing that nobody owns you is, IMAO, the stuff of the true American Dream.

If I was in a home where I wanted to leave within 10 years, I'd just do it now and lock in the equity gains, and rent someone else's disaster. I say that by way of my present experience, as I knew that any home I bought in the last few years, would be temporary (under 10 years), so I rent someone else's headache.

He who sells first, sells best.

Again, this is not personal advice. I put this down as a strict "hypothetical" situation and fodder for the continuing conversation we are having on CCB on the shift in the economic paradigm.

Things are different, so we need to think differently. 98% of financial advisers are still fighting the last war.

Anonymous said...

As you guessed, my intent is to go straight from my home to the funeral home. So the question comes as to how best to protect the asset.

If I pay off the mortgage now, I save a little less than $20K of interest, although the real bite is closer to $15K due to interest deduction. I'm not in AMT territory.

Even using all my "rainy day fund" liquid assets and Roth money, I'd still have to nuke enough traditional retirement money to wind up paying at least $20K in taxes and penalties (I'm under 59 1/2). And I wouldn't have any appreciation of those assets in the 8 years between now and when my mortgage would run out.

So, it would cost more for me to have the peace of mind to be debt free. It seems like a fool's choice, UNLESS the market craters to Dow 2000 (do you really seek it getting that low?) or less AND I lose my job AND can't find new work.

That's a tough short. And even if I win that short bet, I'm still in for a world of hurt (along with everybody else). The "win" is just not having mortgage payments.

A more reasonable choice might be to move enough funds in the IRA to cover the mortgage + penalty + taxes into something that would be more or less stable. That way, it would be there if I need to use it, but otherwise continue with Plan A.

The only problem is that from your analysis, not even bonds seem suitable for that purpose.

I guess that I could buy CDs in the IRA.

Anonymous said...

PS: Even in your worst-case scenario, I won't be underwater on the house, especially considering the over 20 years of use I have gotten out of it.

Since I have no intention to sell, I welcome drops in its value since that reduces my property tax. I was delighted with the $100K assessment hit this year; it mostly makes up for the $130K assessment soar the year before. I'd happily take another $250K assessment hit.

But I'm in a different boat from most other islanders, in that I have no intention of selling; and I hope not to have any need to sell.

Eleua said...

We now are at the point where the specifics of your case are beyond my ability to intelligently discuss. All I am saying is that being in debt is being short dollars, and anything that is directly short, or denominated in US dollars is going to get thumped.

I am a fan of debt free living, as I said before. Yes, tax ramifications of paying down debt may outweigh the bennies at this point, but that is something a qualified tax consultant can address. All I am saying is that most financial advisers have no idea what is coming. They think the worst is behind us and yesterday's paradigm is coming back from a short vacation.

FWIW, someone near and dear to me had a large portfolio that was heavily invested in stocks. When this scenario was presented to their financial adviser in July 07, the FA said that selling now will bring about unnecessary tax ramifications, and a full investment is still warranted.

Over the next 18 months, that portfolio was cut in half.

Food for thought.

As I used to teach when I was a Navy instructor pilot, "Solve the problem that will kill you first."

I wish you the best. As my signature usually says, "Stay solvent."

Anonymous said...

Quick question to Eleua: are money market funds safe in the scenario you describe?

Eleua said...

The IER keeps a good chunk of its cash reserves in MMFs.

Look at the prospectus to see what paper they are holding. If the MMF is a US Treasury fund (primarily short term), you are probably pretty safe. If it is chock full of mortgage backed securities, move to another fund. Recall from the Autumn of 2008, that one of the big problems was MMFs teetering on "breaking the buck."

My pecking order for "safety" would be:

o- Actual cash - as in Ben Franklins in a safe deposit box.
o- Treasury Direct - You can set up an account directly with the Bureau of the Public Debt. It would take a general default to take that out.
o- Treasury backed MMFs

I just checked with the IER's Currency Division, and we agree that the present scenario of having the world's reserve currency funding every asset class reflation in the entire world is a 200 MT nuke rolling around on the floor of the world economy. Once the dollar gets a bid, EVERYTHING is going to get wiped out.

Anonymous said...

Paulsbo? What happened to your spread on Bainbridge?

alreadyhome said...

entertaining stuff. I agree with the debt-free approach--otherwise it's just counting chickens that may or may not hatch. So, pay off the house, Anon! As for Clearcut Bainbridge, please announce your next mtg BEFOREhand so that the discerning public can drop by!

fiona said...

No, seriously. What happened to the Bainbridge place? Did your LL lose it? Did he get pissed off about your comments? Was it just too expensive? Inquiring minds want to know?

Eleua said...

My LL had delusions of selling at a rediculously high price, only to get nothing but crickets chirping in response. She wanted us to stay on a month-to-month basis (at full rent), only to have us go diving out of the house in the dead of winter on a moment's notice.

I also got tired of her not respecting our tenant rights. I told her prop mgt company that if she drops by one more time unannounced, the rent will be cut in half each time she does it. Problem solved.

I offered 1/3 of the rent for that scenario with a 90 day move out, and she said no, so we moved to the Hood Canal area.

It was on the market for 6mos while we were there with only one showing (the RE agent is a friend of mine). She has dropped her price 20% and still has only cricket noises.

I offered $175K and she laughed at me. I told her that this place will go for that amount in the near future, and she thought I was deluaional.

We shall see...I'm not the one with a piece of quality real estate with only one look in a year.

It is a great location, but we outgrew the house, and the family is happier in our new digs.

She is a nice lady, but completely clueless about what is happening around her. Sadly, she is in the majority.

Anonymous said...

May be you are delusional?

Eleua said...

You were saying?


Some really great things talked about on this blog.