Tuesday, December 28, 2010

Morning Update/ Market Thread 12/28 - Bubbles Revisited...

Good Morning,

Equity futures were gaining ahead of the open with the dollar lower, the Yen making a large advance, bonds lower, oil back above $91 a barrel, and gold higher as well.

There was a small change in the McClellan Oscillator yesterday, thus we can expect a large directional move either today or tomorrow.

Case-Shiller Home Prices showed the largest drop in prices in over a year, falling 1.2% in the month of October on a not seasonally adjusted basis and .9% when adjusted. Here’s Econoday:
Home prices are falling at an accelerating rate according to the S&P Case-Shiller report that shows a minus 0.9 percent headline for October's 10-city adjusted composite. Note this index is a three-month average, which in this case smoothes out the depth of October's decline. Declines in the unadjusted readings, reflecting price discounting during cold months, are slightly more severe. October's drop follows three prior declines for the adjusted index: minus 0.8 percent in September, minus 0.5 percent in August, and minus 0.1 percent in July.

Year-on-year, sales are up 0.2 percent for the 10-city adjusted index but are down 0.8 percent for the 20-city index which is being depressed by mid-single digit declines for Atlanta, Detroit and Portland. Phoenix, Charlotte and Seattle, also part of the 20 index, also show sizable on-year declines.

The appearance of on-year declines in this report, which is noted for its breadth and accuracy, raises the risk of a pivotal downshift in home prices. Yet the outlook for home prices isn't completely negative given price gains in last week's reports on existing homes and new homes and also the FHFA house price index. Markets are showing no significant reaction to today's report.

I believe home prices have further to fall and will do so over the next few years.

Consumer Confidence for December cratered again, this time falling to yet another depression era read of 52.5 when 57.4 was expected. This is down from November’s 54.1.

I think it’s important to remind people about the supposed increases in retail sales numbers… those numbers are biased in two ways – first they are measured in dollars, and second they contain substitution bias because they fail to account for stores that have gone out of business. Thus we need to take the comparisons that are offered of this Christmas season to years past with a large grain of salt.

The VIX climbed significantly yesterday despite a rise in stock price, yet another divergence that says some large players are lining up for a reversal. There are 5 distinct waves up since the June low, a higher level correction is coming soon:

Those five waves up are either wave C up of a large A,B,C correction, or they comprise wave 3 up of a primary bull market. If it is a wave C, as I suspect, then next will begin a series of lower lows. If, however, the more bullish stock scenario is playing, then we will get a wave 4 next with a more shallow decline which would then be followed by a higher high. The only way that happens, in my opinion, is if the rampant fraud is continued to be covered up.

I know there are a ton of bulls out there and they now can point to rising prices from March of ’09 which is approaching two years of the bears being on the sidelines. During those two years the markets have been artificially propped with trillions and trillions in artificial support, the markets subverted by the “Fed” and the members that comprise it. Most Americans no longer participate in the market as they know it is trumped up and they have seen what can and will happen when the accounting rules change or when the bankers decide that they are not getting their way. Thus the market is not sustainable, valuations do not support it, incomes do not support outrageous debt levels, and thus it will come to an end, again, in my opinion.

But this is the way with all bubbles, as Hyman Minsky observed and as I wrote about in my book Flight to Financial Freedom prior to the peak in home prices and long before the last crash. I think it’s time to review the Seven Bubble Stages versus today’s stock market once again, I’ll place my current comments within brackets [ ]:
The late Hyman Minsky, Ph.D., was a famous economist who taught for Washington University’s Economics department for more than 25 years prior to his death in 1996. He studied recurring instability of markets and developed the idea that there are seven stages in any economic bubble:

Stage One – Disturbance:
Every financial bubble begins with a disturbance. It could be the invention of a new technology, such as the Internet. It may be a shift in laws or economic policy. The creation of ERISA or unexpected reductions of interest rates are examples. No matter what the cause, the outlook changes for one sector of the economy.
[The innovation and widespread use of derivatives sparked the former bubble, it was the fuel to the fire. What was the latest major change? The unprecedented bailouts of the banking industry, the resumption of mark-to-model accounting, and then the “Fed” began “Quantitative Easing” as a new policy tool, i.e. money printing which now provides the new fuel for the fire]

Stage Two – Expansion/Prices Start to Increase:
Following the disturbance, prices in that sector start to rise. Initially, the increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, more people start to notice.

Stage Three – Euphoria/Easy Credit:
Increasing prices do not, by themselves, create a bubble. Every financial bubble needs fuel; cheap and easy credit is, in most cases, that fuel. Without it, there can’t be speculation. Without it, the consequences of the disturbance die down and the sector returns to a normal state within the bounds of “historical” ratios or measurements. When a bubble starts, that sector is inundated by outsiders; people who normally would not be there. Without cheap and easy credit, the outsiders can’t participate.

The rise in cheap and easy credit is often associated with financial innovation. Many times, a new way of financing is developed that does not reflect the risk involved. In 1929, stock prices were propelled into the stratosphere with the ability to trade via a margin account. Housing prices today skyrocketed as interest-only, variable rate, and reverse amortization mortgages emerged as a viable means for financing overpriced real estate purchases. The latest financing strategy is 40, or even 50 year mortgages.
[Since the world is now saturated with credit, the latest innovation is to simply print money and buy up the markets. This WILL eventually fail as a market is not a market when there are only a very few participants.]

Stage Four – Over-trading/Prices Reach a Peak:
As the effects of cheap and easy credit digs deeper, the market begins to accelerate. Overtrading lifts up volumes and spot shortages emerge. Prices start to zoom, and easy profits are made. This brings in more outsiders, and prices run out of control. This is the point that amateurs, the foolish, the greedy, and the desperate enter the market. Just as a fire is fed by more fuel, a financial bubble needs cheap and easy credit and more outsiders.
[I think we were seeing this particularly in the second half of this year. We are also seeing this again in commodities. Note that China just released its initial commodity allotment for 2011, which is about 15% less than 2010.]

Stage Five – Market Reversal/Insider Profit Taking:
Some wise voices will stand up and say that the bubble can no longer continue. They argue that long run fundamentals, the ratios and measurements, defy sound economic practices. In the bubble, these arguments disappear within one over-riding fact – the price is still rising. The voices of the wise are ignored by the greedy who justify the now insane prices with the euphoric claim that the world has fundamentally changed and this new world means higher prices. Then along comes the cruelest lie of them all, “There will most likely be a ‘soft’ landing!”
[This is the key paragraph that I want to point out. I see fewer and fewer “wise voices” and believe that due to the duration of the current run up in stocks that they are being ignored once again. This is soooo typical of bubbles, it is a hallmark. Those wise voices look foolish in the face of rising and rising prices, only they are proven right in the end. Here’s a wise voice who is being ignored now:

Will he be proven wrong? I don’t think so. In the end the foolish will look as foolish as they always do when a bubble is in full blossom.]

Stage Five is where the real estate industry is today [2005/2006]. This stage can be cruel, as the very people who shouldn’t be buying are. They are the ones who will be hurt the most. The true professionals have found their ‘greater fool’ and are well on their way to the next ‘hot’ sector, like the transition from real estate to commodities now. Those who did not enter the market are caught in a dilemma. They know that they have missed the beginning of the bubble (gold, silver, and oil today [2005/2006]). They are bombarded daily with stories of easy riches and friends who are amassing great wealth. The strong will not enter at stage five and reconcile themselves to the missed opportunity. The ‘fool’ may even realize that prices can’t keep rising forever… however, they just can’t act on their knowledge. Everything appears safe as long as they quit at least one day before the bubble bursts. The weak provide the final fuel for the fire and eventually get burned late in stage six or seven.
[This and Stage Six is where the market is now. The “Fed” is quite intentionally attempting to sucker new entrants into the market. They have even stated that is their intention publically.]

Stage Six – Financial Crisis/Panic:
A bubble requires many people who believe in a bright future, and so long as the euphoria continues, the bubble is sustained. Just as the euphoria takes hold of the outsiders, the insiders remember what’s real. They lose their faith and begin to sneak out the exit. They understand their segment, and they recognize that it has all gone too far. The savvy are long gone, while those who understand the possible outcome begin to slowly cash out. Typically, the insiders try to sneak away unnoticed, and sometimes they get away without notice. Whether the outsiders see the insiders leave or not, insider profit taking signals the beginning of the end (remember who has sold their rental properties?).
[Are insiders sneaking out the door now? YOU BET THEY ARE! And they have been for quite some time. They have been selling to the “Fed” as they fully realize that the true market fundamentals cannot be supported once the “Fed’s” false accounting tricks and phony money are removed from the market.]

Stage seven – Revulsion/Lender of Last Resort:
Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap and easy credit or some unanticipated piece of news. But whatever it is, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in, prices start to tumble downwards, credit dries up, and losses start to accumulate.
[This has already begun in the credit markets, but has yet to begin in equities. It will.]

This is where you may see the “lender of last resort” who is usually the government. The government, although they were talking up a soft landing, are now forced to step in to prevent the crises from spreading to other sectors. Ironically, this is where the savvy investor who profited before, really profits now. With government backing, they are asked to step in and return “normalcy” to a now damaged sector.

The government’s attempt to “put out the fire” usually works. However, the conditions beyond the year 2010 will require oceans of water that the government does not posses. You must be ready!

And here we are… Remember that the “Fed” is NOT the government. At some point the true government, Congress, will be required to step in and clean up the mess in some REAL regard. This has most certainly NOT occurred yet. The true market will be observed in the end…