Irrational Exuberance Got Buried Yesterday: Now What?

Investors seem to have finally woken up to the fact that not all is well with the economy of the USA. Stocks tumbled close to 3% on Thursday and extended their gains in after-hours trading. It looks as investors gave the most recent FOMC statement a close look again and saw the new part which spoke of a credit crunch while headlines on Tuesday were dominated by the repeated inflationary concerns. And I think I could not have been more timely with Wednesday's RED ALERT when president Bush entered the markets discussion. I mean, what does he know?

The markets' action tells me that the term "irrational exuberance" got finally buried on Thursday.

The market action is indeed most worrisome. When not even the gigantic injections of freshly digitized money by the Federal Reserve and the European Central bank to the tune of $150 billion on Thursday alone could quell the slide that continues in the Far East at the time of writing, then we have arrived at one of these moments where Mr. Market takes into hands what was left untouched by policymakers for too long.

Not that any of the facts that culminated in today's sell-off have not been known for a good length of time.

The Bubbles Are Bursting
Only 8 years in the making the new millennium has seen 2 major bubbles that led to a third. Housing was followed by M&A and both fed the hedge fund bubble.

As there is hardly an investor who does not have to serve some sort of credit line in a leveraged world where the notional sum of derivatives outpaces global GDP several times we can prepare for more of the same to come as margin calls will force investors into liquidations of their positions.

To see that not even the liquidity excesses of the central banks are of help leads to the sad confidence that we are going to enter a bear market.

A Bear Barket Is When Everyone Loses
Suddenly it looks as if there are no investment classes one could escape to. Wanna buy consumer stocks? There will be plenty of supply in the near future. Bank shares? They will come a lot cheaper once market players realize that credit risk ultimately means counterparty risk. What does an exploding OTC option help an investor when the issuer goes belly up? Next to this banks will be faced with damage payments coming from non risk-adjusted advice they have given out before in order to fuel the boom in low credit grade investments.

Don't take too much comfort from Thursday's good performance of 10-year US Treasuries. There was no other place that looked remotely as a safe haven like this segment and the initial reaction will fade once markets take a closer look at US debts and the fact that they cannot be repaid without a massive dose of inflation - that will inevitably lead to hyper inflation.

Even the traditionally ultimate store of value fared badly. Precious metals were hammered down in late Thursday trading. But I don't buy reports that this was the result of investors selling the physical. Ted Butler has written enough on the huge short positions in COMEX futures.

But while decliners outpaced advancers in gold and silver mining shares, the sector saw a bit of recovery and many shares closed above their lows, in stark contrast to Wall Street.

In general I wonder why there has been no flight to the real quality in this sector. Can you name any other companies involved in the process of directly producing real money?

Where Will This Lead To?
Verbal economic warfare has escalated in recent days. China threatened to dump its trillion of US debt and president Bush angered the Chinese by calling them foolhardy. Is he the right person to call others foolhardy? The Chinese don't have to sell. They just have to stop buying more US debt to show the USA that a debtor is never in the position do dictate terms unilaterally.

In the broader outlook we are entering uncharted territory insofar as China and India have not been part of the global economy during the last bear market in the 1970s. It has to be seen whether consumers in Asia can fill the gap that will be left by indebted US consumers.

Altogether I would say that nothing is contained in the current state of markets. The outfall from the housing bust is by now felt all over the world, spelling more doom to come.

Central bankers may have been successful in diminishing the status of gold and silver since 1930, replacing it with the Federal Reserve dollar. This is not the case in Asia where 3 billion people will stash more of it once the developing global financial crisis can be felt in their wallets.

The Middle East, long time a major dollar investor, is shifting away from the dollar too. Plans for more gold exchanges in these regions would not proceed if there was no demand.

Suggestions for other safe havens are most welcome in comments. As so many market observers I feel no lack of comprehension of events but I am still working on the solution.

Comments

[emily x:]

"The Chinese don't have to sell. They just have to stop buying more US debt to show the USA that a debtor is never in the position do dictate terms unilaterally." -- True, but like everything in the vast new global economy, it works at least 2 ways: China also has to be concerned about a backlash against poor quality/dangerous products from her biggest customer -- us.

What's strange is how often we've been here before, with gigantic debt suddenly being called in and nobody actually having the cash. What happened to that "huge amount of liquidity" that's supposedly been "sloshing around the globe" lately, according to the wise folks on CNBC? I guess if history teaches us anything, it's that history doesn't teach us anything!

2007 Aug 10 10:25 AM

[irondoor91:]

You know, I was just having the same thought about the liquidity issue in the past couple of days. How many times did David Faber (who is acutally the most astute and connected person on CNBC) say that the "world is awash in liquidity". Why, it was sloshing around in every bilge and sesspool from Red China to Goldman to The City to Dubai.

If we suddenly now have a credit crunch, where did all this liquidity go? If the central banks are "injecting liquidity", where did they get it? Did they just happen to have some of this "old" liquidity sitting aside?

Like most, I am truly baffled. But hey, no worries, as the young folks say.

2007 Aug 13 10:51 AM

[schooly d:]

With respect to safe havens, the TIAA Real Estate account (directly owned RE, not a REIT) has been a calm port in the storm thus far, though it unfortunately is not open to all ships. The account was up .3% for the day yesterday and is up 9.7% YTD, beating out all other TIAA or Vanguard asset classes except mid-cap growth and emerging markets. If we really are on the cusp of a 1970's style bear market then commercial real estate will also take a hit, but for the moment those who have access to TIAA RE might find it a comfortably boring place to shelter assets until the storm passes.

2007 Aug 10 12:23 PM

[irondoor91:]

There is always that "lull me to sleep with soothing words" comfort in holding assets that are not liquid and only occasionally appraised by some "professional". How is it that your illiquid real estate is more valuable than the real estate held in a REIT? Are your tenants paying higher rent than the tenants in REIT real estate? Are your mangers charging lower management fees? Are your lenders giving you better terms?

Perhaps it's just that certain knowledge that, over time, all real estate goes up. Until it doesn't.

2007 Aug 13 10:57 AM