Caveat Emptor Remains the Siren's Song

An economic contraction without credit expansion . . . is a non-starter. That's of course what the permabulls are hoping for; or mistakenly interpreting ongoing funds rate cuts as somehow inferring a restoration of the free-wheeling easy credit 'years of yore'. As should be evident, I'm using that term to denote the suspicion it's not returning, nor in any reasonable way should it, given the damage such unmanaged (or mismanaged, I dare to say in the case of oversight by rating agencies and money managers) robust credit availability generated, beyond the requisite need of the post-debacle 2000 era.

The optimists (as we are too in the very long-run) tend to believe a couple rate cuts will restore or expand growth, which is an impossibility presently. History is replete with examples where lower rates took (on average) 9-18 months to gain the 'traction' necessary to motivate an economic recovery. So since stock markets fairly typically will discount 3-6 months in advance (occasionally earlier; sometimes later); it seems absurdly ridiculous to hear talk of this occurring immediately. No precedent for that really, and that's with far better underlying financial conditions than we're facing.

The magnitude of the slowdown, of course, began to be felt in housing and then ripple effects followed, just as we projected all along to be the case. Labor rates are high, not low, which supports the idea that recession risk (or worse) is a 'mild' description of what we may face. Now others say the Fed may be 'pushing on a string'; thank you, as it's a phrase we've used since July, even before the actual high of the move.

Now, it is likely that less than half of a recession's risk is priced into the market, so that makes it likely that the so-called 'correction identified' bottom some are cheering has little basis in reality other than for a requisite bump-up on 'confirmation' of negativity. In our thinking, something like a 20% decline (give or take, more or less) would seem as a more realistic assessment of where this goes over time, interspersed with rebounds as outlined. In fact, that's why we called it 'Chinese Water Torture' (salami decline), as it made sense to us that the professional managed background wasn't going to face it or give-in (capitulate) as rapidly as in the past. One reason for that was what they are in (CMOs, CDOs, SIVs etc.), tending to mitigate the willingness to be transparent.

One more time: much of the growth in consumer spending was on the back of credit, as became available coincident with the low interest easy-money housing bubble, in a time when it was easy for citizens to tap their credit lines for perceived expenditure purchases, as well as actual necessities. What we've seen here is a hangover from that (now bygone) era and it's not returning. The Fed is trying to facilitate unlocking of an illiquid system (still is, contrary to reports otherwise), not provide fixes to addicts of the consumer explosion. To do so would help the Chinese economy more than our own; it would not create many substantive domestic jobs; and it would increase our debt profile even more dangerously (if that's possible). Risk aversion is what state governments, like Florida, are at this point belatedly embracing. They should have and could have done it sooner.

Fears are rising in the credit markets that the turbulence could last for months as big US and European banks come under pressure due to losses in US mortgage securities. The 'cover' of decent economic activity masks the greatest credit bubble ripple effect risk since the 1907 Panic, if not the 1930s. The similarity is somewhat like I recall in the 1880s when the 'railroad' bond debt fiasco took the nation into a situation taking years to recover from, more so than the 1990 banking mess that led to mergers and a rebounding stock market (though there are similarities, and this isn't going to yield easily).

Frankly, though long-side S&P trading opportunities were expected this week, folks will pay only for real growth prospects in the long run; and for that we'll have to have not just lower funds rates but economic stabilization, as well as a shift in the convoluted inverted vs. longer-term sloping yield curves too. Rally yes, and more, but caveat emptor from an investment basis remains the siren's song after the short-covering romp.