Playing the Bust, Understanding the Boom

In financial markets and boardrooms assets are repositioned based on opinion regarding the presence or absence of recession. These debates are interlinked with debates about recession severity and global contagion fears. Savvy strategists know that you cannot possibly price in a future recession of unknown depth and duration. If we are in or headed to recession, how deep and how long will it be?

Opinion on these questions gyrates and sends share prices on roller coaster rides. We see this in the fact that traders have taken home much more than investors over the last few months. Asset price movements reflect oscillation between deep fears and skittish rebound plays. The trading ranges- long and short- on financial ETF, emerging markets index ETFs and US and European ETFs make this very clear. Moves of greater than 3% per day are commonplace with moves greater than 5% not uncommon.

The Long Plays in emerging markets (EEM), US financials (UYG), China (FXI) and the Nasdaq (QLD) are examples.

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The Short Plays are similarly dramatic. This has been a trader’s market with bias to the downside.

The Shorting ETFs for emerging markets (EUM), US financials (SKF), China (FXP) and the Nasdaq (QID) make this clear.

Swings are created by recession and contagion data flow and emotion. Those arguing for no or minor coming US weakness fight to focus attention on the relatively limited scale of trouble. They point to the emergence of severe difficulty only in the automotive sector, housing, financial and credit markets. Overall employment and economic growth data- while far from strong- are not yet definitely recessionary.

Personal earnings numbers have not radically turned down and neither has employment. We caution that the post 2002 economic boom was uniquely based on consumer credit and asset inflation. Equities rebounded and performed well- particularly outside the US- after 2003. American home prices surged. Employment and personal earnings growth was weak. Thus, it would not be shocking to see less profound earnings and employment downturn as recession begins. If you boom on house price inflation and consumer credit, you bust when they bust.

The Boom

There was a 53% increase in the value of American homes as assets from 2002-2007. The price of all homes increased from $14trillion to $21trillion.

These are paper gains that rise and fall. Home prices have fallen and are falling. We expect additional average declines of 10%-15%, $1.5-2.3 trillion, before the end of 2009. The five years between 2002 and 2007 saw a 73% or $4.4trillion increase in home mortgage debt.

This isn't going away. In fact, thanks to teaser intro rates and balloon options mortgages, it will rise. Consumer credit borrowing increased by $492billion or 25%. We borrowed so much and so fast against our inflating homes that the average American went from owning 56% of their home in 2002 to owning 50% in 2007. As prices fall and debt levels remain the same, this percentage will fall further. Very soon the Average American family will own less than the half the value of "their" home!

From 2002-2007 there was a 55%-$16 trillion- increase in financial asset prices, from $29trillion to $45trillion. The prices of financial assets tend to be sensitive to corporate profits and credit conditions. Over the last 4-5 years corporate profits have risen sharply. In late 2006 and early 2007 profits reached 77 year highs as a percentage of national income. Corporate profit performance has been the mirror image of employee compensation. Low interest rates, productivity gains, stagnant wages, favorable tax policy and financial innovation allowed greater profitability, particular for those engaged in the booming credit and housing markets.

This is the key connect to the credit crisis. Wage growth trailed productivity but, sales could grow through credit and asset inflation funded consumption. Our recent economic performance was the offspring of financial innovation, low interest rates, massive consumer borrowing and asset price inflation. The mechanics of the boom have become the engine of the bust. We don't yet see particular weakness in jobs and earnings because the recent recovery 2003-2007 was spectacularly weak in job and income growth.

The average wage and salary annual percentage gain across 55 years of expansions ran at about 3.8%. Our recent expansion has seen only 1.9% growth in wages and salaries. This is half the average annual wage and salary growth. In 2006 only 51.6% of national income went to wages and salaries, this is the lowest percentage since 1929 when data collection began. We will have to wait to see weakness in the already limping areas of employment and earnings. I expect earnings and employment to fall less and more slowly. This is to be expected from lagging indicators that never boomed.

This was not your father's expansion. It was not based on excellent overall economic growth. It was not based on salary and wage growth. There was only a 31%, $2.4trillion, in disposable income over the last 6 years. Consumer debt increased by $2.4 trillion more than disposable personal income from 2002-2007. Housing and financial price inflation ran at many times the rate of income growth.

Debt growth fueled consumer borrowing. A financial asset and housing boom based on easy money and financial innovation created a national economy dependent on assets and home price increases and further credit access.

The Bust

We are now faced with declining housing prices, falling asset prices and squeamish lenders fearful of overly indebted consumers. This is why I believe we are already in a recession or near recession. The near term future will be defined by economic weakness. It will come from the sectors and areas that furnished the strength. It will be exported and globalized more rapidly and widely than ever before. In short, the bust will run much like the boom. It will not be linear, there will be reverses and all areas and sectors will not be hit evenly or simultaneously. All of this is to say, the bust will be like the boom that fathered it.

We are in the middle stages of asset price deflation and selective credit constriction. This is where we found growth and it will be where we find pain. Strong balance sheets, diversified income streams and advantageous access to scarce credit on beneficial terms will define winners and losers. Babies will be tossed with bathwater. The basic economic realities of boom and bust allude many. This has been and, will continue to produce advantageous long and short opportunities.

Disclosure: I am moving long short between FXI-FXP and SKF-UYG.

Comments

[User 41951]

Max, your perspective on our market big picture was very helpful; good to keep in mind during the daily market gyrations. Re your disclosure of moving long short between FXI-FXP and SKF-UYG could you provide more comment on that thought process. As a small investor, constantly warned about shorting the market, it seems I'm missing the boat.

[Fin]

Like the author I have been playing the short/long strategy on the financial index since late August when the syndrome began, using Proshares SKF and UYG as the ETF tools. The syndrome consisted of strong downward bias with occassional offsetting upward spikes, prior to and immediately after positive announcements for the financials, such as Fed fund cuts, Bank of America announcing their intention to purchase Countrywide etc.

The simple strategy was to keep SKF most of the time, but to immediately sell SKF, and simultaneously buy UYG in anticipation of, or less desirably, in reaction to, positive news in the market discussed above.

Exteme examples of this included the Tuesday morning following Martin Luther King day, immediatley after the Fed made their unscheduled announcement to cut rates 75 bais points, prior to the market opening. Implementation of a premarket SKF/UYG switch immediatly after this announcement and well before the market opening produced the single largest 24 hour gain utilizing this strategy. Another big day occured when BofA announced their intention to purchase Countrywide. While this announcement was impossible to predict, it coincidentally occurred on the same day as a scheduled Fed announcement to cut rates, so if you followed the strategy, you would have enjoyed a very nice day with UYG.


Questions ?

Are the financials close to a "local minimum" or temporary state of equilibrium ? I think so and therefore the fun may temporarily be over. Spikes are decreasing in amplitude and we may be headed towards a slack tide here. Notwithstanding if this is true, then there likely will be a strong buying bias in the not too distant future. If so one can play the same game in reverse i.e. keep UYG most of the time and simultanesouly switch to SKF if/as bad news occurs.

The basis for the syndrome and stategy was: People act emotionally and believe what they hear in the media. More specifically people quicly panicked in mid August when the press went absolutely insane bashing Countrywide to sell news (most of which was either false or misleading). This caused investors to panick losing untold billions in the market. The news and panic quickly spread throughout virtually all mortgage lenders, banks, brokerage houses, insurance companies, real estate companies, and the real estate market in general (virtually every company listed in the financial index) thus creating the syndrome and the strategy.

Thoughts ?

Are we at or very close to a temporary state of equilibrium for the financials ?

Was this a legitimate arbitrage likely to repeat or simply a very lucky speculative set of investments ?

If this was an arbitrage, will it be much more difficult playing in reverse when value based financial buying begins i.e is the emotion of investor greed (effective for the reverse strategy) much less powerful versus the emotion of investor panic which was the basis for the current strategy discussed above ?