The markets are reenacting a Greek Tragedy. The Story of Daedalus and Icarus is remarkably similar to the recent and near term future action. In this tale, Icarus and his father Daedalus are imprisoned in the Labyrinth. Daedalus (structured finance) is a master craftsmen who has run afoul of King Minos (investors/market fundamentals) by creating a hollow cow that enables Minos’ wife to carry on an affair with a bull- I kid you not. The union of the hollow vehicle [CDO] and the randy bull (greed and the always long and levered world) produced a hideous and dangerous beast, the Minotaur (financial losses on opaque, mark to model vehicles).
For safety an angry King Minos (fearful and angry investors) imprison the violent and angry fruit of his wife’s affair in an island prison, Labyrinth. Full of twists and turns (volatility), the Labyrinth is a cruel trap (sustained losses). Daedalus and his son Icarus (structured credit, guilty and innocent equities alike), are exiled to an island prison. The imprisonment on the island might have its market equivalent in the long torturous process of discovering and disclosing losses. Credit losses, like the Minotaur, are the violent, unruly, devious offspring of bad loans (the king’s wife), crafty financial engineering/ratings (Daedalus) and greedy bulls.
Trapped in a prison of their own making, Daedalus and Icarus turn to their crafty skills to escape. They try to talk their way out. Then they turn to plans for escape, attempt to revalue or get a bailout. They build wax wings (false hopes and Fed cuts) to escape the King’s (market’s) Labyrinth (downtrend). To succeed, Icarus must fly perfectly between the potential downside danger of the ocean (recession) and the high side risk of the sun melting the wax wings (inflation). You know how the story ends. Thus, you know where the present flight of hope will land.
Months into a sideways downtrend, the rally arrives. On wax wings we are soaring up on terrible economic news. This was to be expected and if robust, will provide the first really safe large scale shorting investment opportunities since the end of 2007. I assume that similar leadership on the upswing will translate into some predictable weaknesses on the return flight. This rally will eventually plunge into a sea of despair. The Icarus rally cannot fly high enough to avoid being weighted down by recessionary waters nor, low enough to avoid inflationary heat. The same combination of nasty inflation and economic trouble news that buoys spirits and shares today, will eventually end this flight of Icarus.
We expect serious weaknesses to emerge in the developing world as food and energy prices bite hard for large net food and energy importers. The ETFs USO and RJA offer an insight into rising prices and the pressure they are exerting on buyers of energy and grains. Inflation in raw materials and food leads to cash strapped consumers and wage demands.
The recent profit enhancing run of huge credit driven consumption and stagnant wage growth looks very long in the tooth. The performance of financials and the looming risks of further weakness are very real. As shipping costs rise, food costs rise and strapped consumers search for bargains, earnings get harder to come by. Creditors face weak and risky borrowers and the real prospects of inflation and default. We are thus waiting for this rally to produce downswings in FXP, EUM and SKF to allow profitable re-entry.