Equities: Nightmare on Wall Street?

I'm a fan of horror films; it's the toughest genre to get right. The key is not to reveal the chainsaw wielding psychopath/demon/vampire too early, but intimate his presence gradually, building the suspense until he terrifyingly bursts on screen in the final act, splattering gore as he goes. If the director gets it right, by this point some delicate souls will be running for the exits and most brave enough to remain will be distinctly queasy.

For those Wall Streeters heading back from the Hamptons next week (and given the record low NYSE volumes in recent days, the beaches must be packed), I suspect those with a taste for gore will have quite a spectacle to enjoy. Here are some thrilling plot twists while you were away:

1. Credit Spreads are exploding again, and are now at record levels. We have massive rollovers on buyout debt and US banks need to find $50bn in auction-rate securities buybacks alone in coming weeks, not to mention the ongoing Freddie (FRE) and Fannie (FNM) mess. Ominously, both the ECB and Fed are finally becoming more discerning about the quality of collateral they accept from banks in swap deals. Investment grade corporate bonds are trading at over a 300 point premium to Treasuries (from 100bp from 2005-7). If sustained, this will choke off corporate access to the bond markets and hence investment. Yet the VIX is still down at 20, and equities remain in half-hearted rally mode; experience tells me that when credit and equity markets diverge so sharply, the collective intelligence of the bond market usually proves prescient.
2. Tsar Vlad the Bad in Russia is now showing his true colours, and the invasion of Georgia and then recognition of the statelets seeking to secede is very dangerous; expect Russia to stir up its large minority populations in the Ukraine and the Baltic states to create an excuse for further intervention and expansion. Ultimately, this reckless hubris will undermine the fragile Russian economy and the Tsar will probably be overthrown by those Kremlin clans with an economic interest in engagement with the West, but in the meantime the uncertainty will destabilise markets. It's about time the West clamped down on the massive money laundering and corruption that is endemic among the Russian elite all the way to the Kremlin; from Switzerland to Cyprus many billions in kickbacks and bribes are held in offshore accounts by Russian politicians and bureaucrats. That squeeze would hit harder and faster than any military or diplomatic threats...
3. Pakistan (the country with real WMDs the US should have invaded) is now teetering on the verge of political collapse amid an increasingly confident Islamic insurgency spreading from the Tribal Regions (where Al Queda are rumoured to hang out) to the cities; the army and intelligence services are clearly compromised by high ranking sympathisers. It's increasingly possible that the next President will be the nuclear scientist who sold reactor and warhead plans to North Korea, Libya and Iran (almost certainly with the full knowledge of the ruling military elite, but he was a convenient scapegoat). Pakistan looks like Iran in 1979, except with a homegrown nuclear arsenal. A Taliban-lite style government in Pakistan is a truly horrible prospect, with particularly negative implications for Indian financial assets as military confrontation between the countries would inevitably resume.
4. After the recent grim data from Japan and the Eurozone, the G7 economies are now almost certainly headed for at least a mild recession in 2009; I believe that China is growing at just over half the 10% still being officially reported (note a slump in recent Chinese tax revenues, and a series of panicked reflationary measures in recent weeks; the statistics are about as phony as that Olympics opening ceremony). Emerging markets are now recoupling with a vengeance and face a nasty stagflationary cocktail; the IMF will be downgrading its wildly optimistic growth forecasts every month for the foreseeable future until we see 2-2.5% for 2009 global growth.

We may muddle through somehow, but the implications of all the above are likely to precipitate a crisis of confidence at some point this Autumn, as geopolitical risk converges with a darkening economic outlook and the current Bear Rally reverses course.

So far, earnings have been saved by the resilience of the global economy (both for industrial exporters and resource plays benefiting from windfall commodity prices), but this is now clearly faltering, and the dollar has dramatically rallied, as I'd forecast repeatedly (see: The Buck Stops Here...).

In Q2, S&P companies with over 50% foreign exposure grew their earnings on average by 20% qoq, while domestic plays with 90% or more of revenues in the US suffered a 36% qoq slump in earnings. Both resource plays and US multinationals (notably the big tech stocks like Google) now face currency translation and revenue downgrades while the domestic economy is in recession in all but name.

And this is the really horrifying bit; for the price multiple on peak earnings to touch the long-term average of 10.4, the S&P would need to fall to 885.

Extreme perhaps, but I certainly wouldn't be surprised to see the Dow sub 10,000, and the S&P sub 1100 as all this washes through in a climactic bear market sell off. So welcome back guys, and hope it was good. After all, next year, it's a week in Atlantic City. Actually, I hear the Casinos there are hiring...

Disclosure: Short SPY via put options at 10500 and 10000

Comments

[investor88:]

Sean article may make the bulls queasy but the points brought out are useful, thought provoking, relevant and potent. There is careful research and analysis of the data [appreciate the work done and taking the trouble to publish at SeekingAlpha] whether or not one fully agrees with his intrepretation. Dow sub 10,000 and sp500 sub 1100 is not out of the question but it is a scenario we have to plan for. sp500 at 885= pe of 10.4 long term average, this currently looks unthinkable. If you consider that many unthinkable things have become reality [remember no less than the entire US government saying the subprime problem is not a issue and "contained"?] , what is so absurd about sp500 at 10.4x peak earnings the long term average? This is especially when you consider the scale of the problems in the US arising from the unwinding of the debt bubble and its effect on the world economy leading to the negative feedback loop. As always there will come a time when there is sunshine but first the valley of darkness?

2008 Aug 31 08:50 AM

[OldLimey:]

Thanks for a very good post. Is 'Sean Maher' a nom-de-plume for Alistair Darling??

Regarding Russia, students of history might see Georgia as the Rheinland in 1936, Ukraine as Czechoslovakia in 1938, Belorus as Austria in 1939, and the Baltic states and Poland as....the Baltic states and Poland in 1939. Russia's elite needs to know that they, their lifestyles, and their bank balances will pay a price for further aggression. Perhaps we could start with Abramovich's planned 9-figure palace in Knightsbridge???

2008 Aug 31 09:30 AM

[wpdragon:]

Excellent article Sean!!!

Only an arrogant fool with his head in the sand would beat his chest and ignore it... of course, the arrogant fool is probably really only holding hummels and cash despite his hubris.

2008 Aug 31 02:13 PM

[gordon:]

The "West" should clampdown on Russia's elite laundering money in offshore accounts? It sounds like you're shooting from the McCain Hip! A Congressional report 2 weeks ago showed that 65% of the US CORPORATE ELITE payed ZERO corporate and Federal income taxes from 1999-2006. In the boom year 2005, 50% PAYED NO TAX. Did anyone on this esteemed blog report this? How many hours did the media cover it? ONE? Tax breaks allow our (patriotic) elite to open a factory abroad and get massive refunds, or open a subsidiary in a tax-free country, ship product there, then sell it back to Americans and PAY NO TAX ON THE PROFIT. How about starting with our own domestic corporate cesspool ?

2008 Aug 31 06:29 PM

[Xyrus:]

The real nightmare of wall street jockeys is a mop, bucket, and a name tag with their name on it. Everything up to this point has just been testing to see how well all those teflon suits they bought from the government over the past 8 years really work.

~X~

2008 Aug 31 07:57 PM

[whidbey:]

Thanks, good to hear from you.

2008 Aug 31 08:34 PM

[peterthepai...:]

we gonna be inna whole new show nex yeh.. the new show gon be a spin offa dorktreck : lost in space. in order to get outa the nebula the politix are gonna fix space by stoppin time. this they think will re-ignite the boom an save our asses from the bust. this gon be a big mistake, anna Turnerprize gon be split in two. the posh bit atta front gon be spun off to Dubai anna workin stiffs, inna back, gonna be in DEEP SH*T (2000&)NINE a space station stuck inna time warp with stagflation an no gum ta chew.

2008 Sep 02 04:43 AM