Eduard Fischer's  Instablog

 Although there were a number of published models out there well before the economic crisis of 2008 showing why it was inevitable, I have not seen a single model showing how this vaunted economic recovery is supposed to take place considering the present state of consumer and government debt. The crisis was caused by a credit (not real estate) bubble, which has not in any way been realistically addressed. The stimulus package and tax breaks have merely extended consumer credit further by shifting more of the new debt to the US government.  There seems to be no realistic plan in place for even stabilizing the accrual of this debt let alone paying it down.

 

To begin to pay down consumer and government debt the US would have to enter another cycle of sustained economic expansion (including a huge increase in exports to overcome the trade deficit) so consumers and corporations could shoulder substantial tax increases.  Such an expansion of the US economy is no longer possible given world market competition. America cannot be competitive on the world market  because there are not enough Americans employed making things. Most Chinese workers, for instance, are directly engaged in production whereas only a small percentage of US workers are. The vast majority of US workers are employed in “services,” which mostly involves moving stuff or money around; some even, like most of the so called financial advisers, are still simply professionally engaged in the Willy Loman vocation of hustling themselves. Arthur Miller’s character in “Death of a Salesman,” may well metaphorically represent the state of the country today.

 

It is significant that successful American companies like IBM and Wall Mart that are held up to be models of US efficiency sell products that are, for the most part, made overseas.

 

As for all the money “sitting on the sidelines” that is supposed to lift the stock market to much a higher recovery yet: the funds flowing into US treasuries is desperately needed every day to finance the enormous US government deficit that is needed to sustain the system. If that money starts to flow elsewhere, or is pulled out, then the recent financial crisis will turn out to be a mere prelude to a real meltdown.

 

Here’s a quote form Miller’s famous 1949 play: “He's a man way out there in the blue, riding on a smile and a shoeshine. And when they start not smiling back — that's an earthquake. and then you get yourself a couple of spots on your hat, and you're finished. Nobody dast blame this man. A salesman is got to dream, boy. It comes with the territory."

 

Just remember how much of US debt is being financed by foreigners and what may happen if they stop smiling back. In the meantime dream on if you like.

Disclosure: No positions 

Earlier this week I published an article here arguing that, at best, any kind of sustained growth in the US economy was not possible for at least the next ten years. I invited rebuttals from readers but none of the comments disagreed with my gloomy outlook. So either there are a lot of lazy minds out there or my arguments really are irrefutable – Yikes!

 

So the question is: when will the market begin to reflect this reality? Well, almost all the big stock market crashes have happened in the fall; and this spring bear market rally looks uncannily like the charts for the 1929-30 market in the US and the 1990-91market in Japan. Both historical charts show double dips in the fall and late winter and then the big spring rallies. Followed by the really big drops. Although I’m not a chartist I believe that history can repeat its self just because human psychology is so repeatable. Also if this forecast recovery does not show signs of really happening by October or November skepticism will rule again.

 

So what strategy to follow here? First of all, kudos to all the black swans last fall, who held their Nov. 120 SPY puts bought at $1.50, and managed not to buy into the TARP fairy tale and sold them for thirty bucks or so. A 2000% profit in a few weeks is nice, but I unfortunately bought the fairy tale (or at least thought the market would) and dumped mine and will have to forgo early retirement for now. There may be an opportunity like this again but timing will be everything.

 

For the less greedy, simple shorting is a much more conservative play than jumping in too soon and watching your puts expire. I doubt if an even really sustained rally here can breach 10,000 on the Dow, as that would cause interest rates on US Treasuries to rise high enough that it would pull money back away from the stock market This would also once again quickly exacerbate the problems with the housing market, as interest rates in general would have to rise along with Treasuries. Remember that the US government has to raise five trillion dollars in the next year and half or so to pay for tax breaks and stimulus, and this will be a significant drain on the world’s capital. Even Mr. Bernake, during hearings this week, was beginning to sound worried at the prospect of trying to raise so much money.

 

As for myself I will try to time the next big drop (right now I would say October again but that may change) and maximize profit with a leveraged position. In the mean time I am shorting SPY, JPM, or SPG or buying DXD during the big moves on rally days, holding overnight and trading out the next morning. It’s actually a way for a bear to make a little $ change even when the market is moving against him for a week or even months. The trick is to have the discipline to short on the rallies and cover on the dips before they end and not be afraid of missing the big one. Of course that will be the trick – knowing the big one when it really does come.

I won’t go long (except on some gold stocks) just in case the market comes to its senses sooner than I expect.

 

Disclosures: Short SPY, JPM, SPG, or DIA, Long DXD, only overnight, for now.

 

 

 

 

CNN’s survey of 45 “leading economists” last week indicated that 90% of them believe that the recession will end this year and none of them believe that it will persist beyond early next year. This is indeed good news for the market. All the leading economic indicators show that a recovery is imminent with the exception of unemployment, which apparently is of no account since it is a trailing indicator.

 

What puzzles me however is that in all my reading, and conversations with upbeat financial analysts, I have not been able to find a cogent rationale explaining the mechanism that would enable this recovery to take place. Actually, beyond the belief in the voodoo of economic cycles and faith in the prognostication of leading indicators I haven’t even seen a vague rationale. So maybe there are some readers that can help me with this because I would really like to hear a realistic argument for imminent economic recovery. But first I will present some rationales for why I can’t see any kind of significant recovery taking place for the next decade or so and possibly much longer if the reality of the situation continues to be ignored. 

 

1. It’s the debt stupid. The cause of the so-called financial crisis has not been addressed in any meaningful way shape or form.  Excessive consumer, and government debt on the municipal, state and federal level, are what caused the financial crisis and attempting to treat the symptoms while completely ignoring the disease cannot solve the problem. The Fed and the Treasury are doing everything they can to get the banks lending again (but at the same time the banks are being admonished to deleverage and avoid the credit risks of the past). But lend to whom exactly?  To American consumers at least in part I would assume so that they can continue the spending spree that has driven growth not only for the US, but also to a large part, the world economy. But isn’t excessive consumer debt what precipitated this crisis in the first place? It wasn’t just a real estate bubble that set this thing off; it was much more of a credit bubble; it was all the leverage on top of leverage on top of leverage. It was consumers using their home equity as a kind of ATM to buy more goods and services, which was good for the economy for the short run but when one uses debt to create more debt it has to end somewhere. The term real estate bubble may be misleading because price is only relative to what is affordable. Real estate prices in Canada have, on average been higher than the US for a number of years and so far have not come down anywhere close to the extent that US prices have. The difference is that very few Canadians bought homes with no money down and the banks made few sub-prime or teaser rate loans. And liar loans, so common in the US would have been very difficult to obtain in Canada as income on mortgage applications was actually verified. Canadians also on average saved money, unlike Americans whose savings rate went negative some years ago. In addition credit at any level was never, in general, as wildly easy to obtain in Canada as it was in the US. So then explain to me how going back to the easy credit that caused this problem is going to solve it.
2. Americans hate to pay taxes. The US has by far the lowest per capita tax rate in the first world. The economic theory has long been that the more you lower taxes the more you simulate the economy. The US treasury is now attempting to stimulate the economy by taking on an additional debt burden of approximately five trillion dollars over the next two years. This is a staggering sum that must be financed through the sale of US treasury bonds, a big chunk of which must be vended to foreign buyers. So far foreigners have been willing buyers because countries like China and Japan need to keep exporting to the US and have been willing to keep lending to enable the US keep buying from them. But this process is sucking up a considerable amount of the world’s capital and if that capital starts to flow away from treasury bonds to anywhere else interest rates on US bonds will have to go up to whatever level that will continue to attract buyers. Every stock market rally now causes Treasury bond interest rates to rise and this in turn causes mortgage rates and consumer rates to rise in a cycle that will be self-defeating for an economic recovery. It made some sense for the Bush administration to try to avoid having a severe economic downturn on its watch and to delay the inevitable through economic stimulus tactics; but what is the Obama administration trying to buy time for? Divine intervention? Stimulus is somehow an ironically appropriate term for what the government is doing but shouldn’t some measures be taken to bring the economy to real health instead of pumping it full of amphetamines just to jump start it once again for a short time horizon? Isn’t there a danger of killing the patient with these remedies? Tax cuts are merely a method of getting consumers to once again to live beyond their means. Can even the US government afford to swallow this kind of debt or have we now moved completely beyond the realm of Keynesian economic theory and entered that of Peter Pan?
3. China can’t save the world economy. China, unlike the US, has substantial cash reserves, and recent spending on infrastructure by that country’s government has caused a worldwide boom in commodity prices and helped stock markets, especially resource based ones like Canada’s. But China, like Japan, over the long term, must export, not only to thrive but merely to survive, because neither has the natural resources to support their populations. I always found it laughable when American economists, and the politicians who bullied the Japanese government into dropping their rice subsidies, were telling that country to develop an internal market and quit relying on exports. This was coming from people living in a country with vast agricultural lands, oil, natural gas and coal fields and huge mineral resources, addressed to 120 million plus people inhabiting a group of resource poor, rocky islands. China does have more space to grow crops than Japan and has substantial coalfields but its resources are stretched to the limit and it needs to import a great deal of oil, minerals, and fertilizers. Chinas agricultural production has actually fallen steadily over the last decade due to the nutrient depletion of soils and the gradual draining of the deep aquifers under the North China plain. China also faces and enormous deficit problem, no less serious than that of the US although it has not shown up on the monetary ledger yet. I am referring to their looming environmental crisis. Already millions of Chinese are dying every year from the effects of industrial pollution. This environmental debt, which must also be paid, is the elephant that the Chinese government can not come to grips any more than the US government seems able come to grips with its financial debt.
4. The US banking system is corrupt. Enough has been written on Seeking Alpha’s pages about how the major banks were blatantly allowed to cook their books for the first quarter and how billions of dollars of tax payer funds (or borrowing through treasury bonds) was funneled under the radar to banks through the government financing of AIG’s CDSs, so I won’t rehash the details of all that here. That this fraud has been so blatantly ignored by the markets is astounding to me though. Simon Johnson, the former chief economist for the IMF, wrote in last month’s Atlantic that the US economy is in a death spiral, the kind that he has seen many times before among his emerging market clients. He believes that there is no hope for the US economy unless the government takes immediate steps to rid the country of the corrupt oligarchy that controls its financial institutions and hugely influences government policy.
5. The real estate problems aren’t over. This month the wave of resets for ARMS and ALT-As begins to gather new momentum and will carry on through 2012. Many of these kinds of mortgages were bought by speculators and absentee landlords a few years ago who are now deeply upside down in their equity and will have little incentive to renew even if they qualify. Economists are seemingly ignoring this situation as they ignored the sub prime situation two years ago. And remember every stock market rally causes bond and therefore mortgage rates to go up. As I am writing this Dow has ticked up over two hundred points today and ten-year Treasury bond prices have dropped over two dollars (also in one session) with yields rising accordingly. What would a 10,000 plus point Dow cost in interest rates and how could those needing mortgage renewals afford it?
6. Unemployment. Although this is considered a trailing indicator it cannot be ignored. The enormous scaling back of GM and Chrysler’s production will have huge repercussions. The big corporations whose share prices have held up during this down turn, like Wal-Mart and IBM, are the ones who have been, directly or indirectly, responsible for exporting jobs overseas. The world still wants to sell to the US but seems more and more reluctant to buy from it. And US corporations seem less and less willing to set up at home. Even GM is still making a profit in China.
7. This is not a regular economic cycle. The last recession was caused by the collapse of the dot com bubble, which had little relation to the real economy; nevertheless both the S&P and the NASDAQ took a licking from which they never really recovered. This time it’s real estate and investment banks and the real, not just the virtual, economy that have been drubbed. And today GM, for god’s sake, declared bankruptcy. While it’s true that at the end of the second world war the US government had a large debt but it wasn’t as large as this one and it was owed largely to its own citizens through the sale of war bonds; so when it was paid back it was reinvested or spent by its citizens and this helped to cause the post war boom. This time much of the government debt is owed to foreigners so that is not going to happen.

 

If someone could show me how US economic growth can really be revived by next year without a mere middle of the W bounce I would be very pleased. Personally what I see right now for the US economy, at best, is about ten years of flat economic growth and consumer austerity coupled with higher taxes while the government and citizens pay down their debts and work on becoming truly more energy and financially self sufficient. Either that or a prolonged series of dead cat bounces on the way to eventual economic oblivion.

Disclosure: No positions