Peter Cooper's  Instablog

S&P told the Financial Times the Dubai decision ‘may be considered a default under our default criteria, and represents the failure of the Dubai government (not rated) to provide timely financial support to a core government-related entity.’

Bond markets responded with credit spreads immediately widening. But Gulf stock markets are closed for the Eid religious holiday, and this will give the government time to clarify its intensions. Markets will likely tumble when they reopen.

The $59 billion debt mountain belongs to Dubai World whose assets range from the Jebel Ali Free Zone to the quoted ports operator DP World and Nakheel the developer of three palm-shaped islands. Two palm islands lie abandoned as well as a map of the world formed from smaller reclaimed islands.

At the same time as the debt repayment suspension, the government appointed Deloitte’s Aidan Birkett as Chief Restructuring Officer to ‘oversee the restructuring process and ensure the continuity of Dubai World’s operations’. His report will be eagerly awaited by creditors who are very unhappy about the debt suspension.

Only a few weeks ago creditors were assured that the $3.5 billion Nakheel Islamic bond due in December would be repaid. Some speculators had bought the bond earlier this year at a massive discount in expectation of a huge profit that will not now transpire.

A statement said Mr Birkett ‘will start to assess and evaluate the extent of the restructuring required. As a first step, Dubai World intends to ask all providers of financing to Dubai World to “stand still” and extend maturities until at least May 30, 2010′.

But Dubai is not alone in its debt problems. Banks have been falling over themselves to lend money to emerging markets in recent years, and since the financial crisis there has even been a view that emerging markets carry less risk than developed countries.

The carry trade of borrowing in US dollars and investing in emerging markets for high returns is a liquidity bubble and an accident just waiting to happen. Perhaps the situation in Dubai should be regarded as a wake-up call.

Investor perception of stock market risk has just hit a five-year low in the United States. Any contrarian investor would have to conclude that such monstrous complacency could only come before a market crash, as indeed it did last autumn.

Shocks in emerging markets like Dubai are the flutter of butterfly wings that produce a hurricane elsewhere, and $59 billion is a bit more than a butterfly. Investors should exit all stock markets and buy bonds or precious metals or short emerging markets. Gold hit $1,195 as this article was written.

S&P told the Financial Times the Dubai decision ‘may be considered a default under our default criteria, and represents the failure of the Dubai government (not rated) to provide timely financial support to a core government-related entity.’

Bond markets responded with credit spreads immediately widening. But Gulf stock markets are closed for the Eid religious holiday, and this will give the government time to clarify its intensions. Markets will likely tumble when they reopen.

The $59 billion debt mountain belongs to Dubai World whose assets range from the Jebel Ali Free Zone to the quoted ports operator DP World and Nakheel the developer of three palm-shaped islands. Two palm islands lie abandoned as well as a map of the world formed from smaller reclaimed islands.

At the same time as the debt repayment suspension, the government appointed Deloitte’s Aidan Birkett as Chief Restructuring Officer to ‘oversee the restructuring process and ensure the continuity of Dubai World’s operations’. His report will be eagerly awaited by creditors who are very unhappy about the debt suspension.

Only a few weeks ago creditors were assured that the $3.5 billion Nakheel Islamic bond due in December would be repaid. Some speculators had bought the bond earlier this year at a massive discount in expectation of a huge profit that will not now transpire.

A statement said Mr Birkett ‘will start to assess and evaluate the extent of the restructuring required. As a first step, Dubai World intends to ask all providers of financing to Dubai World to “stand still” and extend maturities until at least May 30, 2010′.

But Dubai is not alone in its debt problems. Banks have been falling over themselves to lend money to emerging markets in recent years, and since the financial crisis there has even been a view that emerging markets carry less risk than developed countries.

The carry trade of borrowing in US dollars and investing in emerging markets for high returns is a liquidity bubble and an accident just waiting to happen. Perhaps the situation in Dubai should be regarded as a wake-up call.

Investor perception of stock market risk has just hit a five-year low in the United States. Any contrarian investor would have to conclude that such monstrous complacency could only come before a market crash, as indeed it did last autumn.

Shocks in emerging markets like Dubai are the flutter of butterfly wings that produce a hurricane elsewhere, and $59 billion is a bit more than a butterfly. Investors should exit all stock markets and buy bonds or precious metals or short emerging markets. Gold hit $1,195 as this article was written.

The dollar, for example, bounced off $1.50 and closed higher. Bond yields shrank and bond prices rose. Equities sold off all over the world, though not in a disorderly fashion. Gold hit a new all-time high. Oil prices dipped.

With Thanksgiving coming up on Thursday next week this is expected to be a week of light volumes. But thin trading tends to exaggerate price movements, and if the downtrend has already started it could gain some momentum.

Has the longest and strongest stock market rally in history finally run out of steam, or is it just resting? In order to resume its upward march the US stock market requires some unexpected good news. How likely is that?

Is it not more likely that articles begin to point out that the emperor is actually walking naked these days, and has no clothes on.

First, the S&P sells on a price-to-earnings multiple of 88 after the recent financial results. That is a horrendous overvaluation. A reasonable p/e would be around 18-25. That leaves a 90 per cent downside!

Secondly, the outlook for GDP growth is lackluster in 2010. It is therefore vulnerable to setbacks, and most particularly the impact of a stock market decline that would undo much of the data pointing to a recovery being in prospect. The market has been operating as a positive feedback loop since March, it also works the other way around.

Thirdly, have markets not reached levels that would normally require a correction? Indeed, have they not overshot those levels, and now require a bigger than average correction?

Fourth, with interest rates already on the floor where is the policy response to market weakness going to come from? The Fed will not be able to slash rates to counter a market rout. Will quantitative easing or printing money really rally confidence like a rate cut?

Fifth, markets are relying too much on emerging markets to lead growth in 2010. The data coming out of China and India is suspect and has a huge capacity to disappoint. Financial markets do not like such surprises.

At the risk of stating the obvious, the higher you go the harder you fall, and it is never different this time!

Unscrupulous investment advisers do not worry about such trifles. Their only concern is to get a fat commission on your investment.

It is not as if the warning signs are not obvious. The boom in Chinese stocks has been breaking down since mid-August when astrologers had pointed to a coming crash, and there was indeed a major correction in China. Is that the start of a downtrend? Well, what has gone up usually comes down in stock markets.

But stepping back a little what is really worrying about the 62 per cent surge in emerging market stocks since the beginning of the year, a 94 per cent recovery from the lows of the crisis last year, is the extent of this upswing.

It is so strong and so quick that the only word to describe it is a bubble. In China a stimulus package equal to half of GDP was injected into the economy in the first half of 2009 and this liquidity has been the main cause of the stock market rise.

The fundamentals of a 20-25 per cent collapse in Chinese exports this year are clearly not the market driver. India has seen an even bigger collapse in trade. Russia is suffering from lower hydrocarbon prices. Winning the Olympics is likely a market top for Brazil.

Now liquidity driven stock market rallies are particularly prone to sudden and dramatic corrections without any warning. Basically somebody calls fire and everybody dashes for the exit. In the Middle East things look a little different.

For once the Gulf States are taking a more sober tack. Stock markets are way off their bubble peaks of 2006 and real estate prices have crashed over the past year.

But is this not actually a fairer reflection of the economic outlook and trade flows than the inflated financial markets of the BRIC countries? For the BRIC markets to keep going up they require the developed economies to recover back to their old boom levels, and this is just not likely to happen anytime soon.

Just look at the 263,000 extra jobless in the US for September, worse than forecast, or the 23 per cent fall in US car sales that month as the government’s ‘cash for clunkers’ program came to an end.

Clearly the fall in global trade is not going to be a passing phenomenon but a new economic reality for the emerging markets. In the Gulf States the financial and real estate markets are already beginning to reflect this vision of the future, but are probably still someway from bottoming out.

So would it not be foolish to invest in emerging markets at this point? The volatility of emerging market economies is notorious, and you should wait for the right moment which will only come when today’s investors have lost a great deal of money.

You just know this has to be a signal to buy the offending asset class. It is a neat contrarian moment backed up by some hugely obvious market information that is not a secret to anybody: stocks are massively overvalued in a historically far too long rally, and the traditional month for crashes is October, and we are almost there.

Now I can understand the anti-short ETF case. They can point to the poor tracking record of these ETFs at certain points, their very raison d’etre. And holding these instruments for too long is not recommended because leverage costs money.

However, if I look back at the past three months most of them seem to have done a very fair job of delivering a leveraged performance to their respective index movements.

So my guess would be that if the stock market takes a big lurch down in October then these instruments are going to be among the top performers, even if a few days out or not by exactly the right percentage. It is a no-brainer that shorting stocks is the best way to make a fortune in a crash.

That makes the timing of Cramer’s outburst remarkable, and probably more a matter of linking to the court action pending than the market outlook. It is a bit like arguing over small change with a 10-ton concrete block about to drop on your head.

Perhaps too a little contrarian thinking might consider the third party arranging these ETFs. With all that negative karma in the investment universe will they not grab with both hands a clear opportunity to prove that yes they do track market movements, and can do so fairly well and enough to deliver massive profits.

What a way to demonstrate that their product not only has legs but can run and that it is the investors that have misunderstood them? Case dismissed!

Of course I am not a financial advisor and do not know the financial circumstances of any reader. But would it not be at least a fair point to argue that long ETFs are the ones to sell now, not the short ETFs?