The Credit Bust Is Not Almost Over

Includes: BAC, C, SPY
by: Economic Disconnect

Overhead Resistance
I have offered that a move of 35% off of the lows was both possible and probable. With the major indices coming closer every day, one may be wondering "what's next?" With an eye to the fact that April earnings reports will be brushed aside as "lagging" indicators (unless they are good of course) it seems macro fundamental ideas may not serve an investment strategy for a bit.

While I am not a huge fan of technical analysis, I do use various charting techniques and indicators to fully flesh out market ideas. One of my favorite sites on the web is Tim Knight's Slope of Hope. We could not be more opposite in philosophy, but I respect Tim's great charting abilities and total honesty in his trades.

Looking forward, Slope of Hope had a great chart Thursday that uses almost no technical tricks, little trend extrapolation, and few variable interpretations. This chart of the S&P 500 shows the heavy overhead resistance the market will be facing after a big rally over the last couple of weeks:

From the author:

Although the bulls have a government on their side which is willing to sacrifice the future of the country for some very short-term gains, there is something the bears have on their side as well: an astonishing amount of overhead supply.
The market put on its rocket boosters from 666 to 825 because there was very little standing in its way. The fall from 825 to 666 was swift and virtually uninterrupted. The market, being a two-edged sword, had little trouble moving the other way (a few trillion dollars in freshly-minted currency helped, too).
The point is that, even if sometime this year we do keep pushing our way higher, it's going to be quite a slog. The chart doesn't require interpretation - - - the cold fact of the matter is that from 825 to 1025 there is a giant slime pit of overhead supply that is going to make every point higher a struggle.

I agree with those observations. I think the quick ride up is over. Things will tend to mimic "trench warfare" going forward. As for market direction, overall, I am favoring a slow move up into the early summer.

Longer term I think that the rosy picture of the PPIP program, quantitative easing, and noisy economic indicators will be replaced by shock. Shock that the banks have been carrying loans at ridiculous levels and will face huge losses. Shock at the quick drop of commercial real estate. Shock that the Fed will lose control of borrowing rates. Shock at the ongoing job losses. Things are shaping up for another long summer.

PIMCO Calls for Bubble Values to be Re-Instated at Earliest Convenience
I always look forward to reading any news article that has "PIMCO" in the title. I know ahead of time that I will be amused at the blatant promotion of PIMCO's own investment vehicles, usually at taxpayer expense. Thursday was no exception.
Hat tip to LOLFed that beat me to the punch on this one!

There seems to be a prevailing group think that mortgage backed assets are not permanently impaired, but only now subject to a lack of "liquidity". Holdings selling on the market right now for 30 cents on the dollar are only that low due to a lack of available credit to buy them at 90 cents on the dollar. I know it is silly, but that is the very core of the Fed/Treasury/FDIC's position. PIMCO heartily agrees of course:

Fed needs to double balance sheet: PIMCO
By Faith Hung
TAIPEI (Reuters) - Bond giant Pacific Investment Management Co said the Federal Reserve needs to double its balance sheet up to $6 trillion to replace the amount of wealth destroyed in the United States, an executive said on Thursday.
Liabilities on the Fed's balance sheet should rise to between $5 trillion and $6 trillion later this year amid the financial crisis that roiled global markets, said Brian Baker, chief executive Pimco Asia Ltd.
"Right now, the Fed has spent about $3 trillion. We believe there has to be further stimulus policies put in place," Baker told Reuters.
Pimco is a unit of Allianz Global Investors, which managed about $970 billion in client assets at the end of 2008 and says it is the world's biggest fund house.
Pimco's chief investment officer Bill Gross is one of the industry's most widely watched figures.
Pimco is buying high-yield bonds in some U.S. banks that have received government support.
"We are investing in Citibank (NYSE:C). We are investing in Bank of America (NYSE:BAC). Those are, we believe, national champion banks or financial institutions that will survive," he said.

Of course, with Alan Greenspan serving as a PIMCO advisor, they would not already know ahead of time that Citi and BAC will survive no matter what, would they? No way.

So PIMCO's trading strategy is that the US government will replace the 6 or so trillion dollars that were vaporized when the housing bubble burst and took the insolvent banking system with it. A fair question to ask is:
- Does PIMCO think that housing prices in 2005-2006 were "correct"?
- Does PIMCO think that all the mortgage backed securities that are falling in price because they are backed by empty foreclosed homes in Phoenix, Las Vegas and Miami are really backed by par value assets?

I think the answer is they really could care less. PIMCO just wants to be made whole again. They seem bent on not only taking very little loss, but no losses at all. The craven call for government backing of bets they made expecting exactly that must surely be the most scandalous event of the past 8 months. Yes, even bigger than the AIG bonus situation.

This puts me in mind of a post I had written in February about propping up assets that have undergone structural and permanent impairment. The example I used was the change faced by the metal Aluminum in the late 19th century:

"Aluminum is the most common earth metal, but due to its reactivity it is almost never found in the pure metal state. Aluminum exists as an ore, usually bauxite. Pure aluminum metal was once one of the most sought after and valuable metals on earth. Then disaster struck. [T]wo independent discovers, Charles Martin Hall and Paul Heroult found a way to purify aluminum from all the ores where it could be found! This made pure aluminum as common as wood. From the Legacy section on Wikipedia:

Although aluminium is one of the most commonly occurring elements on Earth, before the invention of the Hall-Héroult process, it was initially found to be exceedingly difficult to extract from its various ores. This made the little available pure aluminium which had been discovered (or refined at great expense) more valuable than gold. Bars of aluminium were exhibited alongside the French crown jewels at the Exposition Universelle of 1855, and Napoleon III was said to have reserved a set of aluminium dinner plates for his most honored guests. Additionally, the pyramidal top to the Washington Monument is made of pure aluminium. At the time of the monument's construction, aluminium was as expensive as silver. Over time, however, the price of the metal has dropped; the invention of the Hall-Héroult process caused the high price of aluminium to permanently collapse.

Now what do you think happened to all the aluminum jewelry makers? What about the shipping industry and mining for pure aluminum? Gone. Busted. This no doubt had a huge effect on asset prices across the board. Did the world end?"

If PIMCO were around at the time they would have favored either government subsidies to preserve Aluminum's lofty price to "maintain wealth" or they would have asked for the government to outlaw the new Hall-Héroult process to protect their holding of Aluminum backed bonds. Imagine the market cap of Alcoa (NYSE:AA) if aluminum was the same price as gold per ounce!

My main reason for thinking the ultimate bottom is not in is based on observations like this on PIMCO. Many still think the assets they bought and the money the banks lent are coming back, and coming back sooner than later. There is a thought process out there that still sees this whole credit bust as temporary. We are well into the 1 year mark for serious evidence to the contrary, but for now many can wait it out a bit longer. How much longer is the answer to how much more room this rally has to go.