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The Great Unwind

The Great Unwind

In our last note, we provided a link to John Hussman’s precise recommendations for much needed reform.  At the time, Dr. Hussman also noted:

When the market is as extended as the current market has become, a thousand events can act as triggers for abrupt weakness, and it makes little sense to single out any particular one. From this perspective, blaming last week’s decline on the proposed Volcker Rule, or on fears of Bernanke’s non-confirmation is like blaming a particular gust of wind for knocking a sideways nickel off of a flagpole.

Despite last week’s sharp and swift correction, risk assets remain intermediate-term overbought and surprisingly overloved by investors.  So a more difficult period should be expected ahead, beyond a predictable bounce from very short-term oversold levels.  Regular readers will not be surprised by our excitement stemming from President Obama’s recent change of heart and new found support of former Fed Chairman Volcker.  While the details of the “Volcker Rule” will be hashed out in coming months, the meat and potatoes are best described in his own words:

The kind of reform I’ve been advocating is acceptance of the fact that the core of the system remains commercial banking. If that breaks down then you have an enormous crisis. And commercial banks have expanded into areas I don’t think are so central. I would cut back their so-called capital market activities—hedge funds, equity funds, commodities trading, trading in derivatives. They’re all legitimate functions, but they’re not so central. And I don’t want to protect all those functions. I don’t want to protect everybody because when people act like they’re protected, you get in trouble. So let’s leave the capital markets to their own devices without any expectation of government protection and keep the existing safety net for the commercial banking system. In my judgment we don’t need to regulate the capital markets so heavily. You have some extreme cases where individual institutions are so big and so vulnerable, yes, you might want some regulation of capital and leverage, but that would be the exception. But if they fail, let ‘em fail. We will have some kind of a new resolution process. Some agency will go in there and say, “You’re going to fail, but we’re going to provide a more orderly exit.”

We remain confident that Volcker is one of few policy makers (regrettably, perhaps the only) with the character and resolve to address the long-term structural reforms desperately needed today.  He is no stranger to making unpopular, but necessary decisions.  That being said, while Volcker just put a very nice shade of lipstick on America’s piggish long term picture, the near term outlook just took a bit hit from the ugly stick.

The financial sector was among the worst performing sectors of the market during last week’s “correction.”  Amusingly, the talking heads are pointing to the minor hit to earnings that an elimination of prop trading would represent to the banks.  We’ll ignore the fact that certain investment “banks” (guess who) have generated the majority of their earnings from such activities in recent years.  The street is still missing the big picture here.  So we will display the big picture for you in the chart below.  The level of global banking assets is now nearly three times global GDP, with virtually all of this massive leverage being ramped up after the repeal of Glass Steagall.  The sixty four thousand dollar question for investors today is, what happens if large banks are forced to reduce their prop desk books or eliminate them altogether?  We’d be prepared for round two of the Great Unwind.



Disclosure: No positions mentioned