Pain!

Economic update

Copper, called "Dr. Copper" because of it's ability to give a tell to the economic growth, rose 1.6% overnight and was briefly over $2.  Also, George Soros has taken a complete economic collapse out of the picture.

But today is still about the beginning of earnings season and perennial disappointer Alcoa (AA) is due out after the bell.  The pessimism around AA's number and guidance is so thick that I cannot see this damaging the market too much barring an announcement of bankruptcy.

We still need financial stocks to lead and with the 50% run in the past 3 weeks, the XLF is due to tread water for a while.  Even a 38% retracement would not be a bad thing.  

SPX: Bullish, but be patient

SPX  Two scenarios exist, one bullish and one bearish... and yes I will make a call.

Bearish case: Declining 50 d MA in an overall bear market, lots of structural damage in the economy, reversion toward the mean after the strongest month in 18 years.

Bullish case: SPX trading above 50 dMA, strong upward price movement on increasing volume, bullish MACD with healthy divergences.  Cash on the sidelines and high short-interest will act as a bid on the market.

I would add a couple more things to the bull case, namely the ability of markets to correct through intervention by government and central banks to counteract unemployment trends and tight credit.    These are huge factors in the global economy and the macroeconomic improvement will certainly be dependent on some co-ordiantion of these institutions which is no small feat.

The good news on that front is that the US is the 800 lb gorilla and even ass-backward policies in the rest of the world can be mitigated by thoughtful intervention here.  Our future is in our hands, and despite the broadsides the administration is recieving by the opposition party, prudent Keynesian stimulus and investment in education and infrastructure will win out in the end.  

Also, while the EU may not sign on to such massive spending and US conservative critics will decry that we are doing too much, we have to remember that Europe already has huge safety nets with more generous unemployment benefits and universal health care, so we need to spend more at this juncture.  Yes, our deficits will be higher, but that's because half our budget is going to unproductive military interventions.  To neglect the necessary spending now would cripple us further in developing our human resources for the next generation.

Conclusion: The US economy is at a nadir but the path we are on is healthy.  The market as a leading indicator will do what markets do as the sausage maker of government debates regulation, spending and taxes, but the longer term trend looks positive.  

Where's the bottom? More pain to come.

Justin Mamis has given us some insight in what to look for at the time of the bottom, and we have covered this before but let's look at it again.  While the current market has met some of the criteria for a Mamis bottom, we still have not had the utter surrender and then the kickback on worse news.  We tried to do some of that the first week of January when rotten economic reports were met with rallies... however, this rally failed miserably and we are now at new lows.

Mamis postulated a chart that looked at different phases of the bottoming process.  My thought is that we have not reached the "D" phase yet where the positive news is met with denial and retracement to "DD".  We really have not had positive news to disbelieve as yet.  So currently, I think we are either before or after "C", and I would favor before.  In other words, the worst is yet to come.

Three Scenarios for the coming weeks/months:

1) Death spiral whereby the bad news begets more stock price deterioraion and the cycle goes on in the fashion that we saw in the last deflationary recession from 1929 to the eventual bottom in 1933.  Slow, painful death of confidence with a vicious cycle of  job losses, equity decline, etc.  The factor that speaks in favor of this scenario is that in the one-dog study of the last century this is the only other deflationary cycle that we have seen, and maybe they all go with unrelenting agony for years.  Of course, the counter position is that Dr. Bernanke and Dr. Romer, Obama's Chairwoman of Council of Economic Advisers, are both students of the Great Depression and seem to  have learned the lesson that unleashing liquidity from central banks coupled with the immense stimulus from the US and Chinese governments can increase consumption and hasten the recovery, unlike what happened with the tight money policies and tariffs of the early 1930's.

2) Wall of Worry begins to take place from the recent lows as depicted in the Mamis chart from E to H.  In my view this is not likely happen since we have not met all the criteria of Mamis' thesis above.  We have had no good economic news that is met with disbelief which speaks against this scenario.  But, the MACD on the bottom of the chart does show some divergence which gives this scenario some possibility.

3) Capitulation to new lows followed by a quick bounce and then smaller retracement.  In other words, we have yet to see the "C" bottom as depicted by Mamis.  I favor this scenario.  The wash out must occur on decent volume with much gnashing of teeth and worldwide consternation with perhaps significant unemployment and labor unrest in less developed markets such as Eastern Europe.  Blood in the streets.  We have just not seen enough evidence of pain that should correlate with the amount of lost industrial production.

I favor this last scenario although the graph is not really drawn to proper scale. The lows could still be several weeks or even months away and we may have a choppy market with gradually lower trends with aggressive fits and starts for quite a while. 

 Marc Faber recently referenced some research that looked at the 1974 (at left), 1982 and 1991 bottoms and noted that from peak to trough in stock price took approximately 400 to 600 days and we have only been at this for 350 trading days since the peak.   So, although the descent in stock prices has been more dramatic with a steeper slope than other recessions, the time series analysis may indicate that we have longer to go, ie, it takes investors time to regain enough confidence to begin purchasing stocks. 

Furthermore, those were inflationary recessions have a different character and tend to finish quickly once the punch bowl of excess liquidity is removed.  Thus, the deflationary nature of the current crisis would speak to even longer prolongation from peak to trough if we use the 1929 to 1933 deflation as our only example, especially if the current populist cry against deficit spending is heeded by our political leaders.  There is no evidence that deflationary recessions resolve more quickly than inflationary recessions, althought the numbers to study are small.

The important factor to remember and get straight is the difference between inflation and deflation.  If we treat this like 1974 and tighten monetary and fiscal policy then we will re-live the early 1930's again and exacerbate the worldwide depression.  So while I may like Rick Santelli as an infotainer and provider of emotional angst (who doesn't like to get the adrenaline pumped), I respectfully disagree with him on this issue.

Why deflation is so terrible...

Eric has a good illustration of how deflation can be a big problem:

I am a bank. So, I have a loan, an ABS [asset backed security] on a home [worth] 300K at 4%;
it's a performer, made to a borrower paying back at full value.  is it toxic?

Well the value of the home is now 230K, but the borrower is still paying it back at 3%.
so that is $1432 coming in every month.

But... at best it has to be written down to .76 on the dollar.
Now it still is $1432 coming in every month..

but the thesis is, I need to get rid of it.... "Get the Toxic Asset off my books", ie Mark to market....

If I take 230K... the value of the bond, which pays 230K at 3% over 30 years.
Right now I can buy Corporate debt AA at 6.86% over 20 years

Which means that the Market rate for my Money the 230K is Twice what it is in my ABS, and the credit risk is much less.

so if the Market rate for my money is twice that of what I'm getting. Then my ABS at .76 cents on the dollar... Is solidly 10-20% below .76 So now the Fair value is .60cents on the dollar.

So if I sell it, I get...$180,000, but it is returning $1400 per month over 30 years. That is $515520 Yield to maturity.

I'm taking 30% of it's yield to maturity value.... Why would I do that??? to make the market happy.

this is very simple look. and there are Tranches, and some mortgages that are not performing, and some ABS that are not at full yield, and will probably only return half of the money. There are some Very bad assets...

but the real problem is that the Value of money has come up, and that instead of bonds at 3% yield, we now have better quality borrowers who will now borrow money at 6-9%. That is where this "Mark to market" thing isn't working.

It's one thing to let the vultures feed, and it's another to Kill someone to Let them feed.

My response:

Excellent illustration. One of the assumptions is that the mortgage holder will continue to pay the $1432 per month and thus the ABS is "secure."

The problem is that assumption may be faulty. The only way the guy can make the $1432 per month is if he remains employed, and his wife also remains employed full-time and her employer is cutting her hours and his employer is laying people off.

Furthermore, this is a non-recourse loan so if the mortgage holder defaults he does not need to file bankruptcy (unlike other loans)... little moral hazard. And he doesn't have any equity in the house anyway, so he'll just walk away.

Sure he needs a place to live, but heck there are tons of houses on the market and someone will surely rent him one for $800 per month after he forecloses.  Then asset prices like houses fall further in a vicious cycle.

So the "S" in the ABS illustration is not very "secure." The $1432 and $515,512 is a big, big assumption.

That is exactly why deflation is worse in some ways than inflation, and it shows why the president's three pronged plan to bolster the banks AND stimulate the economy to save jobs AND immediately help homeowners to prevent foreclosures is important.  If any one of those three legs of the stool fails, the whole stool falls. And once foreclosures start, the pace will quicken and be relentless.

Does it suck?  Sure it does, but that's life.   The Rick Santelli's of the world think that we can all live in isolation of the other actors in the economic system and that is a lethal assumption that could damage the system even more than it is already damaged.

Look out below, de-leveraging in process

Chairman of the FDIC Sheila Bair is on CNBC and talking about the banking system.  She said that when the FDIC took over Indymac Bank, the loan default rate was 22% and assets were sold at 37 cents on the dollar.  Yikes.

But she was quick to say that the banking system as a whole "is solvent."  My question would have been to ask how many individual banks are not solvent.  During the Depression of the 1930's, 25% of banks went bankrupt and while the number today may not be as high, the vast majority of banking activity takes place in a handful of very large institutions.  For all practical purposes Citigroup is dead.  Bank of America committed suicide by purchasing Merrill, and while that couyld be unwound it is still a huge negative for the banking industry.

How much more deleveraging needs to take place before we can see recovery?  I have no idea, but I'm not sure anyone else really knows.