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This is big picture Wednesday Morning Quarterbacking stuff.
Please delete if not interested.
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For the record, the 3-month bill /30 year bond curve just
steepened for the first time since January of last year. I guess some things
never change, even though "this time, it was different".
Also to acknowledge Earl and others, the corporate bond curves
never really inverted, even though the spreads between the AAA and BAAs went out
by a couple hundred bps.
For those learning this stuff, AAA presumes "risk-free" bonds,
BAAs presume "interest risk but no risk to principal" bonds. <FONT
size=2>The theory is that the market's appetite for risk is displayed in the
spread between the 2 grades. When the spread is low, the appetite for market
risk is high, so people are speculative. When the spread is high, the market is
attaching a larger than normal premium to take on interest rate risk, hence my
interpretation is that the market is in defensive mode, not necessarily panicked
but definitely alert for systemic stress.
Which system? I think that would be the liquidity system - the
province of the FRB.
The theory would apply to other markets as well - in a linear
world, non-US bonds would tend to replicate this behavior for each country -
liquidity flows thru from central bank to financial institution to fixed income
to equity and other markets.
With recent yield curves showing inversions here in USA and
steepness in other emerging/developed markets, and the more recent
currency/fixed income action, it seems to me that a long term trend of
investment flows out of the USA and into other developed world economies has
been set into motion.
These trends, when in motion, tend to remain in motion. A
representative chart of the fund that matches the Lehman Bros Aggregate Bond
index is attached. From breakout to high, the move is 15% - and the bigger move
is 30%.
Policy action caused Japan to go into a tailspin after its
equity/property bubble burst back in 89.
While I mean no illwill to the FRB, the concept of a
"Greenspan Put" on USA's asset markets is ostensibly alive and well, but then
"this time, its different" still can come true and the FRB could well make a bad
trade.
Or cause a systemwide purge of bad debt, resulting in cleansed
balance sheets - something they really haven't had a chance to do for quite some
time.
You see, postponing the solution to the problem does not make
the problem "go quietly away"...
History will tell.
This policy shift changes the investment landscape
considerably for the intermediate term and the knee jerk reaction was that the
risk-reward shifts in favor of equities - as countless pundits informed us on
TV, historical stats support this, and the fiscal+monetary infusion of
liquidity soon to come into the US system would tend to lend a bid to the
market.
Or so the textbook says.
My feeling is that essentially what happens subsequent to this
liquidity infusion is a transfer of flows from FRB to US Banks to Offshore
Institutions to offshore asset markets - fixed income, equity, and direct
investment.
Nothing happens to America.
In other words, the trend of offshore asset markets
outperforming SPX (in place for quite a few months now) gets reinforced by a
boost in US liquidity - just as the US asset markets benefited hugely from
Japanese infusion of fund flows from 1995 to recent years.
My conclusion is that this "export" of liquidity - and the
attendant inflation of prices and the creation of offshore bubbles - basically
does nothing to the inward looking US Investor's balance sheet, and we go into
deflation, maybe some lid on asset prices across asset classes (commodities
included) - and at best a trading range equity market (measured by SPX) which
matches the stagnating GDP growth we soon see.
The typical trading range results from sector rotation while
the all-encompassing indices show neutral behavior.
I have some M1/M2 stats of my own that I track - and these are
updated thru Q3, 2000 (source for data = FRB). This is different from the way
Ben/Ron look at this stuff so some of you may find this interesting. More on
this below.
Of immediate worth is the 2 potential CANSLIM breakouts I'm
eyeing in MER and LEH; and the myraid setups taking place in the components of
the Transportation indices. This would follow the textbook
sectoral shifts expected when the market anticipates recovery from recession a
few months down the road.
Tech? I'd not burn the barn door to get in except for a trade.
Probably a position short before the position long, since we're close to the top
of the NDX's 6 month trend channel after the FRB ease.
Note, however, that the standard pullback to 50 ema/200 ema in
the core bear trend would mean a huge %age move - and bear market pullbacks tend
to overshoot the standard 50% retracements.
Among the better XBD components, the 2
brokerages above remain "undervalued" relative to SPX, and also
relative to their companion stocks - giving them the fundamental "fuel" for
multiple expansion under favorable conditions.
Tech continues to suffer from overvaluation - as Earl's logic
has shown, markets tend to go from one extreme to the other - AND STAY
THERE.
There are NO catalysts to be long tech. Every conceivable
product cycle is in transition, from PCs to telecom to new media. Unfortunately,
the last equity market cycle was globally synchronous...
But the other sectors that follow historical shifts should
rally - until everybody expects them to be the best place under the sun and they
stop rallying.
In these days of armchair instant strategy and numbercrunch
communicating, I think people have shown a tendency of getting ahead of
themselves - and in so doing condemned the market to more downside action.
Back in the crises of 1997 and 1998, we could see the fear on
the faces of the media's guest list. I guess now I understand what fear is,
because there is none. What is it they say about freedom? You only know its
worth when you lose it.
This past year, so many people rushed out to call the bottom,
so many people now feel that retail, transportation - AND FINANCIALS -
should do well over the next 6 months, the clock for which started ticking Jan
3. That the lows seen on Jan 3 are going to be THE floor.
But are they?
As usual, it is the surprise that matters, so if much of the
above script is not followed, there must be something seriously wrong with this
market that no amount of "pull a new rabbit out of the hat" can
solve.
For example, Wells Fargo didn't rally while its competitors
did on FRB Ease Day. Why, I wonder. Citigroup, Bank of NY, Merrill, Lehman,
Goldman, Schwab are all DOWN from that day's thrust moves.
Yeah, there's the California crisis, but then there's always
something. What's going on that the market feels the need to discount prices
NOW?
For example, we were told that mortgage applications will now
go thru the roof. Yet Fannie Mae is about to trade back into its pre-breakout
consolidation and the mortagage applications data (market speak for the
trader world) continues to fall off the cliff. Go figure.
For example, we were told that the FRB flooded the market with
liquidity in Y2K and thereafter the drain out caused the market to fall.
But their stats (m1 v/s m2 as a % of gdp chart) basically tell
the following story:
The banks got recapitalized (liquidity went from frb to
bank reserves) but that's where the net infusions stopped - in
mid-1995. The Japanese stepped in, and flodded the US system with
liquidity. This combined recapitalization fueled the bull market from 1995
onwards - the references made in FRB speeches to "asset inflation" confirm this
view. It wasn't CPI inflation, it was financial asset inflation. The
post-Y2K drain in new liquidity wasn't a drain at all - it was just a "freeze"
as can be seen from the last 5 datapoints in the chart.
Meantime, the small investor fuel that flowed through the
markets (and out of small time deposits) was being depleted nonetheless,
directly and through "asset price deflation" - as is the hallmark of "when the
last man standing is on the gravy train, the gravy train will start to
collapse".
Concurrently, it looks like banks
used their reserves (to continue making corporate loans, which continued to
grow regadless of deterioration in the supply of money into banks from retail
accounts and from FRB) - which was a setup for ensuing weakness on
corporate balance sheets - which, unless some magic happens, directly transfers
to Bank balance sheets.
Has anybody taken a moment to wonder why, if the US economy
was widely seen as reverting to average growth after a few years of substantial
expansion, corporate America was overdosing on debt?
For example, how many fiber companies were allowed to borrow
money to setup proprietary fiber network capacity, when that capacity, if that
fiber was ever lit, would be exponentially higher than demand? Now we have a
rock-n-hard-place conundrum because the cash flow streams won't materialize,
since capacity goes underused, so debt servicing goes haywire, so lenders get
squeezed, so we get the tailspin.
The numbers are huge. We're looking at $500 billion of net
new debt in this one sector alone, and $500 billion, for perspective, is
just over 5% of the whole country's GDP.
No doubt, when the lender gets tight in one area (unrelated to
whether the specific borrower is facing problems or not) the lender tends to
tighten across the board. So even "good" borrowers can't borrow at a rate that
will be economically feasible. So borrowing work stops. Now all revenue growth
was based on the assumption that the lubricant to finance that growth would
continue unabated. But it doesn't. Real liquidity dries up - regardless of
the amount of money floating around in the system, the banker is unwilling to
lend and the borrower is unwilling to finance anything themselves because they
do not have the reserves to backstop them from default.
At least, that's how I see it.... the Greenspan Put is alive
and well, but whether, in this time of inflated risk premiums, the put puts a
meaningful floor is in serious doubt.
Yeah, I've heard about the 600 basis point elbow room, but
elbows didn't do Japan any good.
The saving grace?
Every time in history this has happened, every concerned
financial sector intermediary has taken a bath, there have been massive
write-offs, the system has been purged of its excesses and weak balance sheets,
and the whole cycle has begun again with a clean slate.
While it happens, it is painful. It gets better later on,
though. Like 3-4 years later.
That, methinks, is what we're headed towards.
So it would seem, looking at the coffee grinds on this cold
sunny day in New York and intermediate term price action on BKX /
NF.X.
Gitanshu
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