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August 14, 2007

Speculators Take Global Economy Hostage, Central Bankers' Liquidity Concession, With Nothing in Return, Interest Cuts Next? -- Part 1
by Econotech

(Econotech FHPN) - This is the first of a two-part article, which I have broken up due to length. I will post the second part in the next day or two, please look for Part 2, hopefully on the sites you visit that very kindly post or link to my articles, or on my web site link. This first part is under 6,000 words, the second under 4,000. Thanks. -- econotech

Please NOTE well: All bold emphases added in the many quotes from mainstream media throughout this article are by me, NOT in the original. Btw, if I've seemed to put bold emphases on too many superlatives, it's simply to try to accurately convey the highly unusual environment financial markets are currently in. -- econotech

"The calmer tone in global markets yesterday will encourage Federal Reserve policymakers to believe they are striking the right balance in response to credit market upheavals: stepping up liquidity support aggressively when needed, but holding fire on interest rates. But with further credit bombshells likely, there is every possibility that the coming days will see renewed turmoil and fresh pressure on the U.S. central bank to cut rates." FT, Aug 14, "Fed weighs economic impact of market turmoil," Krishna Guha

"Central banks worldwide have injected at least $323.3 billion in the past 48 hours ...the Fed said in a statement that amounted to a promise to do whatever was necessary to keep markets from seizing up. Such statements from the Fed are unusual, with the last having come after the September 11, 2001, terror attacks, and reflect the seriousness that policy-makers view the current disorder in markets. Before the September 11 attacks, the Fed had not offered reassurance on its willingness to provide liquidity since October 20, 1987 -- the day after Black Monday." Reuters, Aug 10

"in times of crisis it [the central bank] should provide unlimited amounts of liquidity to ensure the smooth functioning of the payment system ... When, as happened last week, they dump large amounts of liquidity in the system, they also allow banks that did foolish things to get off the hook. And many banks did foolish things ... More drastic reforms will be necessary. Banks have increasingly been involved in activities outside the supervisory and regulatory framework. They have done so by offloading part of their riskier activities to hedge funds. Banks that engage in such activities should not expect to enjoy the automatic insurance provided by central banks without accepting that there is a price to pay for this. The price is that these hedge fund activities are brought back into the same framework of supervision and regulation as the other banking activities. This will not be easy, because it involves a difficult exercise of international co-operation." FT, Aug 13, op-ed, "Banking bail-out sows seeds of future crises," Paul de Grauwe

"Among today's big fears: that commercial and investment banks, thinking they have used derivatives to lay off the risk of defaults, will discover they effectively bought insurance from hedge funds whose financial survival depends on credit from those same commercial and investment banks; that big firms are exposed to troubled markets in ways they don't realize or haven't disclosed; or that players with heavy borrowing will have to dump their holdings and make everything worse ... Some Fed officials worry a rate cut now might suggest the bank is focused on the markets rather than on the economy. Others see a growing economic justification for easing. Some analysts suspect Mr. Bernanke, who has been in office for 18 months, will be reluctant to cut rates in order to expunge belief in the "Greenspan put" -- Wall Street's term for the perceived readiness of his predecessor to cut rates and bail investors out of bad decisions." WSJ, Aug 13, front page article, Greg Ip, Deborah Solomon and David Wessel

"the Great Unwind of the global credit pyramid still has further to go ... there's a 21st century version of a run on the bank, and the central banks have had to step in to do their prime duty of supplying liquidity when the market won't [the conventional view -- econotech] ... well before the real economy feels much impact from the current financial dislocations." Barron's Online, Aug 9, "Even After $1 Trillion Goes Poof, It Ain't Over," Randall W. Forsyth

"All cosy assumptions have suddenly been called into question ...Central banks should only bail out traders who made bad bets if the financial infrastructure is truly in danger [still a conventional view -- econotech] ...[the Fed] offering funds to banks and saying it would accept mortgage bonds as collateral. This step is more extreme than first appears. The Fed used public money to take risk, in the form of high-quality, but stricken mortgage securities off banks' hands - at least for the short term," FT, Aug 10, "Financial plumber must stem the panic," John Authers

"the question haunting the markets yesterday ... is what on earth has triggered this sudden €94.8bn [ECB liquidity injection] move? One explanation - and the one alarming many traders - is that there is something truly nasty lurking out there in relation to credit losses that only the ECB knows about. If so, let us all pray that it does not involve any of the big dealer banks. However, another explanation - and let us hope this is the correct one [prayer and hope are not the most effective solutions -- econotech] - is that the ECB is engaged in a subtle war of psychology with the commercial paper market." FT, Aug 10, "Has the bank seen something nasty on the horizon?" Gillian Tett

"What's been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up ... This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults ... And here's the truly scary thing about liquidity crises: it's very hard for policy makers to do anything about them ... when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn't do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn't do much if the cash stays in the banks' vaults ... Let's hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn't count on it." [Krugman is a great economist, but hope is not a strategy -- econotech] NYT op-ed, Aug 10, "Very Scary Things," Paul Krugman

"Friday's action by the Fed marked the abandonment of its "business as usual" stance. It told dealers it would re-enter the market as often as necessary, and - in a highly unusual move - accepted high-quality mortgage-backed securities as collateral for the entire $38bn of funds. This amounts to the most extensive liquidity support operation undertaken by the US central bank since the 9/11 terrorist attacks and follows similar steps by the European Central Bank and Japanese central bank in the past two days." FT, Aug 11, front page lead article

"The level of funds markedly exceeded the ECB's only previous major intervention - on the day after 9/11 when it lent €69bn followed by €40bn over subsequent days. Even more striking was its one-day pledge to meet 100 per cent of all funding requests from financial institutions ... The ECB did not offer any detailed explanation for its move, which caught markets by surprise" FT, Aug 10

"Fallout from the intensifying credit crisis stretched from a French bank to the largest home-mortgage lender in the U.S., triggering unusual central-bank interventions and driving the Dow Jones Industrial Average to its second-worst drop this year. The troubles demonstrated both the global reach of the crisis and its impact on a widening circle of markets and companies." WSJ, Aug 10, front-page article

"Federal Reserve Chairman Ben S. Bernanke was wrong. So were U.S. Treasury Secretary Henry Paulson and Merrill Lynch & Co. Chief Executive Officer Stanley O'Neal. The subprime mortgage industry's problems were contained, they all said. It turns out that the turmoil was contagious." Bloomberg, Aug 10, "Bernanke Was Wrong: Subprime Contagion Is Spreading," Bob Ivry

""Like everyone else, [central banks] face uncertainty about the future (most of which is shared uncertainty), but, unlike almost anyone else, they must maintain an aura of wisdom, of being in control, almost as if they did know (a lot) more about the future than the rest of us," writes Ethan Harris, chief economist at Lehman Brothers. "They do not."", thestreet.com, Aug 10, "Bernanke's Bind: No Easy Answers," Liz Rappoport

Financial Markets' and Officials' Panicky Fear of Lurking "Unknown Unknowns" and "Black Swans"

The title of my last article on July 26 link, "Speculators' Liquidity-Leverage Russian Roulette with Economy" may have seemed a little over the top to some at the time, that is, before this past Thursday and Friday, Aug 9-10.

During that 48-hour period, global central bankers injected around $300 billion of liquidity into the banking system, promising unlimited short-term funds, even taking mortgage-backed securities as collateral, extremely unusual moves that evidently only have had two precedents, 9/11 and the Oct 1987 crash, when the U.S. market fell more than 20% in a single day.

So, why did the central bankers concede to speculators' pressure, yet again?

(Btw, I deliberately do not use the term "market's pressure," the ubiquitous but faceless "market" in the mainstream media is, in stark everyday reality, mainly speculators at extremely large global institutions that dominate the financial markets, now caught with some wrong bets, so let's simply call this what it really is, rather than use the common euphemism, "market.")

If you consider that the rampant fear and surprisingly drastic actions occurred, even though global financial markets haven't even begun to really crash, yet, let alone a recession begin to take hold, then isn't that some indication of the seriousness, potentially, of what may really be at stake, right now?

Like de Grauwe, a well-regarded international economist whom I quote above, I have no problem with central banks basically "doing their duty," so to speak, by providing liquidity to try to keep the global financial system from freezing up or melting down, pick your metaphor.

To not do so would be irresponsible to the global economy and populations that rely upon a smoothly functioning financial system for their essential daily and future well-being.

But as de Grauwe's quote somewhat suggests, there needs to be a significant cost to the global speculators of the recent largesse from central bankers, who, in principle, are very high public servants who have been trusted with the awesome responsibility of nations' money supply and credit, most especially in this age of fiat currencies.

And that cost to the speculators is to rein in, ASAP, their ridiculous speculative, selfish antics that are now putting the global economy, and the well-being of billions of innocent people, at risk, yet once again (as Asia, with nearly 4 billion people, fully knows from its earlier run-in with the global speculators in the so-called Asian financial crisis of 1997-98, known in Asia as the IMF crisis).

Very powerful speculators have gained the privilege of stewardship of the global monetary/financial system. So be it, that's current reality. But that reality needs to be changed, as the current credit market dislocations have made clear, yet again.

The global financial system is in another mess, yet again, simply because global speculators, yet again, pushed their search for high yield and excess returns way too far, and because global monetary officials, yet again, facilitated it with E-Z money and allowing them to run amuck.

(Recall the many previous speculators' bubbles, and then remember the old saying, "fool me once, shame on you, fool me twice, shame on me.")

Most importantly, it NEVER had to come to the current situation in the first place. It did, yet again, due to a very basic, ancient human foibles, power, greed, hubris--the global speculators' simply never know when enough is enough, rather they always want more, more, more, with a take no prisoners attitude to get it.

(Exhibit A is the Citigroup CEO quote about dancing to the liquidity beat with which I led off my July 26 article link. Exhibit B is Jim Cramer's now infamous Aug 4 tirade on national tv berating Fed governors on behalf of his Wall Street contacts, which I take up later in part two of this article.)

Given such pitiful performance on the part of both global speculators and monetary officials--and I hope it should be clear by now on my web site link that, while so many seem to focus so much of their ire just on the latter, both are to blame, the prime credit-addicted culprits and huge beneficiaries of the current system are the global speculators, monetary officials are their "enablers," justifiably held accountable for not living up to their public responsibilities--one of their speculative own might adolescently say on tv, "You're fired!"

With the global economy still in good shape, perhaps we should be more tolerant that that, for now, since these really are extremely talented, powerful people, who perhaps may still surprise and do great good in better allocating global capital, if provided with the right economic incentives, ones that encourage innovation and production, not absurd speculation,

So for now, let's as adults, say to them, shape up, or ship out.

Because we don't want nor need you, if you can't control your adolescent absurdly excessive "risk-taking" behavior, which repeatedly puts the global financial system and economy at completely unacceptable risk, mainly for your own selfish gain. More on this later.

My Investment Suggestion Continues to be Hedge Until If/When See Some All Clear Signs

Turning to my investment suggestion, as I've said in my June 21 link and July 26 link articles, I continue to believe that it is best to be hedged, however and as much as each individual prefers, since the basic investment problem continues to simply remain that no one knows how bad things might get, as was clearly demonstrated, yet again, the past week.

Practically, as I will show in a few charts later in this article, equity markets have greatly increased in volatility, but they have NOT yet corrected significantly, this has not even been a normal correction, by historical standards, so far.

So, investors are currently being offered the worst possible combination, very significant risks from increasing volatility, but nowhere near low enough prices to compensate for such risk.

To make that currently unfavorable reward-risk ratio better, either equity prices need to decline significantly further, and/or volatility needs to significantly dampen down.

Or a new bubble, tech redux (watch the price action of a few leading tech stocks for clues), energy (an obvious secular uptrend) or some others, needs to emerge to justify current valuations and volatility, which at the moment seems unlikely.

One of the more glaring anomalies in global financial markets has been the continuing huge disconnect, over many months now, between the increasing turbulence in the credit markets and the so far modest correction in the equity markets. One is wrong. The flight-to-quality 40 bp decline in 10-year bond yields over the past month has helped equity valuation models.

As noted in my July 26 article link, on June 30 I sent out an e-mail saying, "I now feel that there is greater than a 50% chance of a significant correction in the stock market in the 3rd qtr. By significant, I mean at least 5-10%, but it could be much more."

Given how fear already has swept through the global credit markets last week, clearly the probability of the more worse case scenarios is now higher at the moment.

Most mainstream pundits and mainstream media, as good as its coverage of the unfolding credit crises consistently has been for months (I am very grateful for the hard work of many mainstream journalists and columnists, reflected in the large number of quotes in this article), have yet to really emphasize critical potential risks.

One significant exception continues to be noted global portfolio manager Marc Faber, who is on Barron's semi-annual roundtable, and who expertly talks about the U.S. entering a recession and bear market in the upcoming months in these two Bloomberg interviews on Aug 13 link and Aug 10 link, both of which I STRONGLY urge readers to listen to.

But before discussing very serious potential market and economic risks in the next section, let me close this section with the most basic, if seemingly utopian, message of my web site link, whose tag line is "Finance Innovators, not Speculators":

If global leaders and people use the current unfolding financial markets' situation to summon their wisdom and courage to try to just "think the unthinkable," starting with how to change an increasingly dysfunctional global financial/monetary system, also how to restructure taxes to promote productive economic activity rather than rampant speculation based on uneconomical paper capital gains, remove onerous business restrictions (starting with SOX), reform education, fix the health care mess, etc. ...

then the ongoing awesome changes in the global real economy and all areas of science and technology should, without doubt, create an unprecedented era of world peace, just prosperity, creativity, artistic beauty, far surpassing any civilization in human history (and fairly dealing with issues such as global warming, energy, water, demographics, health, etc.).

Why This Time Potentially Could Be Much Worse than LTCM Oct 1998

"Today's turmoil is creating obvious comparisons to 1998. Then, a financial crisis at first crippled emerging Asian economies without threatening the U.S. or other Western economies. But when Russia devalued its currency and defaulted on foreign debts in August, it sent a shock wave through global markets ... hedge fund Long Term Capital Management imploded. Trading in numerous markets came to a near halt. The New York Fed organized a rescue of LTCM, and the Fed cut interest rates by three-quarters of a percentage point between late September and mid-November. The U.S. escaped recession. Whether today's credit crisis looks as bad is a subject of intense dispute. "In 1998, a lot of big boys were really scared," said a former government official and veteran of '98. "Right now a lot of the big boys are saying, 'How can I profit from this?' That feels a little different ... But comparisons are difficult. The greatest stresses today are in markets that were far less important in 1998. Their evolution since then has made it much harder for regulators or Wall Street CEOs to know precisely where the risks lurk." WSJ, Aug 13, front-page article, Greg Ip, Deborah Solomon and David Wessel

"Each time the buy-out funds checked in with Morgan Stanley, Cadbury's adviser, the bank ratcheted up the interest rate on the debt package, according to people close to the matter. For the private equity titans, this unusual behaviour was a confirmation of their worst fears: the world had fundamentally changed, and not in their favour ... That moment could be etched into the memory of buy-out executives for years to come. Just days after Chuck Prince, Citigroup's chief executive, had confidently proclaimed that he was "still dancing" to the tune of the buy-out boom, the music stopped and the self-proclaimed "golden age" of private equity came to an end. Indeed, since the end of July, discussions about large private equity takeovers have virtually ground to a halt, say Wall Street bankers." FT, Aug 14, "Not dancing anymore. How the music stopped for buy-out buccaneers," James Politi and Francesco Guerrera

"Blackstone has warned of a slowdown in large private equity takeovers due to the upheaval in credit markets. But the US buy-out group said the new environment could help boost returns over the long term. Tony James, Blackstone president, said that the meltdown in the financing markets for risky debt would in the short term hit performance by reducing fees and delaying asset sales ... Mr James suggested that in the changed environment Blackstone would be pursuing different kinds of transactions - smaller buy-outs, public equity investments, and buying debt of pending deals at a discount." FT, Aug 14

"Blackstone Group LP, manager of the world's largest private-equity fund, said second-quarter earnings more than tripled as revenue at its four main units increased during a record year for leveraged buyouts." Bloomberg, Aug 13

"Wal-Mart Stores Inc., the world's largest retailer, said second-quarter profit rose less than analysts anticipated and lowered its earnings forecast ... "U.S. consumers continue to be under difficult pressure economically," [CEO] Scott said on the call. "It is no secret that many customers are running out of money toward the end of the month." ... Consumer spending, which makes up about 70 percent of the economy, slowed to a 1.3 percent annual growth rate in the second quarter, the weakest since 2005." Bloomberg, Aug 14

"[Wal-Mart CEO] Mr. Scott said. "The paycheck cycle is, in fact, more pronounced now than it ever has been."" WSJ, Aug 14

"Home Depot on Tuesday reported weak second-quarter earnings, confirming its earlier outlook, and said it expected grim market conditions to continue into 2008 ... Sales in stores that were open for at least a year fell by 5.2 per cent. The worst depression in the housing market in 16 years continues to present a "tough selling environment" for the home improvement retailer, chairman and chief executive Frank Blake said. "We believe the housing and home improvement markets will remain soft into 2008."" FT, Aug 14

"The lending landscape has changed dramatically ... Even if months of absurdly easy credit are simply giving way to a more realistic but stable view of risk, clearing the backlog will take time ... Demoralising subprime-related headlines are also likely to recur as disclosures of real or paper losses at investment funds and banks dribble out over the coming months ... If buy-out firms cannot borrow as aggressively they will pay less for public companies, eroding the premium built into stock prices. Meanwhile, if companies find borrowing tougher, they will indulge in fewer share buy-backs and special dividends, further disappointing equity investors. Tougher lending criteria could also force more of them into bankruptcy. Decent global economic growth could help offset much of this. However, a serious credit crunch could crimp growth by squeezing commercial activity." FT, Aug 12, "Investor should prepare for more of the same at best," Tony Jackson

"U.S. banks increasingly tightened loan conditions on sub-prime and non-traditional mortgages in recent months and became more cautious about prime mortgages, syndicated loans and commercial real estate, according to a survey by the Federal Reserve ... The survey was conducted just before the global credit crunch intensified." FT, Aug 14

"UBS AG, Europe's largest bank, fell to the lowest in a year on the Zurich exchange after acknowledging that "turbulent" markets may reduce profit for the rest of the year." ... UBS has overtaken Morgan Stanley as this year's top underwriter of share sales, according to data compiled by Bloomberg." Bloomberg, Aug 14

"The 14 percent rally in Chinese stocks in the past two weeks has created some of the largest companies in the world by market capitalization and defied a global rout that wiped more than $3.3 trillion from equities worldwide. The gains helped Industrial & Commercial Bank of China Ltd. attain a market value that exceeds all but two U.S. companies ... ICBC's Shanghai-listed shares trade at 39 times reported earnings, almost four times Citigroup's multiple of 11. Shares in China's CSI 300 Index trade at 50 times profit, while those in the Standard & Poor's 500 Index trade at 17 times ... The CSI 300 has more than tripled in the past year ... Trading by individual investors accounts for about 60 percent of market volume ... Investors in China have opened about 33 million brokerage accounts already this year, more than six times the total for 2006. Daily turnover on the nation's two stock markets soared more than fivefold." Bloomberg, Aug 14, "China's Stocks, World's Costliest, Defy Global Slump," Darren Boey and Zhang Shidong

"What makes China's worst inflation scare in a decade doubly dangerous is its deceptively harmless appearance. Many analysts are inclined to write it off as a temporary food shortage, when it actually stems from a serious money glut. The annual inflation rate zoomed to 5.6 percent last month, the highest in more than 10 years ... Just as loose global monetary conditions have caused energy prices to run away in recent years, surplus liquidity in China -- the deluge of money entering the country through its record trade surplus -- is now showing up in food costs, which account for a third of the Chinese consumption basket ... money supply, which grew 18.5 percent in July, the fastest pace in more than a year." Bloomberg, Aug 14, "Blame Money, Not Pigs, for China's Price Scare," Andy Jukherjee

"The spurt in inflation comes at a sensitive time in China's political calendar, ahead of the five-yearly Communist party congress in October, when stability is at a premium. Outbreaks of inflation have triggered political upheaval in the past." FT, Aug 14

"Final reckoning only days away for Musharraf. Time is running out for Pakistan's president to secure his political future and avoid a constitutional crisis," FT, Aug 14

"Poland's ruling coalition crumbles," FT, Aug 14

So, why could this get a lot worse than LTCM and 1998?

Back then the Fed could arrange a Wall Street bailout of one hedge fund, a very easily identifiable locus risk, and Greenspan could quickly cut rates three times (thereby re-affirming the infamous "Greenspan put," perhaps soon to be called the Bernanke-Trichet put, once again creating even more "moral hazard," i.e. speculators are assured that, heads I win, tails I still win, hence you lose.)

The current situation is NOT comparable, and is, potentially, far worse. And the prospect of a global financial meltdown, as bad and unfortunate as that would be, potentially might just be the tip of the iceberg.

That's because, very unfortunately, the underlying strength of the basic financial and economic structure of the U.S., in particular, is now far weaker than in the late 1990s, yet very few in positions of power yet want to admit to it (through sheer denial, many who should know better still maintain that the U.S. remains the omnipotent, ubiquitous sole superpower).

This situation has been reversed in "emerging markets," which are in far better shape now than back then, though that probably will NOT protect them from a global financial meltdown, as Marc Faber notes in the two video links in the section just above, should it occur.

In the late 1990s tech bubble, financial market problems were concentrated in usually risk-averse, unleveraged mutual funds then uncharacteristically gobbling up obscenely over-priced IPO's, and economic problems in capital spending in the corporate sector, which suffered a sharp downturn in the 2001-02 recession, while consumer spending growth did not go negative.

Now, as the mainstream media likes to point out, the corporate sector has high profit margins and growth (still up over 10% in the second quarter, which would be normal at a cyclical peak), and huge amounts of cash (according to Goldman, non-financials in the S&P 500 have $800 billion in cash, 10% of their assets), which it seems to have no better productive use for than economically dubious m&a and stock buybacks, both of which will likely recede from their record levels.

In the current situation, potentially severe problems are now dangerously concentrated in the banking and highly leveraged speculative finance sectors, i.e. hedge and private equity funds and commercial and i-banks, all now much larger, increasingly indistinguishable, and financially cancerous, and in the consumer sector, which has been heavily dependent on its real estate asset "paper wealth effect," due to the stagnation of real incomes in the 2000s. But with real estate prices now declining, and real-world prices rising, consumer spending has been under pressure.

Additional factors usually neglected by the mainstream media that are critically different than in LTCM Oct 1998 and the late 1990s tech bubble include the following: the U.S. has a far larger, huge external debt; a very weak dollar; a budget deficit dependent on cyclically high corporate profits and especially huge capital gains, both of which may peak; very high energy, food, health care and other costs; worrisome slowing productivity (the rapid rise in productive in the late 1990s was the underlying basis of the tech bubble); and just around the corner, huge unfunded pension/health care liabilities.

In addition, much of the world thinks that the U.S.is currently losing two wars and U.S. global standing is very low, as repeatedly shown in polls.

In fact, there has been a dramatic shift in relative economic strength between 1997-98 and now. Back then, Asian nations had current account deficits and currencies under attack.

Asians, now holders of trillions of depreciating U.S. dollars (click on chart to enlarge, courtesy of St. Louis Fed) do not fondly remember U.S. actions protecting American speculators at the expense of Asian living standards in the 1997-98 so-called Asian financial crisis, which some Asians call the IMF crisis and identify with the U.S.

In addition, obviously the global geopolitical situation today is also far worse than in LTCM Oct 1998, not only Iraq and Afghanistan, but also is very worrisome in Pakistan, Iran and elsewhere.

All these potentially destabilizing factors, which especially when taken together are far worse than during LTCM Oct 1998, if for no other reason than they now are now afflicting the U.S., not the more peripheral "emerging markets" as back then, are usually being ignored right now by both financial markets and the mainstream.

But without being alarmist, for most countries, all these factors taken together usually would be the symptoms of an upcoming major financial/economic/political crisis.

Since the dollar is still the world's major reserve currency and the U.S. is by far the dominant military power, that very unfortunate potential outcome has been continually avoided, to the puzzlement of many mainstream economists and other academics, as the rest of the world continues to finance, for now, America's spending spree, both consumer and military.

(I won't go into here the esoterics of financial, not physical, "dark matter" and what economists affiliated with Deutsche Bank cleverly but inaccurately labeled Bretton Woods II back in 2003.)

The Big Positive Difference This Time

Perhaps the main reason, or rationalization, for sweeping the potential very large risks under the rug, at the moment, is the one very obvious, extremely huge positive that many others, and myself on my web site link, have consistently noted, namely extremely strong global economic growth, especially in Asia.

My ultra-simplistic working assumption has been that the U.S. real estate and lbo bubbles were so absurd and so huge, i.e., that it was economically impossible for the Fed to give away essentially free money (negative real interest rates) for so long without creating huge potential problems, therefore that the subsequent credit market problems must be quite large, hence the subsequent pain probably has significantly further to go. Others have analyzed this far more thoroughly than I have, and it is now consensus opinion.

But, on the other hand, as I've also repeatedly said, we've also never lived in an era where so much of the world is now in the market economy, and I believe the ongoing long-term positive benefits of that truly historical change are likely to be continually underestimated also, especially by those in the west.

Real estate and credit market problems have become major daily news in the U.S. The huge positive gains from a market economy in China, India, and elsewhere seem quite remote to the very busy daily lives of most Americans, but these gains continue, day in and day out, rapidly, cumulatively greatly improving the lives of hundreds of millions of people over time.

Asian growth obviously has continued to be extremely strong, even as the U.S. has slowed. E.g. the IMF recently raised its forecast of global growth in 2007 from 4.9% to 5.2%, even while it cut its forecast for the U.S. Whether or not that will continue to be the case if the U.S. goes into an actual recession is still an open question in my mind.

China, which grew 11.9% in the second quarter, will contribute more to global growth this year than the U.S. On the negative side, China's consumer prices have just increased 5.6% in July, well above estimates of 4.6% and the highest rate in more than ten years, from 4.4% in June.

Regardless of the strength of Asian economic growth, a global flight from risk will most likely have a strong negative impact on emerging stock markets, which like others has continued to hold up remarkably well so far and thus remain over-extended and overbought on a long-term basis, as I've shown in charts several times in the past month or two. China's mainland stock markets of course continue to seem to remain in a world of their own, extremely over-extended, and thus remain another potential source of global financial risk and instability.

Financial Markets' Sharply Higher Volatility without Low Enough Prices to Attract Buyers

I will break the main flow of this article for this section to briefly show a few key charts.

Note, the charts in this section were from e-mails sent out last week, Aug 6-10, I did not have the time to update them for this article, but I believe the points they illustrate hopefully are still valid.

This 5-year weekly chart of the S&P 500 (as of Friday, Aug 10) shows that so far the correction has NOT been very severe, though it has broken the uptrend from July 2006 (purple line).

In the short-term, the S&P 500 is oversold, shown in the bottom indicator, "stochastic momentum index," and thus "normally" due for a bounce, though the current financial environment is obviously no longer normal.

Longer-term, this correction would have further to go just to get down well into the bottom of the regression channels, the parallel lines (the red one is 2 std dev from the middle regression line), bringing the "true strength index" trend indicator down to 0 or below.

Going down toward the bottom of the regression channels would create real equity market fear and concern, and perhaps at some point likely more Fed intervention to try to trigger a massive short-covering rally (something Greenspan did with the LTCM crisis in Oct 1998, but which led to all sorts of "moral hazard" problems later).

More so than the S&P 500, most world stock market indexes were so far above-trend and overbought at the peak on July 19, that even a normal modest correction has not brought them down to very attractive entry points so far. I have shown these charts, especially of EEM, the emerging markets etf, a number of times in previous articles on my web site link, so will not do so here.

Greatly compounding the practical investment problems (as Goldman's and other "quant" funds can well attest to) has been the surge in volatility. As shown in this chart (from Tues, Aug 7), VIX (black line), the widely followed S&P volatility index, has been trending sharply upward, and is now significantly higher than it was at the previous peak in May-June 2006.

Yet for the etfs shown, EEM emerging markets (red) and QQQQ Nasdaq 100 (blue), the percentage price declines in that earlier 2006 correction were significantly larger than they have been now.

In other words, to repeat what I said earlier, investors are now facing the worst combination of greatly increased volatility without low enough prices to make the added volatility risk worth taking.

This next chart (from Mon, Aug 6) shows the percent change in three etfs, XHB (black) homebuilder, SPY(blue) S&P 500, and QQQQ (red) Nasdaq 100.

The main point of this chart is that all three were highly correlated up until Feb 2007. Since then, until the past few weeks, SPY and QQQQ ignored the increasing troubles in the real estate sector so clearly reflected in the rapidly declining price of XHB.

Finally, this last chart (from Wed, Aug 8), shows the normal "retracement" bounce of XLF, the financial sector etf, during the seemingly highly manipulated rally Mon-Tues, Aug 6-7. of last week (such as floating rumors of FNM and FRE buying subprime mortgages, similar to the July 12 rally that hyped Wal-Mart sales a day before weak consumer spending was reported), which failed Wed, Aug 8 afternoon, leading to the sharp decline Thurs, Aug 9, when the central bankers threw open their liqudity spigots.

Thanks very much for reading such a long article, I greatly appreciate it. Part 2 to follow in a day or two.

Econotech

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