The following is part of Pivotal Events that was published for our subscribers June 5, 2008.
SIGNS OF THE TIMES:
"Growing Demand May Limit Supply for Poor Countries"
"The ethanol boom in the US is likely to limit corn's availability for food and feed use."
- Wall Street Journal, January 16, 2007
The conclusions were from a study from Earth Policy Institute, which was an accurate call.
Then in early June, the first Bear Stearns disaster was discovered and the cheerleaders cranked up the good news:
"The subprime slump is contained"
- Bloomberg, June 26, 2007
The statement was from Freddie Mac, the number 2 mortgage finance company.
"The subprime mess has been basically looked over and not taken as a big concern."
- That was part of the Bloomberg article and its worth reviewing some sub-prime mortgage bond prices: The BBB, which had rebounded to 84.15 on May 8 (last year), declined to 82.68 on June 1 and then plunged to 42.32 in August as that panic concluded.
* * * * *
After the March debacle, investor spirits soared into mid May and the street celebrated:
"The Federal Reserve has brought the markets back from the brink of disaster", which was recorded by the Wall Street Journal on May 23.
But as we have been noting, sub-primers have been foreshadowing another problem. Since the middle of April, the BBB which had slumped from 10.96 to 6.52 on Friday is now at 4.92 (no typo).
Stock Markets: The crash in the BBB sub-prime from 84 a year ago to less than 5 is a horrendous drop in price - and it is not limited to this one ranking but represents all similar confections, otherwise known as "securities". The loss of market cap is in the trillions of dollars and represents a massive contraction of credit.
This, of course, links to the stock market as the world of investing thrives on credit expansion and, so far, has been bewildered by the dislocations. But, as we have been noting there is much more to the stock markets than earnings, valuations and boasts about the abilities of the Fed.
By last July, the change in the credit markets was sufficient to conclude that the greatest train wreck in history had started. The link to the stock market has been most conveniently represented by the course of sub-prime bond prices.
The initial warning on each slump has been the lengthy decline in lower-grade sub-prime and the condition becomes acute when the higher-ranked break down. This week both the AA and A took out the lows with the March panic. This is a fully-fledged warning on the next slide in the stock markets.
Further discoveries of bad lending will be reported during a weakening stock market.
Most sectors could be vulnerable.
After some firming banks and financials became vulnerable to their two nemeses - deteriorating credit conditions and announcements of banking disasters already committed.
The BKX rallied to 88.7 on May 1 and a few weeks ago, we noted that taking out 74 would resume the downtrend. Also noted was the change in the sub-prime, which would eventually force the breakdown. Today's low was 71.9.
The pendulum with banks on one side and resource stocks on the other side continues, with banks down since May 1 and miners (SPTMN) up since that date. Of interest is that today bankers and miners were both down.
Base metal prices are back to their lows of December, which suggests the miners should be around 700, rather than at the current 860. Last week's high was 894 and the cyclical high was 958 in October.
We like to play the seasonal rally and the best is likely in and we are essentially out of the play. Traders could begin to play the short side.
The Long Bond: Last week minor support at 114 was taken out on a drop to 113.41. Yesterday, this was tested and the bond closed at 114.98.
Some of the recovery seemed due to the heavy stock market, which has become the knee-jerk move. Last week, we noted that the bond may becoming more vulnerable to deteriorating liquidity in lesser-quality issues.
The recovery is from a level not oversold enough to prompt a technical rally. There is overhead resistance at 116--chart plus some moving averages.
Breaking below 113 would really turn the chart down, suggesting the gravity of illiquidity is becoming irresistible.
It is possible that this could occur in the next phase of the contraction when treasury-bill rates would be declining. Traders have been positioned for steepening. The curve flattened into mid May with the 30-year to 3-months coming into 263 bps. This is now out to 286 bps - no big deal, but it could be equivalent to the change last May.
Credit Spreads: With the revival of the "good stuff" out of the March panic, spreads were likely to narrow into May. Then, the seasonal turn could push spreads to severe dislocations by later in the year.
We played this very well in 1998 when LTCM was hit by positioning for narrowing on the grand Euroland scheme that under a common central bank and currency, spreads between most European countries would narrow to next to nothing. LTCM leverage the "convergence" as it was called to the hilt and our view in May of 1998 was that spreads would widen to dislocating conditions by August and September - which was the case.
This seasonal turn to widening will be profound with severe dislocations occurring in many countries. Also, as the boom ends politics could change from authoritarian during the boom to a shift towards the individual, and regionalism.
European financial cohesion could fly apart making the attempt to have the euro trade like the mark seem doubtful.
Gold Sector: For this year we rode the rally into March with the understanding that when the gold/silver ratio turned against silver the action was within two weeks of an important top. The ratio turned on March 6 and the high for both metals was on March 17. That also signaled that senior gold stocks would decline by more than 20% into the first part of May. This happened.
Then, in early May the advice was to get positioned for an intermediate rally, with the understanding that sometime in May crude could conclude its spike and reverse. This would provide another buying opportunity.
The HUI declined to 385 in early May and rebounded to 459. The correction has been to 412 and there seems to be support at 410, which could take some time to build a base.
On the fundamental side, the next financial crisis will increase the investment demand for the unique liquidity of gold.
This could be showing up with the resumption of the uptrend in gold's real price. Our Gold/Commodities Index set its last high at 230 in the January panic. Then with the revival of the "good times" the index declined to 194 in early May. The initial increase made it to 215 on Thursday and Friday, from which it has slipped to 210.
Gold's real price typically increases though a post-bubble contraction and we think that the current uptrend has a couple of years to go.
"The budget should be balanced, the treasury should be refilled, and the public debt should be reduced. The arrogance of officialdom should be tempered and controlled. And the assistance to foreign lands should be curtailed lest we become bankrupt."
- Cicero, 63 B.C.
Link to June 5, 2008 'Bob and Phil Show' on Howestreet.com: http://www.howestreet.com/index.php?pl=/goldradio/index.php/mediaplayer/874