Pivotal Events

By: Bob Hoye | Tue, Sep 30, 2008
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The following is part of Pivotal Events that was published for our subscribers September 25, 2008.


Last Year:

"The whole world, including the U. S. has benefited … from credit availability."

- Henry Paulson, US Treasury Secretary as quoted in Times Online, September 18, 2007

"Yield Curve is Banks' Silver Lining"
"Steepening poses lift to profits and shares despite credit's woes"

- Wall Street Journal, September 18, 2007

Despite strongly held theories about the curve, radical steepening has been the feature of every post-bubble contraction. A year ago, the curve from the 30s to the 2s amounted to only 80 bps and rapid steepening has taken it out to 255 bps this week. This has been accompanied by considerable banking distress, rather than a bounty of profitable lending.

This Year:

"Panic Grips Credit Markets"

- Financial Times, September 17, 2008

"Short-sale Ban Spreads Around The World"

- Wall Street Journal, September 22, 2008

"There is no way to stabilize the markets other than through government intervention."

- Henry Paulson, Wall Street Journal, September 24, 2008

Of course, the call for more intervention and regulation is absurd. The problem is that government and academe spent considerable time touting that intervention had removed risk.

Most participants earnestly believed that policymakers could keep "the recovery going", and if markets faltered policymakers would be there to prevent a recession. In so many words "nothing could go wrong". Then with the Fed accommodating at any point in the business cycle there was no perceived risk and the world leveraged up with unprecedented aggression.

Too much intervention and regulation has been one of the problems and it is naïve to expect yet more of the old recipe will prevent a massive liquidation of recklessly created credit. Anyone who thinks credit markets can be altered or changed doesn't understand credit.

Many who have been employed in the propaganda of interventionist economics are, no doubt, earnestly hoping that the bailouts will work.

* * * * *

Stock Markets: It is a privilege to live in such interesting financial markets. It is like being in the fall of 1929, or 1873, or even 1825. The reason for the comparisons is that each of these disasters is well-documented with heroic beliefs that nothing could go wrong. Or if the markets turned down policymakers would end panics or prevent palpably bad conditions from getting worse. An essay is attached.

What's next? We have been using the 55-day plunge as one guide to the probable end to this phase of the liquidity crisis. This has been backed up by the usual seasonal forces whereby a period of heavy liquidation can complete by late October. Sometimes this can be accompanied by the final arrangement of a rescue package. This occurred in 1907 when J. P. Morgan is widely considered as single-handedly ending the panic. No, by the time he got the pool of credit together the panic was at its natural exhaustion.

This will likely be the case this time around.

Technically, the senior indexes are not yet at an oversold that would prompt a meaningful rally.

Fundamentally, there is a new influence in the equity markets. The long bond is now in a significant downtrend. The importance is that with long treasury rates rising, which with widening spreads will really ramp up the cost of corporate funds. Also money market spreads have been devastated, which increases the cost of short-term funds - if available.

So far, those inappropriately leveraged in credit spreads have been the main culprit of this severe liquidity crisis. They are now about to be joined by those who have been aggressively, but inappropriately, playing the curve.

In the meantime, there could be a couple of opportunities. The Consumers Staples sector has been doing well and is rolling over. The exchange-traded fund is XLP. Consumer Discretionary has enjoyed a sharp rebound and seems vulnerable. An ETF on this index is XLY. Both have options.

Real Long Interest Rates: The rule is straightforward. In a bubble real long rates record an immense decline. In round numbers, the low yield on the long bond was 4% last week. The recent high on the Pre-Clinton calculation of the CPI was 9%. This puts the real rate at -5%. Typically the increase in the post-bubble contraction is 12 percentage points, which is huge. This will be accomplished by the nominal yield increasing as the rate of CPI inflation declines. Of course, we will stay with our vow to avoid using bogus government statistics. Even the Pre-Clinton CPI calculation is doubtful, but is a reasonable proxy.

Any sort of inflation-adjusted bonds should be avoided.

Gold Sector: After a brief correction the real price (relative to commodities) has rallied. Our gold/commodities index rallied to 234 with the July crisis and then slumped to 211 in early September. In jumping to yesterday's 254 it is reflecting a sharp increase in investment demand that typically accompanies a financial panic.

This is back to the cyclical high set in June, 2003 when the late boom was launched. The low was 143 set in May last year when the late boom began to expire.

The real price is indicating a substantial improvement in operating margins and is on a cyclical uptrend. Typically this can run for two to three years during the first cyclical post-bubble contraction.

We have been advising buying senior gold stocks into late October weakness. A week and a half ago the juniors, as represented by the Toronto Venture index, registered a Downside Capitulation on the daily reading. This index doesn't have a long enough history to make some key comparisons. However it dispassionately confirms what everyone knows - it's crapped out.

Most small-cap golds have impossible liquidity, but veterans in this sector can begin accumulation.

After the enormous rush to 74 the gold/silver ratio needed correction. So far, it has made it back to 65. This is healthy and the 50% retrace is at 63. Once it broke above 54 our target has been around 100, which was the level reached with the last bad banking crisis that ended in late 1990.

Silver crashing relative to gold is typical of a severe liquidity crisis and the value of this indicator is enhanced by silver "experts" having trouble explaining it. Today's Wall Street Journal has a storyline: "Persistent Allegations of Manipulation Are Now Taken Seriously". Well whatever, this phase of the crisis is not over and when silver starts another dive it will indicate more distress in the financial markets.



Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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