Pivotal Events

By: Bob Hoye | Tue, Oct 14, 2008
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The following is part of Pivotal Events that was published for our subscribers Wednesday, October 8, 2008.


Last Year:

"The [Spanish] government is confident that scorching real estate prices won't correct."

"A residential real estate slump is unthinkable."

- Wall Street Journal, September 19, 2007

The advice was from a top economic advisor to Spain's prime minister.

"Exorcising Ghost of Octobers Past"

"Despite Housing Slump, [Stock Market] Crashes Likely to Stay Memories"

"I think the Fed has taken care of the summer's harrowing turbulence by cutting short-term interest rates, pumping money into the system and seeming determined to prevent recession."

- Wall Street Journal, October 15, 2007

This Year:

"Credit Markets Go From Bad to Worse to Ugly"

"Commodities Take a Brutal Beating"

"How Lehman's Real-Estate Star Created a Debacle"

- Wall Street Journal, October 1, 2008

"Problems so grave no one country can solve them alone."

- London (CBS/AP), October 7, 2008

On the latter, conventional wisdom has changed from claiming that the "sub-prime problem" was "isolated" and could be "contained'. That was within the US, and despite the world buying tonnes of dubious debt pundits outside America boasted that their economy was "de-coupled" from the US. Even Canadian economists boasted as much. This reminded of 1989 when the best-selling economics textbooks all claimed that the Soviet Union's economy was doing very well. That fateful year saw the very public collapse of that socialist experiment.

Our thinking at the time was that the textbooks' claims about the USSR must have gone along the following reasoning. It was a great experiment in authoritarian government run by interventionist, if not commanding, central planners. The results had to be good - weren't they?

Even with the greatest train wreck in the history of credit becoming so obvious, interventionist economists, while boasting of their remedies, have upped their efforts in claiming that "no one country can solve" the problem.

That is a long way from ad hoc conclusions that the "sub-prime" disaster was "contained".

Even guys in the barber shop will soon be saying: "Stop the rescues - the stock market sets new lows with every bailout".

* * * * *

Stock Markets: For most players now the direction of the market is no longer ambiguous.

Our Monday's ChartWorks outlined what is needed to complete this phase of forced liquidation. If this is a down week for the Dow, or S&P, a Downside Capitulation would register on our proprietary model. On the weekly reading this is rare and, obviously, important. However, it's worth noting that if it comes in it is registering a condition that can end this decline.

In past examples it can take a week or so to begin the rebound, which will likely be a tradable rally in a cyclical bear market. Typically at major lows there will be thousands of individual stocks registering Capitulations and this is not happening yet.

In May we concluded that the seasonal turn to widening credit spreads would lead to "severe conditions" by September-October, and this has been the case. The same has happened to commodities, which should bury Wall Street's claim that commodities was an asset class that moved contrary to the main trends in equities. Another part of modern portfolio theory based upon a short attention span of those dreaming up the theories.

As the saying in physics goes: "If you keep your data base short enough it will fit your theory." For hundreds of years, prices of stocks, doubtful debt and commodities have gone up and down together.

Once this liquidity crisis exhausts - stocks, corporate bonds and commodity prices should rally together.

Our work a few months ago suggested that the decline could climax by late October. Monday's ChartWorks suggests that if the "Capitulation" is registered on Friday then the bottom could be accomplished in the latter part of October.

In January we looked to the patterns in the 1973 and 1937 bears. As the year developed, the common items to both called that upon the hard break in May the decline from the October top would be around 25%, which was the case. The overall decline could amount to 49%, but need not be limited to that.


Credit Spreads have been a disaster. A year ago, for example, junk was yielding 11%, at 6 percentage points over treasuries. Now the numbers are 22% at a huge 17.5 percentage points over treasuries. On price, the plunge is from 108 to 55, or 53 (shudder) points.

Even investment-grade (BBB) has been worked over. At 6% and 130 bps, over a year ago, the yield is now 8.05% at 404 bps, over treasuries. The price drop is around 18 points.

The fateful change was with the usual seasonal reversal and we reviewed it in our May 15 edition: "Often spreads narrow into May, which has been the case and the other part of this seasonality is widening. Once turned, this could trend towards severe conditions by late in the year."

The reversal was accomplished by early June and punctuated by news of fresh disasters the trend has been to ugly. It is not so much that the news has been driving the trend, but that the trend has been forcing the dislocations. It could become "coyote" ugly as the panic runs its course into late October.

As noted last week, bond revulsion has hit the emerging debt market. The MSD is the ETF and it was at 9.65 in early June and seemed to turn down with crude oil. Hanging around 9.25 in early August it has plunged to 5.92 today, with most of the drop since mid September.

In reckless markets the urge for higher yield typically finances extravagant governments in lesser counties that haven't a hope of servicing debt in hard times.

Observations were made by Max Winkler in his study about the horror show in the equivalent to today's emerging debt in the post-1929 contraction. Called Foreign Bonds: An Autopsy was published in 1933, and the summary went as follows:

"The fiscal history of Latin America ... is replete with instances of governmental default. Borrowing and default follow each other with almost perfect regularity. When payment is resumed, the past is easily forgotten and a new borrowing orgy ensues. This process started at the beginning of this past century and has continued down to this present day. It has taught nothing."

Then, after some respite the once-in-a-generation revulsion of debt will continue.

Link to October 10, 2008 ‘ Bob and Phil Show' on Howestreet.com: http://www.howestreet.com/index.php?pl=/goldradio/index.php/mediaplayer/986



Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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