The following article is extracted from Pivotal Events, published for subscribers on March 9th.
Signs Of The Times:
"If long-only fund returns begin to diminish, or even turn negative, an investor rush to get out could set off some pretty spectacular consequences."
- Australian Investment Review, March 1, reporting on a Citygroup review of commodities
Nice to see that a big group can get it right.
It is interesting that yesterday pundits were explaining that the weakness was not due to any change in fundamentals, but due to "fund selling".
As most know, Robert Louis Stevenson did not write a market letter, but one of his observations can be used in one: "Sooner or later in life, we all sit down to a banquet of consequences."
Stock Market: On the process of developing the top in the fateful year of 2000, the DJIA set its high at 11750 on January 14. For this index, it was a cyclical high at the turn-of-the-year window.
For the Nasdaq, which was the focus of one of the greatest manias in history, the high was 5132 on March 10. This was a secular high in March, which month often sees the end of a strong rally or a bull market.
This time around, the Nasdaq set its high at 2333 on January 11, which so far fits the "window" we were looking for. Inspired by reckless opinions about commodities, the S&P, as well as the Dow, set somewhat higher highs in February that we thought would test the January highs.
This seems to be the case, as technical and fundamental aspects, such as money flows, have deteriorated significantly over the past few weeks. The latter includes Lowry's "buying and selling pressures" analysis and by Decision Point's treatment of the Rydex Cash Flow Ratio. (www.decisionpoint.com)
Also, it's worth repeating that the stock market is not a closed loop of management, stories, Fed chairman, and Wall Street pundits. It is only one item in an integrated financial market. This has been and will always be cyclical.
Another item to focus on is that the central bank is not the only issuer of credit/currency. This is the coercive side of the markets and the voluntary side is even more capable at moments of speculative mania in creating as much or maybe even more credit/currency.
One of the major blunders of the establishment is the specious notion that liquidity drives stocks and commodities up. Reality is quite the contrary, as soaring asset prices foster aggressive employment of leverage and, inevitably, such speculation becomes exhausted. Once prices start to decline, it forces liquidation of suddenly unsupportable positions. The break in base metals this week provides a hint.
Of course, the Austrian School of Economics has had the best grasp of credit markets and the following is an essay entitled "Dearth of Credit" by Ludwig von Mises:
"An increase in the quantity of money or fiduciary media is an indispensable condition of the emergence of a boom. The recurrence of boom periods, followed by periods of depression, is the unavoidable outcome of repeated attempts to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
The breakdown appears as soon as the banks become frightened by the accelerated pace of the boom and begin to abstain from further credit expansion. The change in the banks' conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period.
The dearth of credit which marks the crisis is caused not by contraction but by the abstention from further credit expansion. It hurts all enterprises - not only those which are doomed at any rate, but no less those whose business is sound and could flourish if appropriate credit were available. As the outstanding debts are not paid back, the banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict their activities. But there is no means of avoiding these consequences of the preceding boom.
Prices of the factors of production - both material and human - have reached an excessive height in the boom period. They must come down before business can become profitable again. The recovery and return to "normalcy" can only begin when prices and wage rates are so low that a sufficient number of people assume that they will not drop still more."
Typically, the disappearance of liquidity or the dearth of credit is signaled by widening credit spreads and the reversal to curve steepening.
Both the Fed and commercial lending agencies have been approaching the limits of promiscuous lending and, with this, one would not expect any self criticism.
However, in looking around, there must have been someone sober at the NY Fed as a warning on unsound banking was uttered on January 25.
A more specific warning on credit derivatives was made, also by the NY Fed, on February 28.
Also under these conditions, the office of the Comptroller of Currency should be offering similar comments. However, a quick search reveals that this agency's concerns are still focused upon Hurricane Katrina and New Orleans.
Fortunately, advice to banks given by the first Comptroller, Hugh McCulloch, in December, 1863 came to light. Parts are worth reviewing:
"Pay your officers such salaries as will enable them to live comfortably and respectably without stealing; and require of them their entire services. Extravagance, if not a crime, very naturally leads to crime."
"Pursue a straightforward, upright, legitimate banking business. Never be tempted by the prospect of large returns to do anything but what may be properly done under the National Currency Act. "Splendid financiering" is not legitimate banking and "splendid financiers" in banking are generally either humbugs or rascals."
Somehow the latter paragraph brings to mind the current and former chairmen of the Fed.
Stock Market Wrap: Once again, a sharp break in the commodity sectors fostered a rotation into other equity sectors.
However, the crack in base metal prices is a warning on the developing business slowdown.
The yield curve is reversing to steepening and that is reliable in signaling the beginning of the credit contraction.
On the week, there was a minor turn towards credit spread widening. The stock proxy for this - MSD - rallied to 11.39 two weeks ago. Although this is an ETF on the price of emerging debt, it is a reasonable way to position for spread widening.
On the week, it declined to yesterday's 10.82.
Volatility on our Bank Trading Guide has gone wild as it soars to new highs. This continues to be the "alert" and investors can continue to lighten up. Traders can await the "sell" signal.
Recent changes in the critical items are reviewed in the attached update of our Boom Indicators.
This was originally put together as the "Bubble Indicators" in 1999 as an attempt to formally describe that example of extreme financial asset inflation as a "Bubble". However, the description was offensive to some readers and the name was changed to something less offensive but just as useful.
A significant change in the indicators seems to be underway and it is worth monitoring.