A Gathering Perfect Storm?
It has been a while since the last Technical Scoop. But we suppose that is what happens when watching one of the most meandering markets we have ever witnessed. It is almost as if it wants to put you to sleep. The Dow Jones Industrials has trudged almost daily to new all-time highs, but instead of excitement we fight to stifle a yawn. The DJI is up roughly 2.6 per cent on the year and that is about as exciting as it gets. The TSX Composite has fared little better: up 3.2 per cent despite also hitting new all-time highs.
With the Dow Jones Industrials making new highs, it is interesting to note that the S&P 500 remains some 68 points off its all-time highest close. That happened almost seven years ago, on March 24, 2000. The NASDAQ has fared even worse, crawling back to barely 50 per cent of its all-time highest close of 5,048 on March 10, 2000. To be down 50 per cent yet call the last few years a successful bull market is chutzpah. We have to remind everyone that after hitting 5,048 on March 10, the NASDAQ was down 38 per cent by May 23 that year. Even that level near 3000 seems miraculous now although at least now within hailing distance.
Yet today we see some signs of a return to the atmosphere of those heady days leading to the highs in 2000. It is a market that increasingly believes it can't lose. At least back in 2000 there were some doubts as the VXN volatility indicator was at a lofty 61. Today it is under 16. No volatility, no complacency. And so it is with the economy. They are calling it the "Goldilocks economy". Not too hot, not too cold. The bulls chortle, complacency is high, volatility is low. The bears must surely be beaten to death by now, drowning in their own doom and gloom rhetoric.
Trouble is, markets work in mysterious ways. What they really want to do is draw in as many people as possible, and then, when they are feeling the most confident, the plug is pulled and thousands are wiped out. That happened in 2000-02 when the technology/internet bubble burst. During that two-year hiatus the NASDAQ lost 80 per cent of its value and the S&P 500 was down 50 per cent. And in keeping with bear markets that catch as many as possible, numerous bears were wiped out prior to the collapse as they were calling the top too soon and their shorts were buried. It is no surprise that we are probably seeing the same thing today as too many bears get in and short too soon. We see that every time the market pulls back slightly and the put/call ratio jumps. The only major difference between the bulls and the bears is that even at the best of times, the bears make up only a minority - and of that minority another minority are noisy and shrill.
People thought the same thing about the US housing market. That it could just keep going up. Over the past five or six years it has been the prime driver of the economy. Mortgages outstanding soared and lenders were falling all over themselves handing out sub-prime loans and loans up to 125 per cent of the value of the property. Since 2000, mortgage loans outstanding have more than doubled: up over $5 trillion. Consumer credit outstanding in the same period is up 55 per cent, or about $854 billion.
But now that housing prices are falling, delinquencies and defaults and foreclosures are all at record levels. The impact is beginning to be seen at mortgage lenders, with large losses being announced at HSBC (HBC-NYSE), New Century Financial (NEW-NYSE) and most recently at Nova Star Financial (NFI-NYSE), who fell over 40 per cent on February 21, 2007. We expect more problems to follow at financial institutions.
Over the past few years sub-prime loans were one of the fastest-growing segments of the market, growing from $100 billion to over $800 billion. With rising interest rates and falling house prices it will not take much for many of these loans to become delinquent, with defaults leading to foreclosures. Apparently rents are now soaring as many homeowners are being forced out of their homes and looking for rental accommodations.
Another huge growth area over the past few years was the purchase of second homes; many of them for speculation. In 2005 alone it was estimated this segment made up 25 per cent of the market. Again, given low lending rates on a floating basis coupled with loans often exceeding 100 per cent of the value of the property, it doesn't take much of a decline to get into trouble.
We date the start of the decline of the housing market to the hurricanes of 2005, particularly Katrina, Wilma and Rita. Together they devastated (at different times) Florida and the Gulf of Mexico coast of Mississippi, Louisiana and Texas. While much of the well-off areas of New Orleans have been rebuilt, tens of thousands of people remain homeless and are still living in temporary FEMA camps. Thousands more have seen their claims for insurance refused over interpretations of their policies, leaving them with uninhabitable homes and defaulted mortgages. Thousands more are unable to obtain insurance at almost any cost because of the losses taken by the insurance companies. The result is people living in limbo.
While the region fortunately escaped any major storms in 2006, it would only take one or two such storms in 2007 to send many areas over the edge, due to the fact that there remain so many areas that have not recovered from the storms of earlier years.
But a bigger threat to the market lies behind the scenes. The massive growth of sub-prime loans brought in hedge funds that purchased these loans through mortgage-backed securities (MBS). MBS are packages of mortgages bundled together by the banking institutions and then resold into the market in order to lessen risk. Along with the massive growth of the MBS came credit derivatives, which were sold to protect the credit purchased.
Trouble is, the mortgage market blowing up is putting pressure on the MBS held by hedge funds. With pressure growing on the MBS there is also pressure growing on the credit derivatives market. A story in the Financial Times of London in February (Loans warning raises concerns over sub-prime market - Financial Times, February 14, 2007) outlined how credit derivative contracts were exploding as a result of the collapse of the sub-prime mortgage market.
We believe that we have not yet seen the full impact of the collapse of the US housing market. We should note that thus far, this collapse is not universal - meaning that many regions of the US remain unaffected. Canada has not as yet felt the sting either, although the hot Alberta market has been cooling. But we are all reminded that it was the real estate collapse in the late 1980s and early 1990s that led directly to the recession of the early nineties. The period was dominated by high interest rates and the Savings & Loans scandal.
So, how did we get here? The answer is money - lots and lots of money, coupled with low interest rates. The events of the early 1990s convinced central bankers that the only way out of the problems of the day was to rapidly increase money supply growth (M3), while at the same time the Japanese would allow the yen to fall (and in the inverse, the US dollar would rise). They also decided that interest rates needed to be reduced, drastically if required.
These measures were believed to be needed because of the recessions in Japan and the US, the collapse of the US bond market in 1994, and scares due to the Mexican peso crisis (1994) and the British sterling crisis (1992), and a falling US Dollar all of which threatened to disrupt and possibly plunge the world into a deeper financial crisis. Along the way there were other interruptions such as the Asian currency (Asian flu) collapse of 1997 and the Asian/Russian currency crisis of 1998 that led to the failure of the giant hedge fund, Long Term Capital Management (LTCM). There was also Y2K and the events of 9/11 that caused disruptions and economic slowdown into 2002.
Years of abnormally low interest rates and rapid monetary growth set off inflationary bubbles, first in the technology/internet stocks (1996-2000) and then in the housing market (2002-06). It also contributed to the famous carry trades (in the yen and gold primarily). Knowing as they did that (a) the yen was going to fall and the US dollar was going to rise, and (b) interest rates were going to fall, then it was easy to borrow in yen, convert to US$ and invest the proceeds anywhere that would earn a higher rate.
It was around this time that the central banks also embarked on massive lease programs for their gold reserves. Leases were offered at very low rates. The gold carry trade resulted in the gold being sold and the proceeds being used, as with the yen carry trade, to purchase higher-yielding assets. The other side of that program was that gold prices fell, bottoming in 1999-2001. Today it is estimated that possibly upwards of half of the world's central bank reserves of gold have been sold off to meet demand (primarily jewellery) during the years 1994-2000.
Central banks have since grown addicted to rapid monetary growth. Global interest rates have been rising of late, primarily in Europe and Japan, but have thus far failed to rise to a level that has caused any serious bite. That may be coming to an end as interest rates continue to rise in the Euro Zone and Japan even as the Federal Reserve (and the Bank of Canada) have not hiked their rates in months.
Meanwhile, monetary inflation continues. While the Federal Reserve stopped reporting M3 a year ago, some, such as John Williams' Shadow Government Statistics, have created alternative databases for M3 and a host of other economic indicators (www.shadowstats.com). Mr Williams' M3 statistics show it growing at close to 10.7 per cent - a much faster rate than prior to the Fed discontinuing its reporting of M3. Meanwhile M1 has been falling (M1 is physical currency plus demand deposits i.e. chequing and current accounts) and M2 (M1 plus savings accounts, money market accounts and CDs under $100,000) has been growing at a more modest five per cent.
And it is not just the Federal Reserve that has allowed M3 to grow rapidly. Recent figures show that Australia's M4 is +13 per cent, the Euro Zone is +9.3 per cent, Britain (M4) +13 per cent, Korea +10.3 per cent, China (M2) +16 per cent, and Russia (M2) +16 per cent (thanks to James Schildgen www.finanadviz.org).
Rapid growth in M3 money supply, rather than putting money in the hands of the masses, tends to find it concentrated in a few hands. Large investment dealers along with a proliferation of hedge funds and private equity funds have concentrated money like never before, and these funds are engaging in all sorts of speculation and pushing up prices of asset classes all over the world.
Markets globally have been rising, but none more so than China, where since late 2005 the Shanghai Stock Index is up about 180 per cent (chart below).
Given the Chinese propensity for gambling, it now seems that everyone and his grandmother have been piling into the Chinese stock market. As my friend James Schildgen points out, given a strongly acquisitive nature coupled with a banking system falling all over itself to lend money against inflated assets (even at 36 per cent as they try to quell this mania), this is an accident waiting to happen.
If the falling US housing market is the first leg of our gathering perfect storm, China is the second. Compared to North America, the Chinese banking system is the wild, wild west. Sure, Chinese GDP steams ahead thanks to North Americans buying billions of dollars of their products, often produced in substandard manufacturing plants, but it is a shaky big gain as prices are being squeezed even in China. As well, pressure in the US to have the Chinese revalue the Yuan higher is also negative to the Chinese economy.
But what has occurred over the past several years is the placing of billions of dollars of loans in often shaky plants, and used for speculative purposes in the stock and property markets. It is capitalism at its shoddiest, and while some have become obscenely rich and millions more have been pulled into a more middle-class life, the vast majority still wallow in poverty. The banking sector is trying to clamp down through restrictive lending practices and higher interest rates, but with a surging stock market, speculative activity is becoming rampant. We of course do not know when it will end. We only know from experience that when it does end, it will be in a horrendous crash.
A crash will be politically unacceptable to the still dominant Communist party that still lives in a fantasy world as regards the capitalist reality. So they have rampant monetary growth and rampant speculation side by side. A disaster waiting to happen. And remember as well the billions that have been poured into the Chinese markets by Western companies, hedge funds and even private equity funds. A collapse in China would have global consequences. By comparison, the threat of a similar occurrence in India also exists, but is considerably less likely than in China.
Huge chunks of American manufacturing have gone overseas to China and other Asian economies. Over on CNN, Lou Dobbs' habitual dissertations on the "attack on the middle class" cite this jobs migration. In effect, over three million higher-paying manufacturing jobs lost in America over the past seven years have been replaced by low-paying jobs. Many workers are forced to hold two or three jobs to even come close to their old pay scale. As wages have stagnated for the majority a small group has become obscenely rich (think of the pay severance packet for Robert Nardelli of Home Depot who was paid to $210 million to leave; and also think of the $24.5 billion in bonuses paid on Wall Street in 2007, a package the size of the GDP of many countries) and a larger group of professionals and managers have done very well as a result of the boom of the past several years.
The boom in the US over the past several years has (just like the global picture) benefited a few hugely and another layer below considerably. Below that, and for the vast majority, the "good years" have seen their wages stagnate and their living standards lowered, even as they are able to afford the latest in Chinese-made gadgets.
There is growing political pressure to do something about the huge trade deficit ($800 billion per year and growing) - and the deficit with China in particular. Despite the benefit to the platform companies that have hugely profited from this arrangement (platform companies are multinationals which carry out manufacture in low-wage countries and the high-wage finance, design and marketing in the USA), the impact on actual employment is low. Labour-intensive manufacturing employment is ensconced in low-wage countries, while the high-end jobs that employ far fewer are in the USA or Canada.
Those displaced are forced to scramble and to take what they can get. It is now even impacting employment at the service end of the computer industry, as jobs are shipped to India for example. There, $20,000 annually is a fine salary, whereas here the same job would pay well over $60,000.
Naturally, the solutions are just as bad as the displacement of thousands of workers to lower-paying jobs. It would set in motion trade wars, where no one really wins. Recall that the trade wars in the 1930s, brought on by Smoot-Hawley, and triggered the worst of the Great Depression. Still the threat is there. While the Chinese view the Republicans as being hawks on the military front, they view the now Democratic-controlled congress as a potential threat on the financial and trade front that could gravely upset current arrangements (Stratfor - China's concerns in 2007: Fears of the perfect storm - Rodger Baker). Recall as well that the Chinese now hold over $800 billion of US bonds and Treasury bills. It is an arrangement: China is the US's manufacturing base, and in turn China buys US securities to finance their trade and war deficits.
But that could change. While China has adopted a generally laisez faire attitude towards the US's misadventures in Iraq, they would not be so sanguine if the US became involved in Iran. As well continually lurking in the background is the Taiwan/China problem, where the US keeps Taiwan's independence ambitions contained while China stays off the Taiwanese file as long as Taiwan does not declare independence. As well there has been growing rhetoric between the US and China over the growing militarization of China and now its ability to take out satellites in space.
But setting aside Taiwan, the real other risk sitting in the background waiting to explode is Iran. Despite all the usual denials, all the signs point towards a conflict by the US against Iran.
Recall that Iran now accepts only euros for oil and gas and is actively encouraging others to follow. On March 21, 2007 Iran will no longer officially accept US dollars for any transactions. Iran has entered into discussions with Russia to form a gas cartel. Russia and Iran are the world's number 1 and number 5 gas producers, and they are numbers 1 and 2 in natural gas reserves (holding possibly half of the world's natural gas reserves). The currency moves threaten the US dollar's position as the world's reserve currency, and a cartel would be anathema to US interests in the region.
Consider that there has been a heavy build-up of nuclear aircraft carriers off of the coast of Iran. There has been a large build-up of US troops and warships in Dubai in order to protect the Straits of Hormuz. There has been considerable unrest in the Iranian Kurdish zone, the Iranian Azerbaijani zone, and as well with the tribes along the Pakistan/Afghanistan border. The US and Britain have been arming all of these groups (Eric Margolis - Count-Down to War with Iran? February 5, 2007). The US has been arresting Iranian officials in Iraq and blaming Iran for numerous ills against the US in Iraq. The Iranians have been conducting elevated military exercises and there has been a speeding-up of armaments from Russia to Iran. The Iranians have a natural interest in the goings on in the region and remain close to many of the Shiite leaders in Iraq. Naturally, Iran's interests and influence in Iraq comes into direct conflict with the interests of the US.
An explosion in the Mid East would be a shock to the markets, as the markets do not appear to be taking the possibility into account. The markets wavered slightly on February 22 when Iran failed to meet UN deadlines to suspend uranium enrichment. Naturally, oil and gold prices jumped. Granted, we are nowhere near an actual conflict and we suppose there is a chance it may not happen, but the build-up and the sharply rising rhetoric from the US (coupled with heightened denials) are saying that something is going to happen. All it needs is a spark.
When it happens, what will be the response of Russia and China? They have billions of dollars of interests in Iran and will not idly stand by, faced with the risk of the world's fourth-largest oil producer also falling into the US sphere. That is clearly against China and Russia's interests particularly China with their huge energy needs.
A US housing market in sharp decline; rampant speculation in a bubble-like mania in China; growing clouds of war over Iran. These are the elements of the gathering "perfect storm".