The Bear is Back
(An Edition In The Twin Peaks Series)
Sarel Oberholster
At dusk on Friday evenings the black ops teams of the FDIC, the Fed and Treasury descend upon the limping weak, the sick, lame and lazy squad in the banking sector and weed out those already convulsing in the final throes of death, ready to pass on to banking heaven (or is that banking hell). They put them out of their misery, right? No. They feed the dying toxic bank to another and the poison spreads as the half ill consume the rotten like road kill in a quest to keep up pretence of health.
Monetary policies of bad debt generation implemented over the long term have devastated the banking sector and the economy. Excess liquidity creation, ever growing exponentially, compounding and rolling boom bust cycles morphed into an epic global economic debt crises. A structural economic aberration was confirmed in absolute terms when that nonsensical extreme of zero bound interest rates were achieved in all the major global economies.
A super charged bad debt generating system had been created causing massive economic friction and heat. Then it seized up in the first of two crises events. The first was debt saturation for the private sector. The banks could not find sufficient new distribution avenues to maintain the debt creation bubble. Every willing and able debtor had been fed debt until they choked on affordability or over trading. Asset inflations collapsed, collateral values evaporated and nonperforming debt overwhelmed the debt creating and distribution machinery. The modern economies got its first taste of a global debt crises and it faltered.
That set the stage for the second crises event. Governments and central banks stepped in to alleviate the debt crises and to stimulate a global economy in cardiac arrest. An adrenaline shot of government debt with the help of unlimited central bank liquidity was administered directly to the heart of the economy. The 2008/2009 response was even more than that, a triple dose of adrenaline and steroids with a stimulatory propaganda shock or two. The dose was so potent that the economic patient jumped off the operating table and ran the 100 meters in under 9 seconds.
Unfortunately governments must pay for their economic medi-care in either deficits or taxes initially; but eventually tax they must. Thus monetary and fiscal policies evolve into economic policies of Marshall Law, direct interventions and dictatorial regulation. Governments absorbed the debt damage into fiscal policies of extreme deficit creation and central banks cooperated with direct and indirect policies of quantitative easing, commonly known as counterfeiting money. Liquidity was pumped into stock exchanges by opening liquidity channels between investment banks and the central bank. Just as private debt formation hit a wall at debt saturation so must government debt also reach saturation. It usually involves a political process or event. The Greek government encountered a funding revolt, Dubai renegotiated debt repayment, the UK ruling party faces potential defeat at the polls; and a voter revolt in Massachusetts sent a warning to the USA government. Old trouble became the new out of favour as Portugal and Spain joined the queue.
Suddenly the big picture changes. Stimulations which previously flowed freely are now off the table and may even be reversed. Governments find themselves cornered with massive debt to fund, falling tax revenues and taxpayer anger. The bull case which is highly reliant upon endless stimulations now lacks a driving force. All the stimulus bling is on display in the current reporting season but where will the next bling come from? The stimulus cupboard is the future. Drag enough of the future into today and it's a party but tomorrow is the hangover.
Government jealously eyes the liquidity channel to the stock exchanges and starts formulating plans to redirect the liquidity flow into government bonds. It spawns policies to close the liquidity channel between banks and the stock exchange such as a ban on proprietary trading by banks. Historically these policies eventually evolved into direct interventionist regulation such as prescribed ratios of investments into bonds and stocks for financial institutions. Another favourite is to require higher holdings of government bonds or securities at banks. All in the national interest and in the interest of protecting savers from undue risk in volatile stock exchange investments or risky banks. These processes and the political events herald in the second crises, Government debt saturation.
Budget deficits can be colour coded. Governments running up deficits to 3% of GDP are still in control and would warrant a code green. Cross over the 3% of GDP and it becomes code orange. Cross the 6% of GDP barrier and a government enters the high risk area usually associated with reckless fiscal policy. The 10% of GDP level and beyond is the political instability level where the risk of an out of control spiral of state debt will overwhelm any pretence of stimulating an economy. This effect is not just limited to the debt levels, it also goes to state presence in the economy; reliance on the state for economic survival; state demand on available savings starve the private sector and with low interest rates bring all debt into the short term. Available funding for long term investment is extremely limited. Banks are further driven to risk by pooling short funds for long lending with severe interest rate risk to the upside irrespective if such rate was fixed or variable. A fixed rate will hurt the bank directly while a variable rate will hurt the long term borrower and expose the bank to the risk of default.
At this stage another fork in the road presents. Governments have the opportunity to repent and attend to the economic structural distortions. Recent history shows that there is a clear preference for "extend and pretend" policies rather than for "repent and attend". We are fortunate to have the example of the Japanese government's extend and pretend policies to give us an idea of the likely outcome of these policies.
The repent and attend policies would see governments implement policies of free markets in the traditions of Austrian economics. Perhaps we may be surprised by governments moving away from Keynes to Mises but then again we will be equally surprised to find the sun rising in the west. I would therefore guess that we are stuck with the example of Japan and a very historical example of the events after 1929.
That is the thesis for the Twin Peaks essays in which I compare the 1989 peak in the Nikkei with the more recent 2007 peak in the Dow. The ratios are established at the peaks and no adjustments for trading days or rebalancing of the ratios are allowed thereafter. Hence the charts will meander wherever the market takes them.
The March 2009 market rebound produced significant divergence and a growing gap between the evolving Dow and the historical Nikkei until mid January 2010. The up trend reversed in dramatic fashion after 19 January 2010. The gap between the Dow and history is a chasm even though convergence is presently strong.
This is the big picture. Let's zoom in for the near future, also adding the 1929 top and trend to complete the view.
The burning question on everyone's lips is how this will trend for the medium to longer term. Does one buy the dips or sell the peaks? The modern example of Japan and the historical example of 1929 Dow are still compelling given the high probability of similar government responses very much steeped in Keynesian traditions. A meeting of the Dow with history indicates a Dow interim drop into a Dow 5000 range. Time will tell.
I have unveiled a momentum indicator in the January 2010 Twin Peaks essay (Twin Peaks - Jumping in Mud) and explained that this indicator tends to confirm a significant trend change when momentum changes direction and achieves a level of 1.5% or more in the opposite direction. I am using closing data. The second half of January 2010 saw the acceleration of negative momentum which showed up for the first time since the start of the March 2009 rally on the 3rd of November 2009. The trend towards negative momentum has been building since. The Dow momentum indicator reached negative 1.6% in a decisive move today, 4th February 2010, emphasising a high risk of a significant negative trend for term. It is a watershed for a confirmed bear trend. Thus the bear is now dominant until the bulls can retake the initiative and reverse momentum back to a 1.5% positive reading.
Momentum is the difference between the June/July 2009 correction and continuing bull trend and the present downward move. The momentum reading on 10th July 2009 was a whopping positive 8.5% which not only stopped the correction in its tracks but followed through with the bullish rebound. Momentum thereafter faded and flattened out around November 2009, oscillating between positive and negative for two and a half months though the negative bias was building. The 1.5% negative reading is the line in the sand. The bulls must now prove their case by taking back the 1.5% positive.
In fact, bulls have been unable to claim positive 1.5% since 28th September 2009. With government support clearly on the side of the bulls it may take time for the bear momentum to build but the onus of proof has shifted and is no longer pinned on the bears. I would expect the bulls to plead for another sugar spike should the bear momentum accelerate. Perhaps by calling spending, "Investing", they can slip some sugar past bone weary taxpayers but will it be sufficient to swing a 1.5% positive momentum? A holding pattern would not suffice. A stimulus injection of substance will be required as the previous stimulations are decaying fast and are celebrated in the numbers currently being reported. Repeats will require a repeat stimulus effort preferably greater than the previous one. The fact that interest rates are at zero is another obstacle, no further interest rate cuts are forthcoming to help with the lifting.
Professionals may also want to consider shorts on a "Sit and sold" strategy. Just imagine the "investor" who may have invested in a sit and sold strategy on the Nikkei over the past 20 years and don't forget to throw in the positive carry, compounding for 20 years. Where may the brave investor be who shorted the Nikkei in January 1990 and held onto it into the March 2009 bottom, surely that must be the holding pattern Midas trade of the past two decades. Compare that trade against a buy and hold strategy of the Dow over the same period for an emotional response.
Whichever way you're leaning, ponder government policies which purport to solve a debt crises with acceleration of debt policies; address bursting asset bubbles with reflating asset bubbles policies; promote government spending to replace private spending; engage in government spending without the equivalent collection of taxes; and encouraging government sponsored central bank counterfeiting with zero interest rates as a substitute for savings. Contemplate perpetual government debt rolling from one generation to the next trapped in an out of control multi generational debt spiral; warehouses stuffed with commodities and oil tankers not moving oil but converted to floating warehouses all funded with zero interest cost counterfeit money; banks rolling and refinancing massive quantities of real estate debt in the absence of adequate collateral and debtor ability to repay; government sponsored entities in a quasi nationalisation of residential mortgage finance with implied large scale government retail real estate ownership as a result of defaulting residential mortgage debt; all that while central bank liquidity is pumped into speculation; and pension savings are driven into risk taking strategies in a desperate search for income and yield.
Structural economic distortions inevitably resolve in crisis for not even modern governments can sustain these imbalances indefinitely. Economic distortions taken to the extreme and the absolute, such as zero interest rates, debt saturation, central bank acquisition of private debt assets of dubious quality (surreal) and money printing to fund government debt must resolve in economic calamity. A 20 year low level depression with a government consuming the total savings base of the population without solving any of the economic structural stress is an economic nightmare not only for Japan but for all in an integrated global economy.
Soon governments will be forced to each pick the method by which it will clean their respective houses, or not. Will it be hard choices today or even tougher choices 20 years down the road to Japan? The same dynamics applied two years ago but without the mountain of additional government debt. Perhaps some will favour a choice to ignore all warning signs yet again and push an economy beyond the brink with counterfeit money into a hyperinflationary depression. The time to arrange massive "stimulations" to be introduced in concert into the global economy has passed. Each sovereign state will now have to turn its attention inward towards dealing with its own structural distortions.
Can the bulls step up to the plate to provide the momentum to turn the tide back in their favour with governments constrained by debt saturation and political instability? The bears are all but extinct at this stage and are not the drivers of the move down (little use to set bear traps) but the longer the bulls fail to prove their case the stronger the bear will get. What exactly is the bull case without government and central bank interventions?
Take a hard look at the macro economic picture and make up your own mind whether it is dusk or dawn?
Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
4 February 2010
© Sarel Oberholster
Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com .
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