Autumn Melt-Down

De-leveraging the System

"The Federal Reserve deliberately leverages the system -- every cycle seems to get more brazen and dangerous. Fed pump-and-dump operations resemble those of a boiler room penny stock operation -- cram a bunch of leverage (excess credit in the Fed's case) into financial markets, entice investors into excessive long positions in the targeted market (penny stocks for boiler rooms, bonds and equities for those who follow the Fed), push the bubble as far as it can go -- then watch from a distance (and deny responsibility) when inevitably, it all goes up in smoke.

The Fed seems to do one of these pump-and-dump operations about every four years. The last was the 2003 51/2% FED Funds drop to 45 year lows of 1%. Previously was the 1999 Y2K credit expansion, which inflated the early 2000 Nasdaq bubble and led to the subsequent crash. The major one before that was the 1992-93 credit expansion, which culminated in the 1994 global bond market debacle. The process of leveraging up the system sends out a signal -- go forth and speculate. Buy stocks, bonds and houses, build buildings, leverage up your holdings. Take no thought for tomorrow. We are in a NEW PARADIGM. Swing for the fences. At some point, the leveraged Ponzi scheme collapses -- either as a result of a Fed tightening -- or it simply topples from its own dead weight of poor ill advised investments (malinvestments). Investment Balloons like trees can't grow to the sky.

Both the Bond and stock Markets, the Real Estate and Commodity markets as well as the Economy are approaching that point. Even though long term interest have fallen and have only recently started to turn around since the FED started tightening over a year ago, it will indubitably be too much Fed tightening that once again upsets the apple cart. There used to be a rule "three steps up and a stumble" well we just had our 10th rate increase and there is increasing evidence of the beginning of involuntary de-leveraging. (The reason that its taking more than three steps before the stumble is because up until this week we were in negative interest rate territory) Remember Money created out of thin air is not Real Capital. When a loan made out of thin air money is repaid it does not go back to the original saver, it just disappears ( gets wiped off the books) and the money supply shrinks.

  • Money supply growth has begun to slow
  • Banks are beginning to liquidate Treasuries. The Fed has pumped banks full of Treasuries with its low interest rate policy -- and now it is dump time. The model forecast sees an ongoing liquidation of Treasuries by banks.
  • Commercial lending has been going nowhere fast. The model sees no recovery in bank commercial lending.
  • A slowdown in real estate lending. So far it is just the first signs of a slowdown but common sense sees a much bigger real estate lending slowdown ahead. The sub prime lenders should get hit first.
  • We are now witnessing the first significant decrease in refinancing
  • All this involuntary de-leveraging process should feed through into weaker corporate results and economic statistics. Once the present seasonally strong period for earnings and the economy is over, WATCH OUT BELOW. Just look at the weakness in the Banking stocks which it is now spreading to the rest of the financial sector (GE etc.) and especially the sub-prime sector.

So the process of leveraging up the system has run its course and the involuntary de-leveraging is underway but de-leveragings are not low-volatility events -- financial market dislocation is likely to begin sometime in the third quarter or certainly no later than the first quarter of 2006. Ii is likely. that the Manipulated Earnings reporting season is keeping a bid under stocks for now, but the news should be mostly downhill from here. Reported S&P500 earnings growth is at a 50 year highs-- But Comparisons should be much harder from here on in… the profit cycle is probably topping. Overvaluation is still a huge issue -- the S&P500 P/E ratio is still 1.5 to 2 standard deviations above its long term average. That may seem cheap (down from 4 standard deviations in 2000), but the bubble era warped the concept of value. John Templeton says to "buy at a point of maximum pessimism and sell at a point of maximum optimism". For the current cycle -- We are definitely at or near an all time highs in Optimism. That's certainly a lot to stew over. But the big point is that the monetary system itself is now contracting liquidity -- right at the point when the majority feels the liquidity bubble can go on indefinitely. This is how a liquidity bubble collapses under its own weight. I'm afraid that I foresee a "market dislocation" in the third quarter, which as you all know goes along with some of the things that I've been writing about lately. When majority opinion is so well-entrenched on one side, there is not room for everybody to exit gracefully.

Be wary of that Old Wall Street Adage "DON"T FIGHT THE FED" -- Watch what is really happening, not what they are saying.


Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL


14 August 2005

A one-ounce gold nugget is rarer than a five-carat diamond.

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