Market Fatigue ("This Time It’s the Same")

Here it is, Sunday evening. The Asian markets are opening down.

I don’t know about you, but I am already tired of the events of last week. They don’t appear to be ending anytime soon, despite the attempts at reassurance by various people in positions of authority. And no, I didn’t take a beating.

It’s just that it was obvious to know what to think a couple of weeks ago. Risky assets in every market one could conceive of were trading at almost no premium to tame ones. US consumers had been spending more than they earned for two consecutive years. Money supply growth in the US and other major OECD countries has been running well in excess of population and GDP growth. Even though corporate earnings in the US appear to be high, earnings quality is poor and a considerable portion comes from cost cutting and defacto disinvestment. Central bankers have admitted they do not fully comprehend the brave new world of finance, with its proliferation of risk transfer techniques and leverage on leverage. The US housing recovery appears tenuous. The carry trade had sucked up so much capital that it was badly distorting the price of the yen.

I could go on, but you get it. It was easy to see that there was a big disconnect between the widespread complacency and what was actually happening. It was easy to see that things had to change.

But now that that investors have been shocked awake, it’s hard to see what the trajectory will be. There has been a good bit of brave talk, “the only thing we have to fear is fear itself” sort. We have Alan Abelson’s view (courtesy Barry Ritholtz’s Big Picture):

Nothing better illustrates how vivid an impression Tuesday made on ordinary Janes and Joes than the marked change in their sentiment as registered by the American Association of Individual Investors: to 39.6% bearish and 36.6% bullish, from 53.9% bullish and 22.3% bearish the previous week.

By contrast, the Wall Street seers remain stoutly upbeat. The conventional view (wisdom is too fine a word for it) among strategists of various shapes, sizes and dispositions is that the market was obviously overheated and primed for a shakeout.

They didn’t bother to offer it, but the implicit excuse for not sounding the tocsin before the big break was they were too busy crooning on about Goldilocks, the global savings glut and the sea of liquidity as guarantors of the Dow climbing to (insert here the wild number that makes you happy). In any case, no need to fret….

The almost universal conviction is that Tuesday’s plunge was not the start of a full-fledged bear market. Even the savviest sage we know, who has been unequivocally skeptical for a spell now, thinks the odds are against it being the start of a bear market. He reckons there’s one more big move up likely and, after that, perhaps a few month hence, stock prices will begin their journey to the nether depths.

Perhaps. But we wonder. That virtually everyone agrees that Tuesday wasn’t the start of a bear market strikes us as more than reason enough to suspect it just might be.

Oddly, while Abelson’s reading is consistent with the tone in the business media, it conflicts with other surveys. Another poll, courtesy hedge fund newsletter Opalesque) of hedge fund managers, is much more bearish (admittedly it goes out only over the next month):

Greenwich Alternative Investments, LLC released today its market sentiment indicators for U.S. equities, the U.S. Dollar and the U.S. Treasury 10-year Note.

The majority of the managers continue to remain bearish on the S&P 500, as 62% expect U.S. equities to end March lower vs. 23% higher and 15% unchanged. February proved to be a difficult month for the U.S. Dollar, and 70% of the managers expect the Dollar to continue moving lower vs. 15% unchanged and 15% higher. Finally, the dramatic run up in the U.S. 10-year Note has left the group with a divided outlook for March, as 46% anticipate 10-year prices will advance, 31% remain unchanged and 23% move lower.

The Greenwich Alternative Investments Macro Sentiment Indicators are based on the outlook of hedge fund managers employing a macro view and who manage, in aggregate, in excess of $30 billion in assets. The purpose of the indicators is to reveal how these managers believe the S&P 500, the U.S. Dollar and the U.S. Treasury 10-year Note will perform over the current month.

So, in contrast to the Barron’s picture, this isn’t a simple “retail is panicked, the smart money is staying in” story. Some of the pros (and if you believe the hedge fund mythology, the smartest of the pros) are pessimistic too.

A lot of the factoids that make the case that the markets will recover fairly soon are comparisons to past downturns. Note that most of this is technical analysis, the financial world’s version of astrology. And notice how it is invoked more widely at times like now, when markets are jittery than otherwise, in much the same way that psychics are more popular when times are bad.

Of course, in the long run, the markets will almost assuredly recover. But the arguments we are hearing for recovery sooner rather than later are all variants of “this time will be the same.”

It’s funny how many times we’ve heard “this time is different” when bull markets get toppy. Being contrarian by temperament, we are also skeptical of “this time will be the same.”

So how is this time different in ways that might affect how things play out?

1. The Fed has little wriggle room. Investors have gotten used to the “Greenspan put,” but with all the money supply growth of recent years, which has helped fuel the housing bubble and the excess liquidity that has in part gone into risky assets, it doesn’t appear Bernanke can apply much stimulus. Although the last batch of unemployment numbers weren’t pretty, the Fed is worried about overheating. But that concern may have been a cover that would be acceptable to a Democratically-controlled Congress when the real issue may be “we can’t take the dollar down any further.” Our continuing to enjoy the right of seigniorage, which permits us the luxury of issuing debt in our own currency, is that we can’t trash the dollar.

In our humble opinion, the economy is in danger of tipping into stagflation.

2. There may be systemic risk. There has been a lot of hand wringing about hedge funds and the leverage they use. However, the real issue isn’t whether a hedge fund, or two, or twenty, collapses. It’s whether they damage important financial players. And note that many (most?) of the big financial firms, meaning the investment banks, have large proprietary trading desks, and are large market makers. There are at least two areas of the global markets looking seriously dodgy right now: the yen carry trade (which is unwinding even more as of this a.m. in Japan) and the CDO market, in which the investment banks made rich fees in packaging CDOs, but often retained a piece of the most speculative part of the deal. Bloomberg reported last Friday evening that the CDO-linked bonds of major Wall Street firms like Goldman, Merrill, Bear Stearns, and Morgan Stanley, were trading at junk levels, a dramatic decline in a short period of time. Now that may be an overreaction. But it also might not be.

The way one of these firms might be hurt is by an unwitting double (or triple) exposure to the same risk. Consider CDOs. If the investment bank bonds mentioned above are now correctly priced, it says these firms have already taken big losses. Now imagine hedge funds that have big CDO exposures going under. Goldman, Morgan Stanley, and Bear Stearns are the three largest prime brokers by a considerable margin. They might take further writeoffs if their clients couldn’t make margin calls. And if there were rumors that any Wall Street firm had taken really large CDO or prime brokerage losses, you could imagine a flight to quality across all credit markets, which would leave the large investment banks with further losses (I don’t care what anyone says about hedging positions. If you are a market maker, it is well nigh impossible not to be net long on your trading desks).

Now again, I am not saying any of these firms would go under. Quite the contrary. But the specter of any major Wall Street institution taking a large hit would produce distress in the markets, perhaps even short-lived panic.

3. The fundamentals don’t look good. Prevailing P/E ratios of close to 20 with long bond rates near 5% (these were pre-correction levels) says you believe robust growth is ahead. Query where that could possibly have come from. As we have harped on before, consumers are overextended, corporate profits aren’t what they appear to be either. Whether the economy does reasonably well in 2007 depends more than it ought to on housing (particularly now, it could either feed on the concerns created by the market or counter them). But the prospects aren’t encouraging, as Nouriel Roubini report in his post, “Summary: Hard Landing Recession Ahead:”

# New home sales collapsed 16.6% in January. On the heels of a 14.4% fall in housing starts in January it is clear that the housing recession is worsening.
# Cancellation rates – as reported by major home builders – are now in the 30 to 40% range
# The stock of new and existing unsold homes is still rising in absolute and relative terms; so the glut of empty housing is increasing.
# Home prices fell in December according to the S&P/Case-Shiller Index; and home prices are unchanged on a year over year basis. The OFHEO price index – out this week – showed still some price appreciation in Q4 relative to Q3 (1.1%). But even that index shows that the rate of price increase deceleration has been massive in 2006. And even the NAR data on home prices show a price fall in 2006 and in the last month.
# Construction spending fell more than expected in January (-0.8%). More importantly, not only was residential spending down, but non-residential construction was flat (0% change) in January. That is consistent with Q4 GDP figures showing falling real non residential investment.

The only good news is if things are as bad as Roubini says, maybe the Fed will believe it’s safe to lower interest rates. Oh, but I forgot. We still have that problem of not being able to trash the dollar….

This adds up to a rougher ride for a longer time than anyone wants to believe. Let’s hope I’m wrong on this one.

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