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John Riley: If you liked Act 1, just wait until Act 2! (pdf)
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This Link is located in the Public Channel Housing Bubble and Bear Links.
Posted by ian 255 days ago (cornerstoneri.com). Views: 1,710
Tags: credit crisis economy banks |
| Related Tags: economics stock market housing bubble recession bailout gold wall street |
Here's the full text for those who hate pdf (see the pdf or here for numerous excellent charts):
"If you liked Act 1, just wait until Act 2!"
John Riley
Chief Strategist
Cornerstone Investment Services
We’ve broken down our view of the markets and economy into several acts, like a play. Act 1 is full of surprises and designed to bring the audience into the play quickly. Act 2 is where the meat of the play is. It explains the story and sets up the resolution in Act 3.
Act 1
With the passing of the Bailout Bill by Congress and the subsequent global market sell-off, Act 1 appears to be coming to a close. Did it get your attention? Because if you liked Act 1, you are going to love Act 2.
Act 1 was characterized by the realization of the excesses of the previous 13 years. The country was drunk on debt and derivatives which had gotten out of control. And the regulatory authority that was supposed to control such excesses was instead pouring the drinks. Instead of putting a stop to derivatives and debt growth, the Federal Reserve encouraged both by keeping interest rates low, money supply growing and blocking regulation on derivatives.
The housing collapse, market crash and derivative mess were all subjects of reports by Cornerstone for years, (See Cornerstone Commentaries) yet in interview after interview, “The Maestro,” Alan Greenspan denied there were bubbles about to burst. If you want to blame anyone for today’s financial mess, blame Mr. Greenspan’s policies.
More of the same
The Fed’s response to the financial crisis has been more of the hair of the dog that bit ya. Virtually everything the Fed is doing is increasing debt, not decreasing it. It seems that the Fed’s theory is to keep the drunk drinking to avoid the inevitable hangover. As we have said many times, the longer you put it off, the worse the hangover will be. And we are due for a whopper, thanks to the bartender, I mean the Fed’s irresponsible actions.
Act 2
Like it or not, and there is no way around it, years and years of financial excesses have no choice but to result in a reversal of those excesses. The height of the excesses gives an idea on the depth of the aftermath. Its going to be bad. Act 2 will be characterized by rising inflation and a widening of the financial crisis. We do not expect a “V” bottom. The economy won’t rebound sharply from the lows. The market will probably mirror the Japanese market from 1989 through… Don’t expect the market to have a sharp recovery and then everything will be alright. The market will likely have rallies followed by lower lows.
Corporate and Municipal bond defaults could cause the credit squeeze to continue. Long term interest rates will probably reverse and start a new bear market in bonds. Housing will be caught in a vortex of rising unemployment, rising interest rates and declining prices.
Rising inflation (Hyper-inflation?)
Today’s actions by the Fed are inflationary. Pumping the system with liquidity normally results in higher inflation and a lower currency. Today’s low oil and Gold prices will be a distant memory as inflation heats up. The danger of the Fed’s actions is that it may result in hyper-inflation. How bad can hyper-inflation get? Zimbabwe is currently experiencing one million percent inflation. While that would be nice for those on Social Security getting COLA’s, it won’t be good for our economy! (I don’t’ really expect that type of hyper-inflation here.)
Dollar collapse
The Fed’s actions have deteriorated the quality of the assets at the Fed and by running the printing presses full tilt, they have diluted the value of the Dollar. Although other currencies are also in tough shape, (Euro), the damage that the Fed has done puts the US Dollar at risk of a collapse. Currencies trade on intrinsic value and intangibles. At this point, the Dollar’s strength is coming from the intangible of being a safe haven. But as the panic part of this crisis subsides, we believe the intrinsic value of the Dollar will be exposed as lacking and the decline will resume.
Major Bank Failure
It is pretty much a pick’em. Any one of the “Big Three” could be “the” failure. Their irresponsible continuous growth of derivatives and the purchases of failed financial institutions could be their undoing.
We expect the Fed’s response would be the nationalization of the failed bank. (They have a mortgage company and an insurance company, why not a bank too?!)
Banking Holiday
In conjunction with a major bank failure, a banking holiday is possible. This would probably include the closing of most banks and stock markets. Like the last time a banking holiday was called, the Fed would have to send out teams of auditors to check the viability of banks before they are allowed to re-open. It would be a slow process with a consolidation of banks as the Fed facilitated the combination of weaker and stronger banks.
How long would it last? For some banks it might take months to re-open, for others it might be a matter of days. The markets would stay closed for as long as it took to settle investors’ nerves and be able to insure that the reopening would be orderly. A week, a few weeks? Unknown.
Our estimate of the probability of this happening - 50/50.
Failure of Electronic Banking
The failure of a major bank could cause the electronic bank systems to fail leaving people without ATMs and retailers without credit card services. Our personal experience with the failure of RISDIC (state bank insurance in RI) gives us a unique perspective on what a failed banking system looks like. It wouldn’t necessarily be a national outage. It might be regional or limited to certain banking systems and not others.
Crisis Spreads
The financial crisis will likely spread to other industries outside of the financial industry. Candidates for trouble immediately are the autos. Ford and GM are being locked out of the credit markets. Things weren’t very good for the autos anyway, and higher interest rates and a slower economy won’t help.
Small businesses could be hit hard. Many small businesses have lines of credit with their local bank which are renewed annually. This year may see a freeze in credit. The expected renewal of the line might be denied or the line of credit lowered. This could force many small businesses to pay down their debt with the bank at a time when the economy is slowing, making it harder for them to come up with the cash.
Retailers are probably going to be hit hard as the economy contracts. Store closures will only make things worse as they add to the growing unemployment problem.
Industries that rely on debt to finance their growth will be stifled. Companies like GE, Ford Motor Credit and Citigroup are already finding the commercial paper market difficult.
Municipalities around the country are facing growing deficits and with rising interest rates, they will have a tough time borrowing to make up the difference. This puts pressure on municipal services, which will be reduced and taxes will have to be increased. (A good article to see how your state stacks up is in BusinessWeek, titled “States That Can’t Pay For Themselves.”)
No housing recovery
Although inflation drives asset prices higher, it won’t help housing as the supply of houses for sale will continue to hold the market down. Rising unemployment could force delinquencies and foreclosures even higher resulting in even more supply to hit the market. With rising long term interest rates, few will see the advantage of buying a house in this environment.
Strategy
We expect Act 2 to look much like Japan since 1989 and the US during the 1970’s. The market will probably drop and stay down, other than a series of failed rallies. The economy will probably go through a series of bouts with inflation as the Fed desperately tries to keep liquidity
The duration could be years. Years and years. It all depends on how bad things get. It depends on how much the Fed intervenes. The more they interfere, the longer it will last.
We are in the “Let it all fall apart and start over again.” camp. The Fed is in the “Put it off as far as we can” camp. Knowing this gives us some insight into what strategy will work. Like the paradigm shift in investment strategies that occurred early 2000 (what we recognized and Wall Street didn’t) another paradigm shift is happening.
This period will require much more of a nimble approach. Buy and hold is completely dead and indexers will suffer as will those married to Modern Portfolio Theory and US Stocks and bonds.
Investment performance will benefit most from market hedges, gold and hard assets (oil, Ag). If I were to have a gun against my head, I’d say the asset allocation for this period would be 20% market hedges, 20% gold and 20% hard assets. But even these allocations would be cut to zero at certain points in the cycle, and then filled back up again. The rest in cash, ready to trade investments (Stocks, bonds, ETFs) as the opportunities present themselves. At some point, the Fed’s interference will finally fail and they will stop injecting liquidity into the system. This will bring on the final act, Act 3.
Act 3
Deflation is the final act. As the economy falters through inflation and the Fed becomes less and less relevant, the final collapse of the economy will be with a deflationary thud.
We are not painting a pretty scenario. We warned investors about derivatives and debt for years going into Act 1 and not enough people listened.
Our analysis of Act 2 and Act 3 will become clearer as we continue from here. Are there things that could change our vision? Of course. There is always the unknown. But the unknown will probably not be on the upside.
Hiding in cash or CDs in the bank won’t protect investors from the ravages of inflation. Investors will need an advisor that understand just how bad the next act will be and has an understanding of how to negotiate around the problems and to benefit from the negatives.
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So True ...
Well, guess this article nailed it! Grim but true even though some of the "reality" - guys out there put the deflation scenario before
the ticking inflationary bomb ...!
Would love some more thoughts on Act 3 but all in all good!
Thanks,
Nick
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