Shock & Awe!

By Todd Harrison  SEP 24, 2008 7:10 AM

Now that the system is broken, what do we do?

 


“You’re gonna need a bigger boat.”
--Police Chief Brody, Jaws

Sir Isaac Newton offered that for every action, there is an equal and opposite reaction. His laws were clearly created before the advent of derivatives.

The free market system officially broke last week and the ramifications are profound. A new world order is upon us, one that will forever change the construct of capitalism.

We often say that to appreciate where we are, we must understand how we got here. That isn’t a quick conversation or a sound bite; it’s an educational evolution we must all take responsibility for.

That is why we provided a contextual backdrop last week and it’s precisely the reason we created Minyanville.

Discussing the fragility of the financial fabric is a moot point. While the blame game percolates in political circles, the rest of us are left to stress through the mess.

There will be massive opportunities on the other side of this ride. Our goal is to persevere this process of price discovery and be in a position to prosper when the eventual recovery arrives.

As many issues vie for our collective mindshare, we’ll break them down into five things you need to know about our current state of affairs.

Will The Government Bailout Work?

We’ve long offered that the only true solution for what ails the market is debt destruction and opined that this dynamic would come to a head in September when corporate credit came due.

While that ultimate destination is unavoidable, the path we take to get there remains an open question. There are two alternative scenarios, neither of which is particularly pleasant to ponder.

The first is credit cancer that eats its way through various sectors until the body rids itself of disease. This has been in play for years and has spread from homebuilders to banks to technology, retail and other industry segments within our finance-based economy.

The other is a car crash that causes credit to freeze as capital markets seize, price discovery permeates and social mood shifts as the magnitude and consequences of the new world order manifests throughout the financial and societal structure.

The critical diagnosis was evident for years but few policy makers paid attention until after the patient was rushed into the emergency room.

After administering ad hoc drugs with hopes of masking the disease, the government is now attempting to buy the cancer and sell the car crash. If they didn’t implement a comprehensive overhaul, global equity markets—tied together with $500 trillion of derivatives— would have experienced a cataclysmic crash.

That outcome remains within the probability spectrum—they may have been too late—but the likelihood has been reduced, albeit not without profound cost. Government officials are attempting to buy time, snuff out the fuse and stem contagion that has spread like the plague to every corner of the earth.

Price discovery is a process rather than a point and a multitude of factors will affect the ultimate outcome. While we can debate the merits of the proposed plan, we must remember that it introduces the possibility of regulated containment that didn’t otherwise exist.

Before the patient can recover, he must be stabilized. The government initiatives will introduce a plethora of unintended consequences—there are no quick fixes or magic pills—but the best hope, at this stage, is to stop the bleeding before attempting to cure the cancer.

Martial Law for the Markets

Last Friday, the U.S government waved the white flag and surrendered the capital market process when it banned short sales in the financials.

It was a profoundly sad day for the free market system. I felt as if I lost a close friend of seventeen years that I was intimately involved with.

Over the weekend, I discovered there might have been more to that decision than initially met the eye. There was chatter on the beltway that we may have been the victim of economic terrorism, a coordinated short raid that originated in London and Dubai.

While the legitimacy of that remains to be seen, my source is well respected. Further, as the goals of terrorism are economic destruction and social upheaval, it makes intuitive sense. The stock market is the world’s largest thermometer and breaking the capital market construct—as some would say they did last week—would effectively achieve both goals.

This is a separate conversation from the financial fabric itself, a monster created through years of experimental engineering. It simply speaks to the fact that we’re vulnerable and that weakness may have been exposed from afar.

Whether or not that proves true, I expect a coordinated agenda to emerge from Washington akin to what we saw after September 11th, 2001. During that period, the lines of distinction between bullishness and patriotism blurred and it was considered un-American to be a bear.

I will be very clear. Minyanville is as American as apple pie. We love everything this country is supposed to stand for. We love capitalism. We love small business. We love the notion that you can invest in what you believe in and be rewarded for your efforts.

And we’re not bears, per se, we’re simply a community that is trying to navigate the cumulative imbalances and find our way to better days.

With that said and respected, a few elements of the proposed bailout seem particularly egregious.

In particular, "Decisions by the Secretary of the Treasury pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

Perhaps I'm sleep deprived but that seems to fly in the face of the balance of powers that is the fundamental foundation of the United States of America.

Our Wishbone World

We offered in February as we sat at a historic crossroads that the stakes had never been higher.

The ace up the Federal Reserve's sleeve since the turn of the century had been the U.S dollar. They let the greenback devalue with hopes that a legitimate economic recovery would take the place of the credit expansion that has dominated this decade.

From 2002 to 2007, the world's reserve currency declined 40% while everything measured in dollars appreciated in kind. That passed largely unnoticed by stateside players but it was—and remains—a considerable source of stress for foreign holders of dollar-denominated assets.

We called it "asset class deflation vs. dollar devaluation" and toggled between the two as policy makers pulled strings.

On one side, there was the socialization of markets, nationalization by governments and potential hyperinflation. On the other, there was asset class deflation, risk aversion and the unwinding of the debt bubble.

It was clear that decision makers preferred the first scenario. The “have’s” would presumably fare better than the “have not’s” and wealth would be retained by a slimming margin of the society. They knew all too well that the devil of deflation knows no friends on an absolute price basis.

While on television Monday, I was asked if the spike in crude was due to confusion regarding the bailout proposal. My response was that, quite the contrary, the eye-popping commodity rally was an unintended consequence of the plan itself.

That brings us full circle in this discussion. All roads ultimately lead to deflation and debt destruction, which was the natural and progressive path that sliced 25% off the commodity index and caused the dollar rally this summer. The bailout proposal reversed that course in one fell swoop and reintroduced the specter of hyperinflation. That will work until it doesn’t, which is to say that the patience and appetite of foreign holders of deteriorating dollar-denominated assets is extremely strained.

If they scream “Uncle Sam” and debase our currency, the caveats of a fiat currency will hit home in a hurry. If they don’t, the dollar will rally and asset classes of all shapes and sizes will deflate in kind.

Societal Acrimony

Social mood and risk appetites shape the tape and we’ve drawn analogies to periods past. The stock market crash of 1929 didn’t cause The Great Depression, for example, the Great Depression caused the stock market to crash.

Despite numerous discussions on this topic, there is a profound difference between written words and life experience. This presented itself in real-time last week when The Reserve Primary Fund broke the buck, halted redemptions and denied people access to what they believed were liquid and safe capital conduits.

On the other side of the societal spectrum, a different scenario has taken shape. Between the Lehman Brothers toe tag, a shotgun wedding between Bank America (BAC) and Merrill Lynch (MER) and the dressing down at Goldman Sachs (GS) and Morgan Stanley (MS), the crisis arrived for the precious few still in a position to spend.

These seemingly separate situations introduce two very important dynamics: voluntary and involuntary thrift. The former involves people who have savings but choose not to (or can’t) spend it while the latter describes people who can’t afford to fill up their car and take the family to Applebee’s.

Both processes are currently in play. As folks digest personal issues, it stands to reason that social tension manifests as a whole. That curbs risk appetites, which reduces spending habits, harms the economy and drives us deeper into recession. It’s a vicious circle, akin almost to a bubble in reverse.

We flagged this unfortunate theme at the beginning of the year but again, living through it is an entirely different dilemma. The angst is palpable and tension is high as we edge towards what promises to be a very tenuous election.

Indeed, anticipation of social unrest may be the catalyst for the decision to transfer troops back to the States. Beginning October 1st, a military army brigade will be an “on-call federal response force for natural or manmade emergencies and disasters,” the first time an active unit has been given a dedicated assignment of this kind.

Clarity Now

This is far from fun and anything but easy, but in order to get through it, we must go through it.

On the other side of the prolonged period of socioeconomic malaise, an “outside-in” global recovery awaits that will reward those who have preserved capital, reduced debt and armed themselves with financial intelligence.

While opportunities will certainly present themselves, proactive preparation and lucid awareness are far more important than the next best trade.

It’s about building a future so our children will have a stable home.

It’s about winning the war, both in a literal and figurative sense.

It’s about seeing all sides as we edge through historic times.

Identify an appropriate horizon and sync your risk accordingly.

Understand that opportunities are made up easier than losses and the ability not to trade is as important as trading ability.

Remember that risk management trumps reward chasing and profiting is a privilege rather than a right.

Most importantly, take the time to be mindful of the little things in life, situations that you may have once taken for granted.

It should never take something bad to make you realize you’ve got it good.

No matter where you are, it’s never too late to start.

R.P.
No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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