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Will We Get Deflation or Hyperinflation?


A 10% slide in the equity markets seems hardly enough to discount many of the problems underlying the current crisis.


On December 17 I shifted from the "just trade 'em" camp to the bear side and I outlined how I intended to play it.

While at first the depressed state of the Volatility Index (VIX) was frustrating, towards the latter part of last week my slate of index puts started kicking into gear, and I even sold a few (about 2% of them) as the VIX tickled 29. Truth be told, I shut down the screens on Friday thinking that I probably should have sold a few more. Not so, apparently. World markets closed their Monday trade in crash mode, and were taking down commodities 2-4% across the board.

I won't venture to guess how bad it can get because I do not know, and looking at technical support/resistance levels in the midst of a waterfall decline is probably not very helpful. Almost by definition, panic ignores the logic of charts.

What I will offer is that a 10% slide in the equity markets seems hardly enough to discount many of the problems underlying the current crisis.

Debt to Wages

Click to enlarge.

RE Net Worth

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  • Since 2000 the ratio of debt to wages has skyrocketed and the net worth which pretended to support the increase in debt came mostly from real estate inflation. What we are witnessing in the mortgage market are margin calls against collateral for which there is no market.

  • Homebuilder Dominion Homes (DHOM) was taken private on Friday for the value of its outstanding debt, or 2/3 of the book value of its inventory. If this is what the Beazer (BZH), Hovnanian (HOV) and Standard Pacific (SPF) will be measured by – and I believe things are actually worse – the 30-50% discounts in the homebuilders' bonds are about correct, which means that these companies are bankrupt. Consistent with that, Credit Default Swaps on those debts exploded last week.

    Click to enlarge.

  • Once in bankruptcy, these companies won't have to worry about the sale price of their homes; they can/will fire-sell their inventory, and the death spiral of home values will begin in earnest. Welcome to the next round of mortgage write-offs.

  • We have not even started to scratch the surface of the Credit Default Swaps problem, and if PIMCO's Bill Gross is roughly correct about his estimates, the shock waves in the equity markets have not even begun to be felt.

  • No size of interest rate cuts will make much of a difference. The problem is not rates, the problem is risk aversion. Will a lender extend credit to a company if the outlook for its business is uncertain? Why would debtors want to borrow even more, let alone the question of whether we will see again loans for stock buybacks to prop-up prices or special dividends? How well has that strategy worked?

These are not problems discounted with 10% corrections, or 20%, or even 30%. These are structural problems that rarely get resolved without financial upheaval.

One thing I am growing more and more convinced of is that the fork between the roads to deflation or hyperinflation is at hand, or at least it is approaching very very quickly. So far falling asset prices have given the deflation scenario the lead, but follow carefully what comes out of Washington. If individuals and companies refuse to borrow, there is little to forestall an election-year Congress from doing the borrowing itself and handing the cash over to its citizens in the form of fiscal or spending stimuli. It won't resolve anything of course, but with repeated efforts it may bring about hyperinflation as a viable competitor to deflation.

For the here and now, assuming Tuesday morning our markets pick up where the rest of the world left off, my moves will largely consist of shedding index puts in a very wide scale, replacing them with short positions (using assorted Proshares UltraShort Funds), and selling both puts and calls as opportunities arise. But under no circumstances I will want to find myself net long at this point. Even if today were to be the last leg of this decline and we recover by the close, the new lows will likely be retested. Then and only then we can consider if the recovery was the real thing, or a rest within a new cyclical (secular?) bear market.


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