Financial markets reach critical cusp.
"Give me your tired, your poor, your huddled masses yearning to breathe free, the wretched refuse of your teeming shore."-The Statue of Liberty
America's founding principle was to accept those that others cast aside. The government has now applied this concept to financial assets.
As Bear Stearns (BSC) was tossed into last Monday's volcano, wheels on financial wagons wobbled throughout the world. Into that hopeless hysteria, the tempted and tossed found a friend in the Federal Reserve.
During the process of downside price discovery, I shared a few reasons why "we could conceivably see a melt up in the equity space." The initial feedback was uniform in offering the other side of that opinion.
Following a vicious lift that caught many investors looking the wrong way, sentiment has shifted in kind. It's human nature to examine risks when the chips are down and chase rewards when screens are green. Paradoxically, that mindset is the mirror image of successful money management.
Since the beginning of last year's decline, the two previous rallies in the financial sector measured 13% (December) and 16% (January). As that complex is now 16% above last week's low, we've arrived at a juncture that requires serious consideration.
Will we hold and embolden the bulls or fold just as they've started to get comfortable? Welcome to Stock Market 2008, the most interesting juncture in the history of finance.
The Three Phases of Leave
Market psychology involves three distinct phases. Denial, when nobody wants to believe they're wrong. Migration, when everyone realizes they were. And panic, when emotional decisions are made in fear of missing the move.
This process works on both sides of the ride and applies across multiple time horizons.
Last summer, when we were probing all-time highs on a daily basis, the powers that be denied that the potential for credit contagion existed and investors took them at their word.
During the next eight months, as serious structural imbalances manifested, the market migrated down the slippery slope.
In recent weeks, with many of the world's largest financial institutions 50% off their highs, perception caught up with reality as mainstream media championed the risks in the system.
The question I'm wrestling with is whether we've seen sufficient panic to qualify the cycle turn. Throughout my career, true fulcrums of despair have been sloppier than what we saw last week. Remember, capitulation occurs when nobody-and I mean nobody-wants to own stocks.
The wildcard in this equation is the pervasive intervention we've witnessed to date. There is no way to know what the panic phase would have looked like without the trillion-dollar Federal infusion or the Plunge Protection Team working diligently behind the scenes.
A Riot is an Ugly Thing
We can debate the merits of government intervention until we're blue in the face. We've arrived at a point, however, where these policies are like the Iraq war. You may not have agreed with the initial occupation but now that we're there, you can't suddenly pull out without profound consequences.
The government is socializing the markets and will, in my opinion, eventually nationalize Fannie Mae (FNM) and Freddie Mac (FRE). It's too late to shift course, sort of like a cruise ship in a canal trying to navigate the tips of multiple icebergs.
One of three things will ultimately manifest a function of our current course.
- The system will repair itself as real estate rebounds and the underlying collateral starts to appreciate. This preferred path would allow the Fed to transition assets back to the balance sheets of the banks and unwind the most recent round of intervention.
- Foreign holders of dollar denominated assets will finally balk, which is an alternative many nations would have opted for already if they could do so without disrupting their own financial fate.
- If the economy continues to deteriorate, the Federal Reserve would effectively and eventually become insolvent. It won't go bankrupt-it will simply print more currency and further dilute the value of the dollar, which would bring us back to the second scenario.
Déjà Vu All Over Again
Our current conundrum can be traced back of the implosion of the tech bubble. If we were allowed to take our medicine rather than being injected with artificial drugs, we would already be on the road to recovery.
We've now entered the most dangerous juncture in the age of financial engineering, that of desperation. Imbalances continue to cumulatively compress, gaining intensity in terms of magnitude and consequence. It is truly remarkable what we're witnessing with each passing day.
I respect the potential for further strength, particularly given the ease in which the bears have operated and the fact that our first technical test won't arrive until S&P 1405 and DJIA 12,800. And I'm quite conscious that, through the lens of the dollar, most Americans have yet to arrive at the point of recognition.
With that in mind and stepping away from the flickering ticks, I will again offer that the Depression was an era rather than an event. Just as many folks recently realized their portfolios were in pain, a similarly daunting dynamic may manifest in coming years. (MV: )
Students of history will tell you that the stock market crash didn't cause the Great Depression-the Great Depression caused the stock market to crash. It was all about social mood and risk appetites, two issues that continue to percolate in the current environment.
By the time Hollywood finished portraying that period, we were left with bread lines and hungry children. While those unfortunate elements surely littered the landscape, it's important to remember 75% of the country continued to work and the stock market enjoyed several spirited sprints.
Students went to colleges. Businesses were built. Families were formed. Fortunes were made as opportunities emerged from obstacles.
I believe we're in for a similar stretch, one that will last much longer than most people think. It's incumbent upon us to maintain perspective and keep our emotions in check as we find our way.
An eternal optimist tends to look for lights at the end of the tunnel rather than the train to which they're affixed. Understanding they could arrive in tandem will help us properly prepare for the fate that awaits.
Of Smoke and Mirrors
While the financials have cycled through their first phase of pain, the biggest fly in the recovery try remains the other side of zero-percent financing.
Despite the central bank spigot, one that is expected to open globally should the need arise, banks remain hungry for capital and will continue to hoard cash and tighten lending standards. The consumer, 70% of the GDP and dependent on fresh debt to finance existing obligations, faces leaner times still with upwards of $400 billion in mortgages due to reset this year.
The battle lines have been drawn, with hyperinflation on one side and watershed deflation on the other. We've been monitoring this situation carefully at Minyanville and need to respect both sides of that wary war.
How long we'll rally-or how far the dollar will be allowed to fall-remains an open question that I'm not smart enough to answer. I will simply offer that the mechanics of the swing are as important as the results of the at-bat.
Now, more than ever, discipline and lucid decisions will serve us in good stead. Emotions are running rampant all over the world but we would be wise to leave them for weddings and funerals.
One Foot in Front of the Other
Someone once told me that trading, in its simplest form, is the process of capturing the disconnect between perception and reality. As more and more investors subscribe to the notion we've effectively turned the corner, the higher the likelihood becomes they'll eventually be disappointed.
There are few opportunities in our lives to literally watch history tick before our eyes. These are the times our grandchildren will study, like we study the Great Depression, puzzling over the bizarre circumstances that came together to form this perfect storm.
What is most misunderstood is that this not only a financial crossroads, but a societal one as well. The repercussions of government policy and our individual actions will echo loudly throughout future generations.
We have a choice to make. We can face our mistakes with bravery, accepting consequences as they come, confident we can meet the challenge while rebuilding a more sustainable structure; or we can continue to let fear and greed drag us along the road to ruin.
The former, while more challenging, is the path of perseverance. It is the only noble road, one that accepts responsibility for our actions and paves the way to better days.
They say admitting you have a problem is the first step towards solving it. It's about time that we, the people, practice what we preach.
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 firstname.lastname@example.org.
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