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Doorstep of Disaster?


Recapping the long, strange trip toward recession.


Last night I re-read some of the more recent macro pieces I wrote, and which I have been using as a guide to shape my fund's positions. Here are the guts of each article, followed by a brief update on those thoughts:

January 7, 2008 "Street Sees Recession, Or Something Worse":

"In a Friday Buzz I pondered if the behavior of the financials is hinting to a "nuclear size cockroach" about to jump out of the woodwork. This is a weekly chart of the Banking Index (BKX) going back to 1999. Forget about support and resistance levels, retracements, entry points/stops, overbought / oversold, and all the other technical stuff, and just look at the picture. The stocks of the largest financial institutions on the planet, Citigroup (C), Bank of America (BAC), Wachovia (WB), Wells Fargo (WFC), JP Morgan Chase (JPM) – the institutions where money for our finance-based economy lives – are showing extreme distress, more so than at any other time including '02, when the market was in free fall; and back then, debt derivatives (CDS) outstanding were a fraction of what exists today. What's even more worrisome is that the CDS on these banks' debt seem to be confirming such level of distress.

I understand if some readers might dismiss my concern (not belief yet – but definitely concern) that we may be on the verge of something worse than just a recession. But once you have dismissed my worries, please do yourself a favor: listen to Friday's video interview with UBS' Art Cashin. For those unfamiliar with Cashin, he is the NYSE floor director for UBS, a man with decades of experience, and whose commentary consistently adds more to my financial education than just about any of the reams of research I read every day. Watch the whole thing (it's only 3-4 minutes), but listen carefully to what he says from the 2:20 mark on.

Then store his words in your memory bank, and put your antennas up to hear if his worries are expressed in other circles. As I said at the beginning of this piece, crowds can take a "piece of the puzzle" and make it "the piece of the puzzle". If Cashin's fears start spreading, the real "fun" is still ahead of us.

Fast forward to today:

Is the "piece of the puzzle" is in fact becoming THE piece of the puzzle? Ron Insana, whom I respect immensely, suggests that the Federal Reserve should use its "infinite balance sheet to monetize" bad debts. Sounds like Cashin's fears are taking hold.

January 22, 2008 "Will We Get Deflation or Hyperinflation?":

"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... 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

Fast forward to today: With margin calls hitting, Thornburg Mortgage (TMA) discovers the true meaning of "structural problem", and goes from "we cool" to "we gone" in the span of 3 days. Meanwhile, lawsuits over payouts on CDS begin to fly: Shocking!! Alas me thinks that by the time the roaches festering in the underwriting of CDS come to light, TMA's 14:1 leverage model will be bandied about as an example of conservative balance sheet management.

Not to be ignored, Boo is frantically looking for the lithium as the inner voices of "deleveraging asset deflation" and "U.S.-Peso-led hyperinflation" start messing with his head in earnest. Ultimately one of his personalities will prevail (I am leaning toward the latter) but neither will be the type you wanna take home to mom.

February 7, 2008 "Retest May Or May Not Spell Doom For Bulls":

"In early January there was TV chatter that Goldman Sach's (GS) December business had ended horribly, and January had started off worse. Since then GS has been lagging its brethren. Can the market withstand a whiff from the company can do no wrong? Is that type of news what will put in a cyclical bottom within the secular bear market?"

Fast forward to today: The retest failed, and both the S&P 500 (SPX) and GS (is there a difference?) made new closing lows. $100 billion dollar companies don't lose 20% of their value in a few weeks because of "retail selling". Institutions are throwing overboard the bluest of blue chip, THE company that embodies the world of finance. Don't overthink it Minyans, just see it.

So where do we stand now? Umm... right here, right now I'd say on the threshold of "financial catastrophe". Yep, been calling for it for almost three years (trust me, no reminders needed), but I got 14 years of Jesuit school under my belt . I'm a patient man. And if the unwind is half as nasty as I think it'll be, I will have been early, but I won't have been wrong.

Incidentally, I don't think we will have an '87 style crash. I view crashes as born out of sudden rebalancings. For a good portion of our financial system there is nothing to rebalance, there is only to turn out the lights and go away. Kinda of like Enron (R.I.P), which kinda looks like Aunt Fannie (FNM), which sorta reminds me of Citi (C).

Depressed yet? Don't be. Just think of all the good times that've been had running up consumer debt $7.4 trillion dollars in 8 years. As soon as most of it gets devalued (hyperinflation) or written off (deflation) our financial system will be as good as new.

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