Five Things You Need to Know: The Point of Recognition
When the dollar stops going down, the real point of recognition will arrive.
Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. The Point of Recognition
The good news is that we may be about two-thirds of the way through this bear market. No, not the bear market that supposedly began in October, but the big one, the structural one, the one that began eight years ago. The bad news is we have not yet reached the most dangerous part of the bear market, the point of recognition. That is when asset prices suffer the full impact of a deflationary credit unwind.
Denial remains the most powerful force operating in financial markets today. It is so pervasive, bullish sentiment so deeply entrenched, many are simply refusing to accept, and in some cases not bothering to even notice, the sheer magnitude and severity of this debt crisis.
But wait a minute, even with the S&P 500 down a little over 9% year-to-date, that index is still up more than 50% over the past five years. That's a bull market, right? Depends on who is doing the counting, and in what currency they are counting in.
Here is the S&P 500 we are most familiar with, priced in dollars.
But here's the index priced in Euro.
Or, if you prefer, yen.
How about Canadian dollars?
What these charts illustrate is the illusion of prosperity and bullishness painted by credit creation and a declining dollar. So what? We read our brokerage statements in dollars, not euros. That is true, but step back for a moment and consider that the illusion of rising stocks simply masks the destruction of real purchasing power. Globalization, after all, is a two-way street.
Ironically, the growing furor on Main Street over the declining dollar and the destruction of purchasing power is the epitome of a "Careful What You Wish For" scenario. When the dollar stops going down, the real point of recognition will arrive. Days like today, gold and silver down 5% to 7%, bonds higher, stocks down, commodities down, that is what a deflationary credit unwind looks and feels like. The dollar will again have its day, and when it does the myth of the bull market will be exposed for the fraud it really was.
2. Process vs. Event
As tempting as it is to want to believe, this is not a Bear Stearns (BSC) event the Federal Reserve has managed to suddenly solve. Instead, it is a long-term process that will unfold slowly, over time, and ultimately work its way through the system as debt is destroyed, savings increases and attitudes toward consumption and risk shift.
So, while Citigroup (C), Goldman Sachs (GS), JP Morgan (JPM), Lehman (LEH) and the rest of the banking industry continues to horde capital to protect their balance sheets from additional losses on subprime debt, counter-party risk from weaker institutions unable to access credit and an increase in non-performing loans, the ripple effect of the debt crisis finds new, previously unimagined ways to hamper the ability of the Fed to force-feed more credit into the system. Corporate and personal credit lines are the latest perverse wrinkles in the debt crisis.
According to Bloomberg, corporate borrowers from Sprint Nextel (S) to Porsche Automobil
Holding SE (POR3 GR) to MGIC Investment Corp. (MGIC) are drawing on credit lines, a move that may force banks to raise as much as $40 billion in additional capital to protect their balance sheets.
Meanwhile, the 10 largest U.S. banks have the lowest capital levels in at least 17 years, according to Credit Suisse Group. Consequently, companies tapping credit lines will further pressure new lending, exacerbating the credit crunch and making it still more difficult for the Federal Reserve to feed new credit into the economy.
Again, it is critical to understand that this is not an event, but a process. The U.S. economy is dependent on credit consumption. Currently, only those who do not need credit are able to obtain it. Those who need it face increasingly tight lending standards.
3. Fannie Mae, Freddie Mac
As the Federal Reserve continues to bump up against both the limits of monetary policy to reignite credit growth and the size of its balance sheet to take on mortgage related assets as collateral for new loans, we can expect to see more intervention by the Federal Government.
Step one was taken just this morning after the Bush administration reduced the amount of capital Fannie Mae (FNM) and Freddie Mac (FRE) are are required to hold as a cushion against losses, Bloomberg reported. The companies then agreed to expand further their purchases of U.S. mortgages and securities.
Fannie and Freddie to the rescue. It sure sounds like a lot of help. The initiative may immediately pump $200 billion into the mortgage-backed securities market, Office of Federal Housing Enterprise Oversight Director James Lockhart said according to Bloomberg.
The stocks of FNM and FRE rallied more than 10% on the news, the perception of credit-addled analysts being that the capitulation on stricter regulations for the GSE's by the Bush administration means the political landscape has shifted in their favor. The reality is that this is simply the next step in moving bad assets off the balance sheets of banks and onto the government books.
Look, the mortgage market is more than $10 trillion large according to some estimates, and that's probably conservative. The most $200 billion here, and $200 billion there will do is extend the crisis out and make it slightly more manageable. The end result will be sweeping government intervention and support.
Perceived political capitulation on the GSE's is not bullish for shareholders of Fannie and Freddie, it's simply indicative of government laying the groundwork and taking another step closer to full nationalization of them. The least complicated way to facilitate the necessary bailout of the banking industry is to consolidate as much of the bad debt in one place as possible.
4. Finally, Some Good News
General Mills (GIS) this morning reported third quarter profit that exceeded analyst estimates thanks to an ability to pass through high wheat and dairy costs to customers while successfully hedging some of their costs and improving productivity.
Passing through costs to customers, how is that good news? We should have clarified, good news for owners of Consumer Staples companies. Producer prices continue to squeeze profits, but these companies are raising prices and becoming leaner. As commodities sell off as part of a deflationary credit unwind, some of these companies will find themselves with (at least temporarily) increased margins. Price increases don't often get rolled back all at once.
The downside is that in a true deflationary credit unwind, price increases from these companies will eventually get rolled back.
5. Preliminary Mr. T Gold Indicator Sell Signal
Seeing gold down more than 5% today, we were looking around for some signs of Mr. T. It didn't take long to find the culprit. Our analysis of the Mr. T Gold Indicator shows Mr. T will soon be releasing a graphic novel. In fact, the first chapter is in pre-release right now. Bad news for gold. Very bad. We'll have more on this very important indicator very soon.
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