Credit Hurricane To Make Landfall
Time to buy storm shutters.
"Our understanding of the best practice in monetary policy evolved during Alan Greenspan's tenure at the Federal Reserve, and it will continue to evolve in the future."
- Federal Reserve Chairman Ben Bernanke
About ten days ago, I was interviewed on Fox Business News as a part of a Minyanville daily Fox News ritual. The first question I was asked was "What inning of the credit crisis do you think we are in?" I have to confess that the answer I gave was one that I heard one morning on the way to the office. A British economist on Bloomberg Radio stated that "We have heard the National Anthem but we haven't had the Seventh Inning Stretch." I have to admit that I couldn't have said it better myself.
On a recent business trip to New York City and Greenwich, I had the pleasure of speaking with some of the brightest professionals in our industry. My biggest take away from the trip and meetings was that the over-40 crowd is concentrating mostly on the macro-economic or big picture. At Atlantic Advisors, that is where have always begun and let our big picture beliefs guide our asset allocation decisions and let other, more cyclical indicators such as investor sentiment, valuations, cyclicality and short interest influence actual portfolio positioning.
Another important takeaway was that the older and more experienced investors were the more concerned they were. After all, if you haven't lived through a credit crisis, it's hard to fully appreciate what that unwinding of a credit crisis looks like. When we consider that the build-up of credit and derivatives during this past cycle is so unprecedented, the more difficult the unwind is likely to be.
Another analogy I like to use is one of a hurricane (which for someone like me who has lived in Florida for twenty years; I know what one looks like). Hurricanes that hit the East Coast of the USA usually begin to form off of the Western Coast of Africa in the Eastern Atlantic. I'm not usually concerned or ready to take action, but take note just in case it begins to build and heads our way.
This is how I felt several years ago during the 2003-2005 bubble in housing and in low quality credit creation. I became cautious and very aware of the storm forming. As hurricanes begin to gather steam and build in size, the Weather Channel begins to track the storm and project potential paths of the storm. I recall a day in 2004 when Hurricane Charley was heading for Tampa out of the Gulf of Mexico. The storm was supposed to hit Tampa and then bounce off the coast into the Gulf of Mexico but then unexpectedly turned-directly towards Orlando and a dead-on shot to the neighborhood where we live.
To be honest, we had no time to prepare as the meteorologists misjudged the storm. The next thing I knew, Charley was banging on the front door with wins of 110 MPH. Had I known it was coming my way, I would have been gone in a New York minute. But no one had time to react, so everyone just headed toward the most interior part of the house and hoped for the best. Thankfully, no one got hurt, but many lost power for a few weeks. The storm moved quickly out to sea. The outer bands were easily defined, but what was behind it is what took out most of trees in my yard. Just like the bad loans and esoteric securities could take out the foundation of more than one financial institution.
This is how I felt in 2006 when it was clear that the bubble had burst and the implications seemed so negative that I went to a "no credit risk" position, a position that I maintain until this day. The next stage of a hurricane is that the storm nears the shore and we're hit by the outer bands of the storm.
The outer bands are bad enough to get your attention and you take cover. I happen to think that the happenings leading up to the Bear Stearns (BSC) collapse and bailout by J.P. Morgan (JPM) that was completed last week were the outer bands of the hurricane.
What follows the outer bands is a period that is rather benign and lets people breathe easy. Some prudent people living on the coast will then take cover and evacuate. I guess I feel like I am part of the evacuation crowd-in other words, I see the leading edge of the large part of the storm heading our way, and have taken cover in our lowest long-only position in equities since 2000 and continue to avoid credit risk at all costs.
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We've heard so many stories about people that stubbornly refused to leave their homes and then got nailed by the hurricane. Many times it's a "better safe than sorry" move, and that seems to be the majority view on Wall Street these days, that the worst is behind us. To be frank, I could not disagree more vehemently. I believe that the credit crisis is about to rear its ugly head again, potentially unannounced. It is possible that the storm will miss us and that the worst is behind us and if so, the worst thing that will happen is that we will make less money than the next guy, which is OK by me. I believe the next part of the crisis will be more widespread and have a larger impact on the real economy than many believe. Delinquency rates in everything from credit cards, home equity loans, auto loans, utility bills and telephone bills are increasing. The one-two punch of dramatically higher oil and gasoline prices and a slowing economy, along with the high levels of indebtedness are taking its toll. Now back to the hurricane analogy.
If I'm correct, the next stage of the credit crisis, which I firmly believe is at our front door, could make the first stage feel like a walk in the park. This is when the hurricane makes landfall, and many that didn't evacuate as they were instructed to (those taking credit risk at present no matter how disturbing the economic data has become will wish they had). Let's say the storm comes and lasts six to nine months, and the newly elected president will likely blame past administrations and possibly wish they had never run for office, likely having a term of "one and done."
If you're lucky enough to make it past the front part of the hurricane, a seemingly calm period takes place (the eye) and once again, people feel relieved, see the sun and hope that the back end of the storm will break up as it hits shore. This could happen in 2009 at which point Stage 3 shows up, and the back end of a hurricane can be the most damaging and is the knockout punch.
I think this could be a late 2010 event, which could be followed by a huge rally in markets worldwide in both credit and equities. It's possible that this would be a cyclical move within the confines of the secular bear market that began in 2000, but one that we would love to be positioned for. The investor that recognizes the issues we face and is prudently positioned (sometimes with positions to the downside using defined risk via puts) will likely be able to weather the storm, while those that hope it is over will wish they had paid more attention to the news flow. Virtually every data point that I am seeing these days gets worse by the day, yet the data is being greeted with complacency. Since the Fed has played the ultimate 'Moral Hazard Card' by back-stopping banks and brokers with their repo lines and term facilities, I suppose many feel that the Fed will be there to bail them out.
I think they are sadly mistaken and that the Bear Stearns will be nothing close to an isolated instance.
What Might Stage 2 Look Like?
The economy most certainly seems to be stalling with money still growing at rates near 20% annually. It is expected that the Bureau of Labor Statistics will release the fifth consecutive month decline in non-farm payrolls this coming Friday. Who would have thought that the economy would stall with excessive credit growth, bubbles in equities, real estate and commodities over the past ten years?
If the economy were on stable footing, surely the economy would be expanding at a rapid pace and the Fed would be forced to tighten monetary policy, not hand out cash to all its Wall Street buddies. But where is my bailout? When I make a bad decision in a portfolio, I don't have a backstop. Rather, I have to pay for my mistakes, which is now happening at an even greater pace on Main Street. Homes are collapsing in value, equity markets around the world stagnate, credit spreads stay stubbornly wide and delinquencies accelerate.
The sole reason, in my opinion, is that much of the expansion and bubble creation were stoked by credit and derivative creation. Since the creation was unprecedented, we can only conclude that the unwind will be like something we have never seen before. The poster child of the unwind are the bank and brokerage stocks, the parties responsible for providing easy money and financial alchemy.
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