Tim and All, a take on the market, worthy of a look.
It's long, so I copied the part I found most interesting.
financialsense.com
Let's Do A Little Math
The earnings yield is the reciprocal of the P/E ratio. At the moment, forward earnings estimates for the S&P 500 are expected to be $55 a share. If you divide that number by Friday's closing price for the Index at 965.8, you get a P/E multiple of 17.56 which translates into an earnings yield of 5.69% [1/17.56 = 5.69%] This is higher than the yield on 10-Year Treasuries, which makes the S&P 500 undervalued.
See Forbes
This reasoning depends on two assumptions: earnings and interest rates. Assuming that earnings for the S&P500 next year will be $55 a share is a bold prediction. Earnings of $39 to $40 a share is more realistic. The $55 a share number is a lot like this year's predictions for a 12,000 Dow or 1,500 for the S&P 500. The second assumption deals with interest rates on longer-term Treasuries. The Fed may control short-term yields by its influence over Fed Funds, but investors control long-term yields. The following graph taken from Peter Brimelow's article, "No Hiding Place?," in the October 1st issue of Forbe's Magazine, shows that the return from bonds is 50.2% above its long-term trend line. As the graph illustrates, whenever bond returns have gone far above that average, they go into a corrective phase similar to what happens to stocks. With all of the money injections taking place right now, it is more probable that long-term interest rates will rise rather than decline. Higher interest rates and lower earnings for the S&P 500 call into question the Fed's model that stocks are now undervalued.
Banking System Hit Hard As Well
In addition to the destruction of the Trade Center, another part of the financial system was hit by collateral damage. The Clearinghouse Interbank Payment System (CHIPS), the system operated by the New York Clearinghouse Association for the benefit of clearing payments for New York Banks and international banks, saw part of its infrastructure of telecommunications damaged by the collapse of the Trade Center. The biggest banks in the world from J.P. Morgan, Citibank, to Deutsche Bank and Mitsubishi own and operate the system. Over $1 trillion dollars a day passes through this system. It handles hundreds of thousands of currency transactions on a daily basis. The system handles 95% of all dollar payments worldwide. Disruption within the system could trigger a global financial contagion. For these reasons central banks around the globe began to inject hundreds of billions of dollars of liquidity into the system. What was at stake was the avoidance of a spreading brushfire, hopping from one part of the financial system to another. The real danger posed here is the settlement of derivatives between counterparties. If settlement problems appear, they could ripple throughout the financial markets and bring the whole system down.
The Next Rogue Wave?
See 2Q OCC report
Outside this week's trillion-dollar loss in the stock market, one wonders where the next rogue wave will emerge. I believe it will come from either another terrorist attack or from a derivative portfolio being held by a commercial bank, brokerage firm or leveraged hedge fund. The derivative portfolio of commercial banks increased by $7.3 trillion or 39% during the first half of the year. The top 7 banks now own close to $47.8 trillion in their derivative portfolios. One bank, J.P. Morgan Chase accounts for over half of that. The derivative holdings of these banks are almost five times our nations GDP. Backing those leveraged bets is only $43 billion in shareholder equity. That is probably keeping our nations commercial bankers and central bankers up at night.
Most of those derivative holdings are based on models of certainty. The models incorporate 1:2 standard deviations of risk. What happened at the World Trade Center is a once-in-a-lifetime occurrence. It lies at the tail end of the curve. September 11th would have driven models off the charts. Someone, somewhere is unprepared for this. Surely the attacks were a statistical anomaly that would be incalculable, a risk the models didn’t foresee. Somewhere out there in the shadows of this opaque world, there is an anxious trader.
In derivative transactions, there are two or more parties to a trade. One of them is right, while the other is wrong. This is what is known as counterparty risk, the ability of those who are wrong to honor their obligations. What we don’t know now is whose cards will fold?
In the complex world of derivatives, individuals considered to be savvy and well informed set the price of contracts. Nobody seemed to be informed of the Trade Center attack. Our government didn’t know. Law enforcement and intelligence officials were unaware. The financial traders inside those buildings were tragically the last to know. The experts never saw this attack coming. It was an unexpected event. It was a crisis that emerged out of nowhere, at a time they did not expect. It was the one event that was not anticipated. It became the rogue wave that took the financial experts and politicians by surprise.
Stability Models Are Vanquished in The Wake of the Wave
Contract prices are considered to be in constant balance. Trades are done on the basis of never paying more or never paying less than what a contract is worth whether a stock, bond, commodity or the direction of interest rates. But markets aren’t always rational, nor do they remain in balance. Sudden events can turn them upside down. This is not a problem if you aren’t leveraged. Leverage always gives way to a brutal dynamic that magnifies gains when you are right and accelerates losses when you are wrong. It is this danger that is too often ignored in the financial world. The hubris on Wall Street is that the foundation of most trading is based on price. It is as if each day’s print of closing prices is a reliable gauge of the future. Those models are based on the certainty that can only be found in actuarial tables. Those actuarial tables can predict the certainty of a lifespan, but not the sudden tragedy of taking a life. What happened at the World Trade Center unleashed a financial tsunami that has rippled through the world’s financial market. It was a statistical freak, a random event that unleashed tragic consequences for the financial markets. What has emerged from it is chaotic disorder.
At the moment, it is impossible to know who has been right or who has been wrong. Time will flush out the loser. In the world of derivatives, contracts are hedged. Hedges can cancel out risk provided the counterpart to each transaction can be relied on to honor their commitment. It is a giant game of faith. The parties to each transaction are closely knit. If one falls, the other falls. Within the smoke and ruins of the World Trade Center, another fire is smoldering somewhere in those derivative contracts. Every time financial fires have erupted in the financial markets, the trail has led to derivative trades. Remember Barings Bank, Orange County, Metallgesellschaft, Sumitomo Bank and LTCM. The question now is, "Who will be this crisis' next victim?" Stay tuned. The fireworks have only just begun.
The Dollar is Damaged, But Not Decimated
What has emerged from this crisis is that the dollar is no longer considered a safe haven in times of international unrest. The crisis' epicenter was in the heart of America’s financial district. From the first moment of the attack, the dollar has been one of the victims suffering from collateral damage by financial shrapnel. Financial markets in the U.S. have fallen sharply, losing their image of invincibility. While investors around the globe were dumping dollars and shedding equities, they were moving into safe havens like cash, gold and silver. Excluding the shares of select defense stocks, the biggest winner from this crisis has been precious metals. In past crises, the money crowd moved into the dollar. Most of those past crises were centered elsewhere. This one was spawned right on the U.S. mainland.
Recent Trends Intensified
Maturity Yield
3 month 2.18
6 month 2.32
1 year 2.46
2 year 2.81
3 year 3.36
5 year 3.81
10 year 4.77
30 year 5.55
Source: Bloomberg
U. S. Treasury Market as of 9/19/01
Last week's senseless World Trade Center disaster has only served to accelerate trends already in place and help ignite others that were in their formative stage. The economy, the stock market, and the dollar were already in downward trends. The mountains of liquidity being injected into the system are bound to surface somewhere. An eventual stock market rally is still possible however short-lived it may turn out to be. The yield curve has steepened as a result of Fed intervention. As this table indicates, the yield on short-term Treasuries is next to nothing. It shows the paltry returns from short-term maturities. Investors may be tempted to come back with any sign the crisis is over. However, the allegiance to financial assets has been dealt a severe confidence blow. Investors have suffered heavy losses. Allocation models are being rethought. This may be one reason behind all of the trading volume of this week. It has been a week of record losses accompanied by record volume.
New Bubbles Will Emerge
Like pieces on a chessboard, strategies are being reworked. Make no mistake. A new trend is in the process of emerging. The ocean of money being created by central banks will create a new bubble in asset classes. That new bubble is starting to ferment in the metals and energy markets. Soothing words from OPEC helped to bring oil prices down this week. That is before any shooting begins. Most certainly, any U.S. led effort to seek and destroy the terrorists will lead in one way or another to the Middle East. When trouble erupts in the region, oil prices will rise due to the possible disruption of the supply of oil. One of the world’s most vital sources of energy is located in the states that border the Persian Gulf. Some of those states are friendly with the U.S. Others are not. In fact, any spike in the price of oil benefits them all. It is their one precious resource and a major source of revenue for the governments that control the region. America’s dependence on this unstable source of energy points to our vulnerability. Oil is essential to our country’s national security. The President knows this and will make oil supply a priority in securing our homeland's defense.
Trends to Watch
Oil. It's Always Oil
As a result of this week's panic selling, many high-quality oil and natural gas companies are selling at P/E multiples as low as 4 times this year's earnings. Some pay healthy dividends that are two to three times the yield offered by most companies that make up the S&P 500. Insider buying has never been this strong as evidenced by the flow of money into the sector. Finding large oil deposits is getting harder. Great elephants (discoveries of one billion barrels or more) are a rarity. This is why major oil companies are sitting on $40 billion in cash. Majors are more likely to pursue a strategy of takeovers rather than expend money for exploration.
We are moving closer to a world of scarcity. Despite this year’s slowdown in world economic growth, the IEA still forecasts demand growth this year of 460,000 barrels a day. The growth is coming from the developing world in China and India. The Wall Street consensus is still predicting prices will fall below $20 a barrel. Some are predicting a steep fall below $20 a barrel to as low as $15. They have been predicting this for the last two years. Frankly, consensus is almost always wrong. Many of the firms predicting lower oil prices have been the same firms forecasting higher stock prices this year and last.
Precious Metals
Another emerging trend is the explosive rally in gold and silver prices as evidenced by the graphs below. As reported in previous Storm Series installments, the demand for metals has created supply deficits for more than a decade. Central bank selling has made up the deficit. Now much of that gold lies buried underneath the rubble of the World Trade Center. Just imagine what would happen if investors moved even a fraction of their money out of cash and into metals and demanded the physical. A disaster, greater than has been witnessed in the stock market this week, would quickly be upon us.
For silver, the situation is even more serious. Unlike gold, there are no large central bank vaults brimming with silver that could be dumped on the market to drive its price down. The above-ground stockpiles have all been drawn down as evidenced by these charts. Silver prices have been driven down by huge short positions in the paper markets. ED&F Mann is estimated to be short 10-15,000 contracts of silver. While supplies have been consumed, demand continues to grow. The Census Bureau reports that July silver imports are up 34 percent over last year. The silver shorts have boxed themselves into a corner. Maybe they will get lucky in the short-term. Large paper short positions could keep the spot and futures price from percolating short-term. Long-term is another story. In the long-term supply deficits dictate that the natural order of economics prevail. What is scarce and in short supply will always go up over longer periods of time. It is a basic law of economics that remains irrefutable.
Some may argue that basic economic laws have been repealed. They have not read history. There have been short periods of time some lasting decades when paper money has dominated commerce. It happened for a brief period in the 18th century in France and England. It happened again in the 20th century in 1933 and again in 1971. Since the Bretton Woods System collapsed in 1971, the world has revolved around the dollar and a system of fiat currencies. Governments want their citizens to accept its fiat paper. They have in fact enforced its acceptance by making it legal tender. The real battle taking place now is the battle between the government forces of paper and the forces of real money represented by gold and silver.
From Russia, Asia, and India to the Middle East and Mexico, the hard money forces are making a come back. Russia has introduced gold coins to compete with American dollars. In Russia the people spend rubles, but save in dollars. To compete with those dollars, they now have a choice of Russian-minted gold coins. Which do you think will become their savings preference? Mexico is also considering a silver-backed currency. The dollar-based fiat system is about to implode. It will take time, but it will eventually happen. The U.S., as a result of its continuous trade and current account deficit, has been exporting dollars around the world. Billions of those dollars are being held as reserves by the central banks around the globe. When the realization that the dollar's store of wealth is illusionary, they’ll begin to export them back. Once those dollars arrive on American shores, they will be exchanged for physical assets. The consequences of those returned dollars will end the era of deflation. Hyperinflation will be the result.
The Questionable Path of This Present Storm
I’ve already outlined the course of action for whatever course these storms will travel. Tangible assets such as gold, silver, energy and defense stocks are the preferences for stagflation and The Perfect Financial Storm. Cash and short-to-intermediate Treasuries are the preference for deflation. It appears now that we have both forces at work. As the graph of M-3 indicates, the money supply has gone parabolic. Printing this much money will bring inflationary consequences. The Federal Reserve just reported credit data for the second quarter. Credit expansion during the second quarter continued at an annual pace of $1.8 trillion. That's a bucket of money, even for an economy the size of the U.S. On top of that, non-federal borrowing grew by an annual rate of 8.3%. Consumer borrowing grew at an annualized rate of 9.3%. Mortgages grew at a 12% annual pace.
Financial experts and our public leaders have reassured us that our economy is sound. Yet, the market gyrations over the past two weeks point to a different conclusion. Storm fronts are propping up everywhere around the globe. Bear-o-metric Pressure hasn’t dropped this fast in over 70 years. A rogue wave just hit the U.S. Others will follow. One can only speculate as to the extent of the damage of last week's attack. Realistically, it has impaired our financial system. Irrespective of the $1.38 trillion in stock market losses, the system was headed for trouble. A decade of debt accumulation, mounting trade deficits, a mushrooming money supply, and a surfeit of speculation in our stock market has led us to this precipice. The losses in our markets and those in stock markets around the globe make it clear that the global financial system has now become imperiled.
The key question going forward in determining the path of this current storm will be the dollar. If it holds, the storm is heading for a deflationary path. If the dollar collapses, and it repatriated home, then inflation will be the result. |
