MARKET TECHNICALS AND OBSERVATIONS
Richard Russell’s has been arguing that we are still in a primary bull market because the retail guy didn’t pile in at the top this time. In my view, retail did pile in, but it was in real estate rather than stocks. And while you can leverage stocks by 100% (50% down), in the past two years US retail investors have been able to leverage real estate in some cases by infinite leverage (no money down). This is why this market will be driven downwards by the financial economy rather than the real economy this time around. And the amount of leverage undertaken is much more than in previous cycles. Note that prices are driven by the marginal buyer/seller, not the whole.
We’ve seen this movie before, but in different constructs, but with always the same false premise. In the 1970’s banks got into trouble by lending to companies based on the assets on their books rather than the cash flow of the company. Thus, when the recession hit, companies were unable to service their debt and went bankrupt with the banks holding the bag. In the late 1980’s, Japanese banks lent to companies based on asset values rather than cash flow, and when asset values began to fall and banks began to demand more collateral, corporations were unable to meet the margin calls and went bankrupt, as they too did not have the cash flow to service the debt.
This time we are seeing the exact same problem with a different set of customers. This time, the US home buyer (dare we say the UK, Spain, and Australia as well?), buy homes for little or no money down with the money being lent against the value of the home rather than the cash flow of the buyer / investor. Once again, as asset values are now falling, and with back-ended resets on loans, we are seeing that the borrower is not able to service the debt via cash flow since the value of the asset has begun to drop. The banks are once again culpable, but in a different fashion. Rather than have the risk on their books, they’ve simply had it rated “highest grade” as with Penn Central and Coventree and had buyers purchase on the faith of the credibility of the banks and the ratings agencies. Now that they discover they’ve been had, they no longer want any of the paper at any price. Thus, the liquidity crunch.
But I agree with Professor Roubini that the problem goes far beyond a mere liquidity crunch. We now have a solvency crunch. That is, we now have rapidly increasing numbers of US consumers that are bankrupt, and I expect that number to escalate rapidly as resets on mortgages continue to come in with the homeowner unable to refinance at any rate close to what his/her cash flow can support and with basically margin calls coming in as new mortgages will demand 20% down, rather than 0% down. Money the homeowners do not have. So in sum, I think that while the Fed has put a band-aid on the liquidity issue, the larger issue is not going away and it will only grow.
With all that said, the stock market apparently disagrees with my assessment, at least so far. Note that for the month of August the market is up 1.83% and for the year is up 5.54% (including dividends). Even since the beginning of July, the market is only down 1.33%. That hardly conforms with my view of future earnings in the US, as I see a consumer led recession in the near future. The market has been held aloft by sectors such as Home Entertainment, Retail Stocks, and Health Care. Areas such as publishing, homebuilding, autos and financials have offset those gains for the most part. In sum, we’ve seen some dramatic rotations in sectors, yet money has not yet left the markets.
There is always someone prominent who throws in the towel at the top. Julian Robertson gave up and closed his fund a mere 3 months before the top in 2000. Is it possible that Richard Russell, who has been bearish for years and subsequently turned bullish in June has made such a signal this time? For while Richard says we might trade lower, we are merely setting ourselves up for the most powerful rally in the markets yet. He might well be right. But until the markets make new highs, I would rather be either on the sidelines or short, as very long-dated charts show that we just might have made significant “double-tops” in the market. Observe the monthly charts on both the German DAX and the US S&P 500.
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