Mac Chronicles ...
CONCLUSIONS
From either first hand or second hand conversations, I have been in touch with three hedge fund managers who each manage billions upon billions of dollars in funds. Each of these three managers have been trading for at least 25 years, have 20+% annual returns, and have had minimal drawdowns. These managers are the best of the best of the best. They are much smarter and better informed than I ever will be. Each of them, as I understand it, is doing the exact same thing. That is, they are very, very long cash with very few directional bets at all. They are waiting for some “pivot point” or crucial bit of information that will tell them which way to go and then they will put on the trades in huge size. Why the hesitancy to put the trades on at this moment? I think that I see their reasoning - they need to see how the government reacts. Let me explain.
The rationale for them not to be short the market is that they are not sure what the US and European governments are going to do. There is a tremendous temptation by the governments to be seen as “doing something to help the little guy.” And that temptation is to bail out the homeowners and Wall Street by socializing the losses. That is, print money like nobody’s business and inflate the problem away – at least temporarily. My view is that there is little that the Federal Reserve can do, and the risk is that the Federal Government intervenes in some distortive way to stimulate the economy by eliminating the home loan losses. President Bush is trying not to do that, but at the same time be seen to do “something” by “not bailing out Wall Street, but by helping the “little guy.” The Wall Street Journal reported:
Among the moves will be an administrative change to allow the Federal Housing Administration, which insures mortgages for low- and middle-income borrowers, to guarantee loans for delinquent borrowers. The change is intended to help borrowers who are at least 90 days behind in payments but still living in their homes avoid foreclosure; the guarantees help homeowners by allowing them to refinance at more favorable rates.
Mr. Bush also will ask Congress to suspend, for a limited period, an Internal Revenue Service provision that penalizes borrowers who refinance the terms of their mortgage to reduce the size of the loan or who lose their homes to foreclosure. And he will announce an initiative, to be led jointly by the Treasury and Housing and Urban Development departments, to identify people who are in danger of defaulting over the next two years and work with lenders, insurers and others to develop more favorable loan products for those borrowers.
Note that his plan involves only the FHA, which offers loans only to lower class individuals with loans of less than $362,790. That basically eliminates the problem areas in Florida, Arizona, and California where speculation has been rampant, but might help the tremendously pressured workers in places such as Detroit, where home values average US$100,000 and unemployment is approximately 10%. The plan would affect a maximum of 80,000 homeowners in 2008. That is a very small dent in the 2 million or more homeowners that are at risk of defaulting on their mortgages in the next 2 years. So to Bush’s credit, he is trying to target those who are really under pressure for economic reasons without trying to bail out either Wall Street or the speculators who have been purchasing “investment properties” even though they were uneconomic decisions in the first place. However, the risk is that the Democratic Congress with cheerleaders such as Clinton, Obama, and Schumer try to “one-up” Bush and extend the bailout plan to everyone in the nation. While I don’t see how exactly that can be done, the risk is that we experience a basic socialization of losses. That is, the speculator makes the profits on the way up, but the taxpayer covers the losses on the way down.
If this happens, this equates to nothing more than a huge printing of money that is massively inflationary. That could mean that stock prices would go up, and perhaps tremendously. That may be the rationale for Richard Russell’s argument that we are getting ready to see an explosion on the upside in stock prices. While that might be true in US dollar terms, I would think that if that happened, we would see the dollar go into freefall, if not against other currencies (who don’t’ want to see the dollar fall and could possibly bail out their investors as well – notably in Europe), but against other assets such as gold. In fact, if that happened, I would expect gold to explode to the upside. In fact, we saw gold move higher on Friday in response to the Bush proposal. But remember, the Zimbabwe Stock Market has been the best performing stock market in the world for the past eight years in a row. For example, the Zimbabwe market was up 912% in 2006 in local currency terms, but has declined precipitously in US dollar or other foreign currency terms. So while the populist theory would be to socialize the losses, in the long run it would be disastrous. But if it does happen, being short stocks at this point would be disastrous as well.
The problem as I see it has been mismanagement by the Fed in the past five years, basically keeping real interest rates negative and encouraging rampant speculation in all asset classes. This has been true throughout history. For example, in my opinion, the Fed’s mistake was not in setting interest rates lower during the period from 1929 to 1934, but that real rates were negative in the huge run up in prices from 1924 to 1929. The same can be said for the negative interest rates in Hong Kong from 1992 to 1997 and the negative rates in Japan from 1986 to 1989. And to be honest, we are seeing the exact same problem being created in China today. That is, negative real rates encourages excessive investment, mal-investment, and encourages spending in non-productive assets. In the US, we have seen a negative savings rate with money being borrowed to buy uneconomic assets such as homes with cap rates below rental rates and HELOC’s to buy depreciating assets such as cars, boats, computers, big screen TV’s, jet skis, etc. ad nasuem. So the end result is that these assets eventually have to deflate in value while the debt incurred does not deflate, creating massive amounts of solvency problems as people’s and company’s debts exceed the value of their now deflated assets. It is toxic. And the piper has to be paid. There are two ways to solve it – one is as above, creating massive inflation by socializing losses and in effect printing massive amounts of money. The other option is to see a deep recession and many bankruptcies as people now have to go into savings mode and try and work down the massive debts incurred in the last decade.
The other option is to let the market work and let the deflation in assets begin until we once again have solid balance sheets. The problem with this is that it will create a recession, increased unemployment, and a sharp decline in consumption as savings must then increase. And obviously this is not the scenario that politicians want to see. Thus, they are under enormous pressure to do “whatever it takes” to keep this from happening. Even a sharp drop in interest rates may not solve the problem as we saw in the US in the 1930’s and in Japan in the 1990’s. That is because even if rates drop, that doesn’t necessarily mean that lenders are willing to lend nor are borrowers willing to borrow more – unless they expect to be bailed out if they are wrong – the moral hazard that the Fed doesn’t want to embed in the markets, yet the exact thing that Greenspan has done for the past two decades.
That is why I think the very smartest of fund managers are on the sidelines at the moment. They are not sure which way the process will go. But when they do, they’ll go into the market with both feet, filling their boots. If socialization happens, then they will buy gold, sell long-dated bonds and will put on any other trade that will protect them from the inevitable inflation. If the markets are allowed to function as they should, then all asset classes will deflate, and they will get very short the stock market, buy long dated bonds and hide in any other asset that will protect them from the deflation in assets. They don’t yet know which policy will be undertaken, so they sit on their mountains of cash waiting for the signal that tells them which way to invest. I have to think that they are playing it smarter than most everyone else at this moment trying to guess the market. Being long cash is probably a smart move at the moment as smart investors always try to limit their losses so that they can invest when the risk-reward trades are set up in their favor. |
