Wednesday, June 11, 2008

Debt Rattle, June 11 2008: Cheerleading, fear and reality

1930, London, England: The March of the Unemployed from the Thames Embankment to County Hall

Stoneleigh: Many of the stories today reflect the perennial misunderstanding as to the nature of inflation. Price rises are not inflation - inflation and deflation are monetary phenomena. Changes in the money supply can lead to price changes, but prices do not always move in the direction one might expect, as they also depend on other factors such as supply and demand balance, fear of shortages, hoarding behaviour and speculative momentum-chasing.

As George Soros points out, markets are reflexive - the actions of market participants affect expectations that in turn affect prices. Markets are NOT a rational, efficient and dispassionate resource allocation mechanism.

Despite the best efforts of central bankers to talk the market up, reality is catching up with them. Fear has returned, and the fearful are inclined to sell first and ask questions later.

Fear Factor: Off The Charts
When it comes to the world of finance, FEAR is to a rising market what a hot flame is to an air-filled balloon. The challenge comes in knowing beforehand when things are about to go “POP!”
And, because we're talking not about atomic particles but fear, the question is: How does one quantify emotion?
In our experience, one of the most reliable measures of collective investor emotion is the Junk-to-Treasury Yield Spread, or difference between low grade and high-grade debt. The two sides of the spectrum carry the following implications:

* Narrowing yield spread: The public takes greater risks in search of greater rewards. Feelings of optimism encourage speculation and spending, the two engines of economic growth. Stock markets rise.
* A widening spread: The public flees to safe assets. Feelings of pessimism dissuade risk-taking in any form. Stock markets fall.

Therefore, to observe major trend changes in the Yield Spread is like hitting the predictive mother load.

Take the Fed's rosy outlook with a hefty grain of salt
Panic over. Ben Bernanke, chairman of the US Federal Reserve and therefore the world's most powerful central banker, says we can breathe easier. Forget all talk of the return of the dust bowl and the soup kitchen; put to one side concerns that record oil prices are about to trigger a rerun of stagflation. Things, according to the Fed, are about to get better.

If true, that's the sort of message Gordon Brown and Alistair Darling badly want to hear, particularly on a day when it was revealed that child poverty was up for the second consecutive year and pensioner poverty was also on the increase....

....Well, perhaps. There are, in all honesty, quite a lot of provisos involved in this rosy scenario. The first is that the US really has turned the corner as a result of the aggressive cuts in interest rates from the Fed over the past nine months, coupled with a $150bn tax cut from the Bush administration. There have been a few indications that potential buyers are sniffing around the property market after two years of meltdown, but house prices are still falling fast, consumer confidence is at a record low, and last week's unemployment figures showed a sharp jump. To make matters worse, the fall in the value of the dollar is helping to push up oil prices, and with a gallon of gas costing $4, working Americans are feeling the squeeze.

Indeed, the timing of Bernanke's comments is important: there is a concerted effort by the Fed, the US treasury and the White House to talk up the value of the dollar in order to lower the cost of imports - especially oil - and to boost consumer spending power.

The second proviso is that the UK housing market is in better fundamental shape than the US's. Little of the recent evidence has suggested that this is the case; on the contrary, both Anglo-Saxon economies have been through the same depressing cycle of too much funny money pumping up colossal property bubbles. Boom has turned to bust, with the Royal Institution of Chartered Surveyors reporting a collapse in activity at estate agents throughout the UK, and the two leading measures on house prices reporting a drop of about 2.5% last month.

City analysts are now talking about a 30% drop in prices by the end of next year, pushing those who took out mortgages of 100% or more over the past couple of years driven deep into negative equity.

UK house sales drop to lowest level in 30 years
The number of houses changing hands has "collapsed" to the lowest level in 30 years, an influential housing market survey shows today. The fall in sales far exceeds the depths of the last housing crash in the 1990s and is the lowest since records began in 1978....

....While prices have started to fall in earnest only in the past two months, the report makes clear that the property market is in a dire state. Buyers are refusing, or unable, to hand over any money to purchase a house.

"The continuing lack of demand in the housing market is reflected in the collapse in transactions," says the report."

Tim Edmonds, an estate agent and RICS member, said: "Transactions have virtually halted. Where sales have been agreed, it is very difficult to get them through to exchange."

Neil Hunt, a Derbyshire-based estate agent, said: "Demand has plummeted to a crisis point with sales at their lowest May level in memory.

"An avalanche of job losses in the housing industry is beginning to materialise which could make current media stories look like the good old days."

The credit crisis has pushed up the cost of mortgages and first-time buyers need to find deposits of 10 or even 25 per cent to get the best rates from some lenders - equating to more than £30,000.

Shares in top UK housebuilders crumble
More than £400 million was wiped off the combined value of Britain's big seven quoted housebuilders today over fears of impending asset writedowns. Barratt Developments and TaylorWimpey were hit the hardest.

The share price crash leaves the combined market value of the big seven at just under £4 billion. Last year their worth stood at £18.5 billion.

Housing sector stocks have plummeted this week after a string of industry surveys which, among other things, have revealed that confidence in the sector had hit a low not seen since the housing crash in the 1990s.

FSA puts pressure on top five banks to support Bradford & Bingley rights issue
The Financial Services Authority took the unprecedented step of pressuring Britain’s five biggest banks into supporting the revised rescue capital-raising at Bradford & Bingley last week, The Times has learnt. HSBC, Royal Bank of Scotland, Barclays, Lloyds TSB and HBOS are understood to have each agreed to sub-underwrite £20 million-worth of the reworked £258 million rights issue.

The banks agreed to step in when Citigroup and UBS, the lead underwriters, could find no one to whom they could lay off some of the risk. Underwriters typically pass on some of the risk to institutions known as sub-underwriters. The FSA, worried that too much Bradford & Bingley stock would be left with UBS and Citigroup, which are already under pressure, decided in the middle of last week to ask the big five to take some of the risk. Earlier, it had asked them for a Bradford & Bingley back-up rescue plan in case the revised restruc-turing hammered together nine days ago fell apart.

It is unheard of for the FSA, which is responsible for bank supervision, to orchestrate a back-up rescue in this way.

Bank of England Governor wants banks to set up compensation scheme
The Governor of the Bank of England put himself on a collision course with the high street banks yesterday by calling on them to put billions of pounds into a consumer compensation scheme.

Mervyn King used the British Bankers’ Association (BBA) conference, attended by the chief executives of the country’s three biggest banking companies, to suggest that banks make upfront payments to a new scheme to compensate savers who lose money in a bank collapse.

Mr King admitted to the 350 delegates that his suggestion would be unpopular, but described it as decidedly wise. “Some element of prefunding is natural,” he said.

The BBA’s members are desperate to avoid paying upfront into a new compensation pot. Banks, already liable for levies of up to £4 billion a year to an existing compensation scheme, want to provide fundings as and when the scheme needs to make payouts, rather than allow it to sit on a pot of ready cash.

BBA bows to pressure to overhaul Libor
The key Dollar Libor interest rate has registered its biggest increase since near the start of the credit crunch after the British Bankers' Association bowed to industry pressure and announced reforms to its benchmark measure for inter-bank borrowing.

The London inter-bank offered rate for the dollar has been lagging other money market rates, sparking suspicion that banks have been under-reporting their borrowing costs to avoid being stigmatised. The rate for three-month dollar Libor jumped 10 basis points to 2.79 per cent in its biggest increase since last August. The new rate is the highest since the end of April.

Libor is set using a daily survey of 16 panel banks that report the rates they pay to borrow from each other in different currencies and for varying lengths of time. It is thus a key measure of how prepared banking institutions are to lend to each other.

The BBA said it would scrutinise more rigorously the rates that banks submit. It will also expand the membership of its foreign exchange and money markets committee, which oversees Libor, and increase the number of contributors to some of the rate-setting panels.

It will also seek opinions on whether the rate-setting mechanism, which shows what rates banks are reporting, is stigmatising contributors and whether there should be a second rate-fixing process for US dollar Libor after the US market opens. The change for US Libor would aim to set rates more in line with supply and demand for dollar lending.

Inflation shock leaves markets fearing three interest rate increases this year
Investors have bet that the Bank of England will have to raise interest rates as many as three times before the end of the year.

Swap rates - the key money market measure reflecting traders' expectations for borrowing costs - rose at the fastest rate since Black Wednesday 16 years ago after a "shocking" rise in factory gate inflation.

In scenes described by one observer as "carnage", traders embarked on a massive sell-off of UK government bonds, pricing in the likelihood that the Bank's Monetary Policy Committee will lift the official base rate to 5.75pc by the end of the year.

The two-year swap rate, which represents the wholesale cost of fixed-rate borrowing, jumped from 6pc to 6.3pc in the space of a few hours. Only last month the same rate had been down at 5.4pc, implying the Bank would soon cut rates.

Jonathan Loynes, of Capital Economics, said: "I can't remember another day when I've seen a shift in the market like this."

Philip Shaw, of Investec, said: "It was carnage out there. The markets are very tetchy because they do not know how central banks will react to this combination of high inflation and low growth."

Banking... the worst may be yet to come
Neither the data nor the newsflow on the wider economy looks like getting better any time soon. To the contrary, all the evidence is of further deterioration. Alarmingly, last week's survey from Halifax showed house prices were falling at a steeper rate than at any point in the last housing slump of the early 1990s. The read through from this adjustment to the wider economy is still far from clear, but it is hardly likely to be positive.

In any case, we may be moving into a second and even more difficult phase of the banking crisis where conventional bad debts and consequent impairment charges take over from where mortgage-backed securities, leveraged loans and monoline writedowns left off. It only requires a modest rise in bad debt experience to decimate the profits.

The Next Real Estate Crisis
By April, 2009, hundreds of thousands of option ARM mortgages will begin resetting, bringing on a fresh wave of foreclosures

The American homeowner must feel like one of those characters in an old cartoon who has just been hit by a falling piano. After dusting himself off and touching the large bump on his head, he probably doesn't expect another piano to be dangling overhead. But he'd be wrong.

But what's often funny in a cartoon is anything but in real life. With the subprime mortgage crisis already crippling the U.S. economy, some experts are warning that the next wave of foreclosures will begin accelerating in April, 2009. What that means is that hundreds of thousands of borrowers who took out so-called option adjustable-rate mortgages (ARMs) will begin to see their monthly payments skyrocket as they reset. About a million borrowers have option ARMs, but only a fraction have already fallen due.

That was the catch to option ARMs; borrowers were offered low initial payments that would recast higher after several years. Many home buyers thought they could resell their homes before their payments increased. But instead, many of them got trapped. According to Credit Suisse, monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Some of these loans have already started to recast. About 13% of option ARMs that were issued in 2006 were delinquent by 60 days by the time they were 18 months old, Credit Suisse said.

Mortgage Delinquencies Rise Nearly 62 Percent in First Quarter
Borrowers more than 60 days in arrears on their mortgages hit a record high 3.23 percent for the first three months of 2008, TransUnion said — that’s up 8 percent over the previous quarter’s 2.99 percent average, and is a staggering 61.5 percent higher than the first quarter 2007.

Mortgage borrower delinquency rates in the first quarter of 2008 were highest in Nevada (5.81 percent) followed closely by Florida (5.38 percent), while the lowest mortgage delinquency rates were found in North Dakota (1.17 percent), Wyoming (1.41 percent) and South Dakota (1.48 percent). Delinquency trends clearly mirror the regional distress being felt in key states, although it’s worth noting that even states with comparatively lower rates of mortgage distress are still exhibiting historically high amounts of borrower delinquencies.

Somewhat confoundingly, the average national mortgage debt per mortgage borrower rose slightly to $191,917 from the previous quarter’s $191,370 total, TransUnion reported; the first quarter 2008 average represents a 5.38 percent increase in average mortgage debt load compared to the first quarter 2007 of $182,126.

The credit bureau suggested in a press statement that increasing mortgage debt is the result of consumers’ expectation that perhaps 2008 could represent a year with excellent buying opportunities. It also could reflect the distress being felt by consumers, many of whom are seeing their reported loan balances increase due to workouts or loan recapitalization, sources suggested to Housing Wire.

Mortgage Bonds Resume Stumble; Some Debt Nears Lows
Some of the U.S. mortgage bonds at the center of the yearlong credit crisis are slipping toward new lows, as climbing gas prices, unemployment and interest rates deepen concern that homeowner defaults will increase.

The benchmark Markit ABX index linked to the last-to-be- repaid of originally AAA rated subprime-mortgage bonds from the first half of 2007 fell today to a record low of 50.55, down about 16 percent from May 19, suggesting a corresponding drop on similar securities. Top-rated bonds of ``option'' adjustable-rate mortgages are also falling, according to a report yesterday from RBS Greenwich Capital.

UBS takes hit from investor pessimism
Shares in UBS hit a 12-month low and were suspended twice yesterday, the last day of trading the rights for the Swiss bank's SwFr16 billion (£7.9 billion) capital raising. The bank's stock was buffeted by further losses at Lehman Brothers, reports that UBS was due to make a second-quarter loss and concerns that the rights issue would be badly under-subscribed.

Banks and investors that had waited for the last day to decide whether to participate dumped huge amounts of rights on the Zurich stock exchange. A technical glitch meant that they could not be matched immediately with buyers and the exchange was forced to suspend trading in the stock twice while it auctioned the spare rights.

UBS shares dropped 9 per cent to SwFr22.41 each, hitting a 52-week low, before closing down 3.25 per cent at SwFr23.82. Investors have been offered the opportunity to buy seven new shares for every 20 they hold, pricing the new shares at SwFr21 each.

Sentiment surrounding Switzerland's largest bank is low, with speculation rife that a lack of confidence in UBS's management meant investors were reluctant to exercise their rights.

Japanese sub-prime losses up 41%
Japanese banks are feeling the fallout from the US subprime mortgage crisis and the credit crunch, according to the country's financial watchdog.

The Financial Services Agency said losses stemming from US sub-prime lending increased by 41% to 850bn yen ($8bn; £4.1bn) at the end of March.

Total losses on investments related to risky mortgages was far bigger, amounting to $23bn.

But it said Japan's sub-prime hit was not as severe as in Europe and the US.

Losses at Japanese banks have been dwarfed by those suffered by American and European rivals, such as Citigroup and UBS.

But the sector still has been exposed to losses from investments in high-risk financial products, such as residential mortgage-backed securities and collateralised debt obligations.

Japan's second-largest lender Mizuho Financial Group, the hardest hit so far, lost $6.1bn on sub-prime-related investments in the year to March.

TMS or M3? A Reply to Paul van Eeden
A few weeks ago Paul van Eeden (PVE) posted an extremely bearish outlook on bonds that he justified, in large part, by the rapid expansion of M3 money supply. We responded that while we are long-term bearish on bonds (we expect bond yields to move much higher over the coming 5 years), we thought that PVE's premise was wrong. Our reasoning: M3 is a poor indicator of monetary inflation, whereas a vastly superior monetary aggregate, namely the True Money Supply (TMS) developed by Murray Rothbard and Joseph Salerno, reveals a relatively slow rate of monetary inflation....

....We considered M3 to be a reasonable indicator of monetary inflation until early this year, at which time the large divergences between different monetary aggregates prompted us to delve much more deeply into what should, and should not, be counted in the money supply. The research we did during the first few months of this year convinced us that a) flaws in the compositions of M3 and MZM were causing these broad measures of money supply to generate 'major league' false signals, and b) TMS, while perhaps not ideal, was a much better measure of money supply.

Shock move sounds inflation alarm
The Bank of Canada has abruptly shifted its focus away from the slowing economy to target an emerging inflationary threat.

After months of aggressively slashing interest rates to protect the Canadian economy from a U.S. recession, Canada's central bank has now switched paths by deciding yesterday to keep interest rates on hold.

The move signals that the bank has been swept up in the global effort to steer economies through a toxic mix of weak growth and rising inflation. Central bankers have to tackle one or the other – slow growth or rising inflation – and with commodity prices soaring, the bank is coming down on inflation....

....The swift change puts the Bank of Canada on the same wavelength as the European Central Bank and the U.S. Federal Reserve Board, which have heightened their anti-inflation rhetoric in recent days.

Facing inflation, Asia gets more aggressive
Across Asia, the bugbear of inflation is back, and it's not just policy wonks who are feeling the strain. Faced with rippling social unrest over soaring prices for fuel and food, governments are struggling to cushion the blow, while keeping economic growth on track.

With inflation rates at multiple-year highs in Thailand, Vietnam, South Korea, and Indonesia, policymakers are reluctantly raising interest rates in a bid to keep a lid on rising prices. At the same time, Asian governments are having to slash fuel subsidies to stop their own budget blowouts, all the while keeping a wary eye on the political backlash.

Last week, Malaysia raised pump prices by 41 percent for gasoline and 67 percent for diesel, to the dismay of consumers accustomed to cheap fuel, and to the delight of an emboldened opposition that has begun planning nationwide anti-inflation rallies. Reaction was swifter in India, where protests broke out in West Bengal after double-digit fuel price rises that, analysts say, could dent the popularity of the ruling Congress Party.

As global oil prices stay high, the pressure on Asian central banks to tackle inflation is growing. The dilemma is how to raise interest rates without slowing the growth that underpins the popularity of many governments in the region. But there's little doubt that global price trends are forcing policymakers to act now.

Sticker shock at the supermarket
With food prices up 6 percent from last year – flour alone has gone up 87 percent – and gasoline prices up by more than a dollar since 2006, the receipts are adding up, causing a "dramatic" shift in kitchen-table decisions from Albuquerque to Atlanta, says Maura Daly, a spokeswoman for the charitable hunger-relief organization America's Second Harvest in Chicago.

The struggle to put healthy food on the table is tough enough as meat, egg, and veggie prices are rising fastest. But a 15 percent increase in soup-kitchen lines nationwide since last year indicates that many families are struggling to put any food at all on the table.

New evidence of the difficulty: 1.5 million more people use food stamps than a year ago, a 5.7 percent increase, according to the US Department of Agriculture.

At the same time, Americans are trying to stash more money away in savings – indicating a "scrounge" reaction as families dig deeper into their cupboards. Taking place over bins of oranges and stacks of canned soup, this may be the century's biggest test so far of America's consumer resiliency – and inventiveness.

UK petrol sales fall 20 percent as drivers feel the pinch
Petrol retailers have disclosed that fuel sales dropped sharply over the past few weeks and the latest figures appear to show that demand for petrol in Britain has slumped by as much as 20 per cent over the past 12 months.

According to the IEA, a part of the Organisation for Economic Co-operation and Development, motorists are instead choosing to take public transport as their cars become too expensive to run.

Speaking to The Daily Telegraph on Tuesday, Eduardo Lopez, the IEA's chief oil analyst, said: "British motorists are clearly driving less. "They are switching to public transport, which is much easier to do in Britain than in America, where people living in the suburbs often have to drive whether or not they want to."

The analysis provides some of the first hard evidence that motorists are realising that they have to change their behaviour in response to the sharp rise in petrol prices.

The drop in demand for petrol among British drivers is greater than that being experienced in other countries.

Water: The petroleum for the next century?
A catastrophic water shortage could prove an even bigger threat to mankind this century than soaring food prices and the relentless exhaustion of energy reserves, according to a panel of global experts at the Goldman Sachs "Top Five Risks" conference.

Nicholas (Lord) Stern, author of the Government's Stern Review on the economics of climate change, warned that underground aquifers could run dry at the same time as melting glaciers play havoc with fresh supplies of usable water.

"The glaciers on the Himalayas are retreating, and they are the sponge that holds the water back in the rainy season. We're facing the risk of extreme run-off, with water running straight into the Bay of Bengal and taking a lot of topsoil with it," he said.

"A few hundred square miles of the Himalayas are the source for all the major rivers of Asia - the Ganges, the Yellow River, the Yangtze - where three billion people live. That's almost half the world's population," he said.

Lord Stern, the World Bank's former chief economist, said governments had been slow to accept that usable water is running out. "Water is not a renewable resource. People have been mining it without restraint because it has not been priced properly," he said.

Farming makes up 70 per cent of global water demand. Fresh water for irrigation is never returned to underground basins. Most is lost through leaks and evaporation.


Anonymous said...

Hello Stoneleigh,

Thank you for the Safehaven article on TMS.

Elsewhere, I read that:
"The TMS consists of the following: Currency Component of M1, Total Checkable Deposits, Savings Deposits, U.S. Government Demand Deposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and Demand Deposits Due to Foreign Official Institutions."

But I am still left with my questions.
1. TMS + Credit = What? Is there an aggregate that takes credit into account when calculating the overall money supply?
2. Do we not need such an aggregate to determine whether we are in an inflationary or deflationary situation? Otherwise, how do we know?

Thanks for any help with these issues because an understanding of the trend (toward inflation or deflation) will be critical in making decisions in the coming weeks and months.


Anonymous said...

I just want to say how much I despise headline writers who say something like "lowest in 30 years" (3rd article), when actually the records began 30 years ago. This is increasingly common, and a clear mis-representation of the situation towards the positive. Lowest in 30 years sounds a lot better than "lowest in recorded history", which is true.

It reminds me of the Simpson's hurricane episode, where Homer is confident they won't be hit by a hurricane because the records show it never happend. Lisa of course points out the hall of records mysteriously blew away 30 years ago.

Anonymous said...

Hello Stoneleigh,

It occurred to me that if I purchase short term treasuries thru, but the institution that I link to could possibly go boom someday. I suppose there would be some other bank in the area I could setup again, but what if all banks go boom? I couldn't have the government send me a check because there might not be any banks to cash the check. Some days my mind works overtime.
Thank you,
Anonymous reader

Anonymous said...

If all the banks go boom to the point where you can't cash a check anywhere then paper money and probably gold and silver too will be worthless. I have to hope that things won't get quite that bad.

Anonymous said...

I think about the same thing. FWIW, if you go through Legacy Treasury Direct, you can set up multiple accounts with direct deposits to different banks--all with the same SSN. One of the reasons I read this site, though, is to help determine when (how) I should make other arrangements.

Stoneleigh (or anyone!),
I’ve read Nico Isaac’s article on quantifying emotion, but don’t know enough about how markets work to follow his logic. Is there a way you could explain in extremely simple terms how feelings of optimism produce a narrowing yield spread between low and high grade debt and pessimism produces a widening spread? I imagine this is pretty “basic,” but please remember I’m a financially challenged, non-business, English-major-nutso-type who’s pretty dim about markets and I just don’t know how it works.


Anonymous said...

I got an account at Treasury Direct but haven't used it yet. Can anyone say if there is an advantage to using Treasury Direct rather than just buying I or EE series Savings Bonds from my local bank? I know with I series bonds you lose your last 3 months interest if you cash them in before maturity. Any other downsides?

scandia said...

In reviewing statements by " the cheerleaders" to-day I suddenly felt like a subversive. The information presented on TAE is contrary to what Bernacke,Paulson,Carney are saying.
The free speech and sharing of knowledge and analysis practiced here must be driving them crazy! Wonder if they read TAE,Mish,Denninger,Roubini and others?

Anonymous said...


Just wanted to comment on the brilliant call about drop in the markets returning now.

Stoneleigh said...

I am planning to answer people's questions, but I've been dealing with a new arrival out in my barn. One of my sheep gave birth and I've been setting up a mother-and-baby stall (while dodging an aggressive ram). I'll get to the questions as soon as I can.

Farmerod said...

Stoneleigh must still be on the lamb.

(Ewe, just kidding. Hope I didn't get your goat).

Stoneleigh said...


Your comment disappeared, but I think I can remember vaguely what you said. You have a point about cashing out silver. It would be difficult to extract that kind of money from the banking system in cash at this point, given that removing a large amount of cash at once is considered suspect activity.

Not that I know all the details of your situation, but it sounds to me like you have less need to consider cashing out that most, since you have no debt. As long as you have, say, a year's worth of liquidity (not necessarily a year's worth at a high standard of living, but enough to cover the basics for a year), then you could hang on to at least most of your silver as an insurance policy. Be prepared for its value to fall up to two thirds in nominal terms though, as the top appears to be in for silver (see the recent spike high and rapid retreat). The rebound since appears to be a small scale count-trend rally that seems to be essentially over.

If you don't want to hold it as an insurance policy through a fall in price that could last for many years, then you could cash it out and hold short term treasuries rather than cash, as that isn't a suspect activity. Governments are fine with traceable financial flows, but cash makes them jumpy because they can imagine all manner of illegal or tax-avoiding reasons for dealing in cash. Having access to cash is important, but you'd need to get hold of it a bit at a time over quite a while, and you'd need to start ASAP as you may not have all that long.

Stoneleigh said...

To various people who have mentioned TreasuryDirect:

As I'm not American and have never lived there, my knowledge of the specifics of buying American assets in America is incomplete. Ditto my knowledge of American tax law when it comes to such things as cashing out 401K plans. For specifics such as those, it's best to ask a local financial advisor, although you may need to be prepared for him to try to talk you out of what you want to do if he doesn't read TAE :)

Stoneleigh said...

Kypat and Ric,

Thanks Kypat:)

We're very close (less than 50 points) to a trendline that has contained all the downside action since 1975. If this trendline is decisively broken, I would expect it to lead to much greater selling pressure. However, it would be common for there to be a bounce up from that point before breaking the trendline. I wouldn't expect it to be a lasting move like our recent long rally though.

Markets have all manner of fluctuations, with count-trend rallies at all degrees of trend all the time, which can make timing challenging. Timing will be everything for a few years though. Everyone forgets about market timing during long expansions when buy and hold seems so simple, but once volatility is the name of the game (and we should see huge swings on the way down), market timing always makes a comeback.

Those who would tell you that markets are a rational and efficient resource allocation mechanism (which is virtually all economists and many finance professionals by the way), would also say that market timing is impossible. That model of market dynamics is delusional though. Markets are creatures of emotion, of human herding behaviour as investors jump on passing bandwagons too late and end up holding the empty bag. Markets are a predatory wealth concentration mechanism for insiders to feed off the greed and fear of the public. The public may appear to gain during long periods of market euphoria (such as the run up into 2000), but as a group they always hang on too long and end up giving it all back. The public is always fully invested at tops an fully liquid at bottoms, while insiders are contrarian, taking the opposite positions and gaining hugely.

Nico Issac's article deal briefly with the herding impulse, which is subconscious and emotional rather than conscious and rational. Essentially, societies have collective mood swings because we are hardwired to pick up on the emotional responses of others (like deer who run first and ask questions later if one of their number flashes the white underside of their tail to signal danger). These instincts are very deeply ingrained in all social mammals. For more information on the mechanism, google 'mirror neurons'.

Most people who invest have no real information. All they can do is to watch what everyone else is doing and follow the consensus, thereby becoming part of it. Thus the very foundation of markets is destabilizing positive feedback - not the negative feedback tending towards equilibrium that most economists would have you believe. We are programmed to feel acute discomfort if everyone else around us thinks we are crazy because we're bucking the trend. Following trends is a recipe for social inclusion, so trends are powerful forces.

The result is that consensus builds over time, becoming harder and harder to resist until it has suckered in as many people as possible. In the meantime, the insiders who started the trend will have cashed out well before the top, leaving the job of empty-bag holder to the majority who did not. This is essentially a description of a Ponzi, or pyramid scheme, which markets greatly resemble in many ways. The long mania we have lived through is simply the largest pyramid scheme in history - it's high level of social complexity based on cheap credit underpinned by cheap energy.

Society's collective mood swings tell you a lot about what people will collectively do. When the majority is in an optimistic mood, they are prepared to take risks because they see good chance of success. They start companies, and invest for the long term because their 'discount rates' fall as their tolerance for risk increases. In other words, they value the future more than usual (although humans are so biased towards short-termism that this increased valuation of the future is never enough to actually achieve anything that might preserve a future for the next generation). Mainstream environmental movements are always formed near highs in social mood for instance (but they disappear very rapidly when hard time short people's horizons drastically). Optimistic populations also increase the social inclusiveness of their political culture over time, weakening the 'us versus them' dichotomy.

Whereas long upswings generate complacency as to risk, social inclusiveness and environmental concern, among other things (colourful clothing, cheerful if sometimes mindless music, an appreciation of beauty in art and literature etc), downturns generate the opposite. As the mood turns, and a new consensus builds over time, the mood turns from greed to fear to anger, from social inclusion to exclusion (leading to increasing xenophobia and a blame-game), from care for the long term to worrying only about today and maybe tomorrow, and from risk tolerance to risk aversion. (On a more trivial note, people also begin wearing dark or drab colours, listening to angry and dischordant music, developing a taste for horror stories and appreciating artwork that is deliberately ugly.)

From the point of view of markets, risk aversion is the killer because lack of confidence translates very quickly into a lack of liquidity. In a very real sense, confidence is liquidity in a world where money is essentially pulled from a hat through fractional reserve banking. Markets freeze up very quickly when the mood turns, and it can turn on a dime. In fact it makes multiple turns at different degrees of trend, producing counter-trend rallies where everyone goes back to sleep again for a couple of months instance (and starts clapping the Fed on the back for a job well done).

If you read the mood of the crowd and watch consensus develop, you can develop a sense of where things are going, since mood is a leading indicator. Financial decisions follow mood swings, and these are followed in turn by economic effects and then by political fallout from those economic effects. There are even those who quantify such effects by applying fractal geometry and Fibonacci mathematics to markets (and I have seen them be uncannily accurate in their assessment of turning points over the 15 years I have followed such analysis.) See The Misbehaviour of Markets by Benoit Mandelbrot or Conquer the Crash by Robert Prechter (one of our site recommendations below).

I am watching the development of a large scale shift towards a pessimistic mood. I am therefore predicting (in roughly this order due to differing time lags) increasing risk aversion, progressively less liquidity, enormous financial losses, angry recrimination leading to witch hunts of those who have been particularly successful at the expense of others, xenophobic persecution and demonization of other cultures, the election of populists prepared to play the blame-game at great cost to everyone, and finally war.

As an aside, the shift in mood is likely to eat the next president (and leaders in other countries) for breakfast. If I were an American, I would consider voting for the person I hated the most, given that this election is the biggest poisoned chalice in a very long time. The next president - whoever he/she is - is likely to go down in history as an abject failure, as Herbert Hoover did for having the misfortune to preside over the depression, about which he could do exactly nothing. Barack Obama has a lousy sense of timing. If he is elected now and goes down in flames, it is likely to sow the seeds of a new era of racial division in America, which will be simply tragic.

Stoneleigh said...


In short, there is no accurate measure of total outstanding credit, as so much of it is outside the banking system (think from all the way down to in-store financing, store-specific credit cards, and all manner of local credit, to all the way up to fancy swaps, avoidance of marking-to-market and off-balance sheet entities in the derivatives market). Unfortunately, that means it is very difficult to quantify overall credit contraction, especially since masking of credit destruction also muddies the waters. Mish had a good piece on this recently : Deflation in a Fiat Regime.

I'll try to write more on money supply measures when I've finished today's Debt Rattle.

DJ said...

Hi Stoneleigh,

I love this site. It has given me a wealth of information to pass on to my loved ones, even if some (especially those who work in finance) call me crazy. I definitely agree with your comment that Obama has picked a difficult time to become president. I do plan to vote for him, however, precisely because I agree that there isn't much that can be done about the economy from a policy standpoint. I believe that his ability to speak with intelligence and calm in what is bound to be a horrible situation for so many is the one hope we have to avoid an utter breakdown as a society. It might come regardless, but I see him as our best hope of keeping it together. McCain would treat us like 5 year olds and tell us the sky is clear as the rain is hitting us in the face. Besides, while Obama's legacy is certainly at risk if he is elected, there is also a potential for greatness. If he can navigate the nation through this storm by being honest with the American people and prevent the witch hunts, xenophobic persecution, and war that you predict, he would be considered one of the greats.

Stoneleigh said...


I agree with you. I like him too (although he doesn't get it on energy issues), and wish him the best of luck if he's elected. To say that I think he'll need it is an enormous understatement.

Incumbents always take the blame when things go wrong. Politicians who are remembered as great often were merely lucky in their timing. Presiding over a major economic collapse and still ending up being thought of as great would be a first, although one may have the personal satisfaction of having done the best job possible under very difficult circumstances, whatever public opinion might say.

Unfortunately, presidents elected at really inopportune times don't always finish their terms, as public opinion can call for their heads loudly enough for them to be impeached on some pretext (or worse). Barack Obama is a brave man to run for office now if he has any idea at all what's coming.

scandia said...

dj,...some people are born to greatness, some have it thrust upon them...not sure who said that.

EBrown said...

Thanks so much for the lengthy reply to the posted questions on this debt rattle. You have gift for translating complex ideas into easily grasped English.
I hadn't thought long and hard about the herding behavior in the markets until now, but it is quite a factor, eh? I have a good personal example of just this behavior - Last month near the start of this last countertrend rally one of my brothers visited my house and we takled about money/finances and the risks in the market. He went on to pull almost all of his money out of the mutual funds he owned.
But I was not the only person he talked with. While we spoke a very wealthy friend from NY with contacts on the Street called him so my brother asked for another opinion (as an aside, he "made it" by writing some of the software that prices bundled mortgages and indirectly contributed to the credit crisis/mortgage meltdown). This guy (I don't know him) was just as bearish as I am. He essentially said, "nobody is bottom fishing yet. Unless you have inside information on some company it is not a good time to buy anything."
Between what he read, his friend told him, and I said my brother yanked his money from the markets. I still need to convince him to build a cash in the house position (he's very concerned about inflation), but I think it is a good example of your description of mood affecting the markets. My parents raised both me and my brother rigorously to be buy and hold type investors since "little guys can't safely time the market and over the longterm markets tend to rise. Buy Vanguard index funds, etc." My mood soured on this position back in early 2005 when I read in depth about about Peak Oil and thought through the implications of my belief that peak is about now. My brother held on longer, but now is just about as pessimistic as I. If only I could convince my parents and other siblings (I haven't tried too hard yet... but I'll be seeing some of them this weekend and will have at least one frank discussion with them).