Tuesday, June 9, 2009

Ten things you must do

From Karl Denninger, who writes the insightful Market Ticker blog, comes this sobering take on the markets. An excerpt [formatting omitted]:
... The last week's wild gyrations in the bond market have made clear that Bernanke and his "pals" are quickly losing control of the bond curve. Friday's selloff in 2s was particularly ominous as that money did not go into equities or precious metals - it simply "went". The 2year is commonly thought of as the "demarcation line" between the short and long end, so when I saw 2s get sold down the antenna went up in a major way.

It is one thing for people to flee the long end of the bond curve; that's bad. Its another for people to flee Treasury bonds in general - that's an unmitigated disaster. The auctions last week showed that there is an incredible appetite from foreigners for very short term government debt - 4 week to 52 week bills - where the indirect bidder activity was at or close to double historical norms. This, in the face of the incredible amount of issuance that is occurring, tells me that they're selling something to replace it with these short-term instruments. Friday told us what the "something" was.

Folks, we have taken the wrong road. At the fork in mid 2007 and indeed into 2008 when the fork was still accessible I wrote extensively on the path we had to take if we wanted to avoid at best a Japan-style flatline of the economy for years, and at worst something beyond the 1930s in terms of awful.

We have done nothing to rid ourselves of toxic debt. The implosion of the PPIP, the latest incantation of the "Super-SIV" (remember that?) makes clear: government will not force recognition of losses and thus the clearing of the market, as doing so would destroy too many who have bribed, er, made "campaign contributions", to the political sphere.

Worse, government not only took on these debts themselves (via The Fed and Treasury with their "support" programs) but continues to issue more and more debt to fund what is a categorically-insane federal budget - one that is, this fiscal year, going to run a deficit of some forty percent. To put this in perspective when George W. Bush was President many (myself included) were screaming about 10% fiscal deficits. Barack Obama proposes to run a deficit four times greater in percentage terms. Where are all the media and other pundits who were yelling about Bush's "deficits for war"? Silent, that's where, because this time the person doing it is a Democrat.

But math doesn't care about politics. Math IS.

As a consequence we will instead face the music that this debt overhang will impose on us, whether we like it or not. We have now transferred some $12 trillion in either liabilities or "promises" to The Federal Government, representing a tripling of the "public float" of outstanding debt and a doubling of the nominal amount.

This approaches the GDP of the nation in "additions" and exceeds it in total - a demonstrably unsound liability and at or beyond the "warning levels" that Moody's, S&P and Fitch have said would trigger possible "AAA" downgrades. That is coming, whether it happens now or later.

The demographics also cannot be argued with. The boomers have had their retirement decimated. Even with the market levitating at a P/E (on GAAP earnings) of some 120 times (!), they've still lost more than 30%. Computing P/Es on "operating earnings" is a sham and a fraud, declaring that investment and credit losses don't really matter, yet if you go over to the WSJ "data page" or Yahoo's, that's what you'll find. (Why do they do this? That's easy - if you saw a P/E of 120, what would you do as an investor?)

As the boomers are forced to pull their retirement funds they will come out of stocks and ultimately yank the underpinning out from under all asset classes. It is inevitable.

You have undoubtably seen the "quotes" up above on the banner of this page. Those are not abstract musings. They are mathematical computations of where the indices and those names should be trading without the excess liquidity provided by pulled-forward debt demand. Will the indices and names get there? Probably not, because not all debt-driven demand will disappear. But it is a sobering reminder, in your and my (along with everyone else's) face of exactly how much fraud we have countenanced in our financial system.
The risk of a "sudden stop" event where the bond market tells the government to "piss off" has never been higher. A ratcheting up of the yield curve, when the average maturation of government debt is now just under 4 years, could easily double interest expense in the budget. This would put the government in a nasty box: either curtail spending by twice that much (that is, roughly $800 billion) immediately or the addition to the deficit could force another ratchet higher in yield. This is a "death spiral" that can happen with amazing speed. If it does, everything you think the government should provide will disappear and asset prices - all of them - will collapse along with the economy.

How likely is this outcome? About 60%. Not certain - yet - but too high. A couple of years ago I would have pegged this sort of nightmare scenario in the 20% range. Back in September and October, 30-40%. In March, 50%, but driven by pension fund explosions in the large-cap space. Now that seems to be temporarily off the table due to the rally in the stock market (gee, think Bernanke saw that risk too?) but the problem wasn't resolved - they just shifted the risk once more, this time to the Treasury curve. If the government is once again forced to pull liquidity to defend the Treasury complex (and I believe they will) we will ratchet the risk higher, as the stock market will again decline precipitously but we will have cleared nothing, leaving the risks as cumulative.

How many times can we "kick the can"? An infinite number of times? Absolutely not. Each kick fills the can with more and more sand, until you stub your toe.

Do you want to be investing in stocks right now? Why? On the back of a 40% rally? If you missed it, you did. What are the odds of another 40% increase? Back to 2007 highs? With unemployment knocking on 10%? - the "more severe" stress test scenario - and almost certain to not stop there?

Now consider the risk of a 40% decline - that is, back to the March lows or worse. Unthinkable? Think again; it happened before, didn't it? Care to bet against the macro economic environment?

Don't say you weren't warned. ...

Read the whole thing here, including Mr. Denninger's list of ten things you need to do to prepare.

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