Tea Leaves 120809

120809

A READ OF THE TEA LEAVES

By Stanley C. Clayton

December 8, 2009

Economic Tea Leaves

It was mentioned in an earlier Tea Leaves that starting in 2010 there will be a very large rise {again} in mortgage foreclosures.  The chart above, courtesy of Credit Suisse, lays it out in graphic detail from most of 2007 through 2016.  The top three (Option adjustable rate, Subprime, and Alt-A) are of interest as these are the ones that have very large interest rate resets – to a much higher interest rate after the first few years.  We can see the nation was nailed with a huge volume of Subprime loan resets beginning in 2007 and through much of 2008.  2009 was a relative lull.  Now 2010 and 2011 get hit with a huge volume of Option variable rate and Alt-A loan resets.  The peak is about August 2011 and tapers down through the first quarter of 2012 when it finally hits manageable levels by mid-year.  Without timely and effective massive government intervention, there will be another meltdown like 2008.  Banks know this is coming, which may help explain why there is so little bank lending.

Lull Before The Storm

Retailers and manufacturers have been gearing up for Christmas giving a boost to employment and production (GDP).  T''is the season to be jolly, and there are enough actual positives that people can breath a sigh of relief.  We should unabashedly enjoy it for all it's worth and for however long it lasts.

For all the reasons discussed so far in Tea Leaves, tough economic times may lie ahead.  Depending on how it unfolds, it could become the makings of a perfect storm, or if it unfolds differently, the “Great Recession” may transition into the “great doldrums” of stubbornly low prosperity well into the future.  This grist can be for mill next year.

Stock market Tea Leaves

Current market action makes me think of an analogy to Alfred E. Newman (Mad Magazine's “Who me worry?” icon) as the prevailing approach to investing.  But if Alfred starts to worry, even the Fed easing is likely to be insufficient to keep Al in the game.  From this vantage point, it seems likely Alfred will seek a bridge to safety by mid year.  Think he'll make it?

Tea Leaves 112009

112009

A Read of the Tea Leaves

by Stanley C. Clayton

November 20, 2009

“Tea Leaves” from now on will be divided into two distinct parts: Economic Tea Leaves and Stock Market Tea Leaves.

Economic Tea Leaves

The Fed is in full court press mode to flood the world (especially U.S.) with enough dollars to stimulate growth. Results so far, not good. Banks and Wall Street have been saved from their blunders in high risk trading, but the economy continues to do poorly. Top line growth (sales) is going nowhere. The only growth is bottom line (profits) achieved mostly by cost savings and layoffs. The one quarter of 3.5% GDP growth is directly attributed to this and government spending. Many economic writers agree, usual economic growth is almost non-existent.

I find it of special interest that while the Fed continues to expand the supply of dollars, and expresses intentions to continue far into the future, significant head winds are now evident that can curtail this endeavor. 1. Governments and investors around the world are increasingly worried about the expanding supply of dollars decreasing the value of the dollar which reduces the value of the trillions they have invested in U.S. bonds and such. 2. When bonds go down, interest rates are pushed up which runs up the cost of servicing the U.S. debt and slows the U.S. economy. 3. This is forcing other countries to work hard to replace the dollar as the sole currency for international trade settlements.

In short, the Fed imperative is to get the U.S. economy moving on its own before the Fed is forced to stop expanding the money supply. Their stated belief is that failure to do so will result in a major depression. As well it may, as the U.S. will have spent itself into a sinkhole of mind numbing debt. Some have calculated that debt now totals $1,000,000 for each and every household in our country. If that is the case and we stopped running up debt (and did not have to pay interest) and each household paid $200 per month toward the debt, it would take over 416 years to pay it off. Is it any wonder the rest of the world worries we will stiff them for it?

The mortgage market problems that provided the initial trigger for the financial crisis continue to worsen. The mortgage default and foreclosure rates continue to rise, commercial real estate defaults are now being added to the mix, unemployment keeps increasing, new home builders are on the ropes, and banks continue to fail.

It seems fair to say that both current economic conditions and trends look awful.

Stock Market Tea Leaves

The markets continue to power ahead with brief intermissions. I find there is but a single underlying cause: the widespread investor belief that has been in place for decades that when the Fed is easing (i.e.- low interest rates and increasing money supply) the stock market always goes up. “Everybody knows” that this leads to boom times ahead with business growing, retail flourishing, factories humming, and such - so you must buy stocks before they go to the moon. The Fed is stoking the flames by assuring investors that it will keep interest rates super low and expand the money supply way into the distant future. At this juncture, I can find little evidence that investors are concerned that serious progress toward boom times is not evident.

Under these conditions, the logical expectation is the rising stock market will come to a screeching halt should the Fed be forced to stop its monetary expansion before real boom times actually arrive. There is an excellent and readily available indicator that tells us how much longer the Fed can keep its foot on the accelerator. It is the Velocity of Money. [Google this term and find excellent explanations.] This is calculated for us by the St. Louis Fed on their web site. The exact URL is:

http://research.stlouisfed.org/publications/mt/page12.pdf

This is updated periodically for us by the Fed. The measure of money supply preferred by the Fed is MZM, and its velocity has been in decline for some time reaching about 1.5. It has just started to turn the corner and may be headed up or sideways. Nail biting time for the Fed will probably be when it gets up to the 2 to 2.5 range especially if it is accelerating upward. They will know inflation is on the move up. This will kill the market if it has not already rolled over and died - likely from the U.S. dollar losing its status as the sole currency for international trade.

We had best hope the Fed is successful, because if it is not, we will be radically in debt and likely falling into a full scale depression. This is a very high stakes game. What are the odds the Fed succeeds? At this juncture, our debt is increasing far faster than real economic recovery making the odds look poor.

If this assessment is anywhere near correct, it leads me to expect the market to continue up but with increasing down ticks as people start to worry. This seems likely to continue for months rather than weeks or years. Upward movement in the Velocity of Money should be useful as an advance indicator of impending inflation.

In the prediction business, there are “black swans” that are unpredictable events that may happen often rendering predictions somewhat off to hopelessly off base. Black swans are inherent in the real world and may arise at the most unexpected moments. The only thing for sure is that we are likely to be surprised by them from time to time.

NOTE: This is intended as an educational exercise and certainly not as stock market advice. Hopefully by writing this down and sharing it with others, we can learn from seeing where predictions go right and where they go wrong and gain some further practical insight into the world of investing.

Tea Leaves 101909

101909

A Read Of The Tea Leaves

By Stanley C. Clayton

10-19-09

The idea of Tea Leaves is not perfect predicting accuracy but in part as a learning tool for better understanding how thinking changes over time as new evidence emerges. About 5 months have passed (since the last Tea Leaves), and the U.S. economic conditions have worsened by most measures, while the Federal Reserve has attempted to counter the downturn far beyond anyone’s imagination or has ever been done before. So what have we now?

The primary events in play are:

A. Federal spending of money it does not have is far exceeding expectations.

B. The Federal Reserve is putting far more dollars into circulation than expected. The reasons are to [1] fund the huge federal spending and [2] help offset the very strong deflationary pressures (such as declining real estate prices).

C. The value of the dollar is under strong downward pressure from the extreme increase of dollars put into circulation to combat the continuing strong deflationary pressures. [This is a revision on 12-11-09 from the original incorrect statement: The value of the dollar is under strong downward pressure from both the extreme increase of dollars put into circulation and from the continuing strong deflationary pressures.]

D. Governments around the world have become very concerned about the financial actions of the U.S. and are increasingly seeking to reduce their reliance on the dollar as the sole world currency and moving toward using a basket of currencies.

The resulting changes in the predictions:

1. The stock market will eventually reflect the economy, going through many up and down gyrations but settle into the realities of a new reality of modest economic activity.

2. The recovery will take much longer. The higher and longer the U.S. deficits , the longer the recovery. If present trends continue, it will take decades rather than years.

3. Current strong deflationary pressures will keep inflation in check for a while, then inflation will break through. The extra dollars will have to be withdrawn, but the fear is that the Fed will find that very difficult. The more difficult this is, the higher will be inflation.

4. When inflation is taken into consideration, the market will not rise to previous highs well into the far distant future.

5. The world will succeed in replacing the dollar as the sole world exchange currency. This will greatly reduce the ability of the U.S. to force other nations to loan us their money for us to spend. Our nation’s credit binge will come to an end. “Life on the float” for the U.S. government will end forcing our nation to live within its means. This necessarily will result in a notably lower standard of living within the U.S. This will further increase deflationary pressures which may have the positive effect of keeping inflation from becoming a runaway event.

DISCUSSION

With the Fed neck deep in uncharted waters, many fear the untoward effects of what may result in the future, for we are in effect replacing a private sector debt bubble with a U.S. government debt bubble. Simply printing more money is nothing new. Nations with runaway debt have tried this for centuries. The catch is that, as reported by economic historians such as Harvard professor Niall Ferguson, this method has not saved a single country from economic ruin. For the present, however, some has been achieved by so much cash being created by the Fed. Banks are still failing, but at what is likely a much reduced rate than otherwise might have been. Most banks, however remain moribund with little lending going on: banks are not only reluctant to lend, they are calling in loans at a record rate, while companies and individuals are reluctant to borrow and are instead paying down their debts. Banks know huge loan losses lie ahead from more mortgage defaults both residential but especially commercial.

There is a new “game changer”, however. The evidence is mounting that the rest of the world has tired of lending us their money. They see us as a nation addicted to a credit high and no longer capable of acting responsibly on its own. As a professional Criminologist, I agree with those who argue that the U.S. government economic model amounts to a giant and elaborate Ponzi scheme where we borrow from one country to pay our debts to another. It is a game changer because the rest of the world is now catching on to the ruse and is getting serious about replacing the U.S. dollar as the world’s exchange currency. As that takes hold, it will bring to an end our ability to endlessly borrow from other nations. This may take as much as a decade or more to fully unfold, but during that time our nation will increasingly have to live within its means.

The prediction was recovery in 2016. That is too optimistic. A number of experts are predicting decades for recovery. That now seems reasonable. The popular phrase “the new reality” will be a vastly weakened U.S. joining the ranks of other fallen economic superpowers powers such as England and the Roman Empire. Our decline will be orderly at times and less so other times. Many in our nation will watch this unfold in disbelief, while all of us will suffer economically. Our standard of living will decline to yet to be determined levels. Like England, we will survive and adjust to our new lowered station in the world order. It will not be easy and we will not like it, but we will do it because we will have no other choice.

The stock market will continue to do its usual dance occasionally showing some semblance of rationality, though the odds favor an eventual abrupt and rapid decline perhaps testing the earlier lows. Often it will appear as though the market is climbing ever higher, but that will largely be the effect of the declining value of the dollar. Studies show that if you control for inflation, the Dow has been in decline since the nineteen eighties. This will continue and accelerate as the dollar falls: the higher the inflation the more it will appear the markets are going up, but only in terms of dollars and not in buying power (or early nineties). One should be able to invest in a way that will stabilize their buying power, but increasing buying power will be very tough indeed. The rest of the initial prediction remains intact.

ADJUSTMENTS IN THINKING

This comes under the title of “we know so much better than we do”. I know that I focus on long range thinking, but the present exercise has already helped me see that I then expect that others are doing the same. The long range thinking is fine, but I know better than to think others are focused on that as well. Humans are short range oriented both in thought and action meaning they are impulsive based on short term expectations making their actions marginally rational.

Applying this, it seems obvious to me that economic times ahead in the U.S. are going to be challenging with a likely unavoidable substantial erosion in our standard of living. This is clearly already underway and will continue for a long time. This makes me very reluctant to buy into the market at this time. In contrast, the short term thinker may be vaguely aware that some trouble may lie ahead. But even if they sense that, they are not worried - they will cross that bridge when they get to it. They are willing to assume not only will there be a bridge, but they will see it in time to cross it successfully. The evidence is, however, frequently they are unable to pull it off losing most if not all of their profits and may even take a loss.

Now when we apply this to the current stock market, we can make better sense of it. Short term, investors know that when the Fed is expanding the money supply that the markets usually trend higher when this happens. They do not much care about all the underlying dynamics and they certainly do not care that it may all end badly. They focus on the short term, and that trend is up.

Then another tendency kicks in. People abhor change and they want favorable trends to continue. In time, this gets translated into thinking a favorable trend will just keep on going and going. Think about housing prices. They went up for so long, people came to believe that they would always rise. In the stock market, the longer an up trend is in place, the more investors think the trend will continue. They become comfortable and complacent. The market falls off a cliff, and most investors wake up at the bottom in disbelief wondering what happened. Their profits are gone because they failed to see the decline coming in time to cross the bridge to safety.

Then two other tendencies kick in: short term memory and personal charmed destiny. People have been making this category of mistake since the beginning of time. It is like hurricanes in Florida. People quickly forget the devastation caused by earlier hurricanes and soon buy the damaged coastal property. Besides, it would not happen to them - their destiny is charmed. They are so surprised when before long it happens again and their dreams are washed out to sea.

Tea Leaves 051609

051609

A READ OF THE TEA LEAVES

By Stanley C. Clayton

May 16, 2009

As new evidence rolls in over time, the economic picture keeps looking worse - about in proportion to the U.S. stock market going up. The "green shoots" so much talked about recently serve only to focus attention on little insignificant and always present information. In research language, they are stray data bits or noise. Even in the darkest of times, there are specks of positive events just as in the best of times, there are specks of negative events.

Below is a pretty good list of the main current economic events as of about May 1 of this year (copied from a financial newsletter – citation info not available).

- Endless War spending could subsidize every household in America with $1000 per year

- Income is trending down in the United States, England, and Japan

- US banks loan loss reserves are at a 20-year low while profound losses continue

- Of the nearly 9000 US banks, 1575 of them posted a Q1 loss

- Bernanke claims $2 trillion is needed by the big US banks, but they pass the Stress Test

- Municipal bonds and state finances are disasters, as they each appeal for USGovt aid

- A shocking 20% of US homeowners have loan balances greater than their home values

- Half of modified loans result in foreclosure within several months

- Jobs report for April revealed jobless level at 8.9% (massaged) and 15.8% (actual)

- Jobs Report for April included 66k worse revised job losses for March and February

- Continuing jobless claims at 6.56 million, grew 220k just last week

- CALPERS pension fund is insolvent, USGovt pension PBGC guarantee fund in deep deficit

- FDIC requested $500 billion in additional funds to cover bank failures (giant failure coming)

- Car sales still down 40% annually, with steep Japanese car sales declines also

- Detroit car makers are closing down plants, with huge ripples through entire supply chain

- GM & Chrysler restructures are extremely likely to result in Chapter 7 liquidation in time

- GM burned $1.3B in Q1, burns $113 million per day, unable to transition to green cars

- Business investment down 38% in Q1, a RELIABLE LEADING INDICATOR

- Durable goods up 9% in Q1, but only after Q4 was pushed down from bank shock

- Inventory reduction not key, but rather inventory/sales ratio, since sales way down

- Economic contraction despite lower energy costs from crude oil, natural gas, gasoline

- Housing was false foundation since 2002, now in stubborn decline, the Giant Albatross

- Distress sales make up 40% of all housing sales, led by underwater sales and foreclosures

- Cramdown Law rejection means open season on foreclosures, more huge bank losses

- Banks admit that home loan are not modified after all, a revolving door to foreclosure

- Option ARMs, Jumbos, and Commercial mortgage defaults are ramping up fast

- Commercial mortgage bonds have $70-100 billion that cannot be refinanced, sure to default

- Staggering decline in consumer credit, -80% in Q3, minus $31.7B in Q4/Q1

The so called green shoots, in my view, are not as they are presented: they do not portend an economic up turn. It now appears to me that we have a long road of economic difficulties to work through making the secular bear market last until about 2016 (give or take a year or so) with market averages getting to lows that now seem impossible to most. There will be a number of rallies along the way, but they will fail with the markets dropping to yet new lows. As one writer put it, it will be like a rubber ball bouncing down a flight of stairs with some bounces rather high.

A few of the things I think we will see at the actual bottom: Most derivative contracts will have been unwound, unemployment stable, market rallies lead to higher lows, actual good news is ignored and thought of as just another cruel “head fake”. The markets may have a significant flat line (trading range) as we struggle to pay for the heavy government intervention. As usual, the intervention will have moderated the decline somewhat, but at the cost of extending the pain many years. We will have been reminded that Newton's law of an action has an equal opposite reaction is still alive and well. Not until rallies show a pattern of ending at higher lows will we know a new bull market is in the making. The analogy then is a child on a pogo-stick returning up the staircase carrying the rubber ball tucked under his shirt..

Longer Term

Before long, that bull market will run into trouble from insufficient natural resources left in the world - such as iron, copper, and even potable water. This will mark the end of what I think of as the age of plenty and shift to the beginning of an age of scarcity. Pockets of prosperity will still exist, but shift from resource consuming to resource selling countries as wealth is spent buying increasingly costly natural resources. As usual, 10% of the world population will have 90% of the wealth, but they will be new faces in different places. The new poor likely will learn new and beneficial ways to cope with their adversity. We can hope.

A parallel event is likely in China unless their current efforts succeed: buying foreign natural resource companies and establishing mutually beneficial trade relationships with natural resource countries - with the emphasis on “mutually”. Complimenting this is China’s strategic moves to establish their yuan as the regional currency making it a major player in the shift away from the U.S. dollar as the world reserve currency. Their first overt step was their recent authorization for Hong Kong to sell designated yuan denominated bonds. Unless they succumb to internal stresses such as population growth and potable water shortage, China seems destined to become the dominant player on the world stage. It is a high stakes game they have a reasonable chance of winning. If so, they will rise in wealth along with the natural resource countries. The United States could adopt a similar regional strategy in the Americas, but its strong ethnocentrism and culture of superiority are likely to postpone such a move until it is too late. With the wisdom of hindsight, it is likely to be heard saying, “If we had only ...”.

Caveat

As always, the wisdom of foresight pales in comparison to the wisdom of hindsight. Yet is it the former rather than the latter with which we must make our decisions. The best we can do is use hindsight in an effort to improve our foresight. Such is our struggle.