Sunday, June 29, 2008

Crunch Time

Psychologically and fundamentally speaking, it's not looking good in the equity markets. So I've decided to write a macroeconomic analysis in this blog post today.

My thoughts: A liquidity squeeze is back. Stocks are selling off as firms sell equities to raise cash. The Fed is attacking the liquidity squeeze by increasing the money supply. The increasing money supply is accelerating inflation and the devaluation of the U.S. dollar (and other developed world currencies). The only safe haven for cash appears to be in raw materials. Real estate, a traditional hegde against inflation, won't protect against currency devaluation in the current climate. My reasoning follows.

DJIA was down 9.4% in June. Last Thursday 90% of the NYSE trading volume was on downticks.

Usually, these conditions are where a stock market bottom might occur, but these are not ordinary times.

It seemed to me that some institutions might be selling equities to raise cash reserves last week. That's a bit frightening because it implies that there could be a cascade effect. The more banks or funds need to sell equities to raise cash, or the more there are margin calls that must be met, the more stocks will drop.

In August 2007 and January 2008 the Fed put a floor under the markets by:
1) An emergency 75 basis point rate decrease - to increase liquidity for the financial syetem and fixed income markets. This was in response to the rapid deterioration and freezing of the CMO market in August.
2) Setting a floor price at which it would buy CMOs. This was in order to provide emergency liquidity to banks without enough marketable assets on their books (CMOs which could no longer be sold on the open market). This and the bail-out of Bear-Stearns (and facilitating its sale) saved the day this Spring.

But now things are bad again. What's the Fed (and all the other central banks) to do? Well, they have two options:

1) Let the credit crunch unfold. The crunch occurred because collateralized debt obligations (securitized) and other asset-backed securities can no longer be sold on the open market - there aren't enough (any) buyers. Fed non-action could lead to global bank failures and general catastrophe, so it's not really an option. However, there have been worrisome blaming noises coming out of the U.S. Congress - blaming the Fed for bailing out "rich" Wall Street bankers and overstepping their proper regulatory role. If Congress really understood how bad it was in January, and how the SEC was not even tuned in (per the WSJ), they wouldn't be so glib. Fortunately, the New York Fed has been quite vigilant.

2) The only other short-term option I can think of is to pump liquidity into the banking system. This will devalue the U.S. dollar.

Of course, every developed country is in a similar pickle to us. Most countries experienced massive credit borrowing, with scant collateral requirements, unjustified triple-A rated securities as collateral. Now that collateral is either impossible to value (for example, because there is no market for auction rate securities, certain real estate, CDOs, CMOs, and CDSs), or is devalued to the point where margin calls have been placed.

It appears that the Fed (and other central banks) have chosen option number 2. And that's one reason why we're seeing the developed world "devalued." It's true that the dollar's devaluation is primarily due to the massive trade deficit. Massive capital outflows, a rate of $500 billion annually, is occurring to petroleum producing countries. Our trade deficit is enormous (over $600 billion annually), and this puts downward pressure on the U.S. dollar (especially as Middle Eastern countries must de-peg their currencies from the U.S. dollar to slow their domestic inflation).

However, I think we're finally going to see money supply growth contributing significantly to inflation. Liquidity must be injected into the banking system in order to prop up banks and keep lending and the economy running smoothly.

Gold is a traditional hedge against inflation. But there will probably be a ceiling on the Gold price due to Central Bank selling of gold (especially over $1000/oz.). So we're seeing other commodities such as oil, food, metals, and commodified raw materials appreciate rapidly in price. They are the new hedge against inflation.

Real estate isn't going to hedge investors adequately against inflation, not when Europe, the U.S., and Japan are being devalued versus their developing-world peers.

The Fed and other central banks are doing what they must - providing liquidity to our system - so we don't have a banking collapse. This is accelerating the devaluation of our currencies. The only protection appears to be in commodities, and the companies that produce and sell commodities.

That's the way it seems to me currently. I wish I owned more raw materials!

Happy Investing!

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