Agora Financial’s Rude Awakening

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Baltimore, Maryland

· How today’s market compares to histories worst bear runs,
· Greenspan’s reputation tracks the crisis he helped orchestrate,
· Send us your favorite “chicken longs” and plenty more…

Eric Fry, reporting from Baltimore, Maryland….

Greenspan says he is “shocked”…which is utterly shocking…if not also appalling. The former Fed Chairman appeared before the House Oversight Committee yesterday to testify about the causes of the credit crisis. His testimony in brief was as follows:

“It wasn’t my fault.”

According to Greenspan’s tortured explanations, the unregulated finance companies (that he repeatedly refused to regulate), combined with the unbridled issuance of adjustable-rate mortgages (that he publicly extolled), combined with the astronomical growth of complex derivatives (that he enthusiastically encouraged), combined with the lack of governmental oversight and control (that he actively thwarted), had NOTHING to do with the resulting financial disaster.

No, these influences did not cause the problem. And neither – we are led to infer – did the former Fed Chairman’s carreer-long penchant for nurturing asset bubbles, cause the problem. The real culprits, Greenspan argued, were all those bond investors who were demanding high-yield securities. If these nasty bond investors weren’t trying so hard to get high yields, Wall Street would have never created so many mortgage-backed securities. And obviously, if Wall Street hadn’t created so many mortgage-backed securities, it wouldn’t have needed as many mortgages from Main Street. Ergo, fewer bad loans would have come into existence. It’s simple, really…and utterly absurd.

Even if we were to accept Greenspan’s preposterous post-mortem, the inquiring mind would want to inquire, “Why were bond investors seeking high yields?” Hmmm…could part of the reason have been that Greenspan was continuously suppressing short-term interest rates, even when economic conditions did not seem to require them. “Greenspan is maintaining emergency interest rates without an emergency,” James Grant explained at the time.

According to classic economic thought, artificially low interest rates create “mal-investment.” They cause and enable individuals to do things that they would not otherwise do – to take risks that they would not otherwise take. If you could borrow money at 1%, for example, why not do so and invest in something – anything – that yields more than your cost of funds? Why not buy a funky, mortgage-backed security (MBS) that yields 4% and pocket the difference? After all, how risky could the MBS be?

Such was the approximate analysis that inspired trillions of dollars worth of leveraged speculations. But after you peel away the arcane language of the mortgage derivatives market, and the bad math that validated values in this market, and the Greenspan-speak that imparted an air of legitimacy to this market, you find a Superfund cleanup site.

The rest of us will spend the next several years cleaning up this toxic waste.

But let’s not rush to judge Alan Greenspan. He is “in a state of shocked disbelief.” He said so himself. He never dreamed that finance company chieftains would dare to endanger their shareholders. He never imagined that corporate officers – unimpeded by the annoying constraints of regulation, or leverage limits – would EVER try to enrich themselves by putting the shareholders’ capital at risk. Wall Street CEOs have always been model citizens, haven’t they? So why bother regulating them?

We can certainly understand Greenspan’s bewilderment. Haven’t finance companies successfully regulated themselves throughout the generations? Let’s see, let’s count all the times this has occurred in history. There was…um…that time….um…let me think…um…that time when…um…Well, I’m sure there must have been a time when this happened. Why else would Greenspan have been shocked?

After Greenspan concluded his Oscar-worthy performance on Capital Hill, the stock market tanked more than 400 points from its high to its low. How UNLIKE the olden days when every utterance from “the Maestro” inspired a robust rally. Those days are gone…especially now that the former chairman’s reputation is tracking the trajectory of the slumping stock market. We fear that Greenspan’s reputation has much farther to fall before hitting its true, mark-to-market value. Let’s hope, therefore, that the stock market bottoms out much sooner than the Maestro’s plummeting public image.

But trying to gauge the bottom of any bear market is an inexact science, at best. In fact, it is not a science at all. It is a game of pin-the-tail-on-the-donkey. It’s fine to play the game, but don’t expect to hit the donkey the very first time. Dan Denning of the Australian Daily reckoning offers some thoughts on the matter in the column below…

—- Protect Your Assets: The Strategic Short Report —-

Since The July 15 “Bottom” The Market Has Dropped A Whopping 21%.

Could It Fall Another 2,000 points? Even Further? Are You Protected If It Does?

Nobody KNOWS where the real bottom of the market will be, so it pays to hedge your bets either way.

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——————————————

Pin the Tail on the Bull
by Dan Denning

Has this brutal bear market finally ended? Has a new bull market arrived?…Only Warren Buffett knows for sure…The rest of us have to guess. But before guessing, let’s stick our index fingers in the air and try to gauge the direction of recent financial trends…

The good news is that the credit market is unfreezing. The bad news is that no one in the stock market cares. All the hot money being pumped out by central banks is finally starting to de-thaw the inter-bank lending market. You probably now know more about the inter-bank lending market than you ever expected or wanted to know. But the decline in the rate banks charge each other to borrow overnight (LIBOR) really just means that banks have slightly more trust in each other this week than they did last week.

Yet on Wall Street, the Dow merely convulses. The S&P 500 is down 39% year-to-date and 43% from its high last October. You’d think the de-icing of the credit market would have produced a little more joy in the stock market. But investors have other worries on their minds now. Earnings, for one. In the bigger picture, they are wondering just how big this global recession is going to be. How many more layoffs will there be? How bad will it get? Judging by stock prices, pretty bad.

Oil has slumped to less than $70. Gold to nearly $700. These are not the signs of economic vitality. Copper and aluminium are also falling. If you look at the action in these market, investors are pricing in a shocking 2009, not just a run-of-the-mill recession. Are the slumping prices of commodities an indication that inflation poses no threat?

“History shows that recessions solve inflation problems, so much of the world is about to have their inflation problems solved, and pretty rapidly,” an interest rate analyst opined recently. Maybe this analyst is correct, but OTHER history shows you can have rising prices AND a recession. That’s the good old stagflation of the 1970s.

But maybe we’re overly worried about inflation. After all, most central banks target or tolerate annual official inflation of 2% and call it “price stability.” And Jeremy Grantham, who’s been bearish on stocks since at least 2003, seems to think that value will be destroyed in financial asset markets faster than new lending and credit can reflate it into a new bubble. [Grantham is the insightful founder of the investment management firm, Grantham, Mayo, Van Otterloo.]

“Don’t worry at all about inflation,” wrote Grantham in a note to investors. “We can all save up our worries [about that] for a couple of years from now and then really worry! Commodities may have big rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows.”

But Grantham is dipping his toe into equity waters anyway. “At under 1000 on the S&P 500, U.S. stocks are very reasonable buys for brave value managers willing to be early. The same applies to EAFE and emerging equities at October 10th prices, but even more so. History warns, though, that new lows are more likely than not.”

The S&P 500 made its bear market low in October of 2002 at 776. That’s 13.3% below yesterday’s close of 896. And should it decline to that level, it would be exactly 50% below its all time intra-day high of 1,552 (set on October 31st of last year).

By any historical standard, that’s a whopper of a bear market. So Grantham dipping a toe in now is an assumption that this bear market is roughly consistent with similar bear markets of the last 137 years. Take a look below and you’ll see what we mean.

The bear market of 2008 already ranks up there among the all time greats. The only question now is whether the bear market in stocks triggers a bigger recession in the economy that leads to an even greater fall in stocks in the coming years. So is it 1929 or 1974?

It’s tempting to call the massed selling of stocks irrational. But this is based on some investors looking at stock valuations and finding them cheap on an earnings basis, or looking at the cash on the balance sheet. But what we have right now are extremely motivated sellers. We call these sellers, “hedge fund managers.” They HAVE to sell…for many different reasons. They have to sell because almost all of their leveraged bets on stocks, bonds and commodities are blowing up…which means they MUST de-lever to meet margin calls. At the same time, these guys are receiving tens of billions of dollars worth of redemption notices. So that means they have to sell even more to raise the cash to send to their investors. This is not a pleasant situation.

Normally, when a seller has to sell, it’s a very good time to be a buyer, hence Buffett’s chest-thumping op-ed piece. But you don’t want to be a buyer if there’s more forced selling in the pipeline. And that is now the key question in the market. How much leverage is left to be unwound?

Well, before the crisis hit, hedge funds controlled US$2.4 trillion in investor funds. They would have used that capital secure trillions more dollars worth of borrowings (with leverage ratios of 10-1, 20-1, and 100-1). But now, all those assets purchased by hedge funds with borrowed money are being liquidated. And the funds that were not hedged at all (long-only, with massive leverage) are not long for this earth. Who are they going to take with them?

“In a fairly Darwinian manner, many hedge funds will simply disappear,” Emmanuel Roman, co-chief executive officer of GLG Partners Inc., told investors at a hedge fund conference in London. “This will go down in the history books as one of the greatest fiascos of banking in 100 years.”

True that.

Governments want to regulate hedge funds. They’ve already begun to do so by preventing them from shorting. But remember, if a hedge fund can’t short, it can’t really hedge. Performance suffers. Investor redemptions increase. The more hedge fund investors want their money back, the more that the funds must sell. In fact, only the “lock-ups” that hedge funds impose to prevent investors from getting their money back immediately are preventing an even greater pace of redemptions. So it’s easy to see how a new low in the markets is entirely possible.

Our prediction? Stock markets are going to get a hefty global bounce in November. There are at least three events on the horizon that could provide the boost. First, if Obama is elected, you have the end of uncertainty about the U.S. election (and some highly irrational optimism that things will now be different, better, and nicer). Second, you’ll get a new stimulus plan from the Democratic Congress in the U.S., which should give stocks a bit of a kick. And third, the big G20 meeting in Washington. Something that looks and feels good should come from that.

Those three factors may conspire to produce a convincing-looking bear-market rally into Christmas. That would be like the sucker’s rally of 1929-1930 that preceded the stock market’s epic collapse over the ensuing two years. Or, we could be dead wrong and deleveraging may simply overwhelm everything else and take the market down to much lower lows right now, without much of a bounce at all.

Stocks are very cheap. That makes them a buy. Unfortunately, they might get cheaper. That makes them a sell. And so we defer to the seasoned wisdom of Jeremy Grantham, an investor who is BEGINNING to buy, but fully expecting prices to fall even lower.

[Joel's Note: Avid readers will recognize the value of what have come to be known at Rude H.Q. as our “Group Research Projects.” Every so often, your editors offer the floor to the inimitable readership. Tapping this brain trust has, during its brief and under-celebrated history, produced some outstanding insights.

And so, once again, we head to the fountain of Rude wisdom for some thoughts. This time, we ask the reader to submit his or her favorite “chicken longs.” In other words, these ideas would be for stocks that are both cheap now but, in the possible event that the Dow plunges another 2,000 points, won’t be totally laid to waste. These stocks might derive their insulation by paying a very high yield, like the investment trusts we offered in Tuesday’s column, or from some other large margin of safety.

Please submit your ideas, along with a brief explanation as to why you chose them, to the address below. We’ll unveil the very best chicken longs in future issues.

In the meantime, here’s a special Bear Market Strategy Report our colleague Dan Amoss forwarded to us. Unless you’re Warren Buffett and you know precisely when the bottom is in, this report could prove very useful to you. It shouldn’t take more than five or ten minuts to read through and, given that Dan’s average cosed position during this whole crisis is up a whopping 94%, we reckon that’s a few minutes well spent.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com