Financial Tornados 2006

As the FED continues to slowly raise interest rates quarter point by quarter point, the financial environment may seem to be changing very little, but in reality it is becoming increasingly at risk from financial tornadoes; A tornado is a storm that appear suddenly out of a clear blue sky and produces devastation.

Wall Street and the Politicians use conventional economics, where by the different components of the economy are held to be constant or linear and economic growth is held to be exponential, with the economy increasing in size each year by a relatively constant rate. Unfortunately It's an attractive but sterile picture only useful when teaching economics to first year students. It allows simple folk such as politicians and the talking heads of the media and Wall Street, to make seemingly confident predictions of continued economic progress. However, it doesn't bear a great deal of resemblance to reality which is much more complex. These complexities are not simply errors of detail in their standard econometric models, but are fundamental flaws in its underlying principles and mathematics. You only have to read a standard economic textbook to realize that many of the relationships described, such as a demand curve, to realize that they are neither linear nor exponential, but a somewhat quite different relationship -- the standard demand curve, for example, is fairly close to a hyperbola and even then, its only for a fraction of a moment in time and cannot be used to make any definite numerical predictions. Econometricians, who are not particularly good mathematicians but wished to construct computer models of the economy using equations they thought they understood, extrapolated exponential equations without taking into account, the fact that these exponentials interact upon each other and new factors come into play for which no allowances had been made. In reality, a significant number of their equations appear to be on the quadratic or cubic order. This fits economics in with physics, chemistry and the other "hard" sciences where such relationships are common but where Human Nature is not a factor. Although quadratic equations are easily solvable, complex systems with such equations intermingled are not. The principal difference between such systems and economics is the existence of human nature and singularities, where a small change in conditions in a small interval of time produces a large and disproportionate change in the results. Modern mathematics, in particular "catastrophe theory" and "chaos theory" have examined these types of systems in much more detail than was possible 30 years ago. Discontinuities in the system do not occur randomly and over large areas of the system there are no discontinuities, while in other areas where the equation set is "critical" there are many discontinuities or even an infinite number of them. But the worst part of building econometric Models is they have no room for Human Nature. And after all is said and done, is not Economics more about Human Nature than about any thing else.

Turning back to the real world, we can readily observe that, during some periods, there are no crises, and obvious areas of unsoundness in the system have very little effect, continuing on or even intensifying themselves for years, without causing the damage that is predicted because of them. During other periods, crises occur with bewildering rapidity, while institutions that appeared entirely stable and well managed suddenly spiral into bankruptcy with very little warning. Areas of unsoundness that have persisted for years or even decades, without apparently leading to any ill effects, suddenly cause a major financial collapse with large adverse economic consequences, and often cause further collapses in areas only distantly related .(Be wary of today's Hedge Funds)

Late 2001 and early 2002 was one such period. The U.S. economy had undergone a period of very slow growth during 2000-2001. Then the attack on the World Trade Center caused a crisis in confidence that was not reflected by any great movement in financial markets, but was nevertheless pervasive through out the U.S. economy. While the stock market as a whole had already declined and in a manner far more orderly than during the "Crash of 1987," the tech sector had imploded much more severely, and the Nasdaq index was fully 80 percent below its peak level of March 2000. But it reached its low within four weeks of 9/11. The end result was only a small series of financial collapses -- Enron, Global Crossing, WorldCom, Adelphia , and of course most of the Dotcoms-- in business areas largely unrelated to each other, whose shared characteristic was only that well connected and previously much admired corporate managements turned out to have been running Ponzi schemes of one kind or another, at the expense primarily of their gullible shareholders and lenders.

The most notable result was a tightening in corporate disclosure standards, by the Sarbanes-Oxley Act of 2002 and stock option expensing, which was scheduled to come into effect in the third quarter of 2005, accompanied by a further loosening in monetary policy and in early 2003 a second & third tax cuts. Much too almost everyone's relief, this appears to have worked. The spate of unexpected bankruptcies ceased, the stock market began a robust recovery and the U.S. economy, fueled by record volumes of mortgage refinancing and negative savings rates, ended what proved to have been a remarkably short and mild recession.

Citi Corp. is expected to reported excellent earnings but no one is talking about the fact that between Citi and J.P.Morgan they control 90% of the interest rate and currency Derivatives Markets, representing a risk exposure equal to some 20 times or more of there total equity.

For an example of how the world doesn't necessarily end "happily ever after" in this way, examine the three recessions of 1968-9, 1974-5 & 1980-1982, which can increasingly be viewed as a malign "triple dip" linked by a period of high inflation, low economic growth and extremely low or even negative productivity growth. The creativity of the U.S. economy did not cease during this period; indeed it saw a flowering of innovation, with the computer chip, pocket calculators, digital watches and the personal computer all appearing within a relatively short timeframe and changing everybody's life and work habits forever. Yet each dip produced unexpected bankruptcies.

In 1969-70, apart from the collapse of numerous bull-market prodigies such as National Student Marketing, there was the Penn Central bankruptcy, the United States' largest railroad and one of its premier companies. In 1973-74, there was Franklin National Bank and Herstatt, which together rocked the international financial system and caused a huge amount of capital and short term deposits to flow to "solid" Japanese banks in heretofore unheard of amounts. In 1980-81, there was First Pennsylvania Bank, which managed to become insolvent through investing in Treasury bonds (which declined in price as interest rates rose) International Harvester, the Hunt Bro's silver collapse and the de-capitalization of the U.S. savings and loan industry, which happened in this period even though lenient regulators and deposit insurance allowed the industry to stagger on to the end of the 80s. The economic malaise that accompanied these collapses were very severe, worse than anything in the United States since the Great Depression, far worse than the 2000-2 blip, and caused a stock market decline between 1966-82 of 75 % in real terms, second only to 1929-32.

The difference between the two periods arose because of one major difference: This time around there was no New Deal (socialist kill jobs) programs or any price fixing. Capitalism was allowed to heal itself. Greenspan greatly reduced the level of interest rates and rapidly increased the growth in the money supply. When interest rates are low, and real money supply growth is high, crises are few and far between and generally do not lead to unpleasantness in the economy as a whole as long as the rapid expansion of the money supply and credit continues. The Mexican and derivatives crises of 1994, the Asian and Russian crises of 1997-98 and the collapse of Long Term Capital Management in 1998 were all expected to lead to economic disaster, but the U.S. economy and stock market sailed serenely on, rising to new highs year by year. In 2000-01, even though the decline in the stock market and the psychological shock of the World Trade Center attacks caused some unexpected bankruptcies, the flood of cheap money that was pumped into the system combined with proposed extensive Tax Cuts ensured that the adverse effects would be minor. The "landscape" of the economy thus correlates pretty closely, not only with the cost but more importantly the availability of capital. When capital is cheap, with a bubbly stock market and low interest rates, frauds always proliferate but they do little damage; individual bankruptcies and exposed frauds do not lead to adverse economic consequences and the economic ship continues to sail ahead without difficulty.

When real interest rates are high, on the other hand, the stock market is low, and capital is tight, frauds are much less likely, but unexpected bankruptcies caused by the high cost of capital, happen quite often, and the adverse effect on investor confidence and the economy in general from such events is much more severe.

This is why investors today should beware. Short term interest rates are increasing steadily, and may have to increase faster because even at 5 percent the Federal Funds rate remains significantly below the steadily rising rate of inflation. Banks, which have covered up an almost infinite quantity of insane high risk consumer and corporate loans, by the profits from the "treasury carry trade" are looking at a bleak future. Witness the financials anemic participation in the Rally thus far. Either short term rates will overtake long term rates, in which case the "carry trade" will go into reverse, wiping out not only a huge source of profits but a great deal of equity as well, or long term rates will increase enough to prevent this, in which case banks and hedge funds are looking at huge losses on their mostly un-hedged bond portfolios, particularly corporate bonds, (whose yields can be expected to rise and prices fall more that Treasuries) secondly, consumer debt (whose default rates will soar in a period of high rates and tighter money) and mortgage backed securities, whose refinancing rate will drop to zero, defaults rise and maturity extend to infinity, as homeowners can no longer refinance themselves out of financial difficulty.

In the corporate sector, General Motors' debt downgrading will add hugely to its cost of capital, and any severe decline in the stock market will put almost all pension funds irretrievably under water. To make matters worse consumer difficulties will affect both auto sales and auto financing. The same is true at Ford and at DaimlerChrysler (which will also be affected by management's past lack of focus on its Mercedes crown jewel and by the rising euro/dollar exchange rate).

Porsche nearly went bust in the late 80s; a weak dollar is hell for luxury German auto manufacturers. Hedge funds, with more than $1 trillion of capital, have invested altogether unwisely and covered their losses through profits on the "carry trade," which have distorted the government debt market beyond recognition. Expect huge losses of capital in this sector.

Fannie Mae and Freddie Mac can expect their debt ratings to decline further as rates rise and mortgage defaults soar, while their mortgage backed securities portfolios become illiquid. Only Congress can save them now; as Democrat fiefdoms they'd better hope for a big swing to the left in 2006!

Beginning in the Third Quarter the tech sector will have to report sharply lower earnings because of the expensing of stock options, which in itself will affect their stock prices and their ability to raise capital. Also, Moore's Law, by which semiconductor performance doubles every 18-24 months, is clearly approaching its limits, eliminating much of the sector's growth potential.

CONCLUSION

The Cats and Dogs are Running
Regardless of what Wall Street is telling you, 15 - 19 times next years projected earnings, means stocks are grossly overvalued.(only the peak bubble year of 2000 had higher valuations) Expect a repeat of the Nasdaq's fall of 2000-2002; but what is even more troubling, this time is it will not be alone. As Inflation continues its relentless assent and monetary liquidity dries up and interest rates soar the rest of the worlds markets will follow the NASDAQ: Especially Low Caps that have just recently made All Time Highs.

THE TRIGGER

It's the tightening of Credit and Rising Interest Rates that has always been the trigger and once triggered a quick reversal will not stop the carnages. Greenspan 5 ½ % interest rate drop, reversing his 2000 tightening had by themselves little effect until the Bush Tax Cuts were passed. This time there are huge budget deficits instead of budget surpluses and therefore there will be no Tax Cuts to save the day. Once over the edge, watch out below. The only reason that the collapse has not started yet is because interest rates have not yet turned positive There is an old Wall St. adage that says, "the party is not over until the cats and dogs run" Have you all noticed what's been happening to the OTC Pink Sheet Markets, they are not only running but they are into a full sprint on all time high record volumes. And if that's not enough just take a look at the Credit Spreads between AAA rated and Junk Bonds. Is a market crash about to happen tomorrow or next week or next month? To tell you the truth, I don't know but if the unraveling began tomorrow then this letter would be a waste of time. But, like it or not, It will happen and in the not to distant future. We are now in the time period that I called for last November.

"To Be Fore Warned Is To Be Forearmed"
Buy Gold and Gold Stocks. You can also buy Silver and Silver stocks which may even outperform Gold. There is in all likelihood a Silver ETF coming in the near future and I would strongly suggest that you start buying silver before it arrives.

Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
[email protected]
561-840-9767

March 9, 2006