Reading Between the Lines

YOU HEARD IT HERE FIRST

The Junk to Treasury spread is widening rapidly and you ain't seen anything yet.

The credit bubble has sprung a leak and it is beginning to unwind as lending standards are being tightened all over the world. If this keeps up, the result will be a shrinking worldwide money supply that will bring on a Stock Market Crash followed by Recession and perhaps Depression. There is no better measure of Investor confidence than the credit spread for it is a comment on both the economy in general and investor sentiment in particular.

IT'S THE AVAILABILITY STUPID

Wall Street's and the Media's talking heads who can't see any further than their nose can't seem to figure out that it's the availability of credit that is of utmost importance, not how much you pay for it. Reminds me of when I got a job as the Manager of the EF Hutton office in Great Neck NY in 1983 and bought a townhouse; by the time I closed, the mortgage rate was 13% but from the day I moved in, it started to appreciate at a rate of $10,000 a month. Yet two and a half years later, although its price had doubled, the amount that they were renting for had not changed. So I sold it and rented one instead. The moral of the story is: It was not the 1% interest rate, it was the availability and ease of getting a mortgage and the belief that prices would continue to appreciate at a 25% clip that caused the bubble. Now that the bubble has burst, cutting the interest rates while imposing stricter lending standards along with a 20% down payment will not ease the crisis one iota.

CREDIT CRISIS

As creditors become more nervous, they also become more cautious and more conservative. Who you know becomes no longer enough and the cushions that each deal must have become ever larger, while the interest rates charged rise sharply as risk is re-priced, regardless whether or not the FED lowers the Discount or the FED funds rates. This will lead to the biggest CREDIT CRISIS in history as everyone begins to recognize the cesspool of rotting debt for what it really is.

The first signs are already evident. Just look at the Blackstone losses and the amount of troubled Private Equity financing that the Investment Bankers can no longer lay off. If they can no longer package and find buyers for their Guarantees, all Private Equity deals will cease and a major pillar of support for the Stock Market will disappear. Normal issuing of corporate, high yield paper which was $25 Billion in June dropped to zero by the end of July. The Global retreat from risk is spreading as great quantities of debt became cannot find a bid and become virtually worthless overnight.

MONEY SUPPLY

Over the years, I have explained to you many times how "out of thin air" money is created; not by the printing press, but through lending and that the FED has lost control of the money supply. So I remind you now that as lending dries up at any price, the money supply stops expanding and each default shrinks the money supply by a multiple of itself as the banks are forced to call in loans: Remember the Multiplier effect? The Fed can counter somewhat the effect of the necessity calling in of loans because of defaults by adding liquidity through the use of REPO's, but only for a short period of time as they are only good for 30 day periods. The FED can lower interest rates all they want, but when FEAR prevails and lending standards are being tightened across the board, very little lending takes place. Fear is not conducive to lending, which is the basic foundation and prerequisite of an expanding Monet supply.

DEFAULTS = Shrinking money supply = Recession = Crashing Stock Markets.

MODEL BUILDERS

Successful models sow the seeds of their own destruction. All models that appear to be sure things, such as the carry trade, must eventually fail as they become more and more popular until eventually someone notices that all liquidity has dried up and no one can get out as everyone rushes to the exits at the same time. Their non-tradable assets are re-priced overnight and they are forced to liquidate any assets that are still remotely liquid (such as Gold) in order to meet their margin calls in an attempt to stay solvent. For some reason, they all make the same mistake and never include the liquidity factor into their models. It's a good bet there won't be any billion $ bonuses this year and I wonder how much of last year's bonuses will have to be paid back, since they were all based on phony asset prices. Oh to be a Wall St. lawyer!

JUSTIFYING THE UNJUSTIFIABLE

At market peaks, Wall Street gets rid of all of the old guard and replaces them with a cadre of recent graduates with no real world experience so they can justify why PE Ratios of 16 to 20 are consistent with beginnings of new Bull Markets rather than marking their end. The same is done with every other historical method of calculating under and over valuation, such as Price to Book, Price to Dividends, Price to Sales and others.

To make matters worse, they now compare earnings per share to Wall Street expectations instead of past performance: And using corporate cash or worse, debt, to buy back stock at its all time high in order to increase earnings per share is now readily acceptable. Is that a sign of a growing robust company that should command higher PE multiples?

THE MARKET'S INTERNALS

NEW HIGHS/NEW LOWS: The short term spike low on August16 had 648 issues making 52 week lows and that was with the market down only 10% from its all time highs. Compare that to the highest number of new lows (917) made on July 24, 2002, 2 ½ years off the then market's all time highs. That my friends demonstrates just how weak today's market internals really are.

SMALL CAP STOCKS: For over five years, the Small Caps have been the market leaders, but now for the first time, they did not make a new high when the rest of the market did. There is an old Wall Street truism that I'm sure none of the Hot Shot Young Guns know, "the market is not over until after the Cats and Dogs have had their day." Is their day over?

HOME PRICES

"We are about to witness a drop in home (all real estate) prices not seen since the Depression of the 30's," said the CFO of CFC, that was once the nation's largest mortgage lender. Foreclosures are no longer restricted to the sub-prime borrowers, they are quickly spreading all the way up to AAA borrowers as well. Over 1,000,000 people will enter a stage of foreclosure this year. I don't even want to think of next year as the largest contingent of ARM's come up for readjustment. They will not be able to refinance because the the outstanding loan is now 25% larger than the equity. The recently announced home sales and foreclosure numbers are only a hint of things to come.

HISTORY TEACHES, BUT NOBODY WANTS TO LEARN

No amount of FED rate cuts are able to stem the tide of selling once the selling has started. It didn't work in 1929, nor did it work in Japan in 1990 and it didn't work here in 2001 either. Greenspan cut interest rates from 6.5% all the way down to 1%, but the tide did not turn until the Bush Tax cuts were in place. So Cutting rates won't work today either - and what are the chances for a massive tax cut today? What do you think the Republican chances are of winning if we are in a Recession by November 2008 with the party in power always getting the blame. Say goodbye to any chance for tax cuts and say hello to the policies of the New Deal that are already working their way through congress and it is onlt the treat of a Bush veto that has thus far stopped them from getting passed.

THE SOUTH SEA BUBBLE, which is similar in size and duration to today's Grand Super Cycle Top burst in 1720 and the subsequent Depression lasted until 1789 with its ending coinciding with the beginning of America's first BULL MARKET (the final Wave of which began in December 1974). The Mini crashes of 1987, 1990, 1994 and 2002 only served to convince everyone that we are in a new paradigm of just buy and hold and the stock market will bail you out and make you rich. Well we all know what happens to the sure things that everyone has jumped in on. For those of you who don't know, you are about to find out in the not to distant future.

THE CHINESE MARKET is sure to follow or perhaps even lead as their central bank, in its efforts to dampen the craziness and mass speculation as well as hold down inflation, is pursuing the exact same strategies as Greenspan did in 1999 and our FED did in 1929 - raise interest rates. Nobody listened to Greenspan's warning of irrational exuberance then and no one is heeding the Chinese Central Bank's warnings now.

A LIGHT AT THE END OF THE TUNNEL

September has the most consistent record as being the worst month of the year for stocks, while October - December is consistently the best period of the year. So, in my opinion we have a good chance for the market to sell off for two weeks or so to retest the August lows. This sell-off will then be followed by a last ditch rally to a new all time high probably precipitated by a FED interest rate cut of ½ % or more, setting the stage for the biggest BULL TRAP in history. To be forewarned is to be forearmed. Luckily you have time to think before you are forced to act. But for heavens sake, DO NOT JUST LISTEN TO ME. Think for yourselves and then make up your own minds. I am NOT you adviser or your money manager. I just write for my own amusement and to help me clarify my thinking in my own mind.

GOOD LUCK AND GOOD BLESS

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