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Be prepared

Bob Hoye
Institutional Advisors
Posted Feb 13, 2008

The following is part of Pivotal Events that was published for our subscribers February 7, 2008.


Last Year:

"Economists: Hottest Property On the Street"

"One of the hottest job markets in years for economists as pension funds and other new investment vehicles step up the competition for talent on Bay Street."

-Financial Post February 8, 2007

Now, why would investment funds employ economists? Credit markets lead the stock market, which leads the economy. In so many words, the cycle for share certificates leads the business cycle.

And then there is the risk. In 1997 just before failing on the Asian Crisis a NY hedge fund bragged that it had a lot of PhDs using very sophisticated modeling for their strategies and tactics. Then the big tout with Long Term Capital Management was that not only did they have economists, but they had Nobel Prize winners.

And then there is the accumulative accomplishment. The Federal Reserve has been dominated by the theories and practices of interventionist economists and the result has been the deliberate depreciation of the senior currency by 95% in the 94 years since the Fed began operations in that fateful January of 1914.

Naturally, such chronic depreciation has not gone unnoticed by the markets, And as usual, the resultant instability has fueled the ambitions of financial adventures, with a variety of reckless schemes. Without a doubt the Twentieth Century's experiment in interventionist central banking has been the greatest financial adventure in history. The two previous centuries of great inflations occurred in the Sixteenth and Third centuries, and the depreciation was simple - in order to fund unlimited ambition the state straightforwardly confiscated private savings through debasing the coinage.

It was an almost continuous rip-off without the euphemism about manipulating interest rates and the currency to "keep the recovery going". Or, to segue into a great non sequitur, to prevent or end a financial crisis. Only on the minds of interventionist economists can a financial panic run forever.

This Year:

"Harry Macklowe, the New York developer, has failed to refinance $5.8 bn in short-term loans he used to buy seven Manhattan office towers from Equity Properties last February. Deutsch Bank, which provided the loan, has taken control of the buildings and will put them up for sale."

"US commercial property prices have fallen 10 per cent in some markets since August, after rising 90 per cent since 2001."

-Financial Times February 5, 2008

Stock Markets: Using a couple of models a plunge was likely to end in January. As it turned out, the market suffered a classic bout of forced liquidation that culminated on Day 55 from the high in late October. Using the Nasdaq Comp the decline amounted to 23% to the low on January 22.

Technically, the rush to sell generated a rare "Downside Capitulation" on the ChartWorks model, upon which we concluded that the rebound could run into March and retrace some 40% to 50% of the loss. This is a typical pattern within a long bear market, and has been essentially accomplished. In so many words, the natural upside has occurred and has provided a selling opportunity for both investors and traders, and the risk, if anything, is worse than in October. Some churning around for a few weeks is possible, but the hit is irrevocable and has consequences.

Also as noted, this would make the latest moves by panicked policymakers seem successful. As discussed earlier, by the time the authorities become aware of how serious the calamity is and then by the time they implement the dramatic rescue the panic is over. There are a number of examples dating back to the 1720 Bubble.

Formally, the plunge should be classified as the initial crisis that marks the end of the financial mania. We had thought that the rebound would run for some 4 to 6 weeks, but the dynamics were so powerful that the best has been accomplished in only a couple of weeks.

Without a doubt, one of the wisest observations made by The Economist occurred with the selling panic that marked the end of the era of asset inflations in 1873:

"The panic may be over, but the results of the panic are not over."

The subsequent bear ran for five years.

We had been expecting the banks to release some bad reports in January, and this has been the case. Then, at the first of the year economic reports took a dismal turn, and our January 10 edition observed that this put the business cycle in harmony with the stock market. Hitherto, the stock market decline could be described as technical or due to deteriorating credit conditions. Although it is a miserable form of order, the economy is now in line with the stock market.

This harmony can run until the bear market is over. This could be severe enough to eventually change the minds of those who are advising to stay long, as they said in the first part of 1930, "for the long pull".

As for our policy - we will remain patient, prepared for the "results of the panic".


The Long Bond: Our January 24 edition noted that the bond future was very overbought and that traders should begin to play the short side of the market and that investors should sell the long end to become defensive in the 4 to 5-year part of the curve.

From the strong buy at 105 back in June, and with a couple of big swings, it made it to 122.81 on January 23, which was just as the liquidity panic ended. That was a sharp spike up in the bond price, and it is possible that the bond crowd had fully discounted the slowing economy. In which case, we should look to other aspects of the rally. Perhaps the best is in on the fact that it was just another asset that has been in play for some time.

It is interesting that this week brought a shockingly bad ISM report on services. The previous number was 54.5, the consensus estimate was for 51.5 and below 50 indicates a contracting economy. The number was 41.9! And the bond didn't rally.

Our concern has been that the loss in liquidity in corporate bonds and weird stuff would eventually pull down the price of long treasuries. This could be the point when credit-quality risk translates into term risk. It happens during every post-bubble contraction, and the combination of declining asset prices, turndown in business, falling short rates and rising long rates is perplexing to conventional wisdom. We call it "Conundrum II".

Of course, the opposite condition when the bond was rallying in the face of a boom was called a "conundrum" by Greenspan. We were on that rally as yet another asset class, and in looking forward to its opposite called it "Conundrum I".

During the boom, the yield curve naturally inverted, and just as naturally the curve reversed to steepening in May and signaled this contraction. It has been popular this week to claim that the Fed steepened the curve to help bank earnings. Sadly, this is wishful analysis and a quick review of the post-bubble world shows that steepening continues until close to the end of the bear market.

Link to February 8, 2008 'Bob and Phil Show' on


-Bob Hoye
Institutional Advisors


Hoye Archives

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