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Signs Of The Times
Rational De-exuberance

Bob Hoye
Institutional Advisors
Posted May 14, 2008

The following is part of Pivotal Events that was published for our subscribers May 8, 2008.

Last Year:

"After a remarkably permissive first quarter, investors put their collective foot down in April to slow the pace of refinancings to a near halt." -Wall Street Journal, April 27, 2007

"Who Cares if the U.S. Gets a Cold?" -Financial Post, May 7, 2007

* * * * *

This Year:

"Investors are turning to riskier investments as the turmoil that has racked stock and bond markets now show signs of fading." -Wall Street Journal, April 28, 2008

"For the first time in months, analysts and executives sound upbeat."

"The optimists believe it is different this time." -International Herald Tribune, May 2, 2008

"The worst is over." -Warren Buffett, on Bloomberg TV, May 3, 2008

"Stocks Rally on great Expectations" -Wall Street Journal, May 5, 2008

* * * * *

Stock Markets: Our main theme has been that the plunge into January was of a character that typically ends important bull markets. As that panic concluded our view was that the revival in stocks, commodities, and credit spreads would run into March-April. With this, senior stock indexes would likely retrace around 50 per cent of the loss. This has been essentially accomplished.

Although soaring crude oil prices are stimulating the usual worries on Wall Street, we continue with the observation that crude is another commodity that goes up in a boom and down in the contraction. Back in October, 2002 the S&P set a low of 777 as crude plunged to 17.07, and both started a cyclical bull market. Not all elements of a cyclical expansion peak at the same time.

However, all cyclical expansions end in a similar way, which was behind our conclusions beginning last April that the good times would end with "rational exuberance". By that we meant that spiking exuberance - particularly in the credit markets - would mark the beginning of the contraction.

The rational part referred to the pattern whereby a boom runs some 12 to 16 months against rising interest rates and an inverted yield curve. This has been the way financial history works and as we discussed last spring, the count had June, 2007 as the 16th month. Also emphasized was that inversion wasn't the problem, but when the curve reverses to steepening it shouts that the end of a great speculation is at hand. Moreover, we noted that the senior central bank had little, if any, influence on the curve, or spreads.

The next part of the rational transition to a contraction is the reversal in credit spreads from narrowing to widening and as discussed last year - May often sees a seasonal reversal to widening, which worked out with, so far, rather severe dislocations.

Our theme about "Rational Exuberance" has worked out, and now it seems time for the next phase of the big picture, which could be called "Rational De-exuberance."

The process of ending a huge mania begins with a critical change in the credit markets, and the initial plunge is followed by a vigorous rebound. On this one we have cited the example that ran until April, 1930. The other example has been the fabulous bull market that ran until the spring of 1937.

The latter was a five-year bull market out of a collapse of a great mania in tech stocks, The mania to the spring of 2000 was just such a bubble and the bull market out of the October, 2002 washout ran for 5 years.

With so many lamentations about soaring crude oil prices, it is going against conventional wisdom to point out that the next phase of the contraction will involve all asset prices going down. And declining collateral values force a credit contraction, which disproves the arbitrary notion that Fed injections will force prices up - the old "pushing on a string" story.

Investors and traders should be prepared for another slide in most prices of stocks, corporate bonds and commodities.

Sector Comment: After reigning as the complacency sector bank stocks took a well-deserved trashing into January when we thought a 50% retracement rally could run out until spring. However, as noted at the time the rebound to 98 on the BKX was accomplished in only 10 trading days and the price-target was met. The action since has been on one side the favourable period likely to run into April. On the other side, there have been reports of lending disasters, which will continue in all countries.

Our propriety Bank Trading Guide provided another sell signal in early March and some three weeks later the BKX set a high of 89. The original sell signal was provided last July.

The bank index declined to 76 in mid April, when the street concluded that the worst was over, and began to look forward to Pope Ben's scheduled blessing of the markets on April 30. This took banks up to 88 on Friday, which compares to the last high of 89 and the retrace at 98. The record high was 121 in 1Q2007.

There is support at 74, but taking that out would resume the downtrend, which seems likely.

It was not sound banking that created the severe liquidity crisis, but a wild experiment in financial innovation conducted by a "new" school of wizards with no concept of risk. Such innovation has had enthusiasts in academe, government, business, industry, all political parties and even labour unions - not to overlook central banks.

It seems that there have been no bankers, in the proper sense of the word, at the Bank of England or at the Fed. These senior central banks are still in the thrall of innovation as they believe that taking garbage securities out of the market will kick start another credit binge. This is not banking, but a reckless attempt at more financial engineering. If it was in the private sector, one would say that they have bet the ranch.

Base metal miners were also expected to rally up to a seasonal high in March-April. The low for the SPTMN was 598 in January, and the high has been 890 set in mid April. The initial decline was to 790 and the test of the high has made it to 883 on Tuesday. There is a negative divergence as the recent highs have been against diminishing momentum and declining accumulation. Base metals (GYX) have been showing even worse divergences.

Credit Spreads have been expected to generally to be benign to narrowing with the revival out of the January disaster, and then the March trembler.

As noted last week, the lower-ranked sub-prime bonds have been declining for a few weeks. At 11 on April 9, the BBB has dropped to 7.32. Hey, but no need to worry - they are stilled rated as BBB, which means investment grade. They were priced at 100 in August, 2006.

These heading down have led the next decline in the stock market by a number of weeks, and the warning becomes more acute when the higher ranked ones such as the AA roll over. That has happened this week which was accompanied by a turn to widening in Canadian bankers acceptances, over treasury bills.


ABX Indices - AAA, AA, A & BBB

  • Top left Chart (AAA) shows an outstanding rally from 66 to 84. Now it is rolling over.
  • The BBB (bottom right) led the crises of last July, January and March.
  • The pressure becomes acute when the AA (top right) breaks down.


  • Note the widening in the past few days (lower panel).
  • Note the widening going into the July-August crisis.
  • According to some Bay Street strategists, Canada is immune to credit problems in the U.S.

-Bob Hoye
Institutional Advisors


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