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Signs from June

Bob Hoye
Institutional Advisors
Aug 9
, 2007

Signs from June:

Some quotations from June are worth repeating - perhaps for some they may be worth regretting.

"Freddie Mac says the subprime mess is contained."

"Fund manager says, 'The whole subprime mess has been basically looked over and is not taken as a big concern'."

- Bloomberg, June 26

"Bernanke said [mortgage-backed securities] are a valuable market innovation and 'sometimes there are bumps' in the new-product road."

- Market Watch , July 19

The first new era of financial innovation ran until the South Sea collapse of 1720. A dismayed, and possibly damaged observer complained:

"the English Nation run a madding after new inventions, whims, and projects [promotions], that impoverish, fiddle them out of their money, by the strange, un-heard-of engines of discount, transfers, tallies, debentures, shares, projects, and the devil and all figures and hard names."

"U.S. stocks retreat on subprime concerns; American Home plummets [On the day, down 90%]."

- Bloomberg, July 31

"The latest red flag: American Home Mortgage Investment - which doesn't specialize in subprime lending - said it is suffering steep margin calls from its own lenders."

- Wall Street Journal, August 1

Everyone knows that the Chairman has to say comforting words with the early signs of distress. There is no way of knowing his private thoughts, but as someone fully qualified in interventionist theories it is likely that he is sincere in his statements.

As for the above quotations from "Freddie" and the fund manager, they represent blatant cheerleading, with hopes of protecting their book.

It is important to discredit (scary connotation) the very popular notion that it was "liquidity" that was driving the markets and prosperity. Actually, as history so frequently shows, the mechanism works the other way - soaring prices stimulate leverage, which is a practical but impolite word for credit expansion. Then when collateral prices turn down it initiates the credit contraction.

As that occurs the powers of the margin clerk (or mortgage officer) overwhelm the powers of the central banks to inflate credit or, as real bankers used to say, "create money out of thin air."

Stock Markets: Our theme since earlier in the year has been that the yield curve was usually helpful in determining a cyclical peak in the stock markets. Typically the ultimate thrust runs for some 12 to 16 months against an inverted yield curve.

Inversion began in February 2006, which counts out to somewhere close to the second quarter of this year, when a spectacular surge could conclude the bull market. The further refinement was that, while inversion could indicate inevitability of a top, it was when the curve reversed to steepening that - as we phrased it - the wheels begin to come off the most intense speculations.

Such reversal became apparent in late May, and accomplished by mid June.

Obviously the wheels have been coming off. A number of speculations, such as nickel plunged 41% from the May high and the subprime crisis resumed in mid May, which hit traditional corporate spreads in late June.

History's point has been that a credit expansion will eventually culminate in reckless lending and borrowing. Speculation in price will eventually exhaust itself and the price decline will relentlessly force the credit contraction.

This began to be proved, once again, as the turn down in house prices prompted the subprime "mess" which is inducing liquidity concerns in other sectors.

Lacking a comprehensive appraisal of its own limitations, the world of policymaking is confident that financial problems can be contained.

Essentially policy making is reliant upon faulty logic and faulty research. The notion that the Fed can keep a recovery going by expanding credit is based upon the observation that business expansions are accompanied by credit expansions. This is correct, but the assumption that credit expansion will force a business expansion is not.

Indeed, in logic it is a glaring example of a primitive syllogism that assumes that because two things occur at the same time they are causally related. The old example is a rooster crowing causes the sun to rise.

Faulty research by most of the establishment fosters the notion that the Fed will lower interest rates and as an institutional analyst wrote last week, "But let's be clear - the Fed is likely to cut rates - and that should spark a stampede of new buying."

As popular as that thinking is, it is not supported by empirical evidence. Throughout the past 300 years, short-dated market rates of interest increase with a business boom and decline with the contraction. In so many words, so long as short rates are rising the party is on, and this is good. Declining rates typically indicate that the party is over and this is bad.

Three-month treasury bills set their high in late February and, although modest, the decline has been associated with some rather bad stuff.

At the moment the stock market is oversold enough to prompt a sharp rally.

-Bob Hoye
Institutional Advisors


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