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Signs Of The Times

Bob Hoye
Institutional Advisors
Posted Sep 15, 2008

Last Year:

"Banks Seem Fine" "Margins Can Absorb Hit From Credit Fallout"
-Wall Street Journal, September 8, 2007

"Events that models only predicted would happen once in 10,000 years happened every day for three days."
-Wall Street Journal, August 11, 2007

This gem was from a quantitative analyst whose model was designed without basic market history. By this measure, recent events must be in the order of 20,000 years.

"Lowering interest rates will certainly help the stock market. There is no question about it."
-Bloomberg, September 11, 2007

Now let's look at the record. On that date the three-month bill yielded 4.09% and the Dow was at 13308. Now the bill yield is 1.56% and the Dow is at 11231. According to modern portfolio theory the Fed lowers rates and it revives the stock market and prosperity, so the stock market decline with declining rates must be at least a 10,000-year event. Actually the theory has been spun out of thin air and throughout all of market history short rates go up with a boom and decline with the contraction.

One can't help but wonder why this isn't taught in economics or business courses.

This Year:

"The hot dollar is melting steel prices. Hot-rolled is down by 30% since July."
-Business News Network, September 3, 2008

"Intervention Ain't What It Used to Be"

"Government intervention is losing its market mojo. The one-day stock rally sparked by the rescue of Fannie and Freddie was erased by fresh worries about Lehman."
-Wall Street Journal, September 10, 2008

With a more realistic approach to numbers - it is not every day that you see the end of a 95-year experiment in government manipulations of interest rates and currency.

* * * * *

Stock Markets: The sunshine expected in the first week of September failed for the commodity-side of the market after one day, but the teeter-totter with rising banks took the BKX up to 73.6 on Monday. With news of fresh disasters the sunshine window that could have run into this week is now history.

And so is the stock market. The NYSE Comp has declined to new lows. For the past month we have been going on about the developing disaster in corporate bonds. On August 15 spreads widened beyond the distress reached with the July panic - and have continued to widen.

This has been shouting that liquidity is becoming scarce and that all of the heroic efforts by policymakers have not been working. The other reminder we kept putting in has been that there is no evidence of the senior central bank ever preventing the contraction that is consequent to a boom. With all the promotion about the wizardry of government manipulations one of the basic lessons from financial history has been ignored. This is that the boom causes the bust.

History shows it and the Austrian School also figured it out from first principles. Von Mises' Human Action is a lengthy read that this writer summed up as "the up causes the down and that the bigger the up - the bigger the down." That was decades ago and just the evidence of the similarity of booms and busts has provided a very simple and very persuasive argument about the futility of interventionist dogma.

Perhaps there should be an introductory course on "marginal futility."

Technically the market has not been healthy as each rally has had indifferent A/Ds and Lowry's measures of buying and selling power have been weak.

The models (1973 and 1937) identified the May break to the downside as an important step to a 25% slump from the high. That was accomplished in July from which a sharp rebound was possible. This would lead to a choppy August and the brief "sunshine" as fund managers returned from vacation.

Those models also called for a full bear market decline of around 49 percent. It is still uncertain that this can be completed in this immediate season of financial disorder. Also there is no certainty that the ultimate decline will be limited to 49 percent.

Sector Comment: The term rotation seems to have turned into the "teeter-totter" as when resource groups were going up, banks and financials were going down. The opposite took banks up until Monday, when they became rather overbought.

The dollar continues to rally and as with so many moves in previously hot games the rise is becoming impressive and damaging. As we are fond of pointing out a "sound" dollar is the worst thing that could happen to the markets as well as to policymakers. Of course, the latter have been doing the theoretically correct thing by injecting gazillions of credit into the money markets, but it hasn't helped those who have been committing insolvency. And therein lies the problem and as the crisis continues commodities and materials sectors could decline along with the financials. In which case the "teeter-totter" breaks. This could be signaled by widening of money market spreads. This hasn't occurred since the panic of August a year ago and the possibility will be discussed below.


The Long Bond continues to trade off the senior stock indexes, and as we have been noting, the concept of buying the long end as a "flight" to quality won't work when the contraction becomes more severe.

In the meantime, the bond continued the uptrend and reached 121.30 on Tuesday. Last week we noted that the action was approaching an overbought that is sufficient to limit the move. Also there is overhead resistance at 121 to 122.

Traders are flat and waiting to short, but are positioned for significant steepening. Investors are advised to sell the rally and to get defensive in the five-year treasury. Since July, non-US investors have been advised to position the five-year treasury on the possible rally in the US dollar.

When the real flight to safety starts it will drive treasury bill rates down as a rippling revulsion for corporate bonds drives long-dated treasuries up in yield. Typically, postbubble steepening can run for a few years. Yesterday saw the bill rate decline from 167% to 156% as the bond yield increased a little.

Let's take it as a heads up.

Credit Spreads: Even junk is no longer proof against common sense. A year ago in October junk was trading at 607 bps over treasuries. At that halcyon time the yield was 11%, now it is at 16.75%. For those interested in price the decline has been from 108 to 73.75, which is quite a markdown.

Basically, the spread has gone from 6% to 12.5%, over treasuries, and the trend been likely to reach a panic in October-November.

Money market stuff remains complacent since the sudden jump in spreads with the March crisis. On that one the yield ratio between dealer commercial paper and treasury bills widened from 130 in mid February to 467 on March 20. The bill yield collapsed to 0.67% on that flight to liquidity.

This ratio has since come into 160 - probably influenced by ambitious measures of credit being pushed into the money markets. And as we note, the Fed may be able to briefly push short rates, but it has absolutely no influence on credit spreads or the yield curve. Inevitably money market spreads will widen to reflect a growing realization of risk.

The Dollar Index continues the uptrend that has been the feature of a post-bubble contraction. This has been expected to reach a "bothersome" level in the crisis likely to culminate in late October.

The Canadian Dollar is likely to continue its decline into late October. However, a general election has been called for October 14 and it seems highly likely that the governing Conservatives will go from a minority to a majority. Then the leader Stephen Harper can move from cautious Fabian Conservatism to a well-informed reform of almost a century of intrusive federal government.

The C$ could rally on the majority. It could take some time before the reform towards sound government is accompanied by a sound currency.


Our argument on commodities hinged upon the reversal in the credit markets in May- June, 2007. We identified it as a cyclical turn to adversity that would take down a great speculative mania. It has done it a number of times in the past and we expected the change would see "the wheels come off the most blatant speculations".

Starting with nickel, there has been a sequence of spectacular speculative spikes. Lead accomplished one last October, then wheat in February and rice in April. Each was notable for the speed of the collapse and that was as the dollar was bottoming. Then came the compulsion to own crude oil and natural gas, which blew out in early July. That one was accompanied by major bank rescues by the Fed and Treasury such that dollar-bears became convinced that policymakers really would take it to zero.

We argued otherwise, that the dollar would rally and that energy would follow the pattern of broken commodities. Eventually, with enough asset classes going down the Fed's habit of depreciation would be prevented. We were careful to point out that this would not be voluntary, but as with previous post-bubble contractions, would be forced upon the senior central bank.

A cyclical bear for most commodities would likely follow the cyclical credit contraction.

Energy Prices: Our July 4 edition noted that crude had reached an Upside Exhaustion reading on our proprietary model. On the weekly this had not been registered since Iraq invaded Kuwait in 1990. The conclusion was that a cyclical peak was being accomplished and that if the monthly reading came in it would be a secular peak and that both a cyclical and secular bear would follow.

This has been a very good start to both. There will be some swings on the way. The liquidity crisis that is underway will likely take energy equities down to a tradable low by late October.

Base Metal Prices: The above story applies to base metals as well as mining stocks.

Gold Sector: The gold establishment has been surprised that gold and silver have been declining during a financial crisis.

Wasn't gold meant to be a safe haven in times of distress? Under such conditions shouldn't one have enough gold to at least bribe the border guards?

As we have been discussing it is important to rely upon thorough research rather than popular folklore.

The 1873 bubble in financial and tangible assets occurred while the U.S. was experimenting in a fiat currency so there was a price for gold. It declined into November during that fateful crash. In 1929 gold's price was fixed and the real price declined during that infamous crash - until November.

We have been expecting gold in nominal and real terms to decline with the liquidity crisis likely to culminate around the end of October.

The other important point has been that silver would plunge relative to gold, which it always does in a financial panic. The key turn in the gold/silver ratio was the low at 50.7 on May 23 when the credit markets resumed the horrendous trend to contraction. In discussing the transition we noted that at the end of the last U.S. banking calamity in late 1990 the ratio reached 100, which has been our target on this financial catastrophe. The breakout was at 54 which was exceeded on August 11 and this in itself was a signal on this crisis. The ratio is now at 71.

However, gold's action is becoming impetuous and technically working itself into a pattern that can pop a relief rally.

Once past October, gold's real price has been likely to increase for a couple of years. This would restore prosperity to the whole gold sector in the face of a weakening economy.


One of our favourite themes is that politics goes to the left, or authoritarian, during a boom. Then during the inevitable contraction the consensus swings back towards the middle.

Over the centuries the longest running price series is the Phelps-Brown and Hopkins Index, which reliably records prices in England from around 1270 to 1956. Other price indexes keep the record going. The link to political trends is consistent throughout the record and the change back towards the middle can relate to how fast commodities plunge once the speculation fails.

As demonstrated by the Russian Revolution if rebellion breaks out during rapidly rising prices neurotic intellectuals can become murderous in the pursuit of social perfection. That was also the case with the French Revolution in the late 1700s.

Fortunately the reversal in politics relates to the speed of the contraction. For example the commodity spike from 1902 to 1920 was outstanding; as was the collapse. In Russia fully planned communism was abandoned to a form of socialism, and American politician quickly got off the socialist bandwagon and privatized some nationalized railroads. As with the 1990s boom, one of the touts behind the big 1929 market was the opening of new consumer markets in hitherto socialist countries.

H. L. Mencken appropriately described the politics of hysteria with: "The whole aim of practical politics is to keep the populace alarmed (and hence clamorous to be led to safety) by menacing it with an endless series of hobgoblins, all of them imaginary." Well, the hobgoblins still include the specious notion that a committee of philosopher kings are needed to "keep the recovery going", or when that is not an option "to prevent a contraction", or if that seems impossible "to end a panic".

One form of the catechism of superstitions can be called pseudo-science. Early examples include religious zealots who not only predicted the date of the end of the world, but also sold gowns appropriate to the disaster to the true believers. This continued into the 1940s and overlapped with convictions that some inventor had developed a pill that when put the gas tank provided incredible mileage. Of course, along with the legendary Fish carburetor, the patents were bought up by "big oil" to keep them off the market. Rachel Carson's "Silent Spring" was published in 1962 and has been the old testament of emotional science. It is now judged as a rant against DDT based upon personal revelation.

The 1960s and 1970s saw an eruption of political causes that included hysteria about food products that contained only parts per billion of cancerous agents. Oddly enough, this as a political phenomenon overlapped with the homeopathic healing movement that insisted that infinitely small (as in PPB) amounts of toxic stuff in water was a universal remedy. Weird.

However, the mother of all messianic movements has been the tout about anthropogenic global warming. In Mencken's terms this is a hobgoblin, in more current terms it has been an intense promotion of a cause that can only be satisfied by an enormous increase in regulation and taxation.

The need to save the health of the planet is not supported by evidence or logic and is of interest as another political crusade. The original crusades brewed up during periods of soaring prices with the usual increase in social tensions. This was also the case with Jevons and his grave concerns in 1865 that the world was about to run out of coal and modern civilization would collapse.

It seems that a long run of soaring prices prompts unsupportable intellectual hysteria about pseudo-scientific causes. In which case, today's credit crisis and crashing commodities are anticipating a turn from the politics of hysteria to the politics of sobriety that typically follows a mania.

-Bob Hoye
Institutional Advisors

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