Growl of the Bear

It's time to put in perspective more specifically where I think we are. Following a week in which the bulls were emasculated they'll be looking for the bounce. It seems likely at this point that any bounce, while potentially violent in the short run, will be short-lived setting up a failing rally and ending the bull market. Despite ending last week in incredibly ugly fashion the Dow is near a level which could potentially offer support. The S&P however has already broken, but nearing it's 200 dma, so it's a coin flip. At some point next week we'll get a bounce and it's a bounce to sell.

The market has ignored the bad news (or what I like to call reality) for-seemingly-ever. To my eye the market and the fundamentals have never diverged to such an extreme in the ten years I've been following the market. That's a bold statement considering that I remember 1999 very clearly (though at that point I had very little idea what the hell I was doing). In '99 the valuations were more absurd but things were good in the world. We lived in a relatively peaceful world in which the US was the only world power. We enjoyed super cheap energy supplies and solid economic growth. Household balance sheets were solid. Everything was, as they say, honky-dory. Very different picture from today.

Let's step back and look at the big picture:

The Economy: It's slowing folks. The Fed bailed out the economy following the tech stock crash by taking interest rates to historic lows. This action fostered the housing boom. Rather than take our medicine we leveraged household balance sheets in the name of overconsumption. Americans have developed quite a voracious appetite for overconsumption evidenced by the fact the 70% or so of our economy is services. We no longer manufacture anything and our exports are dwarfed by our imports (you can't export mortgage brokers). During the housing boom most of the hiring that went on was in housing related sectors. That plus is now a minus.

To keep the ball rolling consumers have leveraged themselves. Mortgage equity withdrawal and the wealth effect from skyrocketing real estate values have kept consumers happily consuming. That fairy tale (the Goldilocks economy I think it's called) is over.

Real Estate/Housing: In '99 I remember my co-workers tuned into CNBC (I prefer CNBS) throughout the workday. Everyone had a hot stock and we were all going quit to be daytraders. In 2005 everyone was a mortgage broker or had a condo to flip. We are a nation of speculators. Both were bubbles. The difference? In 2007 we are stuck with a trillion dollars in suspect loans. A trillion dollars? Well really who the hell even knows but the number is BIG and GROWING.

You know all the terminology by now...ARMs, cash-out refis, flex-pay, piggybacks, HELOCs, etc...Apparently if you give the American consumer enough rope to hang himself he'll do just that. As far as the financial institutions themselves, a bull would argue that banks have done a good job of spreading the risk around by packaging these loans into securities and selling them. Great. Instead of just cordoning off the troubled banks we have bad paper everywhere. The banks themselves are still holders but so are the brokers and the insurance companies. Probably even your pension fund. This is what they call a systemic risk.

Pundits have been calling the bottom on housing for six months now. Wrong. If we're lucky we've experienced the worst of the price declines but prices aren't going to see a bounce anytime soon. There is a ton of inventory and credit will be harder to get as the lenders begin to pullback thereby taking the final leg out from under the market.

Financial Dark Matter: (term borrowed from Bill Fleckenstein) Financial dark matter are derivatives. Financial nuclear weapons. CDOs, CDS, MBS, etc... Frankly, I only have a cursory understanding of this arcane marketplace. Here's what I know. This shit is toxic. There is a bunch of it, everywhere. It's highly leveraged (like anything else on the Street these days). It's mispriced, in some cases grossly mispriced, due to faulty assumptions and we don't know who is exposed and to what degree. Oh and it's highly illiquid. It all lies cloaked beneath the surface.

The Fed: These guys are a joke. They inflated the tech bubble then bailed it out with a housing bubble. Greenspan was particularly insidious in recommending ARMs just when rates were at their nadir. Expansionary monetary policies have fostered the most well-rooted inflation since Volcker killed it in the 1970s. Even after they do their best to strip from the inflation picture everything that goes up (i.e. ex-food and energy) they still have an inflation above the stated "comfort level". Commodities are in a secular bull market. Now growth is slowing. The Fed is trapped (sooner or later). Cut in an attempt to reignite growth or remain vigilant on inflation (that pesky mandate)? I maintain that the Fed will choose to cut. Growth at all costs. The market is trained to anticipate a bailout. We've had two down days in the market and traders are already looking for a cut in rates.

Bigger Picture: Domestic oil production peaked a long time ago and global production is peaking now. We do not yet have a viable replacement for fossil fuels. Meanwhile China and India are putting new drivers on the road at a breakneck pace. Oil exporters are also using more of their own oil at home. The worldwide scramble to secure energy resources has commenced. It will remain an increasingly hostile environment.
China has us by the balls. I love how we deal with them as if we are in a position of strength. Beating them up over exchange rates though will only bring us higher prices at the Wal-Mart. The dollar is doomed anyway. China is the world's next great power. Sooner rather than later if we continue to rot from within at our current rate. We suffer from a complete lack of coherent political leadership.



So it's all somewhat depressing. Maybe I've got it wrong in regards to the market. Maybe this is a buying opportunity and we are on our way to some sort of super-charged inflation-induced equity orgy but I doubt it. Maybe the financials have their issues contained but I doubt it. Maybe we will find a wondrous new energy source, hope so. I intend to remain flexible and profit either way but I think it might be on the short side of equities as it was this last week.