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Wednesday May 21, 2008 - 12:46:27 GMT
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Forex Blog - Turn me on Dead Man...It Takes an Imagination

Believing in the case being made today for why US stocks and the dollar should rally, and bonds and commodities sell off reminds me of 1970 when an urban legend captured the imagination of teenagers (yes me too) – Paul McCartney was dead and replaced by a look-alike…the evidence was in the Beatles albums like Magical Mystery Tour and Abbey Road.  Play I Am A Walrus backwards and it sounds like John Lennon is singing “Turn me on dead man”…as in Paul.  Both cases required (require) the active imagination of a teenager to believe.  I have not tried playing Abby Joseph Cohen’s bullish US equity forecast backwards (yet), but I think I might have a better look at the future doing so.  Nevertheless the lesson I did learn in 1970 was a healthy dose of skepticism is a necessity for navigating the world of information.  What is different between the two urban legends for me?  Today’s legend I really want to believe - the worst of the credit crisis is over and the Fed has avoided the shoals of recession.  And in 1970 I really did not want to believe the legend that Paul was a dead man.


Since housing is where this mess started it’s probably best to start with this sector.  Housing is not at or near a bottom.  Home prices, home starts, building permits, home sales and construction employment all point to one conclusion more pain…housing bubbles do not burst all at once like the NASDAQ bubble in equities in 2000 did…it takes several years and we are probably mid-point in the housing downturn.  As long as home prices fall, the negative equity walk-away incentive will be a rational choice for many of the weaker homebuyers.  Foreclosures feed lower prices and vice versa…the vicious cycle.  Maybe Congress will legislate a safety net to the subprime sector – Representative Frank has a bill and Senators Dodd and Shelby have a bill.  But these bills may not get out of Congress much less signed into law by the President (Dodd and Shelby bill has a better chance).  With new home construction falling sharply the supply and demand gap will close over time and bring an end to the downturn in housing.  But this is still many months away (late 2009). 


The credit crisis is still unfolding.  Sure spreads are in and credit anxiety well off peaks in March when Bear Stearns saw a run on the bank, there is plenty to worry about still including commercial mortgage backed securities, HELOCS (home equity lines of credit are vast and vulnerable to falling home prices and real economic weakness including rising unemployment), Alt-A mortgages and more subprime.  Bloomberg report Monday pointed out that banks have as much as $35bln in nonperforming subprime exposure that they have not put on the income statement, but is on the balance sheet – hold it long enough and it will come back.  US GSE’s are buying and securitizing 80% of all mortgages and being given new leeway to expand in this business where liberal accounting practice has seen far less in the way of write downs than most think is warranted and where leverage of the balance sheet makes many hedge funds look conservative.  GSE’s are still sprinting and the ground below has gone from pavement to sand and may soon turn to quicksand requiring the government to dig them out.   But even if you believe that the banks will muddle through this crisis and find ways to recapitalize (SWFs), one has to question what banks will do in terms of risk ahead?  Not much other than borrow funds from the Fed and buy low risk securities like Treasuries.  Lending to homebuyers, small businesses, real estate development (commercial and residential), private equity for deals, hedge funds to invest and many firms to expand capacity seem like high risk lines of business that the current environment won’t support.


There is a full blown recession underway in housing, a recession in autos and an unfolding recession in banking…this business model is grim in light on need to cut risk  and expenses and build capital.  I don’t think prop trading is a means to an end for this sector and it is also a reversion to mean business in best of times. 


Can the economy grow with banking, housing and transportation all in the gutter?  Did you notice Paul is in his bare feet on the cover of Abbey Road


To me the clincher for a long and deep recession is oil…household discretionary spending is running on empty.  I still think oil will trade sharply lower ahead, but this will take a clearer sign of a US recession to get the market to question the one-way trade in energy.  In the meantime there is already a cry of pain emerging from US retailers – even high end ones – that business is down and fuel prices are draining household budgets. 


What determines the length and depth of this recession is whether Washington can check the erosion in home prices by keeping homeowners from foreclosing and what happens to employment.  So far jobs data are not suggestive of the outcome I fear – long and deep.  But this snapshot ignores that the labor market adjusts with lags to the business cycle as firms maintain workers as long as they can in light of the high cost of training.  I fear the jobs picture will soon show more rapid deterioration in everything from retail to government (state and local gvt budgets are already feeling the heat of the decline in home prices and eco activity more generally).  I don’t think the Fed’s 325 bps in easing is really much of a stimulus in light of the critical condition the banks are in and likely to remain in ahead. 


The only light in this macro tunnel is from exports which have benefited from a lower dollar and comparatively resilient economic growth outside the US.  But the US economy is not built on exports to the extent that say Germany and Japan are and won’t be ahead. 


Even if we imagine that bankers saying the worst of credit crisis is nearly over are correct, the real economic “crisis” has only started.  And the end of the worst of the crisis in finance is not the same as a return to (banking) business as usual.  Handicapped banks in the developed world, record energy prices (not going away near-term) and a rapid slowdown in US consumption is a recipe for a weak stock market (poor earnings) , weak dollar, steeper yield curve and for the time being high commodity prices (until the US  slowdown brings about a global slowdown).   The $45trln CDS market could also see a serious test akin to RMBS in the event of above-model corporate default rate.


I almost forgot the $600 per person in tax rebate…I suspect this is already spent…it will not do much to sustain consumer-led growth beyond Q2. 


And the Fed on hold?  Turn me on dead man.


David Gilmore



From: David Gilmore [mailto:[email protected]]
Sent: Tuesday, May 20, 2008 4:41 PM
Subject: David Gilmore's Alert. Turn me on Dead Man...It Takes an Imagination



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