What if?
Success in the markets is largely determined by being prepared (at least mentally) for all possible outcomes, regardless of how unlikely they seem. The events of the last few months should leave little question that low probability events do occur or simply put, "markets can do anything"! So I want to play a little game of what if?
What if all of this money the Fed has pumped into the system finds its way into the real economy? Economic growth would revive, but so could inflation as oil headed back up toward $100 a barrel. Gold could break out above $1,000 an ounce. Food prices could increase again. Home prices could stabilize and rents could begin to rise once more. All in all, this is a fairly benign scenario, especially if you are a funny little bearded man named Ben. Most people would probably willingly accept this set of conditions, if possible. (Your retired grandmother living on a fixed income in a rented apartment may not, but hey! Should we all sink to save your grandma?) But how likely is this scenario? It would require "banks" (or the facsimile that we currently label as banks) to start lending again. And lending on a scale that a drunken sailor would not be able to spend. This is because with trillions (yes, that last word begins with a t and an r) in bad debts on the books, it would likely require spending on a similar order of magnitude to move the needle significantly higher in a $12 trillion economy. But the "banks" that would provide this lending have a small problem. A large number of them are insolvent. For example, AIG has $450 billion in bad debts. Citi has $750 billion or so on its books, a big chunk of which is of dubious quality. And who knows how much more has been stashed in SIV's and other entities to keep it "off the books". B of A has $600 B. GS and MS both have about $100 B. Even USB and WFC, the two relatively healthy banks have a combined $250 B in debt. FNM and FRE have a staggering $1.5 trillion between them. Even industrial giant GE has $500 B. Where would all of these companies "invest" this money? It seems clear that the country has all the houses it needs, as least for a few years (maybe a few decades). The appetite for cars does not seem much better. If any more retail space is built, they will be opening Starbucks right next to Starbucks! Flat panel TVs, iPhones and the like are hot, but it would take every man, woman and child in the country buying 3-5 of these each to make a dent. Alternate energy sources is a legitimate need, but it takes years to plan a nuclear power plant, hydro project, or even wind or solar power project. And with energy prices so depressed the economic feasibility of any large scale project is questionable. Even if these investments were pursued, it would leave our already highly leveraged financial institutions with insane leverage of 20-50x, beyond the outlandish 10-25x that helped get us into this mess in the first place. No, it seems more likely that the banks will do what they actually have been doing for the last three months. "Hoarding" cash. That is the rational thing for them to do. That is really the only way for them to survive. Otherwise, the capital ratios would be incredibly thin and any further deterioration in their "assets" would leave them insolvent...again. And vulnerable to another "run" as many essentially experience in Sep through Nov. As it stands now, if the economy and financial markets stabilize around these levels, the debt levels of these companies can be slowly and carefully written off and worked down over the next 3-5 years and balance sheets would begin to have a vague resemblance to that of a healthy company that might be in a position to extend new credit. This is, in a nutshell, the policy that the Fed and Treasury have pursued. But I have failed to mention one critical component of this ad-hoc plan. The balance sheet of the Fed itself. Unfortunately, no one really knows what is on the books of the Fed, at the moment. It could all be baseball cards and old bus transfers for all we know. In some respects, it might as well be. Because the quality of the "assets" (there is that word in parentheses again) are quite possibly extremely poor. It is estimated that these poor quality "assets" represent the bulk of the increase in the Fed's book from around $900 billion to over $2 trillion. These measures are temporary and the Fed will look to unwind them as soon as practical, some say. What if that is not the case? What if the Fed is stuck with these "assets"? Furthermore, what if the value of these "assets" declines further or even implodes as some of the institutions which are backing these instruments fail?
This is an interesting question. I would say THE interesting question which I don't believe anyone is addressing. The Fed, after all, is a bank. Now, it is not your typical bank. But regardless, it is still a bank and it must balance it books at the end of every day. So if the assets which it holds become impaired, it must raise capital somewhere. It could charge its member institutions more (in the form of higher interest rates) but this would have the devastating effect of pulling money out of the banking system. The exact opposite of what the Fed wants. Or they could have the Treasury sell some notes and deposit the proceeds with the Fed. But with the Treasury already slated to push some $2 trillion of debt onto the markets over the next year, how feasible is that? And if it is possible (which it may very well be) wouldn't the net result be the same? As risk-averse investors seek safety in Treasury paper, the private markets would be choked of the very funds needed to finance new economic activity. This is very likely what is occurring right now as Washington gears up for a massive "stimulus" plan. What this plan will likely stimulate is the growth of government and not much more. Maybe it is just me, but it seems unlikely that the Federal government will do a much better job of investing in productive capacity than the private sector. It seems more likely that we will see more "bridges to nowhere", dams of nothing and energy plants producing some of the most costly power known to man. This is essentially what was done during the 1930's and it will likely have the same result. With the key difference being that the USA was a creditor nation in the 1930's. So we are dependent upon the "kindness of strangers". But what if these strangers are no longer interested or capable of lending us the money? Then the Fed would be left with the choice of either charging their members more (higher interest rates) or dropping dollar bills from a helicopter (also likely to produce higher interest rates). Unfortunately, it seems like this latter possibility is the likely outcome of the course which we are on. How ironic that the man at the helm of the Fed who supposedly studied the Great Depression has repeated the mistakes of that era in spades? How catastrophic would a failure of the US Federal Reserve Bank be? How epic would a global run on the world's central bank of central banks be? While it may not yet be inevitable, the path we are taking makes it increasingly likely that we will get the opportunity to witness such an event in the next few years.
The implications for the various markets are staggering. But simply put, they would be negative for stocks. Negative for real assets (at least in the early stages as demand is destroyed). And short-term to medium-term positive for bonds ending with a crushing collapse as the US sovereign debt is repudiated.
Nonetheless, these events will take years to play out. So what is there to do in the meanwhile? When the US stock market seems to have rebounded off a severe oversold position in November and the internals of the market suggest that there could be more upside to the move. While volatility will likely remain higher than it has been in the last 5 years or more with short sharp sell-offs punctuating any rally, my guess is that SPX could reach triple digits in the next 2-3 months in the 1000-1050 range. NDX could reach 1450. The 1090 level is key as any breaches of this number should be short lived. Bonds are likely to sell off after the huge rally of the last month, as investors decide to take on risk again as a resurgent stock market pulls in those afraid of missing the next big move. Bear markets are meant to destroy as many people as possible. What better way than to display one of the strongest rallies ever to occur in market history? And once these "investors" dive back in, the selling can begin in earnest again!
What if all of this money the Fed has pumped into the system finds its way into the real economy? Economic growth would revive, but so could inflation as oil headed back up toward $100 a barrel. Gold could break out above $1,000 an ounce. Food prices could increase again. Home prices could stabilize and rents could begin to rise once more. All in all, this is a fairly benign scenario, especially if you are a funny little bearded man named Ben. Most people would probably willingly accept this set of conditions, if possible. (Your retired grandmother living on a fixed income in a rented apartment may not, but hey! Should we all sink to save your grandma?) But how likely is this scenario? It would require "banks" (or the facsimile that we currently label as banks) to start lending again. And lending on a scale that a drunken sailor would not be able to spend. This is because with trillions (yes, that last word begins with a t and an r) in bad debts on the books, it would likely require spending on a similar order of magnitude to move the needle significantly higher in a $12 trillion economy. But the "banks" that would provide this lending have a small problem. A large number of them are insolvent. For example, AIG has $450 billion in bad debts. Citi has $750 billion or so on its books, a big chunk of which is of dubious quality. And who knows how much more has been stashed in SIV's and other entities to keep it "off the books". B of A has $600 B. GS and MS both have about $100 B. Even USB and WFC, the two relatively healthy banks have a combined $250 B in debt. FNM and FRE have a staggering $1.5 trillion between them. Even industrial giant GE has $500 B. Where would all of these companies "invest" this money? It seems clear that the country has all the houses it needs, as least for a few years (maybe a few decades). The appetite for cars does not seem much better. If any more retail space is built, they will be opening Starbucks right next to Starbucks! Flat panel TVs, iPhones and the like are hot, but it would take every man, woman and child in the country buying 3-5 of these each to make a dent. Alternate energy sources is a legitimate need, but it takes years to plan a nuclear power plant, hydro project, or even wind or solar power project. And with energy prices so depressed the economic feasibility of any large scale project is questionable. Even if these investments were pursued, it would leave our already highly leveraged financial institutions with insane leverage of 20-50x, beyond the outlandish 10-25x that helped get us into this mess in the first place. No, it seems more likely that the banks will do what they actually have been doing for the last three months. "Hoarding" cash. That is the rational thing for them to do. That is really the only way for them to survive. Otherwise, the capital ratios would be incredibly thin and any further deterioration in their "assets" would leave them insolvent...again. And vulnerable to another "run" as many essentially experience in Sep through Nov. As it stands now, if the economy and financial markets stabilize around these levels, the debt levels of these companies can be slowly and carefully written off and worked down over the next 3-5 years and balance sheets would begin to have a vague resemblance to that of a healthy company that might be in a position to extend new credit. This is, in a nutshell, the policy that the Fed and Treasury have pursued. But I have failed to mention one critical component of this ad-hoc plan. The balance sheet of the Fed itself. Unfortunately, no one really knows what is on the books of the Fed, at the moment. It could all be baseball cards and old bus transfers for all we know. In some respects, it might as well be. Because the quality of the "assets" (there is that word in parentheses again) are quite possibly extremely poor. It is estimated that these poor quality "assets" represent the bulk of the increase in the Fed's book from around $900 billion to over $2 trillion. These measures are temporary and the Fed will look to unwind them as soon as practical, some say. What if that is not the case? What if the Fed is stuck with these "assets"? Furthermore, what if the value of these "assets" declines further or even implodes as some of the institutions which are backing these instruments fail?
This is an interesting question. I would say THE interesting question which I don't believe anyone is addressing. The Fed, after all, is a bank. Now, it is not your typical bank. But regardless, it is still a bank and it must balance it books at the end of every day. So if the assets which it holds become impaired, it must raise capital somewhere. It could charge its member institutions more (in the form of higher interest rates) but this would have the devastating effect of pulling money out of the banking system. The exact opposite of what the Fed wants. Or they could have the Treasury sell some notes and deposit the proceeds with the Fed. But with the Treasury already slated to push some $2 trillion of debt onto the markets over the next year, how feasible is that? And if it is possible (which it may very well be) wouldn't the net result be the same? As risk-averse investors seek safety in Treasury paper, the private markets would be choked of the very funds needed to finance new economic activity. This is very likely what is occurring right now as Washington gears up for a massive "stimulus" plan. What this plan will likely stimulate is the growth of government and not much more. Maybe it is just me, but it seems unlikely that the Federal government will do a much better job of investing in productive capacity than the private sector. It seems more likely that we will see more "bridges to nowhere", dams of nothing and energy plants producing some of the most costly power known to man. This is essentially what was done during the 1930's and it will likely have the same result. With the key difference being that the USA was a creditor nation in the 1930's. So we are dependent upon the "kindness of strangers". But what if these strangers are no longer interested or capable of lending us the money? Then the Fed would be left with the choice of either charging their members more (higher interest rates) or dropping dollar bills from a helicopter (also likely to produce higher interest rates). Unfortunately, it seems like this latter possibility is the likely outcome of the course which we are on. How ironic that the man at the helm of the Fed who supposedly studied the Great Depression has repeated the mistakes of that era in spades? How catastrophic would a failure of the US Federal Reserve Bank be? How epic would a global run on the world's central bank of central banks be? While it may not yet be inevitable, the path we are taking makes it increasingly likely that we will get the opportunity to witness such an event in the next few years.
The implications for the various markets are staggering. But simply put, they would be negative for stocks. Negative for real assets (at least in the early stages as demand is destroyed). And short-term to medium-term positive for bonds ending with a crushing collapse as the US sovereign debt is repudiated.
Nonetheless, these events will take years to play out. So what is there to do in the meanwhile? When the US stock market seems to have rebounded off a severe oversold position in November and the internals of the market suggest that there could be more upside to the move. While volatility will likely remain higher than it has been in the last 5 years or more with short sharp sell-offs punctuating any rally, my guess is that SPX could reach triple digits in the next 2-3 months in the 1000-1050 range. NDX could reach 1450. The 1090 level is key as any breaches of this number should be short lived. Bonds are likely to sell off after the huge rally of the last month, as investors decide to take on risk again as a resurgent stock market pulls in those afraid of missing the next big move. Bear markets are meant to destroy as many people as possible. What better way than to display one of the strongest rallies ever to occur in market history? And once these "investors" dive back in, the selling can begin in earnest again!
posted by Matt Butler at 9:27 PM
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