February 20, 2010
Whip-saw transition prefaces the next major plunge
After close on Thursday, the Fed announced it would raise the discount rate from 0.5% to
0.75%, while lowering the duration of these loans to banks from 30-days to overnight. Fears
of an interest rate hike are unfounded, as long as the money supply continues to contract the
Fed will find it difficult to raise interest rates. Along with disappointing weekly jobs data and
contradictory inflation figures, these news events merely magnify the trend, rather than
change its course. This was all part of a symmetrical whip-saw transition prefacing the next
The plunge of October 2007 continues, negating economic recovery
The pattern developing is a complex a-b transition (a-b-a, a-b-b) to the downside. The upside
b is just a bounce, but first we must drop to at least the area of S&P 1070. Once the b is
complete, the Bear Market plunge beginning in October 2007 will resume.
Like the dive that kicked off this entire move, we again have a Diag II at the top, indicating the
start of a long move down. Since waves, like everything in nature tend to be proportional, a
transition this large serves to reinforce the mammoth plunge to follow, and entirely negates
hopes of economic recovery. Like the a-b transition on the top left, this b will likely hit a new
high, as investors pile back in just before the market collapses.
Below is a diagram of the Big Picture, so you can find your bearings, we are on the way down
to c. Although not to scale, we can expect the c wave to drop quite a bit.
Alternation indicates this last leg will likely include a Crash
Markets alternate, meaning what occurred last time, will likely occur inversely or in opposite
form this time. In the first Great Depression the Crash occurred in the initial leg down
beginning in 1929, followed by an intervening rally into 1930, similar to the one just
completed. The 3rd leg down was an unrelenting plunge to the trough in 1932. So far this
second Great Depression in the making has demonstrated the pattern in reverse, with the
long slide behind us, we can expect the crash in this last leg down.
The next Credit crunch on the way
From all directions we are seeing the initial rumblings of the next credit crunch. Liquidity is
being pulled back in China followed by the US and Europe, leading investors to question a
double-dip scenario for the economy. When crisis hits one class of bonds, it affects all the
others. Investors are selling junk bonds at the fastest rate since 2005. They have lower
confidence and that's why bond underwritings are being pulled. Reduced access to capital
markets could lead to higher default rates. When companies can't raise money they go
bankrupt. Foreign demand for US Treasuries fell by a record amount in December. Net
purchases of long-term securities declined sharply to $63.3 billion from $126.4 billion in
November. China has purged Treasury debt to the tune of $45 billion since July, when it held
a peak $800 billion. If China continues shedding US debt, the US will need domestic investors
to pickup the slack at higher coupon rates to fund the deficits. With the issuance of sovereign
debt set to hit record levels this year, concerns about “crowding out” of corporate bonds
becomes a real threat. Sovereign debt like that of Greece is increasingly being viewed much
like an investment grade corporate bond or emerging market asset and will have a crowding
out effect on corporates and emerging market debt which pay lower coupon rates.
Short sales of homes bound to accelerate slide in real estate
With the bulk of US banks embracing short sales in which homeowners settle debts by selling
their properties for less than the mortgage value, we can expect real estate valuations will
plunge all the faster. According to the Mortgage Bankers Association 15% of all home loans
were either in foreclosure or late on a payment, the highest percentage since the survey
began in 1972. As moratoriums on mortgage payments and temporary loan modifications
expire in the coming months, the number of homes entering into foreclosure is expected to
climb to the area of 4.3 million from 3.4 million in 2009, with short sales are rising even faster.
In Nevada, California, Florida, Arizona and Michigan housing prices have fallen more than
Private mortgage financing is dead
Unlike many parts of the capital markets, private mortgage financing has never recovered
from the crisis leaving Freddie Mac and Fanny Mae to provide the funds for virtually all new
mortgages. Under new proposed rules Fanny and Freddie will no longer be allowed to use
sub-prime mortgages to help low-income Americans buy homes. Mortgage backed securities
lost billions as housing valued plunged. Investors who thought their “triple-A” investments
were secure got badly burned. These MBOs were consequently bought up in large amounts
by the Fed in efforts to prop the ailing mortgage market. In March, this buying is set to stop,
and Kansas Fed president, Thomas Hoenig warns of “dire consequences” for the Fed's
prolonged holding of mortgage backed securities.
States budget deficits exceed $3 trillion
The 50 States with already strained budgets have a cumulative shortfall of $3 trillion including
pension and healthcare costs, according to Orin Kramer, chairman of New Jersey's
investment council. In 2008, state pension funds lost 25% of value on average, leaving only
four states with fully funded pensions: Florida, New York, Wisconsin and Washington, down
from 50% in 2000. On the next market plunge these pensions will call into question states
ability to meet pension obligations. As a result public services like education, healthcare and
public safety will likely take big hits. Higher state taxes are inevitable. On the Federal level
Société Général estimates that once off-balance sheet liabilities, such as tomorrow's pensions
and health care bills are factored in, US government debt is five times the the size of the
economy. How can we not go into a severe, protracted Depression?
The Baltic Dry index collapses from excess capacity
The Baltic Dry index is a perfect example of the classic boom/bust cycle espoused by the
Austrian School of Economics. In three months the index has collapsed 40%. Cheap money
caused overbuilding at a time when daily rates for capsize vessels were sky high. Now
surplus supply, due to continue coming on line at increasing rates in 2010, can only make
things worse. That means a collapse in daily freight rates and many likely bankruptcies before
enough vessels are scrapped to bring supply and demand back into equilibrium. Inflation
begets deflation fast in this sequence of events. We can expect the same from natural
resource commodities, including gold, where the IMF found no buyers last week for its
proposed sale of 190 tons. In Japan deflation is becoming entrenched, prices are 3% lower
than a year ago and in an accelerating decline as expectations become self-fulfilling.
The Euro rather than collapsing, should begin rising again
Meanwhile the record number of short €uro positions, betting on a plunge, indicate the
European currency should start to rally soon. Short positions have accelerated, rising from
41,000 contracts to 63,000 contracts over the last three weeks. These shorts now exceed
levels last seen when Lehman collapsed in September 2008. on the contrary, it's the US
Dollar, which spiked to a 8-month high last week, that's due to plunge next .
Diag IIs indicate the beginning of a long move up. But first the dollar must now drop to at least
73.25, where the first Diag began, before reversing back up into wave 3.
The daily chart below shows the transition was the 8-month high and a black candle means a
bullish reversal. From here it’s down for the dollar until we reach at least 73.4.