We’ve seen bonds outperform nearly every other asset class, as the flight to safety has been fast and furious. The short end of the yield curve is yielding 0.335%, which is actually up from the lows of the year. The TED Spread is at record high levels, showing the stress in the credit markets is exacerbated by the uncertainty surrounding the corporate welfare bill for financial companies. The current trend in equity indexes is lower with no sign of abatement. Most emerging markets have been deeply affected, with China down 60% from the peak of last year to the trough of this year’s lows. Russia’s financial crisis worsened to the point where the markets were shut down for days and in India and Brazil we’re seeing inflation continue to plague the central bank policy, causing an abrupt departure away from steady growth.
The world is in limbo right now. Are we going to let institutions fail as capitalism would demand or will we socialize the entire free market in favor of stablizing a fearful world in the aftermath of the biggest asset inflation bubble in world history? While the US Congress debates these issues the markets are deteriorating, as they should, given the uncertainty that forward-looking traders and investors have to factor in every day.
Right now we are on the precipice of the greatest global financial crisis the world has ever seen. Most people are beginning to wake up to that. We’ve seen some liquidation of mutual funds in retirement accounts, money markets become unstable because of Lehman’s collapse and AIG, the world’s largest insurer, have to be taken over by the US Federal Reserve Bank, because of balance sheet insolvency from “mark to make believe” accounting practices. While legislators debate what implications this bill may have and how to oversee it prudently, I fear that this is by far the worst approach to solving a problem that stemmed from bad risk management and greed. You cannot bail out the biggest banks with debt that is created out of borrowing at interest from the Federal Reserve and expect the problem to be eased.
Every government and Fed bail out so far and in the foreseeable future relies off of using public funds to bail out private sector mismanagement of capital. Suddenly the entire financial sector’s balance sheets are reminiscent of Enron and we’re celebrating this by rewarding their worthless paper with billions of dollars from an already heavily debt-burdened Treasury balance sheet. We can’t expect this one to be any different. Sure it may address short term credit market confidence issues for just enough to get us through another quarter, and to a new elected government in 2008, but it is not a solution. It is a bandage on a gaping axe wound. Eventually limbs will have to be lopped off because the infection wasn’t handled by Dr. Ben. This is what I fear is next.
Instead of stemming the risk taking, the policies suggested and enacted thus far have actually created the opposite effect. We give banks easy access to cheap capital as the Fed cuts rates, the dollar weakens and all of these banks target commodities as an investment, instead of putting the money to work back in the US economy. Of course their argument is that they have a fiduciary responsibility to generate capital for their investors, and that allows them to operate in a completely apathetic manner towards the overall wealth of America. Instead, they invest in metals, energy, grains, etc and the rally is the biggest and boldest in decades. It was no coincidence that when credit became harder to access, hedge funds started imploding and the banks that benefited from the rally on the way up started taking profit or reversing positions while the economy slowed down, that the rally completely ceased and reversed. The correction, like the rally, was the unprecedented in its scale and veracity.
In the midst of incredibly expensive short term capital, market participants that relied off leverage to create profits are imploding left and right. Many models, like the ones employed by Bear Stearns, Lehman Brothers, AIG, Washington Mutual, Wachovia, etc. will not function in a world where confidence has eroded because of excessive greed and terrible risk management. Many smaller boutique firms that receive less media coverage have also been facing redemptions, funds have been closing down at an alarming rate. At the end of the day, there are less market participants and those remaining have less capital to employ strategies.
Many elements of the market system are changing very fast. Be careful trading. The risk hasn’t been higher for a long time. Short term strategies seem to be the most feasible, but keep your eyes glued to your terminal! I’m keeping my portfolio in cash with occasional conservative short term trades when the opportunity presents itself. Good luck!