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I feel we are facing significant headwinds moving forward because of the loose monetary policy of the Federal Reserve, the refusal to address the core problems in our financial system and the incredibly opaque derivatives market that has yet to be regulated or even cleared on open exchanges.

The root of the problem

To expand on the first point of loose monetary policy, from my own research I have gathered that the government has put at least $12T, possibly up to $30T worth of guarantees, backstops and other forms of insurance against the prospect of another meltdown. In addition the Federal Reserve has, in my opinion, illegally bailed out AIG through programs they are not authorized to participate in. These actions and other measures have transferred the risk of collapse from the private sector to the US government and to the Federal Reserve.

Interest rates remain below 1% in a range of 0.00% to 0.25%. Combine that with the infusion of US dollars the Federal Reserve has given to other central banks around the world and we have literally created a carry trade scenario. Not only are we repeating the mistakes of Japan, but we are going down a path where should a geopolitical event or other significant negative catalyst occur the repatriation of dollars could create a collapse across nearly every asset class.

Risk grows as stability wanes

This environment that has been created to engender a recovery is not only unsustainable, but it has created more risks than had existed beforehand:

#1 Should another market panic occur where AIG’s credit default swaps are due, the US Treasury and Federal Reserve must cough up the difference. This would lead to another series of bailouts and funneling cash to foreign and domestic banks at the tax payer’s expense on bets that never should have been made and were downright idiotic.

#2 Big banks are BIGGER now than before: JPM, BAC, WFC, USB and others are now larger and present a much more significant risk to the system should, say for example, one of their mark to make believe off balance sheet assets implode — potentially bringing down the entire world financial system, again.

#3 The stress tests were fraudulent and did not expose the off balance sheet asset liquidity vacuum these banks are suffering from. Papering over fraud never leads to a sustainable rebound.

#4 Tax receipts are down across the board – how can counties, cities, states and the Federal government hope to control deficit spending if they are not collecting as much in taxes? They can’t sell bonds forever, bringing me to my next point.

#5 Commercial real estate and corporate bonds are headed towards a potential implosion in the next few years, with major mall holders filing bankruptcy and many occupants of office and retail space vacating as they downsize. Corporations also must refinance their debtload which is ever growing while the global appetite for these bonds is diminishing.

#6 We in the United States are very seriously facing the risk of a sovereign debt default in the future. This prospect is made even more serious by continued bail outs, war spending, entitlements and other programs that are completely unsustainable with our country’s $14T debt burden.

#7 Such a sovereign debt default would lead to a currency collapse and that could engender either an environment of hyperinflation or heavy deflation — all depending on where the chips fall at the end of the day.

Inflation or deflation?

While speculators are now hedging for inflation and shorting the dollar in any way possible, there is another market we must pay close attention to. A market that significantly dwarfs the size of the commodities markets as a whole. That is the US Treasury Bond Market. Last I checked it was $33.5 trillion dollars. I find it interesting that gold is touching $1111.00 an ounce while 10 year bonds are at only 3.625% — who is wrong in this gigantic game of chicken?

Either the folks buying gold are insane to believe inflation is the bogeyman to fear or the much larger, much more influential and liquid bond market is crazy because they obviously fear deflation. Why else would a rational human being buy a bond at 3.625% that they must hold for 10 years? Such an instrument would be less than worthless in an inflationary environment.

First the principle value of the bond erodes as interest rates rise, and secondly the yield would not make up for the rate of inflation. So we are experiencing a financial conundrum right now. Either we are on the verge of a deflationary collapse or a hyperinflationary currency crisis. Which way we’re going to go has not yet been made clear to me because I feel the markets are being propped up, even manipulated.

The most dangerous bubble

Why would I pose such an idea? Let’s start with the P/E of the S&P 500 which is now well over 25 (and was at one point over 100). How can anyone feel that these stocks are reasonably valued with such an absurd P/E? Most of the decrease in P/E from over 100 to over 25 has been from companies downsizing, firing employees, hiding bad assets and not organic growth. In the current global macroeconomic environment there’s no feasible way earnings can catch up, so in my opinion we’re already in a bubble.

Bubbles of the past were not as dangerous because the US government never had such a large stake in the market. Now we’re talking about a situation where if the credit, bond, currency and/or stock markets implode, so does our sovereign debt and currency potentially.

Investing is now speculation

Investing in this environment is difficult at best. During the March panic I was a buyer in the high S&P 600s of just about any material, technology, financial and energy stock I could find, but once we got to the 900s and I saw P/Es jump beyond levels I felt were fair valuations I became a seller of my holdings. I also invested some in to silver, foreign currencies and other commodities during the March lows, but also have since taken a lot of those profits off the table.

We are in a very risky area for people to be entering the market. I don’t feel these lofty levels are sustainable nor do I think the valuations are rational. I don’t know when the rally will end, but I do know that any parabolic move usually ends very badly and any time there has been a carry trade in the history of money it has ended painfully for all the speculators who did not exit in time.

Another collapse coming?

In closing I will say that before Rome’s collapse the government was shaving gold and silver coins down to create more currency. They also had a severe debt crisis. The shaving and continued spending led to awful inflation that eventually catalyzed the empire’s downfall.

History is being made every day and the decisions are going to shape the face of America’s future. It is imperative that we start to take our medicine (meaning we must face the financial problems instead of ignoring them) and deal with the overwhelming burden of debt before it swallows up everything left.

I would like to pose an important societal question to any banker that is willing to answer it:

Why are bankers increasingly hesitant to lend, even drawing back lines of credit, yet at the same time allocating a lot of funds in to commodities, especially oil?

Isn’t it true that oil and consumer consumption are closely correlated?

Are they seeing something that I am not or is this a bit of a logical paradox?  How can the banks create the growth they need for their trade (or investment) to be profitable if they refuse to lend to those that would spend it on consumables?

There has to be more than just dollar weakness factored in to this equation.

There are no shortage of credit problems to navigate through with mortgages (both subprime and now prime), credit cards and commercial lending, potentially indicative of a deflationary credit squeeze for the everyday person who will no longer be able to borrow to buy everything based off their future earnings or assets.  This contraction could also have very negative effects on small business growth and hiring, too.

It’s because consumers and small businesses account for the majority of the US economy that I think we are wise maintain a defensive posture as most of the multi-month rally’s asset allocation haven’t taken this matter in to focus yet.  I believe we are well out of bounds of realistic equity valuations and the dollar is being sacrificed by the printing press of the Federal Reserve, Treasury and Congress to temporarily support financial markets.

Once this liquidity flood induced euphoria wears off there will be severe consequences to the US currency, bond and equity markets that most investors don’t seem to be aware of or have not positioned themselves for.

Sources:

http://market-ticker.denninger.net/uploads/KeyCharts/Credit-y-o-y-large.png

http://www.federalreserve.gov/releases/g19/Current/

http://econompicdata.blogspot.com/2009/09/consumer-credit-freefall.html

http://www.marketwatch.com/story/troubles-shift-to-prime-borrowers-wsj-2009-09-04

http://www.boston.com/realestate/news/blogs/renow/2009/09/mortgage_market.html

http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSN0829660420090909

http://www.reuters.com/article/newsOne/idUSTRE58752720090908

The consumer confidence number bounced significantly.  This is generally  supposed to be positive to the currency, but because the US dollar has become a carry trade currency through the zero interest rate policy, now  good economic news has an inverse effect on the US dollar, moving it lower.

It’s hard to believe that consumers are spending more money when their 401ks, house values and wages are down significantly, unemployment is rising and even if they are spending money retailers have marked down items so low their margins are razor thin.

The problem is that when there is bad macro news, such as the rumor of the US losing its AAA rating, the US dollar sinks, too.  US equities can’t continue to rally if the currency continues to sink at this rate.  All of the consumers will lose their purchasing power

As the rally appears to be running on fumes at this point, I’d like to say that I was a little early saying to sell it before, but one never can trust a bear market rally.  That’s what it still seems like we’re dealing with, too.  The technicals were powerful during the 8 week surge, but we do not yet have a Dow theory buy signal (need a close above 9125) or a break above the 200 day moving average on the S&P 500.  Now the charts are beginning to look more exhausted as the overbought conditions are worked out.  Longer term the trend remains down as we seem to continue with the 10+ year double top formation playing out on the S&P 500.

Banks led the rally up and now they are beginning to give way as fundamentals point to a more pessimistic picture than the prior trading action of their equities might suggest.  While I do feel that the substantive cash injections, ZIRP cheap liquidity and stimulus have filled part of the vacuum left by the implosion of Lehman and the deleveraging process, there is simply too much enthusiasm around when this alleged recovery is due to transpire.

We are quite literally in the midst of a complete reinvention of how the world does business and in that process there likely will be further dislocations and market abberations before settling in to a U or L-shaped recovery — either economic destiny will be determined by the shape of fiscal policy and whether insolvent institutions are infact allowed to fail or continue indefinitely as “zombies”.  Unregulated derivatives markets must be brought in to the light and fully regulated in order to prevent credit default swaps and other leveraged contracts from contributing to widespread system disruptions.

This turning point has been marked by the downfall of the US as the financial capital of the world.  A slow unwinding process that in the decades to come will be much more apparent than it is now.  This is the unfortunate consequence of being the largest debt bearing nation in the world whose currency is quickly losing popularity as reserves for central bankers around the world.  The unraveling is going to degrade the quality of life for Americans and boost domestic inflation considerably.

If nothing can be done to restore confidence by regulating the shadow markets and unraveling the insolvent institutions, then this trying period shall last quite a while.  At this point I don’t feel the actions of the US government or the Federal Reserve have been constructive to that end.  That is why I feel the rally is largely unsustainable and right now we are in a frothy period where short positions in equities and long positions in foreign currencies may be appropriate to consider putting back on the table.

Disclosure: Short US equities, long foreign currencies

Washington is losing sight of the real crisis.  Incompetence, loose money and impulsive decision making are what brought us to near collapse.  Why are we repeating these same mistakes again?

Bonuses of the bailout

The $2B in Merril bonuses and the $187M in AIG bonuses when the government effectively saved these institutions from their own incompetence is far from acceptable.   There is no reason that people who created the systemic risk should be rewarded by the bail out money which is ultimately funded by tax payers facing higher taxation and a reduction in government services.

Having said that, the anger that swept the US House of Representatives to pass an unconstitutional bill that singles out individuals and retroactively taxes them at a 90% rate is equally an unacceptable reaction.  The bail out bill contained the provisions to allow these retention plans and bonuses.  How was this overlooked?  Because most lawmakers don’t read bills before signing them in to law.

Global righteous indignation grows

It’s an unbelievable situation we, as global citizens, find ourselves in.  The international banking conglomerates have failed us.  Our respective governments have failed us.  Yet they now want to claim to be the heroes and the saviours that will restore prosperity to the world.  Cutting interest rates, funding defunct institutions, floating trillions of dollars out to prop up bad debt all to relieve the liquidity vacuum the last bubble bursting left in its wake.

In the last two weeks there was a positive change of character, albeit short-lived, that boosted markets worldwide.  It was the prospect that the rules of the game had been set in the United States to favor a partnership between private capital and government loans that would allow an eventual transition away from the US Treasury and Federal Reserve propping up the every marketplace they can.

In an attempt to quell popular angst over the AIG bonuses, which were 90% less than the Merrill bonuses and 99.9% less than the total bail out AIG dished out to other banks, including non-US banks, the House of Representatives set out to destroy all the good faith that had been built.  Completely ignoring the bigger picture that AIG was simply a proxy for money that was siphoned all over the world, in the billions, not millions.

Who’s really in charge?

Let’s not forget the US Government is a majority stakeholder in AIG.  They own 80% of the shares and easily control any issue put to vote.  They can also demand the board and even CEO are replaced.  These types of extreme actions wouldn’t be positive, but they certainly seem more logical than passing a retroactive 90% tax.

The problem is the government keeps changing the rules in the middle of the game.   It’s very difficult to restore confidence when no one knows what the law will be tomorrow, let alone next week.  Every time there’s some level of complacency that the rules have been set, the rug gets pulled out again from under everyone.

Laws and lawmakers

The rule of law is a fundamental element of successful capitalism.  There is no confidence if laws  can be arbitrarily and retroactively changed or contracts can be freely broken without consequence.  I fear that more of this knee jerk legislation will completely reverse progress we’ve made toward restoring some level of confidence.

It’s unfortunate that we’ve propped up any of these institutions and in my prior entries I’ve always spoken out against bail outs and the corporate welfare environment it engenders.  No business that is unable to continue to sell products or services should be allowed to be given second, third or forth chances funded from the public trust.  Innovate entrepreneurs will create better, more profitable and functional replacements in time.

The problem is, Washington only realized this after the fact.  Only in retrospect do lawmakers seem to understand that most if not all of the effort was a waste of money.  Now, in order to not look foolish before the 2010 elections, lawmakers are putting on a big media circus to scapegoat everyone but themselves, who share in the blame just as much as the banks.  Let’s not forget as citizens that any lawmaker who voted for the TARP or the stimulus was complicit with bonuses and retention plans.

Even back when Fannie and Freddie were taken in to conservatorship, part of the contract with the US government was to guarantee the bonuses and retention plans remained.    The US Congress would have us believe that they were swindled and the bonuses flew under the radar.  Seriously?  Did you guys even bother to read the bill you signed?

Recently there’s been some discussion about regulation and improving oversight of our global markets.  Of course bankers and would be capitalists scoff at the notion.  Why would we want to regulate a free market?

In what seems to be a massive legal loophole being exploited for the gains of insiders with privileged information at publically traded companies, the existence of the JP Morgan PrISM program provides compelling reasons to closely examine the way banks and brokers handle securities and favor their biggest clients at the expense of everyone else.

The creation of a legally rigged market alienates and burns most average market participants, whether they are traders or long term investors.  If insiders are allowed to freely trade their company’s stock with privileged information, where is the incentive for any other person to participate?

Anyone who would knowingly lie, cheat and steal in this manner undermines the very system that allowed them to accumulate wealth and operate a business.   These individuals deserve to be held accountable for their actions, especially now that the world knows how disruptive this level of fraud can be.   What we’ve seen with AIG, Citigroup, Bernie Madoff and the rest of the firms and individuals is nothing short of a cataclysmic blow to free market capitalism.  To restore some level of trust we need to see a lot more folks than just Mr. Madoff going to prison, not passing go and paying BACK the $200 (or however much bailout/bonus/fraud money they received).

Just how many banks have a PrISM-like insider trading system much like JP Morgan?  With cockroaches you know that there’s always more than one.  I feel this scenario plays out much in the same manner.  More banks will have whistleblowers reveal that they also have insider trading and other very unethical programs.

Just how many money managers try to avoid doing their homework and try to cheat the system by getting insider information?  How many will be investigated by the SEC and actually be arrested?  Will the SEC reinvigorate itself to return as the sheriff of Wall Street or will this administration create a new, larger and more overbearing regulatory apparatus?  More importantly, will the crooks go to jail?

Or will we keep the status quo?   A revolving door between the SEC and Wall Street where former officials are given cushy jobs as legal counselors or advisors.  This massive conflict of interest includes members of the Madoff family working for the SEC and Bernie himself being a paid advisor for several years, helping to shape policy for the agency that was supposed to watch out for people like him!

I say we close all the loopholes and start prosecuting the crooks post haste.  No one deserves another breath of fresh air or moment of freedom if they are directly responsible for lying, cheating and stealing our system in to near collapse.

Where is the stimulus for the people that need a first chance?  Why is it all focused on those that need their second chance?  Whether it’s a company or an individual that’s financially distressed, there are many more that are not and just need a push in the right direction to ensure success.

Read more at chamandy.org.