Reflation Nation

As the Federal Reserve, by funneling trillions out to banks in clandestine programs, attempts to boost the economy or at least stabilize the asset deflation mess that the real estate credit bubble left behind, we see a familiar concept once again emerging.  Reflation.

Reflation is when an economy is stimulated by central planners (Congress, Federal Reserve, etc.) through tax cuts or by increasing the money supply.

In this case reflation is being utilized to counter-balance the immense sums of money that are being destroyed.  Bear in mind that money is debt, and as the value of worthless assets contract, so does the current money supply.  The Fed, through its attempt to stimulate the next business cycle, has made money cheap again (1% if you can borrow from them).  At the same time, this non-governmental bank of banks has created numerous programs to temporarily or indefinitely purchase, with the promise of collateral, many troubled asset classes.

Why is this important to consider?  Because if you hold US dollars (also known as Federal Reserve notes), you will eventually pay for this mess.  You will pay through what later could prove to be a massive inflationary currency crash when reality catches up to the dollar once global economies begin raw material consumption again.  Reflation is a dangerous game to play because no one can possibly understand how much or how little is necessary to find the perfect balance.

house of cards

 "Central planning an economy"

Central bankers use computerized models based on algorithms, flow charts and other techniques to determine what possible outcomes there are from many scenarios.  The problem is that our economy does not exist inside their simulation program, with its greatly limited capacity to estimate the potentially chaotic nature of relatively free markets.  Our economy exists in the hearts and minds of humans who command billions of computers.

The disastrous consequences of central bankers planning economies can be seen both with the Dot Com bubble (and bust) as well as the real estate bubble and the meltdown our economy is once again experiencing.  These bubbly boom-bust cycles are all too familiar for those who have experienced the “Greenspan put” of the past two decades.  Under all circumstances former Federal Reserve chairman Alan Greenspan would support the stock market instead of the currency’s purchasing power, creating the illusion of prosperity built on a hidden tax of the American public called inflation.

The days of such blissful ignorance may be drawing to a close, however, as reflation’s capability to generate a bigger bubble than real estate is unlikely.  America can no longer trust in the idea of borrowing against future earnings or investing in the markets for enhancing wealth.   It’s no coincidence that borrowing-based consumerism/corporatism as well as buying and holding stocks have become philosophical dinosaurs at the same moment in history.  Neither practice is rational in an environment where the riches amounted to little more than a modern financial house of cards.

Downtrend may resume

With a week full of potentially sour economic data and political uncertainty, the market may be poised to resume its downtrend and give back much of its gains.  See our chart of the S&P December 2008 futures:

S&P Futures

The chart above shows the potential for the downtrend to resume as the futures have considerably weakened off their overnight rally, which retested Friday’s highs.  We have had a week of mostly gains, with back to back up days.  In this kind of bear market environment it is doubtful that the rally can last too much longer.

Sectorwatch: Airlines (UAUA)

We saw an impressive rally in the airline stocks yesterday:

AMR rose $.94 or 11.4 percent, to $9.20.
AirTran rose $.41 or 11.8 percent, to $3.89.
Continental rose $1.55 or 10.1 percent, to $16.94.
DeltaAir rose $1.56 or 19.5 percent, to $9.55.
JetBlue rose $.70 or 15.5 percent, to $5.21.
Southwest rose $.40 or 3.7 percent, to $11.24.
UAL rose $2.18 or 19.8 percent, to $13.18.

The rally was predicated on the notion that the Delta and Northwest merger would benefit the
industry.  In addition, crude prices have moderated.  Is this enough to justify a 20% rally
on half average volume in United Airlines (UAUA)?  Today we shall see if the stock can hold on
to its gains.

At this point we are watching UAUA closely as we feel it is overbought and stands to correct by
10-20%.  If major support is broken it could return to single digit levels.  The fact is that
during a major global recession, airlines are going to see a lot less business.  United has the
worst balance sheet, inept management and it is doubtful that they will find the capital to
finance any kind of merger.  They also have very high overhead, because of their high employment
and many hubs.  We expect this to take a toll on investor confidence moving forward.

We began building a short position yesterday in anticipation of an overbought market correction
today.  We feel there is still opportunity to short this stock.  Good luck trading!

Bear market rallies are bull traps

Always be careful of how you invest during a bear market.  Rallies happen, but rarely are they a sign of a meaningful bottom, especially if there is no end in sight to the economic problems.  Sometimes the rallies look promising and powerful and the pundits come out of the woodwork to “call the bottom”, in retrospect, of course.  But markets don’t bottom overnight.  It is a constructive process that can take days, weeks or even months and years.

Don’t rush to invest large sums of money you can’t afford to lose in a bear market.  Remember that most money managers lose money in bear markets and they are professionals.  Unless you have a lot of experience and a lot of spare cash burning a hole in your bank account, don’t speculate too much.   A prudent approach would be to invest 5-10% of your income per month in a value-based diversified international mutual fund or ETF.  That way you aren’t attempting to call a bottom and contribute regularly when the market is in the process of revaluation.  This approach works with one necessary future component.  Growth.

Don’t get caught up in the emotion and get stuck on the wrong side of the rally’s collapse.  Technicals help, but are not perfect in this kind of market.  Remember that there are plenty of charts on the bottom of the sea, right along with the ships whose navigators trusted them.  Always watch your positions and use stops.  I don’t feel we are at a bottom yet as the economy stands to deteriorate significantly.

The troubles ahead

With or without a successful resolution to the credit crisis in the near term, we still face a global recession that can potentially compress the margins corporations worldwide.  Some have speculated that this has already been priced in to stocks during the 25% correction we’ve seen in October.  Others, including myself, have a more gloomy picture painted.

One doesn’t need to predict the future to understand the lessons of the past, the human psychology of markets and the massive borrowing that led us to the top of the biggest financial bubble in history.  The tulip mania craze will be seen as a walk in the park compared to the massive leveraged world we live in now.

Simply put, every single person, company and government will finally have to start living within its means, rather than borrowing based on the promise of future earnings.  This will break down consumerism.  Consumer spending accounts for 75% of the US gross domestic product.  What happens when the consumer isn’t spending?  Deep protracted recessions with L-shaped recoveries.

Now our national debt is larger than our GDP.  Of course the United States’ wonderful standard of living is supported by the tremendous generosity of foreign central banks and sovereign wealth funds, to the tune of $2 billion a day.

I have a funny feeling that when our treasury bills are backed by defaulted mortgages, junk credit cards and bad auto loans that our debt rating will be downgraded from AAA and foreign money will flee from the US as it never has before.  Leaving the government without the funds to support social programs or even some vital infrastructure and state funding.  The only option is massive tax hikes or huge program cuts (or perhaps both by mere necessity).

The Untrustables

Everyone wants to have their confidence restored in financial institutions, but when I read headlines like, “SEC Loosens Accounting Rule Banks Blame For Crisis“, I have to start seriously questioning the oversight role the SEC has lackadaisically administrated and the devious flexibility that very lack of supervision gives banks.  What the above headline and the linked article illustrate to me is that the SEC had no handle over what the assets these banks held on their balance sheets may have been worth and now that they’ve taken a peak apparently they are not pleased with what they saw.

Hiding the assets from markets is only going to further ruin confidence.  Now we can no longer trust any earnings from any institution that has exposure to troubled assets.  Not only that, but we can expect them to artificially value the assets higher than their worth and foist them on the Treasury when the TARP (Troubled Asset Relief Program) begins their auctions or direct purchases.

This is a major breach in transparency and a move in the opposite direction from finding a conservative and clear accounting standard that institutions should be held to.  The opacity of today’s bank balance sheets combined with the new ability granted by the SEC to mark assets as banks see fit make this investor lose all confidence in America’s banks.  The situation here is too reminiscent of Japan’s “solution” to their own real estate bubble meltdown.  We all know that Japan’s recovery, if one can even call it that, took decades and is still underway.