Once upon a time, I lived at the peak of civilization, in the greatest nation to ever exist.  But now, we have far too many holes for the Dutchboy to plug and an ocean drawing toward us. 

This morning CNBC is reporting that, the United States Federal Reserve is considering and may begin to issue debt. To review, here is a well done breakdown of the purpose or mandate of the United States Federal Reserve taken from Wikipedia, here.

1. To address the problem of banking panics
2. To serve as the central bank for the United States
3. To strike a balance between private interests of banks and the centralized responsibility of government
   • To supervise and regulate banking institutions
   • To protect the credit rights of consumers
4. To manage the nation’s money supply through monetary policy to achieve the sometimes conflicting goals of
   • maximum employment
   • stable prices
   • moderate long-term interest rates
5. To maintain the stability of the financial system and contain systemic risk in financial markets
6. To provide financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system
   • To facilitate the exchange of payments among regions
   • To respond to local liquidity needs
7. To strengthen U.S. standing in the world economy

These mandates are complex and can within themselves conflict with one another. Its #7 that ought really worry you when you consider this development: the Fed issuing debt. Why?

The United States Treasury already issues debt — loads of it, in fact, almost unimaginable amounts of it.  It does this because our country is currently running a defecit.  In order to address the defecit while cotinuing to operate, Congress borrows and Treasury issues debt. Just one of many fingers plugging one of many economic holes.  Despite the housing crisis, the entire US mortgage market has a book value of around $12 trillion.  Thats an interesting target amount to consider because, so far, the Federal Reserve has had to grow its balance sheet roughly 30% of that — another finger plugging another economic hole. 

If the Federal Reserve now begins to issue debt, it will truly be the end of the United States as an economic world power. It will mean that the United States has become already insolvent and is now dangerously close to bankrupt. Now even the Dutchboy’s hands are full. 

We were right on the money yesterday here at Matt-That.com, with our prediction about the US stock market. As we expected, after washing out a false rally, the market turned downward. Howsoever, the sellers came out, presenting the kind of volume, that suggests we’re only closer to the second part of my prediction: that the market goes unfeelingly sideways.

In today’s session, traders and investors alike, from all around the world, will be forced to learn about a new mechanic taking shape in this market: Conjuration, I call it. Its certainly existed before, but not nearly as it does today.  Conjuration is the first step in creating pump and dump bear traps.

How do you create a Bear trap?  First, you conjure value out of thin air by suggesting if you miss a particular buying opportunity, you will get no other. This conjuration of value creates the same panic used during selling to initiate worry about being left out of the market, causing panic buying.

Today, we will conjure such value, in the form of a rally of immense proportions, with almost no basis in reality. This will form the upside dressing of the next stairstep down, continuing the wash-out of millions of new investors/positions. Soon, this exact ebb and flow will drive the market sideways.  The disinterest will be more profound when there is no dumb money to dump your shares on, nor trade volume to pump them up.

Many people have been taking advantage of the traders nature of this market — full of ups and downs. So, in order to remain safe, how can we time the beginning of this rather troubling event, of a side-ways market, to avoid holding positions on either side?

Monitoring the pessimism, using its reversals, we see its strength has grown to the downside, not diminished. So, we can begin to sell our short positions here (the most leveraged first). And we should not look to acquire many more leveraged positions going forward.  Leverage on any direction is the most dangerous position to be in, in a sideways market.  Logically though, what indicates the coming sideways market?

We’ve had sellers from 14,000 to now 7900.  And sellers came back into this market to take us to those levels. There can be only so much more selling pressure on the sidelines as we go.   But, what about the positive story then?  If we’re out of sellers we must be full of buyers, no? First rally almost 1000 points.  Second rally half, at just 550 points. Third rally, half again, some 250 points.  Strange, we’re running out of buyers too.  And that, is how you end up with a sideways market.

At points of maximum pessimism and optimism there must be cyclical reversals, otherwise a market has no psychological basis with which to use as function for pricing.  Todays cycle suggest the kind of rip-your-face-off rally we saw the first time.  And, like the first time, it will not hold.

The Dow Jones Industrial Average closed yesterday with a 7900 handle, 7997.28 to be exact. It marks the first time these levels were closing levels for the index in over 5 years (almost a full 50% down from the peak of a 14,000 handle just recently set a year ago, in October 2007).

Chart technicians are on both sides about what all this means.

I think its important to point out price action on another closely watched index full of widely held stocks, the Dow Jones Transports Index, which made a fresh low during this sell off. This is suggestive that today we will likely see that same action more broadly. Transports led us through the commodities moves on both sides, which have been nearly dead-locked with the market, in a state of stair-stepping deflation.  Trading volume has also wound down dramatically.

These are not indications of re-valuation of the market, nor are these indications of price re-entrenchment.  These are not indications of capitulation.  These are indications that the US equity market is about to change its tone dramatically.

The final destination of this market, after its traded down, washing out perhaps hundreds of thousands of new investors in hundreds of varied positions, is not excitement.  It is not a psychology of buy & hold. And it is most certainly not a market psychology which leads to rebounds. This market will trade into such low volume, continually taking out players, vaporizing capital turned equity, only further removing opportunities for uptrend trading.

In the end, the action will go side ways as the whole market becomes apathetic. And while all historical indication tells us that we have a green light in a Bull market, a red light in a Bear market, a sideways market has only one indicator and it hangs brightly now over the door: the exit light.

Huxley, Friedman and Roosevelt

Perhaps the deepest truth I know of, is an utterance that comes to us long lost from an English novelist of the 19th Century by the name of Aldous Huxley, who said “That men do not learn very much from the lessons of history is the most important of all the lessons that History has to teach.” Today we live in a literal proof of a society misunderstanding of the profound nature of this observation, at least economically speaking. In 1929, on the day the stock market crashed, the headline of Variety read, Wall Street Lays an Egg. Thats timid compared to whats already been said about today’s circumstances. The fact is though, Variety like today’s media, has it all wrong.

It was the economist Milton Friedman who best summed up the cause of our present-day economic woes with his thoughts on what caused the Great Depression, saying “The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy,” Change came from an usher as desperate as were the times. Just four short years later, in his 1933 campaign speech, Roosevelt said, “It is common sense to take a method and try it. If it fails, admit it frankly and try another. But above all, try something.” And try they did.

Day in the Life

Such brute force as proposed there, howsoever, will serve ill the very different America of today. How different is it? In some ways very different, in others respects not at all.

- Food Shortages: The Tri-State Observer reports that the US has no remaining grain reserves…

According to the May 1, 2008 CCC inventory report there are only 24.1 million bushels of wheat in inventory, so after this sale there will be only 2.7 million bushels of wheat left the entire CCC inventory,” warned Matlack. “Our concern is not that we are using the remainder of our strategic grain reserves for humanitarian relief. AAM fully supports the action and all humanitarian food relief. Our concern is that the U.S. has nothing else in our emergency food pantry. There is no cheese, no butter, no dry milk powder, no grains or anything else left in reserve. The o°©nly thing left in the entire CCC inventory will be 2.7 million bushels of wheat which is about enough wheat to make 1?2 of a loaf of bread for each of the 300 million people in America.”

Here is a direct link to that report.

- Energy Crisis: Fox News asks, “Are We at Risk of a Global Recession Because of Oil?”

- Environmental and Natural Disasters: Some of these Oil spills, Ozone depletion, Earthquake related Tsunamis, a European heatwave that killed over 37,000 in 2003, and Hurricane Katrina just to name a few.

It sounds as if I’m describing doomsday but I’m not. I’m describing today, the 1930s, the 1970s, and I might as well be describing any day at random. The fact is these things happened before and will again. And Huxley’s lesson will continue to escape most of us just as it has done and will continue to do.

Not everyone comes as late to History class fortunately, some realize this and try and find new, more useful ways to look at the past. And some manage to apply what they learn. Current Macroeconomic theory suggests consumers and businesses of Great Depression era relied on cheap credit. Consumers did so purchasing goods, while businesses did so investing in production. This economic behavior fueled rapid, short-term economic growth, creating swells of debt. When prices deflated, growth essentially collapsed. As the corporations and consumers both defaulted on loans, unclaimed, full inventories further deflated prices. The corporations laid off workers reducing consumer spending, eventually creating a kind of self-sustaining cycle, and later the wave of defaults shook banks. Confidence plummeted in corporations, the markets, and finally the banks themselves, creating a ‘run on the bank.’ This suggests a way to look at today.

Today, we face very alike conditions. A systemic networked banking system creates investment banks such as Bear Stearns, called “too big to fail”, that require 30 billion dollar rescues when the same debt-fueled growth cycle causes just their collapse. And while that may have plugged one very apparent hole, the overall cycle will continue.

Starting in 2003 until sometime in 2007, the economy saw the same sort of rapid, short-term growth across a majority of markets, favoring housing, equities and derivatives, relying on the same kind of cheap, plentiful credit used prior to the Great Depression. Today different from the 1930s, that cheap credit has been delivered by sharing the debt amongst banks and further wrapped up as derivatives securities — this, and inter-bank lending creates the systemic connection between banks potentially making them too big to fail.

Before long though, debt-fueled growth causes confidence scares; loans come to term and defaults drive the flow of money out of lenders and spenders and into things like commodities, where the cycle enters the next phase. The new and higher commodity prices push down the equities and other securities and raise costs. The whole tree begins to poison, spreading one branch at a time.

Back to the Future

The future cannot be known but the past is not as limited. Thus, I feel confident in the future I see ahead, so mindful of the past. I say next, we’ll begin to hear about other lenders, spenders and connected investment vehicles; as CNN has only just put it, there are more perils ahead. Problems will crop up with automobile loans and students loans as well the securities that are related. The government may step in or reduced auto sales might help ease certain energy prices; the oil bubble might burst, leaving just food and other inflation to deal with. The student loan market is already drying up though and the government is already getting involved.

Despite the panic in the markets and all the volatility, I’m confident, though I realize quite sadly, to know our future, we needn’t look into any sort of crystal ball, but instead right where Huxley would suggest, using eyes focused backward in time.

Sometimes and especially in the shakiest markets, a portfolio’s best defense is dip buying. As with any investment, questions must be answered on both sides of the transaction. On the one side are questions about the stock being purchased. Today, everyone asks: does the company rely on a lot of credit or have a lot of debt? On the other side, are questions about purchasing power; questions about how putting this money out right now might alter your own bottom line. So, how ’bout it, do you rely on a lot of credit or have a lot of debt?

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Monday

Many questions hung in the air Monday, March 17, 2008. Most of the market waited on edge to find out what would happen at the open. Starting that weekend and leading into Monday morning, it became about four words. Those four magic words — Is this the bottom? — still linger in the minds of analysts and traders now almost a full week later. Very few questions were answered Monday. In fact, it became only more confusing as the week went on. Read the rest of this entry »

All over the world people are asking four magic words: Is this the bottom? The answer from analysts even going back to January 2007 say certainly not — back then predictions suggested 50-60% loss from around a 14,000 DIJA. We’re about half way there despite all the Fed’s recent efforts (with intra-day lows of 11,756.60). If you look closer and pick a giant like Google, there were analysts who predicted it would be at $850 at this time. GOOG trades instead at almost exactly a 50-60% markdown with lows of 412.11.

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It was Marcus Aurelius who said “Each thing is of like form from everlasting and comes round again in its cycle.” Looking toward our future in this age of industrial and technological super-boom, maybe whats looming just ahead, is the justice of a balance only nature must keep. In other words, the eventual, equally unrelenting… Super-bust. Its a topic I’ll continue to discuss from a variety of perspectives going forward. The content shown below is mostly reiterated from here, it describes how something just like this can happen, only with our financial structure.

Financial speculator and billionaire, George Soros states in his FT.com commentary: “the current crisis is the culmination of a super-boom that has lasted for more than 60 years.” In June’s Higher Rates Reflect Default Risk we described the end of the last credit boom: “In 1928, the U.S. Treasury Bond similarly broke out of the channel and rose to a higher yield. This coincided with the end of ‘easy’ money which forced the deleveraging of the economy and concluded with the financial crisis of 1929-1932.” Compare the two Treasury Bond Yield charts below. In 2005-2006 higher bond rates “broke out of the channel” and inflicted damage on the housing market. This marked “the end of ‘easy’ money.” Similarly since 2006, there has also been a flight to quality.

George Soros explains what happens next: “if federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.” As we described last June, we expect 10 year Treasury Bonds to be sold for cash in the panic, just as occurred at the end of the last credit cycle. Billionaire investor Julian Robertson agrees. As he revealed to Fortune: “the biggest bet that Robertson has in his own portfolio at the moment” is “long the price of two-year Treasury and short the price of the ten-year Treasury.”