Earlier this week, in a piece titled “Get Ready for Crash Season,” the following crashes were highlighted (all occurring in a Sept./Oct. timeframe):
- The Panic of 1907
- The Crash of 1929
- The Crash of 1987
- The Russian debt default and LTCM meltdown (August-September 1998)
- The multibillion-dollar Amaranth Advisors blow-up (September 2006)
- The Crash of 2008 (post Lehman Bros. bankruptcy, September 2008)
To that list we can also add September 1931, when the Dow fell 30% after a big rally... September 2000, when the dot-com bubble truly turned bust... September-October 2002, when the telecom grizzly plunged to panic lows... and, just for kicks, we can even throw in the great crash of 1873 (September yet again).
True confession – your humble editor was born in September. Perhaps that helps explain his mild affinity for the bearish side?
When it comes to making the downside case, history no doubt lends a helping hand. And yet, past precedent aside, there are plenty more reasons why the short side looks appealing at current levels. Let’s walk through a few...
Insiders Are Bailing Out
“Company executives are selling stock at a rate not seen in two years,” Reutersreported last week. Research firm Insiderscore.com notes that insider selling activity outpaces buying activity by a factor of two to one.
Insiderscore further observes that insider buying “peaked this year around the market low in early March” – just the time when company valuations were the most compressed. Now those same insiders are cashing out even as they make shiny happy noises for analysts.
Post-1929 Precedent: Big Rally, Big Decline
In the aftermath of the 1929 crash, markets rallied sharply – so sharply, in fact, that the post-‘29 upward trajectory bears an uncanny resemblance to what we have seen in 2009 thus far.
Bad news being, if the post-1929 overlay holds true, right about now – or rather, some time in the next month or two – would be when the rally breaks down and the market takes a fresh dive toward old lows.
Other than a simple chart overlay, what would the rationale be for seeing a repeat of the 1929-1930 experience? Simply put, the dynamics of hope, fear and greed. After the ’29 crash, hope returned to the market as optimists expressed their belief that government would fix things, the economy would bounce back, and all would be well again in a relatively short period of time. When that thesis was finally dashed on the rocks of cold hard reality, the rally evaporated...
Banks Are Still Failing
And how about the banks, those over-leveraged behemoths that by and large got us into this mess?
With trillions of dollars in taxpayer largesse thrown at the nation’s biggest financial institutions, the banks should be looking better now right?
Nope... banks are still failing at a rapid clip. Just this past weekend we saw the demise of Montgomery, Ala.- based Colonial Bank, the sixth-largest bank failure in U.S. history.
Colonial’s demise, according to The Wall Street Journal, “signals an ominous phase in the nation's banking crisis.” The bank had $25 billion in assets, 346 branches in five states, and an unwieldy real estate portfolio.
The WSJ further reports that “Colonial's slide came largely as a result of aggressive real-estate lending in Florida and other frothy markets.” Commercial real estate lending has long been the other shoe to drop... could this be the first big thud?
What’s more, Bloomberg sees at least another 150 banks potentially headed for the brink:
More than 150 publicly traded U.S. lenders own nonperforming loans that equal 5 percent or more of their holdings, a level that former regulators say can wipe out a bank’s equity and threaten its survival.
The number of banks exceeding the threshold more than doubled in the year through June, according to data compiled by Bloomberg, as real estate and credit-card defaults surged. Almost 300 reported 3 percent or more of their loans were nonperforming, a term for commercial and consumer debt that has stopped collecting interest or will no longer be paid in full.
Does that read like “crisis resolved, everything’s super” to you? Nope, me either...
U.S. Homeowners Are Drowning
First American CoreLogic, a research firm, reports that “more than 15.2 million U.S. mortgages, or 32.2 percent of all mortgaged properties, were in negative equity position as of June 30, 2009.”
In layman’s terms, that means that roughly one out of three homeowners is “upside down” on their property. This occurs when the market value of a home (or some other form of property) falls below the initial price paid.
Say, for example, that John Q. Public purchased a house in 2006 for $275,000, and the market value of the house is now $200,000. John would be “upside down” to the tune of $75,000 – forced to make hefty interest payments on a loan taken out against an asset now worth less than what he owes.
First American CoreLogic further reports that when “near negative equity” mortgages are taken into consideration – that is to say, homeowners and such who are almost upside down – the total portion of underwater or near-underwater mortgage properties rises to 38%.
The numbers hide even worse situations in heavily populated boom states. California reportedly has $2.4 trillion in mortgage debt, with 42% of properties showing “negative equity” (i.e. being upside down). Florida has $923 billion in mortgages and 49.4% negative equity... Arizona 51%... and in Nevada, a whopping 65.6% of mortgaged properties are upside down.
A huge chunk of these upside down homes owners simply can’t sell. They literally cannot get out... there is no one willing to buy at a price that will make them whole. The only two options are paying the piper or going the “jingle mail” route – mailing in the keys and walking away.
Meanwhile, the banks are reportedly being much harder on foreclosure candidates than the White House would like, simply because of shortsighted profit dynamics. This, too, is a problem that is getting worse, not better...
Higher Energy Prices Are a Tax on Consumers
In recent months, crude oil has been trading in tandem with the stock market. That is to say, stock prices and oil prices have been rising at the same time, with global recovery believers cheering the uptick in both.
But we have now reached an odd juncture where higher oil prices are more likely to be deflationary than inflationary. This is because higher food and energy costs act like a vicious tax, extracted directly from U.S. consumer wallets.
Recent readings of the Consumer Price Index (CPI) and Producer Price Index (PPI) are at their lowest in more than fifty years. Deflation pressure appears to have triumphed everywhere, with the notable exception of food and energy (the two things that government inflation measures leave out).
This is a double-whammy negative for beaten-down consumers. Even as wages and benefits and property values are declining, the basic cost of living (as dominated by food and energy) is on the rise. The net effect is deflationary because every dollar the U.S. consumer has to save to buy a gallon of gas (or a gallon of milk) is one less dollar that could be spent elsewhere.
Public Companies Have Few Costs Left to Cut
The last round of earnings “beats” that drove stocks higher came largely on the back of slashed-to-the-bone style cost cutting. The process went something like this:
- Analysts sharply lower their earnings per share expectations, creating an easy hurdle.
- Companies cut costs to the bone – mass firing employees, etc. – to beat earnings estimates.
- Investors cheered the “beat,” ignoring the realities of shrinking businesses.
To justify a high-earnings multiple, a business needs to be growing, not shrinking. It’s possible for most any business to boost short-term profits by firing half the staff and dramatically shrinking various departments. This is because the negative effects of the cost-cutting measures show up with a lag.
The question is what happens when there are no more costs left to cut... and how the business maintains healthy growth in the face of reduced staff and resources.
For the market, the question is how many cost cutting rabbits are left for shrinking public companies to pull out of the hat. It’s a trick that can only be repeated so many times, with the “top line” (revenue line) falling only so far before reality can no longer be ignored.
In that respect, the next round of earnings looms...
From Armageddon to Perfection
At the March lows, the stock market was priced for Armageddon. High-quality companies with low debt and excellent long-term prospects were trading at ludicrous levels, as low as three or four times earnings.
Now the market is arguably priced for perfection. That is to say, whereas total disaster was previously priced in, we have now reached the opposite extreme – a near-perfect recovery scenario is wholly priced in.
Earnings multiples now reflect expectations for a smooth-sailing return to global growth, with no significant bumps or hitches along the way.
The risk here is that we get a “double dip” recession – an evaporation of positive sentiment as the U.S. economy (and the global economy) goes back to a negative trajectory.
The odds of a “double dip” are not trivial. In fact they are quite strong. Given all the problems we are facing – and the confirming data that bulls have resolutely ignored – one could argue the odds of “double dip” are far better than a coin flip, maybe even two out of three. And yet markets are priced as if the possibility is zero...
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Who Is Left to Buy?
Finally, it must be asked who is left to buy at this late date. A fresh Merrill Lynch survey indicates the highest level of money manager bullishness in at least five years, with cash levels having fallen to a two-year low of just 3.5%.
This brings around a classic market paradox. When those who are most bullish have put almost 97% of their cash to work, who is left to continue the bulls’ good work? The hope is that ever greater numbers of sidelined investors will bite the bullet and plow yet more cash into mutual funds. But is this a reasonable hope, or just an extended Hail Mary pass?
Not only are the extremely low cash levels of money managers a concern, but the absence of short-squeeze fuel and the desire to preserve long-side gains bode ill for the bull run as well. Much of the present run-up came at the expense of mercilessly squeezed short sellers... a sort of rocket fuel that is surely now close to used up. In addition to that, many long-only hedge fund managers are sitting on some of their best gains in years. It will only be a natural temptation to try and book some of those gains – take them off the table – in the event that the market starts to crater. The combined effect is a sort of potential negative feedback loop that could reverberate with ferocious power once let loose.
A Target-Rich Environment
The net result, as the title of this piece states, is a target-rich environment for bears.
We have very disconcerting historical precedent (the long-established tendency of Mr. Market to puke in September and October). We have the Shanghai A-shares market, barometer of world-savior China, already broken down and flirting with bear-market levels of decline. We have the emotional and logistical parallels between the 2009 U.S. equity rally and the failed post-crash rally of 1929. We have a stock market that is priced for economic perfection moving forward, with many sectors of the market egregiously overvalued relative to their prospects.
And, of course, we have the non-trivial slew of factors mentioned above (plus a few other biggies not mentioned here for the sake of space)...
Markets have a long and sordid history of surprising investors when they least expect it. What’s more, the degree of violence embedded in the surprise tends to be proportional to the degree of complacency that came before it.
That’s one reason why I’m expecting a truly violent dislocation – a potential mega-crash, really – in an arena that many would least expect: global currency markets. You’ll hear more about that first thing next week...
Warm Regards,
JL
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