Wednesday, November 25, 2009

Taipan Daily: Of Roller Coasters and Mortgages

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Wed., November 25, 2009
Taipan Daily: Of Roller Coasters and Mortgages
by Justice Litle, Editorial Director, Taipan Publishing Group

There is a wonderful investment graphic that makes its way round investor inboxes from time to time. It shows a steep rising curve, not unlike that of a roller coaster, followed by a heart-sickening drop and a fresh ascent.

If you have ever ridden a good coaster, you remember the deliciously ominous “click-click-click” while climbing to the top. After that comes a plunge... a breathtaking downward whoosh... and at the end, a swooping curve back upward again.

The roller-coaster image is meant to describe the various moods of Mr. Market... and the attendant risk to investors.

The very top of the coaster (just before the plunge) is labeled “the point of maximum financial risk.” Ironically, it is this point at which investors feel the most confident! As the coaster car chugs higher and higher into the sky, emotions pass through “optimism”... “excitement”... “thrill”... and finally “euphoria.”

Then, the drop. When euphoria disperses, in comes “anxiety”... “denial”... “fear, desperation, panic”... and finally “capitulation, despondency and depression.” Somewhere between despondency and depression, we get “the point of maximum financial opportunity.”

Then, having finally slogged through the trough of dark despair, the trend swings back round to optimism. The whole cycle starts again.

This is how markets work – always in thrall to some dominant emotion, or at the very least always susceptible to one, in a constant oscillation between euphoric highs and despondent lows. This only makes sense because markets are composed of people, and that is how people operate too. The economists who deny this, in vain efforts to portray markets as “rational” and emotion-free, have proven themselves to be fools.

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Après Moi, le Déluge

Every roller coaster (i.e. cyclical period between euphoria and despair) is different. There is no universal blueprint – only a sort of fractal repetition. But, given that, which would you guess we are closer to at moment? A point of maximum opportunity... or a point of maximum risk? It’s not a very hard guess to make...

As mentioned previously in these pages, there are actually two economies to keep tabs on – the real economy and the paper economy. And news of the real economy – i.e. the one that underpins everything – just seems to get grimmer by the day. Not in a rearview mirror type of way, either, but rather a “here comes the flood” type of way.

It’s almost tragicomic. “One in Four Borrowers is Underwater,” The Wall Street Journal reports. “The proportion of U.S. homeowners who owe more on their mortgages than the properties are worth has swelled to about 23%.”

Not so long ago, that number was one in eight. According to First American Core Logic, a California-based real estate analysis firm, 5.3 million households now carry a mortgage at least 20% greater than the home’s actual value.

James Sacaccio, the CEO of RealtyTrac, observed earlier this month that “Rising unemployment and a new variety of mortgage resets continued to gradually shift the nation’s foreclosure epicenters... away from the hot spots of the first two years and toward some metro areas that had avoided the brunt of the first foreclosure wave.”

In other words: The pain is spreading, not receding. The bulk of mortgage rate “resets” – where the size of the monthly payment jumps dramatically in accordance with the fine print – is ahead of us, not behind us.

View Monthly Mortgage Rates Chart

As you can see from the Credit Suisse chart above, the 2007-2009 period was all about subprime (the light green shaded area). The pain of “Option Adjustable Rate” and “Alt-A” mortgage resets (light and dark yellow respectively) is the pain of the future, not the past.

“U.S. Mortgage Delinquencies Reach a Record High,” notes The New York Times. “Unless foreclosure modification efforts begin succeeding on a permanent basis – which many analysts say they think is unlikely – millions more foreclosed homes will come to market.”

That’s why top housing analyst Ivy Zelman – one of the few who spotted the trouble early while colleagues continued to cheer – is convinced home prices have further to fall. “I’ve been pretty bearish on this big ugly pig stuck in the python,” she says, “and this cements my view that home prices are going back down.”

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Yes, it’s all getting worse... and it could well get a lot worse. Right around the time the Fed runs out of ammunition and credibility, reality will come barging in. The government has already attempted to mass-monetize the housing market. It is just too damn big. Further escalation efforts would have a whiff of Zimbabwe to them.

A “Bottom Line” Recovery

Corporate USA isn’t helping much either.

The earnings-driven optimism on the Street as of late has been “bottom line” rather than “top line.” In layman’s terms, that means companies have been improving their earnings per share numbers by firing employees and slashing costs to the bone, not increasing their revenues or growing sales.

Unfortunately, what’s good for the goose is not good for the gander. At the same time that corporate America improves its surface-level appearance by way of ruthless cost-cutting and mass layoffs, the U.S. unemployment situation worsens.

“According to the government’s broadest measure of unemployment,” CNBC reports, “some 17.5 percent [of Americans] are either without a job entirely or unemployed. The so-called U-6 number is at the highest rate since becoming an official labor statistic in 1994.”

“The number dwarfs the statistic most people pay attention to – the U-3 rate – which most recently showed unemployment at 10.2 percent for October, the highest it has been since June 1983.”

Chipper talking heads point out that publicly traded companies have built up a Smaug-like mountain of cash in their vaults. Corporate cash hoarding of this scale and scope has not been seen in decades.

What is not being mentioned, however, is the fact that these companies hoard not out of optimism, but out of fear. The cash is a brace against the slow seizing up of the consumer-driven economy, not happy expectations that it will soon again be time to spend.

Devious by Design

Again, there is the real economy and the paper economy. Thus far, we have been talking about the real one. On the paper side, euphoria still holds.

And why not? As far as Wall Street is concerned, life is still good. The connected are different than you and me. Indicative of this is a New York Times piece pointing out how “Executives Kept Wealth as Firms Failed.”

According to a new Harvard study, “It is an urban myth that executives at Bear Stearns and Lehman were wiped out along with their companies.” To get the true picture, the study points out, one has to consider the collective $2.4 billion that top Lehman and Bear executives took home via bonuses and stock sales between 2000 and 2008.

Again, this type of thing is not a flaw, but a function of how the “system” is supposed to work behind the scenes. Why wouldn’t it benefit those who designed it and now maintain it, both directly and indirectly via influence on Washington?

The “roller coaster” described at the beginning of this piece is, in another manner of speaking, a giant wealth-transfer machine. With each turn of the cycle, large chunks of “real economy” wealth are transferred into the hands of paper-mongers during the euphoria stage... and never given back. To walk away with $100-million-plus after leaving one’s institution in ruins (and a chunk of the economy with it) is de rigueur on Wall Street.

The one flaw in the design is that, as the roller coaster’s euphoric highs get higher, the vicious lows get lower. Such is the price of revelry. Old-line houses like Bear and Lehman went under because Wall Street got too greedy. It failed to tame the demon of its own design. And yet, a few faces and names aside, that doesn't mean things have to change...

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How to Fight Back

So how does one fight back in such an environment? Going to cash is not necessarily the best option – this we know all too well, thanks to the hell beleaguered savers have been put through. To stuff Federal Reserve notes into one’s proverbial mattress is to put one’s life savings at the mercy of the Federal Reserve. Euros, yen and even yuan may ultimately prove not much better.

The only solution your editor can think of boils down to this: Be defensive; be vigilant; be opportunistic.

To be defensive is to recognize the reality of the roller coaster... and to be aware of the fact that Wall Street is a giant wealth-transfer machine (as mutated from its originally intended, now secondary role as a capital allocation machine).

To be defensive is also to understand the worth of solid long-term investment principles... to know where to find reliable, attractive dividend yields for example, and “fortress balance sheet” type investments that can act as both inflation hedge and bear market bulwark in a volatile, dangerous environment.

To be vigilant is to be paying attention... to always be asking cui bono, “who benefits,” and to always and everywhere be taking responsibility for one’s own actions and decisions in the marketplace.

And finally, to be opportunistic is to recognize that, if the game must be played, then the game should be played well. Opportunity exists in up markets, it exists in down markets, and it even exists in the midst of chaos and crisis. Your humble editor suggests that solid, defensive, long-term investing is sensible as a foundation and a core for most any portfolio. But in opportunistic terms, it is no bad thing knowing how to go short... how to use options... and how to hedge.

In sum, the roller coaster may be cresting its arc even as you read this. But those who commit to being defensive, vigilant and opportunistic perhaps have the best chance of not just surviving, but even thriving in the challenge-filled days ahead.

Happy Thanksgiving,


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