Juggling Dynamite

Aron Task at Tech Ticker yesterday interviewed Christopher Whalen of Institutional Risk Analytics on the accelerating credit contraction that is now undermining the economic recovery. As I have said before, longer-term, reducing debt levels is part of the solution to restoring strength and equity in consumer balance sheets and the economy. Near-term though, the adjustment of reducing credit is painful and flies in the face of a quick economic rebound.
Whalen makes some excellent observations about why we have seen speculative capital fleeing into stocks, bonds and commodities the past 2 quarters. It’s not a good sign. It’s the same reason that Chinese people are using government incentives to speculate (gamble) rather than investing in building small business right now: the real economy is presently dying, drowning in over-capacity and still anaemic consumption demand. If entrepreneurs and investors see attractive business opportunity they are encouraged to direct capital and energy into creating enterprise. When they don't see it, they are more inclined to park in cash, buy bonds, speculate, and stock-pile rather than invest in building equity with a long term view.

In the same vein, we note that a significant motivation behind Australia's surprise rate hike yesterday, was the government’s concerns about rapidly re-flating asset bubbles again, particularly house prices:
“The Reserve Bank of Australia had previously voiced concerns that interest rates of just 3%, down 4.25 percentage points from their peak in March 2008, were fuelling excessive house-price inflation. House prices were up 8% in the first eight months of the year, according to the RP Data-Rismark Home Value index.
Australia isn't the only country fretting about asset prices. The Norwegian central bank has voiced similar concerns. Global excess liquidity also looks to be fuelling potentially destabilizing asset surges in several Asian economies, including India, South Korea and Taiwan. The market expects these countries to raise rates early next year. But following Australia's decision, they may feel tempted to move earlier to lean against the wind and try to tame some of the exuberance”
See: WSJ: Australia rate rise poses a global policy change.

This morning the market is euphoric again over news that the Bank of Australia chose to raise interest rates and declare the economic downturn a thing of the past. Too bad Canada didn't sell more of our stuff to Asia. Thanks to massive government stimulus, and widespread speculation and stockpiling, Asia has been pretty much the only hot demand spot in recent months. Australia has therefore naturally seen a pick up in demand for its raw material exports. Over on our side of the world, the US is still floundering and Canada is still desperately seeking some customers with a pulse. Whether Asian demand can continue in light of weak demand everywhere else is doubtful. I suspect Australia may have sounded the all clear a little too soon, time will tell.
Roubini did a CNBC spot yesterday talking about the risk of shock to commodity exporting countries which is likely to come when the world economy does not bounce back as quickly as many are forecasting. He talks about the large disconnect we have seen over recent months between soaring risk assets and real prospects for economic recovery.

I think Roubini is right about the economic headwinds, but as my friend Barry Ritholtz also correctly pointed out this morning, the market can do all sorts of irrational things for longer than we often expect:
“I can show you many eras in history when the economy was awful and nonetheless markets rallied strongly.
There have also been times when earnings did not matter, and profitability was irrelevant. There are times when animal spirits run the show, when irrational exuberance was in charge.
Such is the result of giving two million primates lots of money and keyboards and a belief they can make a living based on numbers and letters moving around — on a screen, in a futures pit, on an exchange floor, or even under a buttonwood tree.”
This is exactly why at our firm we manage money based on actual money flow and observable, objective trend counts rather than our opinion or theory about the world. We try to follow the tape more than anything else. And this is precisely why we have had trouble fully believing in this rally: the money flow has been vapid.
Since June in particular, volume has been declining constantly as prices have spiked relentlessly. And yesterday as the market bounced back from last week's sell-off, volume set a new low!
Ever been on a plane when it hits an air pocket and the floor just seems to drop right out from under you? That is the risk in this type of market: bull markets need volume like airplanes need air pressure under their wings. A few traders trading (no matter how irrational or reckless they may be) do not make a new cyclical bull.
We are watching the tape; but without volume there is no belief in the recovery, and without belief there can be no lasting bull cycle.

Bank analyst Meredith Whitney shared a dim but pragmatic view on the prospects for economic recovery in a Wall Street Journal article last week:
“Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting. Access to credit is being denied at an accelerating pace….small businesses…have never had a harder time getting a loan.”
“Banks…want to lend only to those that don't want to borrow…I believe that we are only in the early stages of the second half of this credit cycle…”
Read the whole article here: WSJ: The credit crunch continues, for a sobering reminder of how important credit is to small business and how important small business is to jobs and stability in our economy.