FedUpUSA

Archive for December 29th, 2009

Inquiring minds are reading Clarity and Valuation by John Hussman.

Last week, the dividend yield on the S&P 500 dropped below 2%, versus a historical average closer to double that level. While part of the reason for the paucity of yield in the current market can be explained by the 20% plunge in dividend payouts over the past year, as financial companies have cut or halted dividends to conserve cash, the fact is that current payouts are not at all out of line with their historical relationship to revenues, and even a full recovery of the past year’s dividend cuts would still leave the yield at a paltry 2.5%. The October 1987 crash occurred from a yield of 2.65%, which was, at the time, the lowest yield observed in history, matched only by the 1972 peak prior to the brutal 1973-74 bear market.

Those two periods had a few other things in common. In the weeks immediately preceding the market downturn, stocks were overbought, had advanced significantly over prior weeks, bond yields were creeping higher, and investment advisory bearishness had dropped below 19%. All of those features should be familiar, because we observed them at the 1987 and 1972 peaks, and we observe them now.

On the basis of normalized profit margins, the average price/earnings ratio for the S&P 500, prior to 1995, was only about 13. Higher historical “norms” reflect the addition into that average of extremely high “recession P/Es,” based on dividing the S&P 500 by extremely low, but temporarily depressed earnings. For example, the P/E for the S&P 500 currently is 86, because earnings have been devastated, but it would be foolish to take that figure at face value, and equally foolish to work it into a historical “average” P/E. The pre-1995 norm of 13 for price-to-normalized earnings is important, because at present – and again, we are not using current depressed earnings, but properly normalized values – the S&P 500 P/E would currently be over 20. That’s higher than 1987 and 1972, and about even with 1929. Of course, valuations have been regularly higher in the period since the late 1990′s (and not surprisingly, subsequent returns, even after the recent advance, have been dismal overall, with the S&P 500 posting a negative total return for the past decade).

So overvalued, check. Overbought, check. Overbullish, check. Upward pressure on yields, check. Market internals? – certainly mixed, but not bad – and there’s the wild card.

It’s important to recognize that when I quote probabilities, I am generally using a form of Bayes’ Rule. So when I say, for example, that I estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year, that figure is based on various combinations of historical evidence, and what has (and has not) happened afterward, and how often. As a side note, a “market plunge” in this context need not be a “crash.” In the context of a credit-driven crash and rebound (which is what I believe we’ve observed), a typical post-rebound correction would be about -28%, but even that would take stocks to less than 20% above the March lows.

From current valuations, durable market returns appear very unlikely. As I noted last week, whatever merit there might be in stocks is decidedly speculative. That doesn’t mean that the returns must be (or even over the very short term, are likely to be) negative. What it does mean is that whatever returns emerge are unlikely to be durably positive. Market gains from these levels will most probably be given back, possibly very abruptly.

Stocks Higher? New Bull Market?

New bull market for the new year? Famed bond investor El-Erian of Pimco says don’t bet on it.

Homes are selling at their fastest clip in nearly three years, the unemployment rate is falling and stocks are up 66 percent since their March lows — the best performance since the 1930s.

What’s not to like?

Plenty, according to Mohamed El-Erian, chief executive of giant bond manager Pimco. The investor says the recovery may be gaining steam but is no different than a kid who eats too much candy at one of the birthday parties his 6-year-old daughter attends.

“We’re on a sugar high,” El-Erian says. “It feels good for a while but is unsustainable.”

His point: This burst of economic activity fed by government spending and near-zero interest rates will soon peter out.

As CEO at Newport Beach, Calif.-based Pimco, El-Erian, 51, oversees nearly $1 trillion in assets, more than the gross domestic product of most countries. So when he talks, people listen.

What he’s saying now:

–Stocks will drop 10 percent in the space of three or four weeks, bringing the Standard & Poor’s 500 index below 1,000 — though he’s not predicting when.

–The unemployment rate will be hovering above 8 percent a year from now.

El-Erian says people are fooling themselves if they think all the bullish data of late means a strong recovery is in the offing. So he’s buying Treasurys and selling riskier stuff.

His bet: Investors will get scared again and want U.S.-guaranteed debt so they know they’ll get repaid.

James Paulsen, chief strategist at Wells Capital Management in Minneapolis, with $355 billion under management, has been pounding the table for months to buy stocks. Just like in the early 1980s, the recovery will take the form of a “V,” he says. The reason: Companies have cut inventories and payrolls to the bone, so just a little revenue growth could translate into a bumper crop of profits.

El-Erian says many of the bulls don’t appreciate just how much the government props still under the economy are masking its weakness. Instead of focusing on the fundamentals today, he says, they’re looking to the past, expecting a quick economic rebound because that’s what’s happened before.

We’re trained to think the “farther you fall, the higher you’ll bounce back,” El-Erian says. “We’re hostage to the V.”

El-Erian says we’ve probably seen the worst of the crisis but consumers, and not just Washington, need to start spending again for the recovery to really take hold.

He doesn’t expect that to happen soon. Like in the Great Depression, Americans are saving more and borrowing less — a shift in attitudes toward family finances that Pimco thinks will last a generation.

That, plus the impact of more regulation and higher taxes, El-Erian says, will crimp growth for years to come.

El-Erian Is An Optimist

As I see it, El-Erian is an optimist. A year from now it is extremely unlikely the unemployment rate will approach 8%. Please note El-Erian is not calling for 8% unemployment, he is only saying it will be above 8%.

How much above 8% are we talking about? Arguably, the answer to that question is another question: How nuts will Congress get with more stimulus packages? Then again, the current stimulus package did not create any lasting jobs, so why would the next one?

It is pretty clear the bulk of the current stimulus efforts is behind us. We will see the results in 4th quarter GDP, with some additional but smaller effect in the 1st quarter 2010 GDP. What then?

Hussman’s viewpoint is very similar to mine. I think the bottom may be in, but returns going forward are unlikely to be very good, and a strong pullback is very likely.

Other possibilities include a scenario in which the market goes nowhere (say +-150 S&P points) in either direction, for a number of years. There is also a 20% chance Congress and the administration totally wrecks the US dollar and stocks magically go flying.

I think the probabilities look something like this:

• 20% chance of a durable rally
• 20% chance the market meanders nowhere for as long as 5 years
• 30% chance of of a hard 25-30% correction
• 30% chance the bottom is not even in

Unlike Hussman, I have not done any statistical analysis of those estimates. Certainly his “estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year” is reasonable enough.

Note that Hussman’s 80% probability of a plunge encompasses a plunge where the bottom holds and also where it doesn’t.

The key for me is that on average it does not pay to be fully invested here, regardless of what the stampede of bulls say. Bear in mind, the bulls were saying exactly the same thing as they are now right at the October 2007 high. I received taunts for several months for my market top call late summer of 2007, about 3% and 3 months early.

Is the top in now? No one knows, but that is not even the right question to be asking. A far better question to be asking is “Is the bottom in?” Even if it is, a major test coming of that bottom down the road is highly likely and that will gore a lot of overly complacent bulls along the way.

In 2007, Chuck Prince former CEO of Citigroup proclaimed “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Once again, bulls are dancing on a clifftop, oblivious to the fact that the next step might be right over the edge.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

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Mike “Mish” Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.
Visit http://www.sitkapacific.com/account_management.html  to learn more about wealth management and capital preservation strategies of Sitka Pacific.

You remember the announcement that Fannie and Freddie would have an “unlimited” credit line from Treasury to cover shortfalls and buy-outs of defaulted loans from MBS, right?

Well then, read this from the forum:

After the Fannie news came out this weekend, a friend called me and his brother works for Chase Mortgage. He told me that Chase is redoing stated income loans and instead of actually appraising the home, they are going back 3 years on the homes valuation in order to get the loan processed. Then they are selling these mortgages to Fannie Mae.

Yes, that’s an anecdotal claim, but if true can someone explain to me how this isn’t out-and-out fraud?

Is Fannie requiring the actual appraisal with the loan package information they buy, or is the entire “verification” nothing more or less than a checkbox that says “yes, we have an appraisal”?

Toxic waste dumping ground?  Maybe. 

But one thing is certain – I’ve not heard of Fannie and Freddie forcing putbacks of loans they purchased from various brokers and originators where there was fraud in the original loan.

Why not?

Why should Fannie and Freddie eat this if in fact the banks breached their reps and warranties in the original tender of the paper?

And since it appears that banks have been tremendously successful in shoveling off garbage paper to Freddie and Fannie while not being held to account for their activity, one has to wonder if this anecdotal report is accurate!

The scam during the housing bubble was to intentionally overstate income (and then take some sort of exotic loan) so as to hide the fact that you couldn’t afford the house.  Your “escape” was that when (remember, houses never go down in price) the loan’s “teaser” expired you’d just go refinance.  The banks loved it (they got to hit you for another round of fees and costs) and the liars loved it – they got to live in $500,000 houses on $50,000 of income – even if they’d never actually own the place.

This, by the way, is a federal offense (lying on a mortgage application) yet The FBI and other law enforcement officials were and are under explicit orders NOT to prosecute these crimes.

Now the scam is to understate your income so as to qualify for a “better” modification – and again, the government is refusing to enforce the law:

Until recently the rules were clear: if you grossly understated your income to qualify for the program, you had to restart the loan modification process. It made sense. After all, we got into this housing mess partly because too many people were dishonest about how much they made.

….

The government needs this program to work — and fast. That’s the only way to explain the Treasury Department’s waiver of a requirement punishing borrowers who understate their income by 25 percent or more when trying to get a modification.

That means a borrower who had told a lender he made $75,000 but was found to make $100,000 doesn’t have to restart the modification process. Under the waiver announced Dec. 16, that person now gets to continue the trial period instead of being rejected immediately.

Isn’t that special?

Are you pissed yet?  You should be.  This sort of game means that the “waterfall” that I posted before goes further down than it should for a given borrower:

Yep.

This is the reality folks: Your neighbor lied about his income to get his house in the first place.  He took out a loan he couldn’t possibly repay on the original terms – an OptionARM or other “exotic” loan, and then (in many cases) HELOC’d out every penny possible and blew it on a Hummer, a Boat and a few exotic vacations.

This caused the “value” of your house to skyrocket.  Cities and states of course got lots of tax revenue as a consequence of these higher “values.”

But these “values” were not real.  They were a fraud.  Remember that a transaction requires a willing (and able) buyer and seller.  Without a willing (and able) buyer, the price does not go up.

When the Ponzi ran out of suckers, people started to default en-masse.  The government panicked – so-called “wealth” was disappearing, and in addition cities and states saw their “revenue” disappear as those who can’t pay mortgages don’t pay property taxes either.

So government rides to the rescue with an alleged plan to help those who are at risk of losing their house due to unemployment and other effects not of their own doing.

What happens?  The very same people who played grift and scam on the way up do it again on the way down. 

The felonies they commit are charged not to them, but to you – by government policy.

This is not a “lie” folks – it’s a crime.  A crime that our government is not only willfully ignoring but is and has been encouraging, and forcing you, the honest American, to pay for.

And let’s be clear: while it is a “dirty secret” the US Attorney’s Manual says:

Prosecutions of fraud ordinarily should not be undertaken if the scheme employed consists of some isolated transactions between individuals, involving minor loss to the victims, in which case the parties should be left to settle their differences by civil or criminal litigation in the state courts. Serious consideration, however, should be given to the prosecution of any scheme which in its nature is directed to defrauding a class of persons, or the general public, with a substantial pattern of conduct.

Got it?

If you lie on your mortgage, the government doesn’t care – even though that was and remains one of the primary causes of both the housing bubble and now is preventing the market from being marked back down to actual fair value and clearing.

The government has in fact declared itself as an accessory to millions of felonies both before and after the fact.

Those of you counting on getting your old assembly line job back in Detroit can forget it.

The recent eight year forecast published by the Bureau of Labor Statistics shows that 4.19 million jobs will be gained in the US in professional and business services, followed by 4 million health care and social assistance jobs, while 1.2 million will be lost in manufacturing. This is great news for website designers, Internet entrepreneurs,  registered nurses, and masseuses in California, but grim tidings for traditional metal bashers in the rust belt manufacturing states like Michigan, Indiana, and Ohio.

I’m so old now that I am no longer asked for a driver’s license to get into a night club. Instead, they ask for a carbon dating. The real challenge for we aged career advisors is that probably half of these new service jobs haven’t even been invented yet, and if they can be described, it is only in a cheesy science fiction paperback with a half dressed blond on the front cover. After all, who heard of a webmaster, a cell phone contract sales person, or a blogger 40 years ago? Where are all these jobs going to? You guessed it, China, and other lower waged, upstream manufacturing countries like Vietnam, where the Middle Kingdom is increasingly subcontracting its own offshoring.

These forecasts may be optimistic, because they assume that Americans can continue to claw their way up the value chain in the global economy, and not get stuck along the way, as the Japanese did in the nineties. The US desperately needs no less than 27 million new jobs to soak up natural population and immigration growth and get us back to a traditional 5% unemployment rate. The only way that is going to happen is for America to invent something new and big, and fast. Personal computers achieved this during the eighties, and the Internet did the trick in the nineties. The fact that we’ve done diddly squat since 2000 but create a giant paper chase explains why job growth since then has been zero, real wage growth has been negative, and American standards of living are falling.

Alternative energy and biotechnology are two possible drivers for a new economy. Unfortunately, the last administration did everything it could to stymie progress in both these fields, coddling big oil so China could steal a lead in several alternative technologies, and starving stem cell researchers of Federal cash, ceding the lead there to others. While the current crop of politicians extol the virtues of education, the reality is that we are dumbing down our public education system. How do we invent the next “new” thing, while shrinking the University of California’s budget by 20% two years in a row? If my local high school can’t afford new computers, how is it going to feed Silicon Valley with computer literate work force? The US has a “Michael Jackson” economy. It’s still living like a rock star, but hasn’t had a hit in 20 years.

China can have all the $20 a day jobs it wants. But if it accelerates its move up the value chain, as it clearly aspires to do, then America is in for even harder times. I’ll be hoping for the best, but preparing for the worst. How do you say “unemployment check” in Mandarin?

That is to say that the wheels of commerce go ‘round & ‘round as long as there is enough “lubrication” to keep the wheels from falling off! Obviously we had some pretty dry wheel bearings last year and during the first quarter of this year, so how are we really looking now? Perhaps everyone is feeling a little bit too comfortable which is usually when the unseen stress makes itself known:

For the purpose of this discussion, there are five primary asset classes:

1. DEBT – all types; personal, corporate, municipal, Treasury notes and bonds.

2. CURRENCIES – The U.S. Dollar interacts with all the other currencies of the world. Almost all dollars are “credit dollars,” meaning that they were brought into existence with interest bearing debt behind it. Most currencies of the world are like this.

3. EQUITY – This is stock in corporations.

4. REAL ESTATE – The earth itself and things attached to it, both developed (residential & commercial), and undeveloped.

5. COMMODITIES – things of the earth, such as gold, silver, oil, grain, aluminum, copper, uranium, etc.

This can be thought of like this, where money flows from one asset class to another in any and all directions:

Or, since money is needed for all transactions, you can place currency at the middle of the hub and this may help you visualize that all assets are first exchanged for money. Money can then move to another major asset class, wherever the holder believes it will be treated best:

But if only it were that easy, the truth is that all asset classes are now interwoven with and surrounded by derivatives of all types that comprise the shadow banking world. This world is fuzzy. It produces leverage and affects our money supply in ways that are not easily measured, much less controlled:

When understanding how capital flows from one asset class to another we must keep in mind some basic rules:

1. All money in our current system is backed by interest bearing debt (actual coins being the only exception). This means that for new money to come into existence, debt must increase.

2. All debt gets repaid WITH INTEREST in ONE WAY OR THE OTHER! This is to say that if one attempts to wiggle out of paying their debts via default or by simply printing more dollars to devalue their currency, then the entire population will pay the debt back, it’ll just be in a different way. For example, when the government prints, the currency is devalued and everybody in society must work more hours to pay for their goods and services. The amount of extra work, no surprise, will approximately equal the debt plus interest.

3. The ultimate purpose of money is to exchange labor. Thus, do not be fooled by financial engineering and how complex our money system has become. Nothing has really changed, the laws of nature still apply – it is the financial engineers and conspirators in government who are being fooled, not you!

4. Too much debt cannot be cured by creating more debt.

5. There are only two ways to get rid of debt. Pay it off per the contract (with interest), or default.

6. Since our money is backed by debt, when debt is defaulted the supply of money goes down.

7. Debt equals leverage.

8. In order to deleverage, you must first convert assets into currency which can then be used to pay back debt. This is the reason the dollar goes up during times of deleveraging – it is in high demand to pay back debt. Once debt is paid back, the supply of money goes down. This is deflation and it’s a spiral that the Central Bankers cannot stand as their own profits go down. To combat this they will do anything to create more money and thus more debt (they designed this system so that they can profit). What they have done is to expand the effective fractional reserve ability. When that was maxed, they resorted to more leverage via derivatives and zero interest rates.

9. Once a person, a business, or a government has pulled forward in time all future income beyond reasonable lending limits, then more debt cannot be forced into that entity without producing a future default. This condition is known as “debt saturation.”

10. Once overall debt saturation nears, as more debt is added, unemployment must rise.

11. Stress in one asset class will cause money to flow into other asset classes, OR it can also flow out of one currency and into another where it then finds an asset class in the new location (international capital flow or flight).

So, keeping in mind all of “Nate’s Rules” above, I began examining the charts with an eye on the way in which capital is flowing from one asset group to another. And naturally, since we’re nearing the end of a year, I began to look back a year, or even longer, to see what I would see…

I find that breaking the charts into each asset group makes this exercise easier to follow; I hope it works the same for you. Might as well begin by looking at the hub of it all, our debt backed money, the dollar!

CURRENCY:

Artwork by AZ Rainman

Interesting, but when we look back one year at the dollar, we find that the dollar, despite being very disparaged, has now only lost 2.5% in the past year!

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Meanwhile, note that the SPX has gained 27% in the past year, despite falling 25% between December and March! Now, that sounds terrific, but let’s note right up front that the S&P 500 is still down 28.4% from its late ’07 peak and has LOST 19.2% in the past DECADE! And that’s WITH substitution bias, meaning that companies that have failed were replaced! Could you have bought the dips and made money? Did you? Uh, huh, that’s what I thought.

But it is interesting that the dollar was down considerably earlier in the year and is now nearly back to even for that period. In general, you would consider a true bull market to be occurring if both the dollar and stocks advance together. However, in this instance, that is not occurring, the only reason the dollar has any relative strength at all is due to the weakness in other currencies which it is measured against. On that I note that gold has risen 25% in the past year, just underperforming the SPX by a whisker. This shows that money is currently flowing into commodities and in the short term into stocks.

The dollar spent a good portion of the year since March forming a descending wedge, the exact opposite of the rising wedge formed in the indices. Just a couple weeks ago the dollar clearly broke up and out of its wedge:

The dollar has been fueling a carry trade with people borrowing inexpensive dollars at low interest here and shipping them overseas where they earned a higher return. But when those dollars go up in value it hurts that carry trade, thus you would expect that equities would suffer as the dollar rose, but so far that has not happened. Will it?

Much of the strength of the recent dollar move has come at the expense of the Euro. Below is a chart showing the EUR/USD cross and how it formed a rising wedge and has now broken back beneath it. Normally you would expect the target on such a wedge to be the base of the wedge:

In this case I can see the Euro falling into the 1.30ish range, and the dollar rising up into the 80 to 82 area. This will not, believe it or not, trip bullish targets on the dollar point and figure chart. The dollar is still in a structural downtrend and the P&F is targeting 63:

While I’m speaking of Point and Figure charts, I want to note that with the recent move above the sideways range that equities have been in that almost all the index charts now have new bullish targets. Again, I think it foolish to argue with these charts, they are very good at spotting broken support and resistance levels, but they are certainly not perfect and often miss major turning points. They can also be whipsawed with throwovers and throwunders.

Keeping in tune with money at the center of our asset wheel, let’s address what is happening to our money supply. Remember that since our money (excluding coins) is backed by debt, as our debt goes, so goes our money. I’ve been showing everyone how total bank credit, consumer credit, and commercial paper are all still very negative, that is being offset by the government which is ramping debt just as fast as they can.

The above chart is the Total Public Debt change from one year ago – nearly $2 trillion that they confess to. That compares to the $600 billion on the previous chart drop in consumer credit and total loans and leases. However, when you add in drops in commercial paper and other modern forms of “money,” you will find that much of that government debt creation is offset.

How? By shrinkage in the shadow banking world of derivatives for one… Again, I point out that although the OCC was talking of rising derivatives in the 2nd quarter, in fact total derivatives were falling as it was the change to allowing investment “banks” like Goldman to become “commercial banks” thereby getting their derivatives counted and giving them access to TARP/ bonus payment funds. When looking at the largest banks like JPMorgan, however, you will see huge shrinkage in their derivative portfolios. This is a decrease of leverage and the multiplication of their credit dollars thus was falling.

Recently released, below is the Treasury’s 3rd quarter OCC report on derivates at commercial banks. Make sure to read the executive summary at the top of the first page. Now that the transition to commercial banks has ended, we can compare apples to apples again in the 2nd and 3rd quarters and here we will find shrinkage in some areas and growth in others:

Here is a snapshot of the quarter 1, 2009 report showing the top 5 banks. Note that Goldman Sachs is NOT on this list and look at JPMorgan’s $90 TRILLION in derivatives, or 64 times the amount of claimed assets:

Next is quarter 2, 2009, when the transition amounts were first reported. Note that although the total derivatives jumped in size, there is a new heavy on the list in Goldman with $40 TRILLION in notional derivatives a whopping 340 times their stated assets. Now note what happened to JPM… they fell from the previous $90 trillion down to “only” $80 trillion – this represents a deleveraging down from 64 times assets to 48 times assets (now remarked to fantasy).

And that brings us to quarter 3, 2009, where we find that JPM gave up another Trillion, GS gained nearly a couple Trillion, and BAC also gained, pushing the grand total of the top 5 up a little. Remember though, that this period was supposedly a GDP growth period and did not see the deleveraging that occurred earlier. That we can see is confirmed here:

So, the shadow banking world was shrinking dramatically and is now apparently growing slightly. What you see in the OCC report, however, does not represent nearly the total amount of derivatives, no, no! It only represents those that are required to be reported to the OCC by commercial banks. Think about all the derivatives that are out there in the hands of retirement funds and municipalities! Huge. I would contend that the world of derivatives acts as a leverage multiplier, ADDING risk into the money system. The money supply charts are basically meaningless unless you take into account the world of derivatives.

Since our money system is backed by debt, then debt is the flip side of our money.

DEBT:

Artwork by AZ Rainman

It used to be, in a time long ago, that debt was a relatively simply thing. No longer! Now there are debts of all types, and the financial engineer whizzes have CONSPIRED with people in the marketing business to get you all lathered up to take on more and more debt! Yeeehaw! Now every nook and cranny of the globe, all our citizens (word to be used to replace “consumer”), our businesses, our corporations, and our government on all levels are saturated with debt.

As all this debt has piled higher and higher, each economic upswing produces more of it and our government is cheering the banks on! Got to keep that credit flowing! Ain’t America great? Then on the downswings government is there to provide stimulus after stimulus, got to keep that credit flowing, let’s lower interest rates! And on each down cycle since 1980 interest rates have gone lower, and lower, and lower, and then ZERO!

See, the government is the only one that, even though they have reached debt saturation, is foolish and crazy enough to keep piling on debt. No one else is that stupid!

And here we are. Short term debt costs zero and so we pile on more and more, got to get that credit flowing, oh thank god the credit’s flowing!

But what happens now? Now that all levels of the economy are saturated with debt and we’re adding more instead of clearing it out, what happens at the bottom of the next cycle? Can interest rates go below zero? No, we resort to monetizing as we have already done – that would be producing money without debt. Actually a smarter game when you realize that if we just printed money at least we wouldn’t owe the central bankers interest on all that we borrow! But the trick, of course, is keeping the QUANTITY of money under control. Something that has never succeeded for long under any system attempted by any country – in the history of man! Not even when the money was backed by gold!

This is what the people calling for imminent hyperinflation see. They see the quantity of money out of control, and for good reason. Our system, because it’s backed by debt would be DEFLATIONARY as interest payments eat away our money… except that the central bankers can’t allow that or their profits fall, so their game is to create never ending growth with larger and larger interests payments and fees, always more fees, that go directly to them. But of course that game ENDS when incomes can no longer support the DEBT. That is where we are now. The only debt that is truly growing is governmental – it will be the last debt to rise, but like all exponential growth, it too will eventually collapse.

Is that beginning now, or is a pullback in government debt about to begin? Could be, it’s the same thing that happened during the Great Depression – stocks fell, they bounced, then corporate debt became more expensive, followed by government debt becoming more expensive.

How is this for a little bit of common sense… if total debt is rising, but the total output of goods and services is falling, then what does that say about the effectiveness of pumping more debt into the system? Well, that’s exactly the situation we now find ourselves. Annual GDP, as trumped up as it is, is still negative, and yet total credit, thanks to government debt, is still growing. This means that debt is no longer effective at producing growth, one of the sure fire signs of total debt saturation.

I’ve shown you this chart before, showing debt contribution to growth. You can clearly see that as we’ve gotten closer to saturation that putting debt into the system gets less and less effective. The trend line was saying that it would be the year 2015 when one dollar of new debt would add ZERO towards GDP.

Well, according to Christopher Rupe, a poster on Ticker Forum who tracks this information by the quarter and charts it, during the third quarter one dollar of debt produced NEGATIVE 15 cents worth of goods and services! We are already PAST ZERO HOUR. Hard to imagine, but adding debt now subtracts from the economy more than it offers – that’

s debt saturation! He gets his data straight from the Treasury and BEA, plugs it into his spreadsheet and viola, out comes a product that is of utmost importance, one that your government fails to track or report:

Remember, MUST GET CREDIT FLOWING! What happens during the next downturn?

Now let’s turn to the charts to examine the Treasury note and bond markets. The spread between the two year and ten year has NEVER been wider. This is a result of the interest rates on the long end rising, bond prices falling, while on the short end money continues to pour in behind Bernanke’s QE keeping short term rates effectively at zero. This MUST CONTINUE OR ELSE! The reason is simple – the government, banks, hedge funds, and others have been borrowing their money short term – some lending long, a very dangerous situation should interest rates rise. Are interest rates going to rise? YES, of course they are! I told you that last January (Bond Market Hide & Seek – A Domed House & 3 Peaks…) where I pointed out that interest rates have declined ever since they peaked in 1980 and have reached zero. There is only one way they can go from zero:

Here is a chart with the entire history of modern day interest rates on it – 3 months to 30 years:

I would love to put the SPX on that chart, but can’t. What I would like to show is the parabolic rise in stocks during the same time period of this chart. While rates were rising into 1980, stocks were going up. This became rapid after 1971 when Nixon was forced to remove us from the gold standard entirely (the third time the quantity of paper to gold was changed since 1913). So, when rates were rising, stocks (as measured by the index) went up, and then when rates began to fall, stocks were still going up! Proof that rates simply do not dictate the action in stocks. Martin Armstrong contends that money will flow from bonds and to stocks as rates begin to rise again. That is one explanation for why stocks are rising now. Let’s examine that. Below is a chart showing the past 3 years of the US Bond Fund (30 year bonds), and it has an SPX overlay:

What you clearly see is that indeed, over the past 3 years that as bonds rose, stocks fell, and then as bonds fell stocks rose. So, we’re seeing that bonds could continue to fall, does that mean that money will continue to flow from bonds and into stocks? I think NOT, at least not for too long.

The reason is simple. Prior to 1980 debt saturation had not occurred. It has now, as it did during the late 20’s, but is more than twice as bad now as then. What happens when the economy is debt saturated is that higher rates require more and more money to service debt and thus REAL economic growth cannot take place until the debt is cleared! Adding more debt will not help, it will HURT. So, do not be surprised when the flow of money ceases to look as clean as it does on the chart above. Remember too, that BONDS ARE DEBT! These charts are charting government bonds, or government DEBT that’s for sale. As money flows out of bonds, rates rise, and thus our government’s cost to carry debt will also rise. They have been borrowing short, and other rates are tied into these rates.

Below is a 2.5 year chart of the USB fund showing a nasty looking Head & Shoulders. A break below the red neckline would produce much higher mortgage rates:

In that bond market article I wrote in January, I showed that TLT, the 20 year bond fund, had created a parabolic shaped curve and a classic topping formation, and top it did! TLT collapsed, as all parabolic shaped curves do, then fell into a rising channel formation at the base of its prior rise. Just recently TLT broke down from that pattern and appears destined to break a head and shoulders neckline:

Here is a one year version of the chart. The neckline is represented by the double blue lines and if it’s drawn in the correct location (it may be lower) then it has already been broken. The target on a break below the neckline is about 62, WAY down there, and much higher interest rates.

And now I’m not the only one seeing higher rates ahead, here’s what Morgan Stanley’s analyst has to say about the 10 year rate:

Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. The surge will push interest rates on 30-year fixed mortgages to 7.5 percent to 8 percent, almost the highest in a decade, Greenlaw said.

But what most analysts see is an “improving” economy and the inevitable rising rates that follow. Not this time. This time it is all about debt saturation and the risk associated thereto.

Since Greenlaw is talking about the ten year, let’s examine TNX, the 10 year treasury fund. Below is a logarithmic 40 year chart of the TNX. Again, you will see a peak in the year 1980 followed by a run down in yield to 2%. Note the long term downtrend line now at about 4.7%:

If what I now s

ee is correct, that line will be broken in the months ahead, here’s why… Below is a 5 year weekly chart of the TNX. We just broke from a small inverted Head & Shoulders pattern that had a target of 4.0%. We’re well on our way there and you can see that 4% breaks the next neckline of a much larger Inverted Head & Shoulders pattern:

Should that pattern complete, the target is 5.8%. Now go back up to the 40 year chart and you will see that 5.8% cleanly breaks the long term downtrend line. Here is a 2 year close up of the H&S pattern:

Guess what, the TNX CANNOT effectively go lower than 2%! Why? Because the Effective Federal Funds rate can’t go below zero and then the Discount rate is added on, and so forth… here is the hierarchy of rates in our current system:

In the United States, the Federal Reserve sets basic rates, called the Federal funds rate. This is the starting point for interest rates; they only go up from there. The hierarchy of rates is as follows (sample rates are for example only):

1. Nominal Rate: This is the target rate set by the Federal Reserve Board of Governors, of which Mr. Ben Bernanke is the current Chairman. He also heads the committee that actually sets nominal interest rates, the Federal Open Market Committee (FOMC). The twelve members of the FOMC meet eight times each year to set rates. The FOMC issues bonds and attempts to maintain their target rate, while working with the U.S. Treasury who is responsible for setting policies regarding the exchange value of the dollar.

2. Federal Funds Rate: This is the interest rate that depository institutions lend federal funds at the Federal Reserve to other institutions overnight.
Discount Rate: This is the interest rate that banks are charged to borrow short term funds directly from the central bank.

3. Prime Rate: This is the interest rate charged by lenders to borrowers who they consider most creditworthy. The prime rate is approximately three percent (3%) above the federal funds rate. For example, if the federal funds rate is 5%, then the prime rate would be 8% (a more normal type of rate).

The longer the duration of debt, the more risk filled it is considered and the higher the rate of interest. The shorter the term of debt, the less risky and thus lower interest rates.

Still on the TNX, below is a 3 month daily chart. Note that rates have been climbing up the upper Bollinger band and just produced a hammer today. That’s a potential reversal indicator but needs to be confirmed by tomorrow’s action. Equities are way overbought here (hammer on the RUT), so I will not be surprised to see directions reverse, at least in the short term, but again, it needs to be confirmed and we have ONLY $175 BILLION in debt issuance this week alone:

Now let’s look at very short term rates via the IRX. Rates on this chart are at zero, the only other times they have been this low was during the Great Depression, last year during the height of the financial crisis, and NOW:

Again, you can see the waves… up then down to a lower low. What happens at the bottom of the next cycle? Oh yeah. SPLAT!

Now let’s follow the money as it flows from debt and into Stocks…

EQUITIES:

Let’s start by looking at a one year logarithmic chart of the DOW. Clearly a rising wedge that was broken on this chart, a flat pattern and a potential breakout last week on extremely thin volume. The divergence between stock price and volume here is HISTORIC in size.

Below is the same chart simply with the log button checked. This is the only index that still has not broken this wedge, but again, this is only on a non logarithmic chart:

Again, the flag break on equities means a run up to about SPX 1,200 is what everyone is expecting. Very risk filled if you ask me.

I didn’t leave the studies on, but there is a clear divergence in the daily and weekly RSI. The weekly MACD is rolling over, a clear sign of tops. Today there were 404 new highs, yet another indicator that a significant top is near.

Next is a one year chart of the Transports. They broke their rising wedge and now prices are climbing along the bottom rising trend line:

The XLF has yet to break the 38.2% retrace and has yet to get near breaking its November high:

The put call ratio hit the territory where turns can happen today. Note that that total put/call ratio has only been lower twice in the past 3 years, once was near the top in ’07:

The VIX broke down below 20 last week and produced a new target of only 14. That would correspond with the bullish targets on the
equity P&F charts, but this is a place where I am VERY weary. Watch the VIX to see if it gets back above 20, it moved a little higher today:

Back to the flow of capital, money doesn’t just have to flow from bonds to stocks. It can also flow right on out of the country. In fact, I think a great deal of our capital has been doing so. Money and Markets produced a chart today showing some of the overseas markets and how they are doing compared to the DOW this past year. Again, this is a sign of capital flow:

Now here’s something else that concerns me. When I look at the NYSE and Nasdaq Advance/Decline lines compared to their respective indices, the divergences are EXTREME, but even more troubling is that they diverge against one another, in different directions!

Here’s what I mean… below is the Nasdaq A/D line (in red/black) verses the Nasdaq price (black). Huge divergence that is larger than during the declines of last year! This shows a complete lack of breadth, in other words only a very few tech stocks are responsible for running prices to bubble heights:

The NYSE is the opposite! The A/D line is at the other extreme, now HIGHER than the ’07 high! And very divergent from the rise in price. This coincides with the extreme number of new highs and very few new lows, again numbers seen at extremes, and this is NOT a bottom!

That leaves two asset classes to discuss, but this is getting very lengthy already, so let’s just summarize. Real estate is obviously still correcting. NAR and others are doing their best to pump up the data, but that will fail miserably as the option ARM resets begin to kick in strongly next year. This will hit higher priced homes hardest and you may begin to see some true bottoming on the low end stuff. The banks will continue to struggle with this and with Commercial Real estate. Money is obviously still flowing out from real estate and I believe will do so for some time to come.

Commodities have been on the opposite end, they have been receiving capital flows over the past decade while equities have been losing. Oil is priced very high right now compared to real demand. Gold is expensive but obviously can go higher should our government continue on their credit pushing ways.

I think it is important to see and view all the major asset classes and watch the money flow between them. The most clear short term trend is that as bonds go down, stocks go up. Again, that is a trend that I do not expect will continue, the difference being DEBT saturation and the ability of incomes to support more interest payments with higher rates of interest.

Yes, it’s true… exponential growth leads to parabolic up moves. When they become too steep, prices tend to crash down the back side, the fall being steeper than the ascent. This is found throughout nature, here’s proof, LOL.