Market Analysis: Just a Sell-Off -- Not a Meltdown. So Far…, by Al Martin

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by Al Martin

Market Analysis: Just a Sell-Off -- Not a Meltdown. So Far…

(7-30-07) Global markets shuddered last week as the so-called “fear” bid prompted investors to transfer their holdings to government Treasury bonds, while $526.1 billion (half a trillion dollars) in shareholder wealth was wiped out from the stocks in the Standard & Poor's 500 index. Even though the market rebounded after a sharp drop, the so-called “flight to quality” bid continued amid concerns that the sub-prime mortgage debacle would infect other housing markets, while the yen carry trade, which facilitates cheap credit on a global scale, is now investors’ primary concern.

Thus while the Dow fell 208.10 (or 1.54 percent) to 13,265.47, with nearly 140 points of that loss coming in the final half-hour of trading, the week's decline was the worst in five years, while the percentage decline was the largest since late March 2003. Nevertheless, it appears that this is just a sell off -- and not a meltdown.

The credit spread baffled many market pundits since junk paper fell to record lows versus high-grade paper. There was, however, a dramatic reversal last week. The flight to quality bid exerted itself in a dramatic rally in U.S. Treasuries.

Everyone, it seems, was going into Treasuries -- and not only U.S. Treasuries, but also Japanese, German and other government bonds. This is the archetypal flight-to-safety trade.

What precipitated it, simply put, was the recognition that suddenly it wasn’t so easy to go out and borrow $20-40 billion off the yen carry trade. In fact many companies are pulling in their horns in terms of borrowing for projected IPO’s and other buyout deals. KKR, for example, has put the stops to its IPO and has completely withdrawn its plan at least for now.

The real problems began last Wednesday (July 25) when the $20-billion Ford credit deal, as it’s known, could not be done. It was finally accomplished, but the way it was done frightened the markets because the commercial and investment bankers behind the deal had to take back $12 billion of the paper.

In other words, they had to finance it personally. Daimler Chrysler’s credit arm had to take back $2 billion of the paper to get the deal done. The remaining $6 billion in paper in the deal that did get floated out was done in the marketplace. They were expected to do that at Treasuries plus 3-1/4% but ultimately floated the paper at 4-1/2%.

The Ford Motor credit deal was the first shot across the bow in what central bankers were hoping would happen.

Meanwhile shares in the recently floated Blackstone deal (BX) continued to decline. Shares traded under $24 by the end of last week, while initially it was floated at $31 and traded as high as $38 on the first day of issue. Now, in the Blackstone Group, you have a lot of Joe Six-Pack, Grassroots Right-Wing Republican, 100-200-share stockholders – because that’s who the deal was aimed at when it was publicly floated. That’s who bought the stock above $35.

People wonder -- why did the equity markets drop so precipitously last week? The equity markets dropped in a response to widening credit spreads and the increased realization that the investment climate is changing and that, in fact, a new process is starting where junk vs. quality spreads are going to increase to reflect true risk.

This is what all governments have been frightened of, and this is what all retail investment houses and investment bankers have been frightened of as well.

Add to this mix the fact that credit agencies like Standard and Poor’s and Fitch’s have downgraded junk debt issues (exotic derivative based debt bombs) which have been overvalued for ages. Investors are wondering why they didn’t do it earlier.

What we’re seeing, then, is a knee-jerk reaction -- all around the planet. We’re seeing knee-jerk reactions from credit-rating agencies and government regulatory agencies, which are desperately seeking to investigate something.

Certainly they want to cover themselves politically in the event that this sell off turns into a real meltdown.

So what will happen? What I think is that you’ll see global equity markets probably soften further and then they’ll try to rally the markets Monday, just like they tried to rally them early Friday. I don’t think we’re ready yet for a large meltdown.

At Insider Intelligence, we’ve been trading from the long side on dips, which has been the right thing to do, late-week. I would recommend that traders continue to adopt that strategy.

What are potential factors that would extend this sell-off into a real meltdown? You need another “shoe to drop,” as it were. What does that mean? It means you need another big deal that can’t get financed or gets busted out. Or you need the collapse of one of the 10 large hedge funds to occur. Then watch out below.

Something more needs to happen to exert further pressure on equity markets, based on where they are trading right now.

The credit downgrading of the CDO’s and the other bonds is part of this. The great fear, particularly in the United States, of the Bush Cheney Regime and bullish pundits everywhere, and especially on CNBC and Bloomberg, is that the sub-prime mortgage debacle would spread into other areas of the economy.

There is a reason why these fears have been accentuated. When did all of this sell-off begin last week? What was the first precipitating factor? It was the release of Countrywide mortgage claims of earnings. Not only were those earnings lower than expected (that wasn’t any surprise to the market), but it was the comments that Countrywide made that unnerved markets globally.

The comments referred to the fact that there are sub-prime portfolios that actually improved a little. But they were seeing dramatic increases in default rates in the so-called Alt-A and Prime paper.

And therein lies the great fear that this debacle is not going to be contained to sub-prime paper, and that the increasing default rates and all of the mortgage companies who reported last week as well as many home builders like Beazer and Horton made comments on their disastrous earnings releases as well as of the dramatic increase, in fact a doubling in the last 12 months, of the default rate in both the Alt-A and Prime paper.

Not only was it unexpected, but it touches the raw nerve and it points out everybody’s Greatest Fear because if you are seeing rapidly rising default rates in Alt-A and Prime paper, that is a bad portent for consumer spending.

If people can’t pay the mortgage, they’re not going to be able to pay for anything else either and certainly that’s part of it.

As long as the credit and mortgage debacle was contained within the sub-prime category, it didn’t constitute that big of a drag on consumer spending. Why? Because the people that have taken out the sub-prime mortgages are almost exclusively in the bottom 40% of the population. It should be noted that the bottom 40% of the population only accounts for one quarter of consumer spending.

The sign that bullish shills were looking for and hoping not to see was a spread of default rates, i.e., rapidly increasing default rates and rapidly expanding arrearage rates in the Alt-A and Prime areas because two thirds of consumer spending is in the Prime mortgage segment

And what about the fall of the dollar vs. the euro? Actually, as political pundits have noted, the dramatic fall in the dollar, which picked up steam last week, had been finally followed by a strong counter-rally at the end of the week, which we had been predicting.

The falling dollar has actually helped the Bush Cheney Regime politically because exports have risen to levels not seen in this country in years. The falling dollar makes U.S. exports cheaper, and that had to finally happen.

Meanwhile global deflationary pressures had been masking the inflationary impact of a falling dollar, and this has also helped the Bush Cheney Regime politically, as well.

You’ll note last week that the Japanese consumer price index was a red number, i.e., a minus number, for the fifth consecutive month. This brings us back to a point that we’ve written about before in this column. You hear this every day in financial media, even from the Federal Reserve. Everyone is adopting this pro-inflation stance, which is really a lie -- Oh, near-term inflation may still be falling, but we are absolutely certain that inflation is going to rise rapidly down the line. After all, it must. We have all the classic signposts indicating that inflation must rise. We’ll be seeing $75/barrel oil because of growing import prices in the United States.

The reality is that oil, just like the bonds, trades on a fear premium. Plus there’s always speculation. You hear this every day. But how much of that $75 price is the fear bid, or the fear “premium”, as they call it?

Some would like to say $10/barrel; others would like to say $20/barrel. I think that it can generally be said – and this is a generality – that about $15/barrel right now is the “fear” premium in the oil. This includes fear of disruption of supplies, fear of geopolitical discontent, and fear of ongoing refinery problems globally.

What surprised everyone is that OPEC’s most recent effort to curtail production has actually worked. If you look at it from their point of view, since oil is largely priced in dollars, their buying power is being reduced by the dollar’s decline.

If you price oil in yen – for instance, you saw last week, the Iranians are now selling oil to Japan, but they’ve got to pay for it in yen.

If you simply transacted oil in yen instead of dollars, it would automatically increase the purchasing power of everyone who’s selling oil. And, of course, the Bush Cheney Regime still has enough political power that it can prevent that from happening. At, let’s say, $75/barrel, oil is currently dramatically overbought relative to its supply/demand equation. In spite of this fear premium.

We expect the oil will give up $10/barrel in the very near term. And it will be a gradual drop

Last week, the oil attempted to break several times. Every time it broke, the commodity funds, out of desperation, since they’re already long so much oil, would come in and bid it up. But that’s what traders call “desperation buying.”

In other words, if you’re already long something and your entire multibillion-dollar commodity fund depends on that oil not dropping in value, you will go out and exhaust all of your remaining capital and borrow more to buy something that is already fundamentally overbought -- simply to support the price.

But the other side of the oil equation is that people aren’t looking at the fact that the planet is swimming in the stuff.

And speaking of collapsed hedge funds, Federal Energy Regulatory Commission (FERC) has begun an investigation into the fact that Amaranth and Brian Hunter lost $6 billion in natural gas futures last year. FERC however doesn’t have any prosecutorial power. Also FERC’s regulatory power has been severely curtailed under the Bush Cheney Regime.

That’s how pro-Bush faction control of media works. They try to blame it on FERC. What everyone tends to forget is that early on the Bush Cheney Regime stripped FERC of much of its regulatory power. One reason why we have $70/barrel oil is that one of the very first actions of the Bush Cheney Regime was to remove the $2 profit margin cap on refining a barrel of oil that had been under FERC’s purview for years.

People wonder why, but here is a very good reason for $75/barrel oil – even while consumption is actually falling and when the world has run out of places to store crude oil.

One of the reasons production is falling -- the oil bulls like to say, “Oh, look. Weekly production numbers. Global oil production is falling.”

The reason it’s falling is because the planet has run out of storage facilities. U.S. domestic oil storage capacity now is above 100%. All of last week, U.S. oil companies are renting oil storage facilities from PEMEX in Mexico. They’re renting oil storage facilities from TransCan in Canada because they’ve run out of room to store the oil.

The planet is swimming in the stuff. And demand is falling.

People want to know – are other hedge funds going to go belly up?

I think there are one or more larger hedge funds, which are the size of the Bear Stearns hedge funds, that are probably on the brink. This could be seen in the way commodity futures acted late-week when, for instance, the industrial commodities all fell. You saw a lot of the soft and tropical commodities fall.

The reason this occurred was because the growing credit problem is going to negatively impact on consumer spending. Of course, fungible commodities are going to fall.

The second reason this happened, and, I think this is more telling, certainly for hedge funds, is that so much borrowed money is on the long side of commodities.

And that’s all primarily equity funds and hedge funds.

Commodity funds, the two largest being Goldman Sachs and Morgan Stanley, still have long positions in the copper and in the nickel, for instance, when the demand for these metals is falling at the same time the supply is increasing.

What makes it so tenuous, in a way it’s never been before, is to say that a hedge fund of any stripe has $10 billion committed to a long position in any fungible commodity, but the $10 billion itself is fictitious because it’s all leveraged, derivatized, and hypothecated, 40-to-1 money.

That’s the situation and it could be likened to a bottomless pit. You really don’t know what’s what. Since the money supporting those commodities has been artificially created, through the yen carry trade and slapping on derivatives and endless re-hypothecation of financial instruments, who’s to say how much support there really is for any given commodity price?

In conclusion, we still tend to think that the latest activities in the market are a sell-off, not a meltdown -- yet. We are still trading the domestic equities from the long side on dips. Also I think, for this sell-off to turn into a real debacle, you need another big shoe to drop, which means you need the collapse of a large hedge fund and/or commodity fund.

So what can we expect? There are a couple of possibilities. Collapse of a large hedge fund cum commodity fund. Or, for example, if S&P;, Moody’s and Fitch’s were to expand their downgrades and to suddenly increase a whole lot more downgrade warnings and ratings, which would throw another tremor into the markets.

There are still a lot of potential shoes out there waiting to drop. However, until they do drop, as it were, this is still a sell-off. Lest we forget, basis the DOW, we’re still only 5% off the highs.

In other words, don’t worry – at least not yet…

* AL MARTIN is an independent economic-political analyst with 25 years of experience as a trader on NYMEX, CME, CBOT and CFTC. As a former contributor to the Presidential Council of Economic Advisors, Al Martin is considered to be a source of independent analysis for financially sophisticated and market savvy investors.

After working as a broker on Wall Street, Al Martin was involved in the so-called "Iran Contra" Affair as a fundraiser for the Bush Cabal from the covert side of government aka the US Shadow Government.

His memoir, "The Conspirators: Secrets of an Iran Contra Insider," (http://www.almartinraw.com) provides an unprecedented look at the frauds of the Bush Cabal during the Iran Contra era. His weekly column, "Behind the Scenes in the Beltway," is published weekly on Al Martin Raw.com, which also publishes a bimonthly newsletter called "Whistleblower Gazette."

Al Martin's new website "Insider Intelligence" (http://www.insiderintelligence.com) will provide a long term macro-view of world markets and how they are affected by backroom realpolitik.

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