Minyanville: The Ultimate Bull Trap?

[Winehole23]

The Ultimate Bull Trap?
Bennet Sedacca Jan 05, 2009 12:00 pm

Trade only best-of-breed companies and sectors.


Bull Trap: A false signal indicating that a declining trend in a stock or index has reversed and is heading upwards when, in fact, the security will continue to decline.

Is the Ultimate Bull Trap Being Set?

Longtime students of the market will tell you that the crowd is usually wrong at extremes. Judging by what I see, hear and read in the media, the current consensus is:

• Stocks bottomed on November 20th-21st;
• An economic recovery will begin in the second half of 2009;
• Corporate bonds are a buy;
• Stocks are cheap;
• The stock market is now discounting all the bad news - which is surely a sign that the worst is likely behind us.

Even though I was looking for a low in the S&P 500 around 750 (it bottomed around 740 on November 21st, only to close at 800 the same day), I continue to believe that was a low point, but not the low point for this bear market.

My firm was a large buyer of mortgage-backed securities during the Wall Street de-leveraging, and we’ve been rewarded with handsome gains - although we began to take some profits on Friday, where appropriate.

Stocks have rallied even more (S&P at 931) and could possibly make a run at 1,000- 1,100 - particularly if “performance anxiety” sets in among those portfolio managers afraid to miss the rally. As an absolute-return investor, I am not afraid: I have the luxury of having missed the big move down from nearly 1,600. The managers subject to performance anxiety are the same ones who managed to get to a market benchmark - only to get tattooed.

Corporate bond spreads have tightened during a slow holiday season, as have spreads in CMBS (commercial mortgage-backed securities). Corporate spreads may or may not tighten further; I believe there will be a wave of issuance at every level - government, emerging markets, corporations, municipalities, etc.

Treasury yields have also crashed, as the Fed has taken the federal funds target rate to a range of 0-0.25%. By manipulating interest rates to zero, the Fed is badly punishing savers. You can sit in cash and earn zero - or you can be forced out onto the risk spectrum, just so you can keep up with inflation or your benchmark.

Forcing money into risky assets is perhaps the most dangerous experiment ever, and we have no idea how it will end. I expect it to end poorly - with hyper-inflation. The funneling of assets into risk is masking the deteriorating fundamentals and giving the appearance of a market that’s already bottomed. But this is sleight of hand - an illusion.

The Fed is setting up the ultimate bull trap - a trap that, when sprung, will leave only sellers standing. And we could see that happen by the end of the first quarter, or the beginning of the second.


Why is the Federal Reserve Punishing Prudence?

Prudent: Wise in handling practical matters; exercising good judgment of common sense. Careful in regard to owns own interests; provident. Careful about one’s conduct; cir spect.
-Webster’s Dictionary

Prudent Man Rule: An investment standard adopted by some US states to govern the action of those responsible for investing money for other people. The fiduciary is required to act as a prudent man or woman would in regards to investing monies of others.
-Bloomberg Financial

Ever since 1995, the Federal Reserve and other authorities have been assisting in the birth of the largest Federal Reserve bubble in our nation’s history. The money supply has grown exponentially, weak businesses have been formed (and have failed), the consumer is leveraged up to his eyeballs, regulation is poor, and savings have dried up. Furthermore:

• The brokerage/investment banking industry has been pummeled beyond recognition;
• Lifelines have been given to everyone from poorly run banks to poorly run auto manufacturers;
• Esoteric securities have been “relocated” from the balance sheets of reckless banks and brokers to the US Treasury, FDIC and Federal Reserve.
• Investors worldwide watched $30 trillion of stock market equity disappear in the past year;
• Home prices have cratered by better than 25%;
• Unemployment on every front is rising;
• Tax receipts are down, and state governments are suffering;
• The debt market -- except that artificially supported by the government -- is closed.
• Earnings estimates for the S&P 500 are down 60% year-over-year.
• Stocks (using the Dow as a proxy) are at the same level they were 10 years ago.
• Industrial production around the globe is imploding.

I could go on and on and on and on, but there's really no point. I could show 25 graphs or more of what is wrong with America’s economy, and, for that matter, with much of the broader global economy and global markets.

Here's the magic question: If there's so much bad news, is it fully discounted in prices? And if so, why are the Fed, FDIC and the Treasury Department so desperate to drive interest rates
down to zero, buy troubled assets, and ruin what used to be an efficient debt market in mortgage-backed securities, corporate bonds and preferred stock?

There seem to be 2 distinct markets that have developed for debt: The one that the US government stands behind (with all of our money), and the one that exists in the “free market.”

Before I show a few examples of why prudence is being penalized -- and why I believe it will a deadly trap for those that fall in it -- allow me to share with you the most recent release from the Federal Open Market Committee, to give you a sense of their desperation.

FOMC Statement, December 16, 2008

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quan ies of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.

The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

I believe that what I’m witnessing in the financial markets is distasteful, dangerous and socialistic. Think for a moment about where the Fed is heading with their policies. It’s the opposite of a free market, totally alien to laissez-faire - in fact, it seems to have been borrowed wholesale from Ayn Rand’s Atlas Shrugged.

Taking all of the new programs and bailouts paid for by “We the People” into account, the following questions become urgent:

• Shouldn’t the consumer, after decades of over-consumption, be allowed to digest that over-indebtedness and save, rather than be encouraged to take risk?
• Shouldn’t companies, no matter what state they reside in, from a political point of view, if run poorly, be allowed to fail or forced to restructure?
• Should taxpayer money be used to make up for the mishaps at financial ins utions worldwide be allowed to wallow in their own mistakes?
• Shouldn’t free markets be “free”?
• When did socialism make its way to our shores?
• How do we choose who's bailed out - and who loses?
• Shouldn’t we place blame on the politicians, bureaucrats and other “decision makers,” and put skilled people who know how to run businesses in place?
• Shouldn’t investors, led blindly down the primrose path of “buy and hold, diversify, and don’t open your brokerage statement except once every 10 years” be allowed to follow the Prudent Man Rule?

Again, there are many questions to be asked, many with answers that no one wants to put in print. When will people stand up and scream “I’m mad as and I’m not going to take this anymore!”

Once the rally in equities and credit ends, we will realize that the patient has only been injected with adrenaline, as opposed to being allowed to recuperate through good old-fashioned bed rest.

Risk-taking in a laissez-faire world should be replaced with risk aversion. Consumers who over-consumed should be allowed to strengthen their balance sheets for the next cycle and increase their savings. Companies that have been kept afloat, bailed out, nationalized, stuck in conservatorship -- that have become part of my national portfolio, whether I like it or not -- should, unless it actually poses systemic risk (which I am not at all in favor of), fail. Period.

Here's what the government has purchased for our national portfolio. Lovely.



After all, where's my bailout?



A Few Examples of the Not-So-Free-Market


Click to enlarge

The picture above is of 30-year Fannie Mae (FNM) 4.5% mortgage pools. Note the recent 13% e, as the Fed announced that it would be buying MBS in order to stabilize the mortgage market. In a free market, these securities would be many points lower; however, because there is an artificial bid (yep, with our money), investors are forced to look elsewhere, toward risky assets.



The chart above may be confusing, but it's actually rather simple: It's the screen our Head Trader and I look at all day in the land of mortgage-backed securities.

If you focus on the middle section, you'll note that 7% Freddie Mac (FRE) (FGLMC) pools trade at the same price as Freddie Mac 6% pools and lower in price than 6.5% pools. This is yet another example of how the markets have become so disorderly and difficult to trade.

For the icing on the cake, feast your eyes on what the Prudent Man would invest in during times of rebuilding one’s balance sheets: Treasury bills.

Yes - cash is now officially trash. If you buy 1-month Treasury bills, you're rewarded with a yield of a gigantic 0.02% per year. That’s right - 2 basis points per year. I suppose people with more than enough money can keep it invested for an entire year and make nothing - or they can suc b to the pressure of “I can’t make zero forever if I hope to retire.”

Now, imagine that you're a professional money manager who's paid 1% annually to invest other people’s money. If you feel that being prudent is to sit on cash and attempt to charge a fee, the math is simple: 0.02% per year minus any reasonable fee is a negative return. This is forcing many people out onto the risk spectrum at precisely the wrong moment - when risks are at their highest ever.



Why Will the Bull Trap Hurt So Many Investors?

You got to know when to hold em, know when to fold em,
Know when to walk away and know when to run.
You never count your money when you’re sittin at the table.
There’ll be time enough for countin' when the dealing’s done.
-Kenny Rogers, "The Gambler"

Markets are clearly driven by fear and greed. At Atlantic Advisors, we operate without regard for market benchmarks; instead we ask ourselves: “In the absence of a benchmark, what would you buy?” This means buying only those securities we believe have the best risk/reward profile, and steering away from those that aren't attractive - even if they're part of the benchmark.

Most money managers are driven by “beating the benchmark” - no matter how imprudent it may be to do so. Like Kenny Rogers sang in “The Gambler”, you have to know when to hold 'em and know when to fold 'em. Knowing when to “fold 'em” -- or play 'em close to the vest -- while everyone around you is partying is perhaps the most difficult task we face as investors.

I am fully aware of the Fed’s goal to both save the system and force everyone out onto the risk spectrum, but I have seen this play before. I believe very strongly that investors who believe they must be invested in risky assets at the expense of prudence will live to regret their decision.

As for stocks: When I consider the risk/reward ratio, with equities at 22 times earnings (using 931 S&P 500 and $42 in earnings in 2009), I cringe when I hear people say that stocks are cheap.

What about municipal bonds? Pundits are declaring municipals cheap relative to Treasury bonds. Treasuries aren't a good barometer, since they're being manipulated lower in yield. With insurers like MBIA (MBI) and Ambac (ABK) faltering, little if any research available on the nearly 50,000 issuers out there, and new downgrades coming in like Noah’s flood, I cringe at the idea they're attractive.

As for junk bonds: With new issuance at zero (a whopping one new issue was completed in the fourth quarter of 2009), they may seem cheap relative to Treasuries. But with the window for new money issuance closed, and money scarce, who will the buyers be? Expect a record high default rate in junk bonds in 2009-2010.

As for preferred stocks, I'm cautious there as well: I wouldn’t be surprised to see Uncle Sam step in to tell banks that they can pay neither common nor preferred dividends. Such is life under socialism.

In sum, I think many investors are being forced into taking risk so as to avoid a zero return, when they would actually prefer to play it safe. Again, I remain conservatively invested, with a trading at ude towards the best-of-breed companies and sectors - those who don't need federal assistance to survive.

[SnakeBoy]

Well the Fed may be setting the trap but the mice just can't resist going after the cheese.

Markets Shrugg off FOMC, Data
Wall Street managed to jump higher Tuesday afternoon as the markets were apparently unfazed by the Federal Reserve's ominous economic outlook and a pair of ugly reports on housing and factory orders.

...
http://www.foxbusiness.com/story/mar...rkets-futures/

[DarkReign]

This entire fiasco was never a mistake. This is how indentured servitude starts and ends, where the holder of debt is the government and they very much expect to be paid.

I havent been posting here for a reason lately. I am disinclined to believe there is leadership in this country. That we are being sold out lock, stock and barrel by our elected leadership and that this is a large plan being executed by the wealthiest of wealthy in order to secure their domination over millions of others.

Basically, our entire system of government has been bought and paid for. Now it is those individuals who have the power to tax, to wage war and to enforce their law.

Its a coup, ladies and gentlemen. We have been taken over without a single drop of blood being spilled.

[Winehole23]

It's the next phase in the globalization of penury. The cartelization of central banking and international finance flips the checkbooks, while the states -- the cons uent districts -- disgorge all their wealth to meet their ever mounting debt.

According to James K. Galbreath, the state in turn preys upon its citizens...the predator state. And then it colludes with money to rape the middle class. The note of class consciousness Galbreath strikes is historically apt. It's sorta forced on us by present economic cir stances.

If God forbid Keynesian rescue fails and there is deflation, it will be the most massive redistribution/confiscation of wealth ever. Those with massive cash positions are massively favored to win.

It's not looking too good for the old republic right now, DR, but you know, things are always darkest before they go completely black.

[Winehole23]

There seem to be 2 distinct markets that have developed for debt: The one that the US government stands behind (with all of our money), and the one that exists in the “free market.”

[Winehole23]

You don't have to follow Galbreath's prescriptions to appreciate his description. In the context of the the ongoing bailout of our insolvent financial sector, his characterization of the state as the predator of the nation's wealth is apropos.


http://tpmcafe.talkingpointsmemo.com...redator_state/

http://www.iht.com/articles/2008/09/...s/IDSIDE27.php

http://news.kontentkonsult.com/2008/...tor-state.html