Weekday Commentary from Jim Puplava
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Taking it in the Shorts
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Market WrapUp for the Week
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Raw Materials
Monday, October 7, 2002
The Cauldron is Bubbling Over
I began “Bubble Troubles” with a quote from Shakespeare that has seemed to have caught on with the financial markets: "Double, double, toil and trouble; fire burn and cauldron bubble." This quote from Macbeth takes place in Act IV of the play as the witches stir the cauldron, calling up apparitions of things to come. That certainly describes today’s financial markets where ominous apparitions of the future are directly in front of us. You can take your pick from the economy to geopolitical events -- all are at major inflection points. The Fed is staring at a nightmare for the most part and it is of its own making. The multiple bubbles created as a result of monetary policy are all starting to unravel. The economy seems destined to head back into recession despite the lowest interest rates in nearly half a century. After 11 interests rate cuts, the Fed has been unable to reinflate the stock market bubble. The major averages have continued their relentless decline. It isn’t just the US markets that have handed investors double-digit losses. It is everywhere. Markets in Europe are hemorrhaging along with markets in Asia and Latin America. All major markets in Europe are down anywhere from 28-49 percent. In Asia they are down 18-22 percent. In Latin America they are down 30-60 percent. There are very few safe havens in stocks.
Despite these declines, stock prices are still too expensive. That is because earnings have declined much faster than prices. Not a day goes by but we hear of one company after another follow each other in unison with warnings over revenues, earnings, more job layoffs, restructuring charges, writedowns, or some disappointment. Wall Street is trying to put the best face on matters with standard clichés. I watched one money manager defend his position with the glib cliché that he’s optimistic and you have to look at the long run. Nobody wants to admit that we are in a protracted bear market that is the result of a bubble deflating. This bubble will deflate and the bear market will continue until such time as the pendulum swings to the extreme. At bear market bottoms, nobody will want to own stocks and P/E multiples and dividend yields will reflect values that will be enticing. We are a long way off form that point. We're only in the second phase of this bear market and it hasn’t completed its cycle. I believe there will be a bear market rally and then the final third phase of the bear market, which will be the final wash out. We're far from a bottom despite the wishful spin coming out of Wall Street.
Worry Menu Grows
Getting back to the worry menu, besides a dock strike on the West Coast, a plethora of earnings warnings, new accounting scandals, the real problem has yet to unfold. Worry signals point to the financial sector. As these charts of J.P. Morgan, Citigroup, Bank America, Goldman Sachs reveal, the financial sector is in trouble and it is bound to worsen in the weeks and months ahead. These companies are in all of the wrong places. Pick a financial hot spot and you will find them there. Derivatives, bad loans in the telecom sector, foreign loans such as Argentina, with Brazil next, gold short positions, mortgages, credit cards, installment debt or interest rate swaps. Any one of these areas could turn into a ten-sigma event.
Troubled Financial Sector
We’re talking just about the financial sector here. There are also plenty of rogue waves and ten-sigma events lying around the geopolitical seas. We can start with an impending war, which the President will address in his speech to the nation tonight. In a war, armies kill and blow things up. Lives are lost, property is destroyed and governments are toppled. War introduces more uncertainties for the financial markets and they abhor uncertainty. This upcoming war won’t be like the last war since the objectives are much more complex. A regime change is being planned and that means there will be an occupation force in the region for quite some time. A $100-$200 billion war budget implies different objectives and a different strategy with multiple outcomes. If things go well in the initial battle ,there may be cause for celebration. It is what happens afterwards that leaves a big question for the financial markets. Rebuilding a nation or a government is a lot more difficult than defeating an army on the battlefield and making it go back home.
So take your pick from either the financial sector, here and around the globe, or the geopolitical minefield and it isn’t hard to understand the gyrations in the financial markets. There is plenty to worry about and it is doubtful whether risk control programs have ten-sigma events programmed into their formulas, especially geopolitical risks.
He Just Doesn't Get It ... or He Just Doesn't Admit It
While financial markets and investors were fretting across the globe, Mr. Greenspan seemed oblivious to all that is around him. Speaking to members of the American Bankers Association, Mr. Bubblemaker extolled the virtues of the financial sector and the consumer’s willingness to take on more debt and spend money as a sign of a healthy economy.”…Households, encouraged by ongoing increases in income and housing wealth, have maintained their expenditures. Low mortgage rates encouraged households to purchase both new and existing homes, the latter enabling sellers to extract large amounts of home equity, previously enhanced by capital gains. Low rates also encouraged refinanced mortgage cash outs and rapid expansion of home loans.” Mr. Greenspan sees no problems with consumer debt ratios setting records along with defaults, delinquencies and bankruptcies. The fact that consumers are spending down their home equity is viewed as healthy.
Mr. Greenspan also went on to praise the growing mountain of leveraged derivatives in our financial system as healthy too. “Financial derivatives…have grown at a phenomenal pace over the past fifteen years. (He thinks this is good!) Conceptual advances in pricing options and other more complex financial products, along with improvements in computer and telecommunication technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. [Speculation opportunities have also grown exponentially.] Moreover, the counterparty credit risk associated with the use of derivative instruments has been mitigated by legally enforceable netting and through the growing use of collateral agreements. [Most contracts are OTC contracts which makes them less liquid and subject to price implosion in the event of a crisis. Derivatives are concentrated in fewer players today and make an event risk like LTCM even more likely.] These increasingly complex financial instruments have been especial contributors, particularly over the past couple of stressful years, to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago.” [Event-driven risks are increasing with each new crisis, bigger than the last. JP Morgan Chase, Citigroup, Bank of America hold most derivatives. Their portfolio makes Enron and LTCM look conservative.]
The Sword of Damocles Over Metal Shorts
In contrast to the large derivative risk, you can look at the large short positions in gold and silver and in the precious metals stocks as not only a symbol of this risk, but also trades that bet on the wrong side of the table. The rise in gold prices and its stubborn persistence to be driven down by relentless short selling speaks volumes about the risks that lie directly ahead of us. Those short positions in gold, as reflected in the large short positions in JPM’s portfolio and other bullion banks, are like a sword of Damocles that hangs over the financial markets. The one thing we all know about the precious metals markets is that they have a tendency, like a quiet volcano, to erupt at a time when nobody expects it. Right now the price of gold is holding up despite repeated attacks to move the price lower. The metals stocks, which have been this year's stellar performers, have come under increased short-selling pressure. Like the scarceness of the bullion itself, it erupts explosively whenever there is demand or when the financial barometer starts dropping like it is today. Because there are very few high quality unhedged mining stocks, they are owned and accumulated by very strong hands. Money flowing into gold funds, because of their superior performance over these last two years, represents a potent buying force as will short covering when a ten-sigma event catches them by surprise. It is one thing to short paper assets when the supply is endless. It is another thing to short gold and precious stocks when there is a growing demand and a limited supply.
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Short Changing The Gold Market: Short Interest on Settlement Date |
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| Gold Stock | 10-15-01 | 01-15-02 | 03-15-02 | 06-14-02 | 09-13-02 |
| Agnico Eagle Mines Ltd. (AEM) | 1,528,891 | 2,491,493 | 3,366,534 | 3,839,396 | 5,081,776 |
| Goldcorp, Inc. (GG) | 146,524 | 513,012 | 2,688,668 | 4,601,437 | 5,731,613 |
| Glamis Gold, Ltd. (GLG) | 80,200 | 108,594 | 778,728 | 1,961,058 | 1,812,717 |
| Meridian Gold, Inc. (MDG) | 120,754 | 596,847 | 297,764 | 2,260,617 | 2,865,722 |
| Source: Nasdaq.com | |||||
LTCM boxed itself into a corner by increasing its leverage as credit spreads widened and ten-sigma events multiplied. The gold shorts are doing the same thing. As more money moves into bullion and into precious metals, the shorts will be forced to cover. They are hoping that things will be much more subdued and quiet when they do. What they are hoping is that the divergence /convergence theme remerges. That’s what their models tell them and that’s what they hope will happen. However, we would suggest with a upcoming war, a slumping economy, growing defaults, bankruptcies, widening credit spreads, rising default premiums, Argentina and next Brazil, divergences are widening -- not converging as their models would suggest. It is just a question of which rogue wave overwhelms them, or worse yet, a series of rogue waves which could in fact be a hundred footer as experienced in the Halloween Perfect Storm of 1991.
Today's Market
While gold holds steady, the price of stocks continue to weaken. The S&P 500 fell below key support levels hitting a five-year low. The five-year return for most mutual funds is now negative. Worries surfaced again today over a rapidly slowing economy and a possible retrenchment by consumers. All three major indexes fell below their July lows. The Dow is now at levels not seen since November 13, 1997. The NASDAQ is now at its August 1, 1996 low. The S&P 500 is now down 32 percent and headed for its third straight year of losses. Pro forma or CRAP earnings keep getting lowered for the third quarter. We dropped down to 5.6 percent today and are still heading lower. Financial sector charts as shown up above are exhibiting perilous chart patterns. The retail sector is also breaking down.
Wall Street is screaming for another Fed induced bailout. They want interest rates to be lowered to zero if necessary. Not that it would help. Just look at Japan if you want to see the efficacy of lowering rates. The Japanese Nikkei fell to 8,688 down from over 39,000 12 years ago. There is absolutely no reason to buy right now. The only thing that has made money this year is shorting the markets and going long gold and precious metals. Even in the washout of the third quarter, the metals held up superbly. You would have to go back three decades to find another time when there was this much uncertainty. Expectations are still far too high as are valuations. NYSE daily lows are back at levels of where they were back in July of this year. The VIX closed at 49.18, up nearly three points for the day. The volatility index is not quite at levels that we saw during the July plunge, but we are slowly getting there and in fact may surpass it. The VXN jumped over 60 to 62.32. It looks like it still wants to rise. We still have a way to go and it appears like it is going to take massive intervention to forestall a decline. Like all crises under Mr. Greenspan's reign, the Fed is more than willing to oblige. Do I hear hyperinflation floating in the air? The next round of intervention in the markets should be not only be breathtaking to watch, but historical in its precedent. John Law’s record may about to be surpassed.
Volume levels came in at 1.54 billion on the NYSE and 1.40 billion on the NASDAQ. Market breath was decidedly negative by 25-7 on the big board and 25-9 on the NASDAQ.
Overseas Markets
European stocks fell, led by drugmakers including GlaxoSmithKline after UBS Warburg lowered its recommendation for the world's second-largest pharmaceutical company. The Dow Jones Stoxx 50 Index dropped 1.1% to 2331.17. All eight major European markets were down during today’s trading.
Japanese stocks fell, with the Nikkei 225 Stock Average having its biggest drop in three months. Banks such as UFJ Holdings Inc. slid on concern the government may seize weak lenders and force their worst customers to fail. The Nikkei sank 3.8%, its biggest decline since June 26, to 8688.00.
Bond Market
Treasuries were bid higher as the sector continued to attract safe-haven flows. The 10-year Treasury note jumped 15/32 to yield 3.61% while the 30-year government bond gained 5/32 to yield 4.705%. Some key reports are on this week's agenda, with September retail sales the most pivotal release. Other reports that'll capture investors' attention this week include the September producer price index and the University of Michigan consumer sentiment index.
© Copyright Jim Puplava, October 7, 2002