Kondratieff wave


I’ve read this stunning post from Big Picture about a bunch of high-profile bottom callers in this market (Dow 20,000). I think most of them have a vested interest to drive sheeples back into stock market, and they will bend their reputation to do so.

But I want to get back to basics – what is a recession and what is a bear market, because we need to keep our records straight. Ok, suppose for a moment that the financial crisis is over. All the mortgage related losses are written down (another $200 bln to go) and Feds take the rest on its balance sheet (not that I think it will happen), there is no more bank failures (he-he) and the panic settles (aha). What’s next?

What is exactly a recession? First of all not every recession starts with financial crisis. It doesn’t have to be this way. As I’m trying to simplify things I think that recession is a culmination of a credit and inflation cycle, the natural sequence of events that are out of control of government and central bank.

The recession happens for the same reason the toy truck pulled by rubber cord will accelerate or stop even if you pull it very carefully. The economy runs on debt. Any entrepreneur who can prove the bank that he can get better return on money then the cost of borrowing will get funding. The bank is borrowing on money market and lends it long. Both the bank and the entrepreneur are risk takers, the money market is risk-free (except some rare cases, but this is not important). So all the risk and all the risk premium is spread in wide web between the money market and enterprise.

Let see the corporate AAA and BAA bond yields (click to zoom):

corporate bonds

On this picture you see:

  • Spreads between AAA and BAA corporate bonds are increasing around recessions (sometimes during, sometimes after). That is a measurement of risk aversion
  • Interest rates for corporations are usually elevated during recessions, while money run into treasuries
  • The Kondratieff wave is visible very well

To keep it short the recession happens when money are expensive and hard to get. This is a vicious cycle, the problem reinforces itself. But lets resolve a chicken and egg problem – what comes first – jump in interest rates or recession? It seems to me sometimes it happens one way, sometimes another. When the economy is booming the demand for credit may just exceeded the supply and yields will go up not because of risk aversion, but just because of lack of money or mounting inflation. Last year the opposite happened, the credit supply was cut because of the mounting losses in CDOs and derivatives. So the trigger could be different each time, but once the recession starts there is no stop until the money return back to the credit market to chase early profits.

So the recession ends when there is a new interest to lend, which clearly overcomes the risk aversion. If we get back to March of 2008 we can clearly say that there is no sight of recover at credit markets. Even if subprime losses are over nobody lends to subprime borrowers. The corporate spreads are widening, TED spread is over 1.5%. What those nuts are expecting here?

This latest “sudden debt” post pointed my attention to what actually happened yesterday. When Bernanke suggested that lenders are better off to write down part of the principal it’s not just another another call for mortgage reworking. It’s a paradigm shift.

During the normal times the bankers have no intention to facilitate the debt burden for any borrower because any preemptive help creates moral hazard and make other borrowers to misbehave. Bankruptcy proceedings are a good way to keep peers on leash.

But now is not the normal times. We are in Kondratieff Winter and the orthodox wave theory says that the Winter is a time of massive deleveraging, i.e. the outstanding debt must decline sharply. All asset prices are bound to fall and all Ponzi units are bound to fail. Read more about Ponzi units here.

The whole idea that preemptive write-down of principal could be more financially sound than sticking to the contract means that Bernanke is recognizing the fact that once you apply some simple quantitative financial conditions filter the Ponzi units will outnumber non-Ponzi units within the filtered set. That means that by reducing the principal for the whole working set you are mostly helping the Ponzi units rather then have a moral hazard of helping non-Ponzi units. And reducing the principal is the most sound way to deal with Ponzi unit. If we were not in Kodratieff Winter one would expect the collateral to start rising again, but Bernanke just demonstrated that he has no illusions.
In simple example, it’s obvious that writing off 5% of the mortgage balance is much better then losing 50% of the loan in foreclosure. Any temporary measure, like freezing the rate is not working, because the borrower with negative equity is not motivated even by reduced rates, but he is motivated if his equity is made positive.

This approach is universal and now Bernanke is trying to gently point the banking community in the right way before it’s too late. Now it’s just a mortgage market, but then it will be municipal, corporate and commercial real estate markets, all marching into massive defaults. I expect massive writedowns of principal as a suggested mutually-beneficial way to end the Winter and move into Spring. Should take time though

I’m sure this is already posted everywhere, but anyway:

From 1984 through 2006, only 13 auctions failed, typically because of changes in the credit of the borrower, according to Moody’s Investors Service. There were 31 failures in the second half of 2007, and 32 during a two-week period beginning in January. That compares with more than 480 failures yesterday alone, according to figures compiled by Deutsche Bank AG, Wilmington Trust Corp. and Bank of New York Mellon Corp.

We are witnessing something unprecedented in all aspects. As you know that I always was a supporter of Kondratieff wave theory and so I’m ready to see many 75-year old records, in whatever form they will come

P.S. About jobless claims today. Great economist David Rosenberg said that by his calculations the break-even number for NFP growth is at 350k of weekly jobless claims. Right now the 4-week average is at 361k, i.e. negative NFP number is guaranteed.

Another interesting point (from briefing.com): 4-week average at start of 1990 recession was 362K, 2001 recession was 373K. In this recession jobs are not falling as fast as before and this fooled everyone. But in fact the “Sudden Debt” blog explained that due the reduction in relative employment in manufacturing this time the jobless numbers will not grow as fast as in previous recessions. He predicted this few months ago and he’s proven to be right

According to Minsky theory there are three basic modus vivendi of a financial unit: hedge, speculative and Ponzi. For hedge units cash receipts exceed cash payment commitments, for speculative units they are equal and for Ponzi units cash receipts are insufficient to match obligations and require taking additional debt on a regular basis.

The main and major problem of our economy is that millions of families and thousands of businesses were able to run Ponzi scheme of operation for substantial amount of time, some of them for over a decade. That was possible thanks to the Autumn period of the Kondratieff wave, where interest rates are constantly falling thus providing the incentives to increase the debt levels substantially above the levels possible in previous periods. The last time U.S. economy was in Kondratieff Autumn in 1920s and it ended badly.

Every Ponzi unit eventually either bankrupts on its own personal pace or participates in a wider Minsky moment, i.e. widespread risk aversion of creditors away from Ponzi units.

The only two scenarios that can potentially prevent the bankruptcy of a Ponzi unit are:

  • Substantially increase the cash receipts on a permanent, not temporary basis
  • Substantially reduce the outstanding debt that will convert (upgrade) the Ponzi unit to at least the speculative unit

As far as I can see none of the proposed measures is addressing the problem even in a slightest manner. It was just used as an excuse for Bush and his GOPniks to push their personal agenda of cutting taxes for riches.

I outlined my own proposals in one of the previous posts

At this moment the way #1 is pretty much impossible for most, especially in a declining economic environment. The $800 will not help unless it is sent every month.

And the way #2 for most corporations and families means bankruptcy or foreclosure. Mish recently observed a trend of intentional foreclosures, i.e. a person decides to foreclose on “his” house not because he can’t keep up with the payments but because he observes that foreclosure is a sound financial decision in his case. So, instead of wasting budget money to prevent foreclosures they must work to make the foreclosure less painful. It’s not good to waste your time – it’s better to foreclose when you are young and still keep your savings than foreclose when you are old and maxed out on your credit cards

Oh, what a year it will be, even compared with all the turbulences of 2007!

Before going into the forecast let me wish you from all my heart to be surrounded by love and friendship that will help you to go through the tough times, good luck to avoid what is not under your control and the brain to change what you can! If those wishes materialize – believe me – you will be fine 🙂

Recession

I do not make any recession call for 2008, because we are already in the recession since December of 2007. But my forecast is that the recession won’t be over this year

Credit crunch

The important feature of credit crunch is that it happens fast. Remember, the over-hyped Blackstone (the flagship crazy loaner) IPO was a huge success at June 21st and the full-scale credit crunch happened at August 10.

In 2007 the credit crunch was all about subprime mortgages, while in fact it was just the first wheel that came off. We will have some more major credit problems to develop in 2008:

  • Mortgages in general, including prime loans. Option ARMs – mortgages made for people who didn’t plan to pay from the day one
  • Commercial real estate
  • Credit cards
  • Auto loans
  • Municipal bonds

Each of those problems will come out of blue sky and cause major losses and panic across the board

Real estate

Whatever metric you chose there is no bottom in 2008 and it’s too early to say when that will bottom. For the details go to Calculated Risk, he’s the RE boss 🙂

Major bankruptcies

It takes time for a company to bankrupt and even then most corporations finally do survive and re-emerge back from the bankruptcy, like Delta Airlines did. I have a list of companies that will bankrupt by 2010, but some of them (2 or 3) will seek the chapter 11 protection as soon as in 2008:

  • Countrywide
  • Washington Mutual – when this happens, it will be blood on the streets
  • Bkuna
  • Downey Financial
  • Chrysler (restructuring through bk, nothing special)
  • Standard Pacific
  • Beazer Homes
  • Hovnanian
  • Major problems (but no bankruptcy) for Fannie and Freddie

Stock market

The only thing I can say for sure is that we will be in the bear market for the whole year, with the first leg down in February. I have no idea how far down it will go – 5%? 30%? Who knows…

There are couple of sectors that will bottom and start drifting up already this year. That will be:

  • Utilities
  • Consumer staples
  • Financials. Yes, I’m not kidding. It will be a horrible year for financials but that will be a bottom, at some point. Two more panics like we had in August and I’m buying the big-cap banks and broker dealers, but not the small regional banks, those will not recover for years. I think the best day to go long will be a day when Washington Mutual goes bankrupt
  • Maybe Transports, hard to say

There are some sectors that will enter (or stay in) a violent bear market and have no recovery in 2008:

  • Cyclicals, Industrials
  • Consumer discretionary
  • Materials
  • Commercial real estate, REITs
  • Mortgage lenders, homebuilders

I have no doubt that the market in general will not bottom this year, but I will have many long positions going into year end, as I have many longs right now

Emerging markets

I think the first cracks in the Chinese economy will happen as soon as this year. They have three related major problems, each of nightmarish scale:

  • Almost all of the Chinese economy is very cyclical, they have very little counter-cyclical exposure. It’s similar to the industrialization in US back in 1920s. Moreover, the majority of industrial production is operating at the tiny margin, even no, when there is a boom, many businesses are operating at loss and receive government help. In comparison, US economy in 1920s had much better profit margins
  • Hundreds of millions of peasants left the countryside to work in cities for $1-$3 per day. They have no savings, no property. When the factory they work on finally bankrupt they will run out of food within days. There is no proper infrastructure to feed them, the only solution to the problem they will have is to take some weapons and kill for food, and there will be many millions of people like that. There will be blood on the streets
  • The Chinese middle class is fully invested at margin into grossly overvalued stock market. When market will start tanking for real it will have no bids, the 80% decline top to bottom is pretty much my target. This again reminds US in 1920s.

China is heavily dependent on the exports into Western world, and when the downturn happens we will have the upper hand. We can live with less imported junk, they can’t scale back. When we sneeze they’ll get sick, when we get sick, they will be in coma

Energy

I think oil will stay in the trading range until Chinese Olympics, probably making a last run to $100. After that the downturn will be so obvious that we’ll see $85 this year and $60-$70 in 2009. At some point oil will kiss $50, but it will be years from now, unless some kind of war happens

I think most people will say I fell from the moon but I think this week spike in CPI/PPI is actually good news. Let see Y/Y CPI:

And PPI:

Compare with crude goods:

First, there is very clear sign of economic slowdown. While crude goods are trending around 20% Y/Y the finished goods are clearly below peaks established in the last few years. When producers can’t pass costs to consumers they have to cut costs and take all measures to improve productivity, which we are already observing.

I think there is a very little danger of financial system to fall into hyper-inflation – it’s just too late for that. Hyper-inflation had to happen back in 2005, now money supply is very constrained. So the good news #1 is that there is no hyper-inflation in sight.

Second, it seems that we will fall into recession well before we fall into deflation, that’s good news #2. It’s very positive to inflate a little big that popping housing bubble, that will make the nominal price declines less horrible. Inflation is bad for new borrowers, old borrowers feel better. While the credit crunch is restraining the issuance of new debt anyway the existing debt will be easier to pay off. When the recession finally comes (very soon) new debt won’t be an issue anyway.

Third, Federal reserve finally got a very good excuse to not lower interest rates. The recent very tight Fed policy hints me that Bernanke actually want the economy to fall into recession as soon as possible. The reason for that is that the spike of productivity that usually comes with recession will be one more bullet to fire into coming deflation. High productivity always give Federal reserve more space for rate cuts and it will need those rate cuts later on. That’s good news #3.

In short, the most optimistic scenario is that we will have the recession very soon, hopefully by February. That will help to finally start the necessary wave of corporate bankruptcies and increase productivity. The stock market and economy will be hit fast and bad, but without falling into deflationary depression. Then we’ll have a quick recovery, maybe a year or two and then we will finally fall into deflation, but the preceding recession will hopefully cut most of inefficiency away from the economy and the second, deflationary recession will not produce a depression. It will be bad, but not as bad as USA in 1930s or Japan in 1990s.

You see, I’m optimist, I’m not your typical “doom and gloom” bear 🙂

Ian A. Gordon wrote in this article:

My deceased friend, Teddy
Butler-Henderson, met Alan
Greenspan in the 1960’s. They
apparently discussed the
Kondratieff Cycle. According to
Teddy, Alan Greenspan confided
that he hoped he could
be Federal Reserve Chairman
at the onset of a Kondratieff
winter, because he felt he
could defeat winter by substantially
increasing the money
supply and reducing interest
rates to near zero. He had his
wish and effected those actions
following the 2000 stock
market peak.

I think it’s a very shocking statement. So the (likely) coming deflationary shock was fully expected by Alan Greenspan 40 years ago and he effectively spent his whole life preparing to battle with deflation. The problem is, of course, that one cannot jump over any phase of the Kondratieff wave. One can only postpone a phase and thus make it more powerful when it finally comes.

No wonder now we have the most notorious scholar of the Great Depression, Ben Bernanke, as the Fed chairman – because the Depression is what he will have to deal with

Incidentally, Mr. Greenspan
told Teddy during that same
conversation that if he failed to
thwart the Kondratieff winter, it
would make what followed
1929 look like a ‘Sunday
school picnic.’

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