Complacency and Panic   (October 10, 2008)

This was written before the market fell sharply on 10/9/08; now fear is finally becoming visible.

Judging by the mainstream financial media, the world has had little to fear.

Even the skeptics and Bears are seeing a bottom and hence a tradable rally.

Where everyone else seems to see a consensus of panic and hence a bottom, I see massive, widespread near-universal complacency, which means the bottom is nowhere in sight. The only panic I see is in our fearless leaders Paulson and Bernanke, which also doesn't bode well for the future,

Longtime correspondent Cheryl A. posed several questions which are shared by many inquiring minds:

I read with horror Karl Denninger's post for 10/9/08. The possibility of S&P at 150 and oil at $20. Do you think this is a little too severe?

Conversely, I thought Mish's position was surprising -- I assume he is expecting a significant rally:

"Risk reward is no longer on the short side even if longer term fundamental issues to the downside are not finished. This is a good place to be lightening up on shorts, taking profits on PUTs, and heading for the sidelines for further directional clues"

Meanwhile, Jesse posted that "The Treasury is going to devalue the US dollar by 30 to 40 percent, or more, from here." jesse's crossroads cafe.

Before I attempt a response: it seems 90% of commentators, pundits and even chartists are expecting a rally. I am hard pressed to find anyone who doesn't think it's about time for a major (i.e. more than a few hours or days) rally (OK, Bill Fleckenstein: Danger: The wipeout is still ahead ).

Here is a typical one: a bearish perspective but bullish on the market:

It's a great time to be afraid by Jon Markham:

There's an opportunity now for a 300-point move higher in the S&P 500 as world central banks finally coordinate on huge interest rate cuts and smart traders with cash switch to the fear of missing such a major bear-market rally.
The market rarely rewards 90% of the players. Ironically, most of those forecasting a rally claim to be contrarians because sentiment is so negative; yet by being in the majority, they cannot be contrarian.

This is one result of charts and information being readily available to all of us, all the time. Indicators like Bollinger bands, MACD and investor sentiment used to be confidential information jealously guarded by investment banks and brokers; non-institutional technical analysts had to plot charts by hand.

Now that everyone has all these indicators 24/7, then exactly how accurate is "negative sentiment"? If everyone knows the same data, and uses it to forecast a rally, then how is that "contrarian"? And how can indicators which everyone knows be accurate if everyone is using the same ones to plan their trades?

A bottom is rarely reached when everyone is anticipating it, forecasting it and expecting it. When everyone is going the same way--today, that's the "contrarian" expectation for a rally--the market usually rewards that consensus with staggering losses.

As Jesse Livermore (the legendary trader) noted, a Bull market takes along the fewest possible participants.

We don't have panic, we have complacency--deep, complete, total complacency. For example, here is the Wall Street Journal: We're Not Headed for a Depression.

And from the WSJ's Marketbeat:

Barry Ritholtz of Fusion IQ hits upon a new blog, simply called “Sad Guys on Trading Floors,” which doesn’t seem to have any purpose other than to highlight photos of, well, morose-looking traders. “For our purposes, its a yet another in a list of contrary indicators that suggests things are getting overdone, and that sentiment is moving towards an extreme,” Mr. Ritholtz writes on his blog.
As Dire as the Times May Seem, History Isn't About to Repeat Itself (WSJ):

Today, our mortgage mess looks like a disaster, too, but at least banks made loans against houses, assets that should continue to have at least some value. In the second quarter of this year, according to the Mortgage Bankers Association, 6.4% of mortgages were at least one payment behind and 2.75% were in foreclosure -- modern-day records, to be sure, but not depression levels. The long-term impact remains to be seen, but the acknowledgment and quick action by the Federal Reserve and Congress truly set this crisis apart from 1929.

Beaten by one negative story after another, we have become numb to stories like this one about housing:

Housing Pain Gauge: Nearly 1 in 6 Owners 'Under Water' (WSJ)

Housing markets don't tend to turn around quickly. The price slump in California in the early 1990s, for instance, was a long grind. According to the S&P/Case-Shiller home-price indexes, Los Angeles prices peaked in June 1990 and didn't bottom until March 1996. They didn't get back to their 1990 peak until 2000.

Stories like this now seem tediously repetitive; we are numb to bad news about derivatives, banks, LIBOR, housing, the yen carry trade and indeed everything else.

Weapons of Financial Mass Destruction: (thanks to U. Doran for the link)

According to the Mortgage Bankers Association, 40% of sub-prime adjustable-rate mortgages are in foreclosure or had late payments, for prime adjustable-rate home loans the rate was 12% and for mortgages of all types it was 9.2% in the second quarter.

Japanese investors increased their exposure to overseas assets by 59-trillion yen ($566 billion) last year, to a record 610-trillion yen ($5.9 trillion), making Japan the world’s largest creditor nation for the 17th straight year. In addition, global speculators borrowed $1.2 trillion worth of Japanese yen, in order to buy higher yielding currencies, commodities, and stocks held abroad.

Because of historically high oil prices, Persian Gulf sovereign wealth funds belonging to Kuwait, Qatar, Saudi Arabia and the United Arab Emirates, amassed $1.5 trillion at the end of last year. Yet that’s only one-fourth the size of assets held overseas by Japanese investors, making the “yen carry” trade one of the most feared weapons of mass destruction in global currency, commodity and stock markets.

Amidst a sea of numb indifference and complacency, the only desperation I see is in Treasury Secretary Paulson and Federal Reserve Chairman Bernanke:

Paulson Says U.S. to Use All `Authorities' in Crisis:

Treasury Secretary Henry Paulson said he's considering plans to pump capital into U.S. financial institutions and pledged to use everything under his power to stem the worst credit crisis since the Great Depression.
If that isn't desperation, what is? First Paulson begs for everyone to give the "fixes" time, and then he chambers his final "magic bullet" and pulls the trigger: outright ownership of banks, i.e. nationalizing the banks in everything but name.

Paulson and Bernanke call to mind two greenhorns who encounter a big hungry grizzly bear in a remote wilderness. In their initial panic, they pump a few rounds of .22 into the animal, but that just annoys it.

Seeing their first efforts fail, they then toss a few spears at the irritated bear. This further arouses the beast, so then they try macing it.

The bear is really starting not to appreciate their efforts to drive him/her away, so they start throwing rocks at it. This succeeds in totally pissing the bear off, and as they empty their magazines into the approaching bear, they keep pulling their weapons' triggers but all they're getting for their panicky exertions is futile clicking.

Out of ammo, out of rocks, out of mace, out of spears, they've got nothing left but threats and assurances, so they shout at the bear, "We're gonna use everything in our power to stop you!"

Do you reckon the bear will stop, turn around and slink off, defeated by those desperate words of surrender?

Nothing has changed because they've simply given the debt junkie one fix after another and done nothing to resolve the underlying causes of the meltdown: opacity or leverage. Their interventions will ultimately fail. They've used up all their weapons: loaning corporations money directly, promising to pour fresh capital (i.e. Treasuries) into insolvent banks, etc. etc. Now that they've cut interest rates and promised to pour money down the ratholes known as banks, and they don't even have any rocks left.

They are now reduced to praying for a "magic bullet" to appear out of nowhere, or for a Star Trek transporter to whisk them away to a happier place.

Meanwhile, back in reality, Wells Fargo's 30 year fixed mortgage is now 9.429% (Thanks to Patrick of for this link.)

NOTE: Dana T., who is in the mortgage business, alerted me that this is a Jumbo loan rate; the conventional mortgage rate is 6.25%, still low by historical standards. Dana wrote: "6.25% is still very affordable money and I and many others are funding loans everyday." Thank you, Dana, for the clarification.

Given that stocks are supposed to reflect profits, what companies are poised to reap hefty, sustained profits next year? Certainly not homebuilders--based on future profits, they are already worth zero, though the market is pricing TOL (Toll Brothers, luxury homebuilder) as being worth $3.16 billion, even as its cash is $1.5 billion and its debts are $2.26 billion.(Source: Yahoo Finance.)

As of October 31, 2007, the company operated 368 communities containing approximately 27,900 home sites that it owned or controlled through options. It also owned or controlled through options approximately 31,400 home sites in 239 proposed communities.
How much are building lots and options on lots worth when there is a stupendous inventory of existing homes on the market? How about near-zero? The effective value of this company is effectively zero yet its shares are priced at $20. This is a rational market? I beg to differ.

(Disclosure: I sold my put options on TOL yesterday for a 104% profit. I have no position in TOL.)

If sales keep dropping and profits are expected in some distant future, what will prop up a rally in homebuilders and lenders? Nothing except the Pavlovian expectation that a rally is due.

To answer Cheryl's questions:

Over the next few years I see (as I've said) the DJIA as trading between 2700-3000. Oil could briefly fall to $50 in the "head-fake" I've predicted but there isn't enough supply to enable a drop to $20 IMO. The contraction of credit will devastate the global economy and so why own stocks? That's a big question, and the same can be asked of real estate. Any investment worthy of the name must generate cash flow and profits in a deep Depression. Alternatively, it must retain its equivalent purchasing power i.e. either match or exceed the value of gold.

If PEs (price-earnings ratios) contract to 7 or 8 as they tend to do in Bear markets, that suggests trhat companies churning out $1 in net profit will be worth $7 - $8 per share maximum.

For example: if by some miracle Apple continues netting $5/share in profits in a global recession, then at Bear market valuations it would be worth about $35-$40 per share, compared to its current valuation of $92/share. If its profit slipped in half to $2.50/share, then its fair market value would be about $17/share.

If profits contract then so will valuations. Where the bottom will be no one knows. But as I have illustrated with charts in recent weeks (courtesy of Harun), a round-trip to 850 on the DJIA is certainly possible.

The fantasy that everything will soon return to normal is so powerful even smart people are being seduced by the dream that the bumbling tag-team of Bernanke and Paulson's endless bailouts, injections and cheerleading will soon make everything right again. It's what we want to believe, even if we sense it is a con.

A bottom is in when everyone who bought in previous "bottoms" gets wiped out and vows never to try catching a falling knife again. A bottom is when everyone with any brains avoids stocks like the plague because they've lost most of their money trying to play previous bottoms. Or a bottom catches everyone off guard, like a 2000 point decline in the DJIA followed by a second day of 2000 points down, something which "everyone" considers "impossible." I certainly don't think it impossible; that's just called "snapback."

Am I saying there won't be a rally? No, I expect one now because it is a self-fulfilling mechanism.

Let's say I have enough money to move the markets, even briefly, via buying futures or even shares of select bellweather companies. Now I read that everybody and their brother and sister is looking at DJIA 9,000 and SPX 960 as "lines in the sand." If I want to spark a sell-off, I need to engineer a brief downleg which triggers all the quants' "black box" (computerized) selling and traders' stops.

If I want to engineer a rally, I step in and buy every time the market threatens to dip below those levels of support. Then one day I start bidding way above the ask, popping the averages well off these support levels. That triggers buying by the black boxes and then traders jump in, fearful of missing a huge rally.

Since everyone is watching the same lines in the sand, this sort of manipulation is very straightforward. Spook the herd to run one way, or send in a few dogs to herd it the other way.

I close with a comment by Harun I.:

For ever buyer there must be a seller, which means there must be a balance of competing opinions. All the bottom-callers can start buying if that is the way they operate. As long as they control risk they are no more right or wrong than anyone else. It is when we let our opinions divorce us from reality is when we get in trouble.

King Canutes are everywhere. The tide comes in and goes out because it has to. The expansion and now contraction occurred and is occurring because they had to. Bernanke and Paulson and the central banks of the world can stand at the shore and will drown as the tsunami of bad debt rushes over them.

Financial Market Imitate Nature, the headlines should read. Hundreds of trillions of dollars have collapsed into something the size of a penny in less than the blink of an eye, forming a black hole. For all the fiat financial matter being created at the speed of light by central banks the world over, there is no escape from its event horizon.

"This guy is THE leading visionary on reality. He routinely discusses things which no one else has talked about, yet, turn out to be quite relevant months later."
--An anonymous comment about CHS posted on another blog.

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