Thursday, March 3, 2011

Big Picture Outlook: Waves

I have stated over the years that the big picture economic crisis would come in multiple waves.

The first wave was the credit growth and bubble of the real estate markets around the world.  The bubble burst in the United States in 2007, bringing down our financial system and taking the rest of the world down with it.  This is due to the interconnected nature of financial markets around the world.

The second wave was the policy response from both governments and central banks to the crisis.  The steps taken to prevent re-structuring and postponing the true pain were remarkable:

1.  The federal reserve backstopped $22.5 trillion within the market.  They printed and purchased $1.25 trillion of mortgage bonds and $300 billion of treasury bonds in 2009. (QE1)  They are currently completing QE2; they will print and purchase $900 billion in additional treasury bonds through June 2011.

2. The federal government responded with massive stimulus policies and social safety nets.  Unemployment insurance was increased to 99 weeks.  Food stamps, social security, medicare, medicaid, and government insured mortgages (which now account for 95% of new loans) all put a safety net under our society.

Similar responses were seen around the world, where leaders decided to back their banks and create stimulus programs with tax payer money. (debt)

These measure have created a period of artificial prosperity where the free money and government spending have been injected like a dose of heroin into the economy.  Everyone is on a high, which can be seen by the sentiment levels in markets across the board that today clock in more positive than the all time highs seen back in 2007, just before the collapse.

The stock market is an obvious case, where dividend payments now average 1.5%.  Cash levels are back at historical lows at mutual fund companies (they are all invested in stocks) and leverage is back up to 2007 pre-crisis levels.  This means investors such as hedge funds are so confident the markets are going higher, that they are borrowing money to buy stocks.  This scenario created the cascading effect seen during the collapse in 2008.

The same can be seen in the real estate markets.  I read this week that "trophy" apartment communities in my Charlotte home town now have bidding wars.  Investors are paying lower cap rates (sub 5%) than they paid at the peak of the real estate bubble.  Another article I read said that Real Estate Investment Trusts (REITs) have so much capital pouring in that they are forced to enter these bidding wars.

The third wave of the crisis has just begun.  It is where governments around the world who backstopped the banks and poured money into the economy with the use of debt, now face their own debt crisis.

The warning shot was in Dubai during late 2009.  Then it moved to Greece and Ireland in 2010, and has found its way into the heart of Portugal and Spain as we move into 2011.  This process will start slow and then build speed as we move along, exactly as the real estate crisis did during 2006-2008.

The important question is:  What happens to markets during this next wave?

I believe that we will see one more deflationary scare with markets selling off across the board.  It is tough to pinpoint what will spark this next leg down but there are three catalysts I am tracking closely:

1.  The Irish people voted out the government that agreed to their bailout last week.  If the new government has the testicular fortitude to re-negotiate terms and ask banks to shoulder some of the losses, it will create a "Lehman Brothers" type domino effect within the financial markets.

2.  If Ireland cannot stomach the ability to renegotiate then eyes will move toward Portugal and Spain.  If a bail out cannot be created for either country (Spain is massive) then a similar Lehman type event will occur.

3. The Chinese property bubble in their coastal cities has now grown into dangerous territory.  Just as the Federal Reserve began raising rates in 2004-2006 to calm speculation in American real estate, the Chinese central banks have been raising rates relentlessly for about 9 months.  Chinese real estate increased at the slowest pace in 6 months this past month, and is close to the point of turning negative.

Countries such as Australia, Canada, and Brazil count on exports to China which has been driven in large part to this property bubble.  Over 25% of the Chinese economy is based on construction.  If it were to slow, then commodity and emerging market stock prices could be severely impacted.

The next wave down will subsequently bring the next round of government stimulus and central bank intervention.

This is why I believe that while certain assets will be impacted in the short term, it will provide a tremendous buying opportunity for investors that understand the big picture and final outcome of this wave structured environment.

This is the time to both determine which assets are in long term secular bull markets, and build a large amount of safe cash to have as ammo when these buying opportunities appear.

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