Monday, October 30, 2006

Behind Dow 12,000, an economy at risk / fleckenstein

Don't let the soaring Dow industrials fool you. Sober experts' predictions include big trouble ahead for the stock market and the housing market, and possibly a recession.

These days, it's hard for any sober thoughts regarding risk, the stock market or the housing market to be heard over the din of "Dow 12,000." In that vein, I'd like to share a few views that I find interesting.

Mamis: His rapier wit finds its mark
Longtime market observer Justin Mamis this week opined: "It's clear that the (stock) market is tired, and there's a possibility that this is sufficiently 'it.' ....."

Next, Mamis mused on a remarkable phenomenon that occurs in the dead-fish/corporate community: "Isn't it peculiar that the consensus misses are so lopsidedly 'under'? Good thing we don't understand what fundamental analysts do at their desks, or else we might suspect that the analysts and the companies are in cahoots to underestimate so they can report 'better than expected' results. After all, 71% is too high a percentage not to be suspicious of something."

Continuing on, he took aim at Bubblevision: "These gripes suggest that anyone who watches such matters unfold on CNBC has a less than even money chance of learning something useful. Indeed, we'd say the odds are 2 to 1 against. And, if one watches with the sound on, the chance of being uselessly informed about some company or other (and/or the short-term market direction) would be more like 4 to 1. And, if we counted being 'late' as also being 'useless,' make that 10 to 1." (good one!)

.....Rubin on risk,
the uninvited guest In a more serious vein, I'd like to quote further from Citigroup's interview with former Treasury Secretary Robert Rubin. I'll begin with his assessment of risk:

"Sandy Weill (the former Citigroup chairman) made a good comment to me. Nobody's going to ring a bell to tell you, but someday you may wake up and find out that these risks have materialized."

Rubin observed that many people seem to think the risks that do exist won't matter in the short run. Therefore, they're fully invested -- "because that's not their time horizon in calculating an expected value. … Also, some assume that they can get off before the music stops. You know, not everybody is going to get off before the music stops."

Selective vision earns derision
Continuing on, Rubin made an important point about the macro/stock-market environment: "I think there's been a curious phenomenon in the equity markets, at least in the last few months: When there is news that the U.S. economy is slowing, the market often gets stronger because investors figure the Fed will stop raising rates, or maybe lower rates -- or maybe they think bond yields will decline. For some reason, they don't seem to say to themselves that earnings may be lower. I think it's very strange."

Next, he shared his views on the dollar: "You have to figure out some way -- which I have not done, I might add -- to protect yourself should we have a real currency problem here. (He makes a number of points about why that could occur.) I'm not saying what the odds are. I have no idea. Maybe the odds are very low. But that is one concern."

Levy: When subprime's time is up
Now for one man's view of the post-housing-bubble era, as described by David Levy of the Jerome Levy Forecasting Center. ....

Levy said: "Eventually, lenders are going to be forced to tighten standards, which will only intensify problems in the housing market, increase the drag on consumer spending, and worsen household debt loads. That, I'm afraid, will amount to a vicious cycle, leading to a recession and prolonged credit crunch."

When financial dark matter finally matters
"The other issue is the fact that the concept of distributing risk, more broadly -- the idea that financial innovation protects us from risk -- is only partly true. And, in one sense, is exactly wrong. It is true that derivatives increase the tolerance for problems, much in the same way that when you link together several mountain climbers on the mountain, you reduce the risk that one will fall to his doom.

"However, the overall risk increases because of this sense of security. Eventually, you get to the point where, in essence, the mountain climbers have climbed higher and higher onto more and more slippery slopes. So, you have more than one or two fall together, dragging the entire party down." Yes, I think that financial dark matter has been the glue that's held together the housing market and the economy.

As for folks' belief that there aren't any problems, and what may come next, Levy made another fine point: "It's just human nature to believe more strongly in a trend the longer it continues. So, what happens when an unsustainable trend continues is that people find more and more reasons to believe that it's not unsustainable."

Ladies and gentlemen, that description encapsulates not just the stock market but also folks' wrongheaded conclusions about the housing market: that the decline is behind us and we're on course to better times.

Of prudence and pain avoidance
I don't see how anyone with a modest amount of intelligence or knowledge of history can conclude that this is not one of the more dangerous times our economy has seen. It's my belief that these comments from Rubin and Levy, among others that I could share, offer serious food for thought -- which folks ignore at their peril.


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