The Root of All Financial Evil

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Around noon yesterday here at the Old Hat Factory, a little daemon whispered in your editor’s ear, “The bottom is in for the year of the ASX.”

“Huh?” We looked around to try and spot the little green devil. He’s been in our ear before. But he was nowhere to be found. We could still hear his voice.

“Think about you fool. It is now safe to be dogmatically bearish on the front page of the newspapers. The hedge funds have been forced to liquidate. The mob followed on the fund industry’s heels, sold everything, and headed for the hills. The hills are full! Can’t you see what this means?”

“No.”

“The selling has exhausted itself for the year you moron! Roubini recommends a $400 million stimulus package. It’s a sign. The liquidation of the long commodities/short dollar and yen trades has got to be nearly over. The moves in the currency markets have been massive. It can’t go on. And if it does…well if it does then this is the second Great Depression and you’ll have other things to worry about.”

But what if you’re wrong?

“Then I’m wrong. If you’re going to be in the equity markets at all for the next year, you should own the world’s best businesses. You’re not going to see them this cheap again for awhile. If you don’t want to own theses businesses, why bother being in the market at all?”

God may not whisper in everyone’s ear. But we find daemons more than willing to have a chat, usually when our judgement is most in doubt. Still, we couldn’t help following through the thoughts of our little green devil to their logical conclusion. And in his own way, he makes perfect sense.

Bob Prechter and the Elliott Wave theorists (if we’re not mistaken) believe that ‘social mood’ is what determines the direction of the stock market. And the market then leads the economy. But what leads the social mood?

Well, that’s a tough one. At the Border’s on Chapel Street this weekend, we noticed that Bill Bonner and Lila Rajiva’s book, Mobs, Messiahs, and Markets had moved up to number seven on the hardback best seller list. People are trying to understand why investors act like a flock of birds or a school of fish, all seeming to move in the same direction at once, without cause or explanation.

People are wacky. The great mistake of market analysts (and most socialists) is to assume that people are rational and make economic decisions after calm, rational calculation. This is a figment of the rational imagination.

People often take leave of their senses. And these days, it’s hard to say just why some people are selling and no one is buying. As we’ve said here, we think it’s the massive unwinding in leverage that’s forcing stocks to be sold. There are simply not enough buyers to sop up all the selling (at least not until last night in New York, when some of that cash got back in the game).

It doesn’t help that you have a slowing global economy and a credit crunch. When you combine all that, the social mood turns decidedly sour. The beer goes flat. The smoke, rather than being a pleasant cloud in the lungs and making everyone look sophisticated and cool, just burns the eyes.

What our little daemon told us yesterday, we think, is that the social mood couldn’t possibly get any more sour. “Consumer confidence drops to record low,” reports Bloomberg this morning. There was dust and tumbleweeds blowing through the markets this week. It was fast becoming a barren wasteland.

But yesterday in New York, the first intrepid investors popped their head out from above their fallout shelters. Squinting in the sun, they found that perfectly healthy world-class businesses were lying around in the street for the taking. They were taken. The Dow was up double digits.

Don’t get us wrong. This still feels like the beginning of the 50% rally the Dow experienced in late 1929 and early 1930. But a man can take only so much depression in one quarter.

It is not hard to see a simultaneous round of global interest rate cuts, a massive stimulus package in the U.S., and the election of Obama in the States (did somebody say Messiahs?) as just the things to turn the social mood around. And that’s what makes for a rally.

An improvement in the social mood won’t do much to improve the structural causes of the mess we’re in. FedEx CEO Fred Smith was recently interviewed in the Wall Street Journal. He made some fantastic points about why we are where we are…and how to get out of it.

“Things became so flipped upside down,” in the financial economy. “The assets at these banks became the liabilities and the liabilities became the assets. These people were making these fantastic returns at places like Fannie Mae and Freddie Mac but in reality they weren’t adding a lot of value. I have said time and again that there is a fundamental tendency in good times in the financial sector to over-leverage. Our national policies actively encouraged all this debt.”

Smith points out that Anglo-Saxon capitalism favours speculation over actual capital accumulation and production. It does this through a tax policy and monetary policy. The corporate tax rate in the U.S. is 38%, compared to 25% in Germany. When you throw in loose monetary policy-money available at cheap rates to borrow and speculate with-you see how a company like GE went from being a company that made things to a company that made loans.

If the regulators failed to restrict the amount of leveraging possible in the financial system, then corporate boards and CEOs equally failed. They took the easy way up, banking quick financial profits with borrowed money. They did not realise-or more likely ignored the fact-that leveraging financial returns with borrowed money is not a long-term business strategy. Leverage is the root of all our cotemporary financial evil.

The last two months have seen the collapse of leverage and the deflating of the credit bubble as money drains from the global financial system (faster than the Feds can pump it back in). The hedge funds are delivering. The banks, despite infusions of new capital, probably still have too much leverage. What’s Paulson going to do about that? Hmmn.

In the meantime, you can be sure that there will be more corporate dirty laundry aired in the coming months. Unwinding that bank leverage may involve more selling of assets, perhaps to the government at an artificially high price (or to sovereign wealth funds and private equity if market prices prevail). The credit crisis, though improved, is not entirely over. More bad debts from mortgages loom on the horizon. And Europe faces trouble from emerging market debt.

But for now, the social mood seems to have lightened. How long will it last? We’ll ask our green devil if he shows up again. We’ll see if we can get him to tell us what he’s buying, between drinks of champagne.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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2 Comments on "The Root of All Financial Evil"

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Roger Beck
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You say the hedge funds are delivering. I am a confused by this statement. What are they delivering and how are they doing ‘it’?
I think you are saying that they are draining the financial system as opposed to the feds pumping but I don’t understand the mechanism.

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