Investors are Getting Ready for 2007… the Odds Favour the Contrarian

The Dow hit a new record yesterday. With only two days left to go in the year, traders and investors are getting ready for 2007...adding the shares they want to own...snorting with confidence...chaffing at the bit to begin another run around the track.

The IMF says investors are 'too complacent.' We agree. That's why we have issued our Crash Warning. Not that we know something is going to go wrong soon...it's just that if something were to go wrong, a lot of people would be greatly inconvenienced. The are so many optimists...betting so heavily that things will continue as they have been...that the odds favor the contrarian, the naysayer, the pessismist, the crank doom and gloomer.

The typical investor owns stocks that are too expensive...compared to the dividend yield he receives. And the typical householder owes too much money to too many people - especially the people who've lent him money on his house. His house, too, is over-priced for what it is; if he had to rent it out, he'd never get enough money to cover his costs and give him a fair return on his capital.

But the news dribbles in day by day...and so far, the news is not bad. New house sales are greater than expected, according to the most recent report. So, investors and economists are beginning to think - as Alan Greenspan has proclaimed - that the worst of the housing slump is behind us.

'The worst is behind us' is a remarkably upbeat assessment. We turn our heads and we don't see anything bad back there. Stocks have been hitting new highs...consumers are still spending...and even house prices are, officially, holding at their highs or even creeping up a little. If that's the worst there is - well, bring it on!

Oops...there, we've said it, haven't we? Like George W. Bush, we've tempted the gods. Now, they will want to teach us a lesson; that there are some times when you don't 'muddle through.' Most of the time, trends in motion tend to stay in motion. But not all the time. Sometimes, they stop and a new, different trend begins. That is when the gods 'bring it on' and give it to us good and hard. And that is when you discover that all those things that you thought were so smart, were too clever by half.

Who are the smartest people around today? Derivatives traders and hedge fund managers, of course. They're the ones earning millions of dollars each year. They are building huge houses in the Hamptons and bidding up prices of Picassos. What do they do to earn so much money? What do they produce? What do they make that so improves others' lives that they deserve to get filthy rich? Don't bother to ask, dear reader. You won't get a clear answer. Instead, you will be told that they 'allocate capital' or 'arbitrage discrepancies' in the modern capitalist system. What they are really doing, of course, is the same thing that people do in Las Vegas - they are gambling.

And as long as the pot is getting bigger...they will probably do all right.

John Succo, a hedge fund manager, addressed a letter to the New York Times, explaining:

"The Federal Reserve creates credit through its open market operations like REPOS and coupon passes. If the Fed wants to inject liquidity (credit) into the system, they simply call up large broker dealers and buy some of their bonds with credit they create out of thin air (this expands their balance sheet). The dealer then passes this credit on to "the market" by making loans to mortgage companies or margin accounts or whatever. Because each layer of lender is only required to keep marginal capital on hand, a $1 billion REPO done by the Fed eventually creates as much as $100 billion in new credit to the consumer.

"That credit creates the liquidity for additional consumption in the U.S., but these days we are buying our stuff from China (other countries too but we will just say China to make it easy). When a Chinese company receives dollars in trade, this normally would drive up U.S. interest rates: the company goes to the central bank of China to exchange Yuan for dollars; the central bank of China would normally sell those dollars into the currency market for Yuan thus driving up U.S. interest rates. But in our world of today these dollars are being sterilized: the central bank of China prints the Yuan to give to the company and takes the dollars and buys U.S. securities.

"It is not the excess savings of Chinese investors that are buying U.S. securities. It is central banks creating credit themselves to buy those securities. The tick data that measure foreign inflows of money does not distinguish between private investors and central banks going through brokers to buy U.S. securities. We believe that as much as 90% of foreign money buying U.S. securities (not just Treasury bonds, but corporate bonds, mortgages, and yes, stocks) is not private investment, but central banks.

"In order for other central banks like China's to print the Yuan necessary, they too must create credit. Public debt in Asian countries is expanding as a result and creating worries: this is why Thailand came out essentially raising margin requirements to reduce speculation that is occurring as a result. Notice how they were quickly slapped down by their trading partners who do not want to rock the boat at this time.

"This situation is very unstable in the long run. The Federal Reserves' balance sheet this year alone has expanded by $30 billion in this way and created $3.5 trillion of new credit in the U.S. Public debt around the world is growing exponentially and total debt in the U.S. now stands at nearly 3.6 times GDP (1929 was 2.8 times).

"My hedge fund's position is the opposite of the carry trade you mention. There is coming (timing is unclear where it may be tomorrow or may be years away) a massive correction in debt and derivatives whose magnitude is only growing with time."

It could be tomorrow. It could be years away. But it will be eventually. And the more complacent people are, the more they will suffer when it does come. But we will have more specific guesses for the New Year soon...

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