Twelve Unusual Items Affecting the Markets Now

1) The TED [Treasury-Eurodollar] spread, which is a measure of market confidence, is up dramatically over the past two months, from 18 basis points to 52 at present. That indicates decreased confidence in the banking system, though swap spreads have not widened to confirm that judgment.

2) The Indian Rupee has rallied almost 10% against the dollar over the past two months, because of the need to recycle the US current account deficit, and restrain inflation at home, tighter monetary policy is needed in India, and many other developing nations. That means upward pressure on their local currencies, which will hurt their exporters. India is letting that process happen at present, other developing countries are allowing dollar liquidity to further inflate their economies.

My view is that the next major blow-up will happen as a result of a neophyte developing large country central bank overshooting on their tightening of monetary policy. China is my lead candidate, but India could do it as well.

3) Ordinarily I like what Jack Ciesielski has to say. He is far beyond me in terms of understanding the nuances of accounting standards, and I recommend his work to all professionals. I think his recent Barron’s article misses a nuance of SFAS 159, though. If SFAS 159 were mandatory, Fannie and Freddie might have some difficulties. But SFAS 159 can be ignored by any company that wants to ignore it, and used to the degree that any company wants to use it, so long as they disclose where they are using it and where they aren’t using it. So, I’m not sure the SFAS 159 has much relevance to Fannie and Freddie over the short run. Over the long run, it might be different if SFAS 159 becomes mandatory, or if the US adopts International Financial Reporting Standards.

4) I have posted at RealMoney on numerous occasions regarding overvaluation of many risky asset classes versus safe asset classes. I appreciated the piece at regarding Jeremy Grantham, and the piece over at The Big Picture discussing it. I think he is right, but early. We haven’t run out of liquidity yet, and perhaps we get an exponential rise in risky assets that signifies the end. On the other hand, tightening global central banks in aggregate could be the end. For the cycle to change, we need a fall in profit margins, and a rise in discount rates. I think both are on the way, but they don’t come like clockwork.

As an aside, if managed timber is still cheap to Mr. Grantham, that could be a good place to hide. Decent return, and some inflation protection.

5) Dig this article from Businessweek. Know what it reminds me of? Manufactured housing back in 2000-2003. Lenders bent over backwards to keep loans current, at a price of future credit quality, and only gave up when their companies were facing death. Most died; a couple survived and much of the remaining corpus is part of Berky now.

The banks will keep marginal lending alive until it becomes a serious threat to their well-being; after that they will act to protect the banks. The severity of loan defaults thereafter will be very high.

6) How much international goodwill has the US lost through unilateralism? Part of that cost is measured by the fall in the dollar. The current account deficit presumes on the good graces of the rest of the world, but at the edges, if our policies aren’t well-liked, the deficit will get cleared at lower exchange rates for the dollar. Just another reason that I am long foreign currencies.

7) Central bank tightenings? Look at Japan and China. I have a little more belief that China will continue to tighten; they have been doing so for the last year. The acid test is how much they are willing to let their currency appreciate, and I think China will let that happen.

I am more skeptical about Japan. Their central bank is not very independent, and regardless of the article I cited, there isn’t a lot of reason for the Bank of Japan to act rapidly. Central Banks are political creatures that avoid pain; they are not entrepreneurs, particularly not in Japan.

8) What’s better in accounting, rules or principles? The current mood in accounting leads toward principles. The idea is that principles allow for a more accurate description of the corporate economics than the application of rules that though consistent, may not fit all companies well.

I split the difference on this issue. We need rules and principles. Rules for consistency and comparability, and principles for accuracy to individual situations. That is why I would have two income statements and two balance sheets. One off of amortized cost that would be consistent and comparable across all firms, and one off of fair market value, that would give management’s view of the economics of their firm.

9) I had been critical of the FOMC over at RealMoney because they had not been injecting enough reserves into the banking system in order to keep the Fed funds rate at 5.25%. Over the last week they have amended their ways. They have bought bonds and sold cash, and now Fed funds resides more comfortably near 5.25%. (I would post a link, but as I write the Fed website is not responding.

10) A harbinger of things to come: Fitch downgrades some 2006 subprime deals.

11) The Wall Street Journal was “dead on” this morning about talking about the degree of leverage being applied to the markets. I’ve been writing about this at RealMoney for some time, and I would advise everyone to look closely at their asset portfolios, and ask what assets would be at the most risk if financing were interrupted. For equity investors, I would encourage you to be long stocks with high ROAs, not high ROEs.

Do derivatives make a mockery of margin requirements? You bet they do, and we can start with furures and options, before moving on to private agreements.

12) Leave it to Caroline Baum to catch the mood of the government, and apologists for the current economy. Ex-housing, we are doing fine. Another way to say it is housing is doing lousy, and export-oriented sectors have not made up the difference.


That’s what I am seeing now. Are you seeing thing I am missing, or do you disagree with what I have said? Post here, and let’s discuss it.


  • Excellent round up, Dave!

    Very nicely done

  • Thank you, Barry. I value your insight and commentary.

  • AllanF says:

    While I can’t offer the cachet of Barry Ritholtz, I will nonetheless express thanks for an excellent post and moreso an excellent blog. It is appreciated.

  • Thank you, Allan. I appreciate all of my readers, especially those who comment.

  • amccabe says:

    About #11 – I’ve been looking at industries where the replacement cost of physical assets with long expected service times has increased a lot and stands a good chance of increasing in the future, and then looking for established mid to large companies with fairly low debt within them. Steel, shipping, drilling, and mining came up a lot. I just worry that they would see demand drop badly if there were widerspread liquidity issues, though.

  • AllanF says:

    I just wanted to make sure you weren’t getting discouraged over a lack of comments. IMO reading blog comments is like panning for gold. There’s usually a nugget in there somewhere, but it’s long, cold work. :-)

    Regarding the economy and housing in particular, to my mind as soon as employment breaks, its all over but the recriminations. Now, as to the straw that breaks the camel’s back and the ultimate timing of it, I don’t know. You seem to be suggesting watch the liquidity? How would you suggest a lay-person watch that.

    Also, it seems to me the combination of residential RE building and mortgage equity withdrawal to GDP for the past 3 years was substantial and now it’s not going to be there in 2007. Unless that premis is wrong, a recession should be a foregone conclusion.

    I just don’t see what could keep things going up (really loose money and inflation be damned?). Now seems a very perilous time to be long equities.

  • AllanF says:

    “straw that breaks the camel’s back and the ultimate timing of it, I don’t know.”

    Just read Jeremy Grantham piece and corresponding Big Picture link. If I read it right, Grantham is saying the timing is impossible to predict. So, I guess I am in good company. :-)

    Nonetheless, David (or anyone) if you want to add something along these lines I’m interested in reading it.

  • Paul in Kansas City says:

    It does appear that consumer withdrawals from home equity are ending; where I live you see tons of older homes for sale and I see some unfinished houses bought buy flippers; I’m seeing repo buys in our lake subdivision. The suburb of Kansas City I live in has tons of new homes for sales and I think builders are getting stretched and definitely the banks are getting on the smaller ones (from my two contractor clients). It appears though the economy is doing pretty well in our area. Your comments on point 5 i thnk are on the mark; as an aside my real estate business partner bought it for about $4,000 a repossessed manufactured home (totally trashed on the inside) from Greentree (?), put it on a vacant lot, rebuilt it into a double wide and now has it on the market. Inside it looks great, outside it’s still a double wide trailer; but for $55 a square foot with a decent sized lot it has a good chance of selling (it’s in a small town in the middle of western Iowa).

    Great commentary David. I really learn a lot from your thoughts and appreciate your efforts.

  • ammcabe — yes, replacement cost, where estimable, is desirable in an environment like this. One thing to be careful about is that asset values deflate after a peak in the market. My preferred way is looking for industries that have gotten whacked, and pulling the strong ones out of the rubble.

    AllanF — I was getting concerned that commentary on the blog had really declined. Regarding liquidity, I would watch M3 in the various large countries of the world… that is a very good proxy for the willingness to extend credit. I would also watch for assets that don’t attract vultures that previously did. The subprime loans were easily digested — too easily digested. The losers took a 5 cent per dollar at worst on the loans as a group. We need to see 80% losses on dud assets before this is done; so long as we are below 20% losses, the market is bullish.

    I can’t give you a time. I can give qualitative signals to watch for. In 2000, I knew the game had changed in early March when vendors were not extended more financing, and they found the secondary IPO door shut.

    Paul, yes, mortgage equity withdrawal is declining, if for no other reason, that credit standards are rising. Also, when many lenders decide to extend the terms of delinquent loans at the same time, it is usually a bad sign for credit quality. The banks are only delaying the inevitable.

  • AllanF says:

    Thanks David.

    “In 2000, I knew the game had changed in early March when vendors were not extended more financing, and they found the secondary IPO door shut.”

    1) This seems extremely hard to know unless one is really plugged-in to the industry.

    2) That said, I think the game has changed in res. real-estate. And apropos to it taking 2 years and an ~80% drop for the Internet bubble to fully discount, it is worth remembering that and maintaining patience when trying to figure out why the Alt-A’s mortgage co’s have held up while the sub-primes have gone belly-up. I have a hard time believing there is that large a difference in quality between the two. If anything, I tend to think Alt-A is more dubious. Maybe less leveraged is all which means the blow-up/out will take longer. But I have no data for that, just a hunch.

  • The jury is still out on Alt-A. A lot depends on how the residential real estate market reacts to all of the excess supply. In September 2005, I noticed a qualitative change in behavior of market participants when deals stopped being snapped at. Anytime one sees extreme speculation, look for the weak link, the one where financing is the tightest, and watch for when their liquidity proves inadequate.

  • Rajiv says:

    Read this interesting news article:
    Indian Rupee should go back to Rs 45/USD