Hope Part II - De-leveraging

O.K.! I am remiss in posting the second half of the article, and as is typical these days, a lot has happened this last week. Before I continue with the three themes that will dominate the attention of strategists and financial mavens this coming year, I have to mention two things. First this last week has seen a fundamental threat to the market, and second a technical look at broad market activity indicates uncertainty.

The fundamental event was the selloff of Bank of America equities this last week. There was a swirl of news around BofA last week that you can read about if you have not already heard, but I believe the most significant fundamental blow to the market is uncertainly and lack of transparency about what the government’s role in BofA has been. What initially spooked the market was the nationalization of Banks in Britain. U.S. markets were further spooked on BofA equity when the U.S. government “backstopped” bad debt that BofA took on when they bought Merrill Lynch last fall. This has left investors wondering what deal might have been struck between the U.S. treasury and BofA when this deal was consummated. That deal was seen by some to be a shotgun wedding with Mr. Paulsen holding the gun. The markets have seen common shareholders wiped out when the government took over Fannie Mae and Freddie Mac, hence a great deal of nervousness now surrounds both BofA and Citigroup. The markets discounted this news this last week and it has cast yet another pall and fundamental uncertainly over market risk as we begin the New Year.

The second event is technical. I have been watching the charts of two exchange traded funds that mirror the Dow and the S&P 500 (DIA and SPY). In both cases they have been range bound in a narrow trading range or channel. They look to be forming what chartist call a triangle, and triangles usually resolve in a significant break either up or down. At this point most traders are flummoxed as to whether that break will be up or down. If markets are an aggregate measure of known geopolitical and financial risks, then this last week spells increased risk to markets and to geopolitics. This last week dovetails with where we began last week’s discussion of the themes for 2009. So let’s get to the second theme of debt or de-leveraging.

Some of the smart money out there believes that the de-leveraging of excess debt largely caused by the housing bubble will take up to five years to unwind. If that is true, then we have another three and one-half years to go in this cycle since the deleveraging began in July of 2007. Now that the real economy has and is faltering and people are losing their jobs, the next round of default will be consumer loans. The banks have been criticized by members of Congress for taking taxpayer money and then not lending to the consumer. The banks are merely shoring up their balance sheets to withstand the coming losses they will absorb as consumers default on their credit card and auto debt. Oddly enough the same government that criticizes the banks for not lending will also shut a bank down when its reserves fall too low. It was excess debt that created the problem so how is it that more debt will fix it?

At this point government is the only player taking on more debt. Consumers and corporations are shoring up their balance sheets by paying off debt and increasing savings. With job losses and loan defaults increasing few in the private sector are in a position to take on much more debt, and corporations have had trouble obtaining loans at rates they can afford. This all spells trouble for equities. The smart money is seeing, at best, 5% to 8% returns on equities. This will demoralize great number of retirement investors and set up a psychological state in which many retirement investors will compound their fear of loss with more bad decisions about how to deploy their retirement savings. Savings they will need to pay for higher energy costs.

Next we will look at energy, and hopefully keep up on the fast moving events that are whip sawing the markets.