"Altruistica": Seeking a return to full financial disclosure and regulatory oversight. A financial market analysis blog for "entertainment purposes" only by an experienced CFA seeking new hedge fund engagements for investment writing and analysis. The author has experience investing internationally, running a hedge fund, making angel investments, and helping launch five startup companies. Investors should do their own due diligence.

11 December 2006

Why There is something seriously wrong with the markets

by Dr. Chris Martenson
December 11, 2006

Something about the stock market just doesn’t feel right to me. Ditto for our economy. There is something in the air that is not being reflected in the either the stock market indexes or government supplied economic data.

As I peered about this week searching for indications that the housing market malaise has spread to other markets, several prime candidates emerged:

1) Weakness in the durables orders. ‘Durables’ are consumer items meant to last three or more years and a new house consumes a lot of them. Washing machines, water heaters, and stoves would be examples.

2) A drop in trucking tonnage (all the materials to build houses arrive by truck).

3) Significant stress in the subprime bond market.

One large and potentially dangerous part of the subprime market is encompassed within the pleasant sounding name “asset back securities”, or ABS market. As the name implies, these are pools of loans backed by some sort of asset. They could be a pool of credit card receivables, a pool of auto loans, or a pool of home equity loans. One feature of an ABS is that all the loans in the pool share a similar risk profile. Imagine that all of the loans in a given pool had been made to men like your drunken uncle, and you’ll have the right mental image.

OK. Why do we care about all this? In far too many cases, mortgage applicants were allowed to state their income (usually lying in grand fashion while doing so), while obtaining an interest-only negative-amortization loan with a piggyback so that they could walk away from the signing with cash and a loan-to-value ratio in excess of 100%. I wish I were joking, but I am not. In 2005, 25% of all mortgages option ARMs where the borrowers overstated their income by 50% or more.

And now, predictably enough, even while the economy is officially described as ‘strong’, mortgage defaults are rising sharply all across the land, sub-prime mortgage companies are going out of business, and we’re seeing weakness in the ABS markets. Here’s how the Washington Post summed it all up (emphasis mine in all cases below):

It's been more than a year since we've heard from those who denied there was a housing bubble. But just when you're feeling hopeful again, you get reports like yesterday's Wall Street Journal piece reporting that delinquency rates are suddenly soaring on all those loosey-goosey subprime mortgages. They are starting to cause real heartburn for pension funds and other investors who bought securities backed by those mortgages on the theory that they were no more risky than a Treasury bond.

"We are a bit surprised by how fast this has unraveled," Thomas Zimmerman, head of asset-backed securities research at UBS, told the Journal, removing his head from the sand. Trust me, Tom, you ain't seen nothin' yet. After the subprime loans come the 100 percent, interest-only loans, followed by the meltdown in the overbuilt multi-family housing sector.

Sarcasm aside, fraud is a key characteristic of periods defined by loose lending standards and abundant, easy credit. Relaxed lending standards and fraud gave us the S&L crisis in the mid-1980’s and we will uncover massive amounts of fraud this time as well. That’s just how these things work. Just how much the fraud will contribute to the overall crisis remains to be seen.

Of course we have nothing to worry about in the housing market because government figures reveal that house prices remain firm, right? Unfortunately, as this New York Times article reveals, the government numbers do not mesh with reality.

The truth is that the official numbers on house prices — the last refuge of soothing information about the real estate market on the coasts — are deeply misleading. Depending on which set you look at, you’ll see that prices have either continued to rise, albeit modestly, or have fallen slightly over the last year.

John Williams of Shadow Statistics explains the how’s and why’s of this far better than anybody and I invite you to take a tour at his site if you are not already familiar with the motivations and methods of our government in producing deeply flawed, if not fraudulent, economic statistics.

But imagine if you were a pensioner in the UK and were experiencing an 8.9% rate of inflation but were being compensated by a government that had adjusted your pension check for a 2.4% rate. It wouldn’t be long before you’d be unable to provide for yourself. When confronted with the inadequacy of their methodology, how did the UK government see fit to respond? They said:

A spokesman for the Office for National Statistics said: "The CPI and RPI are specifically not intended to measure what people often refer to as 'the cost of living'."

Well than, what are their inflation gauges ‘specifically intended to measure’ if not the ‘cost of living’? The price of dying? The cost of survival? I didn’t realize there was any other proper intended use for an inflation measure besides tracking the cost of living. Really I am stumped by this particular rationalization

Moving on, one other item you should keep a close eye upon is the amount of insider selling of stocks that we are experiencing. While companies have been using profits (and new debt) to repurchase record amounts of their stock off the open market, thereby supporting stock prices, the executives of those same companies have been dumping their personal shares at the fastest clip since 1987.

December 7, 2006 -- America's corporate chiefs are unloading their own stocks at one of the boldest paces in 20 years. In cases of the very rich, such as Microsoft's Bill Gates and Google's top brass, the executives are selling a whopping $63 for each $1 of stock they bought, says a report by Bloomberg. In November alone, leaders of public companies dumped $8.4 billion worth of stock they owned as insiders, most of it awarded as compensation, bonuses or other management incentives. Because they are better positioned than anybody, insiders generally do not dump their stock if they think their company prospects are good. In the past, high levels of insider selling have been a reliable indicator of impending economic weakness.

In summary, housing has clearly weakened to the point that we are now seeing stress both directly and indirectly as durables, trucking and mortgage based ABS securities have fallen off. Further confirmation of impending weakness is provided by the massive stampede of insiders getting out of their own company stock.

The only place we haven’t yet seen the weakness is in the stock market itself but there are any number of valid reasons why there should be more gauges on your dashboard than the stock market index levels.

© 2006 Dr. Chris Martenson


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