The Long View for Short Sellers

Sell Gold, buy financial stocks...? Because the US Fed has fixed Wall Street...?

AS FAR AS MOST mainstream commentators are concerned, July 15th this summer marked the bottom in US financial stock prices, writes Dan Amoss for the Rude Awakening.

   I strongly disagree. I expect another ugly leg down in financial stocks before the end of 2008. Recent bank earnings reports have all hinted that we're still only in the early stages of the credit loss cycle.

   What we've seen thus far has been the insolvency of those who levered up their personal or corporate balance sheets to buy houses and mortgage securities at the top of the bubble. Home equity, credit card, and auto loan delinquencies have just started getting bad. The fallout from rising unemployment and shrinking discretionary income is just starting to impact corporate default rates.

   Edward Altman, a professor at New York University and founder of the "Altman Z-Score", is one of the world's top authorities on the history of corporate defaults. He thinks this credit loss cycle is not close to being over. (You can find an excellent interview with Altman at Bloomberg...)

   We have yet to see the impact of a real recession on default rates. But in the Aug. 1st issue of his Gloom, Boom & Doom Report, Dr. Marc Faber describes how most institutional investors fail to recognize the existence of big, generational changes in financial markets – even several years into the trend:

   "What are the most overlooked and misunderstood big changes?

   "In my opinion, the most misunderstood recent big change, in terms of its economic consequences, is the bursting of the credit bubble in 2007. It is as important a milestone in economic history as was 1929, when the markets began to fall apart, and as was 1981-1982, when bonds and equities entered a secular bull phase that would last for about 20 years.

   "In 2007, the old order ended – the old order under which, in the United States, credit growth continuously outpaced GDP growth and, therefore, drove total credit market debt as a percentage of GDP from 130% in 1980 to around 350% at present (unfunded liabilities excluded). And while I am not suggesting that this excessive debt growth was the only factor driving the financial markets higher, it was certainly the key factor and led, from 1981 onward, to unprecedented asset inflation across a broad range of the investment spectrum."

   For me, it makes sense to hold onto, or add to, long-dated puts on financial stocks. The past few weeks have been tough for short sellers, it is true. This market environment has been challenging.

   Right now, the "hot money" herd, whether it's day traders or computer-driven hedge funds, is in the process of unwinding speculative trades that were built upon the assumption of a strong Euro. And so here's the current popular sentiment:

   As the "Euro bull" case is unraveling, traders are dumping commodities. Since commodities are falling, many are starting to believe the Federal Reserve won't have to tighten monetary policy to "fight" inflation. Therefore, you should buy financials and short energy, Gold, and commodity stocks.

   This is nonsense. The short summer trend of commodities down, financials up trade is not likely to go much further in terms of price. So let's stick with the lasting trends instead – the trends that are supported by sound fundamental research, rather than hope.

   Here are three reasons why the managers running tens of trillions in financial assets will, over the next few years, move into investments related to energy and infrastructure, and away from investments related to debt-financed discretionary consumption:

#1. The Fed will keep "unconventional" monetary policy in place to keep the megabanks on life support. Once the Fed's balance sheet runs out of room to absorb more toxic assets, it will be forced to expand its assets and liabilities, which is inflationary. Rather than sit and watch as bad loans get written off and dozens of financial institutions fail, governments and central banks are "doing something" about it.

   The government has no resources beyond its power to tax and inflate, so that is its only real option if it wants to "do something" about the crisis. These actions will have far-reaching consequences, which include heavily diluting shareholders of financial institutions. What about those toxic securities currently on the Fed's balance sheet? They will eventually return from whence they came, and this will eventually inflict more write-downs on bank shareholders.

#2. Growing global competition for scarce commodities will put a floor under prices, especially when measured in Western currencies. As Asian and Middle Eastern currencies rise versus Western currencies, which they will, they will attract more of the world's commodities at lower prices. Just because Western consumers are slowing in their already high per capita consumption, doesn't mean that a) the rest of the world won't stop increasing its already low per capita consumption, or b) adequate long-term commodity supply will magically appear.

   Sure, there are corrections along the way. But we must not confuse corrections with the end of bull markets.

#3. Western consumer retrenchment and deleveraging will probably lead to a return of Keynesian government policies: a more progressive tax code, deficit spending, and more onerous regulations. An excessively progressive tax code punishes capital investment and promotes consumption overproduction, which boosts the CPI; see the late 1970s for a parallel.

   Such an environment would not benefit the United States' reputation as a "safe haven" for the world's capital. And yes, this type of investment environment will be challenging. But these three long-term trends should yield many attractive short sale opportunities in the stock market.