MARKET OBSERVATIONS

LIVING ON DE FAULT LINE?

MARKET OBSERVATIONS - 3/16

Faux Paux...Last week we inadvertently screwed up our little NASDAQ historical retrospective.  We said it took 17 months to go from 3000 to 4000 on the NASDAQ.  Make that 17 weeks.  We've redone the table and put everything on an apples-to-apples basis.  (Of course, it's simply more dramatic that way, don't you agree?)

Living On De Fault Line...Wouldn't you know that it's time again for a review of the Federal Reserve Flow of Funds report.  It seems like only yesterday that we were pointing out the simply gargantuan rise in debt in all sectors of the economy.  Oh well, time just seems to fly when growth in margin debt is annualizing at an unprecedented 200% over the last four months.  The current Flow of Funds report covers the period ended 4Q 1999.  Highlights?  We got'em.  In 1999, Mortgage Debt increased $422 billion, a 10.4% Y/Y rise.  Non-Financial Sector debt was up an equally impressive $444 billion, or 10.6% Y/Y.  But the granddaddy of them all, Financial Sector Debt, increased $1.1 trillion in 1999, a rather strong 16.7% Y/Y rate.  Forget government debt, forget corporate debt, and forget consumer credit.  These three little sectors mentioned accounted for $2 trillion in new debt for our fair economy.  Quite a showing.  It's just a good thing that common stocks are a never ending wealth creation machine.  Right?

Living On Borrowed Time?...Let's get right to the numbers, shall we:

Clearly the outlier here is Domestic Sector Financial debt, about which we have made many a comment.  Remember, at the current time a lot of this is simply out of control of the Fed.  It's money and credit created outside of the banking system proper.  The numbers look pretty staggering when looked at over a 25 year period.  To be fair, they should be compared to some type of relative benchmark.  It's pretty hard to make the case that they should be compared to the rate of inflation.  After all, inflation is not up 50-100% since 1994.  Of course you know our favorite comparator - the stock market.

As with Financial Sector Debt, in this chart the NASDAQ is the special case.  What else would you expect in a blow off?  What is interesting though, is that the increase in the Dow and the S&P for each time interval is a bit more than twice the increase in comparable debt levels for similar periods.  Could it be that stock purchases have been half financed with debt and half financed with savings over the past 25 years? 

Sound far fetched?  The immediate observation to contradict this viewpoint is that we have blatantly forgot to include real estate in our presupposition of debt financing our collective asset net worth.  It just so happens that in the Fed Flow of Funds report, the Fed reports a number regarding debt and real estate that is only published once annually.  This report just happens to mark the happy event one more time.  It's the number described as "owners equity as a percentage of household real estate value".  In the Fed's own notes, they describe their calculation of "real estate value" as market value.  As we have noted before, ContraryInvestor is located in the San Francisco Bay Area.  From our local experience, we would have guessed that owners equity has simply mushroomed relative to market values given the fact that current market values around here are nothing if not mind boggling.  Although the SF Bay Area is clearly a "science fiction" real estate market at the moment, real estate values around the country haven't exactly been soft.

Quite the opposite to our guess regarding trend is the following chart.  The owners equity number reported for 4Q 1999 just happens to be the lowest number in postwar history.  Since 1989, its dropped from 62% to 55%.  Here's the trend in the last decade-plus:

What this forcefully tells us is that homeowners have borrowed every nickel of appreciation out of their homes and then some in the last decade.  Owners equity in real estate has fallen in almost each and every year.  As you know, there are only two ways this can happen.  Either real estate values are declining (which they are not, at the moment), or increasing leverage is being applied against real estate asset values.  Clearly it's the latter.  From our vantage point, this increased leverage could only have been used for two things over the last 11 years - current consumption or stock market investments.  Our bet is that it has been for both.

If the Fed's own data does not suggest that a good portion of our self proclaimed prosperity has been debt financed, then we just don't know what does.  If the Fed is unconcerned about it's own Flow of Funds data, certainly it cannot ignore the blatant rise in margin debt.  From October of last year, margin debt outstanding in the US has risen from $182 billion to $265 billion at February month end.  A staggering $83 billion 46% increase in just four months.  Greenspan has raised interest rates repeatedly over the last 12 months.  He has started talking a bit tougher over the past few months.  The Fed credit creation machine has slowed YTD.  Is it simply time for harsher medicine?  On the way up in any asset inflationary environment, debt underlying/supporting the inflating asset is never considered a serious problem.  On the way down, it becomes the worst enemy to asset price.  Given recent price action in stocks, are we about to learn this lesson yet again?  It sure seems that way.

Amplitude...The inter and intra day volatility in the major averages (including SOX, Bank Stock index, Biotech Index, NDX 100, etc.) seems close to incomprehensible.  To call this "investing" any longer is simply laughable, at best.  We're telling you right now that this is not unprecedented action.  It has occurred before.  In our wonderful scouring of market history, we can only come up with one other example - 1929 pre crash.  Have a look:

Leading up to the crash in 1929, amplitude of daily index swings increased almost linearly.  As you know, we are now doing much the same in the current market.  2% intra-day index swings have become 3%, 4% and 5%.  Swings in sector indices are recording double digit daily ranges.  Like a gyroscope spinning out of control, deviations from center become more and more pronounced until the gyroscope simply topples over.  The pace of change in index and individual stock prices has become frantic.  Perceptions and perspectives are changing on a dime and reversing violently.  At this point, truly anything goes.  There is simply no telling where we go over the short term.  Leverage, manic trading, and epic greed will dictate our path.  Like we said a number of times in our past weekly commentaries (which, unfortunately, so far is coming true), record volume and price moves still lie ahead.  Be prepared for anything.

Breaking Out is Hard to Do?...Of course the technical traders (is there really any other kind left?) now know that new highs lie directly in front of us.  Here's Tim's take on life:

Until we meet again.  

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