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 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 17-Sep-2009
Stock market goes dangerously parabolic, as day traders bid prices up

Web Log - September, 2009

Stock market goes dangerously parabolic, as day traders bid prices up

Wall Street markets shot up 1-1.5% on Wednesday, 48% above the March lows.

As we wrote last month in "Stock markets reflect increasingly delusional Wall Street," this new stock market bubble represents an increasingly dangerous situation. It's like stretching a spring; the more you stretch it, the more violently it snaps back when you release it.

The surge appears to be related to a strong showing by day traders -- people who trade stocks several times a day in order to take advantage of minute by minute movements in the price of the stock -- according to a WSJ article:

"Return of Day Traders Drives Rise in Volume

Even as mom-and-pop investors sit out the rally, short-term players -- including some classic individual day traders -- appear to be making a comeback.

Trading volume surged 14% or more last month from July at online brokerage firms....

Total daily average revenue trades at E*Trade rose 37% from a year earlier in August.

It amounts to an unusually large jump in online trading, traditionally the domain of smaller investors. "Usually, August is one of the worst months of the year," said Richard Repetto of Sandler O'Neill Partners L.P., with volume typically falling 10% from July.

The trading surge coincided with a powerful rally in stock prices -- a wave these traders may have been trying to ride. The Dow Jones Industrial Average is up 14% from the start of July and 4% from the beginning of August. On Tuesday, the Dow closed at 9683.41, up 0.59%, its highest level since Oct. 6, 2008.

The revival of short-term trading doesn't necessarily reflect long-term confidence in stocks. That's because a lot of long-term money is still sitting on the sidelines."

If true, then this new stock market bubble is actually being caused by day traders competing with each other to bid up stock prices. This is dangerous because bad news can cause stock prices to fall very rapidly, if day traders begin to panic.

That's what happened to the Shanghai stock market, which was pushed by day traders to high bubble levels, and then crashed to below 50% of its peak.

Thus, there's no way to tell how long or how high the current stock market bubble will grow, but the concern is that when it bursts, it will do so rapidly.

The bubble is propelled by the fantasy that there's a full-fledged economic recovery in progress. This fantasy is put forth by the politicians, who have votes to gain, and by CNBC and other financial media, who have advertisers to please.

Looking at some of the actual data, we see a very different picture.

Job openings vs unemployed <font face=Arial size=-2>(Source: Dave Rosenberg, Gluskin Shiff)</font>
Job openings vs unemployed (Source: Dave Rosenberg, Gluskin Shiff)

The unemployment picture continues to worsen, and even the Administration agrees that unemployment is going to go well above 10%. However, Dave Rosenberg of Gluskin Shiff, in his September 11 "Breakfast with Dave Rosenberg" commentary (or click here for PDF file) says that the job situation is much worse than government officials are saying:

"The problem is not so much with firings any more; itís more about a complete lack of new hiring. The NFIB index that measures job openings fell again in August ó from 9.0 to a 27-year low of 8.0. Challenger hiring plans collapsed 24% in August to a three-month low. Someone obviously forgot to tell the folks at Manpower that the recession was over because its employment plan index for the U.S. just broke below the worst levels of the last three economic downturns. The JOLTS data from the Bureau of Labor Statistics also showed that job openings plunged 121,000 in July and we now officially, for the first time on record, have six unemployed people competing for every possible job opening out there. No wonder organic wages and salaries are deflating a record [Year on Year] rate of nearly 5%."

This comes at a time of increasing monetary deflation, according to Rosenberg. He says that over the four weeks up to August 24, bank credit shrank at an "epic" 9% annual pace, the M2 money supply shrank at 12.2% and M1 shrank at 6.5%. "For the first time in the post-WW2 [Second World War] era, we have deflation in credit, wages and rents and, from our lens, this is a toxic brew," he said. Credit is shrinking at a "Great Depression" rate, according to Ambrose Evans-Pritchard.

This is the deflationary spiral that I've been talking about for years. Each day, there's less money in the world than there was the day before, as the money created during the real estate and credit bubbles continues to be destroyed. There is absolutely nothing about this that points to a recovery, or justifies the current parabolic behavior of the stock market.

Nouriel Roubini was interviewed by CNBC on Monday morning, and he painted a very harsh picture of the current economy, calling it "Death by a thousand cuts":

"On the issue of the banks, let's be realistic about it. 350 non-bank mortgage lenders have gone out of business more than 100 banks have gone out of business. The banks that are on the list of the FDIC that are in trouble are already 400. So at the end of the day we might have over 1000 financial institutions, and even some of the big ones, like Fannie and Freddie, Bear Stearns, AIG, Lehman have gone bust.

So this is a severe financial crisis. Now, how would I have dealt with the issue of the banks?

My view of it is that there are still many losses that have not been acknowledged. There's now massive forebearance. For example, $2 trillion of commercial real estate is in trouble. They have default rates of 30%. But now the regulators have said, "Forebearance. Let's pretend that these assets are now worth face value. We're going to wait."

[[This is a point that I've been making frequently. Not only have bankers been defrauding the public, and continue to do so, but regulators are complicit in the fraud, and are urging banks to continue to defraud the public. - JX]]

And eventually, there's going to be trouble -- for regional banks, and for smaller banks.

If you think about it, subprime went to near prime and prime. Now it's commercial real estate, credit cards, auto loans, student loans, leveraged loans, industrial and commercial loans, corporate bonds, muni bonds -- all these losses slowly slowly are adding up. It's going to be death by a thousand cuts.

We're not going to have another blow-up like Lehman, because we've decided that nothing that's systemically important is going to be allowed to collapse again like Lehman.

But the financial system is severely damaged. It's not just the banks. Most of the shadow banking system has completely disappeared. There is no securitization, there is no credit growth. So how is the economy going to grow?

Let's recognize that things are much better than a year ago, of course, and I credit the policy makers and their strong actions, but there is still huge amount of damage in the financial system, and in the real economy.

[[Question about interest-only mortgages]]

Nouriel Roubini <font face=Arial size=-2>(Source: CNBC)</font>
Nouriel Roubini (Source: CNBC)

Absolutely. Right now, delinquencies are rising from sub-prime to near-prime and prime on the interest-only mortgages.

There is now, by the way, a moratorium on foreclosure. Because of that, the excess supply of homes on the market has been limited, but eventually this moratorium is going to disappear, and people who looked at the data, they see a massive increase in the supply of existing homes that are going to come on the market in the next six to 12 months.

So while the quantities in the housing market have now stabilized because they fell 80% from the peak demand and supply, the gap between demand and supply is so huge, you can stop producing homes for a year to get rid of the inventories. And about 1/3 of all existing home sales are distress sales, short sales or sales of foreclosed homes, and that's going to increase.

So the price adjustment, in my view, is going to continue for another year, and on a cumulative basis, 40% reduction in home prices some time next year from the peak. That means that half of the people that have a mortgage are going to be under water, with negative equity in their homes. That's what we're facing right now."

I wanted to provide this quote from Roubini at length, because he gives a lengthy laundry list of the problems in the economy, including the expected 40% cumulative reduction in home prices. Roubini has flip-flopped several times on how long and how deep the recession will be, and even whether it will lead to a new Great Depression, which he was worried about a year ago, but no longer considers possible.

Roubini has a brilliant "bottom up" view of the economy that allows him to see how these different economic components are coming together to produce a further financial crisis. However, he has very weak "top-down" vision, and can't see that we will indeed have other blowups like Lehman, or that we will indeed have a new Great Depression, as is predicted by Generational Dynamics.

I've been writing about the deflationary trend for six years, and the deflationary spiral since 2007. I still receive e-mail messages from people who disagree with me on this point, even when they agree with other things. However, there's plenty of evidence pointing to a continuing deflationary spiral, including a recent WSJ article which says that deflation is being caused by a reduction in liquidity, caused in turn by a reduction in the velocity of money:

The collapsing velocity of money leads to further deflation <font size=-2>(Source:</font>
The collapsing velocity of money leads to further deflation (Source:

"As Liquidity Drains, So Does Inflation Risk ...

In fact, whether by accident or design, some liquidity already seems to be draining away. M2 money supply, a measure that includes time deposits such as certificates of deposit, has fallen for four weeks in a row, at a 12% annualized rate, according to Gluskin Sheff chief economist David Rosenberg.

A separate measure by the Federal Reserve Bank of St. Louis, called MZM and designed to better gauge broad liquidity, has fallen at a 16% annualized pace in that time.

At $8.3 trillion and $9.5 trillion, respectively, both money measures still are near records. But money velocity, or the speed with which cash is spent, is declining. ..."

The graph shows that the money supply increased during the massive credit bubble of 2003-2007, but has been falling sharply since the beginning of the deflationary spiral that began in August, 2007.

This measure of the money supply actually ties together monetary policy with considerations from generational theory.

As a society enters a generational Crisis era (such as the current one), people become risk-averse, and stop spending or lending money. This lowers the velocity of money, causing deflation (rather than inflation).

As the crisis continues, people will become even more risk-averse, and the velocity of money is going to go even lower, causing further deflation. It's still my expectation that the CPI will fall by 30% in the next few years, despite bailouts, stimulus, and quantitative easing.

This deflationary spiral makes the stock market incredibly dangerous for everybody, even for people who understand that we're in a deflationary spiral.

I've previously written about Higgenbotham, a member of the Generational Dynamics forum, who last month had already lost about 4% of his net worth by going short in the market. He was betting that the rally would end and the market would go sharply down. This would make a lot of money when it happened, but first he'd have to risk more and more money as the rally continued.

Well, on Thursday, as the market continued its rally and appeared to be going parabolic, he posted the following:

"I took my loss today, as what is going on looks nothing like what I expected (for example, look how much gold and silver went up today and how low the dollar is - I had predicted that would not happen). Shorting this bear market rally destroyed almost 8% of my net worth. The S&P is up 13.5% from where I started shorting.

Analyzing my psychology heading into this exercise in Maximum Ruin (which has probably been gleaned by anyone reading this thread): First, I had made some money in the previous bubble from 2003 until 2007, although I did sell everything 1-2 years before their respective highs (real estate, stocks, etc). Then I was short at the top of the stock market in 2007 and made some money there. And, as we know from the forum, I made a little money last Fall buying and selling stocks. So I hadn't lost a dime going into this exercise. I think what can happen in such cases is that a person becomes overconfident and doesn't consider their actions carefully enough. In addition, the overconfidence results in the failure to take the actions that one knows should be taken. I knew that I should be in safe cash and tangibles and should not be fooling with the market.

As I watched my money get destroyed today, I told myself over and over that this will be the last time I ever speculate. I realized that the actions that had led to my previous success (or perhaps luck would be a better word) were based on similar thinking to what had led to taking the short position to begin with, but that I was basically standing in front of a tsunami that I had incorrectly identified. As we stated the other day, this market environment is nothing like that which existed previous to the crisis (and perhaps will be less similar to the past generational crisis than anticipated). During that time, it always seemed like the market would forgive your errors and let you out gently.

Generally, the country hasn't learned this lesson yet, but this small exercise in Maximum Ruin gives me a taste of what is coming and how people are going to feel when it is over. It's going to be a very different world once this market crashes for real. Of course, having an understanding of what is coming makes all the difference because we all know that the days of easy money are over and once your savings are lost it will be impossible to recover them. One of the big problems I see is that our leaders have convinced many that the days of easy money are not over, when in fact they most likely are. Without that knowledge, losing this money probably wouldn't have bothered me much. For example, about 12 years ago, I lost about 20% of my money in the market. At that time, it didn't bother me nearly as much as losing 8% today and, in fact, I hadn't ever calculated the percentage until just recently. Looking back on that now, I must have been nuts...."

Intuitively, you would think that the bulls who buy and hold stock ("longs") and the bears who short stock are complementary in some way. You would think that the bulls make money if and only if the bears lose money, and vice-versa.

But that's not entirely true in a deflationary spiral. What's happening is that there's less money in the world every day, and the deflationary spiral pulls money from everywhere that money is changing hands.

Thus, in the current situation, the bears are losing money because of this new bubble / rally. Also, the bulls are staying in the market, and they're going to lose money when the market plunges again.

During the bubble, hundreds of trillions of dollars of new money were being created all the time. So everyone, both bulls and bears, could make money.

But now that the bubble is leaking, all of that money is disappearing, and the money is being pulled from every possible source.

That's the Principle of Maximum Ruin, and it applies to both bears and bulls in a deflationary spiral.

That's why literally stuffing the money into your mattress is the safest thing to do. Keep the money out of play, where the deflationary spiral can't get at it. That's the only way to stay ahead of everybody else.

(Comments: For reader comments, questions and discussion, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (17-Sep-2009) Permanent Link
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