Musings Report #4 1-25-14 In a Typhoon, Even Pigs Can Fly (for a while)

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I would also like to mention the critical distinction between stating something should happen and that it will happen for structural reasons. I want to emphasize this because many of you earn your livelihoods in sectors such as healthcare, government, finance and higher education that have received critiques here and on the blog.

In discussing the systemic reasons that these sectors are unsustainable as currently configured, the focus is on what will happen, regardless of our personal views and desires. When systems erode or crumble, the process is entirely impersonal. The goal of the analysis is to ask what could be done to transform the unsustainable into something that is more sustainable.

I have no desire to offend any reader, or deprive anyone of a livelihood. My work is all about identifying the dynamics in systems and structures that cannot be suppressed or masked for long, so we will have to deal with them at some point whether we want to or not. Understanding the dynamics aids clear thinking and practical decision-making. The blog and the Musings boil down to this simple purpose.

In a Typhoon, Even Pigs Can Fly (for a while)

The Chinese culture has a wonderful vocabulary of colorful analogies and metaphors, and today's title refers to the typhoon of liquidity (freely available credit) that is sweeping around the global economy.

The source of the phrase is Liu Chuanzhi, the Chairman of Lenovo and the iconic figure of Chinese manufacturing. When asked a few years ago why 60% of Lenovo Group’s profit came from asset investment and only 40% came from manufacturing. He said “when the typhoons come, even a pig can fly in the sky. Everybody is profiteering from this. Why can’t we?” The typhoons refers to the property frenzy and the easy ways to make money.

I think the critical distinction to make about typhoons of credit-driven speculation (in China, Japan, the U.S., Europe and elsewhere) is between liquidity and valuation/solvency. Let's take a household as an example. Say the household owns a $300,000 house with a $150,000 mortgage. The household has home equity of $150,000.

Let's say one of the household jobholders loses their job and the sole remaining income is not enough to pay the monthly bills. This is a liquidity crisis. The household could borrow money based on the collateral of the home equity to tide them over until the unemployed spouse finds a new job.

A valuation crisis is different: let's say the household decides to sell the house and discovers the market value is only $150,000--the same as the mortgage. After deducting the real estate transaction costs, the household has negative equity. So instead, the owners claim the house is worth $250,000 and try to get a home equity line of credit based on the phantom collateral. (Stating the real market value is called mark-to-market, and claiming phantom value is called mark-to-model.)

The point here is access to easy credit can solve a temporary liquidity problem, but it can't increase the value of collateral or generate income. The owner can misrepresent the value of the collateral to borrow money based on phantom wealth, but that doesn't change the market value of the underlying asset/collateral or increase the income needed to make loan payments.

Simply put, credit/liquidity cannot solve valuation/collateral crises. Correspondent J.B. recently addressed this in an email to me:

"RE: accounting and real life. Sometimes they differ but over the long run they always synch up. For instance let's say a bank has a lot of quality assets but a liquidity issue. It will take that good paper to the Fed to get liquidity for the bank to get through the hard time (no write down required and it works out). On the other hand if the bank has a bunch of bad assets, it now has a solvency issue and not a liquidity issue (i.e. not marking to market does not agree with reality). If the commercial real estate market goes bad the bank can postpone marking it to market for a while but soon it has no cash flow and accounting does not matter because it cannot pay its bills, payroll or redeem demand deposits. The failure to properly mark assets to market will not save it and ultimately accounting and reality will re-synch."

The world's central banks and governments have tried for the past five years to fix a valuation/collateral/income crisis with liquidity. No wonder they've failed--enabling insolvent owners to borrow more money doesn't make the borrowers any less insolvent.

Once the liquidity typhoon runs its course, the insolvent pigs will plummet back to earth. I think that's what we're seeing in the periphery economies and shadow banking systems around the world.

Summary of the Blog This Past Week

The Recent "New High" in Stocks Is as Bogus as the Unemployment Rate (1/25/14)

The Fed's Solution to Income Stagnation: Make Everyone a Speculator (1/24/14)

Two Powder Kegs Ready to Blow: China & India (1/23/14)

Dead Mall Syndrome: The Self-Reinforcing Death Spiral of Retail (1/22/14)

The First Domino to Fall: Retail-CRE (Commercial Real Estate) (1/21/14)

After Seven Lean Years, Part 2: US Commercial Real Estate: The Present Position and Future Prospects (1/20/14)

Correspondent Mark G. and I make a thorough case for commercial real estate being the equivalent of subprime mortgages in 2007-8, i.e. overleveraged domino that will topple once its collateral is revealed as phantom.

Best Thing That Happened To Me This Week

68 people responded to my annual request for subscriptions/contributions. The total number of financial contributors is about 4.5% of the core readership of 10,000 per day. Perhaps unsurprisingly, that is pretty close to the 4/64 Pareto Distribution: the 4% who support the site financially have an outsized influence on the rest of the readership, and on all the ripples that extend out from that core readership into the wider world via reprints (Zero Hedge, Max Keiser et al.).

Market Musings

Let's look at a weekly chart of the S&P 500 and ask the key question: is this decline signaling a change in trend, or is this just another test of long-term moving averages? As we can see in the chart, the SPX swooned big-time in 2011, dropping all the way down to test support at its 200-week moving average (MA). Since then, swoons have stopped at the 50-week MA.

There is plentiful evidence that the foundations of this 5-year rally are eroding the world over. That gives credence to the view that this is potentially the trend change (from Bull to Bear) that many of us have been expecting, based on the negative fundamentals (pigs flying in liquidity typhoons, etc.)

But technical analysis is less about predictions that asking "what if?" questions and seeking answers in price and indicators. If price breaks through the 50-week MA at 1,678, then the 200-week MA at 1,382 looms as a target. If that breaks down, lower targets come into view.

In my view, we can expect plenty of rallies to confuse Bears and give hope to Bulls. A nominal new high is not yet out of the question--but then neither is a further 150-point drop.

From Left Field

Silk Road as a Self-Regulating Black Market (via Lew G.)
"If a scattered group of ne’er-do-wells on the internet can manage to peacefully exchange in a high-risk, extralegal market traditionally fraught with violence, it is worth wondering what upstanding merchants and customers might be similarly capable of in the absence of centrally-imposed regulation."

Cairo Photo essay: Life in the City of the Dead by Virginie Nguyen -- fascinating look into the lives of people who live amidst the crypts of Cairo because it's the only place where they can afford the rent

Former BP geologist: peak oil is here and it will 'break economies' -- basic idea is powerful: at $150/barrel, there's an incentive to get more oil but the high price pushes inefficient economies into recession....

Freedom in 704 Square Feet -- interesting high-end small house. I would think a less costly version could be had for a fraction of their costs ($135,000)

A New Direction-- Our changing relationship with driving -- we're driving a lot less.

How Inactivity Changes the Brain: (via Joel M.) Being sedentary appears to alter the brain in ways that may affect heart health, a new study found.

City With No Rulers Proves Government is Not Needed

Utah solved homelessness by giving people homes -- note they also provide social workers to manage the troubled homeless

Two Classes, Divided by ‘I Do’
“It is the privileged Americans who are marrying, and marrying helps them stay privileged,” said Andrew Cherlin, a sociologist at Johns Hopkins University. -- very simply: two incomes are way better than one.

The Power of Community. How Cuba Survived Peak Oil (via John D. - 53 minute documentary)

Brave new L.A.: Los Angeles is an unlikely model of urban sustainability for the West and the world. (via Joel M.)

The Intelligent Plant (via John D.) by Michael Pollan -- on plants' sensory capabilities, signaling and communities. This will interest anyone who likes the ultimate plant/animal community, soil, a.k.a. dirt...

Senate Select Committee on Intelligence Report: Review of the Terrorist Attacks on U.S. Facilities in Benghazi, Libya, September 11-12, 2012 (via Lew G.) -- decide for yourself what the Senate wasn't told, and what this report isn't divulging... some redacted sections, but this clearly shows agencies that needed to collaborate were not collaborating.
Here's the devastating conclusion:
"It is also imperative that those in decisionmaking positions in Washington, D.C. heed the concerns and wisdom of those on the front lines and make resource and security decisions with those concerns in mind. The United States government did not meet this standard of care in Benghazi, but we believe this report's findings and recommendations will help avoid similar tragedies."

"If Tyranny and Oppression come to this land, it will be in the guise of fighting a foreign enemy." James Madison

Thanks for reading--

charles