Market Corrections

I am neither pessimist nor optimist in my approach to broad market trends. I wont bore with the statistics and detailed historical data concerning corrections, but the fact is they happen as a natural part of market dynamics. What many fail to realize is that corrections occur in both directions. A market correction is simply the market trying to find its own balance, or level. As a mathematical process, a market has an equilibrium that is based in a “sum zero” format. The formula for this balance is based on valuations, earnings, pricing power, growth trends and profit. This model is used by economists, traders, investors and governments to forecast economic models for a variety of reasons. Without this baseline value, the market system wouldnt work, we would be at the mercy of a rudimentary barter system to fuel economies,companies and governments. Not good. Not good at all.

Now we factor in my favorite part of a mathematical market process.

Chaos. Gotta looovvveee that chaos.

In this model, chaos comes in the form of volatility. The whitecaps and troughs of our financial sea. Chaos is catalysed by several factors but the two most important are flip sides of a coin. Fear and greed.

Fear of loss.

Greed for more and more.

These two emotions account for nearly half of all market volatility but are equaled by my personal favorite market catylyst.

Ego.

Ego has created legends and broken kings. Often the same person wore both mantels at different times. While the market is not a living organism itself, its parts are. Ego is the one emotion that even the baseline model adherents fall prey to. While you and I are allowed to trade on fear and greed, the true market shapers are not. They trade on the model forecasts. Period. Icahn probably cant spell candlestick. Soros doesnt care what last months volume was. Their time horizon is far to long and their bets are far to large to risk on a five day trend. They only care what the model does. When the trend is in line with the model, they stay and often add to their holdings, thus perpetuating the trend and the model.

When the model begins to break down, I.E. some catalyst unexpectedly occurs that drasticly alters a component of the model such as a major spike in fuel costs, they begin to look at the updated model and then they re-allocate their portfolio accordingly. This isnt done very often, moving billions and billions of dollars worth of securities from one sector to another has problems of its own, and can alter the model itself, which creates yet another problem.

Corrections occur when two things collide, the ego of these 10 digit traders and the reality of market catalysts that come one after the other after the other. At some point, the big players will decide that enough is enough. The model is broken, it is time to re-evaluate the financial landscape and preserve capital. This is the downside correction.

We have already lived the latest upside correction.

This occured when the markets began to recover from the bursting of the tech bubble. The two are directly related.

After the tech bubble deflated, the models were re-done using the new landscape which was littered with the bones of former giants. The telecom industry , so many computer companies, research companies, marketing and advertising companies, distribution and warehousing companies.. Are you getting where I am going with this?

The death of tech left tens of billions in real estate, prime business property, offices, factories,warehouses, etc.. All dirt cheap. Some saw a despairing sight of broken dreams and lost jobs. Others saw opportunity. There is an old saw” Buy land boy, thats one thing they aint making more of”. That was taken to heart in the new baseline models.

This cheap property was snapped up by investors at far below market value.

I know, you’re asking if the economy was in such shambles, who would need the property? Well, every correction is sector biased. (One that isn’t, is a depression) While the tech industry was floundering in a sea of debt and falling valuation, the pharma, energy, service and financial services sectors were picking up steam. And property to grow on. As the formerly dirt cheap commercial and industrial property gained value by leaps and bounds, the sectors that needed this space did as well. The jobs in these sectors though, were home based. One cant outsource a Home Depot, a Scottrade, a Regions Bank, a natural gas plant, etc..

As the growth in these sectors progressed, so did the incomes of the workers. As the local incomes began to climb, so did the need for the companies to get that money back. So, the financial sector, desperate to keep its investors happy with profit growth, began to create new vehicles to provide that increasing profit growth. Thus was born the Consolidated debt Obligation. Originally conceived as a bundling of corporate debt backed by real property, it was soon realised that personal dwellings were debts backed by property as well.With just a little finagling, these could be bundled and marketed as easily as commercial paper.The problem was, only so many mortgages qualified as quality debt. They soon ran out of these high end,high interest obligations. But the pressure to profit was not abating. The big investment houses, the national banks, they all wanted more. Well the financial sector had no more to give. Or did they? All of these workers in these newly grown areas were trying to get their slice of the American dream.It wouldnt take much to grant that noble wish to these low to mid income wage earners. Why, the banks would be doing them a favor.

Several things began to occur at this point. Energy costs began to slowly increase, interest rates began a precipitous fall, credit qualification’s were changed to allow people without adequate income or history to take out loans far larger than they could repay. This created an entirely new class of CDO, armed with millions of these low quality mortgages(backed by immensely over priced property) the banks had a huge new supply of obligations to sell. And sell them they did. A veritable cornucopia of untenable debt was placed in the market and passed off as investment grade debt.

Huge amounts of this bad paper were based in areas with high concentrations of automotive, energy, and service sector workers as the debtors.

Next , the regulations were successfully changed that allowed banking sector and insurance sector to cross pollinate. Oh, great. Now the same bank that was making these loans to unqualified debtors on those grossly over valued homes, were also insuring those homes. And in many cases, the debts.
The situation was primed for a visit from Murphy.

A situation ripe for a debacle.

It is at this point that my own model and many others, began to break down. The toxic combination of falling interest rates, low wages, burgeoning property values and bad fiscal policy had dramaticly altered the face of baseline economics. Creeping inflation in non-discretionary staples(food,fuel,etc..) was eating at the stagnant incomes of a low and mid range wage earners. The influx of “undocumented workers” was distorting the retail sectors earnings, and by this distortion, the buying power of the taxpaying workforce. The key here was the negative savings rate but increasing retail sales of discretionary items. The money was coming from somewhere, and the percentage of HELOC debt could account for bearly half.

So here, we have unsustainable earnings growth in the retail sector, a credit industry beyond capacity and growing, a financial sector subsisting on bad debt and shady lending to people being squeezed by inflation and stagnant/decreasing wages. All of this financed by growth primarily in what now was a single sector= financial/insurance. Remember, the rules had been changed to help fuel the finance sector. They now not only lent the money on all of this sub-prime debt, but they had sold it as face value based on false property valuations. And now they insured not only the overvalued property, but the debts themselves to the tune of hundreds of billions. Much of it geographically concentrated near the growth sectors hottest regions. These would be Florida, the Gulf coast, and Refinery alley.

The situation was primed for a visit from Murphy.

Boy howdy, did Murphy ever pay a visit to the financial sector.

While cracks were beginning to show in the foundations of the financial sector as early as 2004, the beginning of the end was ,literally, inevitable and spectacular. The body blow came in from Africa and had a vengeful bulls eye painted dead center of both the sub-prime housing sector and the insurance sectors Achilles heel. The concentration of over valued and double risk (remember, the same issuers of the debt were now also its insurers) property was enormous. So was Katrina.

Three years later, many thousands of homes are still vacant, the insurers are still fighting against paying off. The losses to the financiers and insurers are still unknown, estimates range from many tens of billions to near 200 billion. Those estimates are replacement value not insured. Remember, the insured value was on the way over hyped boom days when a two bath row house was loan valued at 125% to 150% of today’s value.

The hits against the financial sector have continued with alarming regularity. Midwest floods, layoffs, lawsuits, all continue to hammer real estate and insurance. Auto companies are scaling back or closing outright. Construction, both residential and commercial is falling. Earnings across the board are dropping. Energy is a Trojan horse, the many billions being made their are mostly going overseas, not back into our economy in the form of more jobs and domestic expansion.

With the loss of domestic growth industries the bad lending practices of recent years are coming to fruition. And it ain’t Bordeax were smelling. It is the rotten fruit and bitter grapes of an ever advancing rate of default on both residential and commercial real estate debt. This default continues to eat at the vehicles issued using inflated property valuations as collateral. the disparity between the obligated amount and actual worth of the underlying property grows daily. Perpetuating the slide downward.

So here we are, looking at a coming correction to the downside. A natural result of the latest correction to the upside.