DummySpots.com

Both my main man Barry Ritholtz and my Atlanta hero Trader Mike have linked to this Wall Street Journal Article about people with high credit scores getting into subprime loans.

The WSJ describes these Poor Victims as being “caught in the subprime trap.”

I call bullshit. These people are caught in the greedy yuppie peer pressure materialism, keep up with the Joneses, entitled but not responsible trap.

Easy credit opened the gap between what we could afford and what we could qualify for. Even easier credit expanded that gap. Zero interest for 60 months on that new car (go ahead and get the leather and navigation system now). Six percent for 360 months on the new house, or better yet, four percent interest-only with nothing down so you can get into a house you can’t afford. Whether someone takes the bait is their decision.

But the consequences are theirs also. Well, should be theirs. Actually, now they’re becoming mine. Those poor victims.

My credit score is over 800. The house I’m sitting in right now is cheap, and paid for. The house I bought in October cost less than I make in one year. I don’t have to rush as I remodel it. I plan to pay it off before most people would pay off a new car. And then, thanks to these “unforeseen” developments in real estate, I might just buy myself a larger house for half of what its previous owners mortgaged. Those poor victims.

I can grill ribeye steaks for my girls anytime they want, while my friends’ kids are home alone on MySpace chatting with a pedophile because their parents are working second jobs to make the note on the mansion, only to come home and eat Ramen noodles, or else eat out with the Joneses and put it all on the credit card. Those poor victims. (The kids, I mean).

A man is rich in proportion to the number of things he can let alone - HD Thoreau.

The American Dream has run amok. I wrote a post about that, and real estate, almost 2 years ago. But this is all a recent development, a surprise, right? Here’s that post.

We’re all grown up. People should make their grown-up decisions, and take the consequences. Or try to dump them on responsible dummies like me. Whatever. But Jesus, stop all this crying and whining- it’s pathetic.

And as for Alan Greenspan and John Maynard Keynes: Rappaccini! And is this the upshot of your experiment?

It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions. (from Ben Bernanke’s Aug. 31 speech)

The Chairman is exactly right, and I’d go a step further: It is also not the responsibility of the taxpayers to protect lenders or investors.

As I’ve mentioned, one of my core beliefs is that true adulthood and maturity are the result of learning to accept and deal with the consequences of our own decisions. More importantly, it’s learning to consider the consequences before we commit to a decision, not just whether “I want it.”

Giving others (our children, our spouses, entitlement recipients, Katrina victims, subprime borrowers, Citibank, Long Term Capital Management, the United States Congress) the freedom to make decisions without having to consider the consequences does nothing but induce a spiral of more and more irresponsible behavior.

It is our job, as parents, friends, citizens, fellow humans, to maintain the connection between Freedom and Responsibility. That’s how they become independent and self-sufficient, instead of mewling, manipulative exploiters unable to control themselves and always needing someone else to bail them out.

The Problem With Subprime Defaults: The Deflationary Shock

Unfortunately, the consequences materializing from the actions of irresponsible lenders and borrowers don’t affect just them. Otherwise the solution would be easy- let the bums feel the sting! Trouble is, that sting is like a firecracker under a butane tank, the butane tank which is our entire economy- and those consequences would snowball into something that seriously hurts all of us.

You see, due to the way our fiat money system works, debt is money. Banks create money by loaning their excess reserves (how much excess exists in the system at a given time is one way the Fed exerts its influence). These loaned dollars (someone’s debt) are in turn deposited by the recipient, and the bank gets to count that money on its balance sheet, and turn around and loan most of it back out, which is then re-deposited somewhere else, etc.

This multi-generational money creation machine (think biblical- “10 dollars begat 9 dollars which begat 8 dollars…”) is how a few billion dollars added to the system can balloon into many many billions of new dollars floating around our economy in search of a product to purchase (or a 3BR, 1.5BA w/ 2CG and WBFP).

Now the ugly flip side: It works the same way in reverse. Drain a few billion dollars out of the system, and it results in many many billions fewer dollars floating around, since the cornerstone of the pyramid has been removed.

Fewer dollars chasing the same products- that’s also known as deflation, and as it ripples through the economy it affects us all. A deflationary spiral occurs when such a ripple adversely affects other borrowers (deflation makes debt more expensive and harder to pay off with future earnings), and those borrowers begin to default, which removes more money (debt) from the system, which compounds the problem and makes the deflation worse, and on and on…

Eventually the system can contract so much that massive defaults begin to occur even in “prime” loans. If we get that far, we’re in another Great Depression.

How To Prevent The Losers From Triggering A Depression - Refinance

As with your kid who’s been arrested for getting caught smoking pot naked in the back seat of the Lexus with the preacher’s daughter… it’s a little too late to go back and say, “DON’T DO THAT, YOU IDIOT!”

What we’re faced with is a choice between the lesser of evils. To do nothing and “let the bums feel the sting” is to do great damage to our own financial future through the mechanism of debt-deflation.

To write hundreds of billions of dollars of taxpayer-funded checks to the banks and relieve the bums of their responsibility is even worse. As I described above, that would just encourage more of the same behavior, from the bums and from the banks.

As much as possible and although we hate it, we need to prevent the bums from defaulting, but we need them to continue to carry their debt and make payments on it. The answer? Some type of refinancing solution. In this scenario, the banks take a little hit, the taxpayers take a hit (the refinanced loans would doubtless involve some type of government backing, which means it would cost us… but significantly less than actually taking on the debt itself), the irresponsible bums keep their loans at a lower rate which (hopefully) they can make payments on. The debt-money stays in the system, and we have a much better chance of weathering the coming recession. Oh yeah, did I mention that?

I believe this is why Chairman Bernanke is encouraging banks and legislators to pursue a refinancing solution, as in his letter to the honorable Chuckey Schumer:

The federal banking regulators have encouraged banks and thrifts to work actively with troubled borrowers to modify loans or to refinance as needed to avoid default or foreclosure…

and

It might be worth considering at this juncture whether the private and public sectors, separately or in collaboration, could help the situation by developing a broader range of mortgage products which are appropriate for low-and moderate-income borrowers, including those seeking to refinance. Such products could be designed to avoid or mitigate the risk of payment shock and to be more transparent with respect to their terms.

In short, there is no easy way out of this mess. There’s painful, and there’s more painful. Those are our choices, our consequences for allowing a system which rewards greed, immediate gratification and irresponsibility.

Jeff over at A Dash of Insight has written another excellent article, this one entitled “Do Internet and Media Resources Help the Individual Investor?” However, he makes a couple of points which themselves reveal a bit of bias, and I’d like to look at them through my particular shade of Rose-colored glasses.

I Reject the Facts Based on my Anecdotal Observations

Jeff points out that Ms. Olick from CNBC overgeneralizes based on what she sees as “typical behavior,” implying that her view on real estate is unreasonably biased. He says that

“Homeowner behavior is a distribution, not a unique point.”

I completely agree, which is why Jeff’s example (his Utopian neighborhood where the homeowners are thriving and confident, the men are strong and all the children are above average) is at least as misleading as Ms. Olick’s.

Homeowner behavior is a distribution– one which has already shifted significantly due to uncertainty about the future value of our homes, and which will continue to shift as this uncertainty becomes a self-fulfilling prophecy of negative sentiment and reduced spending.

Rising home equity has fueled the spending binge which has largely contributed to keeping our economy afloat the last decade. As that equity stops rising (or worse, begins to fall), we’ll get an extreme slowdown in spending as people find their credit card balances bouncing up against their limits (again), but this time discover they’re unable to “cash out some equity,” pay down the balance, and keep on spending. It will take some time for the credit cards to max out (pay $200, charge $300, balance gradually and inexorably creeps upward), so the most serious slowdown in spending will lag the recession in home prices by some months. In other words, the worst is yet to come.

I Have More Letters Behind My Name Than You

As for the impressive credentials of Mr. Blinder and Mr. Gault, they do imply that these gentlemen are far more qualified to talk theory than Ms. Olick (or me). But it doesn’t make their opinions about the future any more valid than those of a reasonably intelligent person who has taken the time to educate himself, examine the evidence and form a considered opinion.

How many experts were alerting us to danger in 1999, compared to the number using the words “New Paradigm”? How many experts publicly warned of falling home prices before the fact hit them in the head like a brick? (I’m no expert, and even I saw this coming).

As a matter of fact, I’d argue that those same credentials often insulate people from reality, leading the “experts” to ignore even flagrant evidence if it contradicts them. Thus catastrophe sometimes results as these people begin to think of themselves as infallible. Remember Long Term Capital Management? Myron Sholes and Robert Merton, both Nobel prize winners. Two of the smartest guys on earth. Lots of letters behind their names.

How about the multitude of hedge funds which are currently in the process of imploding or at least unwinding? Many of them populated with Ph.D. “experts” from the top educational institutions in the world. Not a single secretary or cotton farmer to be found among them. Does that mean that the secretaries and cotton farmers can’t see what’s going on with the economy and that their opinions about the future are less valid?

Personally, I found Ms. Olick’s (limited) part of the segment to do a great job of making a connection between the jargon of the experts and the concerns of the average person. The expert guests both agreed that the housing slowdown is a fact, and nothing Diana said contradicted them. Here’s her part, as best I could get it from the CNBC video (which I kept having to restart until I finally gave up):

It’s about sentiment. Obviously people feel that their wealth is in their home. For Americans, it’s their biggest investment by far. So when you feel that your home is not worth what it once was, that you can’t pull home equity out of your house like you might have been able to a couple of years ago, you just don’t feel as wealthy as you once did, and that of course translates into consumer spending and how we’re going to spend our money.

We’re already hearing from the homebuilders that renovations are starting to fall… and that dribbles over into places like Home Depot that fuel everything that goes into our houses. All of these things have a ripple effect, so when you feel that your home is not worth as much as it was before, even if you’re not putting it on the market, it definitely has a fundamental effect on how you see your own wealth.

I Agree With Jeff

The above being said, I wholeheartedly agree with the premise of Jeff’s article: that the media and much of the “information” on the internet are likely to do more harm than good, particularly by misleading investors into thinking this stuff is easy, and usually with the hidden motive of trying to sell them something. I hate marketing disguised as information or education, and I think Jeff has hit the nail on the head with that point.

We got our buy signal, and we got long. In the previous post I’d said

I see Thursday 8/16/07 as a PRIME, and possibly the LAST, opportunity for a buy signal to emerge before we have to look away

and I also said

I will get long very aggressively on any good OGRe (Opening Gap Reversal) once it trades back into today’s range.

This OGRe wasn’t a pretty one, however. (For a more thorough discussion of how I view OGRes, see this post about Trading Opening Gap Reversals). We got our gap down, but then spent the day alternating between ecstasy and agony with those wide swings… until 3pm EST, that is. Then we got that outrageous “4 dollars straight up in 50 minutes on huge volume” rally right at the end:

The daily chart looks more like a nice clean OGRe since it doesn’t show those intraday vascillations:

Note that, per the Gospel According to Steve Nison (aka Japanese Candlestick Charting Techniques) it’s not a hammer since the lower shadow isn’t at least twice the length of the real body. However, the real body on this monster is $2.31 wide, and the lower shadow is another $2.79 below that, which is still jaw-dropping.

Long, But Not For Long

This trade, like most I’ve written about the last few months, is based on my current RSI(4) -based methodology. These trades typically last from a few days up to about three weeks, with the majority on the “few days” end. So this is still a quick little swing trade in my book, not a pronouncement that we’re headed back for all-time highs.

So Was This The Bottom?

I don’t think so. The macroeconomic factors haven’t resolved in the least. In fact, I’ve continually made fun of the talking heads’ using euphemistic language like “housing slowdown,” “slump” and the ubiquitous “soft landing” … we’re not even close to the last shoe dropping on the housing bubble (can we all agree on that term now?). I firmly believe there’s a Dragon in the Corner and that we’re about to enter the recession portended by the yield curve inversion starting in December 2005 (remember, the recession often takes 18-24 months to show up, but of course the choir has endlessly sang “This Time Is Different”).

Note the deflationary symptoms rapidly emerging: tight credit, reduced money velocity, and hey bugs… check your gold prices– who says gold goes up because people buy it when they’re scared? People are scared as hell right now, but gold is faltering because of the risk of big “D”. Oil’s down, too, thanks to the stronger dollar. And yes, I believe the Fed’s response will be to lower the target Funds Rate soon and start increasing money supply vigorously, but in this case, I’d agree that it’s about their only choice since we’re so far down the Rabbit Hole.

Also, I’ve extensively (exhaustively, painfully) backtested the RSI(4) method I currently use, and it’s told me something: in uptrends, it tends to cycle from the high 20s to the mid 80s, sometimes spiking into the 90s (i.e. skewed upwards overall). In downtrends, on the other hand, it tends to drift up into the 70s, then soar down into the low teens or even lower. The last few cycles, it’s been acting less and less like these are “pullback in an uptrend” swings, and more like full-fledged downtrend thrusts. I may be switching from buying drops to shorting rallies in the very near future.

So You’re Overtly Negative, But You’re Aggressively Long Right Now…

Precisely!

We’re at a historically important crossroad right now for the U.S. Dollar. That crossroad is at the top of a jagged mountain, and we stand atop a precipice with a perilous plunge on all sides except for one narrow, treacherous path leading to safer ground (the path of solid, steady economic growth which seems so unlikely right now). And I’m about out of metaphors.

I’ve written sporadically about currencies and how important it is that we keep an eye on them. They’re not the tail that wags the equity dog. They’re the bank that finances the debt that built the home where the little equity dog lives out back. (Ok, so maybe I’m not out of metaphors). Point is, currencies are just that big a deal. As I’ve mentioned before, the currency market dwarfs both the bond market and the stock market by a considerable margin. The weakening or strengthening of the dollar, combined with the reasons for that weakening or strengthening (economic growth or lack thereof, Fed policies) influence global economic activity and account for the growth or failure of the companies whose stock we trade, and just as importantly, the companies who employ many of us.

Here’s a chart of the Dollar vs. Euro from last weekend:

The dollar “climbing” on this chart is actually the dollar weakening (more dollars to buy one Euro). If you’re not used to thinking “up” and “weakening” at the same time, here’s the same chart flipped, which makes the weakening even more obvious:

This chart, which goes all the way back to 2002, shows how the dollar weakened through the beginning of 2005, then drew a Head and Shoulders pattern through mid-2006. The pattern then failed as the dollar broke upwards (weaker) from the right shoulder.

We now sit between the critical levels of 1.3666 dollars/euro as the last line in the sand before a dollar plunge, and the 1.295 area as a support level which, if broken, would portend further strengthening of the dollar.

The main question is which one do we wish for? For me, the answer is that we wish for a stronger dollar to help offset the likely-approaching events which will serve to further weaken it, namely, lackluster economic growth, Fed easing and the continued strengthening of the Yen and Renminbi (yuan).

If the U.S. economy caught a little gust of wind in its sails and actually began picking up steam (which it most definitely has not, considering the unprecedented liquidity poured into it the last few years), the dollar would strengthen, we’d get a tad of inflation, life would be good. It may even allow enough breathing room for China to let the yuan strengthen a bit more without cratering the dollar.

However, the economy doesn’t seem to be “catching fire” at all, no matter how many trillions of dollars have been thrown into the tinder box over the last decade or so. That’s bad, bad news.

The late, great, brilliant economist Milton Friedman tied inflation directly to money supply. Flood the market with more dollars than the economy requires for current growth, and the result is inflation. Lots more dollars chasing a little more product. Those excess dollars sloshing around in the economy get spent and re-spent, increasing the velocity at which money flows through the economy. It’s that money velocity which results in upward-spiraling prices and wages, i.e. inflation.

Conversely, if the Fed were to start reducing the money supply, or even increasing it, but at a rate slower than required by current growth, money velocity would slow down, people would hold their dollars longer, those dollars would begin to increase in value… voila, deflation.

Deflation is not good. The ideal balance for economic growth and happy peasants… er, citizens, is what they call “a little inflation.” Maybe 2-3%. Why? That’s an article in itself, but the short version is that prices go up easily, but are “sticky” on the way down… they don’t fall in proportion to the decreased money velocity. Particularly wages. Would you be agreeable to having your pay cut during recessions (i.e. really tied to the “cost of living”)?? Nobody would. So what can happen is the dreaded deflationary death spiral, where people spend less- so money velocity slows- so economic growth slows- so people spend less… There is only one known way to (try to) abort such a spiral:

• The Fed floods the economy with money (by lowering the Funds rate) so that people loosen up and spend more

• The economy grows and people get jobs and buy houses and feel good (the intended effect), and we get some inflation from the excess money supply (a side effect)

• The Fed then steps in and gradually slows money supply growth by raising the Funds rate, ostensibly to fight inflation, its media mandate.

• If all goes well, we settle back in at 2% inflation and everything’s back on track. Right?

Right, in a perfect world. But that’s where we should be right now, after the hundreds and hundreds of billions of dollars added to the economy in recent years, which resulted in trillions of dollars of extra spending:

1. We had the LTCM debacle in 1998

2. The Y2K recession and stock market meltdown, and

3. 9/11…

In response to each of these situations the Fed, under Alan Greenspan’s leadership, did exactly what he and Paul Volker had learned to do after studying the mistakes the Fed made which deepened and prolonged the Great Depression… Greenspan’s Fed flooded the eoncomy with money- in the case of 9/11, by cutting rates by a half percent at a time and pouring liquidity into the market as fast as the 1s and 0s could cross the wires.

And it worked. Sort of. The economy didn’t go into a death spiral, and it even began to grow a little. But not nearly as much as it should be growing. We should have nearly- out- of- control inflation. Fed with Funds rates at 8% trying to calm the flames. Pay skyrocketing due to job demand created by the surging economy.

That is not where we are right now. We have an economy frothing with money, but no growth to speak of (compared to what should be expected).

What we have is an economy that’s trying to stall in spite of all the excess money. What happened to all that money, and where’s the inflation? That money caused a vast inflation in home prices, in case you didn’t notice. Why didn’t that show up in the CPI so that we’d all hear Maria moaning about it on CNBC? Hint: they don’t count it because it would look too bad. We might think our economy wasn’t as “stable” as it so obviously is. Wink. Nod. Consumer prices have been very stable, except for the stuff we don’t want to count.

Including home prices, we would have been showing outrageous inflation over the past 5 years with very very little economic growth. Stagnant, even. Bingo- stagflation.

Now we have the beginning of the collapse of the real estate bubble. Not the end, not the middle. Remember when the “experts” were all chirping about how home prices may “slow in their rate of increase,” but would never go down overall. I remember, because I laughed at them. Not only that, I went on the record and wrote one of my first soapbox articles on Dummyspots about it.

Well, those same “experts” are the ones pronouncing the collapse over, that we have or are near a soft landing, etc. And they’re still just as wrong.

As home prices continue to decline, people will stop spending, not because they’re responsible, but because their ATMs (i.e. cash-out refi’s) have been taken away. Money velocity is decreasing. Economic activity is waning.

If this continues, all the Fed can do is pull the same rabbit out of its hat- the rate decrease. The bond market is already predicting a decrease.

But this decrease won’t be very effective. The Fed doesn’t have the power, with rates at only 5.25%, to drop them far enough to re-liquify to the economy and abort the spiral.

Without some serious economic growth, and seriously quickly, we’re the next Japan of 1988. And the chart of our stock markets may very well look like the chart of the Nikkei in the 90s.

What to do? Watch your charts. Watch your stops. Hope for economic growth. (click) Economic growth.(click) There’s no place like home. Here’s to hoping…

Today’s economic news saw the PPI rising 0.1%, with the core rate falling by 0.4%. Estimates were for up 0.3% and 0.2%, respectively.

Discussion currently seems to revolve around whether the Fed will definitely stay “on pause” now, or perhaps whether they “went too far” with the string of rate increases.

I want to use this opportunity to bring out an OLD soapbox of mine: the increase in the money supply in the early years of this century was waaay overdone and credit was loosened waaay too much. The resulting spending binge we Americans went on, which was multiplied as we re-financed and re-re-financed our golden geese rapidly-appreciating homes, should have sent the economy into a hypertensive crisis. The Fed should have had to raise by leaps and bounds to get things under control, and should have had to overshoot “normal” to cool off the economy, “normal” being a 6+% Funds Rate.

Instead, we’re sitting at 5.25%. The Fed has not “hit the brakes,” it has only let off the accelerator somewhat. For the economy to be slowing, or even threatening to slow at this point, is ominous. Spooky. Dark clouds on the horizon.

I was encouraged by the recent reports of healthy economic growth, the little blip in bond yields, and the slight strengthening of the US Dollar, which is skating on the thinnest of ice.

Now we’re placed squarely back in a position where we could be faced with waning economic growth, unmanageable debt, a falling dollar, and rising interest rates all at the same time. Yes, rising. If… no, make that when, the Chinese and Japanese slow the rate at which they are accumulating US Treasury debt, the price of that debt (i.e. those bonds) will fall with the slowing demand, and the yield will of course rise, causing the rates on virtually all credit products to rise as well.

These are ingredients for a terribly nasty-tasting economic cake. Let’s hope today’s PPI is subject to some significant revision, and that the economy continues to grow at least at a simmering pace for a number of months.

We are due a recession- overdue if you count the one the flood of new money a few years ago postponed. I think the inverted yield curve is telegraphing that fact. But remember, we need something to recede from.

Note: I’m turning off comments on this post– for some strange reason, it seems to be the target for a flood of comment spam.

From an article in BusinessWeek:

Borrowing a tactic from 12-hour specials at department stores, homebuilder Centex Corp. on Wednesday unveiled a promotion aimed at spurring sales in northern California by offering to cut prices on some models by up to $100,000 for 12 hours next Saturday.

Anyone else see a little red flag here? Perhaps a slight hissing sound, like air escaping from something?

An interesting quote from Barron’s noted on the excellent maoxian site:

That is precisely the nature of a bubble. It is concentrated in a relatively narrow sector. The 2000 bubble in the stock market was concentrated in TMT [telecom, media and technology]. There wasn’t a bubble in U.S. Steel or copper stocks or oil. The apologists for the housing-market bubble in the U.S. always point out that it is concentrated in a few markets, but that has always been the case. I don’t buy that if the bubble in California, Florida and Texas deflates, it won’t have an impact on the economy…
Marc Faber