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July 30, 2008

Pivotal Events
by Bob Hoye

The following is part of Pivotal Events that was published for our subscribers July 24, 2008.

SIGNS OF THE TIMES:

Interesting Events At Lesser Exchanges:

"Vietnamese Stocks Bedazzle Investors"

- Wall Street Journal, February 23, 2007

"Almost 100 million accounts open now - including 310,000 just this past Friday."

"So far, sellers haven't reported any problems, and the only jostling this year has been for places in line to open brokerage accounts."

That was from a May 22, 2007 Wall Street Journal article on the Shanghai market.

"40% of Chinese households plan to invest in the stock markets, a 10 percentage point rise since 1Q."

- A June 2007 Peoples Bank of China survey

"Inside a crowded brokerage in this central Chinese city, Zhang Waniong was getting anxious as China's stock market ticked to a new high. The problem: He couldn't find an unoccupied trading terminal to buy shares."

- Wall Street Journal, November 13, 2007

The story had been filed some weeks earlier, and the record high was 6124 set on October 16. So far, the low has been 2566 in early July.

"Violence Erupts Over Pakistan Stock Drop"

"Smashed windows of the Karachi Stock Exchange"

- Financial Times, July 17, 2008

Although the violence erupted in Karachi, the time line is a classic example of a collapsing bubble in lesser exchanges. Back in 1873 New York was the equivalent market and when some important financial firms began to fail newspapers reported:

"No one could have been more surprised if snow had had fallen amid the sunshine of a summer noon."

Then when Cooke stopped payment "A monstrous yell went up and seemed to literally shake the building in which these mad brokers were for the moment confined."

"Brokers were trampled in the panic, dragged away, and taken to hospital."

The significance of the 1873 boom was that it occurred when the US was on fiat currency, which as the leading newspaper argued was proof against a contraction. The bubble included both financial and tangible assets, such that mining stocks were also high-flyers. The initial bear lasted for five years.

Although the usual business cycle came and went, the overall contraction was lengthy. In 1884 leading economists began analysing it as "The Great Depression", which lasted until 1895.

Stock Markets: Last week's edition reviewed the models that provided the most likely path that the decline would follow, which has been working out.

This included the initial slump of around 15% from May and the expectation of a quick 30% retracement of the loss. This has been generally clocked and the rebound in the banks was greater.

The outlook for the rest of the summer is choppy to down and it is worth keeping in mind that in unwinding the excesses of a great speculation the fall often is the season of forced liquidation.

The three models we have been using are the declines following the 1973, 1937, and 1907 peaks. As tabled last week, by the time the bear completed the senior indexes had given up 49 per cent.

The credit contraction, as signaled by the massive change in the credit markets, began in May a year ago. This, of course, anticipated the August panic, and the next deterioration in credit pushed the markets down to the January panic. Traditional corporate spreads are now wider than reached with the March disaster. While curve steepening is giving another warning it is not at the extreme reached in March.

It is worth emphasizing that although the Fed can push short rates down a little, it has no influence on the curve or spreads. These trends and their critical changes are set by market forces that regularly inconvenience policymakers. Besides that, short-dated market rates of interest always decline during a post-bubble bear market. During the initial phase of the post-1873 bear the senior central bank (BoE) administered rate declined from 9% to 2.5%.

Energy: Although it seemed to happen slowly, there was a quick succession of Upside Exhaustion signals. First for natural gas, then for coal stocks, followed up by the big one for crude oil. This was reviewed in the July 4 Pivot, when we advised that the weekly reading had not been registered since Iraq's invasion of Kuwait in 1990. Also noted was that the action was working on the biggest monthly reading since the monster high in 1980.

Big time stuff and decline since in the energy sector is impressive, as well as timely. However, natgas has a habit of spiking almost straight up and then almost straight down. Last week we advised that we would watch for an oversold condition and it is approaching. In the meantime, there could be some whipsaws.

Much the same holds for crude oil, but it has a history of testing the high. A quick test could happen soon.

For crude, this is a cyclical high and if the monthly exhaustion is accomplished it would be a secular peak. In so many words - Peak Oil. The change in the credit markets since last May-June suggests the latter is possible.

Editorial: Some have asked why we dwell so much upon the probability of things going wrong.

This contrasts with the Wall Street consensus that policymakers are well-informed and wise in judgment. That is reasonable in a world of normal growth and normal business cycles. On the latter when a recession happened it was always deemed as a policy "overshoot" with too much stimulation during the boom, and without a breath of irony, the recession was a result of an "overshoot" on attempting to temper inflation at the top.

For those who have been active in research for over six such business cycles this is tedious nonsense. The marketplace sets the peaks and troughs of the business cycle and all that intervention does is exaggerate the rate of currency depreciation on the way up the booms. Without deliberate depreciation the business cycle would continue much as it has with reliable documentation back to the early 1500s.

This record also includes two centuries of chronic depreciation--the hundred years ending in the early 1600s and the hundred years, perhaps ending in the first part of this century. The end of each such century was marked by a bitter struggle between authoritarian government with its clamoring clientele and the productive portion of the public. Persuasions have ranged from the "Genius of the Emperor" in Roman times, the "infallibility" of the Vatican when it was power mad in the 1500s and the "genius" of the Politburo until the 1980s and in the West, of central banking, until recent.

According to textbook nostrums this credit contraction should not only not be happening, but it shouldn't be so violently encompassing. The problem is that the revered "lender of last resort" has been on a bender of last resort. Moreover, recklessness was built in with the notion that manipulating interest rates and currency depreciation would always be beneficial. Both theory and practice have been reckless, but the belief in the system accumulated to the point that with such perfection there was no risk and participants leveraged up accordingly. The unwinding of unsupportable positions has been ugly and if the past continues to guide, it is not over yet.

However, there is something policymakers could do to end the contraction right now. All they have to do is get all participants in the credit markets to behave as recklessly as they were two years ago. This, of course, is impossible now that the street has discovered risk. Eventually the public will discover just who have been the real agents of risk all along.

It will take some time and a lot of pain before the public demands un-manipulated currency.

In the meantime, its timely to review our approach. The inverted yield curve indicated the boom was on and it was likely to reverse to steepening last May-June. It did in such a convincing manner that in that fateful July we concluded that "The greatest train wreck in the history of credit" had begun. This would be a "new" paradigm to those unfamiliar to the violent history of credit.

Within those who are familiar with credit is the Austrian School and from around March to August we ran "The Dearth Of Credit" by von Mises about three times. The nub of this piece is that for a contraction to occur bankers need not call loans--just become a little concerned and stop making them.

Wednesday's WSJ reported: "Developer John Thomas says he had nearly finished building a 222-unit condominium and hotel project in California, when his lender wouldn't release the final $6 million from his $40 million construction loan.". This seems to fit the recipe.

This contraction seems to be fitting Austrian School theories, as well as the model provided by five previous outstanding eras of asset inflations since the first big one in 1720.

Once a mania goes through the period of soaring prices against the inverted curve and then the curve reverses to steepening there is no record of the senior central bank preventing a severe contraction. Maybe, as the saying goes, "this time it is going to be different". Doubtful.

Link to July 25, 2008 'Bob and Phil Show' on Howestreet.com: http://www.howestreet.com/index.php?pl=/goldradio/index.php/mediaplayer/908

Bob Hoye
Institutional Advisors

The opinions in this report are solely those of the author. The information herein was obtained from various sources; however we do not guarantee its accuracy or completeness. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance.

Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities or options or futures contracts. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.

Moreover, from time to time, members of the Institutional Advisors team may be long or short positions discussed in our publications.

Copyright © 2003-2008 Bob Hoye

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