No Quick and Easy Fix for This Market

Doug Kass

This blog post originally appeared on RealMoney Silver on Aug. 13 at 8:17 a.m. EDT.

Since the housing market's collapse, cheerleading government officials, audaciously bullish strategists, investment bankers, commercial bankers and money managers, extrapolating economists and even irresponsible ratings agencies have felt the economy would not be affected. Skeptics were discredited (and forced to drink cheap tequila on the cold linoleum floor) because, in large measure, worldwide share prices continued to trace a pattern of nearly uninterrupted advances. They were all wrong; the economy has not been unaffected.

Many of those same observers have felt that the subprime disaster would not infect other parts of the credit market. They were wrong there, too, as the credit markets around the world have seized up and have been forced to rely on the injection of liquidity by central bankers in order to temporarily halt a full-fledged credit crunch.

The bullish cabal is now again arguing containment -- that a combination of potential policy decisions, such as allowing Fannie Mae (FNM) and Freddie Mac (FRE) to expand their lending ability, Fed easing and central bank liquidity adds, will be the ticket to a return to stability.

They will be wrong again for the following reasons:

• The cleansing process will take time. There is no short-term fix. The pendulum of the credit cycle is only in its early stage in what appears to be a swing back to normalcy. And the magnitude of the leveraging of the worldwide economy and of hedge fund investors will not allow for normalcy overnight.

  The worldwide helicopter drop of money last week (through central bank injections of liquidity) was in response to the banking industry's demand for cash. Over here, fed funds were boosted to a panicky 6.00% in early Friday trading, well above the target level of 5.25%. Over there, it was even worse as market participants have been late in responding to and understanding the magnitude of the subprime problem. (It was only last week that three European funds and Bank Paribas acknowledged losses.)

  Unfortunately, these (de facto easing) moves will likely serve only as a Band-Aid to a system that has dined at the trough of leverage for years.

• The economic consequences have not even begun to be felt. We have not even begun to feel the economic effects of rising delinquency and foreclosure rates, to say nothing of the broadening crisis in credit. It was only in late 2006 that these rates began to climb.

  Consumer and, more importantly, business confidence is about to hit the skids as the credit event morphs into an economic event. And the private-equity model (of leveraging up Corporate America) is now in jeopardy. Consider the near $300 billion backlog of non-syndicated bridge loans and unsold junk bonds in the pipeline. With interest rates for levered transactions shooting up in recent weeks (if those sort of loans are even available at all), many of these deals are in jeopardy to be completed.

  For example, how in the world does J.C. Flowers finance the more than $16 billion of debt to acquire Sallie Mae? The answer? It doesn't, and the company will likely cite the "adverse event" defense in an attempt to walk away from the near $1 billion breakup fee obligation.

• The commercial banking and investment banking industry is overconfident, overleveraged and under-reserved. And so, too, are the dominant investors of the new millennium (i.e., hedge funds and the fund of funds community. Recklessness will be replaced by conservatism in the months (and possibly years) to come.
• The government-sponsored entities are still bruising from more than $10 billion of fraud/losses and the associated political fallout. Given the recent histrionics, FNM and FRE -- I shorted both late Friday -- are likely to stay limited in their ability to support the housing markets outside of conforming mortgages.

  What is needed is a more permanent fix, a comprehensive housing Marshall Plan aimed at clearing the housing mess up over the next one to three years. Unsold inventories, stretched affordability and reticent mortgage lenders seem unlikely to be importantly affected by a cut in the fed funds rate.

• A full-fledged credit crunch will be the mainstay of housing for at least another year. In periods of stress, fear is amplified. This helps to explain why mortgage rates for jumbo loans (even to creditworthy borrowers) are skyrocketing without a concomitant rise in the general level of interest rates -- in fact, the opposite is occurring -- and why mortgages are so difficult to come by. The purchase and refinance mortgage market is effectively shut down.

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Been walking my mind to an easy time my back turned towards the sun
Lord knows when the cold wind blows it'll turn your head around
Well, there's hours of time on the telephone line to talk about things to come
Sweet dreams and flying machines in pieces on the ground.
--James Taylor, "Fire and Rain"

What we have learned from the last month is that in a period in which nearly every asset class rises in unison, disbelief tends to be suspended. When all investors are doing the same thing and making money, the hard questions are never asked because skepticism goes on holiday. And, importantly, when risk is hijacked, models misbehave.

As I have suggested for the past two years, investors should be looking less closely at put/call ratios and investor sentiment surveys and instead should be reading the investment books that intelligently put credit and speculative market cycles in perspective. They should be reading books like Roger Lowenstein's When Genius Failed: The Rise and Fall of Long-Term Capital Management, Charles Mackay's Extraordinary Popular Delusions & the Madness of Crowds and James Grant's Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken.

In our tightly wound and levered financial system, investors today might be advised to concern themselves now with return of capital; it is likely too early to be concerned with return on capital.

Amazingly, in last week's credit crisis, equities ended the week higher -- even despite Thursday's schmeissing. And, even more surprisingly, is that the S&P 500 is flat on the month of August and still up by 2.5% on the year. (Of course, non-rigorous bullish market technicians, who never seem to find a sentiment indicator that doesn't shine positively for equities, will no doubt view this positive market performance as constructive.)

With corporate profit margins vulnerable to a regression back to the mean, price-to-earnings multiples still high -- until recently the median P/E on the S&P 500 was about 20 times -- and the many non-investment threats (political and geopolitical) enumerated daily on The Edge, the outlook for equities has turned sour.

We will have vicious rallies in the bear market that I envision, but they will be fakeouts. Buy on the dip? Not with my investors' money. Sell or short the rips, as (you can bet your bottom dollar that) "the sun will not come out tomorrow."

I see fire, and I see rain.

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