Kass: A Market on the Brink (Perhaps of Recovery?)

This blog post originally appeared on RealMoney Silver on March 7 at 7:46 a.m. EST.

"The hedge fund community (especially of a quant-kind) is disintermediated in 2008. Outflows accelerate, abetting an already conspicuous trend of rising volatility in a market that behaves more like a commodity than ever."

-- Yours truly, "20 Surprises for 2008"

Back in mid December 2007, I described the market as on the brink as rising inflationary pressures and slowing economic growth had increased the possibility of stagflation, a condition that has historically led to a contraction in P/E ratios and poor equity returns. I went on to describe the current credit crunch as "unlike anything we have seen in modern financial history" and stated that the "availability of credit will be markedly reduced in the years ahead."

The full column is here and warrants a rereading and so does our surprises for 2008 piece, which, in large measure, has become of a list of current events.

One of my primary concerns has been the impact that the de-accumulation of credit/debt would have on the world's increasingly unwieldy and unregulated financial system. The process, as we have long expected, has uncovered an abuse of leverage and the pervasive (and uncontrolled) growth of toxic credit and interest rate swaps in all the wrong places -- in hedge funds, municipalities, in activist portfolios, in government-sponsored agencies, in municipal bond funds, in money market funds, in financial institutions and elsewhere.

That deleveraging of credit/debt has accelerated with astounding speed over the last week. Bond spreads of every description have blown out, and investors (individual and institutional) are unloading assets (good and bad) at breakneck speed in order to reduce leverage (risk) and exposure. The carnage has been broad-based, as almost every asset class is suffering, which is an abrupt change from the experience of a synchronized upward move (of bonds, stocks, commodities, residential and non-residential real estate, etc.) in 2002-2007.

For some time, I have been worried, to borrow from M. Ramsey King Securities' Bill King, that hedge funds "using immense leverage to pick up nickels (small spread) in front of a bulldozer and who used the gains from compressing spreads to lure more capital and credit" would be the financial system's undoing. So I haven't been surprised by the consequences of their massive unloading of assets.

Indeed, this week we are facing an almost unprecedented, self-reinforcing spiral of asset sales in which the margin clerks and risk managers (not the portfolio managers), who don't know what a P/E ratio is or even care, are in control of the books. By now, it is too late for those whose collective heads were firmly in the sand and who embarked upon a strategy of enhancing yield, while, at the same time, abandoning common sense and due diligence as they continued to employ ever larger amounts of leverage.

Where it will all end cannot be known. It certainly does not help that The Three Stooges of 21st Century Finance, who reside in the Executive Branch, the Treasury Department and the Federal Reserve, lack financial leadership. Nor does it help that many talking heads (especially of a media-kind) view the current reality as hyperbole and are still dismissing the dollar's destruction, the incipient rise in inflation, the spreading credit crisis and the stock market's plunge as nothing more than a bump in the proverbial road.

Nevertheless, history shows that cycles go to extremes in both directions: Just look at the Nasdaq's schmeissing after the bubble of the late 1990s and its subsequent rally early in this decade.

From my perch -- and I have been on these problems like a fly on garbage -- there is a silver lining. Forced selling almost always means we are in the later innings of the ball game.

I just hope that the credit crisis plays out more like the 2007 Boston Red Sox than the 2007 New York Yankees.

Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.