Triple D

‘Well, what do you know?’ says one trader to the other.

‘Just covered my Steel’ is the reply. ‘Too much company. Everybody seems to be short’

‘Everybody I’ve seen thinks just as you do. Each one has covered because he thinks everybody else is short – still the market doesn’t rally much. I don’t believe there’s much short interest left, and if that’s the case, we shall get another break’

‘Yes, that’s what they all say – and they’ve all sold short again because they think everybody else has covered. I believe there’s just as much short interest now as there was before’

From ‘The Psychology of the Stock Market’
By G.C. Seldon, 1912

Seldon went on to say that these mental gymnastics could go on & on – and that it highlighted a fundamentally different mindset among those that are short, and those that are long. Often jittery, technical – they speculate. But few ever ‘invest’ in a short position.

So it is worth asking – now we’ve seen a decent break in the markets, do I believe what we just saw was a technical correction lower? A reaction that gets weak players out, so the strong holders can build again for the new bull market? Or, are we in a more serious type of trouble? The type of trouble that will lead to a break of the March lowers to new, deeper, lows beyond.

That brings me to Jesse Livermore’s epiphany. He started out making a small fortune in the bucket shops – the equivalent of spread betting accounts today. Then he moved to a full retail brokerage, where he proceeded to lose money fast. One day he saw this old guy in the office, who went by the moniker Mr Partridge. Something to do with how his head was stuck halfway down his chest. The young guys would come up to him, saying he should cover his Steel, on account a rally was coming. Partridge said – yes, yes, thank you young man, you’re most likely right. When, asked after a decent pop, whether he’d covered, he said ‘No, I didn’t want to lose my position’.

And as he went on, Livermore came to see the wisdom in Mr Partridge’s ways – you could only make big money on the major moves. Working out whether people were short and covering might be good for a turn. But likely harmful to making the big dollars.

That is where I stand right now. I bought my net short down some on Tuesday and Wednesday last week. Mainly for technical reasons; panic selling of the UK banks, people no longer bullish etc. But fundamentally, I’m still bearish, and I’m still over 100% short.

And that’s because I think we are a small way through a big movement lower. In short – I think we’re headed for a triple derating. The events of the last fortnight, I suspect, have made this even more likely. So, how will this come about?

The first derating will come from the expectation, and then the realisation, of slower growth. The leading indicators in Europe and the UK have fallen off a cliff. And I think the US economy will ‘double-dip’ in the autumn when the tax break fades and the ‘end-of-destocking’ ends. But this isn’t the trouble. I think the big problem is that the slowdown may start reinforcing itself. I think that credit will play the central role.

In Bernanke’s ‘Essays on the Great Depression’, he did not think that a lack of credit available to small firms caused the depression. After all, big, cash rich firms could have used to invest and replace the smaller firms. Funny, you hear the same arguments today. But back then, the big cash rich firms just stopped investing. Why?

Because aggregate demand fell. Why did aggregate demand fall? Bernanke found that bank crises were a significant cause (he modelled it in some detail – but I’ll spare you that). Why? Because bank crises disrupted financial intermediation between consumers. Consumers could save at the ‘safe’ rate – which was, as it is now in the US, pretty low. And that’s if they trusted the bank. But consumers could only borrow at a much higher rate – if at all – due to banks’ unwillingness to lend. That kind of behaviour leads to asset price deflation and a reduction in the ability and willingness to lend, again. It was when the money stopped circulating, after the credit boom of the ‘20s, that the trouble really started.

There’s little doubt that this has started to happen in the US. My suspicion is that it’s going to get even worse than that in Europe and the UK.

Second, equity markets will derate as two year rates rise. This hasn’t been obvious, and that’s why so many people have lost their shirts buying short sterling, Euribor etc in recent weeks. What’s happened is that the rules have changed. In the 1990s, slower growth meant lower yields, and once slower growth was halfway done, stock rerating – as the discount on future earnings shrunk, and expectations of future growth improved.

But now we have shortages in oil. Shortages in food. And now consumers’ inflation expectations are fraying as a result – so the inflation targeting central banks are stuck. And, as I’ve discussed before, the unwinding of the European Banks’ structured product positions is also a big factor. So now we have slowing growth and rising two year yields. It’s a double derating; we’re discounting future earnings by more, just as we’re starting to suspect that future growth will worsen.

And if that’s not bad enough, I now think we get de-rating, part III.

What’s stage III? Well, I think we’re headed right into the jaws of a good old fashioned currency crisis. I think the ‘Bretton Woods II’ construct now unravels. And with it will come the kind of fear and volatility that will get stocks genuinely cheap. Cheap enough to buy.

I think three main forces are in place. The most important – the US current account deficit is now shrinking, after blowing out by 7.5% in five years. There’s a spooky similarity – in timing and magnitude - between that and the collapse in the US current account surplus in the years prior to the collapse of Bretton Woods I. A shrinking surplus or a rising deficit allows for both guns and butter. If the Fed holds to it's line that inflation expectations must remain anchored, and i believe that it will, the deficit will shrink further. A shrinking deficit means the butter, and then the guns, have to go.

What else blows up Bretton Woods II?

We have the structural weakness in the reflator states - the Stans, the Baltics, Southern Europe, Ireland and the UK; the inflated property, the consumer debt, the foreign borrowing, the current account deficits.

And we have the infrastructure and spending boom in the resource rich inflator countries like Mexico, the Gulf States, Russia, Kazakhstan and several African states. They are subsidising domestic oil consumption, they are ramping up spending on infrastructure and the domestic industrial base, they are tolerating escalating inflation. And they are crowding out everyone else to boot. These guys are on an inexorable road from consuming less than their small oil earnings back in 2002/3 to consuming more than their much larger earnings in the coming years.

The symptoms of this lot so far….yields are rising in Europe because consumption in the oil exporters is out of control. The global monetary system is no longer making good things happen, as it did from 2003-6. It has started to make bad things happen.

That is the stuff of which confusion and panics are made.
It is also the stuff of regime change. Regime change is what I’m working on right now. I thought I’d get the thoughts of the master - so I’ve started reading Barry Eichengreen’s ‘Global Imbalances & the Lessons of Bretton Woods’. I’ll report back later in the week.