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#1 TTHQ Staff

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Posted 15 September 2008 - 07:24 AM

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This is Deleveraging Not Deflation


I went out of town last week to the Resource Investment Conference in Las Vegas. I'llget to that in a second, but so much is happening that this is going to be a longermessage than usual. This weekend we are seeing Lehman go broke, Merrill Lynch in adesperate buyout, AIG try to fend of bankruptcy, and a frightening gap down in the marketthis morning. And of course last weekend we saw Fannie Mae and Freddie Mac get taken overby the government last Monday. That spurred a beefy gap up that immediately got sold - andthat selling pressure sparked a cascade of selling, which in turned caused only what I candescribe as a crash in gold stocks.

That drop caused a lot of gold bugs to throw in the towel and others to claim that weare now in a deflationary environment. I don't think so, I think this environment can bebest described as deleveraging. Deflation is normally used to describe a decrease in thegeneral price level or a decrease in the money supply. I do not see either one of thesehappening right now. In fact consumer and producer prices are still growing while the Fedis printing more money and will print enormous amounts of money in the future as a resultof its buyout of Fannie and Freddie.

That event is extremely inflationary, not deflationary.

Yet, despite that fact last week the dollar rose in value while gold fell.

Commodity prices have fallen sharply off of their highs of the summer and that hascaused many to claim we are now in deflation.

I disagree - I see this as a temporary and violent correction in commodities due towidespread deleveraging in the financial system and once that comes to an end we shouldsee commodity prices and gold reassert their market leadership.

What is clear is that we are in a bear market when it comes to the broad market. Bearmarkets come through three main stages - in the first stage market participants fail torecognize the reality of the bear market and think that dips are just temporarycorrections.

As their losses add up the second stage begins as the reality of the bear market takeshold and people begin to recognize problems in the economy and the markets. That is wherewe are now. In the third and final stage there is a general liquidation as people sell outin a panic in fear of suffering further losses. Each bear leg down also goes through thiscycle as a panic washout ends each downtrend and causes the VIX and put/call ratio tospike up. But this cycle also runs the gamut of the whole bear market and can take two orthree years to play out.

We have seen structural changes to the stock market over the past ten years that insome ways makes the market more different and dangerous than it has ever been before - andthat main change can be summed up in one word leverage.

The bust in real estate and collapse of Fannie Mae and Freddie Mac are a direct resultof too much leverage in the banking system. Real estate industry cheerleaders have beensaying throughout this whole real estate bust that the percentage of loans that wereissued as "subprime" were a small percentage of the overall mortgages andtherefore were not a problem. However, the real problem isn't the number of subprime loansbut the crazy leverage that banks and hedge funds went on to buy too many of them. Fannieand Freddie failed due to the wild amount of leverage that Congress allowed them to have.

When you look at the stock market itself over the past ten years hedge funds have takenon a larger and larger role - and that means so has leverage. Last year right at themarket peak there was a record amount of NYSE margin debt in the market - almost 50% morethan that seen at the 2000 market peak. At the same time so called "programtrading," which comes from hedge funds and institutional investors reached a maniclevel a year ago. Back in the late 1990's about 20% of all of the trades on the NYSE camefrom program trading. That level gradually rose year after year as more hedge funds cameinto the market and reached over 50% in 2004 and hit the crazy level of 90% for a fewmonths in 2007 right before the credit crisis erupted.

Most hedge fund managers are not market wizards - and if we have learned anything overthe past year it is that hot shot institutional traders that work for investment banks arenot either. What we have seen is mediocre traders that really don't know what they aredoing use leverage and trading models and programs to make investment decisions that haveturned out to be deeply flawed.

The problem is I don't know anyone who got rich in the market using a trading program.Almost all trading programs are created with formulas based on back tested data to matchwhat the market did in the past. If the market patterns change - and they never lastforever - then the trading program goes bust. The most famous hedge fund bust was theLong-Term Capital hedge fund that used a mathematical formula to go on margin approaching100-1 leverage. And how many banks used mathematical models to buy mortgages based on datathat came from decades of rising real estate prices? Once real estate topped and began abear market the models no longer worked.

All of this smacks to me of pure arrogance and stupidity. In last weekend's Barronsthere is an amazing letter from Anthony Piszel, the CFO of Freddie Mac. In this letterPiszel tried to claim that there is nothing wrong with Freddie. He claimed that those thatthink Freddie will go under need to look away from "Freddie Mac's fair-value balancesheet to ascertain our financial condition. Freddie Mac is a buy-and-hold investor- weinvest in mortgages with the intent of holding them to maturity. So today's mortgagevaluations are less relevant a measure of our financial condition, especially given thehighly subjective nature of these valuations in today's market."

In other words the market has been wrong to lower the value of Freddie Mac's mortgagesecurities and we at Freddie Mac believe they deserve more value than they have right nowand if they did our balance sheet would look fine so don't look at our balance sheet tofigure out the financial condition of our company, but instead listen to what we tell you.

Two days after this letter was published Freddie Mac accepted a takeover by the USgovernment.

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This same sort of arrogance has also been alive and well in the hedge fund world -where there are traders that have been using massive leverage based on mathematical modelsand are now blowing themselves up. When I was Vegas last week I wondered into a hedge fundconference. I found hedge fund managers and sellers of program trading and accountingsoftware milling around.

What struck me though were the titles of the seminars these people were going to. Mostof them had fancy sounding titles that were designed to impress, but said nothing ofsubstance.

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For instance look at this photo I took of the morning schedule for one of the seminarrooms. The second two titles full of hype and no descriptive value refer to some sort ofprogram trading software while the first one is a fancy way of saying - "what do whenyou are F***** - or to put it politely "what to do when you get margin calls andredemptions and blow yourself up."

To me though these titles sum up what is happening right now in the financial market.We are witnessing a wave of redemptions and deleveraging coming from hedge funds that hasbeen asserting tremendous selling pressure on commodity stocks lately.

Oil and commodities were the best performing sectors in the first half of this year anda lot of hedge fund and hot money flowed into them. As those sectors peaked in July theycorrected and that correction turned into a mini-crash last week.

Forced selling was evident and at this point there are few retail sellers left in thecommodity markets - the sellers that remain - and probably did most of the selling lastweek - are hedge fund managers who never entered their positions as investments or due tofundamentals, but because their models said to do it.

There is something attractive to using a model when you run institutional money. If youhave no track record or little experience in the market you can sell your fund by talkingup its fancy sounding trading program. And as you run the fund you can use the models togive yourself the confidence to go on margin and leverage the fund up to make more money.It all works though until the trend that has made the model works comes to an end.

That happened with mortgage securities last year and happened with commodity stocksthis month as they reached oversold technical readings never seen before and fell anyway.

The result was forced selling and a mini-crash in gold and gold stocks that haspractically caused anyone to sell to do so. And a stock market on the verge of going intoa mini-crash today.

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When I went to the gold investment conference it was like walking into a ghost town. Igot there just as gold stocks were trading down 10% for the day. I had never seen one ofthese conferences like this before. There were about a quarter of the booths as therenormally are and hardly anyone was there. It made me wonder if in fact everyone hadactually sold out. It certainly was a good sign from a contrarian standpoint

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It wasn't just the number of booths that was surprising, but the lack of peoplelistening to the presentations that was shocking. Over half the seats were empty. Someonetold me it hadn't been this empty since the gold bear market bottom around 2000.

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And the people who were in attendance weren't too chipper. To top it off there was evena black bird flying around. I couldn't take the negative energy and didn't stay aroundlong, meeting people outside of the show.

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I try to use trading tactics to find entry points in larger trends. I had thought inthe summer that gold stocks would breakout and run through the end of the year in part inresponse to the coming blow up of Freddie and Fannie Mae. Based on this belief I usetechnical trading tactics to pick gold stock bottoms twice in the past seven weeks. Whengold stocks bounced and then turned back down to go through my buy point I realized that Iwas wrong to think I had bought a bottom and sold. My stop loss points got hit.

The problem is with hedge funds and big investors who don't use a good game plan whenit comes to money management. They refused to recognize that their trading models were nolonger working and rode out their positions for huge losses. As a result they ended upselling in panic. And then another problem is retail investors who bought with no gameplan and then sold out too.

Right now I don't have a position in gold stocks, but I'm going to watch them carefullyagain in the coming weeks. They do appear that they may have put in a bottom. I am worriedthough about the broad market possibly weakening them in the short-term, because themarket is in a very precarious position, but if gold stocks base and provide a good entrypoint I will buy them again.

This is how a trader has to think, but if you are an investor in gold stocks then itreally makes no sense to sell at this point. If you held through an over 50% drop thattook place in less than two months it really makes no sense to sell. Unless gold is goingto $500 there simply should not be much more downside to these gold stocks even if theymade new lows again.

And I don't believe gold is going to $500, because I believe this correction isn'tcaused by deflation, but by hedge funds and large institutional investors who were overlyleveraged blowing themselves up and selling to get off margin and to meet redemptions - aprocess that could last into the end of this year.

To put it this way if you held through a 50% drop as an investor it makes no sense tosell out in fear of another possible 10% drop. Large producing gold stocks are not goingto zero.

We may have also reached a point with gold stocks that even if these people keepselling the stocks won't make new lows and fall hard anymore, because on a fundamentalbasis they have reached levels that make them so cheap that a bid from industry insidersand value investors could keep them from falling further.

Looking back at what has happened I think there is a very simple fundamental storygoing on - that is ultimately very bullish for gold. In July it became clear to the Fedand Treasury that Fannie Mae and Freddie Mac were going to have to be taken over by thegovernment. The market was on shaky ground at the time so they took steps to interveneahead of a takeover.

When Paulson announced the takeover of Fannie and Freddie last weekend he said he wasacting at that moment, because the market was in a calming period. In his writtenannouncement of the takeover he said the market was in a "time out" that madeacting now prudent.

The Fed, Treasury, and SEC created this short-lived "time out" period. Firstthe SEC created new short selling rules for a host of banking stocks in July to force ashort-squeeze rally in them. Then the Treasury acted with the G-8 in early August to startsome sort of rally in the dollar. These two moves helped spur a short-lived rally in thestock market in August, but more importantly started a correction in commodities and gold.That correction picked up steam and took a life of its own when it reached the point thatit hit stop loss points and forced leveraged players to exit the market - that forcedselling created what can only be described as a crash in gold stocks last week.

These moves were necessary to make so that a takeover of Fannie and Freddie couldhappen in a time of relative calm in the market. Imagine if the takeover was announced inJuly or right now what could have happened to the market.

I do not believe that the government is constantly intervening in the gold market. Topressure gold all they have to do is work together with several central banks to knockdown the price through key support levels from time to time - or do so on the opposite endin the currency markets - and the selling will naturally pick up speed. This seems to bewhat happened in August. But in September I see the selling coming primarily from marketparticipants stuck with huge losses instead of from than government intervention.

As a trader though I don't factor manipulation into my decisions. I base my decision oncharts and trends in order to quantify my risk and set stop loss points. If I get stoppedout due to a move caused by Fed intervention that is fine, because that intervention willlikely drive the market much lower than my stop loss point and I rather not get hurt byit. As an investor one has to simply decide how much of one's assets one is comfortableholding for the long-term no matter what temporarily losses could occur.

Ultimately the Fred and Fannie news is going to be bullish for gold, because it isgoing to mean that the Treasury Department is going to end up printing hundreds ofbillions of dollars over the next two years or so to pay for their losses - and thataddition to the national debt will eventually be a drag on the dollar. This is why I findthe deflation story hard to swallow.

That is the future. Last week and now though is a different story. In periods ofdeleveraging investors sell assets and go into cash. Since most margin is done throughdollars that means a demand for dollars to raise cash to get off margin. And onceinstitutional investors are in cash their money flows into money market funds and Treasurybills - hence the rising bond prices in the face of what will eventually be an even moreinflationary environment.

We are now facing the potential of a panic drop in the broad market in the face of thisweekend's news. I'm actually short the market and have to decide whether to cover mypositions and take profits. You see every time we have had a huge gap down in the marketthis year like this we have seen the government cut rates or announce some sort ofintervention and the market rally. Will this happen now? What do we need to take from thisweekend's news?

Here is my take.

This article continues in the WSW Power Investor section of this website.

About author


Mike Swanson is the founder and chief editor of WallStreetWindow. He beganinvesting and trading in 1997 and achieved a return in excess of 800% from 1997 to 2001.In 2002 he won second place in the 2002 Robbins Trading Contest and ran a hedge fund from2003 to 2006 that generated a return of over 78% for its investors during that time frame.In 2005 out of 3,621 hedge funds tracked by HedgeFund.Net only 35 other funds had a betterreturn that year. Mike holds a Masters Degree in history from the University of Virginiaand has a knowledge of the history and political economy of the United States and theworld financial markets. Besides writing about financial matters he is also working on ahistory of the state of Virginia. To subscribe to his free stock market newsletter click here.