Benson's Economic
& Market Trends
The financial
markets are leveraged for a crash...
Richard Benson
April 1, 2004
...The only question
is when?
The financial press has been noticing that the small investor
is still putting massive sums of cash into stock mutual funds,
while corporate insiders are, on average, selling like crazy.
The average investor, who benefited from increased stock prices
through January 2004, is just like the major hedge funds who
are sitting on "pins and needles." They have one finger on the buy button
and another finger on the sell button and are ready to jump one
way or the other at a moment's notice.
We predict that before the spring of 2005, the vast majority
of investors and hedge funds will be hitting the sell button.
The average investor is constantly told by Wall Street that he
is an investor but it is becoming clear, in this market, that
there are only speculators. Meanwhile, investors such as Warren
Buffet are already sitting on over $32 billion in cash with at
least $12 Billion in foreign currencies that benefit from a falling
dollar. Why is it, then, that some of the biggest and smartest
money managers are already in cash? Don't they know that with
Japan buying our 10-year Treasury yield down to 3.75 percent,
the United States will have another mortgage REFI boom and there
will be great corporate earnings released this April? We expect
that Wall Street will be hyping stocks as cheap to the investing
sheep.
The problem for the American investor and, consequently, world
stock and bond markets, is excess and unsustainable leverage.
Stock and bond prices can only be sustained if interest rates
are held artificially low. The riskiest stuff such as internet
stocks, junk bonds, and emerging markets, have gone up the most
in price and are "flying pigs" priced for perfection.
The financial markets need constant jolts of new stimulus to
keep them up in the air.
The Fed has given our stock and bond markets a major simulative
jolt by cutting the Fed funds rate to 1 percent and holding it
down even as inflation is starting to "heat up." Whether the Fed likes
it or not in this election year, rising inflation will "take
the punch bowl away." A major market event seems inevitable.
Meanwhile, we wait patiently for the market to tighten, forcing
the Fed to follow.
Alan Greenspan has encouraged new credit creation primarily through
the borrowing against single family homes to levels that, just
a few years ago, could not be contemplated. Currently, our financial
system has at least $2 Trillion of mortgages directly financed
at 1 percent with Fed Funds and REPO, and the financial system
including banks, Wall Street, the GSEs and hedge funds, puts
total leveraged finance closer to $10 Trillion. Everything is
financed with almost no money down and anyone can get credit.
Take a moment to examine the terms you can get today on a
new car, home, a mortgage, treasury to junk bonds, commodities
and foreign currencies.
The capital markets have become one massive casino anyone
and everyone can come in and play and everyone's credit is good!
Our financial system supports about $35 Trillion of debt and
we have virtually no savings. Very few people believe they are
gambling with their own money because borrowing with other people's
money to place the bets has become so easy. The market is really
wild!
Money is being made in the leveraged carry trade or in speculating
on margin. Even the average patriotic homeowner with a variable
rate mortgage is borrowing short-term to buy stocks, and to pay
the bills. The NASD has finally come out and warned brokers
that they should not be suggesting to their individual clients
to borrow against their houses to buy stocks. This warning may
be too late!
What happens when investors want to reduce their risk and
need to sell but can't find a buyer? The old story from the
stock market crash of 1929 comes to mind about an investor who
kept buying a stock from his broker that continued going up in
price. Finally, the investor asked his broker to sell. The Broker
responded, "Who am I supposed to sell the stock to? You're
the buyer!"
That is why the elephants like Warren Buffet and other smart
players are already in cash! You can sell a few million dollars
worth of stock without rocking the market too badly. But, can
you imagine what might happen if some really large hedge fund
or Wall Street firm wants to unwind a small $100 billion of levered
"cash and carry" trade in mortgage securities. What
if a few hedge funds decided to sell a measly $500 billion in
mortgage securities? They would be trapped because the markets
are just not that liquid, especially when everyone wants to sell!
That's why it's important to be in cash before the crash!
The situation today could be much worse than 1929. In 1929, the
major fault in the financial system was stock market leverage.
In the 1920's, stocks could be bought with 10% down! Those
who waited to sell stocks were crushed. Stock prices triggered
margin calls and forced them to sell. This is not a virtuous
cycle; it's called de-leveraging and it causes a crash. Paying
off debt reduces the money supply. [Money is borrowed into
existence and paying down debt destroys money].
The problem for our financial system is that in many asset
classes, the leverage is extreme. In order to run a leveraged
position in mortgage-backed securities, a firm may only need
5 percent equity and can run leverage at 20 to 1. This leverage
is way beyond the leverage that crushed stocks in 1929 to 1934.
A small rise in short-term interest rates is all that is
necessary to trigger a sale of mortgages and treasuries by financial
institutions. With respect to bonds, a 5 percent fall in prices
is not major and can occur very quickly. Unfortunately, a 5%
fall in bond prices could wipe out 100 percent of a financial
player's equity!
As the prices for stocks and bonds begin to fall and you still
own them, you may wonder who in the world you can sell to, because
everyone else is selling. Of course, you pray you can sell to
a central bank. Japan's central bank has already financed half
of the United States treasury deficit; that leaves the Federal
Reserve. Can you imagine what will happen to money growth in
the United States if the Federal Reserve suddenly has to buy
$200 to $500 Billion in Treasury and GSE securities?
Moreover, the direct leverage in the financial system is only
"the tip of the iceberg" of total leverage. Our financial
system is held together with more than $150 Trillion of notional
derivatives and "spit and bubble gum." A crash in stocks
or bonds will shatter the derivatives market. It is inevitable
that major counter parties to these contracts will fail. When
that occurs, you do not want to be on the other side of the
trade. Indeed, Right Now and Right Here in River City, the
U.S. financial markets are nothing more than a huge "Long
Term Capital."
The pressure points are everywhere. In the silver, copper, gold
and other commodity markets, the open interest in long and short
futures positions dwarf the actual physical markets. Steel is
being horded and there is likely to be an obvious world shortage
by July. Existing stock piles of copper at the current rates
of consumption and production may be gone by June. How does a
metal exchange operate when there is no metal for delivery? In
silver, there are well over 1,000 individuals and financial institutions
who, at today's prices, could buy each and every last ounce of
silver in silver bars above ground. Meanwhile, the demand for
silver has outstripped the annual supply for the last 14 years.
In many cases, the short financial derivative positions in financials
can not possibly be delivered in physical form. Exchanges will
suffer financial distress and likely need aid; smaller counter
parties will be wiped out. Brokerage firms will fail. The biggest
hedge funds and derivative players, such as Fannie Mae, Freddie
Mac, JP Morgan Chase, as well as one or more Wall Street firms,
may need to be effectively taken over by our central bank.
Ultimately, if an investor is risk adverse, there are very few
places to keep your money safe. Holding gold coins works because,
by weight, the value is high. For silver, if you have a safe
place to store it, physical holding is certainly preferable to
leaving it in any financial institution or exchange. Short-term
Treasuries, bank CD's (but only up to $100,000 per institution),
I-bonds, and TIPS are a wonderful place to sit out any potential
storm. Asset managers who run bearish funds are worth a serious
look.
The stock markets have been under pressure since February and
we sense the anticipation of great pain when interest rates go
up for those who are long stocks and bonds.
If we must pick a scenario, the Federal Reserve and Japan's Central
Bank engineered one last rally in the 10-year Treasury to get
the mortgage money machine pumping "lucky bucks" into
the consumer's pockets before the November election. This may
only work until June.
For investors knowledgeable about the Treasury financing cycle,
following is the most likely time frame when we expect the "wheels
might come off and the markets and roll over a cliff:"
In January
to March of this year, the U.S. Treasury financing need was $177
Billion and the Japanese bought over $142 Billion (15 trillion
Yen) of our debt. (In the February 2004 refunding, Asian central
banks bought 50% of the auctions, which caught the world's attention).
In April to
June, the U.S. Treasury receives both quarter-end and annual
tax payments, keeping the financing need a modest $75 Billion.
In July to
December, the U.S. Treasury has to raise $300 Billion. The August
and November re-fundings will be critical. If the Japanese and
the rest of Asia don't come in to buy $200 Billion, bond prices
are virtually certain to roll off that cliff. Our entire deficit
needs to be financed with newly printed American, Asian or European
central bank currency.
Worse yet,
the Fed funds rate is 1 percent, and the 10-year Treasury note
yield is 3.75 percent. In the first 2 months of 2004, the CPI
was up 0.8 percent, or a 4.8 percent annual rate. Even if the
CPI settles down to 0.3 percent a month for the rest of the year,
the CPI for 2004 will be tracking 4 percent! Inflation from rising
commodity, oil, and a weak dollar, is seeping in. No investor
in their right mind will accept a 10-year note yield of 4 percent
with 3 to 4 percent inflation. By July, just in time for the
Treasury's August re-funding, it will be clear that inflation
is too high to justify a Fed funds rate of 1 percent, and 10-year
Treasury rates of 4 percent.
The big money players in the "carry trade" aren't known
for being totally blind or stupid. These big owners of Treasuries
and GSE bonds will want out! The carry trade will have to test
the "Greenspan put" and we do not intend to be long
stocks or bonds when the test comes.
Indeed, this spring would be an opportune time to go to cash
using any rally to get liquid, and out of margin debt. Going
short on some of the "flying pigs" is greedy, but tempting,
because if the markets go down with a thud and we are not positioned
properly, it could be devastating to our ego. However, for the
average investor who is risk adverse and for any investor who
considers losing a dollar, worse than making a dollar, our advice
is to get into cash and be prepared to wait until early 2005.
Good hunters know how to wait and good things happen to those
who are patient, like buying what they like at half price!
But remember, you can only buy assets at a discount if you have
the cash. If you understand this, you can truly appreciate Warren
Buffet's greatest secret - having the patience to sit on cash
earning little but losing nothing, until the great deals come
his way! Nothing beats cash and patience in the long run.
Richard Benson
President
Specialty
Finance Group, LLC
Member NASD/SIPC
2505 S. Ocean Boulevard
- Suite 212
Palm Beach, Florida 33480
1 800-860-2907
eMail: rbenson@sfgroup.org
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321gold Inc
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