Introduction

October 25, 2011 – It looks to us like the “breather” (which turned out to be rather large) after the 2007, 2008, 2009 downturn that we forecasted (see our Older Blogs and our Annual Forecasts) is ending or has ended and “the contraction” has resumed.

This blog (also in reverse chronological order) will document and discuss our forecast for the Resumption of the unfortunately very large, economic contraction.  This time we will include all the previous elements of the older blogs (- Deflation Watch – Elements of Market Tops- Major Trend Changes ) into this single blog, The Contraction Resumes.

We believe “The Contraction” will be evident in all sorts of areas.  Of course, it will be reflected in declining prices of assets (like equities and real estate) and in increasing yields, especially of lower quality bonds.  We believe it will also be evidenced in increasing levels of discord in all sorts of areas – we are using such examples as a confirmation of the resumption of the contraction.  Unfortunately, we’ve begun to see a lot of signs of discontentment, not only abroad but now in the United States.

——————————————————————

April 10, 2012 Update – There have been a lot of things going on in the markets over the past six months.  Not very long ago, in early October 2011 most equity indices were at or below their January 2010 highs.  The S&P 500, for example, was back at the same level it was at on 10-12-2009.  However, the very sharp rally from October 2011 through a week or so ago of just under 30% seemed to wipe that fact from most “investors’ memories.”

Our point is that just the other day we were at levels from 2 years ago – now we had this big rally BUT it can be taken away even quicker than it formed. All our forecasts still hold and are still on track (unfortunately).

While all the incredibly long term terrible fundamentals that we (and others) have documented are still intact, there are several important things going on right now in the markets.  One is that the four stocks “that are in the [irrational] race to $1,000 per share” ( Apple (“AAPL”), Google (“GOOG”), Priceline (“PCLN”), and Intuitive Surgical (“ISRG”)) all likely have just broken their parabolic uptrends.  Also,  the junk bond taxable market which often turns down prior to stocks turned down in late February 2012.  An easy proxy to follow is a junk ETF with the symbol “JNK” – it peaked 2-28-2012 and is down 3.5%. And, unfortunately, many of the broad and widely followed stock market indices have just broken their downtrends and have already had notable losses.  The Russell 2000 (“RUT”), for example is down 7.57% from its 3-27-2012 high.  Similarly, the S&P 500 broke its trendlines and is down 4.43% from its 4-2-2012 high.  Ditto NASDAQ, Dow Jones Industrials, etc.

Over a longer term horizon, we note that the Moody’s index of prices of BBB-rated taxable bonds peaked in August 2011 (actually yields inverted) at essentially the same level it was at during April 2010.  Also notable is that the Dow Jones Transportation Index’s 7-7-11 peak is still intact, with the index currently being almost 10% below that level.  The KBW Bank Index (“BKX”) (largest 24 exchange-traded banks) saw its rebound (from the March 2009 lows) peak of 4-23-10 remain intact – it is currently almost 20% below that level and almost 7% below its recent peak on 3-20-2012.  Another index that peaked quite a while ago is the NYSE Composite Index (“NYA”) which includes all common stocks listed on the NYSE, including ADRs, REITs, and tracking stocks – it is a very broad index encompassing 61% of the total market capitalization of all publicly traded companies around the world (according to Bloomberg).  This index peaked on 4-29-2011 and is currently almost 10% below that level and is 5.5% below its recent peak on 3-19-2012.

Commodities – So several equity indices actually still have their peaks from one or two years ago still intact.  This is also the case as we foretasted for most commodities.  For example, the ThompsonReuters/Jefferies CRB index’s (“CRY”) rebound top on 4-29-2011 (from its March 2009 low) is still intact and we are currently almost 19% below that rebound peak, and it is almost 8% below its recent peak on 2-24-2012.

Real Estate – Unfortunately contracting even more so.  The Case Shiller Composite Index or housing prices peaked (from its April 2009 low) in July 2010.  Unfortunately, that small rebound peak is still intact and we are now below the April 2009 super low. Looking forward, there have been a few articles on how foreclosures are starting to ramp up now that the bank lender “robo-signing” title problems have been resolved; unfortunately, it should very interesting.

Abroad – The world abroad is also a significant part of the contraction.  Unfortunately, Europe is even worse off and/or ahead of us.  The Euro Stoxx 50′ (“SX5E” – index of 50 European blue-chip stocks) rebound peak (from its March 2009 bottom) of 2-18-2011 is still intact.  The SX5E is currently 24% below that level and it is 11% below its recent peak of 3-16-2012.

Our overall point on this Update is that the resumption of the contraction is taking place over a number of years with various indicies topping at different times as we have forecasted and explained several times previously.  At some point all the categories will be heading down together similarly to 2008 and early 2009.  Unfortunately, we very well could be arriving at that time now – time will tell.

January 27, 2012 We have included part of a table from our January 2012 Annual Forecast to show that the Contraction, even though it is not in the major media, very well may have begun earlier this year.  Look at the table – April 29, 2011 looks to be the date:

December 11, 2011 “Rehypothecation” – we believe this very likely will be the word for the resumption of the contraction.  Similarly the word for the 2007/2008/2009 crash was probably “CDO” or “collateralized debt obligation;” however, there were many to choose from.  This time, Reuters broke a story last Wednesday on December 7th, 2011  detailing the “rehypothecation” that was going on at MF Global.  We’ve seen not a peep on this story by the major media (other than Reuters article) nor much on the internet (except on one site); however, we think it could be very important.

According to Wikipedia:

Hypothecation is the practice where a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral, but it is “hypothetically” controlled by the creditor in that he has the right to seize possession if the borrower defaults. A common example occurs when a consumer enters into a mortgage agreement, in which the consumer’s house becomes collateral until the mortgage loan is paid off.

The detailed practice and rules regulating hypothecation vary depending on context and on the jurisdiction where it takes place. In the US, the legal right for the creditor to take ownership of the collateral if the debtor defaults is classified as a lien.

Rehypothecation is a practice that occurs principally in the financial markets, where a bank or other broker-dealer reuses the collateral pledged by its clients as collateral for its own borrowing.

The case is being made that MF Global’s implosion is because it was reusing collateral, possibly including client’s collateral, several times.  It is allowable up to 140% in the U.S. but, apparently, in England, where MF Global had a subsidiary, there are no restrictions.  Also, very important is that most of it was “off balance sheet.” And, in the news you may have read of a lawsuit against MF Global to determine the ownership of large amounts of gold.  The implication is that it is not only securities that were “rehypothecated” but also commodities, which is very interesting since many people own gold and silver for “safety” through broker dealers/commodity dealers and also through exchange traded funds, that may or may not have exposure to counter-party risk, in addition, to possible price declines if ”owners” rush to monetize their precious metals.

Our other key points with this issue is that it points to possibly huge amounts of leveraging on limited amounts of collateral – and, now that MF Global has collapsed, it could be very likely that the contraction of all that leverage and its associated “liquidity” may have begun.  This situation may be why “The Fed and Five Central Banks Lowered [their] Interest Rate on Dollar Swaps” for emergency dollar funding for European banks somewhat out of the blue on November 30th, 2011.  Although we did not write about it here, we did question why? including the timing.  It seems this is also the issue in which Jefferies (whom we discussed below) was put under the microscope.

Reuters did detail in its article the amounts of rehypothecation by the large banks – The amounts are large but likely not a problem unless there is a lot more off-balance sheet and done through London subsidiaries where there are apparently no official regulatory constraints (according to what I’ve read).  However, it is more likely that considerable rehypothecation was done in the “shadow banking” areas.  If so, we could see a considerable contraction in debt/credit/leverage and liquidity which would most likely have a negative impact on asset prices.

It will be very interesting to see how this unfolds over the next few weeks (or longer) and if it is material or not.  Certainly, it is not at all in the major media (yet).  We fell upon it from only one of the many sources we monitor, in part, because we are looking to find evidence of contraction and forces of continuing contraction.

November 29, 2011 Tonight, S&P changed their credit ratings of many large banks:

Downgraded:
Banco Bilbao Vizcaya Argentaria S.A.
Bank of America Corp.
Bank of New York Mellon Corp.
Barclays Plc
Citigroup Inc.
Rabobank Nederland
Goldman Sachs Group Inc.
HSBC Holdings Plc
JPMorgan Chase & Co.
Lloyds Banking Group Plc
Morgan Stanley
Royal Bank of Scotland Plc
UBS AG
Wells Fargo & Co.

Upgraded:
Bank of China Ltd.
China Construction Bank Corp.

According to BLOOMBERG, “S&P, a unit of New York-based McGraw-Hill Cos., has been changing the way it looks at debt after its faulty grades contributed to the credit-market seizure that brought down Lehman Brothers Holdings Inc. and Bear Stearns Cos. It started to review the methodology in December 2008, months after the collapse of those two firms.”

Quoting again from the article, “Downgrades ‘could likely have a material adverse effect on our liquidity, potential loss of access to credit markets, the related cost of funds, our businesses  and on certain trading revenues, particularly in those businesses where counterparty creditworthiness is critical,’ Charlotte, North Carolina-based Bank of America said in its quarterly filing.”

Their point about declining liquidity, etc. due to lower credit ratings is well taken and fits our view of the contraction resuming.

November 29, 2011 BLOOMBERG, “AMR-backed Municipal Airport Debt Falls on Bankruptcy Filing.”  Yes, AMR, parent of American Airlines declared bankruptcy last night.  Unsecured municipal bonds backed by the company officially dropped 86% in price.  The company has issued $3.2 billion face value of debt backing airport facilities, most of it unsecured.  We did check the price of a high yield municipal bond fund and it dropped about 1.3% from yesterday to today.  Unfortunately, bondholders, employee jobs and employee benefits are likely to hits, which is contractionary.

November 22, 2011 BLOOMBERG, “Jefferson County Asks Judge to Temporarily Stop Bond Payments.”  This is in regards to the Jefferson County, AL Water & Sewer bonds.  Importantly, they are backed by a dedicated source of revenues.  If the payments are not made on the normal schedule, it will likely be shock to the municipal bond market as most participates did/do not think this could happen.

In regards, to my comments on November 9th, 2011 (below), the major media barely reported the largest municipal bankruptcy in U.S. history; they were much more focuses on the “affairs” of Presidential candidates.  However, the bankruptcy’s impact is slowly seeping into the system and people’s’ consciousness.

November 9, 2011 – Municipal Bonds – Late today, Jefferson County, Alabama filed the largest municipal bankruptcy in U.S. history, $3.1 billion in debts.  Jefferson County has been teetering on bankruptcy for over three years.  We’ve expected them to file while general market consensus has been that they would work things out outside of bankruptcy.  In the most recent out-of-bankruptcy agreement that just failed, creditors of mostly toxic waste derivative securities had agreed to forgive $1.1 billion; however, the county, which has the highest water and sewer rates in the nation was to be required to raise rates by over 8% per year over the next three years; thus, creating a “debtor’s prison” of sorts for the rank and file citizens.  (You can see how this situation is similar to what has been happening in Europe, which is also in “contraction.”) Apparently, there was a difference of $140 million that kept the deal from being done.  For us, the filing is “contractionary” – credit has contracted here and rippling effects of the largest municipal bankruptcy filing will likely cause more credit contraction in other sectors of the municipal bond market.  In addition, we do not believe this bankruptcy is “in the price” of the municipal bond market in general.  Of course, we’ve highlighted numerous risks in the municipal bond market that we do not believe are properly reflecting in the prices and yields.  It maybe that this very large event will make investors, especially “retail investors,” more cognizant of the risks and they could very likely start selling out some positions.  Tomorrow and the following weeks could be very interesting in the general municipal bond market, especially as the news media covers the story.  We would not be that surprised to see general outflows from the municipal bond market, with lower quality credits trading off.  This situation could be in conjunction with the large selloff in equities and commodities that we are forecasting and be a part of a general flight to quality.

November 4, 2011 – With respect to Greece (and others) we believe the choices are “official default” or “unofficial default and austerity.”  With official bankruptcy, the pain will spread quickly to other domino nations; however, with austerity (Greece’s and others’) the pain will be spread out over a longer period of time (similar to Japan from 1989).  Either way, we view both as “contractionary” but one as much faster than the other.

November 4, 2011 – “Jefferies Fires Back as Investors ‘Shoot First” on Street,” BLOOMBERG.  The first paragraph of this article gets to our points: ” The speed and severity of Jefferies Group Inc.”s swoon shows how skeptical investors have become of Wall Street firms after the collapse of MF Global Holdings Ltd. reminded people of 2008.”

To us, these activities and happenings are “contractionary.”  MF Global turned out to be heavily leveraged and made poor bets on international (Europe) situations.  The company imploded mostly because of the amount of leverage that was used, in conjunction with its investments heading south.  This situation has again brought concerns that lenders may not get their money back from highly leveraged entities.  One place it is showing is in the prices of broker dealer Jefferies’ stock and bonds, rightly or wrongly.  Accordingly, it looks to us like credit is beginning to contract again.  Of course, we will see.

October 25, 2011 – “Occupy Groups” – We believe one of the indications of the resumption in The Contraction is the emergence o the “Occupy” groups.  Certainly we understand why the groups feel discontented and angry.  As far as “The Contraction,” it is important to us in that they have emerged as a force.  During the Contraction we expect to see more and more discontent and anger, unfortunately.  We also believe these groups will multiply and grow throughout the rest of the Contraction, which we’ve forecasted previously as ending between 2016 and 2018.  Already the “Occupy Wall Street” group has morphed into several other groups and locations across the country.  It’s original message of discontent has also multiplied, even as far as an “Occupy MOMA (Modern of Modern Art)” protesting what is being called “capitalist art.”

Importantly, with respect to this blog, we also believe the “Occupy” actions will likely hasten the contraction.  Protesting in front of large financial institutions could result in customers moving their business elsewhere, for example.  In fact, some of the Occupy members have already closed bank accounts and are cheering others to do likewise.  Another example is their announced desired 1% transaction tax on financial transactions.  We believe such a tax is contractionary although it might be ethically the right thing to do.

October 25, 2011 – High Quality Interest Rates –  As bond managers, of course, we are always watching interest rates.  Starting several weeks ago we noticed that the U.S. Treasury five year, ten year, and thirty year seemed to put in a price high (yield bottom).  We are watching these trends closely as we believe it could be very likely that we are seeing a major bottom in the highest quality interest rates.  How could interest rates rise with the economy so weak and with us forecasting a resumption of The Contraction?  We believe those that participated in the flights to quality in U.S. Treasuries may eventually have to raise cash – especially those abroad.  Thus, while we are forecasting events similar to 2007, 2008, 2009 with the U.S. Dollar going up and most asset prices plummeting, we also expect higher quality interest rates to eventually go up (and also for credit quality yield spreads to widen – low quality interest rates to go up much more quickly).  I can understand why people think this is impossible right now; however, when it happens they will suddenly be able to understand it very quickly.  If it is a major interest rate bottom, rising interest rates will certainly push prices of interest sensitive investments downward.  It could be a very big drop with a contraction in credit at the same time as rates rise and spreads widening out, unfortunately.  Bottom line – we are more confident in our forecast of “The Contraction,” of asset prices dropping, and of all but the highest quality interest rates rising – as for the highest quality bonds, we believe we could have already put in the low or will likely do so the next time the stock, commodity, and real estate markets plummet.