The Wealth Effect, Unwinding

Addison Wiggin – August 9, 2011

  • Yesterday’s sell-off nearly wipes out QE2’s “wealth effect”… conveniently, the Fed convenes today…
  • A glaring buy signal? You decide… the VIX reaches height seen only five times before…
  • Meltdown mystery: Who made a nearly $1 billion bet on a U.S. downgrade?
  • Bank of America’s bad-news trifecta… yet another candidate for our list of next financial crisis triggers…
  • California’s petty play on solar panels… reader’s “nullification” solution… your final chance at a principal-protected metals play… a special invitation… and more!

   In the wake of “Great S&P Downgrade” volatility in the stock market as measured by the VIX — the volume of S&P 500 index options — jumped 50% yesterday.

The market’s “fear gauge” closed out the day at 48.

You may recall we noticed “fear is cheap” several occasions in the last year as the VIX hovered around 20.

Political stunt or no, the S&P downgrade of U.S. Treasuries shocked traders and investors more than Mssrs. Forbes, Summers, Buffett, Geithner or Greenspan would like to admit.

   Going back to its inception in 1993, there are only five other episodes in which the VIX topped 45:

  • September 1998: Russian default
  • October 1998: Long-Term Capital Management (LTCM) implosion
  • August 2002: WorldCom collapse
  • September 2008: Lehman Bros. bankruptcy and ensuing Panic of ‘08
  • May 2010: The incestuous “flash crash.”

In four of five of these spooky episodes, you could have done very nicely for yourself buying the Dow 30 as soon as the VIX topped 45… and holding those shares for a year. The blue chips picked up between 1,500-2,500 points each time.

   The 2008 episode, however, proved to be a horrendous “head fake” for traders trying to cash in on the trend.

On Sept. 29, 2008, when the Dow experienced its worst point drop ever, the VIX topped 45. The VIX then settled back down for a few days only to shoot up to 80 by Nov. 20. The Dow spiraled downward for the ensuing winter… until early March 2009.

A full 12 months after that 2008 “head fake,” the Dow was still off its peak by more than 600 points.

So today, after yesterday’s VIX spike, you have to ask yourself, in the immortal words of Clint Eastwood, “Do I feel lucky?”

   Before you answer, consider there’s a Fed meeting today.

The announcement will be out by the time you read this, and we’ll have some kind of signal about the prospects for “QE3” — yet another round of easy money — and an attempt to goose the flagging market anew.

You might expect Fed chief Ben Bernanke to laud QE2 because of its effect on stock prices: Easy money fuels the “wealth effect”… people feel flush as their brokerage accounts grow… and then go out and spend money.

Of course, it’s a dopey notion — based on the idea that consumption grows the economy, not savings and production. But it is what it is.

At yesterday’s close, the S&P 500 is only 70 points away from where the whole QE2 process started nearly a year ago — when Bernanke winked and said it was all but a done deal during his annual speech in Jackson Hole, Wyo.

When Bernanke indicated during his first news conference on April 27, 2011 that QE2 would wind down as scheduled at the end of June, the market topped two days later. The market then entered a holding pattern until the circus over the debt ceiling concluded… then, well, the last week of July through this morning tells the rest of the story.

Our best guess this morning? About $7.9 trillion in paper wealth has disappeared from the stock market in the last nine trading days.

   “I think it’s reasonable to expect the Fed will hint of renewed easing plans in its post-meeting statement,” says Strategic Short Report’s Dan Amoss.

Combined with the European Central Bank’s own easing move — buying Italian and Spanish bonds — Dan sees a short-term bounce coming. “Tactically, we’re probably setting up for a sharp rebound in stock markets on a redoubling of central bank money-printing efforts.”

With that in mind, he told readers to take profits on three positions during yesterday’s meltdown for gains of 37%… 53%… and 131%. Don’t feel bad if you missed out: Dan sees plenty more opportunity where those came from.

   The stock market bounced big on the open, only to give up most of those gains after the first 15 minutes of trading.

For the moment, everything hinges on the Fed statement that comes a couple hours before the close. We’ll go through the highlights and sort out what it all means tomorrow.

   “The loss of AAA is psychologically important,” says Chris Mayer. “But it also will set in motion a series of events.”

“Some institutions can hold only AAA-rated debt. So they will have to amend their charters or sell U.S. debt. Also, across the economy, interest rates are set from the baseline of U.S. Treasuries. So if the downgrade means interest rates tick up a few notches, it will create a ripple effect across the economy. That means another credit squeeze at a time when the economy is already weak.”

   Sure enough, Standard and Poor’s has followed up its downgrade of the United States, Fannie Mae and Freddie Mac with similar downgrades of municipal bonds.

Thousands of bonds linked in some way to the federal government have been moved down a notch from AAA to AA+. They run the gamut from school construction bonds in Texas to a bond series for an apartment complex in California.

Strangely, S&P could not provide a dollar figure for the affected debt. It did say, however, that no general-obligation bonds issued by state governments are currently at risk of a downgrade.

   “Politicians complain that U.S. companies are hoarding cash, not investing and creating jobs,” Chris Mayer goes on. “The impact of recent days will only make that trend stronger.”

“Already, a Wall Street Journal headline reads, ‘Firms Look to Raise Cash as Volatility Rises.’ Who will want to build businesses and risk capital in this environment? Fewer than might otherwise, that’s for sure.”

   Indeed, the Small Business Optimism Index compiled by the National Federation of Independent Business (NFIB) fell in July for the fifth straight month. At 89.9, the index sits at a 10-month low.

“Expectations for future real sales growth and improved business conditions were the major contributors to the decline in optimism,” says the NFIB statement accompanying the number.

   Here’s another way of measuring of the impact of Uncle Sam’s debt load on the broader economy: The “Insolvency Index.”

Coined by Steve McCann at American Thinker, the Insolvency Index is the sum of two numbers: the federal deficit as a percentage of GDP and the unemployment rate.

The postwar average of the Insolvency Index, up through 2008, was 6.9.

“On an aggregate basis,” McCann writes, “a combination of these percentages should always remain below 10. The higher this ‘National Insolvency Index’ above 10, the greater the problems that country is experiencing, and if that index remains above 10 for three years or more, the viable solutions to solve the dilemmas will be increasingly difficult to enact.”

Behold, the last three years:

    2009       19.1
    2010       18.5
    2011       20.2

Worse, if you take the Government Accountability Office’s deficit projections… and the Congressional Budget Office’s unemployment projections… the number is destined to stay above 10, well above, for the rest of the decade.

“A disaster of monumental proportions is in the offing,” McCann concludes… and matters are worse than the numbers show: “The optimistic outlook by the Congressional Budget Office (CBO) that the unemployment rate would be at 5.5% by 2016 will never happen.”

   Following yesterday’s episode, do you think China’s government is upset with Washington’s fiscal conduct? Ordinary Chinese are even more upset with their own government for playing the role of Uncle Sam’s “enabler.”

China’s “microbloggers,” reports The New York Times, have let loose with a torrent of fury ever since the S&P downgrade. These bloggers, as much as they can get away with criticizing the government, think their own leaders are foolish to have sunk nearly half of China’s $3.2 trillion in foreign reserves into U.S. Treasuries.

“China is always bowing to the United States,” writes one, “when will China really rise up and cast aside its constant fear of the United States’ reactions!”

“Chinese people are working so hard, day in and day out,” says another, “the economic environment is so good, but people’s livelihoods are not so great — turns out it is because the government is tightening people’s waist belts to lend money to the United States.”

We expect more of this to come… and have passed it on to our friend Dee Woo in Beijing for a firsthand comment. Stay tuned.

   Among the anomalies following the S&P announcement that have gone underexamined: Who placed a $1 billion bet on a downgrade last month?

According to ETF Daily News, a mystery investor or hedge fund placed two block trades on July 21 — one on 10-year Treasury futures the other on 30-year Treasury futures.

At post-downgrade prices, the buyer is sitting on a 10-to-1 payout.

Speculation about the mystery buyer naturally centers on George Soros, i.e. “the man who broke the Bank of England” with his bet against the pound in 1992. An anonymous source “with knowledge of the firm” told the U.K. Daily Mail Soros was not involved.

   Overlooked in yesterday’s drama, too, was a meltdown at Bank of America (BAC). While the S&P 500 fell 11% between Thursday and yesterday, BAC plunged 32%.

  • Last Thursday, BAC disclosed that claims by Fannie Mae and Freddie Mac on soured mortgage loans inherited from Countrywide are pouring in “in numbers that were not expected based on historical experience.” In other words, the $30 billion BAC set aside for such losses probably won’t be enough
  • Friday, New York Attorney General Eric Schneiderman asked a judge to reject an $8.5 billion settlement between Bank of America and a host of its mortgage investors. Schneiderman claims investors’ trustee, Bank of New York Mellon, colluded with Countrywide to hide just how rotten the mortgages were
  • Yesterday, AIG sued BAC for $10 billion, claiming that Countrywide lied through its teeth about the quality of the mortgages it bundled into securities.

$10 billion? Heh, Bank of America lost more than that in market cap yesterday. It’s down to $70 billion this morning.

The question is this: Can BAC keep all these angry mortgage investors at bay? If not, how will the Fed and the Treasury conjure up the funds to keep Bank of America’s doors open? And how will the U.S. government’s creditors react to that?

Among a host of potential candidates, Bank of America could prove to be the trigger event for the crisis we’ve been eyeballing since June 1. To learn how it unfolds afterward, and how to protect yourself, take a look at this.

   Gold is soaring again. After piercing $1,700 yesterday, the Midas metal crested the auspicious price of $1,775 overnight… and at the moment has settled back to $1,747.

   Coincidentally or otherwise, gold popped overnight again the moment Chinese inflation figures came out. July’s year-over-year increase of 6.5% was the highest in more than three years.

   The greenback is weakening, but not appreciably. As we write, the dollar index sits at 74.4.

   Commodities are staging a weak comeback today. The CRB index sits at 319 — still near an eight-month low, but slightly higher all the same.

Oil, after dipping below $79 a barrel in overnight trading, has recovered to $81.20. Copper, after slipping below $4 a pound, is stabilizing at $4.01 — still a two-month low.

   Just what is it that California has against solar power? A few weeks ago, we noted Riverside County’s shelved plan to impose a 2% “sun tax” on the gross revenue of solar power projects.

Now from the state’s wine country comes word that fire inspectors are giving homeowners with solar ambitions a hard time. Santa Rosa is ranked among the top 25 American cities for its support of solar… but that honor is in jeopardy. The local government is now requiring solar panels be set back three feet from the eaves and ridgelines of roofs.

The idea may be laudable: Give firefighters safe passage in the event of fire.

But “since the Fire Department began enforcing the new rules in January,” reports the Santa Rosa Press Democrat, “solar installations now require separate plan reviews and field inspections by fire inspectors. Those are in addition to plan reviews and site inspections conducted by city building officials.”

“Measure twice,” the saying goes… still might not be good enough for the inspectors

“System sales in the city are down, systems we are installing are smaller and the installations are costing more,” says solar contractor Jeff Mathias. “Nobody is a winner here.”

Each of these new inspections costs $270.

“The fees are designed to recover the cost of administering the program,” the local rag explains, “although the work is being handled by existing staff in the city fire marshal’s office.” Hmmn…

Just another in the long line of new taxes and weird fees we chronicle in our new forecast? Perhaps. If the collectors haven’t knocked on your door yet for some strange new fee… get ready.

   “I love your understated humor,” writes a reader, “you wrote: ‘Likewise, the dollar index rallied by 22% as ‘investors’ piled into money market funds.’”

“Might those happen to be money market funds that are heavily invested in European credit default swaps? Talk about ‘out of the frying pan and into the fire’!”

The 5: Indeed, the very same. For a refresher, we broke down the exposure U.S. money market funds have to the “Greek contagion,” should it go viral. Unfortunately, your own bank is probably exposed.

   “Thank you,” writes another “for showing the income of the federal government versus expenses… and then taking eight zeros off to make it more down to earth.”

“One question comes to mind: Why is the ratio of the national debt compared to the GDP, instead of to the federal income? If the comparison were national debt to federal income, it seems to me that would be a much more appropriate comparison. Yeah, the U.S. would be at over 700% debt-to-income ratio and have been declared bankrupt a long time ago.”

“No way would prudent lenders let someone with $21,000 per year income get buried into $142,000 of debt. Thus I believe the idea of measuring a nation’s fiscal health with GDP to national debt ratio is severely flawed.”

The 5: That’s a good point. But then you’re thinking like a rational human being. There were plenty of imprudent lenders who would have written that loan in a heartbeat lo just a few years ago.

In government, it gets worse. The GDP of the nation’s citizens IS considered government income. Not “officially,” but certainly by attitude.

You’ll note that when “they” are discussing the deficit, they begin with the assumption that as a percentage of GDP, the government’s spending is fine… revenues from the citizens just to don’t match the outflow. It’s the hubris of the political class, regardless what party they belong to.

So much for ‘the land of the free’…

   “My answer is a resounding ‘yes’!” another writes in response to Mr. Byron King’s comment Friday, “Does the future still have a place for our quaint, 1787-vintage Anglo-Saxon political model?”’

“The problem is that the current central government under which we now suffer has little resemblance to the limited federal government envisioned by the Founding Fathers. The state governments were not vigilant in their duty to protect the people against the usurpation of their power by the federal government.”

“Over time, the states silently acquiesced to measures taken by the federal government that violated the Constitution, to the point where now all the powers that were originally, and rightfully, reserved to the states have been gradually absorbed and consolidated in central government.”

“It is nothing short of central government indoctrination, in the guise of public education, that excludes the main ideas of our Founding Fathers for restricting the path of the federal government from usurping and maintaining power.”

“Lord Byron got it right when he said, ‘Who would be free, themselves must strike the blow.’”

“I’m not insinuating open rebellion, but for the states to reassume their rightful powers from the federal government via such actions as nullification, establishing state tax escrows in which the states determine what to release to the central government.”

The 5: On a related note, we encourage you to read the Bill Bonner’s address at the 2011 Agora Financial Investment Symposium, here, in three parts.

   “I couldn’t help but ponder,” writes a reader from the Great White North, “how there is so much demand for employment in the part of the country where we live.”

“We reside in oil-rich northern Alberta. There is so much opportunity for anyone who is a tradesperson. There is a shortage of power engineers, carpenters, flooring installers, electricians, plumbers and pretty well any other trade that exists. If you call for any of these services, you are put on a waiting list.”

“There are drilling rigs that are unable to go to work for lack of manpower to operate them. It seems amazing that there is such a disparity of supply/demand in the work force.”

“By the way, I find your column informative and interesting… it’s like getting a condensed version of the best news of the day.”

The 5: Thank you for reading. Funny how enterprise has a way of putting productive people to work… hmmmn.


Addison Wiggin
Agora Financial’s 5 Min. Forecast

P.S. Only a few days remain in which you can take advantage of EverBank’s MarketSafe Timeless Metals CD. This unique product gives you exposure to both precious metals and industrial metals.

EverBank’s MarketSafe products have become enormously popular, and for good reason: You capture all the potential upside of the underlying asset while your principal remains completely protected in the event of a market downdraft. This is the final MarketSafe offering EverBank will have in 2011. If you don’t currently have an EverBank account, you still have seven business days in which to take care of the paperwork and fund the account. Here’s where to get started.

P.P.S. If you were an attendee at this year’s Symposium in Vancouver, please read the following letter from Symposium director Bruce Robertson:


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