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FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

Why Wall Street's Record Performance Spells Danger For Investors

Stock-Markets / Stock Markets 2011 Jan 11, 2011 - 06:13 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleMartin Hutchinson writes: When U.S. taxpayers bailed out Wall Street back in 2008, the consensus was that this Main-Street-led handout would bring down the curtain on a 25-year stretch of rampant - and too often reckless - speculation.

But that hasn't been the case.

In fact, in some areas, Wall Street deal volume is running at record levels.

In most cases, when an industry, sector or business is humming along and setting all sorts of records, that's very good news. It means profits are high, firms are hiring and shareholders are happy.

But when it's Wall Street setting the records, it can mean there's trouble ahead - lots of trouble. For instance, while overall profitability is down, those bottom-line figures do not determine Wall Street bonuses, which are expected to set a new per capita record. Junk bonds are being issued at double the previous record rate. Merger deals are cooking. And private equity is humming.

Smart investors will take steps to protect themselves from the looming fallout.

Junk Bonds: The Next Crisis?
Much of this frenzied activity we're seeing on Wall Street is pretty toxic for the world economy, and is likely to cause major problems down the road. The junk-bond boom is a good example of the financial wallop headed our way. Issue volume for 2010 is approaching $300 billion, almost twice the previous record.

The doubling in junk-bond sales has been caused by exceptionally low interest rates, which induced investors to take on excessive risk in the search for "reasonable" returns.

Individual investors, in particular, were often not investing in junk bonds before 2008. So they don't realize that their high-yield holdings - via a loss in market value or an outright default - can cost them just as much in a big downturn as any stock portfolio.

The junk-bond boom has enabled banks to avoid what had been thought as one of their biggest problems - the need to refinance the debts associated with the private-equity leveraged buyout mania of 2006-07.

As a result of this boom, much of this risk has been passed off to bondholders - greatly helping the banking system.

That's not to say that the risks have gone away: After all, an overpriced deal is an overpriced deal, and once interest rates start rising (as they seem to be starting to do), the cash flows of many of those leveraged companies will prove thoroughly unstable.

The upshot: We'll see a big spike in bankruptcies and forced restructurings, with huge losses to the unfortunate holders of the new junk bonds.

A Preview of the Private-Equity Peril
Just in case there are not enough over-leveraged disasters waiting to happen, the volume of private equity transactions has rebounded sharply from the lows of 2009 to once again reach the frenzied level of 2008.

The earliest private-equity transactions - engineered in the 1980s - created genuine financial value: They increased the efficiency with which assets were managed and expanded the opportunities for investors.

However, the vast increase in volume we've seen since that time has led to an explosion in the number of deals driven by "financial engineering" - a fancy term for increasing debt levels, since interest rates are low and interest payments are tax-deductible. Needless to say, the jobs of the unfortunate workers toiling for the target companies of these private-equity players are greatly endangered by this process, and little economic benefit accrues from these late-cycle transactions.

The initial public offering (IPO) market has also been active. Indeed, two of the three largest IPOs of all time were launched in 2010 - both of them in Asia. The Agricultural Bank of China Ltd. (PINK: ACGBF), which had missed the previous 2006 flurry of Chinese bank IPOs because its loan book was too much of a mess, was the largest of all.

Needless to say, bringing out the lowest quality Chinese bank at a higher price than all the better ones is the sort of thing that typically occurs only at the very top of a bubble. And the other Asian IPO I mentioned was a stock offering for the Asian operations of American International Group Inc. (NYSE: AIG). Given what we know about AIG's financial travails, that's a financial asset I wouldn't touch.

M&A Mania/Derivatives Drama
Mergers and acquisitions (M&A) deals also are nearing record levels, though they are still below the peak of 2006-07. In one recent instance, $25 billion of deals - most of them cross-border in nature - were announced in a single week.

Innumerable studies have demonstrated that large acquisitions are value-destroying for the suitor and its shareholders. However, these deals sure don't destroy "value" for the acquiring company's top management team. If you don't believe that, just look at the $26 million in compensation paid out to Kraft Foods Inc. (NYSE: KFT) CEO Irene Rosenfeld - in part as a reward for her having engineered the hostile takeover of rival Cadbury PLC (and long before there was any chance of that overpriced acquisition bearing financial fruit for shareholders).

Finally, after a dip caused by the global financial crisis, the total value of derivatives outstanding in the marketplace has returned to around $600 trillion. And trading volumes on derivatives exchanges have been sharply up in the last few months.

All this activity has been only moderately good for Wall Street's profits. The major investment banks are forced to hold more capital against their positions than they used to and the compliance bureaucracies have multiplied.

Thus, their profits are likely to be lower in 2010 than in 2009 - although 2009 was a record-breaking year as banks took advantage of the market recovery, the U.S. Federal Reserve's "free" money and the U.S. Treasury Department's bailouts.

In any case, 2010's profits will be the second-highest on record, higher than in any pre-crisis year - and bonuses, while lower overall, are expected to be 5% to 10% higher than 2009 in per capita terms.

For the global economy, the prognostications are less bright. Wall Street's activities mostly add some value, but their value added is highest in depressed markets, or in the early part of a growth cycle.

In those periods, a successful junk-bond issue, an IPO, a private-equity takeover or a well-chosen merger may allow undervalued assets (which might otherwise have been lost in bankruptcy) to be redeployed more profitably. Or those transactions might enable new and exciting business ideas to gain the financing they need.

But when markets are bubbly, as they are now, the percentage of deals that ultimately end up destroying value is much higher, as normal metrics are ignored and optimistic business plans are taken at face value. The speculative bubble of 2005-08 was such a period, and has led to enormous losses.

Since October 2008, the government and the Fed have encouraged Wall Street to re-inflate the bubble. That has replaced the moderate volume of value-added deals that would have occurred after such a deep crash to be replaced with two more years' worth of worthless bubble-era deals.

That's great for Wall Street, but for the global economy it simply means that the long-term destruction of value is greater than it needed to be. Wall Street has created several new bubbles, and they will lead to vast losses.

If we ultimately see a second "dip" to this recession - as we well could - it will be largely Wall Street's doing.

Action to Take: Given Wall Street's miscreant machinations, we could very well end up experiencing a "double-dip" recession.

If that's what's going to happen, it's time to stock up on gold, silver and canned goods! When it comes to the canned goods, you're pretty much on your own. But when it comes to gold or silver, here's some of Money Morning's best research, which we'll put at your disposal.

For Gold: Check out Money Morning's forecast for gold for 2011, published as part of our "Outlook 2011" economic forecast series: Gold Price Forecast: Four Reasons the "Yellow Metal" Will Hit $1,900 an Ounce in 2011. Also worth your time, especially if you're a newcomer to precious-metals investing is our gold investment primer: Money Morning Special Report: How to Buy Gold.

For Silver: For silver, take a careful look at the Money Morning "Outlook 2011" economic forecast series installment: Silver Price Forecast: Investment Strategies for the "Other" Precious Metal in 2011.If you're new to precious metal investing, and would like a primer, check out Special Report: How to Buy Silver.

•For a more-specialized silver strategy focusing on so-called "junk silver," take a look our special report: Though it's Called "Junk Silver," the Profits Aren't Trash.
•If you'd like to understand just why silver is suddenly in the headlines alongside gold, we'd like to recommend: Silver is Emerging From Under Gold's Shadow.
•If options are part of your personal portfolio strategy, here's a piece that ran just this week that deals specifically with using options to profit from silver: Three Ways to Play the Silver Rally - While Limiting Your Risks with Options.
•Finally, at least as far as silver goes, take a look at more-specialized columns that we published, including "Buy, Sell or Hold" piece on Silver Wheaton Corp. (NYSE: SLW) and a detailed strategy piece that caters to more-experienced investors: Investing in Silver: Three Ways to Profit From the Projected Breakout.

[Editor's Note: If you like the insights that our "Outlook" series provides, but you want to receive this kind of financial-market intelligence throughout the year, you should look at our monthly affiliate newsletter, The Money Map Report.

Each month, the gurus who write for Money Morning get together and identify the very best profit opportunities you'll find anywhere in the world today.

Our writers use proprietary money-flow indicators to identify and isolate the most timely profit opportunities you'll find anywhere. For more information about The Money Map Report, please click here.]

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Money Morning/The Money Map Report

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