Sectors Rotating into Recession as Credit Contraction Deepens

By: Kurt_Kasun

Things are about to get really bad. Rotating bubbles are now becoming rotating sector recessions as the positive feedback loops, created as money and credit growth ballooned over the last 25 years, have reversed and are now becoming negative feedback loops. I expect to see those 25 years of excesses to dramatically unwind over the course of the next few years. The evaporation of paper wealth will be breathtaking. A "buy on the dips" mentality has been replaced by "sell on the rallies." Declining house values will further hinder the finance sector which will impede the real economy, causing asset prices to further plunge. The tipping point for debt creation's positive impact has been reached and we can expect economic convulsions similar to what a drug addict experiences after kicking the habit "cold turkey."

"The credit crunch is morphing from an American-centered financial crisis into a global economic crisis," according to David Bowers of Absolutely Strategy. The policy of creating more money than could be put to productive use in the real economy that allowed rising asset prices would more than compensate for a lack of ‘real' wage gains in the real economy and for consumers to continue to borrow and spend more than they earn at an accelerating pace failed once the excess money began to flow to commodities rather than to real estate or stock prices.

Growth is now demonstrably slowing in all parts of the world. Central Banks around the world will be embarking on a campaign of lowering their interest rates. Participants in the US stock market, fresh off an artificially trumped up GDP restatement (trumped up due to the stimulus package and severe understatement of the GDP deflator), will take a while to realize that gains in the dollar are due to relative underperformance of other currencies and a massive liquidity contraction. The gains will be short-lived and will result in pain and agony as those investors are lured into another bear trap that will reveal itself once much of the sidelined money comes back into the market.

The fall in commodity prices will be wrongly interpreted as a reason for the economy to rebound and for stocks to rally. While the dollar will likely continue to rise over the short term it is ultimately destined to suffer the same disastrous fate as the other fiat currencies of the world. After the sucker's rally has run its course over the next few weeks or so, the reality of an unserviceable and un-payable debt overhang will set in and the second wave of financial calamity will ensue. This time around it will be the result of the effects emanating from the negative feedback loop coming from the real economy.

Scott Bugie of Standard & Poor's writes that the second phase of credit crunch could be severe: "The credit crunch is entering a second, 'post-subprime' phase where banks' loan books deteriorate more rapidly and capital-raising efforts might become harder, says Scott Bugie, credit analyst at Standard & Poor's. Loan book deterioration is starting to hit a wider array of financial institutions, as credit losses migrate from subprime into other sectors of household finance, such as credit cards, Alt-A and prime mortgages, and auto loans well into 2009,' he says.

Other mainstream economists are have also been sounding the warning trumpets: "The US is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say the worst is to come," according to Professor Ken Rogoff who was chief economist at the IMF from 2001 to 2004 and who now teaches at Harvard. He goes on to say, "We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper, we're going to see a big one - one of the big investment banks or big banks."

In 2002 Dr. Marc Faber, author of the GloomBoomDoom Report and highly-sought guest for CNBC and Bloomberg TV, wrote a book titled, Tomorrow's Gold-Asia's Age of Discovery . Those who read the book and followed Faber's investment advice to invest in commodities and Asian and other emerging market equities have significantly outperformed those who primarily invested in US stocks (tech, consumer and financials). But Faber had recently cautioned against this "short dollar trade" as it had become stretched and crowded. He presciently warned investors late last year. More recently, referring to commodities, he said "Prices have made a peak...Whether that is a final peak or an intermediate peak followed by higher prices, we don't know yet. It could go lower."

He echoed similar sentiments in a Bloomberg TV interview this morning. I found his most recent market commentary, issued on August 20, 2008 titled, "Contracting Global Liquidity," quite compelling. He uses several charts to demonstrate how liquidity is contracting, the dollar is strengthening, commodities are declining, and what the relationships that exist between them predict for the future. He writes:

"In sum, credit growth and liquidity are contracting, a vicious economic downturn is about to unfold ( China could surprise on the downside and put additional pressure on commodity prices) and asset markets are still high by historical standards and, therefore, remain vulnerable. I would use equity rallies as a selling opportunity and further weakness in gold as a buying opportunity for long term holders with significant cash and cash flows."

Faber has an enviable track record over the long, intermediate and shorter term. Not many investment strategists can boast of getting the market right over these three terms. He is an open-minded contrarian who is not afraid to change his views. He was way in front of the investment community predicting the rise of China and commodity prices six years ago. He correctly wrote that the US currency and stock markets would relatively outperform others last year. And he got the April-May S&P 500 rally to 1440 right also.

The one longer-term trend Faber appears to have the most confidence in is the "long gold/short the DJIA" trade that has been working, despite the recent pullback, since 2001. Over the intermediate term he is a looking for what can be described as nothing less than a US stock market crash, perhaps by the end of this year.

Rather than the US markets leading the rest of the world higher, the evidence points toward the rest of the world leading US markets lower. The global slowdown had begun in earnest. The US is now more dependent on world growth than the world is reliant upon the US . This is especially true since the US consumer is seeing his credit cut off and US banks and financial institutions suffer the effects of the second wave of the credit crunch. Once the relief rally has run its course and investors see that the US economic rebound has not staying power and only worn out consumers trying to pay off 25 years of accumulated debt, the dollar will rejoin the ranks of the other fiat currencies and resume its decline versus the price of gold.

Excerpted from the 9/2/08 Global MegaTrends Portofolio's Newsletter: To learn more about Kurt's Kasun's Global MegaTrends Portfolio, click here . 

By Kurt Kasun

A contributing writer to GreenFaucet.com , Kurt Kasun writes a high-end investment timing service, GlobalMacro, which is focused on identifying opportunities that produce returns in excess of market with reasonable risk. He is strategically located in Washington , D.C. , a key to maintaining contacts and relationships which help Kurt understand global policy and economic factors as they emerge. His investment approach has always been macro in nature largely due to his undergraduate studies at the U.S. Military Academy at West Point (B. S. National Security, Public Affairs, 1989) and his graduate studies at George Mason University (M.A. International Commerce and Policy, 2006).

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