The speculative mania galore in full throttle: US Edition

Last week I noted that the intensity of speculation in the Philippines reached a new peak as “locals rotated into the more ‘speculative’ and illiquid issues that paved way for the spectacular record trade churning run supported by the record breaking broader market activities.”

I guess this phenomenon has not just been in the Philippines. A similar thrust towards yield chasing on illiquid stocks has also been heating up in the US

From the Wall Street Journal (bold mine)

Investors are piling into the shares of small, risky companies at the fastest clip on record, in search of investments that promise a chance of outsize returns.

The investors are buying up so-called penny stocks—shares of mostly tiny companies that aren't listed on major U.S. exchanges—at a pace that far eclipses the tech boom of the late 1990s. Those include firms that focus on areas from medical marijuana and biotechnology to fuel-cell development and precious-metals mining—industries that are perceived by some investors as carrying strong growth potential.

Average monthly trading volume at OTC Markets Group Inc., which handles trading in shares that aren't listed on the New York Stock Exchange or Nasdaq Stock Market, has risen 40% this year in dollar terms from a year ago, to a record $23.5 billion.

The renewed interest in a market that used to be known as the pink sheets—because of the colored pieces of paper once used to record prices for unlisted stocks—shows investors are ramping up risk in a bid to boost returns as U.S. stock indexes are hovering near highs and stock valuations have risen above historical norms.

It’s not just pink sheets, retail investors have been pouring in

The rebound also comes as individual investors are showing signs of increased interest in stock trading in general. Discount brokers TD Ameritrade Holding Corp. and E*Trade Financial Corp. last month reported jumps in daily trading volume in the first quarter from the same period a year ago.

The rising volume in the tiniest of stocks is taking more investors into what is arguably the riskiest part of the stock market. These companies have less regulatory oversight than those traded on the exchanges, and their low prices mean that small price moves can quickly add up to big percentage moves.

In addition, penny stocks are often prime hunting grounds for scammers and "pump and dump" schemes. Stock promoters—often masquerading as regular investors on chat boards—tout a name, only to unload shares into a thinly traded market, taking profits for themselves but inflicting losses on other investors.

As of the end of 2013, based on the latest update of the US equity flow of fund from Yardeni.com, retail investors has been stampeding into US stock via Mutual Funds and ETF as institutional investors exit.

I guess a wild speculative ramp has been going on in many places of the world.

Implied volatility covering various global asset classes reveals extreme complacency levels echoing 2007! (chart from the IIF). 

And more interesting is that yields of riskiest bonds have even broken the 2007 lows. Mike Larson of moneyandmarket.com remarks “When you earn rock-bottom yields, you’re not getting the compensation you deserve for the risk of default you’re taking on. After all, the average cumulative default rate for corporate bonds rated CCC to C (at the bottom of the ratings scale) is north of 40 percent to 50 percent over a multi-year time horizon!”

Oh while Wall Street continues to party, subprime lending has also been ballooning.

From Bloomberg:

Doug Naidus made his fortune selling a mortgage company to Deutsche Bank AG months before the U.S. housing market collapsed. Now he’s found a way to profit from loans to business owners with bad credit.

From an office near New York’s Times Square, people trained by a veteran of Jordan Belfort’s boiler room call truckers, contractors and florists across the country pitching loans with annual interest rates as high as 125 percent, according to more than two dozen former employees and clients. When borrowers can’t pay, Naidus’s World Business Lenders LLC seizes their vehicles and assets, sometimes sending them into bankruptcy…

Subprime business lending -- the industry prefers to be called “alternative” -- has swelled to more than $3 billion a year, estimates Marc Glazer, who has researched his competitors as head of Business Financial Services Inc., a lender in Coral Springs, Florida. That’s twice the volume of small loans guaranteed by the Small Business Administration.

All the above suggest the deepening of the GREED environment: extreme overconfidence and over complacency, insatiable hunger for yield and reckless and rampant speculative activities.

Behold the speculative mania galore in full throttle!

Inflationary Policies Have Vastly Been Changing The Market Landscape

``During a boom, inflation creates illusory profits and distorts economic calculation. What the free market does best is penalize the inefficient and reward the efficient. But when you get a boom, the rising tide lifts all boats…Because of these illusory profits, everybody wants to get in on the boom. Everyone thinks they can do everything…Furthermore, during inflation, the quality of work goes down. Everyone tries to manufacture products as quickly as they can. There's no emphasis on how long things will last…In general, people become enamored with get-rich-quick schemes. In fact, entire countries have done this with the collateralized debt obligation (CDO) market. Iceland, for instance, has become one big hedge fund. And now we're going to have entire countries go broke.” Doug French, Bubble Economics: The Illusion of Wealth

In the field of politics, rendering social services for the people is always bruited about as the ultimate goal.

Unfortunately, the harsh reality of life is that policymakers or political leaders and their bureaucracy are only concerned with their self interests. But the sad fact is that their erroneous interventionist policies have lasting adverse consequences on the society’s standard of living.

Worst of all, is that a big segment of the public have been deluded to adamantly embrace the promises of politicians and of the attendant false ideologies in support of their “robbing Peter to pay Paul” policies.

Also, in no way do inflationary policies work better than the market forces.

Another proof?

From an earlier article Myths From Subprime Mortgage Crisis, Ms. Yuliya Demyanyk of the Federal Reserve of Cleveland wrote how policies aimed to increase homeownership has markedly failed.

Again from Ms. Yuliya Demyanyk (bold emphasis mine)

``The availability of subprime mortgages in the United States did not facilitate increased homeownership. Between 2000 and 2006, approximately one million borrowers took subprime mortgages to finance the purchase of their first home. These subprime loans did contribute to an increased level of homeownership in the country—at the time of mortgage origination. Unfortunately, many homebuyers with subprime loans defaulted within a couple of years of origination. The number of such defaults outweighs the number of first-time homebuyers with subprime mortgages.

``Given that there were more defaults among all (not just first-time) homebuyers with subprime loans than there were first-time homebuyers with subprime loans, it is impossible to conclude that subprime mortgages promoted homeownership."

That’s why it pays never to trust politicians.

So in general, society vastly suffers under the artificial nature of bubble cycles caused by government interventionism.

Moreover, it isn’t just me this time bewailing how interventionism or how inflationary policies have been obscuring traditional means of evaluating financial markets.

Mr. David Kotok of Cumblerland Advisors in a fantastic discussion about Ricardian Equivalence [or as defined by investopedia.org as ``An economic theory that suggests that when a government tries to stimulate demand by increasing debt-financed government spending, demand remains unchanged. This is because the public will save its excess money in order to pay for future tax increases that will be initiated to pay off the debt”] demonstrates this.

From Mr. Kotok, (bold highlights mine, all caps his)

``We are issuing massive amounts of debt in order to finance loads of current consumption. Rational expectations would have the markets immediately adjust prices for the future tax burden associated with the servicing of the debt. But more than HALF OF THE WAGE EARNERS IN THE COUNTRY ARE NOW NOT PAYING ANY SIGNIFICANT INCOME TAXES. Sure, they are paying Social Security withholding and state taxes, but their share of the federal personal income tax receipts is very small. They are positioned with inconsistency when thinking about Ricardian equivalence, since they do not experience nor expect to experience the tax burden associated with the huge debt…

``The taxing decisions that impact the minority of the American wage-earner population are not made by them. Those decisions emanate from the Congress and the White House. Those policy makers have a time inconsistency which conflicts with successful Ricardian equivalence. Their time horizon is mostly less than two years until the next election. In the case of Obama it is less than four years, and the handlers of his political apparatus are already at work on the re-election campaign.

``So we have two inconsistencies at work. Agent inconsistency exists, wherein only the minority of the taxpayers is paying the longer-term burden of the substitution of debt for taxes. And time inconsistency, where the decision-maker's time horizon is much shorter than the expected debt-load servicing time horizon. Two inconsistencies equal a failure of the Ricardian equivalence.

``For portfolio managers this poses a difficult dilemma. We know about the inconsistencies. We can estimate the impacts when they are finally resolved. But we have no way to estimate WHEN the inconsistencies will emerge as the force that alters market values. And we cannot be sure of the method by which they will impose their imprint on the markets when they do. Sure, it could be higher taxation or slower growth or more inflation or a weaker dollar or flight of citizens or less productivity or diminished innovation. There are many such characteristics of a society that has overextended itself and has to pay the price. But WHEN and HOW and at WHAT COST? These are the imponderables.”

Again, parallel to the China example, the conflict of interests between the interests of policymakers and their preferred policies relative to the consequences to markets and the political economy are evolving to become major variables in the asset pricing dynamics and have increasingly been contributing to the growing state of non-Priceable Knightean uncertainty conditions.

When a group of distinguished economists wrote to the Queen of England explaining why “no one foresaw the timing, extent and severity of the recession”, they failed to explain to Her Majesty the following:

1) mainstream economics (via monetary and fiscal inflation) had been the primary cause of it, and since they’ve been the principal advocates they wouldn’t undermine the underlying theories that support it. In other words, mainstream economists are blighted with a bias blind spot.

As Murray N. Rothbard explains in Money Inflation and Price Inflation, ``There are very 'good reasons why monetary inflation cannot bring endless prosperity. In the first place, even if there were no price inflation, monetary inflation is a bad proposition. For monetary inflation is counterfeiting, plain and simple. As in counterfeiting, the creation of new money simply diverts resources from producers, who have gotten their money honestly, to the early recipients of the new money-to the counterfeiters, and to those on whom they spend their money.” (emphasis added)

2) mainstream economics deal with superficialities and unrealistic models and is constrained by the short term outlook.

``I think it is the inability to reconcile a reasonable treatment of radical uncertainty with the strictures of out-of-control formalism” observed Professor Mario Rizzo.

3) it isn’t true that no one foresaw the crisis since even US congressman Ron Paul saw this crisis and along with Dr. Marc Faber, Jim Rogers, Stephen Roach, Nouriel Roubini, Gerald Celente, George Soros and many more (this includes us) especially the underappreciated Austrian School of Economics.

The point is mainstream economics and financial models have failed miserably.

In a world where inflationary forces are fast becoming the dominant factors in asset pricing dynamics, traditional fundamentalism have been ineffective in keeping apace with the underlying structural changes in the risk equation.

So the mainstream can dream about the financial fiction of PE, Book Values, or etc… when money printing bubble cycles are becoming the chief dynamic in pricing stock markets as well as in the other asset markets.

US Financial Crisis: It Ain’t Over Until The Fat Lady Sings!

``For speculative and especially for Ponzi finance units a rise in interest rates can transform a positive net worth into a negative net worth. If solvency matters for the continued normal functioning of an economy, then large increases and wild swings in interest rates will affect the behavior of an economy with large proportions of speculative and Ponzi finance.” Hyman Minsky, Inflation Recession and Economic Policy

Price signals have a powerful psychological impact. The recent upsurge in global stock markets has been heralded by many as an end to the crisis.

We beg to differ.

In contrast, we think that this is a lull before the storm for the US.

Further, we think that this appears to be seminal phase to an even more severe crisis in the future; one that will deal with a possibility of combined bubbles of private and public sector debt in the face of outsized inflation!

Figure 4: IMF: Global Financial Stability Report (2007)

As you can see in Figure 4, for most of 2009 the reset schedule for subprime mortgages have indeed been at a diminishing pace. Hence, the seeming moratorium in the market turmoil as these subprime resets ease.

However, renewed pressures on foreclosures will likely be felt or experienced later this year as Option adjustable rate and Alt-A mortgage resets mount and is expected to accelerate and culminate by 2011!

Burning Platform’s James Quinn gives us the details (bold highlights mine), ``There are over 4 million homes for sale in the U.S. today. This is about one year’s worth of inventory at current sales levels. You can be sure that another one million people would love to sell their homes, but haven’t put their homes on the market. The shills touting their investments on CNBC every day fail to mention the approaching tsunami of Alt-A mortgage resets that will get under way in 2010 and not peak until 2013. These Alt-A mortgages are already defaulting at a 20% rate today. There are $2.4 trillion Alt-A loans outstanding. Alt-A mortgages are characterized by borrowers with less than full documentation, lower credit scores, higher loan-to-values, and more investment properties.

``There are more than 2 million Alt-A loans in the U.S. 28 percent of these loans are held by investors who don’t live in the properties they own. That includes interest-only home loans and pay-option adjustable rate mortgages. Option ARMs allow borrowers to pay less than they owe, with the rest added to the principal of the loan. When the debt exceeds a pre-set amount, or after a pre- determined time period has passed, the loan requires a bigger monthly payment.”

And yes, the US economic system will be envisaged with more bouts of deflation….

McKinsey Quarterly estimates that some $2 trillion worth of losses has yet to be recognized.

About half of these losses will be accounted for the US financial system, see Figure 5.

Figure 5: McKinsey Quarterly: $3.12 trillion of losses from 2007-2010

Let me quote the McKinsey Quarterly in What’s Next For US Banks (bold emphasis mine),

``While 2008 was the year for taking losses on broker–dealers, this year and next will be the years for taking losses on assets subject to hold-to-maturity accounting. These are the losses that show up in stress tests, in which regulators make assumptions about how the economy will perform and calculate the resulting loan losses under various economic outcomes. For example, credit card losses are highly correlated with unemployment. By projecting unemployment rising to a certain level, stress testing can then project the attendant credit losses.

``McKinsey research estimates that total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession (Exhibit 2). Some $1 trillion of these losses has already been realized. Since US banks hold about half of US-originated debt, the US banking and securities industry will incur about $750 billion to $1 trillion of the remaining $1.5 trillion to $2 trillion of projected losses on this debt, which includes residential mortgages, commercial mortgages, credit card losses, and high-yield/leveraged debt. These numbers are in the same range as those of the US government, which calculated a $600 billion high-end estimate of credit losses for the 19 largest institutions.”

So despite the declaration by Mr. Ben Bernanke in the US Congress last week that, ``The Federal Reserve will not monetise the debt” and even warned of the burgeoining deficits (Financial Times), we believe that Mr. Bernanke isn’t being forthright.

He wasn’t even trying to be funny.

The fact that the US Federal Reserve earmarked $1.25 trillion to acquire $750 billion of agency mortgage backed securities and $300 billion in longer term treasury securities belies Mr. Bernanke’s statement.

Moreover, the Wall Street Journal reports that the ``Fed has purchased $156.5 billion of government bonds” and ``has bought $555.9 billion of mortgage securities.” (see figure 6)

In short, the Mr. Bernanke hasn’t only been talking, he has been nearly exhausting its allocation for Quantitative Easing (QE) or effectively monetizing debt!

Figure 6: WSJ: Fed to Keep Lid on Bond Buys

So we can’t easily buy into cacophonous signals shown by the Fed that they are having second thoughts on buying more of the above government securities. As the WSJ reports, ``Fed officials have become more confident recently that they have stabilized the economy and set the stage for recovery. But divisions are brewing within the Fed over whether it should do more to speed the healing, pause, or start pulling back to avoid an outbreak of inflation.”

Just wait until the pressures from Alt-A and Option adjustable resets, combined with strains from the commercial mortgages, credit cards and auto and leveraged loans escalates, then all these appearances of jawboning against inflation will be moot.

This means that more episodes of systemic deflation should translate to even more inflation from the US government via Ben Bernanke’s Federal Reserve and Tim Geithner’s US Treasury!

Global Inflation Transmission From Quantitative Easing

I might like to also add that perhaps the US dollar reserves recently harvested by the BRICs, as earlier noted, could have been proceeds from US Federal Reserves purchases of Long term Treasuries and Agency backed mortgages than from export revenues or portfolio inflows, both of which while exhibiting some signs of improvements are less likely to have contributed to such material reserve accumulation.

Foreigners own a substantial segment of US treasuries as much as it owns mortgage debt backed by the Agencies. As of 2007, according to Yale Global’s Ashok Bardhan and Dwight Jaffee, ``Foreign ownership of US Agency securities, bonds and mortgage-backed securities (MBS) issued or backed by agencies such as Ginnie Mae, Fannie Mae and Freddie Mac totaled just under $1.5 trillion. While the absolute amounts may be large, it’s the share held by foreign investors of total US securities outstanding that conveys the significance of these global financial flows.”

So even while foreigners have been selling agency debt prior to the Fed QE program, the recent activities could have opened the window for more accelerated liquidations on the part of Emerging Market central banks on their portfolio holdings of US mortgage securities backed by Federal Agencies.

And part of these proceeds could have been recycled into short term US T-bills.

AND as the Federal Reserve prints money to buy US securities held by foreigners, this could, effectively, serve as transmission channels for many of the global monetary inflation taking place, aside from, of course, the collective national fiscal spending being undertaken worldwide.

So it matters less that the current account balances have been improving due to reduced consumption and rising savings, since the inflationary mechanism appears to be retransmitted via the financial claims channel into the world.

And perhaps part of the outperformance by emerging markets could have been driven by such inflationary leakages.

And more of this could be in play see figure 7.

Figure 7: Casey Room: Rapidly Expanding Government Debt

And perhaps too, Mssrs. Bernanke and Geithner could be tacitly rooting for Emerging markets and Asia to miraculously pull the US out of the doldrums which implies even more QE!

Conclusion

The main issue is if US government liability issuances to fund the US deficit spending programs would eclipse the ability by the world or by US savers to finance these. Then the US will either be faced with massively inflating or defaulting.

Don’t forget that aside from rescue packages and the prospective entitlement (Social Security, and Medicare) strains, President Obama has ambitious health, environment, infrastructure, education and energy programs that could equally pose as additional pressures to US taxpayers.

Hence the recent overtures by BRICs to fund the IMF (WSJ) instead of recycling spare reserves into the US could be another proverbial “writing on the wall”.

Lastly, it isn’t total borrowing that should be THE concern, as some observers opine as necessary.

The last boom saw household and financial sector borrowing explode, which brought the world economy to the brink of a collapse through its unraveling.

This was in spite of US Federal debt not being in play.

The crux of the issue is if the present debt load incurred by either the private sector or by government or both can be paid for by the economy operating under a new environment characterized by higher tax rates, vastly increased regulations, lesser degree of a free markets and a hefty politicization of the economy.

As Hyman Minsky wrote in Finance and Profits: The Changing Nature of American Business Cycles, 1980 ``Three financial postures for firms, households, and government units can be differentiated by the relation between the contractual payment commitments due to their liabilities and their primary cash flows. These financial postures are hedge, speculative, and ‘Ponzi.’ The stability of an economy’s financial structure depends upon the mix of financial postures. For any given regime of financial institutions and government interventions the greater the weight of hedge financing in the economy the greater the stability of the economy whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.” (bold highlight mine)

Hence if the deficit spending programs equates to another form of “Ponzi financing” then financial instability is to be expected in the fullness of time.

So it ain’t over until the fat lady sings!