Beware Relief Rallies - Eric Janszen

[EJ]

Beware Relief Rallies

We’re not out of the woods. In fact, we’re flying into them.

If the world economy is a passenger jet, its engines are economic surplus, its fuel human creativity, energy, and credit, and among its passengers investors in global stock, bond, and commodity markets.

Earlier this year, the credit fuel was mostly cut off and the engines shut down. The sound that followed is the one you never want to hear when you are an airplane passenger–of rushing wind and nothing more. The passengers noticed and sent markets down in a wave of panic selling.

The response is similar on an actual aircraft under those circumstances. I know because it happened to me on a flight during a business trip to Asia. The engines shut down briefly mid-flight, we were never told why, and then restarted.

I'll try to convey the sensation. There you are on an aircraft packed with strangers 20,000 feet over the Yamanashi forest in southern Japan when silence replaces the drone of jet engines. At first no one noticed. Then one by one the passengers looked at each other and began to ask, What is that? What is going on? There is no engine noise. Why aren’t the engines running?

The aircraft slowed and began to descend. The passengers looked out the windows and down at the lush woods below. We extrapolated our collective prospects. In an instant your body heats up, as if overtaken by fever, a flight response to danger except there is nowhere to go. As panic began to reverberate around the cabin, the engines restarted. Just as quickly as the panic set in it vanished. My fellow passengers and I returned to reading books, hammering out spreadsheets and presentations on laptops, or whatever we were doing before the terrifying event occurred.

The desire for a return to normalcy is a powerful human drive.

The rally we are seeing in the markets now is largely driven by that impulse, the overwhelming desire for normalcy, the return of the familiar roar of engines from a surge of cheap credit. The response was elicited by the election of a new president who promises change. Perhaps, the passengers think, as part of the promised change this president can get the cheap credit fuel flowing and the engines running again. He has promised massive injections of government credit fuel, and that is certainly the legacy of the political party he represents. What can a Democratic president combined with a Democratic Congress possibly mean but the passing of orders for trillions of gallons of credit fuel from the latter to the former with little chance of veto? All credit fuel orders shall be filled and injected in-flight.

This longing for normalcy is causing passengers to err in their assessment of medium term future conditions as the forest floor approaches. An economic aircraft so gravely impaired and sinking through thousands of feet of clouds and air toward the woods cannot respond so quickly to promises or even the fact of fiscal stimulus. The engines are still not providing enough thrust to slow the decent. Now the wings are clipping the tops of the trees.

GM's October sales plunged 45%, Ford Motor Co. (F) recorded a 30% drop and Toyota Motor Corp. (TM) reported a 23% decline.
US Oct Auto Sales Slump; GM Sales Down 45%, CNN, October 2008

Hammered by an economy in which consumer spending is coming to a screeching halt, credit is hard to get and competition is heightening, Circuit City said Monday that it is closing 155 stores (33% nationally), 10 of them in the Bay Area. The closures could put as many as 7,300 employees out of work in what is becoming one of the worst of times.
Circuit City closing 155 stores, SFGate, October 2008

The [Baltic Dry Goods index] has dropped 89 percent this year, driving down the combined market capitalization of the 12- company Bloomberg Dry Ships Index, led by Athens-based Diana Shipping Inc., to $5.5 billion from $32 billion a year ago.
Baltic Dry Index Drops Below 1,000 for First Time in Six Years, Bloomberg, October 2008

The official Xinhua News Agency reported this week that 3,631 toy exporters -- 52.7 percent of the industry's enterprises -- went out of business in 2008.
Factory closure in China a sign of global woes, CNN, October 2008

Japan's economy has joined much of the developed world in a recession, economists polled by Reuters say, with GDP seen contracting for a second consecutive quarter as the financial crisis hits exports and capital investment.
The Economic Times, October 2008

The global financial crisis is pushing the whole European Union into recession, official forecasts said on Monday, as South Korea unveiled its own 8.5 billion dollar stimulus package against the turmoil.
AFP, October 2008

Once the din of cheers over the hopes for a quick injection of credit subsides, the passengers will turn their focus to the banging and crunching of the economy trimming the tree tops.

We’re not out of the woods yet. In fact, we’re flying into them. We see this understandable relief rally, driven by a mass craving for normalcy, as an opportunity to build cash and to calibrate for a new, post cheap credit world. If “normal” means a steady flow of credit fuel from foreign creditors and financially engineered credit products, the economy and markets will never be “normal” again. As for the government credit injections, they are coming but with the unintended consequences, a topic for another day.

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