Findings & Forecasts 12/05/2012

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Economy

Deriv­a­tives. After the near-total melt­down of the finan­cial sector in 2008, one might expect that big banks would cur­tail their exces­sive risk-taking behavior. Alas, not so. In fact, just the oppo­site has occurred: More risk exists in today’s banks than at any time in history.

The largest nine banks have an overall expo­sure to deriv­a­tives of over $200 tril­lion, a figure that is more than three times the size of the entire global economy. For all global banks, the total “notional” value of deriv­a­tives is well over $1,500 tril­lion; $1,000 tril­lion is $1 quadrillion.

There is no reg­u­la­tion in the deriv­a­tives mar­kets, where only the law of the jungle pre­sides. Preda­tors and prey jockey for sur­vival in dimly lit trading rooms. If a fellow predator gets “eaten,” the news of it is taken with sat­is­fac­tion that more is left over for the remaining survivors.

In sim­plest terms, a deriv­a­tive is a bet on the out­come of some future event. While a bookie takes a bet on the out­come of next week’s horse race, deriv­a­tive traders make bets on events months and years into the future.

A bet works like this. I pur­chase $1 mil­lion in low-rated cor­po­rate bonds that cur­rently yield 6 per­cent and are not due for repay­ment for another 10 years. I’m going for the higher income knowing that there is a higher risk of default. Thus, I seek to find a bettor that will bet against that risk for a tol­er­able fee. Banker X thinks my bonds will be paid off when due, and charges me $25,000 for the assur­ance that if the cor­po­ra­tion does default, the bank will make up any dif­fer­ence. My $25,000 pay­ment is pure income to the bank, and there is no off­set­ting lia­bility recorded.

How­ever, if my cor­po­ra­tion defaults five years down the road, and I lose $800,000 in the process, then banker X imme­di­ately owes me $800,000, which, by the way, is also the so-called “notional value” of the con­tract. Because of all the uncer­tainty, the cur­rent notional value of a deriv­a­tive con­tract can only be guessed at.

If you ask a bookie what his “expo­sure” is, he may say some­thing like $100,000, but he knows that he will not lose all of his bets. Some will cost and some will profit. If he is really good, he will take home a pay­check every week — fewer pay­outs than bets received. If the odds go against him and he cannot pay, then clients with crow­bars are chasing him down the street.

Bankers think the same way about deriv­a­tives. Of course they know that they will lose some bets, but given their mega­lo­ma­niac per­son­al­i­ties, they figure they will win more than they lose and hence, the more bets that they can make, the more money they can pocket. This is why the deriv­a­tives market con­tinues to expand.

Sellers of deriv­a­tives have cul­ti­vated (suck­ered) an industry of pur­chasers who wrongly believe that they can lower their actual risk by adding deriv­a­tives to their overly-risky invest­ments. Put another way, if there were no deriv­a­tive market, people would not make such risky invest­ments in the first place. The temp­ta­tion to take on too much risk because deriv­a­tives are avail­able is called “moral hazard.” In this writer’s opinion, the entire deriv­a­tives market is one big cesspool of moral hazard.

When things go wrong again, this market will destroy the entire global finan­cial system: Cen­tral banks, banks, insur­ance com­pa­nies, wealthy investors, pen­sion funds, sov­er­eign wealth funds, national trea­suries, etc.

How­ever, there is another moral hazard that is enabled by the deriv­a­tives market: That is, for those who long for the death of cap­i­talism, finan­cial armageddon may be per­ceived as only be a few trades away…

Eating our seed corn. It’s farmer’s wisdom to always put enough seed away from this year’s crop to allow for replanting next year. Such wisdom has been lost to the rest of America, which has been rou­tinely eating its seed corn every year for sev­eral years now.

The above chart shows Net Domestic Invest­ment as a per­centage of nom­inal GDP, or Gross Domestic Product. NDI sub­tracts out con­sump­tion of fixed cap­ital, com­monly knows as depre­ci­a­tion. Since 1965, the rate of growth of NDI has steadily declined and is cur­rently stuck at zero growth.

There are a number of things that could be inferred from this chart, but the most promi­nent is that a healthy society con­tin­u­ously replaces its invest­ment cap­ital, and a declining society does not. To truly turn eco­nomic America around would require 6 – 10 per­cent of our GDP to be invested into cap­ital goods and infra­struc­ture — the means of pro­duc­tion. Given the cur­rent eco­nomic con­di­tions, this is absolutely impos­sible… the seed corn is gone.

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Market

The Cycli­cally Adjusted Price Earn­ings (CAPE) ratio is a valu­able tool in deter­mining rel­a­tive market value.

Cycli­cally Adjusted Price Earn­ings (CAPE)

Since the 2000 peak of 44, which also rep­re­sents the start of the cur­rent sec­ular bear market, the index is cur­rently resting at 21.44. Looking back to the 1880’s, one can readily see that 21.44 is at the high end of the his­tor­ical record. It is also obvious that bear market bot­toms are asso­ci­ated with read­ings between 5 and 7.

This is a ratio, not an absolute value. How­ever, if earn­ings stayed con­stant at 2012 levels, the DJIA would see a CAPE of 7 at 4,200. If earn­ings col­lapsed by 50 per­cent from cur­rent levels, the DJIA would see 2,100.

This bear market has a long way to go.

Today’s ini­tial decline gave way to a strong rally, in which the DJIA made a mar­ginal new high. Other indexes did NOT con­firm the DJIA’s high, how­ever. Since this counter-trend rally began on Nov. 16, each suc­ceeding up day occurred on weaker advance/decline ratios, and today was no excep­tion. Today’s A/D closed at 1.10:1, which is just about even.

If the S&P 500 and NASDAQ indexes do not rise to new highs this week, it will be inter­preted as a bearish non-confirmation.

Both gold and silver have now com­pleted an impul­sive 5-wave series down, and should bounce some­what before embarking on another 5-wave series down. If this week’s lows are vio­lated, it means lower prices right away.

The dollar con­tinues weak, but has found some trend-line sup­port at its cur­rent level of 78.81. There is no evi­dence that the inverse linkage between stocks, gold and the dollar has been broken. Prices always gyrate in the short term, but looking back over ten years, the cor­re­la­tion is clear.

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5 Responses to Findings & Forecasts 12/05/2012

  1. Frank Landrey December 5, 2012 at 7:56 pm #

    So… What are we to do with our money? If the seed corn is gone, the crops won’t be planted and the future will be famine for growers and con­sumers. How do we pre­pare to out­last this event and save lib­erty?
    “An August F & R Member in Good Standing’
    Frank Lan­drey
    434 – 944-2728

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  2. Jack December 5, 2012 at 8:40 pm #

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  3. Thomas Woodward December 7, 2012 at 5:03 pm #

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  4. Ware December 8, 2012 at 9:00 am #

    The “Amounts out­standing of over-the-counter (OTC) deriv­a­tives” is $647 tril­lion, not $1500 trillion.

    link: http://www.bis.org/publ/qtrpdf/r_qa1209.pdf

  5. Patrick Wood December 8, 2012 at 3:25 pm #

    Yes, this is the esti­mate offered by the Bank for Inter­na­tional Set­tle­ments (BIS). Other bodies have dif­ferent esti­mates. Because there is no reg­u­la­tion of this market, nor are there any agreed-upon stan­dards for val­u­a­tion, it is impos­sible to find agree­ment between one esti­mate and another.

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