Tuesday, September 29, 2009

Peter Thiel is Absolutely Correct!

Already barely a year from last year's financial meltdown with the DOW crashing over 700 points, we behold the exact same constellation of factors aligning for a new bubble. And with no effective restraints imposed on "the Street" we may expect their henchmen and innovators to soon trump even the credit default swaps which wrought so much havoc.

Add to this unemployment remaining at 9.7% and you have a nasty mix, indeed, which doesn't bode well. Numerous organs of high finance, from The Financial Times, to The Wall Street Journal, to FORTUNE and even investor-oriented MONEY, have already noted there is no practical basis for the rise in the DOW toward 10,000 we are seeing. After all with so many unemployed consumption is retreating and making do with less, and even big spenders are tightening their wallets or purse strings. So why are investors so caught up in this trap?

One who isn't buying it is Peter Thiel, co-founder of online payment company Paypal, who "thinks the economy is far from recovered and has bet with the bears amid the relentless rally" (Wall Street Journal, Sept. 28, page C1, 'Pessimism Exacts a Price on the Skeptics')

While other Hedge funds have experienced bonanzas in investment, Thiel's (Clarium Capital) "has seen double digit declines". (WSJ, ibid.)

Thiel is not repentant, nor should he be. As he put it (ibid.):

"The recovery is not real. Deep structural problems haven't been solved and it's unclear how we will create jobs and get the economy growing again- that's long been my thesis and it still is".

In the WSJ piece, of course, Thiel is referred to as a "contrarian" but this is misplaced. In fact, Thiel is one of the few sane folks not caught up in the syndrome of "irrational exuberance" that Alan Greenspan first coined in 1997. He is level-headed enough to see the signs and portents don't warrant a market buy in, though millions of lemmings seem to believe otherwise.

What does Thiel mean when he asserts "the recovery is not real"? First, note the clue in his reference to "deep structural problems". The core issue is illustrated in the diagram at top showing two banks with different levels or thresholds of net equity. Bank A is in much better position than Bank B by virtue of it having far less exposure to the toxic debt (actually bets on mortgage debt) known as CDS or credit default swaps.
To refresh memories, these were first clearly articulated in the fascinating (but terrifying!) FORTUNE article: 'The $55 TRILLION QUESTION' (October, 2008, p. 135). Quoted in the piece, a University econ professor (Frank Partnoy) who doubles as a Morgan Stanley derivatives salesman noted:
"The big problem is there are so many public companies- banks and corporations, and no one really knows how much exposure they have to CDS (credit default swap) contracts."
Since most CDS contracts are made "on the fly" in no formal mode, and often by word of mouth on cell phones (ibid.) no one even knows where all the $55 trillion of this toxic waste is buried. As another hedge fund operator (Chris Wolf) quoted in the article put it:
"This has become essentially the dark matter of the financial universe" - comparing it to the dark matter discovered in astrophysics.”
Finally, and most apropos, as the FORTUNE piece observed:
“you can guess how Wall Street's cowboys responded to the opportunity to make deals that: 1) can be struck in a minute, 2) require little or no cash upfront and 3) can cover anything.”

Now, the government's TARP (toxic assets relief program) was designed to eliminate the hidden CDS in all the exposed banks' ledgers, and thereby increase their aggregate equity to make mutual (interbank) and other loans feasible again. The chief fly in the ointment is that barely $100 billion has been allocated to deal with a $55 TRILLION bank black holes incepted by their purchase of these things. To make matters even worse, banks haven't even neen using the TARP money to eliminate their CDS exposure, but to bolster their own bottom lines and ledgers and enhance their individual equity.
But who can blame them? After all no "mark to market" indicators have been forthcoming, so there's no guidance on what any given credit default swap contract should be sold for. Pennies on the dollar? Ten cents? How much? Even ten cents on the dollar (which most banks certainly wouldn't accept, given the losses) means $5.5 TRILLION needed to get back to the status quo of bank equity before the meltdown.
But no one has made any decisions, so banks not only retain TARP money for their own use but are actually starting to make risky loans once more. On the bet that in the heating DOW climate they can make back money faster than under any Fed TARP deal. Thus, like it or not, CDS are still lying around like so many financial "bombs" ready to detonate again. No wonder Thiel isn't buying into the pseudo-rally!
Thiel's worry concerning the extent of job creation is also not irrelevant. Without job creation, and by the literal millions, people won't start major spending again. Since consumer purchases account for 70% of GDP in this country, it means a lower GDP is in the making and quite possibly a long term decline - ushering in the sort of long term deflation we've already seen during the 90s in Japan.
To recap that, after the Japanese market meltdown in the early 90s, and major job losses, Japanese consumers pulled in their purse strings and enhanced savings rates to well over 10-12%. This ushered in a prolonged period of zero or no spending, and deflation. Recall that in deflation prices uniformly plummet. While it sounds superficially good, what it means is that companies can't sell to make a profit, and hence must lay more people off to meet their bottom lines. The more people without jobs the less further spending, and the more layoffs ...and so the vicious cycle goes.
The key point is without consumer spending - fueled by decent paying jobs- companies can have no real growth. This was a point made by William Wolman and Anne Colamosca in The Great 401k Hoax, noting that believable returns on any financial speculative instrument (say like an equity stock) cannot exceed by more than 1% or so what the company's actual growth rate is. If a company is only experiencing 0.3% growth per annum, but its stock is selling with a retrun of 7%, watch out! It's bogus! The Price to earnings ratio (P-E ratio) is out of whack and you are looking at a bubble.
Bubbles get punctured or burst, as we've seen with the tech bubble.
Message here: Pay attention to Pete Thiel's reticence to buy into this market.
And: Caveat emptor!

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