Can I Have Another Piece of Chocolate Cake?

How does the bailout change my outlook on investing in the next year? Not much. Kirk on Reasons Unbeknowst asked this question in the post The Most Predictable Meltdown in History:

Would you rather get punched in the nose hard once or would you prefer a good slap in the face every morning for a year?

As I write this post it looks like our lawmakers are going to pass a bailout plan. In other words, they have decided we will be getting a good slap in the face every morning. Kicking the can forward and passing the debt forward to some future date. Is this the right move? In a post earlier this week, Jim and myself listed how the smart guys in the room are lining up on this issue.

  • Mish is opposed.
  • Karl Denninger is opposed.
  • John Mauldin is in favor.

I’ve learned a lot about markets and finance from these three. These are my main economic mentors for the past year and they don’t agree. Mauldin thinks we crash if don’t get the bailout. Denninger thinks we crash if don’t add transparency immediately. Both men are highly experienced traders and it is possible they are both right.

The end result may be that half the investors lose faith in the markets when their side doesn’t prevail. That may enough to cause a crash. Half want immediate honesty. The other half wants massive amounts of cash immediately.

The Sovereign Speculator sums up the state of the market brilliantly in the post Credit markets iced over. Put your head between your knees.

If the fundamentals were not so horrible and stock prices not so high (with earnings falling off a cliff, real PEs are in the stratosphere and dividend yields are pathetic), this would be a promising time to go long, at least for a trade. As is, that would be Russian Roulette, because it would be hard to imagine a market more primed to absolutely crash than this one.

My quick scorecard looks like this:

  • Lack of trust in US markets.
  • Real PEs way too high given the slowdown in the economy.
  • Tax revenues declining.
  • Unemployment rising.
  • Home prices still too high given tighter lending standards and huge inventories.
  • Bans on stock shorting makes a crash scenario much more likely. (EX: China down 65% in 3 months)

The bailout may provide a little bounce, but it won’t hold. The deleveraging of the largest credit expansion in history will continue. My target for the S&P 500 was 1000. Now I’m lowering it to 900. If your 401K is in equities, either move your money to fixed income or get ready for a punch in the nose.

Even though I’m a long-term bull on America, I can’t help but to think of this line from the Crowded House song Chocolate Cake when I see all the bailouts.

Now the excess of fat on your American bones
Will cushion the impact as you sink like a stone

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MAS

Critical MAS is the blog for Michael Allen Smith of Seattle, Washington. My interests include traditional food, fitness, economics, and web development.

10 thoughts on “Can I Have Another Piece of Chocolate Cake?”

  1. Glad you liked my post. Like your blog, too. I remember a few days back I found your excellent work digging into the nuts and bolts of short ETFs, “My counterparty is over.” I’m easing out of them, though the bailout is a bit of a blessing in disguise for shorts who use these and options, since it should put some heft behind the counterparties and the Options Clearing Corporation.

    PS — My own target for the S&P is about 350. At least that’s the number I’m not afraid to use in public. Take PEs and earnings each down by 50% off peak levels and that’s what you get.

    PPS — Mauldin is a weenie.

  2. I like Mauldin because he isn’t a bull or a bear. He is sort like a line judge in a tennis match. And he has an excellent grasp of history and financial probabilities.

    I really liked your post Why bailouts will not stop the depression. Great explanation of why we are going to get continued deflation – at least in the short run.

  3. I heard a good explanation about why this will not help unfreeze the credit markets on David Horowitz’s podcast this morning (The Disciplined Investor from iTunes).

    The argument is that as bad debt is realized this hurts the bank’s margins (% they need to hold by law). They will sell their bad debt to the government to meet their margin requirements …but that’s it. They still won’t be running around loaning a bunch of money because they are still trying to deleverage.

    Anyway, I don’t know if it will play out this way, but it’s a realistic scenario. IF it is true though, we end up like Japan in the 90s …enough government support to keep zombie banks limping along for years.

    Also, for the record, I like Mauldin alot also, but his “muddle through” theory was way too bullish in my opinion. On the flipside I think Karl is too bearish at times, though I know he is trying to be balanced. I think we are in such uncharted territory that if anyone “get’s it right” they are probably just being lucky.

    My current price targets (based on multi-year head and shoulders patterns) are:
    S&P – 950 (~22% down)
    DJI – 8000 (~30% down)
    NASDAQ – 1600 (~27% down)
    R2K – 450 (~36% down)

    I hope I am wrong …this is financial devastation, but this pattern is supposed to be fairly reliable.

    Final note on counterparty risk …GRZZX is one way to go (already discussed), but shorting double-longs is another. YOU hold the etf, so counter-party failure only helps you. I still have some double shorts, but I think I may switch to shorting double longs after the likely “bail-out” rally.

    BTW, nice posts guys …it is fun to be part of an adult informed conversation.

  4. Hmmm …my counterparty risk with ETFs was explained wrong. This is the real deal…

    You borrowed their ETF and sold it at market price. In the future you have to buy it again (from the market) and give it back. Assuming a financial meltdown occurrs, the ETF should be cheaper, but counterparty failure should make it even more cheaper.

    I may be wrong, but I assume ProShares would spread the loss evenly across all shares if a “counterparty” goes bk and can’t pay up.

    Also, my “~XX% down” meant down from HERE, not down from the peak or YTD or some other starting point. These are also 6-18 month targets …the next plunge may not go this low.

  5. Good stuff JIM. We seem to have the same basic outlook.

    I talked to some regular Joes yesterday. Smart people that are good at their professions, but just clueless when it comes to economics. They are about to get gobsmacked. They are still buying the “buy and hold” line.

    I’m going to do another post on that topic.

  6. Looks like they “get gobsmacked” today! 🙁

    At this rate we are going to hit my price targets by Friday …jeeeesh!!

  7. I have no idea what’s going to happen, especially after today, you all may be indeed correct.

    However, to add some levity to the situation please enjoy this …

    Sound Financial Advice

    If you had purchased $1,000.00 of Delta Air Lines stock one year ago you would have $49.00 left.

    With Enron, you would have had $16.50 left of the original $1,000.00.

    With WorldCom, you would have had less than $5.00 left.

    But, if you had purchased $1,000.00 worth of beer one year ago, drank all of the beer, then turned in the cans for the aluminum recycling REFUND, you would have $214.00 cash.

    Based on the above, the best current investment advice is to drink heavily and recycle.

    It’s called the 401-Keg.

    A recent study found the average American walks about 900 miles a year.

    Another study found Americans drink, on the average, 22 gallons of alcohol a year.

    That means, on average, Americans get about 41 miles to the gallon.

    Makes You Proud To Be An American!

  8. I used to read Irwin’s post every week, because he was one of the first to note the inverted yield curve (a recession harbinger).

    Occasionally he has been spot on, but occasionally he writes economic nonsense too (stopped clock effect).

    I think this is one of those nonsense pieces.

    Most of the rhetoric has been overly bullish until very recently. If anything, stocks are over valued because of this.

    I also don’t think he has a clue how bad it could get …and it’s too early to know at this point.

    Just my 2 cents…

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