The Ouroboros, 2008 And Deflation

The Ouroboros, 2008 and Deflation 2008 was disastrous but fascinating year in the financial trading marketplace. I recall no period with such widespread misunderstanding of market conditions and policy needs. The problems that devastated the markets began to reveal themselves in late 2007 when two Bear Stearns funds collapsed because securities they held could not be sold. Then Libor rates exploded as banks began to take a look at their own portfolios and became suspicious of the portfolios of other banks and stopped lending to one another. This was misinterpreted as tight money so the Fed responded with rate cuts. But the real cause was a slow realization that bogus triple A rated mortgage securities based on mongrel pools of thousands of subprime mortgages mixed with prime mortgages were grossly mis-rated by ethically challenged, fee seeking, rating agencies. The asset class collapsed and thus seriously impaired bank capital ratios. But not until Bear Stearns failed was this widely recognized. Solvency was the problem not tight money, and that is why Fed rate cutting was not generating any result. They were treating a virus with an antibiotic. The Ouroboros pictured above is a mythical creature that eats its own tail and is generally used to represent eternal recurrence. But it also represents a system consuming itself, and that is what we have. Inattentive regulation of new securities fed by greedy and over confident investment bankers led to a massive over leveraging aided by loose policies under the Greenspan Fed. Collapsing asset values in the huge mortgage backed securities market turned leverage ratios of 40-1 backward and bank and hedge fund equity consumed itself. Fear began to spread and the 3 week period surrounding the seizure of Fannie and Freddie and the bankruptcy of Lehman set off panic in the public and in institutions. Margin calls triggered wave after wave of liquidation of positions and equities, commodities and corporate debt all plummeted. Game over. The reason central banks always fear deflation more than inflation is deflation is self sustaining. Rational behavior by the individual to increase liquidity is a disaster for the economy which is losing systemic liquidity. The central banks are relatively powerless to stop the feedback cycle until the panic subsides and the fear begins to dissipate. The actions they can take are too slow to take effect for the results to dampen fear quickly and thus the Fed and Treasury appear inept. That was 2008.

2009 will be quite different. The panic has ended, though it could reignite, as positions were largely liquidated by leveraged funds and institutions before year end. Furthermore the natural optimism of a new year, the extraordinary optimism attached to the incoming Obama administration, and finally some effects of the massive monetary stimulus initiated by Fed and Treasury programs put in place beginning in August should coalesce to create a more positive psychological environment for investors. This will be a year where sentiment will be more important than ever. At Infinium we have always believed personal psychology is the most important component in success. This year group psychology will be just as important. Three trillion plus dollars was pulled back in to money funds and probably equal amounts to bank accounts and other non market exposed mattresses. Will confidence or greed for yield be enough to start dragging that money back into the market? Or will continuing negative economic news and ballooning unemployment maintain a level of fear that continues to depress money velocity? That is the pivot point for the market and the economy. The positive in this for us is continued volatility and opportunity for intelligent risk taking and edge collection. Big Themes Reflation trades still good. The central banks will continue to fight deflation longer than necessary and now fiscal stimulus will be in place as well. Trading opportunities will exist in short versus long rates, spreads between treasury and investment grade and high yield bonds, forex crosses; also individual stocks and equities that benefit from or are harmed by specific pieces of stimulus legislation. Country Indices outright or spread based on differentials in growth estimates or policy proposals and national financial solvency. Commodity trades will be more differentiated than last years correlated boom in the first half and even more correlated crash in the second half. Examples are: precious metals as the only not currency specific trade, grains on weather and carryover. base metals and oil on rising demand from infrastructure projects fueled by government stimulus. Politics will play a much bigger part of the action because of a new administration and one sided Congress rather than just bluster surrounding the election contest. Infrastructure companies, utilities, autos, healthcare and pharma are all likely to be heavily affected by legislation. Type and quality of fiscal stimulus proposals will push the debt markets around. Geopolitical policy will move currency, debt and country indices. Specific Themes Some I favor now. Infrastructure stocks that operate worldwide based on stated stimulus plans in the US, China, Mexico, Brazil, and India, Europe likely. Precious metal are the currency alternative in an era of competitive debasement of paper currency. Platinum is outperforming. Strong balance sheets versus cash poor companies.

Fed will hold short rates low to press for shrinkage of quality risk spreads. China relative strength Long corporate and high yield bond funds outright ( these have had a big move during last week) and spreads of etfs of different underlying quality and maturity length Conclusion I do not expect nearly as much high correlation or so many enduring trends as 2008 because I believe positions are smaller and there will be more crosscurrents among trading instruments. I do expect significant opportunities for the alert. Surprises are likely to come from geopolitical conflict, legislative proposals after the first quarter, state and municipal finance, and crop failure, failure of large European banks tied to credit default swaps. Fire away criticism is welcome. (except about my weight) Bruce Lawrence Global Strategist Infinium Capital Management Jan2, 2009