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y dependent on its real estate asset paper wealth effect due to the stagnation of real incomes in the 2000s households did accumulate enormous paper wealth in the 2000s but much of that is concentrated in the upper percentiles especially at the very top the huge winners in the current system much of their winnings coming from lightly taxed speculative capital gains for average income wealth households with real estate prices now declining and real world prices rising consumer spending has been under pressure additional factors usually neglected by the mainstream media that are critically different than in ltcm oct 1998 and the late 1990s tech bubble include the following the u s has a far larger current account deficit and external debt a very weak dollar a budget deficit dependent on cyclically high corporate profits and especially huge capital gains both of which may peak high energy food health care and other prices worrisome slowing productivity the rapid rise in productivity in the late 1990s was the underlying basis of the tech bubble and just around the corner huge unfunded pension health care liabilities in addition much of the world thinks that the u s is currently losing two wars and u s global standing is very low as repeatedly shown in polls in fact there has been a dramatic shift in relative economic strength between 1997 98 and now back then asian nations had current account deficits and currencies under attack asians now holders of trillions of depreciating u s dollars left click on chart to enlarge courtesy of st louis fed do not fondly remember u s actions protecting american speculators at the expense of asian living standards in the 1997 98 so called asian financial crisis which some asians call the imf crisis and identify with the u s in addition obviously the global geopolitical situation today is also far worse than in ltcm oct 1998 not only iraq and afghanistan but also very worrisome in pakistan a nuclear power iran and elsewhere all these potentially destabilizing factors which especially when taken together are far worse than during ltcm oct 1998 if for no other reason than they now are now afflicting the u s not the more peripheral emerging markets as back then are usually being ignored right now by both financial markets and the mainstream but without being alarmist for most countries all these factors taken together usually would be the symptoms of an upcoming major financial economic political crisis since the dollar is still the world s major reserve currency and the u s is by far the dominant military power that very unfortunate potential outcome has been continually avoided to the puzzlement of many mainstream economists and other academics as the rest of the world continues to finance for now america s spending spree both consumer and military i won t go into here the esoterics of financial not physical dark matter and what economists affiliated with deutsche bank cleverly but inaccurately labeled bretton woods ii back in 2003 the big positive difference this time perhaps the main reason or rationalization for sweeping the potential very large risks under the rug at the moment is the one very obvious extremely huge positive that many others and myself on my web site link have consistently noted namely extremely strong global economic growth especially in asia my ultra simplistic working assumption has been that the u s real estate and lbo bubbles were so absurd and so huge i e that it was economically impossible for the fed to give away essentially free money negative real interest rates for so long without creating huge potential problems therefore that the subsequent credit market problems must be quite large hence the subsequent pain probably has significantly further to go kudos and thanks to others who have analyzed this far more thoroughly than i have and it is now almost consensus opinion but on the other hand as i ve also repeatedly said we ve also never lived in an era where so much of the world is now in the market economy and i believe the ongoing long term positive benefits of that truly historical change are likely to be continually underestimated also especially by those in the west real estate and credit market problems have become major daily news in the u s the huge positive gains from a market economy in china india and elsewhere seem quite remote to the very busy daily lives of most americans but these gains continue day in and day out rapidly cumulatively greatly improving the lives of hundreds of millions of people over time asian growth obviously has continued to be extremely strong even as the u s has slowed e g the imf recently raised its forecast of global growth in 2007 from 4 9 to 5 2 even while it cut its forecast for the u s whether or not that will continue to be the case if the u s goes into an actual recession is still an open question in my mind china which grew 11 9 in the second quarter will contribute more to global growth this year than the u s on the negative side china s consumer prices have just increased 5 6 in july well above estimates of 4 6 and the highest rate in more than ten years from 4 4 in june regardless of the strength of asian economic growth a global flight from risk will most likely have a strong negative impact on emerging stock markets which like others has continued to hold up remarkably well so far and thus remain over extended and overbought on a long term basis as i ve shown in charts several times in the past month or two china s mainland stock markets of course continue to seem to be in a world of their own extremely over extended and thus remain another potential source of global financial risk and instability financial markets sharply higher volatility without low enough prices to attract buyers i will break the main flow of this article with this section to briefly show a few key charts note well this article is posted tues aug 14 the charts in this section were from e mails sent out last week aug 6 10 i did not have time to update them for this article but i believe the points they illustrate hopefully are still valid left click on the charts to enlarge this 5 year weekly chart of the s p 500 as of friday aug 10 shows that so far the correction has not been very severe though it has broken the uptrend from july 2006 purple line in the short term the s p 500 is oversold shown in the bottom indicator stochastic momentum index and thus normally due for a bounce though the current financial environment is obviously no longer normal longer term this correction would have further to go just to get down well into the bottom of the regression channels the parallel lines the red one is 2 std dev from the middle regression line bringing the true strength index trend indicator down to 0 or below going down toward the bottom of the regression channels would create real equity market fear and concern and perhaps at some point more fed intervention to try to trigger a massive short covering rally something greenspan did with the ltcm crisis in oct 1998 but which led to all sorts of moral hazard problems later more so than the s p 500 most world stock market indexes were so far above trend and overbought at the peak on july 19 that even a normal modest correction has not brought them down to very attractive entry points so far i have shown these charts especially of eem the emerging markets etf a number of times in previous articles on my web site link so will not do so here greatly compounding the practical investment problems as goldman s and other quant funds can well attest to has been the surge in volatility as shown in this chart from tues aug 7 vix black line the widely followed s p volatility index has been trending sharply upward and is now significantly higher than it was at the previous peak in may june 2006 yet for the etfs shown eem emerging markets red and qqqq nasdaq 100 blue the percentage price declines in that earlier 2006 correction were significantly larger than they have been now in other words to repeat what i said earlier equity investors are now facing the worst combination of greatly increased volatility without low enough prices to make the added volatility risk worth taking this next chart from mon aug 6 shows the percent change in three etfs xhb black homebuilder spy blue s p 500 and qqqq red nasdaq 100 the main point of this chart is that all three were highly correlated up until feb 2007 since then until the past few weeks spy and qqqq ignored the increasing troubles in the real estate sector so clearly reflected in the rapidly declining price of xhb finally this last chart from wed aug 8 shows the normal retracement bounce of xlf the financial sector etf during the seemingly highly manipulated rally mon tues aug 6 7 of last week such as floating rumors of fnm and fre buying subprime mortgages similar to the july 12 rally that hyped wal mart sales a day before weak consumer spending was reported which failed wed aug 8 afternoon leading to the sharp decline thurs aug 9 when the central bankers threw open their liqudity spigots thanks very much for reading such a long article i greatly appreciate it part 2 to follow in a day or two econotech posted by econotech 11 17 am thursday july 26 2007 7 26 speculators liquidity leverage russian roulette with economy real cap gains tax scandal july 26 econotech fhpn the point is that these innovations have externalities for the entire financial system that are hard to measure but dominate their apparent value rather than adding complexity and then trying to manage its consequences with regulation we should rein in the sources of complexity at the outset linked to the need to reduce market complexity is the need to relax tight coupling a less disruptive course of action is to reduce the amount of leverage that comes as a result of liquidity since this is ultimately the culprit that high liquidity and speed of execution breeds the externalities to high leverage are greater than they appear because on most days everything runs smoothly but as we have seen time and again in the instances where it really matters the liquidity that is supposed to justify the leverage will disappear with a resulting spiral into crisis simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets richard bookstaber a demon of our own design markets hedge funds and the perils of financial innovation 2007 wiley pg 260 bold emphasis added by econotech chuck prince yesterday dismissed fears that the music was about to stop for the cheap credit fuelled buy out boom declaring that citigroup was still dancing the citigroup chief executive told the financial times that the party would end at some point but there was so much liquidity at the moment it would not be disrupted by the turmoil in the us subprime mortgage market he also denied that citigroup one of the biggest providers of finance to private equity deals was pulling back in spite of problems with some financings when the music stops in terms of liquidity things will be complicated but as long as the music is playing you ve got to get up and dance we re still dancing the depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be at some point the disruptive event will be so significant that instead of liquidity filling in the liquidity will go the other way i don t think we re at that point ft july 10 front page bold emphasis added by econotech this article is mainly about whether to practically deal with an increasingly risky current investment environment via hedging as a follow up on previous articles the bookstaber quote above addresses the far larger issue of the safety of the current financial system and what could be done to increase it i strongly recommend the new one hour interview with bookstaber at financialsense com link dr bookstaber s mit economics ph d practical knowledge of derivatives and credit markets has been earned since the early 1980s as a financial engineer and quant at morgan stanley salomon bros and a hedge fund as for the above quote from citigroup s ceo prince i will comment in the next to last section of this article on his it s not my fault the liquidity made me do it rationalization for continuing the credit bubble for now i will just ask is the almost adolescent yet high stakes game of liquidity leverage russian roulette or chicken or musical chairs to adapt prince s dance metaphor any way to finance a modern global economy who do you think benefits from doing so and who will lose if when the music stops if you ve seen this movie before it might feel like watching a car wreck in seeming slow motion you cringe but can t stop it from happening but you can the current rules of finance are not the same as the immutable laws of physics e g capital gains taxes which encourage the ongoing orgy of speculation can be changed as i discuss in the third from last section the last section talks about my web site s link new tag line finance innovators not speculators for just global development to restore america s purpose and values what to do if when liquidity leverage music winds down with a sell off in u s stock markets july 24 i would like to give an update today july 26 to my june 21 article goldilocks 65 basis pts higher link specifically the last section titled if and when to hedge where i wrote as i ve tried to imply earlier in this article and in recent previous ones while i have consistently presented the long term uptrend is your friend view on my web site since the middle of the sharp global sell off may june 2006 starting with my june 2 2006 article link now might be one of those times to consider incurring the costs of hedging your bets in some way to some extent depending on your preferences again in terms of timing a hedge strategy july like most first months of each quarter tends to be seasonally stronger after negative earnings news comes out in the previous month i have not given specific investment suggestions on my web site link that is not its intent nor purpose but by hedge i meant exactly that hedge perhaps with puts or however else one is most comfortable including simply raising cash lowering beta using stop losses buying precious metals etc or perhaps even easier consider using calls similar to going long both securities and puts to limit downside risk and avoid the difficult task of trying to match up hedges with longs rising volatility is making the use of options more costly i tried to be a little more specific in a private e mail distribution on june 30 to get right to the bottom line i now feel that there is greater than a 50 chance of a significant correction in the stock market in the 3rd qtr by significant i mean at least 5 10 but it could be much more for the very little that it s worth my guess is that the stock market might be...