Munch on the credit crunch!!!

A $700 billion dollar bailout plan was on the radar screen of every investor and trader. It came and went. I was surprised by the market reaction. Bear markets have a common trait, all good news is sold into. It happened again today as well. I was speaking and expecting this from the last one week. It was very evident in the FedSpeak and ECB's remarks that all Cenbanks would ease on rates. Again the market didn't move much. Its not important to be a bull or a bear in markets. You just need to be very objective. The current bear market began with two broad important themes -

A. Inflation induced by crude, food and money

B. Stressed interbank markets due to a rise in foreclosures and rising defaults

Investment banks all over the world took a lot of risky loan assets on their books in order to sell it off in the form of CDOs and other leveraged instruments. The underlying loans assets of these instrument were housing loans. Quite a few of them were of inferior quality because banks didn't care about the creditworthiness of the borrower as they would sell these loan assets in a bundled form to investment banks. Underlying loans were quite disastrous like NINJA loans - No income, No job or Assets loans and Alt-A, subprime et al. MTM losses forced banks to raise capital which become scant as Central banks reigened in money supply to ease inflation.

Then came the headlines made famous by the financial press. Toxic debt made the issue even messier. I was quite curious to find an exact number which can define the extent of 'money' that is required to set the mess to rest. There were a few estimates. Like $1.3 trillion net of the toxic debt, $5 trillion of financial aid required, $60 trillion of gross worthless mortgage CDS and $1300 trillion mess worldwide in all sorts of loans.

I really don't know which number is the correct one. I don't even care whether any number is correct or not, neither does the guy who has put in his money in some supposedly 'risk free', 'large cap' stocks. It is quite simple and evident that the total liability of poor mortgages and inferior assets that banks held in their balance sheets is too big to be cleaned up quickly. As I picked up some of the financial magazines for the current week I noticed a glaring similarity between investor sentiment, the crowd psychology and the headlines. The businessWeek headline read - Is it safe YET? The NewsWeek read - It's not as bad as you think! and the rest. In the last one month the sentiment among the investors world over has went from bad to worse, the volumes have suffered considerably, futures in stocks are gyrating like drunkard and all of a sudden the indispensable CRUDE OIL doesn't matter anymore.

Most of us would believe or like to believe that history repeats itself. It is indeed repeating now. We are very much on the some line as we were just 100 years ago. Reading a few books about the great market crashes will let you know that the first decade of the 20th century suffered the same fate as the world economy is suffering now. JP Morgan came to the rescue then and again it stands tall though on crutches provided by the Federal Reserve and the political clout of the US government. There are quite a few articles in economist and the ET on the similarity between 1907 and 2008.

Many banks fail in every big recession and there is a massive slowdown that follows. Credit is the backbone of most business and when it dries up it leave lot of people and businesses very hungry. Currently there is lack of trust which is the life support of the financial system. Banks and other financial institutions have serious doubts over each others financial health and credit worthiness. The action of the US government by purchasing corporate commercial paper is a direct way of lending to corporates at rock bottom rates. This would provide much needed funds to corporates who require quick cash to run their businesses. It would infuse confidence in the system as well.

The U.S. Fed, ECB, BOE and other major central banks moved today to slash key interest rates as part of an ongoing effort to quell financial turmoil. I think this step is a crucial one and a number of cuts will help revive confidence in the system. Though the problem right now is not the cost of borrowing but the availability of credit. The inter bank market across the world are virtually still and there is very little activity that is happening. Still lower rates would increase risk taking capacity and help household spending and business spending in the short term.

Is the main street unaffected by the current crisis ?

If we move to look at the real economy and see what has been the past trends in the bear markets, we would notice some signals. Firstly this bear market has been in place well before the actual economy has shown signs of remarkable slowdown. Most stock indices have been cut in half and there has been comparisons drawn to 1930s. There is little by way of comparison right now. Unemployment in the US is at 6.2%, it was at 25% in few months of the bear market. 4000 banks failed in 6 weeks, 26 have failed or rescued in last one year. There was a glut of inventory, which is quite low at present. To top it all in present slowdown, each commodity has seen a rise in demand in the last one year. So real economy has not suffered as much as the financial part of it due to faulty troubled assets. But it will show signs of slowdown in near future which would be much more visible.

I think its pretty outlandish to think that the real economy doesn't undergo a slowdown if banks fail. It is for sure a hit on everyone pocket as growth slows and wage and price inflation fades. It leads to stagnation or low growth in the standard of living. The current crisis is a mix of things.

A. It was created by cheap loans to people who could never repay. These loans were bundled up as 'assets' and sold to the smart money as high yielders. Some banks were actually trading even the bundles.
B. Inflation forced the central banks to raise rates, which stopped the vicious circle of cheap credit ballooning asset values beyond reason.

C. The world grew 25% more in just 10 years. World population has accelerated to 6.6 billion. One out of every 8 person on earth is an Indian, and 1 out of every 5 is a Chinese. Indian economy grew at an average of 8.5% in last three years and Chinese economy grew at 10.5% for the last three years.

Now the question to most of us right now ( it is actually always the supreme question) is - Where are we headed ?

Stocks indices have come off their highs in a gradual manner which has been steep for some markets like shanghai. There has been a conscious effort from central banks to help stabilize the financial markets, especially from the US, EU and Japan.

In purely technical analysis terms there are very little signs of trend reversal yet. Though my studies say that we are very near to end of price corrections or probably a bear market low. It might take the market some time to recover but the price correction might get over in few weeks time. In my previous posts I have mentioned the fall in Nifty as to be an important part of the bear cycle. All upmoves have been counter trending and surprisingly very short. Threre would be more counter trend rallies unless we have a set low in place. For that to happen we must have some price pattern which hints ate it. I think it is getting formed in the daily graphs of most of the Asian stock Indices.

Talking about levels I feel 3370 should not be broken on Nifty on a daily close. If we close below that level, we will get into further price deterioation.

I will post graphs on Nifty with the wave count. Gold elliott wave count has served quite well in the last 6 months and the current upmove its getting stronger by the day.

I would be posting regularly in the next few weeks.


Sahil Kapoor

Comments are welcome.