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POSTS: Weekend, 02-05-2011
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TIPPING POINTS

Process of Abstraction

Research Process

1- Sovereign Debt Crisis
2- EU Banking Crisis
3- Bond Bubble
4- State & Local Government
5 - Risk Reversal
 
6 - Residential Real Estate -
Phase II
7 - Commercial Real Estate
8 - Central & Eastern Europe
9 - Chronic Unemployment
10 - US Banking Crisis II
11 - Pension - Entitlement Crisis
12 - North & South Korea
 
13 - Public Policy MIscues
14 - Rising Interest Pressures
15 - Food Price Pressures
16 - US Stock Market Valuations
17- Finance & Insurance Balance Sheet Write-Offs
18 - Japan Debt Deflation Spiral
19 -Credit Contraction II
 
20 - US Reserve Currency
21 - US Fiscal, Trade and Account ImBalances
22 - China Bubble
23- Government Backstop Insurance
24 - Corporate Bankruptcies
25 - Slowing Retail & Consumer Sales
26 - Public Sentiment & Confidence
27 - Shrinking Revenue Growth Rate
28 - US Dollar Weakness
29 -Global Output Gap
30 - Oil Price Pressures
31 -Natural Disaster
32 - Pandemic
33 - Iran Nuclear Threat
34 - Crisis Programs Expiration
35 - Terrorist Event

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TIPPING POINTS

"The moment of critical mass, the threshold, the boiling point"

The tipping point is the critical point in an evolving situation that leads to a new and irreversible development. The term is said to have originated in the field of epidemiology when an infectious disease reaches a point beyond any local ability to control it from spreading more widely. A tipping point is often considered to be a turning point. The term is now used in many fields. Journalists apply it to social phenomena, demographic data, and almost any change that is likely to lead to additional consequences. Marketers see it as a threshold that, once reached, will result in additional sales. In some usage, a tipping point is simply an addition or increment that in itself might not seem extraordinary but that unexpectedly is just the amount of additional change that will lead to a big effect. In the butterfly effect of chaos theory , for example, the small flap of the butterfly's wings that in time leads to unexpected and unpredictable results could be considered a tipping point. However, more often, the effects of reaching a tipping point are more immediately evident. A tipping point may simply occur because a critical mass has been reached.

The Tipping Point: How Little Things Can Make a Big Difference is a book by Malcolm Gladwell, first published by Little Brown in 2000. Gladwell defines a tipping point as "the moment of critical mass, the threshold, the boiling point." The book seeks to explain and describe the "mysterious" sociological changes that mark everyday life. As Gladwell states, "Ideas and products and messages and behaviors spread like viruses do."

The three rules of epidemics

Gladwell describes the "three rules of epidemics" (or the three "agents of change") in the tipping points of epidemics.

  • Connectors are the people who "link us up with the world ... people with a special gift for bringing the world together." They are "a handful of people with a truly extraordinary knack [... for] making friends and acquaintances". He characterizes these individuals as having social networks of over one hundred people. To illustrate, Gladwell cites the following examples: the midnight ride of Paul Revere, Milgram's experiments in the small world problem, the "Six Degrees of Kevin Bacon" trivia game, Dallas businessman Roger Horchow, and Chicagoan Lois Weisberg, a person who understands the concept of the weak tie. Gladwell attributes the social success of Connectors to "their ability to span many different worlds [... as] a function of something intrinsic to their personality, some combination of curiosity, self-confidence, sociability, and energy."
  • Mavens are "information specialists", or "people we rely upon to connect us with new information." They accumulate knowledge, especially about the marketplace, and know how to share it with others. Gladwell cites Mark Alpert as a prototypical Maven who is "almost pathologically helpful", further adding, "he can't help himself". In this vein, Alpert himself concedes, "A Maven is someone who wants to solve other people's problems, generally by solving his own". According to Gladwell, Mavens start "word-of-mouth epidemics" due to their knowledge, social skills, and ability to communicate. As Gladwell states, "Mavens are really information brokers, sharing and trading what they know".
  • Salesmen are "persuaders", charismatic people with powerful negotiation skills. They tend to have an indefinable trait that goes beyond what they say, which makes others want to agree with them. Gladwell's examples include California businessman Tom Gau and news anchor Peter Jennings, and he cites several studies about the persuasive implications of non-verbal cues, including a headphone nod study (conducted by Gary Wells of the University of Alberta and Richard Petty of the University of Missouri) and William Condon's cultural microrhythms study.

 

RESEARCH METHODOLOGY

 

PROCESS OF ABSTRACTION

 

 

SOVEREIGN DEBT & CREDIT CRISIS

 

Inverted chart of 30-year Treasury yields courtesy of Doug Short and Chris Kimble. As you can see, yields are at a "support" area that's held for 17 years.

If it breaks down (i.e., yields break out) watch out!

The state budget crisis will continue next year, and it could be worse than ever. That's part of what's freaking out muni investors, who last week dumped them like they haven't in ages.

States face a $112.3 billion gap for next year, according to the Center on Budget and Policy Priorities. If the shortfall grows during the year -- as it does in most years -- FY2012 will approach the record $191 billion gap of 2010. Remember, with each successive shortfall state budgets have become more bare.

Things could be especially bad if House Republicans push through a plan to cut off non-security discretionary funding for states, opening an additional $32 billion gap. 

MUNI BOND OUTFLOWS

RISK REVERSAL

 

RESIDENTIAL REAL ESTATE - PHASE II

 

COMMERCIAL REAL ESTATE

2011 will see the largest magnitude of US bank commercial real estate mortgage maturities on record.

2012 should be a top tick record setter for bank CRE maturities looking both backward and forward over the half decade ahead at least.

Will this be an issue for an industry that has been supporting reported earnings growth in part by reduced loan loss reserves over the recent past? In 2010, approximately $250 billion in commercial real estate mortgage maturities occurred. In the next three years we have four times that much paper coming due.

Will CRE woes, (published or unpublished) further restrain private sector credit creation ahead via the commercial banking conduit?

Wiil the regulators force the large banks to show any increase in loan impairment. Again, given the incredible political clout of the financial sector, I doubt it.

We have experienced one of the most robust corporate profit recoveries on record over the last half century. We know reported financial sector earnings are questionable at best, but the regulators will do absolutely nothing to change that.

So once again we find ourselves in a period of Fed sponsored asset appreciation. The thought, of course, being that if stock prices levitate so will consumer confidence. Which, according to Mr. Bernanke will lead to increased spending and a virtuous circle of economic growth. Oh really? The final chart below tells us consumer confidence is not driven by higher stock prices, but by job growth.

9 - CHRONIC UNEMPLOYMENT

There are 3 major inflationary drivers underway.

1- Negative Real Interest Rates Worldwide - with policy makers' reluctant to let their currencies appreciate to market levels. If no-one can devalue against competing currencies then they must devalue against something else. That something is goods, services and assets.

2- Structural Shift by China- to a) Hike Real Wages, b) Slowly appreciate the Currency and c) Increase Interest Rates.

3- Ongoing Corporate Restructuring and Consolidation - placing pricing power increasingly back in the hands of companies as opposed to the consumer.

FOOD PRICE PRESSURES

RICE: Abdolreza Abbassian, at the FAO in Rome, says the price of rice, one of the two most critical staples for global food security, remains below the peaks of 2007-08, providing breathing space for 3bn people in poor countries. Rice prices hit $1,050 a tonne in May 2008, but now trade at about $550 a tonne.

WHEAT: The cost of wheat, the other staple critical for global food security, is rising, but has not yet surpassed the highs of 2007-08. US wheat prices peaked at about $450 a tonne in early 2008. They are now trading just under $300 a tonne.

The surge in the FAO food index is principally on the back of rising costs for corn, sugar, vegetable oil and meat, which are less important than rice and wheat for food-insecure countries such as Ethiopia, Bangladesh and Haiti. At the same time, local prices in poor countries have been subdued by good harvests in Africa and Asia.

 

- In India, January food prices reflected a year-on-year increase of 18%t.

- Buyers must now pay 80%t more in global markets for wheat, a key commodity in the world's food supply, than they did last summer. The poor are especially hard-hit. "We will be dealing with the issue of food inflation for quite a while," analysts with Frankfurt investment firm Lupus Alpha predict.

- Within a year, the price of sugar on the world market has gone up by 25%.

US STOCK MARKET VALUATIONS

 

WORLD ECONOMIC FORUM

Potential credit demand to meet forecast economic growth to 2020


The study forecast the global stock of loans outstanding from 2010 to 2020, assuming a consensus projection of global
economic growth at 6.3% (nominal) per annum. Three scenarios of credit growth for 2009-2020 were modelled:


• Global leverage decrease. Global credit stock would grow at 5.5% per annum, reaching US$ 196 trillion in 2020. To
meet consensus economic growth under this scenario, equity would need to grow almost twice as fast as GDP.
• Global leverage increase. Global credit stock would grow at 6.6% per annum, reaching US$ 220 trillion in 2020.
Likely deleveraging in currently overheated segments militates against this scenario.
• Flat global leverage. Global credit stock would grow at 6.3% per annum to 2020, tracking GDP growth and reaching
US$ 213 trillion in 2020 – almost double the total in 2009. This scenario, which assumes that modest
deleveraging in developed markets will be offset by credit growth in developing markets, provides the primary credit
growth forecast used in this report.

Will credit growth be sufficient to meet demand?


Rapid growth of both capital markets and bank lending will be required to meet the increased demand for credit – and it is
not assured that either has the required capacity. There are four main challenges.


Low levels of financial development in countries with rapid credit demand growth. Future coldspots may result from the
fact that the highest expected credit demand growth is among countries with relatively low levels of financial access. In
many of these countries, a high proportion of the population is unbanked, and capital markets are relatively undeveloped.


Challenges in meeting new demand for bank lending. By 2020, some US$ 28 trillion of new bank lending will be
required in Asia, excluding Japan (a 265% increase from 2009 lending volumes) – nearly US$ 19 trillion of it in China
alone. The 27 EU countries will require US$ 13 trillion in new bank lending over this period, and the US close to US$
10 trillion. Increased bank lending will grow banks’ balance sheets, and regulators are likely to impose additional capital
requirements on both new and existing assets, creating an additional global capital requirement of around US$ 9 trillion
(Exhibit vi). While large parts of this additional requirement can be satisfied by retained earnings, a significant capital gap in
the system will remain, particularly in Europe.

The need to revitalize securitization markets. Without a revitalization of securitization markets in key markets, it is doubtful
that forecast credit growth is realizable. There is potential for securitization to recover: market participants surveyed by
McKinsey in 2009 expected the securitization market to return to around 50% of its pre-crisis volume within three years.
But to rebuild investor confidence, there will need to be increased price transparency, better data on collateral pools, and
better quality ratings.


The importance of cross-border financing. Asian savers will continue to fund Western consumers and governments:
China and Japan will have large net funding surpluses in 2020 (of US$ 8.5 trillion and US$ 5.7 trillion respectively), while
the US and other Western countries will have significant funding gaps. The implication is that financial systems must
remain global for economies to obtain the required refinancing; “financial protectionism” would lock up liquidity and stifle
growth.

 

US$ RESERVE CURRENCY

SocGen crafts strategy for China hard-landing

Société Générale fears China has lost control over its red-hot economy and risks lurching from boom to bust over the next year, with major ramifications for the rest of the world.

Société Générale said China's overheating may reach 'peak frenzy' in mid-2011

- The French bank has told clients to hedge against the danger of a blow-off spike in Chinese growth over coming months that will push commodity prices much higher, followed by a sudden reversal as China slams on the brakes. In a report entitled The Dragon which played with Fire, the bank's global team said China had carried out its own version of "quantitative easing", cranking up credit by 20 trillion (£1.9 trillion) or 50pc of GDP over the past two years.

- It has waited too long to drain excess stimulus. "Policy makers are already behind the curve. According to our Taylor Rule analysis, the tightening needed is about 250 basis points," said the report, by Alain Bokobza, Glenn Maguire and Wei Yao.

- The Politiburo may be tempted to put off hard decisions until the leadership transition in 2012 is safe. "The skew of risks is very much for an extended period of overheating, and therefore uncontained inflation," it said. Under the bank's "risk scenario" - a 30pc probability - inflation will hit 10pc by the summer. "This would cause tremendous pain and fuel widespread social discontent," and risks a "pernicious wage-price spiral".

- The bank said overheating may reach "peak frenzy" in mid-2011. Markets will then start to anticipate a hard-landing, which would see non-perfoming loans rise to 20pc (as in early 1990s) and a fall in bank shares of 50pc to 75pc over the following 12 months. "We think growth could slow to 5pc by early 2012, which would be a drama for China. It would be the first hard-landing since 1994 and would destabilise the global economy. It is not our central scenario, but if it happens: commodities won't like it; Asian equities won't like it; and emerging markets won't like it," said Mr Bokobza, head of global asset allocation. However, it may bring down bond yields and lead to better growth in Europe and the US, a mirror image of the recent outperformance by the BRICs (Brazil, Russia, India and China).

- Diana Choyleva from Lombard Street Research said the drop in headline inflation from 5.1pc to 4.6pc in December is meaningless because the regime has resorted to price controls on energy, water, food and other essentials. The regulators pick off those goods rising fastest. The index itself is rejigged, without disclosure. She said inflation is running at 7.6pc on a six-month annualised basis, and the sheer force of money creation will push it higher. "Until China engineers a more substantial tightening, core inflation is set to accelerate.

- The longer growth stays above trend, the worse the necessary downswing. China's violent cycle could be highly destabilising for the world." Charles Dumas, Lombard's global strategist, said the Chinese and emerging market boom may end the same way as the bubble in the 1990s. "The basic strategy of the go-go funds is wrong: they risk losing half their money like last time."

- Société Générale said runaway inflation in China will push gold higher yet, but "take profits before year end".

- The picture is more nuanced for food and industrial commodities. China accounts for 35pc of global use of base metals, 21pc of grains, and 10pc of crude oil. Prices will keep climbing under a soft-landing, a 70pc probability. A hard-landing will set off a "substantial reversal". Copper is "particularly exposed", and might slump from $9,600 a tonne to its average production cost near $4,000. Chinese real estate and energy equities will prosper under a soft-landing,

- The bank likes regional exposure through the Tokyo bourse, which is undervalued but poised to recover as Japan comes out of its deflation trap. If you fear a hard landing, avoid the whole gamut of Chinese equities. It will be clear enough by June which of these two outcomes is baked in the pie.

SocGen crafts strategy for China hard-landing Pritchard

PUBLIC SENTIMENT & CONFIDENCE

 

 

SHRINKING REVENUE GROWTH RATES

PIMCO'S NEW NORMAL: According to PIMCO, the coiners of the term, the new normal is also explained as an environment wherein “the snapshot for ‘consensus expectations’ has shifted: from traditional bell-shaped curves – with a high likelihood mean and thin tails (indicating most economists have similar expectations) – to a much flatter distribution of outcomes with fatter tails (where opinion is divided and expectations vary considerably).” That is to say, the distribution of forecasts has become more uniform (as per Exhibit 1).

At 64.2%, the labor force participation rate (as a percentage of the total civilian noninstitutional population) is now at a fresh 26 year low, the lowest since March 1984, and is the only reason why the unemployment rate dropped to 9% (labor force declined from 153,690 to 153,186).

Those not in the Labor Force has increased from 83.9 million to 86.2 million, or 2.2 million in one year!

As for the numerator in the fraction, the number of unemployed, it has plunged from 15 million to 13.9 million in two months!

The only reason for this is due to the increasing disenchantment of those who completely fall off the BLS rolls and no longer even try to look for a job.

Lastly, we won't even show what the labor force is as a percentage of total population. It is a vertical plunge.

The stock market is at a highly vulnerable point, both fundamentally and technically. 

Fundamentally: The current rate of economic growth is unsustainable and the valuation of the S&P 500 is significantly above its long-term average. 

Technically: The market is overbought and is losing momentum. 

We cite the following points:

1- Consumer spending has been outpacing the ability to spend.  Spending has exceeded income in five of the last six months.  During this time nominal spending has increased 2.8%, compared to only 1.9% in personal income.  In order to accomplish this, households took their savings rate down to 5.3% of income from 6.3% six months earlier.   As we have pointed out numerous times, household debt is still near record levels and consumers still have a long way to go in deleveraging their balance sheets.

2- Housing remains a major weak spot with a rising pipeline of coming foreclosures, excess inventories and falling prices.  In addition rising bond rates are causing mortgage rates to climb.

3- States and local governments are slashing budgets through a combination of raising taxes and cutting spending.  This, obviously, is a major drag on the overall economy.

4- Private jobs have increased at an average of 112,000 a month over the past year, but about half of that has been in low-paying health care, social services and temporary employment.

5- QE2 is scheduled to end in five months.  Just as the anticipation of QE2 in August led to a substantial rise in the market, the anticipation of its ending may well have the opposite effect, combined with the other factors we mention.

6- With commodity prices soaring and consumers unable or unwilling to accept price increases, a large number of corporations will undergo major cost increases that will squeeze profit margins, a factor not calculated into current earnings forecasts.

7- Europe's sovereign debt problems have not been solved and the crisis will continue to fester.  Any real solution will not be friendly to economic growth.

8- The crisis in Tunisia and Egypt are not random exogenous events.  Soaring food prices, high unemployment and wealth disparities are as much a factor as repressive governments.  People tend to tolerate dictatorships more when they aren't hungry.

9- China is a bubble waiting to burst.  Think back to the late 80's when everyone was as optimistic about Japan as they are about China today.

10- At today's closing price the S&P 500 is selling at 19.2 times cyclically smoothed reported earnings, compared to a historical average of about 15.

11- In addition to the above fundamentals the market is technically vulnerable.  It has climbed about 95% over the last 23 months and 30% since the July low. 

- Sentiment has become heavily bullish

- the market is losing momentum as fewer stocks are moving higher on each successive top. 

- Volume for advancing stocks is dropping while volume for declining stocks is rising. 

- The number of new daily highs is also dropping as is the percentage of stocks making new 50-day highs.

In sum the current excitement about the market reminds us of the extreme bullishness exhibited near the tops in early 2000 and late 2007.  The outcome is likely to be the same.   

Stocks have been correlated for a long time pretty nicely with initial claims, and, well, check out this chart of the S&P 500 vs. the inverse of initial claims since 2008. The red is the stock market, blue is the inverse of initial claims. See, they match up pretty nicely, even during the mid 2010 slump. It's not perfect, but it makes just as much sense as saying that Bernanke controls the market.

And lest you think this is a recent phenomenon, it's not. Let's go back to 2000.

There are some weird things going on in this morning's jobs report, but the headline number was a joke, and as such, the scariest jobs chart ever looks horrid.

As you can see, via Calculated Risk, the pace of the jobs recovery is not only not in line with past "recoveries" it's not even at the pace it was a few months ago.

Our economy, our culture, our entire world, is built upon debt. No one ever asked us if that’s how we wanted it, it is simply how the system was designed when we came into it. Many of us have lived our entire lives under the assumption that debt is a necessary function of daily commerce and a valuable driver of successful society. Most households in America operate at a steep loss, trapped in constantly building cycles of liability and interest. There are even widely held schools of economic thought that are centered completely on the production and utilization of nothing but debt. Only recently have many people begun to ask themselves what the tangible benefits are (if any) in being dependent on debt based finance.

After careful examination, it becomes evident that debt does not fuel economy, it suffocates it. It does not nurture growth, it stunts and poisons it. Extreme debt is not a fundamental organ in a body of commerce; it is an aberration, a spreading cancer which disrupts the circulation of healthy trade. Debt is, in large part, unnecessary.

The secret to breaking the circle of debt is to adopt a policy of decentralization, and self sufficiency. To take back control of our local commerce and to establish micro-economies with self contained methods of trade. Debt must be removed from the equation altogether, and systems protected by flexibility and redundancy must be applied. Savings and meaningful production would have to take the place of endless spending and outsourcing. The claustrophobic nurse-maid philosophies of globalism would have to be cast aside and replaced with goals of independence and self reliance. By cutting our dependency on the corrupt establishment, we sever its ability to feed off of us. By building a better system, we make the faulty one obsolete. Whether or not we throw off the trappings of the debt machine is entirely up to us.

Two very important steps are required; the realization that debt is not the only way, and, the realization that debt is the worst way. Prosperity is not achieved at the expense of the future. The society that finally takes this fact to heart will accomplish incredible things indeed…