Good case comparison from Dave Rosenberg

Some times you have to look beyond the numbers and conduct case comparison. This is especially appropriate if you are looking at business cycles because we just do not have that many occurrences of recessions. (Thankfully.) The table above provides a comparison with the '82 recovery with the current recovery. The early '80's saw the worst recession in the post-WWII period prior to our current problem.

The conclusion is that the environment is just not very good for a strong recovery. Every category looks like a problem.

Interest rates have nowhere to go but up.
Budget deficit getting worse with structural problems.
Inflation rising.
Misery index rising.

I could go on but you get the picture. There economy needs a game changer and there does not seem to be one. You have to be defensive in this environment and look elsewhere for opportunities then from being long stocks.

Currency intervention- Pressure has been reduced with the dollar rally

From FT Alphaville:

"Morgan Stanley has knocked up some currency-intervention models to help guide you through the uncertainty.

These are based on the following four criteria:

(1) market mis-pricing of relative growth outlooks;
(2) significant deviation of the real exchange rate from historical trend;
(3) excessive market positioning;
(4) increased momentum in exchange rate moves."

What the dollar rally has done is take away a significant amount of the pressure for intervention. The currency markets now have a 5% cushion to retrace before central banks start to again have that nervous feeling that the dollar has moved too much. We have not explicitly followed this type of model, but we track many of the components that are used in the MS model.

We ask the following questions to measure the potential for intervention:

• What is the momentum or trend in rates? Strong directional moves will be the catalysts for action even though it is called "excessive volatility". Range-bound high volatility will not get the attention of central banks.

• What is the exchange rate direction central banks want?Excessive market positioning is code for carry or short-term capital flows. One way flows will more likely cause intervention by central banks. Carry will often push exchange rates in the direction that central banks do not want.
  

• Are there significant deviations from fair value? Significant deviations from real exchange rates especially if the exchange rate is overvalued is a reason for intervention.

In the near-term we think the potential for intervention has declined. This may change if we again see dollar decline pressure.

What are we doing to help liquidity?

Clearly, the Fed and other central banks have provided huge amounts of liquidity by adding assets to their balance sheets. These efforts have reduced the economic decline but the issue of liquidity is more complex then flooding reserves. The drinking from a liquidity fire hose does not solve longer-term problems of how markets and banks function. In fact, we still have the problem that banks will not lend. For example, the bank reserve addition does not directly address liquidity issues in the shadow banking system which has exploded through the ABS market.

Barron's had a good article in the December 28th 2009 issue called "A Flat Dow for 10 years? Why it could happen" describing the research work on liquidity by some leading economists. The conclusions now seem obvious; nevertheless, we now have to learn to find policies that will solve liquidity problems. Here are some observations on liquidity that I have gained from reading this literature. This is more than a banking issue since many loan products are now traded as securities.

• Leverage will have a real economic impact. However, what drives institutions to take levered trades is less clear. Lack of regulation may be one part but not the whole story. Think of China where there is a strong state run system that is having a property and leverage boom. Leverage is a function of what abks perceive as the risks. The environment matters and if the government sends signals or behaves in a manner that suggests thatere is limited downside risk, more leverage will be taken on by the market.
• The shadow banking system and securitization is fundamental to the working of credit markets. Lending is not just a banking activity. Hence, regulation between banks and securities has to integrated.
• Just because something is securitized does not mean that it is a liquid security. Similarly, just because something has a triple-A rating does not mean that it is liquid.
• Liquidity spirals are a problem. Whenever there is a capital call in one market, there is the potential for a ripple effect into other markets. The raising of capital in one market will require the selling of more liquid securities.
• The selling of some securities will lead to more selling if there is a price effect. Feedback effects are real. Price pressure even temporary can lead to liquidity crises.
• Liquidity is related to the level of information that players have in the market. Less information means less liquidity.
• Skill effects the liquidity of securities. If the valuation of security requires skill, there will be less liquidity.
• Simple securities will always have more liquidity than complex securities.
• Complex securities will require a liquidity premium independent of its level of specialization. More specialized or customized securities require more liquidity.
• Confidence effects liquidity. If there are loses in a type of security, there will be a loss of confidence which will affect the willingness of investors to re-enter the market. Hence, there will be a loss of liquidity.
• More data and information on securities will increase the level of liquidity. Data is a public good that helps all market participants even though it may hurt profits for a given market maker.
• Liquidity will affect arbitrage opportunities. Arbitrage will not take place without a premium if there is a the perception that there is less liquidity in the market.

Unfortnately, there has not been anything done to improve the liquidity in the markets by regulators. This does not seem to be an area of concern.

Quotes to start the new year

There is nothing so disturbing to one's well-being and judgment as to see a friend get rich.

- Charles Kindleberger

The great research on financial panics always had greater insights on the human condition. 2010 will be a period where envy may get in the way of good economic policy. But then that has usually been the case.

Ignorance more frequently begets confidence than does knowledge.

- Charles Darwin

This can explain some of the winners of the Darwin awards.

Panics do not destroy capital. they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.

-John Stuart Mills

This may be one of the best single comments on the impact of panics.

There is only one difference between a bad and good economist. the bad one confines himself to the visible effect, the good economist takes into account both the effect that can be seen and those effects than cannot be foreseen.

-F Bastiat

The essential Greenspan legacy is the idea that the Fed will allow nothing to go wrong.

-James Grant

The Greenspan put is alive and well regardless of what government officials say about moral hazard problems.

The superior man understand what is right, the inferior man understands what will sell.

-Confusius