Monday, March 12, 2007

On Business Cycle and Consequences of Short Squeeze (Part 2)

We will start where we left off...on the Misinterpretations of Armstrong’s theory of business cycles.

Often, it is easy to snarl at this unorthodox theory that takes the boom-burst cycle from within our control into the realm of some natural cycle. On due consideration, we will realize however that Armstrong talk of Business NOT Economic Cycle. While the stock market correlates more with business cycles, it is a forward predictor of the state of the economy and economic cycles. Hence even though the economy was strong between 1999 and 2000, the stock market crashed in anticipation of the quick recession (correction) of 2001-02. Same can be said of the strength of 1994-95 in the midst of very bad economic indicators. Hence the stock market is not an absolute measure of economy: it is better used as a predictor of how the economy will perform in the near future as investors (always thinking of themselves as smarter than the average Joe) always want to pre-empt economy weaknesses or strengths.

However, stock indexes are more closely co-related with business performance: we have no better proof than Wall Street’s obsession with quarterly reports and earnings estimate and the far long lasting impact of a quarterly report on stock pricing than those weekly economic indicators that are usually shaken off as soon as their forward economic ramifications are swallowed. Hence, Armstrong’s analysis (a product of analyzing the market) can only suffice for actual business cycle not economic boom or bursts which is a lagging function as far as stock market performance is concerned. In addition to this, a peaking of a singular self driven factor relative to the rest generally result in a spasm across board which jumpstarts a boom or a recession.

Current Business Cycle Dissected
The questions we should ask are: did we have a business cycle up until Feb 27? What are the unintended consequences driving the “turn” in that business cycle? What/ when is the next business cycle and what consequences does it have on our personal finance?

Of course, there was a business cycle on the offing especially since the end of 2002. Since then, the stock market have been hitting new highs every quarter courtesy of a number of reasons chief amongst them being: Cheap Money (read low interest rates), high corporate profit and BRIC (I prefer CRIB) Boom which opened up a considerably huge market in highly populated China, India and Brazil. The net consequential effect of all of these was a booming housing market and net overall increase in wealth and spending in the internal economy.

What are the factors external factors and unintended consequences driving the turn? Like any good balanced natural cycle, the same thing responsible for the boom is responsible for the burst. In this case, cheap money have made the internal economy soaked in high public deficit spending (ask those drunk legislators in DC) and the escalating home value has caused your neighbor to borrow all the equity off his property putting your own portfolio at considerable risk (ask holders of NEW and NFI stocks that have fell 80% since January whether they were credit bingers too). In addition to all of these, we have the New Communist (sorry Democratic) Party in Congress that is determined to stifle China, and promote protectionism all factors that will drive huge private equity buy outs(where the big boys are) and low risk taking and Feds insistence on driving up rates to negate those and other extreme corporate action.

What has peaked?
Remember the one trick pony argument of Armstrong which I deduced in the last post as: “a peaking of a singular self driven factor relative to the rest generally result in a spasm across board which jumpstarts a boom or a recession” Hence, what singular factor will peak this year and cause the correction that is all but assured?

Naturally, I realize this factor is not going to be plainly obvious but deducible from the immediate impacts of such spasms. One that however seems to stand out is the flattening out of corporate profits; there is no doubt that corporate profit have been growing with no commensurate re-investment (may be due to Sarbanes-Oxley and/or limited growth opportunities). This eventually results in high cash on books, and saturation of growth room. This results in eventual profit flattening and a consequential inability of financing houses that have previously been willing to extend credit to speculative entities to do so again. Erstwhile, they had made these speculative credit offerings on the believe of a healthy balance sheet going forward that will more than adequately cover the debt or possibility of a buy out by one of the blue chips with a lot of cash on hand and no growth room. What a flat profit margin will do is to induce a waiting game by the blue chips that are cash rich to buy the speculative in fire sale bargain instead i.e. a buyers market instead of the current sellers’ market phenomenon. The spasm of flattening profit is then felt first on the credit side not on the balance sheet and eventually in the buy out/ M&A field where a lot of killing has been made in the past few years. This is exactly what we see in the failings of the sub-prime lenders and the effect it is having on big dogs like HSBC and Credit Suisse.

1 comment:

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