Twin Peaks

I’m definitely a fundamental investor when it comes to dissecting financial markets and securities. However, I’ve grown to appreciate technicals as a nice complimentary tool. One basic chart formation is called a “double-top” , which is defined as a bearish reversal pattern characterized by two highs at roughly equal value. If you look at the S&P Index monthly chart above, it appears we have put in a double top. Fundamentals would also argue for a double-top or twin peaks as I like to call them. The first peak in the S&P was caused by the Internet bubble and the second peak by the real estate bubble. While at first blush it may seem the Internet bubble was more troubling, the real estate bubble is in fact much more troubling and will cause more collateral damage.

Why you ask? See while the Internet seemed much more frenzied and speculative, etc…, it spawned a whole new wave of innovation and productivity for our economy. Sure it was a bubble and a big one at that, but it was funded mostly with equity and had little leverage attached to it other than some margin debt. So after the speculative investment bubble popped, only equity values were impaired and we still had a continuing beneficial impact from innovation/productivity gains.

However, the real estate bubble is a completely different story. Bigger houses and more home improvement centers don’t make our economy any more efficient or competitive. The real estate bubble is reflective of the golden age of financial engineering driven by the Fed’s high octane mix of negative real interest rates and lax regulation on financial instruments. Excessive risk, speculation and leverage were the name of the game and housing was the poster child. We are now paying the price for these excesses. The leverage is being worked out of the system but the problem is that there is more than meets the eye. In addition to vertical leverage (debt), there’s also a lot of horizontal leverage (counterparty risk).

The great money machine of Wall St. is now closed for business and likely so for several years. The benign growth environment we have enjoyed for the past 25 years (e.g., low inflation, low interest rates and low tax rates—both personal/corporate and capital gains) is in the rearview mirror. These factors were unsustainable and are now reversing, which will cause a reversion to the mean in economic growth and household wealth. It will be interesting to see how it all plays out but I predict a long slow grind down to the 1,000-1,100 level for the S&P Index. Few people comprehend the tremendous wealth effect these benign growth factors have had on the New York area. NYC real estate is in the cross-hairs.

On a different but somewhat related topic, lately I’ve been questioning how “economic” our growth really is considering 70% of our GDP is based on consumption. The government gave tax rebates in order to reinforce our bad consumption habits and the market rallied when retail sales were up 1% last month. This is good, how? The government is stretched and so is the consumer. The tax rebates were the equivalent of a financially unstable drug dealer giving away dope for free to an addict in the hopes it revives his/her appetite for drugs to drive revenues – yet the addict can’t afford anymore drugs nor can the dealer afford to incent growth. Something’s gotta give.