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  Posted on: Thursday, October 21, 2010
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Market Is Facing Major Headwinds

   
 
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The current market rally is not based on a self-sustained typical economic recovery, but on blind faith that the Fed can pull out a magic wand and cure everything with another round of quantitative easing (QE2).  As we pointed out last week, this a desperate attempt by the Fed to try non-conventional means to get the economy going again after a massive dose of conventional measures resulted in failure.  The members of the FOMC know this, but with further fiscal measures off the table, they are aware that they are the only game in town.  The Fed's acknowledgement that the economy is in trouble is again highlighted by the latest Beige Book released yesterday.  The following are some excerpts from the report:

"National economic activity continued to rise, albeit at a modest pace..consumer spending was steady to up slightly, but consumers remained price-sensitive, and purchases were mostly limited to necessities and non-discretionary items..Housing markets remained weak..Most reports suggested overall home sales were sluggish or declining..Home inventories were elevated or rising..Conditions in the commercial real estate market were subdued, and construction was expected to remain weak.Reports suggested that rental rates continued to decline for most commercial property types..industry contacts appeared to believe that the commercial real estate and construction sectors would remain weak for some time..Hiring remained limited, with many firms reluctant to add to permanent payrolls, given economic softness..Future capital spending plans appeared to be limited"

So there you have an outline of the anemic economic picture in the Fed's own words.  To be sure, they indicated some strong points as well.   But the weakness in consumer spending, housing, capital expenditures, commercial real estate and employment pretty much accounts for some 85% of the overall economy.

In addition some of the major problems that worried the market earlier have not really gone away.  The sovereign debt problems of the weaker EU nations have been papered over without being solved and are still lingering just beneath the surface.  The looming currency wars that were shoved down the road by the recent G-20 meeting are also a major threat to the global economy. 

Furthermore the Chinese housing bubble previously highlighted by bearish investor Jim Chanos and others has now appeared on the front page of the New York Times.  A new district of the city of Ordos, China, covering 12 square miles and consisting of tens of thousands of houses and dozens of office buildings remains a virtual ghost town, cited as "proof of a speculative real estate bubble that will soon pop, sending shock waves through the banking system of a country that..has been the prime engine of global growth."  According to the article there are as much as a dozen other ghost towns similar to Ordos.

Another looming crisis that will not go away anytime soon is the recently revealed mess with mortgage foreclosure paper work.  This is no mere technicality that some would have you believe.  Due to the complications introduced by securitized mortgages and the slicing and dicing of mortgages into various tranches, it appears that large numbers of mortgage proceedings were brought by parties with no legal right to do so. 

The gravity of the situation is highlighted by the fact that the New York Federal reserve bank and Freddie Mac along with giant investment houses such as Pimco, Blackrock, Neuberger Berman and Met Life, sued Bank of America to take back securitized mortgages that they bought from the bank or its Countrywide subsidiary.  Other leading banks may subsequently be sued as well, and other purchasers are likely to join the fray.   In addition the situation is being investigated by the FBI, various federal regulatory agencies and most of the states' attorney-generals.  With the huge sums of money involved, it does not take much imagination to realize that this could turn out to be another big threat to the financial system.

All in all it seems to us that the market rally is based on the shaky assumption that the Fed can now solve all the above problems with unproven, non-conventional monetary measures that couldn't be solved by the massive stimulus provided by either conventional monetary or fiscal tools.  With the prospect of QE2 already baked in the cake, we think the market is highly vulnerable in the period ahead.

 

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