Sunday Musings: Dead Men Walking

Despite the market’s sharp rebound off the March lows, I have questioned the fundamental reasons on which this alleged economic recovery was based.

To me, it was nothing but government stimulus along with wishful thinking that supported this move into the stratosphere. What happens when the stimulus ends?

My concern has always been that a recovery, such as we’ve seen, can never have staying power unless it is accompanied by job growth. While job growth is considered to be a lagging indicator, I simply can’t see any job creation because of rampant overcapacity in most industries.

One hedge fund manager has similar concerns in “Hedge manager Sprott sees trouble when easing ends:”

When so-called quantitative easing by central banks ends, the world economy may slip back into trouble, Canadian hedge fund manager Eric Sprott warned on Tuesday.

Toronto-based Sprott called Citigroup, Fannie Mae, Freddie Mac, and General Motors “dead men walking” in late 2007. On Tuesday, he said the U.S. government is the new dead man walking, partly because it may struggle to keep borrowing enough money if the Federal Reserve stops buying Treasury bonds.

Sprott’s Canadian hedge fund, Sprott Hedge Fund LP, is up more than 400% since inception in 2000 as it rode a surge in gold prices and shares of gold miners and other raw materials companies.

Bank bailouts and other dramatic efforts by central banks have stopped the world “going into the abyss,” Sprott said during a presentation at the Value Investing Congress in New York.

The “granddaddy” of all those bailout efforts is quantitative easing, in which central banks in the U.S. and the U.K. especially buy government bonds to keep interest rates low, Sprott said.

The U.S. government has raised roughly 200% more by selling bonds this year, versus last year, Sprott noted. Through the end of the second quarter of 2009, he said the only major buyers of these government bonds were central banks.

“When quantitative easing ends, what’s going to happen?” he added, noting that there are already two clues to answer that question.

When the U.S. government’s cash-for-clunkers program ended, car sales slumped. Meanwhile, as the end of the government’s first-time homebuyer incentive approaches, recent data suggest weakness building again in the housing market, Sprott said.

Roughly 35% of all homes bought in the U.S. recently were purchased through the incentive program. If it is not extended, December home sales could slump 25%, Sprott estimated.

Sprott remains concerned about banks and other financial institutions in the U.S., because he thinks they remain too leveraged.

Banks leveraged roughly 20 to 1, have about 5% of equity supporting mostly paper assets. If those assets fall by more than 5%, the institutions are effectively bankrupt, Sprott said.

I agree with his assessment. While there is nothing about the potential outcome you and I can do, it helps to be aware of the likely consequences, even though we may be entering un-chartered territory.

I believe the market at current levels has more limited upside potential, but poses tremendous downside risks. Again, as trend followers, we don’t predict or worry about which way the trend will turn.

If continued government stimulus occurs, we will most likely run with the bulls. If not, and the trend reverses favoring the bears, we will let our trailing sell stops guide us as to when to exit.

While I am singing the same old tune, I believe it’s crucial to have a plan in place so you don’t end up like the buy-and-hold crowd, because they’re doomed to repeat the mistakes of 2008 again.

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