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Bubble Morphology: Welcome to the 2007 Summer Rally  
by Michael Nystrom, MBA
July 12, 2007

Disclaimer: The following should be read for entertainment purposes only, and should not be construed as investment advice.

Back in 2001, when I started the website depression2.tv, I was convinced that we were headed for a repeat of 1929, and a second great depression.  By the way things look now, I was either completely wrong or just half a decade early.  But in Y2.001K, after the dot.com implosion and terrorist attacks, the economy looked to be on shaky ground, and prospects for growth appeared grim indeed.  The end was nigh, or so I thought. 

That was prior to my intensive course of study in the subject of Bubble Morphology, School of Hard Knocks (2001-2005).  Ever since the start of the Iraq War in March 2003, the stock market has been on a plodding, steady upward path powered in part by the war industry and military-industrial complex.   I’ve written about this elsewhere in “Bullish on War.” To date, the war sector remains a stellar performer and market leader, showing no signs of slowing. 

How does war stimulate the economy?  A recent documentary revealed (among other things) that the government has been paying Haliburton/KBR $100 for each bag of laundry it washes for our troops in the field.  (According to interviews, troops are not allowed to wash their own laundry.)  Let’s just work that out with some quick math:  130,000 troops in Iraq times $100 per bag of laundry works out to … let’s see … $13 million dollars paid to Cheney’s ex-company Haliburton/KBR each week.  That’s $676 million per year -- just for laundry. No wonder this war is so expensive.  But as for the laundryman, it’s not a bad gig, if you know who – er, how to get it.

Of course, under the trickle down theory, that money eventually works its way back into the economy and down to the little people like us.  Corporate executives get their multi-million dollar bonuses that they use to invest in hedge funds, buy expensive houses, jet planes, fancy cars, jewelry, etc.  That in turn creates more demand throughout the economy not only for gardeners, maids, car washers, and chauffeurs, but also for more executives, investment bankers, analysts, clerks, receptionists, and cab drivers, too.

At least, that is the general theory that seems to be driving this new era of corporatism, which looks to have replaced free market capitalism as the operative economic system in 21st century America.

A different form of corporatism also helped the stock market and economy to hold up so well over the past five years: The House-as-ATM phenomenon, spurred by the housing boom, and intertwined with the sub-prime phenomenon, but ultimately funded by the fire-sale rates on money charged by the Federal Reserve. 

Except for the ultra-wealthy, who have seen their incomes rise dramatically, wages for most Americans have stagnated across the board.   With real interest rates lowered below the rate of inflation, it made rational sense for everyone to borrow. So naturally, cash-strapped people borrowed money to try to get ahead.  Renters borrowed to buy homes they ultimately couldn’t afford, and middle-class owners borrowed against their homes to continue funding lifestyles that they were used to, but that inflation was making impossible to maintain.

Now that the housing boom seems to have run its course, and interest rates are – gasp! – rising, it's starting to look like the jig is finally up.  Housing – what many believe to be the final bubble – has at last popped, and the Fed appears to be left holding a gun without any bullets.  Economic news is looking as dire as it ever has.  Talk of a second great depression is even making its way into mainstream newspapers (albeit so far only in Britain). And here’s a sample of some of the grim news I’ve posted on the homepage of my site in the past few weeks:

First Quarter Growth Weakest in Four Years
Durable Goods Orders Tumble 2.8%
US Banks Face Severe Credit Crunch; Banks 'set to call in swathe of loans'
Pension Funds Left Vulnerable After Unlikely Bet on CDOs
A Great Depression Fall Looms

Things look grim indeed. Furthermore, people have been coming out of the woodwork – the equivalent of the famous shoe shine boys with stock tips – emailing me at my website that now is the time! The market is going to CRASH! 

And yet the market parties on.

“This time is really It!”
Over the years, I’ve had a variation on the same conversation - though with a variety of different people – that I have come to call the “This time is really It!” conversation.  Back in Seattle, I used to have this conversation with a friend of mine every few months.  After a day or week in which the Dow had dropped a few hundred points, he would inevitably call up and say, “You know, I really think this time is really It!” referring to the Big Crash we’d both been waiting for.  Shortly after such conversations – after he’d loaded up on some more Rydex inverse funds – the market would rally 2 or 3 percent, flushing him and the rest of the bears out. 

Now I’ve got a new friend out here in Boston that I have the exact same conversation with every few months.  After the big 160 point drop on Tuesday, he called me up with the same story – “This time,” he said, “I really think this is It!” 

Mind you, however, this is a guy who has been waiting for the crash and the second great depression since 1987.

Perspective
Meeting people even more bearish than myself has done wonders for my studies in Bubble Morphology.  A few years ago, I don’t think it was possible to meet anyone more bearish than me.  In 2001, I was convinced that there was no way of avoiding a second great depression.  I didn’t foresee the housing boom, the equity extraction, nor the simulative effects of the massive war spending and tax cuts.  Neither did either of my bearish friends above.  In our most recent conversation, I asked my friend, “What other tricks could the Powers that Be (PTB) possibly pull out of their hats to keep the market humming along?” 

“I can’t think of any,” he said. “I think they’re done.  This is It!” he told me. 

Yet we bears have consistently underestimated the ability of TPB to morph one bubble near seamlessly into newer and bigger ones.  TPB most certainly never run out of tricks (whether the tricks work or not is another story entirely), so it is incumbent upon us to sniff those tricks out.  A good bubble morphologist, after studying what’s going on, should be able to at least give some kind of scenario (plausible or not) for how the bubbles will continue to blow. 

So here’s my crack at it.  Two articles from venerable publications crystallized the following for me this week:  It’s the hedge funds, stupid!  Last week the NY Times, in true this-time-its-different fashion, wrote that the difference between the hedge funds and the dot.coms of yore is that “Hedge funds make money.”

Yeah, right.  Smells like the bubble is morphing, and the MSM is being put to use once again as head corporate cheerleader.  Another case in point, this week’s Barron’s led with a story by Michael Santili titled, “Abolutely, Positively, No One’s Safe.”  The article talks about how even a company like FedEx, with a market cap of $34 billion, could be taken private in an LBO – at a 20% premium! The money is out there. Forget the “fact” that liquidity is drying up.  FedEx has 700 planes and 44,000 trucks that could be used as collateral against which to issue debt.   At the moment, it is undeniable that the hedge funds, or LBO-firms – whatever you want to call them – are the current force lifting all market boats. 

Given that last week’s offer by Blackstone to take Hilton Hotels private at a 40% premium resulted in a rally of hotel stocks across the board, it is hard to miss the impact that private equity / hedge funds are having.  Traders want to make quick profits, so they will increase the intensity in the search for the next potential buyout target, like kids looking for the golden certificates in Willy Wonka bars.  Who doesn’t want to hit a jackpot like Hilton?  Stocks will fly along with buyouts and rumors of buyouts. The old Wall Street adage “Even turkeys can fly in a hurricane” will be seen in full force.

Like an expert tai-chi move, bulls continue to use the bears own energy and momentum against them, forcing them to cover their shorts and causing the exact opposite of their intended results: big market gains.   At 3:45pm ET, the Dow is up 271 points - an even 2% - to a new all time high! With today’s rally, I can hear the little bulls across the country starting to lick their chops: “Hey Martha! This article here in the Times says hedge funds make money! Do you think we should buy some?”

Maybe little bull, but go in with your eyes open.  Hedge funds make money the same way vampires stay alive: by sucking the lifeblood from another living entity.   But more important is this: the Dow is up around 10% so far this year, but according to both Richard Russell and James Stack, the small investors are so far staying away.  They’re skeptical, and rightfully so. To the man on the street, the economy looks weak, it is hard to make ends meet, and every day prices seem to go up a little bit more.  Things do not seem to be getting better. 

Until today, the market has been no place for the small investor to play.    But after today, or certainly after the Dow smashes through 14,000, the timid little bulls that were afraid to get into the market for fear of a meltdown will suddenly be clamoring to get in for fear of a melt up!  Forget the fundamentals and the abundant bad news - prices are going up! Summer rally here we come!

So this is how this bubble will likely roll on – at least for a little while.  Private equity can still borrow big to buy big, profitable companies (e.g. FedEx), extract a lot of fat banking & consulting fees from the company’s wealth, pay the fund managers’ and consultants’ salaries, slash jobs, cut services and squeeze even more booty out of the company, then turn around and sell the whole thing out in an IPO.  Ca-ching!  The fat cat hedge fund managers will cash out into the world of billionaire-ism by selling their shares to the billionaire-wanna-be’s known as the general public, who get their investment tips from the New York Times (newsstand price, $1).  Shares thus pass from strong hands to weak as the market quietly tops amidst jubilation and cheer.

Later, after all the money is banked, and the managers have moved on, and the hedge-fund shares are in the toilet, we’ll find that the service at FedEx (or whoever the lucky target companies may be) has mysteriously deteriorated and earnings are down.  Not so mysterious, really, when outside managers come in to butcher the company and kill morale.   Profits decline and assets – those 700 planes and 44,000 trucks – start getting sold off at pennies on the dollar.  Eventually all that remains of the company is a pathetic shell of its former self, the corporate vamps having sucked it dry of its vitality and life, just like the subprime borrowers who today find themselves both homeless and penniless, walking away from their payments on a mortgage under water.  That, friends, is when the second great depression begins. 

In the mean time, this is the housing bubble strategy all over again, just in a new form:  Lend, borrow, buy, extract, sell, repeat.  Through the alchemy of finance, the day of reckoning has once again been postponed, though who knows for how long?  When things start looking grim again, PTB will have a new strategy to keep things rolling along that keen bubble morphologists will be required to sniff out.  

But for now, enjoy the summer rally.  Take a dip - the water is fine.  Just make sure you don’t get yourself in too deep.  The sharks are circling in the distance, and they are getting hungry.

Sign up here for future updates on the morphing of this bubble. Feel free to email me with your comments on this article.



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