2007: The Year of The Financial Flameout
2007: The Year of The Financial Flameout
12/31/2007 12:50:58 PM
Editor’s Note: The following is an excerpt from the January 2007 Elliott Wave Financial Forecast. A new special section with a new theme for 2008 is online now. DETAILS>>
By Steven Hochberg and Peter Kendall
Editors for The Elliott Wave Financial Forecast
As EWFF has noted in the past, financial firms survived the plunge of 2000-2002 and thrived through the rebound of 2002-2006 by pushing clients, and increasingly their own capital, into riskier investments. By amplifying the leverage and rechanneling the speculative intensity of a Grand Supercycle peak from technology in 2000 to housing in 2005 and commodities in 2006, financial firms kept the fire alive. Thanks to hedge funds, leverage and financial engineering have been pushed into every available asset class. When hard assets, such as copper and silver, which were abandoned in favor of paper assets in 1980, were pulled into the fervor and pushed into exponential uptrends, the end was near. The May 11 peak in the Reuters/Jefferies CRB Index of commodities appeared to be the last bubble, but financial engineers found a new object of investor affections—themselves. Recent issues of EWFF reveal some of the myriad ways in which Wall Street became the focal point of speculation. The street’s fabulous year-end bonuses are the latest example (see Cultural Trends below for the emerging bear market response). Of course, the financial industry’s position so close to the center of the mania can only mean one thing; it is only a matter of time before it joins tech stocks, real estate and commodities in the great turn lower.
A sure sign of a financial zenith is the recent massive media acknowledgment of the liquidity boom that underlies the Great Asset Mania. The Wall Street Journal and Newsweek opened the year with major articles extolling the virtues of a “world awash in cash.” “Let The Good Times Roll,” says Newsweek. “The world has been building toward this critical moment for some time. It’s no accident that financial markets have flourished. Now regulators, central banks and markets around the world are poised to make moves that could turn an expansion into an explosion.” Newsweek is exactly right and wrong at the same time. It is a “critical moment,” but the “explosion” will come in the opposite direction than the media now project. This is clear by the evidence that it offers for a further boom. Newsweek, for instance, again cites the bullish implications of the global bidding frenzy to own financial exchanges. But as EWFF explained last month—and previously in 1999 when the major U.S. exchanges announced public offerings—a century of NYSE seat price history shows that extremes in the demand for exchanges come at major peaks.
The other incredible expanding story is the “staggering” size and volume of corporate acquisitions. Newsweek and countless other articles find the rash of “bigger and bigger” deals “Phenomenally Positive” for the stock market. Even though he “is not in the business of predicting where stock markets go,” a M&A specialist says, “It really props up the market.” Another article reveals that private equity firms now have enough cash to “fund the acquisition of every company on the NASDAQ and the London Stock Exchange.” But as noted here last month and at the peak in 2000, one of the key signs of a peak in stocks “is the folly surrounding corporate takeovers.” It can’t get much crazier than this.
Even the most pessimistic economists and central bankers see little sign that the liquidity boom, and the benign financial environment that it has fostered will disappear soon. Confidence in the current environment stems from financial innovations and new financial players that have helped disperse risk more quickly and more broadly than ever before. While the argument that things are different has always been dangerous, many economists now subscribe to the brave new cycle, or a cycle in which the ups and downs have become much more muted, largely thanks to the stabilizing influence of new financial technology.
A cycle that doesn’t cycle? We heard the same thing in January 2000 when belief in the New Economy grabbed hold amid assurances that the business cycle had become an anachronism. This time, “financial innovation” replaces technology as the holy grail of economic growth. Our chart shows that the influence of finance has been growing for three decades, but only now is its “magnitude and persistence” itself the reason for the boom. The psychology is so powerful, and dangerous, that many of the financial system’s most fundamental weaknesses are listed as strengths: it’s “easier for the less creditworthy to borrow than ever before;” “the biggest banks don’t hold much debt, having sold it on to others;” securitization has distributed debts “far and wide, so no single holder has significant exposures;” derivatives insure “the holders of debt against losses.” But the pervasive spread of risk doesn’t mitigate it, it simply intensifies it and snares everyone.
The Journal even suggests that one factor making it different this time is “How easy it is to borrow money.” This certainly keeps the economy juiced, but it also explains why the trend must eventually reverse and hints at the extent of the eventual damage. Today’s bullish buzz concentrates on the process by which liquidity is created, whether via the yen carry trade, Federal Reserve repos or the securitization of bizarre credit instruments. This focus completely misses the point, in our opinion. Regardless of the process, the psychological foundation of liquidity is confidence. We cannot stress this point strongly enough. When investors are optimistic, confidence remains high and liquidity expands. When this optimism goes away, the spigot will run dry, no matter what the “reasons” that people may place on it. People are bullish because they are bullish. But they celebrate the condition and come to view it as a “self-sustaining” virtue only when it is nearly over.
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