Four Hidden Surprises

Watch out. Four major new market forces could jump out from behind the curtains and catch you by surprise.

I know how it feels. Because not long ago, it happened to me.

In 1998, I had just left Bloomberg News for a new job at Bankrate.com. It was an ordinary job, and mostly calm.

But that summer, all heck broke loose. Reason: Long-Term Capital Management (LTCM), a hedge fund darling, imploded.

By all accounts, LTCM had everything going for it – Nobel-prize winning founders, well-connected traders, Ivy League analysts. Unfortunately, they relied too much on history. They thought they had the global bond market all figured out. Turns out they didn’t have a clue.

They assumed high-risk bonds (like those issued by Russia) would perform nearly as well as low-risk bonds (like U.S. Treasuries). Then, they used massive leverage to place big bets on that theory.

But their theory was wrong: Russia defaulted on its debt in August and September of 1998. Investors dumped the Russian bonds and flooded into the safest havens they could find, especially Treasuries. That caused Russian bonds to tank and U.S. Treasury securities to surge in value. LTCM’s theory was blown out of the water.

Result: LTCM was wiped out and its failure sent shock waves throughout the financial world. The Fed panicked and slashed interest rates. Stocks plunged. And the global financial markets were on the verge of a meltdown.

I was shocked. But it taught me a lesson – to look behind the headlines … never accept the easy, superficial explanations … and keep my eyes open for more looming surprises.

And right now, I see four:

Looming Surprise #1
A Housing Market Collapse

Forget that “soft landing” crap that the real estate industry is feeding you. By virtually every possible measure, the U.S. housing market is caving in: Sales are crumbling. Inventories are exploding. Order cancellations are rocketing. Builder confidence is plunging.

Just look at the latest sales figures for April: Wall Street cheered the new home sales, which technically “rose” between March and April …

The Census Bureau drastically revised figures downward for the previous two months. The March cut? 71,000. The February cut? 46,000. And those reductions were almost double the size of April’s gain!
The inventory of homes for sale rose to a fresh record high of 565,500. And it looks like the only way most builders can move homes is by giving cash incentives. They’re throwing “cash on the hood,” just like GM or Ford. Up next: Outright price declines … month after month after month.
Sales of existing home sales fell 2% month-over-month and 5.7% from last April.
The number of condos, co-ops, and single-family homes hit 3.38 million. That’s a fresh high – and a mind-boggling 36.7% gain from a year ago. I don’t know about you, but when I see the demand for something fall almost 6% while supply jumps almost 37%, I can only come to one conclusion: Prices need to fall – big time!

The hottest, most speculative markets are already crumbling. I can tell you from first-hand experience.

The greater West Palm Beach/Boca Raton area saw a whopping 43% year-over-year plunge in sales last month.

Soon, the pain will be spreading to other hot markets.

Looming Surprise #2
An Inflation Spike

The latest Consumer Price Index (CPI) report is out, and there’s no sugar-coating the facts – they were awful:

The overall CPI jumped 0.6% in April after rising 0.4% a month earlier.
The Fed’s beloved “core” CPI climbed 0.3% for the second month in a row.That means core inflation hit an annualized rate of 3.2% over the past three months – a big acceleration from last year.
The pundits seem to think this is as bad as it could get. So they actually gave the impression that they “welcomed” the news.

The big surprise ahead: The CPI numbers, especially the “core” ones, could just keep getting worse.

Reason: Rents and estimated rents are a major component of the CPI measure. And these rents have been suppressed for a long time due to the housing market boom. Anyone with a pulse could buy a home, leaving many rental units vacant. But not now! Now, we’re seeing rents climb as homes become unaffordable and consumers flock back to rentals.

It’s not like the Fed can just ignore rent, either. Officials try to ignore food (as if nobody eats). They try to ignore gas (as if nobody drives). But can officials really say – with a straight face – that our most well-known inflation figure should exclude the cost of keeping a roof over your head?

No way! The rising rents are going to pop up in the CPI. And the inflation surge is going to surprise everyone.

Looming Surprise #3
A Tighter Fed

Fed officials are finally – ever so slightly – acknowledging that inflation is getting out of control. Suddenly, all those voices of “no more rate hikes,” have been silenced.

Richmond Fed President Jeffrey Lacker puts it this way:

“The inflation outlook is at the borderline of acceptable and perhaps moving beyond … Unfavorable inflation numbers and adverse movements in inflation expectations are going to require a higher path for real interest rates, and are going to make a pause less likely.”

Separately, St. Louis Fed President William Poole, said,

“We should not believe that the inflation problem is necessarily going to go away if the economy softens.”

These are the first signs that the Fed is actually not totally blind. Up until now, everything has been happy talk about how “well-contained” inflation is. Could the Fed have more in store than a “one and done” rate hike in June? Absolutely!

If so, Wall Street could be in for a big shock. But you shouldn’t be surprised.

Looming Surprise #4
Another Blow-Up Like
Long-Term Capital
Management?

This could be the biggest surprise of all.

I don’t have the inside scoop on who or where. But I’m beginning to see some of the symptoms:

Stocks have been getting pounded. So have higher-risk bonds and leveraged investments of all shapes and sizes. Meanwhile, Treasuries rallied a bit, despite the nasty inflation picture.

I’ve also been noticing some weird trading patterns and anomalies:

And volatility measures like the VIX index are breaking out of multi-year downtrends.

Could there be another major hedge fund that’s about to blow up?

Could we get a bout of panic selling and more flight to quality?

Very possible. And if I see more signs, I’ll let you know.

Consider These Moves

In uncertain times like these, it’s important to remember the lessons of LTCM. And it’s important to take a few steps, in my view …

Keep a sizable chunk of money in safe investments. That includes short-term Treasuries, Treasury only money funds, even short-term bank certificates of deposit or money market accounts.

Stay away from most high-risk corporate and mortgage bonds. I see a whole lot of risk, and not much extra reward. It’s just not worth stretching for yield, especially when the capital markets are going haywire like they are now.

Avoid stocks with exposure to housing, construction, and risky lending. I see a serious meltdown brewing in the housing and construction sectors. And I see a Fed that’s caught between a rock and a hard place. It may want to stop raising rates … or even ease them … to spare homeowners a lot of pain. But it can’t with global inflation pressures building.

Until next time,

Mike Larson

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About MONEY AND MARKETS

MONEY AND MARKETS (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, and Tony Sagami. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Colleen Collins, Amber Dakar, Ekaterina Evseeva, Monica Lewman-Garcia, Wendy Montes de Oca, Jennifer Moran, Red Morgan, and Julie Trudeau.

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