Downgrades and Mellonists: This is What the Market Fears

August 6, 2011
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In a historic move — and some would say a total ambush — S&P chose to downgrade the U.S. credit rating Friday night.

(We should perhaps send them a thank-you note, having maintained significant short positions in the Live Feed, after partial profit scale-outs last week.)

What does the downgrade mean for the coming days, other than one hell of a roller coaster ride?

We’ll find out soon enough…

Below is some off-the-cuff analysis from yours truly, via email exchange with a colleague in Europe.

Before scrolling down, though, I encourage you to read this Andrew Mellon wikipedia excerpt to get a feel for the psychological mood shift here.

A rise of the Mellonist mentality, even as clear signs of slowdown abound, is exactly what Mr. Market fears.

In addition to the unknown logistical fallout from a debt downgrade (ripple effects throughout the credit system, impacting general borrowing costs and debt covenants at state and local levels), there is a sense of foreboding that political leadership may shut down — or even encourage disaster — at the worst possible time.

~~~

(via 08/06 email exchange)

If forced to express an opinion, I would say I do not believe recovery is imminent. I think the markets have been living on borrowed time.

– The stimulus borrowed great amounts from the future and spread cash among banks and corporations

– Western corporate profits soared in part by way of layoffs, streamlining and offshoring

– Businesses did well that oriented themselves to the top 30% of consumers (or even top 10%)

– The bottom 70% of consumers were neglected, and even abused, via stealth inflation pressures (food and energy) and permanently lost jobs

– Reflation policies of US and China did nothing for the poor and lower middle class (labor class), and may have actively harmed them

– Unemployment persistently high, debt rising, psychological effects of stimulus running out, and now political obstacles

I would further argue that the shape and tenor of the debt ceiling debate has revealed a major sea change. The rise of the “Tea Party,” and other obstructionist elements in government, means that the U.S. government will be deadlocked on future spending and aid request in a sort of 1937 style scenario.

There is a new paradigm being priced in. The market potentially sees a future dangerously influenced by Mellonists: “Liquidate, liquidate, liquidate” — and a Federal Reserve out of bullets.

This can then be overlaid with the Austrian paradigm of gross malinvestment — what money being spent, having been spent poorly — and greater than ever concerns about total debt loads.

I mean switching to Europe for example… why take concern on Italy’s debt load now?: What has changed? The market tends to ignore the growing warning signs of macroeconomic crisis — right up until it starts paying attention. For long stretches these things seem not to matter at all — until one day they do.

With all that said, I am not inclined to over think things. In the near to medium term it is all a matter of price action.

If I had to go with a long-term scenario, though, it would be something like this:

– poorly conceived stimulus efforts fail

– the cost of propping up bad actors (inefficient banks) comes to light

– political gridlock and anger over debt levels lead to paralysis of some sort

– sharp declines follow (especially if global slowdown blows holes in China and Germany)

– at some point, new emergency measures are taken and some sort of quasi-hyperinflationary event ensues

…I am comfortable not predicting. But it would not surprise me to see the S&P in triple digits by Christmas. This is not just a one-off psychological event but the crystallization of a very, very bad development in terms of entrenched psyches in the Mellonist mold.

Let it further be said that, in terms of long run economic health, the liquidationists may have a point… but it is a point that will hurt like hell to get across.

And if the Federal Reserve sees itself as the last Lancelot that can slay this dragon, gold could go to $5,000.

Again, not predicting. But I think we are seeing some big shifts of awareness here.

p.s. This Forbes column is a clear example of what I’m talking about — not taking sides ideologically here, but rather seeking to articulate Mr. Market’s point of view.

JS

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