Small Cap Stocks

This from Reuters:

“While credit conditions have improved in the past few months, “reports on bank lending show significant declines in consumer loans, including credit card loans, and commercial and industrial loans,” Geithner said.”

And what’s wrong with lower lending and leverage? Nothing, unless your friends make their money by flipping loans.

Lower leverage from ponzi finance in the economy will ultimately be very positive. So let’s hope the ponzi financiers continue to report significant declines in lending, so as to create a credit system which helps the real economy, rather than a credit system that is an end on itself with no connection to the real economy.

This from Bloomberg:

“The Federal Reserve’s requests from borrowers for loans to buy asset-backed securities fell 64 percent from last month as investors balked at visa limits and possible political efforts to tax earnings.

The decline hinders Fed Chairman Ben S. Bernanke’s efforts to lower borrowing costs and extends a slow start for a program that the Obama administration is using as a cornerstone of plans to revive credit and end the recession. The Fed is struggling to lure investors, such as hedge funds, that are wary of government restrictions or the risk of future intervention.

“It is a big disappointment,” said Stephen Stanley, chief economist at RBS Securities Inc. in Greenwich, Connecticut. “There are some folks who have decided they just don’t want to play in any government programs.”

Personally, whatever their particular reasons, I am very grateful that major hedge funds are refusing to participate in the government’s fraudulent programs, like the TALF. Ultimately, the more funds hold back from participating in these frauds, the greater the chances the government will finally do the right thing and simply restructure the banks in a truthful and effective manner.

This fascinating story from Reuters:

“The U.S. Treasury Department is planning to delay the release of any completed bank stress test results until after the first-quarter earnings season to avoid complicating stock market reaction, a source familiar with Treasury’s discussions said on Tuesday…The Treasury is still talking about how results of the regulatory stress tests on the 19 largest U.S. banks will be released, and may disclose them as summary results that are not institution-specific, the source said…

“There will be definitely be some information that will be provided at the end of it, but exactly what that will be, and when it will be provided, will come forth later,” Comptroller of the Currency John Dugan, who supervises some of the nation’s largest banks, said last week.”

Clearly the Treasury is waiting to release stress test results because first quarter earnings will be propped up by phony short-term profits at banks due to a wide variety of accounting gimmicks and government interventions (e.g. Fed buying mortgage paper to reduce rates and encourage refinancing, a situation which is obviously not sustainable, unless Bernanke truly hope to turn the US into the Weimer Republic). The hope, of course, is that these earnings reports will cause a rally providing a more friendly environment in which to release bad news and force some banks to raise capital.

The key question, as noted in prior posts,: Bet bullish on the premise that the Market will believe in the short-term earnings fraud or Bet bearish on the premise that the Market always recognizes that these types scams cannot be sustained on a long-term basis?

All in all, a simply astonishing, and depressing, state of affairs. It’s simply amazing how the government refuses to just tell the truth about the banks and begin a period of significant restructuring and ultimately a sustainable recovery from the crisis. As any turnaround investor knows, the most successful investments happen when mistakes are admitted, and major financial and management restructuring is undertaken. But, the longer mistakes are hidden, reality is ignored and fraudulent activity is perpetuated, the longer it takes for a real and sustainable economic recovery.

In attempting to understand the key psychological drivers of the current market rally, I think that an important meme is: If you can’t beat em’ join em’.

It seems certain to me that any rational observer recognizes that current government economic policies, e.g. printing of trillions of dollars to save insolvent banks, are simply insane and bound to provide no help whatsoever to the real economy.

However, at the same time, I believe that the vast majority of people feel completely powerless against this financial idiocracy. Moreover, they realize that many firms, e.g. Goldman, are simply making a fortune of the financial crisis, and stand to profit enormously from the Fed bailouts, notwithstanding the criminal source of income.

In the face of this , the only rational conclusion, since we all need to survive and move on with life, seems to be: If you can’t beat em’, join em’.

If there will be no repercussions for financial fraud, and if the Fed stands ready and willing to print another couple of trillion to support failed banks, what else can we do other than join in this game? This thought process is clearly playing a role in the current rally.

It’s difficult to argue with this meme, as I myself have used it to justify purchases of various stocks recently. However, can this argument lead to a sustainable bull market?

I believe that it can’t. Ultimately the stock market is a social game built on trust. We buy shares because we trust in the underlying companies, we trust that the financial statements are not fake, and we believe that other people play by the same rules. Basically, people hold onto shares because they believe in the companies and they believe other people believe in the companies. But, if there was widespread belief that the only reason to buy is because some players are being subsidized by the government, and are being allowed to legally falsify financial statements, then is there really any underlying trust in the system? At some point massive selling must resume, since nobody really believes in what they are buying and everyone is just waiting to unload at the first sign of danger.

There is an excellent article today in the FT titled: Bailed-out banks eye toxic asset buys.

Here’s a brief quote:

US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system. The plans proved controversial, with critics charging that the government’s public-private partnership – which provide generous loans to investors – are intended to help banks sell, rather than acquire, troubled securities and loans. Spencer Bachus, the top Republican on the House financial services committee, vowed after being told of the plans by the FT to introduce legislation to stop financial institutions ”gaming the system to reap taxpayer-subsidised windfalls”. Mr Bachus added it would mark ”a new level of absurdity” if financial institutions were ”colluding to swap assets at inflated prices using taxpayers’ dollars.

Of course the banks offer ingenuous justifications for their purchases of toxic securities, with government money, for immediate resale back to the government. And I’m sure Geithner, Obama, and Bernanke will also offer pleasant sounding rationalizations for this type of activity, as well, though it is patently the precise definition of a shell game, which used to be a crime. In any normal state of business affairs, the arrangement currently being pursued by the banks, would surely be considered an outright ponzi scheme and fraud.

More importantly, it is patently absurd. Just imagine if every single company in the US suddenly decided to recognize revenue by borrowing money from the government, to buy fake products, which it will then sell right back to the government. All the revenues would obviously be a sham and ultimately nothing would ever get produced in the economy. Markets would of course at some point completely collapse when people realized they were simply playing in a vast ponzi scheme.

So how are the banks allowed to engaged in the shell game? The only answer would appear to be that it is now become accepted wisdom, that financial fraud is the solution to the financial crisis. And interestingly the stock market is buying this solution. Presumably, those buying stocks now know this is a scam, but of course, if you can’t beat the crooks, why not join them? The justification goes something like this: The government is perpetrating a vast financial fraud and nobody is doing anything about it, as such profits at banks will be humongous, additional profits will flow into the economy etc. One only has to look at the price of Goldman Sachs to see the power of this argument in play. Goldman has of course perpetrated a huge fraud via AIG, as any rational observer can see, and yet the stock has doubled, entirely based on the meme: If you can’t beat ‘em, you should join em.

However, the question remains: If fraud is now the accepted solution to the financial crisis, how will this play out over the long term?

Government sponsored fraud has a long history in third-world countries with dire economic and social consequences.

When the entire economic system of a country is based on legalized fraud (Argentina is a good example), Markets become a giant casino where valuations are completely meaningless, since buyers have justifiably no faith in the system. In the real economy, almost nothing of value gets produced, since there is no incentive to produce anything when you can just sell garbage back to your friends in the government. Income inequality becomes vast, since with tainted money, there is an incentive to hoard it, and launder it, not share it. In other words, there is no trickle down effect.

As for investing: You cannot rationally invest long-term in countries where government-sponsored fraud is the accepted economic policy. Yes, you can trade in these markets, as long as you take your profits quickly and get your money out. Even in places, like Argentina, those who act swiftly can always make a quick buck. But with fraud, the next crisis is always right around the corner. Ponzi schemes are by nature not sustainable.

As for the social implications: There is obviously not enough space to go into the social repercussions of legalized fraud, though I suspect everyone understands why fraud on a large scale is very damaging to society. One important point, though, is that fraud increases selfishness to a large degree, since everyone becomes suspicious of everyone else. Interestingly, however, since our government was and is probably still run by Ayn Rand fanatics (i.e. Greenspan remains a huge Rand follower), it should probably come as no surprise why fraud is becoming the accepted solution to the financial crisis. Astonishingly, Rand penned a famous book: The Virtue of Selfishness. Need I say more?

The recent resurgence in the share prices of the chinese solar companies (we exposed the financial weaknesses of these companies last summer when the shares were at their all-time highs), lends some credence to the view that the recent market rally is set to top out soon. Of course, it’s possible that this time may be different, but in the past, rallies in these names has coincided with market tops, as these are truly junk companies, nearly all of which are already bankrupt if one takes basic financial rules into consideration.

The rally in the shares has been sparked by the announcement of future subsidies from the Chinese government to support the growth of the local Chinese solar market. Since I can’t read Chinese, I can’t possibly comment on the effects that the Chinese solar plan may have for the China solar market both in the near and long term. However, at the same time, I am reasonably confident that not one analyst on Wall Street who covers these names can actually read Chinese either, so it’s doubtful their bullish comments on the group, which in the past have cost investors tons of money, have any credence. Moreover, has Obama’s much touted alternative energy plans helped any of the US solar names, e.g. ENER, stage a sustained rally? I’m not sure one can base any investment decisions on government subsidy programs, given how corrupt and fickle all governments actually are.

With the new Market to Market rules news now out, the question is whether what the big bank defenders hoped for will actually help. The contrarian view is that M2M changes will do nothing and may in fact stall the rally. Why? The rules will effectively make Geithner’s plan a no go. So who is in charge here? FASB or Geithner?

From a recent AP News Story:

In an ironic twist, the new leeway for banks could undercut the government’s new financial rescue program in which it is joining with private investors to buy up about $500 billion in toxic assets from banks, some experts say. The fear is that companies will use the leeway to boost the value of the assets on their books to “unrealistic levels,” Robert Willens, an expert on tax and accounting issues for Wall Street clients, told The Associated Press last week. “The FASB’s relaxation of these rules might come at the most inopportune time,” he said.

In the short run, banks would benefit by raising the value of the assets. But higher values could drive away prospective private investors — who don’t like to overpay, even though the government will absorb most of the risk. If the assets remain on banks’ books, they may continue to be reluctant to lend as they fret over the assets’ future performance. That could work against the purpose of the government’s program: to break the logjam in lending and get the economy pumping again.

My bet: Now, after the massive rally in anticipation of this news, is probably a good time to short the banks again via the ETF’s. Phonying up financials, even with a government mandate, cannot possibly lead to a sustained recovery. Moreover, by making financial chicanery legal, the government has once again undermined the reliability of the market, at precisely the time when more truthful financial disclosure is sorely needed to regain investor trust. Finally, it’s difficult not to be shocked by the fact that the government can somehow allow completely contradictory financial rescue programs to operate simultaneously. The only logical conclusion: the government has absolutely no clue what they are doing.

Update: For a good take on the Market to Market debate, see this post at The Baseline Scenario.