Small Cap Stocks

As mentioned in a previous post, the current rally in the market is mainly supported by the propagation of a new meme: “Big Banks will earn their way out of this mess.”

However, even though this meme is flawed, without evidence to the contrary the market can continue to rally. Nevertheless, by understanding the factors that will undermine the new meme, I think it will possible to trade profitably around this new rally.

Briefly, I think there are three reasons, why this meme may soon become extinct. Interestingly, only one of three predictions need to come true for the market to reverse back to its downward trend of the last year and half.

Bailout Blow Up Causes a Renewed Capital Shortage at Major Banks

After the revelation of the facts surrounding the AIG bailout, I think it should now be crystal clear to any rational observer that our financial system is being run by common criminals with the full support of the US government. The situation is no different, and vastly more corrupt than any third-world country, such as Argentina.

Financial fraud on such an unprecedented scale must have significant economic repercussions, as it has had in every economic system where fraud becomes the centerpiece of business activity. The most pressing of these outcomes will be the inability (unless new fraudulent means, like shell AIG companies, are found) to disburse new bailout money due to growing outrage and skepticism towards the bailout fraud. But without bailout money, it is certain that our major financial institutions will run very short on capital, the lifeblood of their business and their earnings power. With a capital shortage, banks can’t lend, they can’t make money, and they must collapse.

Failure of the TALF Program

Even though I was initially hopeful that the TALF could be arranged so as to stabilize financial markets, it now seems to clear to me that the TALF, in its current form at least, will ultimately fail leading to renewed worry about the solvency of big banks. The simple reason is that after Geithner’s orchestration of the AIG bailout fraud, no hedge fund in their right mind will want to participate in another government bailout scheme. It’s simply too risky to join in these programs anymore and face the prospect of being outed by the media as abetting fraud and profiting from the recession. It’s not worth the stress and there are other ways funds can make money.

Disappointment over M2M and Stress Tests

There is a lot of hope that proposed changes in the Mark-To-Market rules will help banks and that the government stress tests will reveal that our banks are well capitalized. Both positive expectations will prove to be wrong.

As for M2M, as explained in the past, M2M is vital because banks make money from securitizations/trading and not from basic lending. Repealing M2M only makes sense if banks revert back to the 1920’s (Bernanke would like this) and decide to hold loans until maturity. But, of course this won’t happen as the lifeblood of big banks are securitizations/trading and the vast array of derivatives sold around securitizations.

Furthermore, if holding the loans on the books is such a good idea, of what use is the TALF? The TALF and a repeal of M2M are entirely contradictory.

As for the stress tests, like all good criminals who have been exposed, the Treasury will now try to jettison support by performing a “good deed”. It is therefore very likely, in my opinion, that in effort to demonstrate that they are not favoring big banks and that they are not cowards, the stress test will at show that at least one big bank is quite vulnerable and in need in of additional capital, calling into question the solvency of other banks.

Note: After writing this post, I saw that the Fed announced that they were set to buy $300 billion of Treasuries in the next few months. This is sheer lunacy and proof that the financial situation is out of control. Buying Treasuries is the exact equivalent of printing money. I’m not sure direct printing of money has ever led to anything good for an economy. But, maybe it will work this time? Slim chance. Massive hyperinflation is in store.

As we evidenced by the recent AIG bonus scandal this weekend and the continued disclosure on the AIG bailout money, it seems clear that the US Government, in a reversal of the basic moral principles that support any democracy, has decided that fraudulent conveyance, is completely legal. In choosing to uphold what are clearly fraudulent contracts over basic social contracts, the government, in the guise of a “lender of last resort”, has put the financial system at a great risk of disintegrating into complete anarchy.

At this point, it is very hard to see how there is a way out of this mess without another major disruption in the financial markets.

On the one hand, I believe it is highly unlikely that the continued fraudulent transfer of wealth from US taxpayers to major financial institutions via the AIG shell game will continue. The fraud is now too obvious and too well covered by the media. One at least hopes that Obama will put a stop to this fraud soon.

However, the problem is that when this gigantic pilfering comes to a halt the remaining financial players, who are only surviving due to fraudulent AIG transfers, must surely collapse bringing tremendous short-term harm to the financial system.

If on the other hand, government officials continue in their blatant disregard of outright theft by major financial institutions, there will undoubtedly be a major social upheaval in this country, which would surely bring down our financial system and cause significant long-term damage. I find it highly doubtful that US citizens will continue to sit idly by as their savings and future income are compromised by incompetent government officials who have been either hoodwinked, or in some cases in cahoots, with major banks.

So it would seem that no matter what happens now, our current financial system will need to be radically restructured sooner rather than later and this must lead to a further large decline in the stock market. One would hope that the government will choose short-term pain over long-term and irreparable damage, but based on the recent past that optimism may be misguided.

About the only thing that can save the market is if the government and other market shills succeed in somehow convincing a large majority of investors that banks can “earn their way out of this mess”, as long as we keep printing money and forking it over to the banks? But can this new version of trickle down economics possibly be taken seriously?

It’s doubtful, which is why I’d still be very cautious on any market rally and continue to trade aggressively. I think one can only seriously consider investing again in the Market, when, and if the government decides to actually restructure the financial system, instead of maintaining the status quo.

In re-reading Minsky’s fabulous book of essays, “Can It Happen Again”, which deals with the possibility of another Great Depression, I came across this excellent quote which I think conveys a truth that investors need to remember:
“The fundamental instability of capitalism is upwards. “

This touches upon a deep truth of capitalism: Despite short periods of extreme distress, as we find ourselves in now, the economy and most asset prices, in due time, always bounce back.

The reason is simply because it is the job of the Federal Reserve and Treasury, the chief captains of capitalism, to ensure steady inflation, so as to enrich creditors (i.e. banks) and financial speculators, both of whom are needed for a proper functioning of financial markets.

When the current financial crisis deepened late last year, the problem was that the government simply didn’t do enough to placate creditors and financial speculators. In fact, Paulson’s actions were arbitrary and very damaging to many speculators. Both Paulson and, especially the “academic” Bernanke, were operating in the past, with Bernanke making policy decisions based on his interpretation of events from over 70 years ago! Unfortunately, the financial world is quite different now than it was in the Great Depression.

Fortunately, however, Geithner has a better understanding of modern financial markets than either Bernanke and Paulson, and hence his solution, despite its extreme social unfairness, will work over time, notwithstanding enormous short-term pain, as I’ve noted in prior posts.

Basically, as I’ve touched on in the past, Geithner understands that securitization, not classical lending, is the heart of the financial economy and the only way to get those markets humming again is to fork over trillions of dollars of free money (in fancy terms this is called: “non-recourse loans”) to the financial speculators irregardless of the moral implications.

Of course, when you’re about to receive trillions of dollars of free money from the government to speculate in securities, you’re guaranteed to make your opponent pee in their pants, until they sell these securities to you at pennies on the dollar. This explains the current market meltdown, but also provides hope for the future.

Once funds receive Geithner’s two trillion in capital, and they are able to purchase securities at insanely cheap prices, there will be an enormous amount of profit generated by these funds (my estimate is well over $200 billion). This will in turn lead to renewed speculation and a return to the fundamental instability of capitalism: upward prices.

The only issue for smaller investors is the timing of this massive transfer of wealth, which will mark the bottom of this crisis. My belief is that since the crisis is deepening by the day some major deals will happen sooner rather than later, making it a smart move to accumulate cheap equities, especially micro caps selling at negative enterprise values, at this time. I would also note that every major financial crisis ends with a crescendo of fraud discoveries. The sudden daily increase in the SEC’s ponzi scheme list, which now includes Stanford, is therefore a sure sign that the financial crisis is bottoming out.