(8-11-08) Commodity prices continue to fall back, while equities
(stocks) continue to rise. Why? There are several factors which should
be mentioned in order to understand how a brand new speculative bubble
in the stock market has been created. The recent rally in the equities
can be tied to the bogus rally in the dollar which has exerted
downward pressure on commodity prices. This is then being construed as
an immediate bullish factor for the equities, when in reality, it is
not bullish at all. In the immediate sense, we see that the energy and
commodity stock indexes have exerted downward pressure within the
larger equity indices.

It is being construed as bullish because typically lower commodity
prices mean lower costs and thus increased corporate profits. It
should be remembered, however, that it took several quarters of the
commodity rally to really begin to weigh on corporate earnings. The
effects of cheaper commodity prices will not be felt in higher
corporate earnings for at least another two quarters.

Also there is this sense that the Fed and the Treasury have adopted an
attitude that now no one will be allowed to fail, everybody will be
bailed out and that the government can pass endless housing initiative
to prevent further foreclosures and provide cheaper money, when in
fact all the legislation passed in the last 90 days to supposedly help
prevent a further debacle in housing, will have very little impact
because it affects, on a percentage basis, very few homeowners.

In addition, as US Treasury Secretary Hank Paulson admits, it would
take at least 12 months for any of these government sponsored
initiatives to have any real impact. Furthermore as Paulson admitted
how workable these various foreclosure prevention plans are is really
not known because it would involve the creation of a whole new
government bureaucracy which would have to break down mortgage pools
and track down individual homeowners.

Another factor is this growing Bullish Shillism on the Street that the
sub-prime problem is over, that we have seen the bulk of the sub-prime
write-offs and that there is probably only another $300 billion left
to go, which is quantifiable. What is being swept under the carpet is
the trillion dollar loss still ahead in home equity lines of credit,
auto finance paper and credit card debt.

The speculative bubble in equities should be apparent to everyone –
but evidently it’s not. For instance, the S&P 500 (SPX) earnings have
been falling for 4 consecutive quarters and, over that period of time,
have fallen an aggregate of 50%%. SPX earnings will continue to fall in
the third and fourth quarter of ’08, probably reaching total six
quarter declines of two-thirds. This type of contraction in earnings
has not been seen since the Great Depression.

This is coming at a time, by the way, when total dollar volume SPX
cash dividends are also falling. The S&P price/earnings ratio closed
at 26 on Friday (August 8, 2008). This is nearly double the 50-year
historical average. We really haven’t seen a situation like this since
the summer of 1930, which was known as the “Absurd Rally.” This
continued before beginning to collapse again in 1931, wherein equity
prices from the summer of 1930 to the summer of 1932 fell by two-
thirds.

Now we are in a very unusual period for which there is really only one
historical comparison where the SPX P/E can trade at twice the 50-year
historical average – after earnings have already fallen by 50%% in the
previous 4 quarters and will continue to fall in the ensuing 2
quarters with a trillion dollars in losses within the “financials” yet
to come.

This is occurring during a time when the unemployment rate is also
rising.

The reason why this speculative bubble in equities can’t last is the
same reason it didn’t last in the summer of 1930, i.e. liquidity
levels in the marketplaces are so low that traditional buyers
(domestic common stock mutual funds) are out of money because they
have suffered net outflows for 2 years. The big Street firms are
effectively out of money. They are now raising capital simply to
support their dividends.

A good example of what helped shill the market higher last week was
the various settlements regarding the so-called auction rate short
term securities which had become illiquid. New York Attorney General
Andrew Cuomo, who arranged these settlements, is not the great
crusader for Main Street America as he has been billed by the
financial media. The only reason he filed the action was because they
already knew that UBS, Merrill Lynch, CitiGroup, etc., the large
market makers in these instruments, were ready to settle. In other
words, Cuomo knew it would be an easy political victory. This however
got spun in financial media as being wildly “bullish” for equities
because it’s yet another “problem solved.”

However what nobody seems to be looking at is the other side of the
“solving” of the problem. Where is UBS, Merrill Lynch, Citigroup,
Morgan Stanley, etc. (whose capital is exhausted and who are in net
negative positions and who have all raised money repeatedly in the
last 90 days) going to get the fresh billions necessary to repurchase
these securities and put them back on their books?

They are going to have to raise ever more dilutive capital at ever
higher costs. That’s the other side of “correcting” a problem. It
isn’t simply a one-way bullish street. Liquidity is drying up to such
an extent that they don’t have many places to go. The first place
they’re going to go is back to the sovereign wealth funds -- back to
Mr. (Abu) Dhabi.

The problem is that Mr. Dhabi and Mr. Chen are not passing out the
bundles of cash like they used to before because they’re concerned
about sinking more money into a rat hole. They’re getting smarter too.
They’re demanding higher rates for these secondary offerings and
they’re demanding discounts on the mandatory stock conversions that
are implicit in these deals.

The large liquid Asian and Middle Eastern sovereign wealth funds are
beginning to treat the United States like the third-world debtor
nation that the United States has in fact become.

It should also be mentioned that Fannie Mae and Freddie Mac last week
both cut their dividends by 80-90%%. It is likely that ultimately they
will have to eliminate any remaining dividend, and it is unlikely that
they will continue to remain in business as they are now. It is also
likely that the remaining shareholder equity will fall to zero. Even
Treasury Secretary Hank Paulson has said so and yet people continue to
buy the stock.

Why? They don’t know any better. The unwashed are going to be stuck
with a huge tab because if there is ultimately some sort of government
bailout (which there is going to have to be) no matter how you couch
it, in the form of a conservatorship or some sort of lending-swap
deal, existing common shareholder equity will fall to zero. What isn’t
known and where I think the real surprise is coming is for the
preferred shareholders because some of these preferred shareholders
are very new who have bought Fannie and Freddie preferred secondaries.
Will the government allow any preferred payouts? I wouldn’t think so.
Not if taxpayer money is at risk. It would be politically impossible
to provide guarantees for preferred shareholders or even the
bondholders.

Who’s most at risk? The Joe Six-pack 300-Shareholders of Fannie and
Freddie – and there are millions of them. The preferreds have been
largely bought by Carlyle and KKR syndicates. This is the smart money.
They have put on derivative hedges, so that if the paper ultimately
turns out to be worthless, they won’t lose any money. But Joe Six-pack
isn’t smart enough to do that and has no knowledge of it.

In conclusion, domestic equity prices are now dangerously overbought.
We are no longer using the term “severely overbought” or using any
other typical market parlance. I think the term “dangerously
overbought” is in order because another correction in equity prices
with the underpinnings of the global financial system teetering,
another substantial correction in equity prices would not only simply
erode confidence, but would diminish liquidity which is already in a
negative balance.

The new speculative bubble in equity prices is now a threat to the
global economy which has been severely weakened under Bushonomics.
Meanwhile the Asian and Eurozone markets continue to trade at what I
call “fantasy” levels. Thus it is a global pattern of the
overvaluation of equities. How I see this panning out is in a reversal
– which is going to be “bloody.” In a “dangerously overbought” market.

This idea is being fostered by the Bush Cheney Regime (and indeed all
governments) that we’ve got to prop up and save the equity markets
through a lot of jawboning and bogus promises that we can’t fulfill as
well as loosening regulations.

Meanwhile the Russian-Georgian conflict had about a 3-minute ripple in
the markets on Friday morning, August 9. The reason you can tell that
markets are in a fantasy land is because they are no longer reacting
to any negative economic news or negative geopolitical tensions. The
markets are not reacting to anything, other than a feeding frenzy of
buying on borrowed money.