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How To Save The World In 2008

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Sep 18 2008

This story was first sent out as an email to paying subscribers on Monday.

By Rudi Filapek-Vandyck, editor FNArena

Somewhere between the long overdue demise of Lehman Brothers, the takeover of Merrill Lynch and the most severe correction for commodities in decades, including the price of oil falling below US$100 per barrel, is one story that despite its obvious importance remains untold; the missing link between the main events over the weeks past.

It doesn’t happen very often that high profiled market experts at Wall Street firms engage in the discussion and analysis of conspiracy theories. Usually it is the other way around: when conspiracy theories fly around the internet they often involve Wall Street firms as accomplices to schemes concocted by the powers that be. Think, for example, the artificial price suppression of precious metals, gold and silver in particular.

This time is different, however. This time Wall Street firms have been caught napping and the damage has been nothing but severe: the worst correction in commodities since many in the market can remember. True financial damage for many an exposed financial market participant has yet to be determined. There will be more losses, no doubt, and more casualties than the few names that have already hit the news headlines.

Depending on whose side you’re on this was either a brilliant piece of war-chess, or a brutal act of … (well, pick your own words).

As with many stories, this one starts with an obvious observation: current Secretary of the US Treasury, Hank Paulson, is a former Goldman Sachs CEO. There’s at least one generic conclusion that stands out: people at the top of leading Wall Street firms know how financial markets operate.

Remember that one for later.

Let’s first go back a few weeks in time. In early June I wrote a story titled “Leashing The Inner Beast”. The basic premise was that commodities needed both a fundamental story and eager financial market participants, flush with cash, to milk the opportunity as long and as hard as possible to reach the record prices we’ve seen for uranium, oil, nickel, zinc et cetera.

I also stated that as long as those “speculators” pushed the limits in industrial markets they were seen as relatively harmless by political leaders across the world. Natural market reflexes such as new supply, substitution and demand destruction would ultimately take care of things. However, all that changed when the focus shifted to agricultural markets and energy in the first half of 2008.

Food and fuel; this combination is no longer something that can be loosely criticised in public and subsequently ignored. Higher prices for food and fuel impact on everything for everyone, be they in Zimbabwe or in China or in the US, young and old, poor and rich.

As 2008 progressed, higher prices for food and fuel were pushing up inflation in all corners of the globe. As such, elevated consumer prices were not only making life difficult for politicians and central bankers trying to prevent economic mayhem, they simply became a threat to the global economic system, not the least since the world’s major developed economies were already in dire straits, not to mention their banks.

It was from this perspective that I wrote at the time: the world has identified a new Adolf Hitler. I didn’t name him, but it was clear from my storyline that I was referring to the financial speculator. He would be taught a lesson. But how? And when?

I couldn’t give any precise indications at the time. There was no way I could predict how the powers that be would turn on financial speculators in the market. For a while I seriously considered all US lawmakers would come up with were toothless changes in legislation and bourse regulations. Yeah, that’ll teach them, those nasty self-centred, money-hungry, no-good speculators!

I always suspected there was a genuine possibility for much stronger action, if it were needed. It turned out, teaching financial speculators a lesson, the hard way, and saving the global financial system from collapse were two Siamese syblings connected at the waist.

Never underestimate an ex-Goldman Sachs CEO in a primary role at the US Treasury.

In hindsight, finding the weak spots in financial markets prior to mid-July was not that difficult. Ruling wisdom was that you had to be short US financials, short the US dollar, and long commodities.

Easy.

Aim: relieve the pressure off the heavily-levered banks who need breathing space to repair their balance sheets, get rid of bad assets and pull in extra capital.

Question: when will authorities be able to achieve maximum result (which in essence translates into maximum pain for levered financial speculators) by causing a sudden reversal in market trends?

Answer: when Asian markets are opening on Monday (which is the US weekend). Not only is there less liquidity around (the biggest markets in the US and London are closed) but as dominos subsequently start tumbling, the process of reversal (read: unwinding of market positions) will already be in a frenzy by the time US markets are trying to catch up.

And so it was that on Sunday, July 13, just before the opening of Asian markets, the US Treasury announced that troubled US mortgage providers Fannie and Freddie would receive government support if necessary. Prior to the statement hints had been given that a US dollar at 1.60 euro was the ultimate limit. On Monday, the Securities and Exchange Commission announced a temporary tightening in short-selling practices for US financial stocks, Fannie and Freddie in particular.

The brilliance in this strategy was that it utilised the excess leverage among hedge funds (and other speculators) to take the pressure off the overlevered banks, which held huge exposure to Fannie and Freddie paper, guarantees, and preferred shares; and all simply by letting the markets do their own thing (and without being publicly identified as the evil mastermind).

One only has to look at the sudden and sharp price movements across the commodities spectrum to see how successful this strategy by US Treasury and the Federal Reserve has proved to be. Oil, to name but one example, has fallen below US$100 per barrel while prior US$150 and higher seemed but a matter of time. (Whether that was ever justified on fundamental basics alone remains a matter of hot public debate).

Conclusion number one: One swallow does not make a full blown summer. One victory does not necessarily win the entire war. What we are experiencing is a very, very serious crisis. And we’re far from out of the woods just yet.

Conclusion number two: US authorities may arguably have been slow to act decisively, but they are willing to use anything -anything!- to prevent this world from ending up like the Titanic at the bottom of the ocean.

Conclusion number three: Don’t mess with the powers that be. Financial markets clearly had forgotten the ultimate powers resident at the US government and the US Federal Reserve. They needed to be reminded, and they have been.

Conclusion number four: Nothing remains without consequences. Change begets change. One domino falling onto another one creates ripples that turn into waves that reach the next domino, previously believed too remote to ever be touched. Tomorrow will never be the same than yesterday.

Hence the main question that now remains is: as US authorities can only do so much, and as they are probably facing the most powerful challenges they have ever encountered, will they succeed? Paulson and Bernanke have managed to outsmart financial markets. But will it be enough?

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