Murphy's Trade

Capt. Edward A. Murphy is the man after whom Murphy’s Law
is named.

He was an engineer in the air force, working on a project
to see how much deceleration a pilot could withstand in a
crash. One day, he lost his temper with a technician.

The guy had wired a switchboard incorrectly, says the
legend, and when Murphy discovered the mistake, he cursed
the technician saying, “If there is any way to do it wrong,
he’ll find it.”

There’s an interesting approach to market forecasting that
starts with Murphy’s Law as its premise. Those who follow
this approach take the line that, if it can go wrong, it
will go wrong, and when it does go wrong, it’ll take down
the greatest number of people with it.

Look at these returns over the last 3 years:

U.S. Stocks (S&P)                          +24%                              
U.S. Bonds (TLT)                            +33%                          
U.S Real estate (OFHEO)                +19%                      
Europe stocks (IEV)                        +10%                          
European Bonds (Framlington)         +19%                     
Europe real estate  (FinFacts)          +17%                       
UK stocks (FTSE)                           +12%                          
UK bonds (S&P services)                 +30%                     
UK real estate    (Halifax)                 +25%                         
Emerging markets (EEM 28 months) +114%
Copper (Kitco)                                 +105%                              
Gold (Kitco)                                     +40%                               
Crude Oil    (AP)                              +117%                            
Japanese stocks (ITF)                      +3%                           
Pacific Stocks Ex-Japan (EPP)         +17%                  

All the standard metrics used to measure the value of these
assets are off the chart. There are no more obviously cheap
stocks however you look at them, real estate prices bear no
relation to rental yields, and bond yields don’t even
compensate you for inflation.

Everything is up.

Across the board, asset prices have been pushed higher by
excess liquidity. The source of liquidity: The 2001-2
recession – aided by the tech wreck, Y2K, Enron’s collapse,
and 9/11 – pushed U.S monetary administrators to take
drastic action. They cut interest rates to 46-year lows and
flooded the markets with cheap credit. The cheap credit
flowed into global asset markets like rainwater to a
gutter, and pushed prices up everywhere.

“Had the government not intervened four years ago,” writes
Fred Hickey’s High-Tech Strategist, “the national savings
rate would not have been driven to zero on the eve of the
retirements of the early baby-boomer generation.”

“The current account deficit would not have doubled,
household mortgage debt would not be nearly $3 trillion
higher and we wouldn’t be so reliant on the generosity of
foreign lenders, who own nearly 45% of the publicly-owned
portion ($4.5 trillion) of our $7.84 trillion national debt
(up over $2 trillion in less than 4 years).”

Debt has been used as a way to prolong consumption and
consequently, Americans as a whole owe large amounts of
money. The majority is a debtor. Murphy’s Law says the
majority gets it.

Picture all that debt. Debt gets paid in cash. Cash is
liquidity. The worst thing that can happen to a debtor is
that liquidity dries up and he is unable to pay the
interest on his debt. Bankruptcy ensues.

Here’s the debtor’s worst-case scenario, the Murphy’s Law
prediction:

Bond traders keep pushing bond prices higher. This is
exactly the kind of trade bond vigilantes like, because it
puts the Fed over a barrel.

The more prices on 10-year and 30-year Treasury bonds rise
– prices the bond vigilantes control – the tighter the rope
around the economy’s neck becomes. That’s because when
short-term bond prices are higher than long-term bond
prices – a situation known as an inverted yield curve –
there’s no incentive for banks to make loans and they pull
money out of the system. Liquidity dries up.

Debt still needs to be serviced. The country will be
screaming out for cash to pay its debts like a junkie
screams for more drugs as he’s being strapped to his bed.
Anyone with debt feels the pain, and in America, that’s
most people.

A self-fulfilling circle will have been put in motion.
Higher bond prices will choke the economy of even more
liquidity as the curve inverts further. Consumerism will
grind to a halt. The U.S. economy will hit a wall. Assets
that went up will come down fast. You’ll get bankruptcies,
profit warnings and unemployment…

A cash crunch ensues. People panic and rush into safe haven
investments. Treasury bonds are still the most trusted
instruments in the world; they will be popular and their
prices will spike even higher. People will talk about a
bubble in bonds.

Here’s the Fed’s problem. They’ll do anything to avoid this
“deflationary” scenario and the bond market knows it. So by
choking the economy, the bond market essentially forces the
Fed to pump more artificial liquidity into the economy or
face financial reckoning day.

The bond market has a golden opportunity to put the Fed in
this tight spot. Buying bonds is a bet they take it. 

Bulls continue to dominate the broad market, with bears
thin on the ground.  The attitude continues to be: “Eat,
drink and be merry, for tomorrow who cares.”  Gold stocks
have been unable to hold their gains in this surreal
environment, and so we are on the sidelines there once
again. 

Citigroup fired a shot across the bow on Monday, with
earnings hit by a flattening yield curve. Nor is Bank of
America faring too well. Considering that financial
activity makes up close to half of all S&P profits, this is
a clear sign that cracks are beginning to show.  But for
now, the market has chosen to focus on the good news from
IBM… ignoring the fact that Big Blue has taken a trick
from GM’s playbook and cannibalized future earnings. 

In this dangerously lopsided environment, few sectors are
facing real selling pressure. One group that is
experiencing heavy pressure, however, is that of the health
care providers of the hospital variety. The Morgan Stanley
Health Care Providers Index (RXH) has broken down, treading
water at the 50 day MA, on an earnings warning from
hospital leader HCA (HCA:NYSE). 

The news was exceptionally troubling because it foreshadows
what’s to come. HCA is expecting poor earnings due to,
among other things, “bad debt from the uninsured.”  (We
will find out just how bad on July 27th, when HCA reports.) 
Deteriorating credit is not just hurting wall street giants
like Citigroup… it is wending its way to main street…
and an influx of new patients may bring more credit
problems to hospital balance sheets.  Large hospital
operators are also losing patients to smaller outpatient
facilities, seen as more friendly and accessible.  Last but
not least, the arrival of hurricane season in Florida—the
retirement mecca of the US—is putting a dent in hospital
earnings. 

As industry leader, HCA is now leading the group down after
a gap lower on July 13th.