Paulson, the dollar and a bewildered rabbit (or, greed is bad)

Flash is hardly trading at all - in part because most of his long positions have been wiped out, in part because he's busy with other stuff, and most importantly because he doesn't have the time to watch the screen - and when the intraday moves in the S&P 500 have been over 3% practically every day for the last week there's a lot of screen watching to do.

There seem to be two possible views about where the market has got to right now.

The orthodox view at the moment seems to be roughly as follows:

A central bank bailout of the toxic debts held by the banks radically weakens the dollar. On the back of this, sentiment has moved sharply against the dollar, gold went stratospheric (that's a move Flash would have liked to have got some quick and dirty profits from, but half the rest of the world got on that bandwagon), and commodity prices have pushed back up. The only reason for this that Flash can spot is that the dollar's weakness means prices need to increase, plus a sentimental flight to 'safety' of gold. But gold isn't worth anything if no-one has the cash to buy it. Nothing has changed on the commodity demand front. If anything, demand will be weakening. To some extent the inflationary pressure of oil heading back up for everywhere other than the US will have been somewhat dampened by the currency move. So all the signs point to more contraction and a drop in commodity prices.

OK - so what has driven the collapse in the dollar's value? The orthodox view says that a bailout increases the US national debt enormously. And Flash understands perfectly why politicians and citizens are furious about having to buy a ton of currently worthless junk debts off the greedy bankers. But there are some wider considerations.

If the entire wholesale credit market collapses then the entire US economy collapses. A lot of domestic value is held in property and if half the country goes into negative equity then the consequences for the banking system are severe. Perhaps this pain is a necessary adjustment - it's a pretty bleak thing for people who need to eat, sleep, live and look after each other - but for those people that like capitalism, deeply ironically it requires one of the the biggest state subsidies the world has ever seen. It would be interesting to know what the ultra free market libertarians make of this: Flash is guessing that the ones that bet big the banks would collapse are shouting 'bring it on', but ultimately no-one will gain if we're into a 21st century great depression.

Regardless of what happens there will be a continued contraction in available credit as the banks rebuild their battered balance sheets. And discretionary, risky lending has already reduced, but borrowing is just going to get more and more expensive in real terms; credit in emerging markets who have been dependent on a one trick cash cow - resources - is going to get even tighter.

And the cost to taxpayers of doing nothing needs to be considered too - mass unemployment, crime rate goes through the roof, millions made homeless, businesses failing. And remember that companies are taxpayers too - and perhaps taxes will have to rise to cover some of this, but in Flash's book that's not such a bad thing, and isn't the end of the world as we know it. The alternative probably is.

Now if the US goes for a bank bailout plus a fiscal stimulus package - new deal mark II, with some protection for homeowners - some sort of government trust which backs distressed equity, then the outlook looks rather more positive.

If the US goes for a rate cut then although it might weaken the dollar it might also accelerate growth - hence strengthening the US economy against the negative growth of the rest of the planet. Similarly in europe and in the antipodean world - rate cuts may help boost liquidity and that is sorely needed.

Now a second question is - how inflationary is this?

Common sense would suggest that injecting this much cash, and cutting rates would have an inflationary effect. But wait a minute. Is cash actually being injected into the system? Well, quite a bit went in last week, but not just in the US - it was a co-ordinated action across the globe. So it's more like an emergency blood transfusion than a flooding of the arteries.

Buying these bad debts is not necessarily a complete disaster for the USA – what would be a complete disaster is if nothing is done – mass unemployment, complete collapse of wholesale credit market, and thus business/consumer credit market. And the position of these toxic MBS only weakens if the housing market doesn't improve.

But perhaps there's a line to be drawn between the inflationary pressure of rate cuts and stimulus, and the drag on demand caused by the fact that most people have completely run out of money. No-one's buying anything much right now. And ultimately if the US recovers more quickly then that's good for the dollar. And it will take another year for any kind of confidence to return to the housing market. So this could be a great time to buy property if you're cash rich.

So, the second, perhaps counterintuitive view is as follows:

How sustainable is the rally in GBP, EUR, AUD, NZD etc against the dollar when arguably these economies, and thus currencies are even more vulnerable? Flash suspects that other governments will also have to commit funds to back up some of the toxic debts in their system too. Actually Flash thinks the UK might not come out of this as badly as others expect - the UK economy is more flexible than most, and Keynesian public sector investment is providing some ballast, despite the crazy property boom. Hence he is still long GBP/EUR, a trade that's actually worked over the last two months.

So it comes down to two views (and many thanks to some more intelligent economic commentators who have helped Flash build up enough of a picture in his thick head to write this).

View one (indefinite armageddon)

- because of the weakening dollar, commodity prices rise:
- gold, because of it’s ‘safe haven’ status carries on rising - but only as a hedge, and we all know what happened last time everyone tried to hedge their equity losses by going long commodities
- oil rises on the back of a weakening dollar

If inflationary pressures mount, then central banks can’t act to cut rates

- essentially stagflation/recession/late 1970s
- no stimulus
- massive bust
- house prices halve
- borrowing collapses
- liquidity and lending between banks collapses

...and then some sort of rescue plan is put in place, or else we all go back to barter/self-sufficiency/feudalism - aspects of which might not be a bad thing. So Flash is looking for companies that understand this new world - trouble is, not many of them seem to. And technological innovation/flexibility/responsiveness will still be important. But it means a total depression in the price of stocks. A total write off. Massive destruction of value. And even cash loses its value because inflation is totally out of control. But it would be a good time to be in venture capital. Funding start-ups which understand this new world. And perhaps buying companies involved in public services, prisons, policing/security, healthcare, water, rail, energy efficiency, transport. Or pawnbrokers?

View 2 (some sort of bottoming out)

A ‘new deal’ stimulus, particularly under a democratic administration could give the US a huge rebound over an 18 - 24 month period:

- The US trade deficit shrinks because import demand is dropping so fast in the US. US labour costs and wage growth falls because competition for jobs is more fierce.
- Dollars become more scarce, hence more expensive because there are fewer of them around...perhaps?
- The rest of the world goes into an even steeper downturn than the US
- US leads a recovery - not rapid but not slow either. By spring next year there are signs of recovery in the housing market, by which time it will be a bit late to buy into the housebuilders.
- Inflation poses even bigger a threat to emerging economy growth than the developed world and if demand for all the goods the developed world produces falls off, then those economies go into steep decline too.
- On the other hand, petrodollars are plentiful but if prices rise then demand falls off even more – so Flash is looking for a bigger correction – oil down to $75, even if production slows
- China is in trouble because it's fuelled by demand for manufactured goods and cheap overheads - but demand is falling off and overheads have massively increased. Hence food riots, higher infrastructure development costs, falling property values and a creeping problem of growing unemployment, linked to political discontent and the collapse of the consumerist dream.
- Emerging market banks and BRICs sell off foreign reserves to stay liquid, and credit growth in emerging markets collapses, emerging market growth therefore slows.
- Demand destruction pushes down commodity prices
- Self-sufficiency and energy efficiency become even more important and we probably see an increase in protectionism. The end of breathless millennial Free Trade. The break up of the WTO. But commodity prices fall because demand drops off rapidly.

For this reason, Flash is looking to be bullish on some US-consumer facing equities, particularly those which have been heavily sold – housebuilders, some of the financials, large cap retailers, infrastructure – rail, water, roads, some technology stocks – he just bought back into Apple.

Flash will sell down some of the resource stocks if a rescue plan is agreed.

Flash is looking for an entry point to go long USD, short gold, short oil. He sold EUR/USD on the manufacturing PMI figures out yesterday. Other economies also likely to need to do bank bailouts – the contagion isn’t limited to the US.

He does have one dow long running from 10687 but came within a hairbreadth of closing it out yesterday to recover some of his losses on some of the other long equity positions he'd been trying to hold.

But this is just a view. Trying to piece it together. For now, he's very, very cautious and just wishes some of those index shorts had been left alone.

In these markets you seem to get caned whatever you try to do.