The Doomsday Scenario

The Barron's roundtable issue came out this weekend. Putting together the various insights that were elucidated during the interview, I came up with a Doomsday Scenario. It's not something that I think will happen, but as a possibility, I should have a contingency plan, and I should throw a couple eggs in this basket to hedge against its possibility. It also jives with my view of the Dollar, so my currency bets are already 50% there. The other 50% consists of switching my bet against the Yen to against the Pound Sterling.

Here's the Doomsday Scenario in a nutshell. It's a massive correction in all financial markets and commodity prices. I'll lay out how it could happen this year, and then I'll examine the steps.

The Doomsday Scenario may have already started with plummeting oil prices. High oil prices have been the boon of financial markets, especially the bond markets. Scott Black of Delphi Management says that lower oil prices could eliminate $200-300 billion of inflows from OPEC nations. What about petrodollars from non-OPEC nations? Another $200-300 million? When the well dries up, the plants die. What I mean by this is that the financial markets need a continual source of money inflows to grow and flourish. They are much more affected by a loss of liquidity than by a temporary loss of asset values such as the $2 trillion correction in commodities and emerging markets last May. If liquidity starts drying up, then volatility will go up. In other words, the market will get choppier. If it gets choppy enough, and Japan raises rates, then the carry trade will end. That will further dry up liquidity. At this point it could become a vicious cycle. But, by this point, the Fed would probably have eased already. However, the global economy could stall if the flow of dollars reverses significantly. Right now, dollars flow from the U.S. to countries for oil, manufactured goods, and other commodities. If oil gets low enough, and volatility choppy enough, emerging markets will disintegrate (they had $140 billion in U.S. investor inflows last year) and all the money will come back here. Right now, only most of it does. A strong dollar is bad for the stock market, as is disinflation, as is volatility. These factors together would cause a flight to quality, namely, long-term Treasuries. If enough liquidity shrinks just when commodities plunge, emerging markets will be choked, further dropping commodity demand. If.... Lots of if's here, but these are some pretty big IF's, and these different scenarios could come together this year, which was impossible last year.

Here's the recap:

Oil down = liquidity down = volatility up = end of carry trade = Yen up, liquidity way down, dollar up = financial markets way down.

Despite this, I think the U.S. economy will escape a recession. GDP could still stay at 3-4%. But that doesn't necessarily mean that the stock market will go up. In fact, Bill Gross from Pimco says that if inflation goes to 1% and nominal GDP isn't greater than 3%, that will be deflationary for asset prices. He and Scott Black both see Bernanke lowering rates when inflation comes in abnormally low in the next few months.

Time to reverse my put option on 10-yr. Treasury bills tomorrow. I will close the put, and look for August calls over 112, or as far out and as high as I can go. They should be cheap. The Treasury bulls have fled the field and will take time to regroup.

How about stocks? Dividend stocks will do well if rates go down. Airlines should do well as slower growth would just further cement more than offsetting gains from falling oil. Companies with low debt will do better than leveraged ones. Financial companies will have a tough time. Staples, like the cigarette companies, will do well because their cash flow is safe.

On the flip side, there's this crazy guy in Iran who might stop pumping oil (although I think he's more likely to do that if he got a nuke), and emerging markets may be strong enough to stand on their own. (Do Chinese banks lose business if foreigners sell their stock?) In other words, could emerging markets keep chugging along even if their stock markets suffer a serious correction?