The next crisis has already begun

By Bill Fleckenstein

This week I'd like to update readers on the funding crisis. That's the third in the three-baseball-game analogy that I dreamed up last fall (read "Economy sinks as we save bankers") as a way to think through the enormous problems we faced.

The first and second games (crises) -- the credit meltdown and the economic downturn -- have been pretty easy for folks to understand, as they were front and center in the news.

The view from the dugout

Essentially, the financial crisis now lies behind us (with the economic crisis in full bloom, the recent economic "bounce" notwithstanding). That's due to all the moves put together by former Treasury Secretary Hank Paulson and other government officials. Those actions stopped the vaporization of the financial system, essentially giving everyone a do-over.

But therein lay the seeds for the funding crisis -- which, as I noted in my daily column at FleckensteinCapital.com on May 21, appears to have started.

This is a much more subtle but pernicious crisis in some ways, as it's not so apparent but is disastrous in the long term.

My reason for saying so? Because if the dollar is called into question (as now appears to have begun) and if the Federal Reserve's monetization cannot lower interest rates (and in fact causes them to rise, due to the consequences of printing so much money), then the Fed is trapped. The more it tries to solve the problem by printing more money, the worse it all becomes.

• Talk back: Are you concerned about a weakening dollar?

How that will play out exactly, how long it will take and what the road map along the way might look like is difficult to say, due to the many permutations of how events might interact.

But the ultimate outcome will be a weaker currency, more inflation and higher rates until such time as the printing press is finally taken away from the Fed.

The model bites back

Away from the nuance that is the funding crisis, the action in recent stock trading cannot lay claim to subtlety. Indeed, there's no mistaking the bizarre behavior on display, wherein so-called low-quality stocks outperform so-called high-quality stocks. To explain this disconnect, let me first reprise remarks from my Oct. 8, 2007, column:

"At a recent New York conference, investor Jim Chanos noted a couple of anomalies that, in all likelihood, are a direct function of quant trading. They highlight a disconnect between stocks and their underlying fundamentals that only a computer could love.

"It turns out there are two -- and for all I know, more -- closed-end mutual funds that own mundane large-cap S&P-oriented stocks: the Cornerstone Total Return Fund (CRF) and the Cornerstone Strategic Value Fund (CLM). Inexplicably, these funds trade at premiums of better than 50% to net asset value. . . .

"The connection to the quant universe is that Renaissance Technologies, among the biggest quant hedge funds and certainly a very successful one, is the fourth-largest shareholder in both Cornerstone funds.

"You have to scratch your head and ask: What is a quant fund doing paying a huge premium for an easily replicated portfolio?

"The only logical answer would be that the stock-price characteristics have behaved in a way that makes Renaissance's computer -- obviously programmed by someone -- think these funds are a good thing to buy, regardless of the fact that their valuation is beyond absurd. . . .

"That's what the computer-driven models at quantitative funds do, setting aside the fundamental questions of what a company actually makes or does and what that business is really worth."

Continued: Fast-forward to now

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