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I feel we are facing significant headwinds moving forward because of the loose monetary policy of the Federal Reserve, the refusal to address the core problems in our financial system and the incredibly opaque derivatives market that has yet to be regulated or even cleared on open exchanges.

The root of the problem

To expand on the first point of loose monetary policy, from my own research I have gathered that the government has put at least $12T, possibly up to $30T worth of guarantees, backstops and other forms of insurance against the prospect of another meltdown. In addition the Federal Reserve has, in my opinion, illegally taken control of AIG through programs they are not authorized to participate in. These actions and other measures have transferred the risk of collapse from the private sector to the US government and to the Federal Reserve.

Interest rates remain below 1% in a range of 0.00% to 0.25%. Combine that with the infusion of US dollars the Federal Reserve has given to other central banks around the world and we have literally created a carry trade scenario. Not only are we repeating the mistakes of Japan, but we are going down a path where should a geopolitical event or other significant negative catalyst occur the repatriation of dollars could create a collapse across nearly every asset class.

Risk grows as stability wanes

This environment that has been created to engender a recovery is not only unsustainable, but it has created more risks than had existed beforehand:

#1 Should another market panic occur where AIG’s credit default swaps are due, the US Treasury and Federal Reserve must cough up the difference. This would lead to another series of bailouts and funneling cash to foreign and domestic banks at the tax payer’s expense on bets that never should have been made and were downright idiotic.

#2 Big banks are BIGGER now than before: JPM, BAC, WFC, USB and others are now larger and present a much more significant risk to the system should, say for example, one of their mark to make believe off balance sheet assets implode — potentially bringing down the entire world financial system, again.

#3 The stress tests were fraudulent and did not expose the off balance sheet asset liquidity vacuum these banks are suffering from. Papering over fraud never leads to a sustainable rebound.

#4 Tax receipts are down across the board – how can counties, cities, states and the Federal government hope to control deficit spending if they are not collecting as much in taxes? They can’t sell bonds forever, bringing me to my next point.

#5 Commercial real estate and corporate bonds are headed towards a potential implosion in the next few years, with major mall holders filing bankruptcy and many occupants of office and retail space vacating as they downsize. Corporations also must refinance their debtload which is ever growing while the global appetite for these bonds is diminishing.

#6 We in the United States are very seriously facing the risk of a sovereign debt default in the future. This prospect is made even more serious by continued bail outs, war spending, entitlements and other programs that are completely unsustainable with our country’s $14T debt burden.

#7 Such a sovereign debt default would lead to a currency collapse and that could engender either an environment of hyperinflation or heavy deflation — all depending on where the chips fall at the end of the day.

Inflation or deflation?

While speculators are now hedging for inflation and shorting the dollar in any way possible, there is another market we must pay close attention to. A market that significantly dwarfs the size of the commodities markets as a whole. That is the US Treasury Bond Market. Last I checked it was $33.5 trillion dollars. I find it interesting that gold is touching $1111.00 an ounce while 10 year bonds are at only 3.625% — who is wrong in this gigantic game of chicken?

Either the folks buying gold are insane to believe inflation is the bogeyman to fear or the much larger, much more influential and liquid bond market is crazy because they obviously fear deflation. Why else would a rational human being buy a bond at 3.625% that they must hold for 10 years? Such an instrument would be less than worthless in an inflationary environment.

First the principle value of the bond erodes as interest rates rise, and secondly the yield would not make up for the rate of inflation. So we are experiencing a financial conundrum right now. Either we are on the verge of a deflationary collapse or a hyperinflationary currency crisis. Which way we’re going to go has not yet been made clear to me because I feel the markets are being propped up, even manipulated.

The most dangerous bubble

Why would I pose such an idea? Let’s start with the P/E of the S&P 500 which is now well over 25 (and was at one point over 100). How can anyone feel that these stocks are reasonably valued with such an absurd P/E? Most of the decrease in P/E from over 100 to over 25 has been from companies downsizing, firing employees, hiding bad assets and not organic growth. In the current global macroeconomic environment there’s no feasible way earnings can catch up, so in my opinion we’re already in a bubble.

Bubbles of the past were not as dangerous because the US government never had such a large stake in the market. Now we’re talking about a situation where if the credit, bond, currency and/or stock markets implode, so does our sovereign debt and currency potentially.

Investing is now speculation

Investing in this environment is difficult at best. During the March panic I was a buyer in the high S&P 600s of just about any material, technology, financial and energy stock I could find, but once we got to the 900s and I saw P/Es jump beyond levels I felt were fair valuations I became a seller of my holdings. I also invested some in to silver, foreign currencies and other commodities during the March lows, but also have since taken a lot of those profits off the table.

We are in a very risky area for people to be entering the market. I don’t feel these lofty levels are sustainable nor do I think the valuations are rational. I don’t know when the rally will end, but I do know that any parabolic move usually ends very badly and any time there has been a carry trade in the history of money it has ended painfully for all the speculators who did not exit in time.

Another collapse coming?

In closing I will say that before Rome’s collapse the government was shaving gold and silver coins down to create more currency. They also had a severe debt crisis. The shaving and continued spending led to awful inflation that eventually catalyzed the empire’s downfall.

History is being made every day and the decisions are going to shape the face of America’s future. It is imperative that we start to take our medicine (meaning we must face the financial problems instead of ignoring them) and deal with the overwhelming burden of debt before it swallows up everything left.

I would like to pose an important societal question to any banker that is willing to answer it:

Why are bankers increasingly hesitant to lend, even drawing back lines of credit, yet at the same time allocating a lot of funds in to commodities, especially oil?

Isn’t it true that oil and consumer consumption are closely correlated?

Are they seeing something that I am not or is this a bit of a logical paradox?  How can the banks create the growth they need for their trade (or investment) to be profitable if they refuse to lend to those that would spend it on consumables?

There has to be more than just dollar weakness factored in to this equation.

At this point there is some distortion between energy and metals which have a direct relationship as energy must be expended to mine the metals. usually the ratio is 10x the price of a barrel of oil for an ounce of gold, but now it’s been in a range of 12.5x-15x.

Either oil is very undervalued (which is unlikely) or gold is overbought at these levels.

Today’s close of the stock markets and oil seems to indicative of a risk repricing that began last week.

960 (around the 50 day moving average) on the S&P 500 and $65 a barrel on light sweet crude are my downside targets short term, but if either breaks we could trade to much lower support levels.

In addition, when examining the huge sell off in natural gas prices, it’s near certain that energy has more negative catalysts than positive because industrial utilization continues to lag despite the green shoots propaganda that we keep hearing.

Finally, there are a growing number of bears calling for a shake out of March’s lows coming this fall because of a new leg down in commercial real estate that will bleed liquidity out of the equity markets and REITs.

Now that the equity markets around the world have rallied about 50% or more it seems that interest rates have heightened around the world as well. In the US 10 year bonds were as low as 2% in March and now have neared 4%.

If home owners need to refinance their mortgages to lower rates, but those rates are no longer available how can we have a sustainable recovery in housing (which is always a driver behind economic recoveries here)? Doesn’t this lack of available credit and affordable interest rates undermine the recovery efforts?

In addition, with many bright minds believing China was the key to the recovery how does China’s correction affect the views of equity investors? Is the global rally in question?

It looks like safe haven assets like bonds, yen and dollars are becoming more attractive vs. risky assets like commodity currencies, commodities, equities and emerging markets in general.

I think we may be entering the next leg down as Mohamed El-Erian and others have expressed the same sentiment I have. The rally is running on fumes.

We probably will retest the lows in the market and bring some fear back in to the trading. VIX is up 6%+ today and we’re seeing a lot more put buying as institutions either bet against or insure profits in stocks.

Consumer sentiment was terrible and there is now some question as to whether the FDIC is solvent after taking over Colonial Bank. All the Maes are probably completely toxic now, too. I hope foreign central banks continue their generosity or the falloff here could become a disaster.

The flight from US treasuries, equities and the dollar is a category five hurricane against the once safe haven.  Is it fear of hyperinflation or just a ripple of the recession?

Speculation is increasing that the US will not be able to pay off its mounting debt and it is showing in the markets.  Most currencies, especially commodity driven ones like the Australian and Canadian dollar, are rallying.  The US treasury bonds are selling off at an alarming rate.  The stock market is starting to either consolidate or make a larger move down.

If the hyperinflation hits and creates a panic, this type of activity will increase markedly.  If instead this is a ripple from the recession tarnishing the confidence of other markets it is still a negative because it shows that central banks around the world are not supporting US debt to the degree that they did in the past during a time when the US is creating more debt than ever before.

The implications are vast and will have an effect on purchasing power, employment, wages and the types of jobs available moving forward.

What do silver, the Australian and Canadian dollars all have in common? They should all be considered good inflation hedges for US dollar-based portfolios.  The Australian and Canadian dollar are commodity-based currencies, because their underlying economies are very much driven by the production of commodities such as gold, silver, oil, industrial metals, etc.  Silver itself is very undervalued against ever increasing real world demand for coinage, jewelry, electrical and chemical applications.  The combination of all three assets, in two different asset classes (foreign currencies and commodities) provide strong upside as the dollar weakens and world growth comes more from emerging economies than industrial economies.

The Australian dollar ETF can be bought through symbol FXA, the Canadian dollar ETF through FXC and silver through SLV.  I currently have holdings in all three assets and advise those concerned about inflation to consider what their long term investment goals are and how these assets may or may not fit in to their strategy.

The action in precious metals lately has been impressive.  Silver and gold caught a bid amidst the chaos in currency markets and bank balance sheets.  The nervousness has created an atmosphere of fleeing away from equity in to safer havens.  With gold seemingly gaining steam to make another move to the upside, is $1000 within sight?

Looking ahead

Markets tend to discount the here and now and focus on the future.  Has gold already priced in potential inflation or is that a variable being gauged on a daily basis?  Options traders in GLD would suggest that $95 to $100 (or around 950-1000/oz) are reasonable price targets given their usually large call positions.

Charting the course

Right now $1000 is resistance long term, without some extraordinary volatility to the upside.  Below is a three year, weekly chart of GLD.  The bollinger bands are a great indication of potential support and resistance in price moves.  We’re using a longer term chart to get a very broad view of GLD’s price action over the last 150 weeks.

Past performance

While past performance is no indication of future gains, GLD has outperformed the SPY (S&P 500) consistently for quite some time.  Gold has always provided a safe haven for value.  For thousands of years, gold has had the same purchasing power.

It is wise for investors with long term objectives to have some precious metals exposure in any portfolio as a hedge against inflation, which is expected to increase significantly in time.  Traders may want to be more aggressive playing the rally depending on your strategy.

With the US poised to announce multiple government endorsed packages  to stimulate the economy and assist banks, it is likely that a dramatic weakening of the US dollar will occur.  The Canadian dollar seems especially well positioned to rally, perhaps even back to par with the US dollar.

We can see in the above chart a bottoming process in the Canadian dollar beginning to take shape. Now that oil is also potentially bottoming and some commodities are finding strength, the trend serves the commodity-driven Canadian dollar well.  Watch the USDCAD pair and the FXC Canadian dollar ETF.

The stock market cheered the US central bank’s historic interest rate cut today, surging nearly 5% on the S&P 500 back above 900 to 911.82. The rate cut, combined with continued quantitative easing in Treasury bonds was evident in today’s trading, with a flood out of US dollars in to commodities and other currencies as well as bond yields dropping sharply.

The implications are clear. Inflation will begin in some measure of time, whether it is days, weeks or months. We can see traders already preparing by taking long positions in anything that stands to benefit from the dollar’s fall. Near term we could see the US dollar index fall as low as 72, retesting its prior lows and further confirming the head and shoulders pattern. Commodities and currencies remain attractive buys.

The US dollar index is forming an all too familiar pattern.  This is certainly a result of wreckless monetary policy turning deflation in to a potential stagflationary situation. At this point we recommend purchasing commodities (DYY is a good ETF because it is 2x leveraged and well diversified) and other currencies while there are reasonably priced opportunities.  We like the Euro and Yen for this trade.

US dollar index shows head and shoulders pattern

The courageous may consider purchasing commodities stocks as they will likely participate, but the future of the equities market is not necessarily certain as the recession is deepening.  Today’s unemployment claims were higher than the expected 525k at 573k.  That is a very bad sign that the worst is far from over in terms of how many layoffs we can expect.

Commodities have had tremendous strength for the past few days along with commodities stocks seeing money pour in. This is a potential trend worth watching and it is continuing pre-market today.   I will have more detail in a later post.

This is not a call on either side, but a recommendation instead to watch the action in DRYS as we are seeing incredible buying interest in this stock over the last few days and especially today. Again, I don’t recommend buying or shorting here. The interesting factor is how this optimism is related to the future expected performance of and demand for commodities.

Commodities have seen a sharp and unprecedented sell off after their inflationary highs earlier in the year. Many, including myself, feel this sell off is overdone. The action in DRYS may confirm that theory. Watch this one closely in the days and weeks ahead!

He plans to potentially cut rates to 0%, creating a liquidity trap, much like our friends in Japan did in the late 90s.    This is an absurd solution to a problem that originated with too much cheap credit availability.  It is also naive to speculate with trillions of dollars, mortgaging our next generation’s future for the mistakes of bankers and regulators.

What if it doesn’t work?

There is a strong likelihood that this “fix” will create stability (not necessarily growth) in other asset classes by sacrificing the dollar.  If it doesn’t work, however, we could see a protracted global depression with many central banks already having expended their monetary policy ammunition prematurely.  Japan’s crisis never technically ended.  Their stock markets never regained their 1990 highs.  Since then they have been in a deflationary environment for 18 years.

Won’t the bail outs help the country?

Probably not.  Capitalism was built on the philosophy of letting the strong prosper and the weak fail.  If a company can not make a profit or has made terrible investment decisions, the tax payer should never be held accountable.  Bailing out the weak also stifles real growth and innovation.   Other companies are usually poised to fill the gaps left behind by the weak companies failing with better products or services.

If it won’t help, why try?

Central planning rarely works, but is often utilized in times of crisis to provide moral support.  We are going down a dangerous road that could end in the socialization of corporate America while leaving the middle class to decay.  The favoritism employed by Treasury and Federal Reserve officials to arbitrarily choose what lives and what dies is the polar opposite of free market capitalism.  It undermines the very framework that could have been the solution to our credit woes.

How do you make money in this environment?

So far short term trading, while risky, seems to be more reliable than any buy and hold approach.  Some folks are playing the double and triple leveraged ETFs based entirely off of technical indicators and having good success.  Others are accumulating positions in commodities for what they expect to be an extremely inflationary environment.  My take is that both strategies are applicable, depending on your risk tolerance, time horizon and availability to watch this volatile market.

Markets have been a wild seesaw ride through positive and negative territory all day.  No sign that this indecisiveness will let up before a decision is reached, one way or the other, by the US Congress.   Commodities markets are mixed as players are uncertain of where to put cash to work.  Foreign exchange markets have shown some dollar strength vs. European currencies.  Overall, a day that most could have slept through without regret.

We’ve seen bonds outperform nearly every other asset class, as the flight to safety has been fast and furious.  The short end of the yield curve is yielding 0.335%, which is actually up from the lows of the year.  The TED Spread is at record high levels, showing the stress in the credit markets is exacerbated by the uncertainty surrounding the corporate welfare bill for financial companies.  The current trend in equity indexes is lower with no sign of abatement.  Most emerging markets have been deeply affected, with China down 60% from the peak of last year to the trough of this year’s lows.  Russia’s financial crisis worsened to the point where the markets were shut down for days and in India and Brazil we’re seeing inflation continue to plague the central bank policy, causing an abrupt departure away from steady growth.

The world is in limbo right now.  Are we going to let institutions fail as capitalism would demand or will we socialize the entire free market in favor of stablizing a fearful world in the aftermath of the biggest asset inflation bubble in world history?  While the US Congress debates these issues the markets are deteriorating, as they should, given the uncertainty that forward-looking traders and investors have to factor in every day.

Right now we are on the precipice of the greatest global financial crisis the world has ever seen.  Most people are beginning to wake up to that.  We’ve seen some liquidation of mutual funds in retirement accounts, money markets become unstable because of Lehman’s collapse and AIG, the world’s largest insurer, have to be taken over by the US Federal Reserve Bank, because of balance sheet insolvency from “mark to make believe” accounting practices.  While legislators debate what implications this bill may have and how to oversee it prudently, I fear that this is by far the worst approach to solving a problem that stemmed from bad risk management and greed.  You cannot bail out the biggest banks with debt that is created out of borrowing at interest from the Federal Reserve and expect the problem to be eased.

Every government and Fed bail out so far and in the foreseeable future relies off of using public funds to bail out private sector mismanagement of capital.  Suddenly the entire financial sector’s balance sheets are reminiscent of Enron and we’re celebrating this by rewarding their worthless paper with billions of dollars from an already heavily debt-burdened Treasury balance sheet. We can’t expect this one to be any different.  Sure it may address short term credit market confidence issues for just enough to get us through another quarter, and to a new elected government in 2008, but it is not a solution.  It is a bandage on a gaping axe wound.  Eventually limbs will have to be lopped off because the infection wasn’t handled by Dr. Ben.  This is what I fear is next.

Instead of stemming the risk taking, the policies suggested and enacted thus far have actually created the opposite effect.  We give banks easy access to cheap capital as the Fed cuts rates, the dollar weakens and all of these banks target commodities as an investment, instead of putting the money to work back in the US economy.  Of course their argument is that they have a fiduciary responsibility to generate capital for their investors, and that allows them to operate in a completely apathetic manner towards the overall wealth of America.  Instead, they invest in metals, energy, grains, etc and the rally is the biggest and boldest in decades.  It was no coincidence that when credit became harder to access, hedge funds started imploding and the banks that benefited from the rally on the way up started taking profit or reversing positions while the economy slowed down, that the rally completely ceased and reversed.  The correction, like the rally, was the unprecedented in its scale and veracity.

In the midst of incredibly expensive short term capital, market participants that relied off leverage to create profits are imploding left and right.  Many models, like the ones employed by Bear Stearns, Lehman Brothers, AIG, Washington Mutual, Wachovia, etc. will not function in a world where confidence has eroded because of excessive greed and terrible risk management.  Many smaller boutique firms that receive less media coverage have also been facing redemptions, funds have been closing down at an alarming rate.   At the end of the day, there are less market participants and those remaining have less capital to employ strategies.

Many elements of the market system are changing very fast.  Be careful trading.  The risk hasn’t been higher for a long time.  Short term strategies seem to be the most feasible, but keep your eyes glued to your terminal!  I’m keeping my portfolio in cash with occasional conservative short term trades when the opportunity presents itself.  Good luck!

The Fed has no room to move in either direction; inflation is high and growth is slow.  Unemployment remains stubbornly high while at the same time, despite the correction in commodities, inflation is also a great concern.  The amount of money (debt) creation the Federal Reserve and Treasury must engage in to prevent the credit bubble from catastrophically failing will have deleterious effects on the US dollar and put increasing pressure on the consumer to remain afloat.

Home foreclosures are bound to continue increasing as home prices continue lower amidst tighter credit standards for mortgages restricting potential buyers and up ticks in adjustable rate mortgages increasing monthly payments to unaffordable levels.  In addition, the price increases for agriculture and energy have yet to hit the consumer fully.  Some increases are still being passed on and will be for some time.

The credit bubble, which started as a subprime crisis, has spread to affect assets of all classes and created great uncertainty in the fixed income markets.  Many question the fundamental underpinnings of the debt driven US economy given that the consumer is under the aforementioned pressures, the Fed is tied down and the dollar, while strong lately, has still weakened nearly 40% in the last six years.

In my estimate, we are about one third of the way through navigating this crisis, and thus far too much ammunition from the Fed and Treasury has been expended.  I am looking for the S&P in the triple digits by years’ end and home prices down another 15-20%.

We saw gold drop $14 this week, gold stocks were punished and the market showed a lot of fear and trepidation. With such volatility, you might ask, why do I think gold is good? It’s simple.

That’s right, simplicity. That makes an asset attractive. For the past two years gold has outperformed the S&P 500, Dow Jones and NASDAQ.

If this isn’t enough for you, however, you should note a few very significant facts:

1. Gold trades in US dollars. That means when the dollar is weak, gold is strong. The dollar has strengthened recently because of a “lack of liquidity”. Liquidity usually refers to US dollars flowing in and out of different equities and other asset classes. When it dries up, that means there are less “dollars” (whether in hard or soft form) in the system. This creates a temporary boost in the value of the dollar and temporary weakness in gold.
2. India and China are now the world’s largest consumers of gold and their appetites are likely to keep expanding. This creates more demand and pressures the supply, thusly raising prices.
3. Gold is the world’s oldest asset and is only gaining in popularity and probably the world’s most liquid asset.
4. Hedge funds bought gold as an appreciable asset, not fully understanding the implicit lack of hedging this creates when other funds mimic the same behavior.  Gold was oversold this week because of investors having to cover their losses in other assets by selling their profitable investments.

Gold is now ready to rebound and it closed today bullishly up $9.70 in to the weekend, indicating investors are willing to stay in their positions. Gold stocks rebounded positively as did the precious metals indices. The overselling that occurred mostly to cover losses is over and the bargain buying has already begun.

The next step is for the Federal Reserve to cut interest rates in September (or sooner). Once this happens, the dollar will further weaken because of the increased availability of credit (which is essentially virtual money flooding the system). This weakening dollar and increased availability of credit encourages investors to flock back towards gold, stocks and other oversold assets.

It may just be time to buy some gold ETFs (IAU, GLD), futures or stocks (AUY). Have a Mooriffic weekend!

Gold trades myopically based on fear and greed, generally not taking the larger picture in to consideration (long term: weakening dollar, US economy slowing, inflation growing). As such, opportunities arise to exploit fear and greed to yield a high profit.

As you can see in the image below, gold oversold based on fear this morning that the market would collapse based on credit concerns. I bought here $675.00 because I felt gold, being down about $20 from the day before, was oversold.

As you can see, it quickly rallied to $686.00, where I sold, because I felt the rally was overdone by traders relieved by the Federal Reserve injecting $19B in liquidity to banks suffering from a lack thereof.

That’s basically how the fear/greed trade works. This is a single trade that can span minutes, hours, days, weeks, even months and years depending on your strategy and outlook.