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Caution! Market crash could be imminent

With growing uncertainty surrounding the European debt crisis, and the contagion spreading to much larger sovereigns, such as Italy, we now see risk aversion back on the table.  US markets are down over 3%, the headlines seem to be getting progressively worse and many fear that the situation could deteriorate much further — giving up much of the gains achieved in October.

Growing concern as market whipsaws

This kind of volatility, both up and down, is historically an indicator of very large market moves.  With the bias largely negative, it seems that a market crash could be coming if no resolution is found for the EU debt implosion.  Alternatively, should a large scale bailout ($2T+) occur, we could see a significant rally, especially within precious metals spot prices and miners.

For investors and traders, this type of price action is stressful.  Seeing fluctuations of multiple percentage points in indices and nearly 10% in stocks can cause forced position liquidation because of stop loss orders being triggered.  For traders, who generally capitalize on multi-day moves rather than moves within a single day, this type of action can cause significant losses should one be caught on the wrong side of the market action.  High frequency trading machines may capture gains, but are not providing liquidity or improving market efficiency, especially during periods of intense market moves.  Instead, evidence seems to be growing that the machine-based traders are making the market less stable and more prone to large price swings.

World view deteriorates

Global markets plunged as well, with Italy down over 9%, Poland down nearly 9%, Germany down over 7% and other European markets leading weakness as stock prices bleed, especially within the financial sector.  The lackadaisical response out of the EU, ECB and IMF leadership seems to be draining confidence and sparking fear in the markets.

US banks have hundreds of billions of dollars worth of exposure to European sovereign debt, banks and other related instruments.  Many have written credit default swaps, a form of insurance that has no capital reserve (see AIG implosion circa 2008) against European debt, exposing them to significant risks should the EU situation worsen.

Broken bonds from backwards economies

Many Western countries now face the prospect of sovereign debt problems, as their economies continue to slow, while investors fear that they will not be able to pay back the debt.  The United States is no exception, as its official debt reaches 100% of GDP, and by some estimates, their total outstanding unfunded liabilities have reached $75 trillion.

Japan has a 200% debt-to-GDP ratio, which is only made possible by the fact that most of their debt is held by Japanese banks and pensioners, but the situation there is deteriorating with growing political and economic instability.  Even China is no exception, as their economy is slowing down and the yield curve on Chinese debt has inverted for the first time — causing serious concern for those that felt China would lead the world out of recession.

The coming crisis

What happens next is not clear, but what is evident is that the world is changing.  Slowing economic growth, the bursting of the largest credit bubble in history, significant deterioration in debt-driven consumption and resource depletion all leads to a potential crisis.  All of the new debt that has been created to attempt to stem the last debt crisis has only exacerbated the underlying structural economic problems we are facing.  Papering over large amounts of fraud within the financial system and ignoring the peril of main street has divided the Western world.  Growing civil unrest and lack of available employment, especially for the young, has created the potential for large scale disruptions (think of the “Occupy” movement, but on a global scale with a significant percentage of the population participating).

I feel that unless we start seeing accountability within the financial sector and governments of the world, prosecution of the enormous fraud, transparency within the political and electoral process and erosion of corporate personhood in so far as money is considered free speech, as well as more regulation of over the counter derivatives, we will look back at the 2008 crisis and think of it as a relatively calm and orderly time within the financial markets compared to what could happen next.

S&P 500 uptrend intact for now

The S&P 500′s uptrend remains intact in a defined channel that found support today, during the stock market sell-off, at the 20 day moving average. The chart below shows the trend channel as well as the moving averages.

S&P 500 chart

Uptrend channel intact

There are some technical issues at play here, however, that we cannot discount. First and foremost, as I mentioned in the previous post there is a double top pattern in the S&P 500 that is playing out and causing a decent amount of fear. Combine that with Chinese inflation worries that toppled the Shanghai index down over 5% last night and we find the markets climbing a wall of worries in to the weekend. Most commodities took extreme hits today, with sugar, silver, palladium, gold, cotton and various grains falling off their highs. Oddly enough the dollar was weak while all this selling in commodities and equities was taking place, which is contrary to what we’ve seen in the past months.

Seasonally this time of year tends to be rather positive for equities. The holiday season usually gives earnings and employment a boost and consumer sentiment usually picks up — except for what we witnessed in 2008 of course. Next week should shed more light on the technicals and fundamentals of these markets. As we see trading begin in Asia it will be interesting to see if the appetite for precious metals is once again renewed as it was after the silver sell off on Tuesday after the CFTC raised margin requirements by 20% (from 5% to 6%).

Is the rally topping out or just starting?

We’ve seen a significant gain since the bottom in March of 2009, up about 80% since those 666 S&P 500 lows.  Now the market is facing significant resistance, even after the massive $600 billion QE2 plan to inject more liquidity.  The resistance comes both in the US dollar beginning to find trend line support and the S&P 500 showing potential resistance at what could become a double top formation.

First let’s have a look at the long term dollar chart:

US dollar long term chart

It’s clear that the US dollar, despite a large drop in recent months, is beginning to find support at the trend line formed from previous lows. If this trend holds it could bolster the ailing US currency and provide room for not only a short term reversal, but some significant appreciation on the back of Europe’s woes and a correction in the commodity currencies. On the other side, the dollar is seeing significant headwinds towards sustainable appreciation because of the unsustainable forward looking debt load of the US government combined with the massive stimulus and easing programs.

Now let’s have a look at the S&P 500 chart:

We see the potential for a double top formation in the index around 1220. If this level can not be broken to the upside then we have some serious downside potential to contend with in the US stock market. The rally of around 15% over the last two months indicates that many are confident in putting their money in to equities, rather than bonds, and with that a lot of speculative stocks have seen impressive gains. But another side of this rally is that it has largely been supported by extremely loose monetary policy, a “Bernanke put,” is what many are calling it, meaning that there’s no reason to buy protection (or put options) on your investments because the Fed will be there to prop up the market.

This is an inflection point. It has the potential to decide the direction of where many different markets, including currencies, commodities, equities and bonds, will be trading for the next several months ahead. Should the dollar fail its trend line support and the S&P break to the upside of the resistance around 1220 we’ll see a massive rally in other currencies, commodities and equities. If instead we see the dollar hold firm and appreciate against other currencies, reinforcing the trend line support and the S&P breaks down at the aforementioned resistance level then we could see a daunting correction in other currencies, equities and commodities.

All we can do now is watch, wait and act accordingly…

Market bounces on extreme oversold condition

On Friday the US stock market enjoyed a bounce because of an extremely oversold technical market condition.  These market conditions often happen when there are extreme emotions in the market.  It may seem obvious, but excessive greed leads to overbought conditions and fear leads to oversold conditions, such as the one we recently experienced.

NYSE index

The above chart of the NYSE index (a broad US stock-based composite) depicts the rally and the recent selling.

This chart illustrates levels that are considered overbought or oversold on the NYSE McClellan Oscillator.

The condition, illustrated by the red arrow in the chart, has not been fully worked out so there is still room for more buying.  On a technical basis, oversold conditions typically occur after waves of selling that knock an asset out of balance with supply and demand creating a void that must be filled.  They are measured by various technical indicators.  I prefer the NYSE McClellan Oscillator.

As you can see in the above charts when there is an oversold or overbought condition that reaches an extreme, it is typically corrected and often with violent reverberations throughout the markets.

Downtrend to continue?

Even as the oversold condition resets, it is unlikely that we have seen the last of the selling.  Global market conditions are worsening.  Sovereign debt defaults, EU stability and China’s perceived slowdown are at the forefront of concerns by market participants.

Typically there is a large bounce that resets the oversold condition to neutral or even overbought and then the downward volatility will continue, assuming that the market is going to continue to keep its eye on the powerful headwinds a global recovery faces.

Fundamentals failing

So far the rally since March of 2009 has priced in what economists call a “V-shaped recovery”.  That is to say, a powerful drop and an equally powerful recovery.  In order for this theory to play out there must be improving macroeconomic fundamentals, but instead the exact opposite is occurring as the fundamentals deteriorate.

US Government debt and GDP percentage of debt graphic

This chart shows US government debt is climbing fast and already at multiples of our GDP.

Western government debt is soaring much faster than any GDP growth.  The GDP growth projections are just as unrealistic as the expectation that a debt crisis can be solved with more debt. 

A pronounced fear is building up that this surge in global stock prices we’ve seen for the last year may have been nothing more than a mirage without a basis in reality.  It’s likely that massive tax increases and spending cuts across many governments are going to be inevitable. Such actions will crush the economies of those countries and create more problems for the global economy.

Alternative measure of unemployment     Americans not finding enough work

Unemployment continues to stay at high levels.  In the US unemployment as measured by the Department of Labor U6 survey is at 17%, meaning over 1/6 people cannot find enough work, if any.  U3, a more conservative measure is close to 10%. 

These levels of unemployment are devastating to everyone trying to support themselves financially. Another effect is that it creates a vacuum of sustainable durable or discretionary spending now and in the future hurting businesses everywhere.

The coming correction

At some point there is going to be an even more significant correction than what we’ve seen so far.  One that brings asset prices back in to parity with fundamentals.

While zero percent interest rates and government bailouts may have buoyed the markets, they have not improved the economy.  Some would say these actions actually damaged the economy because the failing companies were not allowed to dissolve.

As the flight to safety occurs we may see an appreciation in US Treasuries, US Dollars and perhaps even gold.  The Japanese Yen will probably also appreciate, damaging the nation’s ability to be competitive with its export prices.

US Government probes JP Morgan silver trades

Federal agents are probing JPMorgan Chase’s silver trading activity in order to determine if the bank used derivatives to artificially lower the price of the precious metal.

Part of a larger problem

It is estimated that JPMorgan holds up to 40% of the world’s silver short.  If this is true it is certainly indicative of price manipulation as JPMorgan doesn’t possess 40% of the physical silver.

Derivatives played a large role in the market collapse that began in 2006 that was largely blamed on subprime loans.  Because these mortgage backed securities, credit default swaps and other instruments weren’t on exchanges there would be a very wide difference between the bid and ask (or the spread), especially during market volatility.

This could lead to huge price swings in the instruments, making holders uncertain what the true value really was.

Light must be shed

When reflecting on this opaque market’s role in recent events it’s clear that something must be done.  We need more transparency with derivatives.

They should be traded on open exchanges where they can be settled every trading day.

Shorting silver

The reason silver (and to a large extent gold) have been shorted is to artificially depress the prices of precious metals vs. the prices of stocks and bonds, helping to hide the true effects of inflation.

In fact, using these derivatives to add liquidity to their balance sheet by shorting silver, it’s likely that JPMorgan would use that cash to invest in stocks and US Treasury bonds.

Bribing Washington

Wall Street sends $500 million to Washington every year, using lobbyists to shape the opinion of lawmakers.  There is also a shameful revolving door between government and the private sector that often hinders regulators from employing their full might.

Consequences of manipulation

The DOJ and CFTC are looking at both civil and criminal charges as the investigation continues.  They are examining trading tickets and other information.  I expect the probe may expand to other assets, too.

It is possible that the firm will be fined, but I’d be very surprised if anyone goes to jail.

It’s time for a new and improved uptick rule

Since the SEC eliminated the uptick rule on July 6th, 2007 there has been a marked increase in volatility.  Of course other factors significantly contributed, but in all likelihood with the uptick rule in place, selling would have been more controlled and orderly.

Another Black Thursday

After the most recent Black Thursday on May 6th the market dipped almost 1,000 points because of what the exchanges claim were computer errors (and probably the bid disappearing because market makers were running scared), it’s time to look at reinstating the uptick rule.

Black Thursday resulted in many investors losing money, including retirements and pensions. Whether it was a computer event, human error or some combination of both the fact remains that a rule to prevent short selling without first an uptick in prices would have curbed losses.

History of the rule

The uptick rule was originally enacted in 1938 as a response to concentrated short selling.  It forbid short selling a stock unless there was first a positive tick in prices.

Short sellers today claim that the rule was largely symbolic and only affected a few exchanges.  They’re right, it was not broad enough and regulation did not keep up with the way markets changed.

A better rule needed

The new uptick rule should affect all US stock, options, forex and futures exchanges to ban short selling except on an uptick in prices.  This would, in effect, buffer investors and exchanges from the cataclysmic stock market losses that we saw on Black Thursday.

Another benefit is it would force the computerized programs to, by law, have protection mechanisms built in to prevent endless selling.

Regulators must regulate

Now that the carnage that’s only possible without more balance in the market has been witnessed, it’s time for regulators, like the SEC and CFTC, to stand up and enforce existing regulations more stringently and insist on new regulations, such as a new and improved uptick rule.

It’s time to sell the rally

For the past seven weeks there has been an impressive, rip roaring 30% bear market rally from the March lows.  There has been no fundamental reason or glimmer of hope that truly spells the end of this recession.  Instead what we have are bank earnings that no one in their right mind can trust with the amount of accounting trickery taking place.  Consumer credit card interest rates skyrocketing.  Record foreclosures in both residential and commercial real estate.  And a parade of uninspiring earnings and guidance from the S&P 500.

Room for gloom and doom

The market has been ignoring bearish news which  could be viewed as bullish, except it is also ignoring the fundamental macroeconomic picture.  Emerging markets in Eastern Europe and Asia are hard hit by the global economic crisis.  Some are on the brink of default with their sovereign debt, forcing them to seek loans from the IMF.  Others are rapidly devaluing their currencies.  Either  path demonstrates signs of extreme financial stress.

There is no end in sight to the problems with real estate, which led us in to this mess.  We have yet to see a meaningful bottom in housing and now commercial real estate is suffering.  GM is on the verge of bankruptcy with few alternatives and to top it off global GDP will likely shrink the first time in decades.

Froth at the top

On a technical basis the S&P 500 seems to be overextended.  It has been overbought too quickly for most of the momentum to be sustainable.  In the last week we’ve seen a lot of that momentum fall to the wayside.  While consolidation is normal, we can’t with any confidence declare this as more than a bear market rally to which an abrupt and painful end may be in sight.  The bank stress tests are expected to start being released to banks this Friday and to the public in early May.  The old adage “Sell in May” could be a very meaningful pronouncement for this Summer.

Keep your powder dry

I recommend using this rally as an opportunity to raise cash, sit on the sidelines and wait for a good buying opportunity for the long term.  Short term the best position is a short bias.  I don’t feel that being constructive after such a massive build up, especially when some of the larger gains have been on light volume, is warranted.  Possible support exists at 850, 830, 800 and 775.  At this point it is conceivable that we also retest the lows in the 660s over the Summer depending on how severe some of the interim problems become.


S&P 500 hangs in the balance

Overnight the tone of futures markets has been pretty negative, pushing the major indexes to levels that could retest the trend line support at open if we stay this low.  The S&P has been flirting with 820, a very key level that if significantly violated to the downside, 813 and 800 remain as important support levels.  After 800, we have a vacuum that could reach the November lows.  Of course a violation of 820 on the downside will be seen as a breakdown of the modest uptrend and that could catalyse a wave of selling.

SPY

One discouraging sign is since the small rally in early January, every time the S&P 500 has bumped the 50 day moving average we’ve seen a wave of selling.   Market participants are not commiting to long term positions, but range / trend trading short term and this action is increasing volatility.

Auto bail out talks break down

Talks in the US Senate to create a compromise in the auto bail out bill have failed. The US futures, Asian and European equity markets are taking a large hit. The S&P 500 is below 850 pre-market, meaning if we open that way the support level has been breached. Car makers, industrials and energy companies are taking a big hit. These are unprecedented times with big news every day. Keep your eye on the markets!

Nasdaq one day chart: head and shoulders

We are seeing confirmation of a head and shoulders pattern on the NASDAQ composite. This pattern is potentially very destructive to the rally that has taken place thus far. If you are still long this market, a stop slightly below 880 on the S&P or 1550 on the NASDAQ composite is wise, as that seems to be the only level holding back a collapse of the uptrend.

Watch this trend closely because the weekly chart on the NASDAQ composite shows the same pattern forming, meaning we could be retesting our lows in short order if it traces out the right shoulder and breaks below the neckline.