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.

Twist, but don’t shout

(Updated at 4:25 p.m.) The Federal Reserve announced that it will begin selling shorter term US Treasury securities and use the funds raised to buy in to the 6 to 30 year space.  They also indicated more easing in the mortgage-backed security market.  Stock and commodity markets had a knee jerk reaction lower, selling off on the statement’s release.  The total size of the program is expected to be about $400 billion — but there is no balance sheet expansion, just swapping of securities.   Notably the Fed did not reduce interest rates on bank reserves, thus there is no expectation that banks will lend more when they are poised to make even less because of the yield curve compression.

I believe that this is the beginning of more aggressive approach that the Federal Reserve will implement to lower borrowing rates for consumers on both fixed-rate mortgages and revolving lines of credit.  Whether this action has any material impact on the ailing economy remains to be seen, but I am highly skeptical as I don’t believe the Federal Reserve is capable of doing much more than delaying the deleveraging that must happen in all sectors of the economy.

Fed causes sell-off of equities with twist

Traders are apparently not enthused by Fed's maturity "twist."

Because of the renewed pressure on equities and the lackluster reaction to the policy release, I now expect the head and shoulders pattern to play out on major US indices.  These stock market indices have decisively broken down below the 10 day moving average, indicating a loss of upward momentum.

A sell-off down to the 10,000 area on the Dow could occur within the next week or two, and if that area does not provide technical support to markets, additional downside pressure could bring markets to the 9,750 to 9,500 area in relatively short order.  If frenzied selling occurs, perhaps as a result of news-driven events in Europe or more bombshells being revealed in the American banking sector we could see the 9,000 area give way to much lower stock prices.

Curiously silver is outperforming gold today, with gold weaker and silver spending much of the trading day in the green.  Even more interesting, however, was the difference in action in the paper and physical markets.  SLV and silver futures took a hit after the announcement and did not recover, but PSLV (the Sprott Asset Management physically-backed silver fund) saw selling and then filled the gap almost immediately, albeit temporarily.  Does this bifurcation in trading indicate that investors are more confident in the real thing or is it only a blip that will be arbitraged by the quants?  At this point it looks like an aberration as the gains have been given back, and then some.

Overall I think this monetary policy shift should be bullish in the long term for hard assets, especially gold and silver, as the maturity “twist” diminishes the interest rates on long-dated fixed-income securities and provides less “safe havens” for investors to seek returns in the paper markets.  In the short to intermediate term a longer period of consolidation and possibly a correction across the commodity spectrum is growing more likely.

Full Fed statement here:

It’s time to default on our debt to China

Let’s face it, China is not our friend. They never have been. Their government regularly engages in military and industrial espionage against our interests. Hacking in to thousands of American companies, government installations and harvesting sensitive information for their benefit are not the acts of an ally. Neither is attempting to harm our people, interests at home and abroad as well as our economy.

The Chinese government is anxious to usurp US influence by using the bonds they own (about $1 trillion worth) to undermine US interests. In the past they’ve used bond purchases as a way to keep rates artificially low so they can exploit the consumption-oriented nature of our debt-ridden economy and now they’re threatening to use these bond sales as a tool to manipulate our government’s policies.

For example, the US sells arms to Taiwan and China sells bonds to “punish” our government. The Chinese government also reneged on energy derivatives contracts on behalf of their state-owned energy companies because the bets simply didn’t go their way. Are we really going to tolerate this childish economic warfare and these dishonest business practices?

I’m sure most people have read about the well publicised hacking of Google, but that was just the tip of a massive iceberg. China’s government has hacked in to countless Fortune 500 firms to steal valuable trade secrets and other intellectual property. They also gained access to sensitive US government communications and intelligence information.

It’s time that we show the Chinese government that we are not their ally any more than they are our ally. This dispute has gone on far too long and it has resulted in an economic catastrophe. We are losing jobs, wealth and our sovereignty is being eroded. And for what? So we can have children’s toys tainted with poison and poor quality consumer products? Why should we put up with this nonsense from a country that has nothing but ill intentions for our government and more importantly for our people?

America didn’t dig itself in to this recession alone. We had help and there is plenty of blame go to around the world. We are supposed to believe that China is helping us out of this mess, but China’s interests are only within making their communist regime more powerful and domineering in world affairs. Do we really want to see this goal come to fruition? China is not a world leader. They are more of a string pulling, manipulative bully.

The Chinese government censors the Internet trying to prevent its citizenry from communicating with each other or finding out the truth about past events like Tiananmen Square and the repeated massacres of the Tibetan people. They also monitor forums, e-mails and chat lines in real-time attempting to squelch any civil unrest with brutal force and often times indefinite detention or worse.

How can we put our trust in to a country that has absolutely no freedom? If you dare speak out against the government they’ll throw you in prison and you have a good chance of being executed, having your organs harvested for sale or being forced in to slave labor.

Their propaganda machine portrays the Chinese government as godlike and faultless. Nothing could be farther from the truth. Their government is a one party autocracy with no accountability or checks and balances against the corruption that is prevalent amongst government officials.

It’s time to ask yourself, is it truly worth sacrificing everything we believe in and stand for just to have lower interest rates? I don’t think so. Let’s show the Chinese government we mean business and tell them their actions against our interests have violated international law, constitute acts of aggression, if not war and we will retaliate by invalidating the debt that they own. In addition, let’s stop supporting this war against America by refusing to purchase Chinese made products. We must derail the money train to Beijing before its too late.

Potential risk reversal in global markets

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.

Washington is losing sight of the real crisis

Washington is losing sight of the real crisis.  Incompetence, loose money and impulsive decision making are what brought us to near collapse.  Why are we repeating these same mistakes again?

Bonuses of the bailout

The $2B in Merril bonuses and the $187M in AIG bonuses when the government effectively saved these institutions from their own incompetence is far from acceptable.   There is no reason that people who created the systemic risk should be rewarded by the bail out money which is ultimately funded by tax payers facing higher taxation and a reduction in government services.

Having said that, the anger that swept the US House of Representatives to pass an unconstitutional bill that singles out individuals and retroactively taxes them at a 90% rate is equally an unacceptable reaction.  The bail out bill contained the provisions to allow these retention plans and bonuses.  How was this overlooked?  Because most lawmakers don’t read bills before signing them in to law.

Global righteous indignation grows

It’s an unbelievable situation we, as global citizens, find ourselves in.  The international banking conglomerates have failed us.  Our respective governments have failed us.  Yet they now want to claim to be the heroes and the saviours that will restore prosperity to the world.  Cutting interest rates, funding defunct institutions, floating trillions of dollars out to prop up bad debt all to relieve the liquidity vacuum the last bubble bursting left in its wake.

In the last two weeks there was a positive change of character, albeit short-lived, that boosted markets worldwide.  It was the prospect that the rules of the game had been set in the United States to favor a partnership between private capital and government loans that would allow an eventual transition away from the US Treasury and Federal Reserve propping up the every marketplace they can.

In an attempt to quell popular angst over the AIG bonuses, which were 90% less than the Merrill bonuses and 99.9% less than the total bail out AIG dished out to other banks, including non-US banks, the House of Representatives set out to destroy all the good faith that had been built.  Completely ignoring the bigger picture that AIG was simply a proxy for money that was siphoned all over the world, in the billions, not millions.

Who’s really in charge?

Let’s not forget the US Government is a majority stakeholder in AIG.  They own 80% of the shares and easily control any issue put to vote.  They can also demand the board and even CEO are replaced.  These types of extreme actions wouldn’t be positive, but they certainly seem more logical than passing a retroactive 90% tax.

The problem is the government keeps changing the rules in the middle of the game.   It’s very difficult to restore confidence when no one knows what the law will be tomorrow, let alone next week.  Every time there’s some level of complacency that the rules have been set, the rug gets pulled out again from under everyone.

Laws and lawmakers

The rule of law is a fundamental element of successful capitalism.  There is no confidence if laws  can be arbitrarily and retroactively changed or contracts can be freely broken without consequence.  I fear that more of this knee jerk legislation will completely reverse progress we’ve made toward restoring some level of confidence.

It’s unfortunate that we’ve propped up any of these institutions and in my prior entries I’ve always spoken out against bail outs and the corporate welfare environment it engenders.  No business that is unable to continue to sell products or services should be allowed to be given second, third or forth chances funded from the public trust.  Innovate entrepreneurs will create better, more profitable and functional replacements in time.

The problem is, Washington only realized this after the fact.  Only in retrospect do lawmakers seem to understand that most if not all of the effort was a waste of money.  Now, in order to not look foolish before the 2010 elections, lawmakers are putting on a big media circus to scapegoat everyone but themselves, who share in the blame just as much as the banks.  Let’s not forget as citizens that any lawmaker who voted for the TARP or the stimulus was complicit with bonuses and retention plans.

Even back when Fannie and Freddie were taken in to conservatorship, part of the contract with the US government was to guarantee the bonuses and retention plans remained.    The US Congress would have us believe that they were swindled and the bonuses flew under the radar.  Seriously?  Did you guys even bother to read the bill you signed?

Doubling down on debt

I’m afraid that there’s no easy way to stop the debt avalanche now that it has begun.  Trillions have been committed, tens of trillions more of entitlements and other debts stand to hit us during the years to come.  We’re entering a deep, protracted global recession and deficit spending on pork barrel legislation will not have any tangible stimulative effect.  Instead it creates the potential for a depression when US Treasury bonds suffer from a lack of confidence and the government is no longer able to borrow to pay the interest on its ever growing debt.

I’ve done everything I can, writing the media, my elected representatives and trying to stir the minds of those I know with economic discipline.  There is no quick fix for this crisis, it will be difficult for every single hard working American.  Mortgaging the next generation’s future to prop up the corrupt edifice of insolvent banks and bail out home buyers who never should have gambled is a terrible approach to the underlying problem.

Capitalism is not dead, but any company, individual or even government that cannot sustain itself must be allowed to fail.  That is one of the most important and fundamental underpinnings of American capitalism.  Socialism will not be an effective stick save.  It engenders an environment where the most innovative are allowed to fail in favor of those who cannot compete.

America is still a great country and our dollar is still the reserve currency of the world.  In order to keep our economy the global leader we cannot spiral out of control with debt, but instead must reign in spending on all fronts and embrace an era of thrift while we recover our bearings and wealth.