Monday, February 18, 2013

Making the bearish case

Bear capitulation rules the land.  The Fed has POMO in high gear, and stocks simply will not be permitted to fall.  When one leader does stumble, the indicies absorb the blow, rotate from one sector into another, and find support.  At the worst we may see a pullback, a dip which will be bought.

In 2007 the obvious RE bubble and subprime mess did not matter because everyone was hedged.  When Lehman went away, so did that last sense of security, and we had the crash.  Fed intervention and POMO is taking the place of derivative strategies this time around, they are in complete control of things, and they won't let events get ahead of them again.  Well ... we'll see about that.

I believe that we can crash again, but that there will be a period of bear market violence in the market, with sharp sell-offs and vicious rallies -- in other words, a repeat of 2007.

The deflation case is as strong as ever -- my friend Reverse Engineer penned a good restatement of it the other day -- but it's not going to take the market down all at once.  It needs a starting point, and time to build, gradually, into larger waves, until we finally get that surprise that takes us down in a grand finale.

I contend that that surprise may be Germany withdrawing from the Euro this Christmas, using the holidays to declare a bank holiday and a conversion back to the Mark.  This summer will witness increased shocks and strains within the Eurozone, with the usual fingers pointed towards Germany, slurs against the "Nazis", demands for them to pay their share.  There will be rumors, but there were rumors before.

And in the winter, Germany will shrug, and take its own path.  I say this now, not for the sake of prediction or prophecy, but because if it all works out, I intend to put all the firepower I can into index puts on the very eve of this great event, and I want this record to show that I suspected it was coming.  OK, SEC?  We clear on this?

We have plenty of room on the long-term DJIA log chart to plummet to long-term support.  The entire market rally since 1995 could come right off (and I think it will).

But for now, the big bearish wedge needs to hold.  We have that McHugh phi mate turn date coming up in a couple of weeks, which happens to hit the fedgov sequester on March 1.  I think we see complacency up until that very moment and then oh shit, they actually let it happen.

SPX 02-17
But it won't all come off at once.

We've got to fight it out first, just like 2007.  And we need POMO for this.  We have got to keep a bid under this market, and faith among the market bulls ("maniacs" as Permabear Doomster calls them).

Prechter's lightning-bolt crash into the dirt is one of the worst things that ever happened in bear-dom.  It fed the idea that it could all go to shit at once, without retrace, without mercy, so you had better have an iron in the fire just in case.  So bears held puts, or 3x inverse ETFs, and they got eaten alive, because it appears we actually had to work our way out of the hole.  We had to get back to this insane extreme, where bullishness is off the charts and the unthinkable is again unthinkable.  The Fed has got everything under control ... no worries ... go long with leverage ...

As bears, we don't want a collapse, we want a tradable market.  We absolutely do not want to see it all go no-bid and go all at once, until it is ready.  To the extent that the Fed and ongoing POMO can keep this from happening, and to give us awesome bear-market rip rallies, let us watch for these situations, and enjoy them.

But first we need our top.  The wedge is important.  So is March 1st.  If we shoot higher, we'll try to make sense of it with TA, do the best we can.  It's all we have got.

My macro-thesis is that we get one more massive wave of deflation, before the bond market and the US dollar itself come under fire, and we experience the true hyperinflation -- rejection of the dollar as a store of value, particularly in exchange for energy in the form of crude oil.

Like 2007-2009, the crash proceeds in 3 waves, an A-B-C pattern.  2013 gives us A and B, the early stresses and contention, and the beginning of C.

When Germany reintroduces the Mark, we get in 2014 the equivalent of the 2008 waterfall.

A-B-and-nasty-C to support

How can this scenario still be tradable?  Because it will not yet hit the dollar and the (US) bond market itself.  European credit may fly all to hell, but the $DXY will be well above 100 and the 10-year Treasury bond will be under 1% in yield.  For now, for us, the interest-rate derivative monster will be controlled, "easy-peasy, lemon squeezy", as my four year-old daughter says.

It only gets dicey when the European situation is resolved, and the US dollar itself comes under fire.

IMO, the final hyperinflation of the dollar may have several causes, alone or in concert:

1. With crude oil at $20 and the S&P below 500, the basic faith that the deflated US economy can afford the obligations on and off the books will simply evaporate.  Interest rates will dislocate and our money will enter a death spiral.

2. By 2014 or 2015, the bleak reality of peak oil and the world energy situation will be increasingly obvious.  The very idea of the petrodollar will come under assault, which, along with our carriers and H-bombs, is the only real backing for our money.  As long as you can trade a dollar for oil, it's a very hard currency.  Once that ends, it's toast.

3. The crash of 2014 and the death of one or more TBTF U.S. banks forces the Fed/Treasury to break the rules and issue a true naked issuance of currency, to cover the depositors.  Bank of America uses its deposits to back its derivatives book today.  What will happen if this goes to zero (or much lower?)  The Fed buying MBS with newly-created money is pretty close to printing (because they will never repo this trash), but it still stays within the "rules" as we know them.  That may change.

4. When the market tanks again, and Obama's approval flatlines at 13.1%, disgruntled insiders leak the college records and or other key documents on the man.  Then we get a category 5 constitutional crisis which would nuke any remaining faith in our institutions and little details like shared national obligations.  This one is out there as a possibility, but until this is settled satisfactorily it is still very much out there.

Plenty of scenarios pointing toward the eventual death of the dollar.  But there is plenty of room on the charts, and in my narrative, for a scary deflationary convulsion before we get there.

Too many claims on real wealth.  Too little real wealth.

The suburbs and strip malls of the America ... are the collateral for its debts.

Hey!  Don't just sit around waiting to see if the upcoming turn date hits or not.  In the meantime, do yourself a favor and order Dmitry Orlov's new book.

Get a signed copy, if there are any left.


bmihogh said...

Well, two small points: Germany will never quit the Euro. It's actual price is quite convenient for them, and as it'll loose some value it'll be even more convenient - underpriced money is a classic element of any economical boosting.

Of course, the Euro is still overpriced for everybody else in the EU. But who cares? Germany will just shrug if somebody leaves: they can even make profit from picking up the pieces falling apart... Like in Greece, ya?

Other point is, that the function of an overshoot at the top would be to finish off all the remaining shorts. Sentiment is extreme - it'll show it even more extreme.

And with the shorts closed - and I bet that shorting will be banished after the first wave falling - who will start buying a bottom?

Albertarocks said...

This is a great writeup Christian and a 'fun' read to boot. Thanks... and keep 'em coming.

Bicycle said...

I also don't see how Germany leaves the Euro any time soon, it is their way to access any oil at all and the sheiks already hold probably hundreds of billions in Euros--no way the mid east lets them do that. Germany will not be allowed to be a military threat. They are in the same position as Greece, they are just less worse off. They will keep the Euro as long as they think they can keep their petroleum based society, and only at the point that they no longer can will they choose a new currency. Its far more likely that German manufacturers will just continue to move their auto production to the United States as auto consumption in Europe falls, as is already happening (Japan is doing the same).

We also don't need an external shock for things to go haywire here, either. I paid $4.20 for diesel yesterday and my state average for regular is now $3.95. Unless the next western oil-consuming nation is impoverished quickly (will it be France? Japan? GB?), we'll see 5 bucks at the pump all over the place this year and that will take a huge bite out of US GDP.

Sandor said...

The fulcrum to asset (equity) prices is the credit market and the collateral chain between financial institutions, especially the ability of the central banks to act in a collateral crisis. We must ask what are the limits for Fed/ECB action? How much more QE/LTRO is possible before there is a dearth of acceptable collateral? For example, in the US MBS market, after 1T of direct QE, there are not enough MBS left. This leaves T-Bonds only.

For a cascading sell-off to occur, there must be forced selling/deleveraging by the banks. In 08-09, this came from haircuts in the repo market. The only trigger I see in the EU banking system is a spike in Spanish/Italian yields followed by a failure of these countries to apply to ECB for OMT relief or the political inability of these countries to agree to conditional reforms. The dislocation has to happen in the bond market, which drives this bus.

What's the impetus for Germany to leave the Euro in 2013? Why would their banks be better off going back to the d-mark? Status quo seeks stability at all costs.

I share the same macro thesis of deflation leading to explicit USD devaluation. However, I think it is far more probable that the next waterfall follows a different pattern, so I am not looking for 07-09 as a guide. I can see the S&P shedding 200-400 handles, but I am trying to figure out how the central bank 'put' fails past this point when the Fed is intent on propping up the S&P at all costs? Realistically, how do we get back to S&P at 500? Who is going to default on such a large scale? The trigger has to be in Europe, no?

stanley j g crouch said...

Pretty much the realistic scenario..!!

Most alternatives to yours are fantasies.

Buy hey, yours is only based on math and stuff...!!

Permabear Doomster said...

If there is one thing I am certain of this year...

Merkel will get the boot.

Remember how few expected Sarkozy to get kicked out? Well, Merkel is on way more shaky ground than Sarkozy ever was.

The German people are simmering underneath, they've had enough of propping up other nations.

There are MANY surveys, all show that a massive percentage want the Mark back. Yes, they liked the Euro at first, but its sadly failed due to the ongoing depression in the southern states.

So..Merkel out, and then its a case of will the new leading party do a 'Sunday night surprise'?

We should get some warning, besides come election time, the leading opposition party might make a commitment to return to the mark anyway.

Christian Gustafson said...

Re the German question, I'll be interested to see what monsters emerge from the European sovereign debt swamp over the summer, and how the small players look to Germany to take up the next round of bailouts. Maybe France can lower its retirement age another notch as well, to help the process along.

Yesterday we closed above the giant wedge! So we're either in "throwover" territory, or the structure of the wedge will break down at some point and morph into something else. Ugh.

Upon further review, the giant wedge looks like it starts at SPX 1202, at the very end of December, 2011. Wave 3 of the wedge is of special interest, running 208 pts from 1266 to 1474.

If we are in wave 5 of the giant wedge now, and wave 3 cannot be the shortest, then simple math tells us that this count depends on us staying below 1343 + 208, or 1551.

SPX 1550 on March 1st would be about as far as this take on the bubble can go, again, before it morphs into something else.

Bicycle said...

So what does everyone think happened to WTI today. RBOB was bleeding off all morning but then at 11 ET WTI got smoked. Nanex and ZH are implying it was the PPT. What broke?

Sandor said...

Re: WTI. This is nothing new. Any cursory study of intraday charts will show this pattern recurring several times a year in commodities markets. Selling begets more selling, stops are triggered, etc. There have been instances of WTI dropping $9-10 in a single session, so today's move was unremarkable. Gold has dropped $80 in a session before, so today's $40 plunge, while very large, is also unremarkable. There is no need to search for 'reasons' outside of market architecture, changing perceptions, and the leveraged positioning of players. This is how 'price discovery' happens.

That said, the commodities complex is foreshadowing an equities plunge. There is a huge divergence developing, and today's FOMC minutes sell-off sets up the dreaded 'outside day' reversal pattern for the first time in 2013. A broader sell-off probably follows within the next 10 days.

Christian Gustafson said...

Sandor -- I'm just glad glad glad we are back inside the big scary wedge.

Some more pullback, then we can take one last crack at it ... and fail.

Bryan Franco said...

Likelihood of phi mate marking a bottom? Separately, but related, fwiw, i looked at peak to peak, and trough to peaks on spx and cpi-adjusted spx going back to '00, and cannot find what the heck mchugh is refering to. The fib ratios i was getting were in the. 8s using a mar 1 end date. What intervals is Mchugh using?

Bryan Franco said...

Gold mining index broke obvious long term support on heavy volume today. Copper also supporting the deflation case CG... this could get really interesting in the days/weeks ahead. CG, i appreciate the work you do to this end. Specifically, you seem to appreciate 'outliers', those nasty things that cause history to move in discontinuous jumps!

mannfm11 said...

There is a delusion going on right now that the central banks can fix everything. Whose money? These are nothing but balance sheet entries, but they take an asset out of the system. It is zero sum.

Also, Bank of America's deposits are pledged for nothing. Deposits are liabilities and exist only to the extent the debit side of the balance sheet can support them. 100% of them created in some bank the exact same way the Federal Reserve is creating money that will reside, not in accounts, but on the debit side of the banking system balance sheet, Like Herpes, they can't get rid of the stuff, save for giving it to extinguish deposit liabilities for customers to hide in their matresses. 2008, there were NO RESERVES. When the US supply of cash is around $800 billion and they find $1 billion in a drug dealers semi truck in Chicago, think the banks had any left? Didn't they say Saddam had $1 billion in the wall of one of his palaces? Think Mexicans are hoarding pesos or keeping them in their bank accounts, waiting for the next 40% devaluation overnight? The stuff works because there is a liability for every entry.