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THE
DOMINO EFFECT
So, in knowing this the question then arises, ‘does this mean 2008 could turn out to be a surprisingly bad year in both the stock market and economy, which unfortunately for us in giving banks and brokers so much power in our lives these days, are inextricably linked?’ Of course market observers would point out the from a Decennial Pattern perspective years ending in an 8 have a tendency to be quite robust, but to them a reminder of Long-Term Capital Management (LTCM) and 1998 appears appropriate then, and that prior to this every year with a LTCM type event ending with a low in November was followed by a lower low the following year. Thus, since the subprime mess qualifies as LTCM event to the 'nth' degree, one should be expecting lower lows in stocks next spring if history is a good guide. What’s more, and as Alex Wallenwein skillfully points out in his latest, what the media is dubbing a ‘credit crunch’ is actually a credit collapse, a reality that is now showing up not only in consumer credit stats, but commercial paper is also beginning to contract as well. And this is happening right into a period of seasonal strength for the economy. Does it end there? Heck no – one domino falling will lead to another (the domino effect), where all forms of credit (debt) will in turn be affected by this collapse, from credit card debt to AAA mortgages before it’s all over, right down (or up) the line as it may be. And of course the risks associated with all this becoming a problem they can’t fix is also multiplied in the realization that lenders of all varieties (both foreign and domestic) will be far less willing to take on more US debt (both private and public) knowing the cake eaters in Washington think they can rewrite contracts to their own benefit after the fact. Do you think this might create an instance of unintended consequences, where price managers finally make the big blunder and get both stocks and bonds falling at the same time? (i.e. and for the same reason that even a first year economics student could understand?) But won’t all the steps being implemented by authorities prevent this from happening? While some think these measures will at least stall a severe downturn in the economy due to credit collapse, libor rates are telling a different story, where if they don’t improve on this side of the pond after Tuesday’s Fed meeting, things could get uglier faster in a race to zero in the bond market, never mind in currency devaluation. You will remember from our last meeting, we pointed to the possibility of an unexpectedly situation developing (perhaps coincident with the Fed meeting) where both stocks and bonds begin to fall at the same time, which as you may know is when the worst market declines occur, with true panic seen in various markets such as the CBOE Volatility Index (VIX). Here, many do not know the VIX went to 150 in 1987. And others think it couldn't happen again, not with all the controls in place today. Enter the Fed, where it has already signaled its intension to cut rates on Tuesday, and maybe by 50-basis points not only in the Discount Rate, but also possibly the Fed Funds Rate, which would be a surprise considering futures are only forecasting a quarter-point cut here. Why would the Fed surprise the market with a larger than anticipated cut in Fed Funds? Answer, because libor rates are still forecasting Armageddon, where widening spreads indicate liquidity (and the larger credit picture) continue to deteriorate in spite of all the measures authorities have taken thus far to relieve a stressed system. What’s more, this means the market thinks the Fed is behind the curve, where if they were to do what the futures market is predicting this week, meaning only cut the Fed Funds Rate by a quarter, then even if they drop the Discount Rate by more (50-basis points) citing their desire to improve liquidity between financial institutions, the positive effects of such a move could last only seconds literally, that being the time it takes crazed speculators to jam S&P 500 (SPX) futures higher thinking this will matter. And as you may know, this is especially true in consideration of the fact put / call ratios on the SPX have been dropping, and are in fact plumbing multi-year lows at this time. The significance of this observation is in just how overbought the stock market is in the big picture (looking at a monthly plot here), where stocks could fall dramatically with the loss of this very important support mechanism. But – who can be short with a big rate cut, 2008 (think Decennial Pattern), and seasonal strength dead ahead right? Answer: Those who know how markets work, which is why we intend to get very short either on Fed day, and / or by week’s end depending how things shake out. Of course stocks could already be plunging by week’s end, but because the equity complex tends to strengthen as the week moves on, it might be wise to ‘feather in’ positions gradually with this in mind. Prior to Copernicus, and much like the US (or any other dynasty of the day) views itself today, mankind thought we were center of the universe, and that the sun revolved around the earth. And it’s this brand of egocentric thinking that has most market participants hallucinating that because the US consumer needs it, interest will remain low in spite of credit unworthiness and / or the trust factor. So, change here would be a big shocker to most Americans not realizing this is already happening, along with all the other cake eaters in what has been dubbed ‘the West’. (i.e. Europe, etc.) And this is likely putting it mildly. For this reason then, and in turning to the charts now to show you this is exactly what is happening, and what the consequences of such a change will likely be, one should note long-term market rates (TNX) took off with a vengeance on Friday, just when crazed stock market players saw fit to bang both the VIX and yen to new lows in what I view as their corrective moves currently underway. And it’s this misplaced optimism with respect to the US condition created by stock market related euphoria that keeps both market rates (and monetizations of course) and yield curves lower (a rising curve means contracting liquidity), but as alluded to above, this could be set to change very soon. This is why the brokers and bankers are attempting to get a merger mania rolling once again (the need for speed), because the machine needs to be fed soon or it will collapse onto it’s own oversized and increasing indigent colossus. (i.e. the machine needs to be fed increasing amounts as the credit cycle matures, meaning hyperinflation is the only remedy left at this point to meet the simultaneously exploding needs of increasing interest payments to keep bankers fat and happy, along with grease in the wheels to keep us normal folks functioning.) (See Figure 1) Figure
1 That was a mouthful, so I hope you take some time in attempting to understand the point I am conveying here. Again then, because the credit cycle needs increasing payments to maintain growth, all other things remaining constant, either a greater percentage of existing money supply growth must be assigned to this need at the expense of others or enough new money (more money) must be printed at an accelerating rate to meet all needs. So, what happens if all needs are not met? Does this mean that if more of our incomes need go to pay interest payments things will be fine anyway? What about consumption – wouldn’t consumption suffer under such circumstances? Obviously the answer to this last question is the one that deserves a ‘yes’, where again then, it should be understood companies (and government with lower tax receipts) will soon have earnings crashes (if not already) if money supply growth rates do not keep accelerating here. Perhaps now then you might be better able to understand why a rising market rate (see below) / yield curve profile is so dangerous at this time. (See Figure 2) Figure
2 What’s more, perhaps with this understanding you grasp the significance of a rising yen profile as well then, where again, basically the picture being painted by this circumstance set is one of contracting liquidity, not expanding (or even stable), which is of course not what an increasingly hungry credit cycle needs to survive. Here’s another long-term look at the yen then, this time via a weekly plot because I wanted to show you the compelling bullish technicals coming to bare at present. In this respect, it shouldn’t take you long to put two and two together if you’ve been paying attention, where while short-term anything is possible given the rate cut bone being waved in front of Pavlov’s dogs, the fate of the larger equity complex is at best on shaky ground given it's hyperinflate time or die in the credit cycle. Furthermore, it should be noted the yen has already traced out a minimal (three-wave) retrace lower, where the bullish technicals associated with weekly and monthly plots could take over at anytime. (See Figure 3) Figure
3 And if you have any questions, comments, or criticisms regarding the above, please feel free to drop us a line. We very much enjoy hearing from you on these matters. Good investing in 2008 all. Captain Hook
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