Perception is 9/10ths of Reality - Act II

By: Erik Swarts | Wed, Sep 21, 2011
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I typically pan the "what if" aisle at the local book emporium, mostly because it is next to the self-help section and quite frankly those people spook me with their heightened desperation. Who am I to judge these days, and Tony Robbins does seem like a decent fellow, but come on - "Unlimited Power", what do we look like voting members on the Federal Reserve?

(climbing back up the theoretical soap-box)

We will never know what would have happened if the Fed sat idly by in the face of the financial crisis. Would the markets have rebooted on their own inertia as they did in 1907 (go check the 1907 parallel - it is pretty darn close...) during a similar banking panic - or would we have followed the deflationary fates of Japan and the U.S during the 1930's?

The truth is it's not a like comparison, because (get ready for it...) - it's different this time.

The cynics will declare that I just invoked the forbidden phrase, "it's different this time" - thus, disqualifying my thoughts from henceforth. Perhaps, but I would argue that this would imply, capitalism - or whatever we will call this today - is a static and closed system. In the face of history and what we know of the considerable structural chances to the financial system in the last forty years - that is clearly not what has transpired. It is very much evolving and changing in a attempt to meet the issues of globalization and market interconnectivity.

Let me unequivocally state, that I am not an advocate of how the global banking system has been constructed over the last forty years. I liked the simple toaster exchange. I am merely describing its reality to the markets today.

We could argue over whether it was the chicken or the egg, in terms of which came first, the Too Big To Fail banking paradigm or the interventive methods now commonplace in the global central banking system - but the fact remains they both are here to stay and there is no going back to those halcyon days when banking was just banking and central bankers were not the most powerful people on the planet.

(climbing higher on the theoretical soap-box)

The simple truth is the Fed can not have smaller banking institutions to effectively manage the system as it now stands. Just as in fluid dynamics - they need bigger pipes for greater liquidity reach. Instead of thousands of disparately held institutions - they manage through several large global banks with broad effect. Certainly the financial crisis exposed the inherent weakness in this model - but the strong market recovery has also displayed its often discounted advantages. I think we can agree that things are bad, but it is not your grandfather's depression.

Our monetary handlers, be it the Fed or the concerted global central banking system - have the resources today to effectively stimulate risk back into the system in a crisis. To argue anything counter to that point would be ignoring a market reality that has been in place for the last two decades. Whether it jives with the politics in each respective country is another story - but the fire hoses are there when the sparks inevitably break out.


Theoretical Technical Forensics (TTF)

Prior to the crash in 2008, the market was respecting the downtrend channel that had established itself with the late summer swoon in 2007. To a certain extent it was quite similar to the downtrend in the previous part of the decade that extended from 2000 to 2003. The range was tighter, but the magnitude of the declines and the downtrend velocities were quite similar.


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This all changed in the Fall of 2008 when the market lost its long term support and crashed. It was precisely at the market's meridian that the issues surrounding Lehman, AIG and other major financial institutions all hit the tape at once - causing the bottom to fall out. Not soon after, issues such as the one brought by Mr.Shedlock in my previous note arose concerning the potential fallout to enormous pools of capital in the private and public pension systems.

The ripples from the crash were spreading.


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Bernanke, being one of the preeminent scholars of the Great Depression, clearly did not want to take any chances with a deflationary scenario or further systemic issues - such as the country's pension system. To mitigate these risks to the best of their ability, they hit the markets hard with both structural changes (e.g. accounting standards) and liquidity measures (e.g. quantitative easing). The market quickly recaptured the downtrend channel and broke through the top of its resistance by January 1st 2010.

The least expected outcome of a V bottom had been achieved - at least for the time being.

By the summer of 2010, the market had once again pivoted back down and was resting on the top of the downtrend channel from 2007. Coincidentally (no not really), Bernanke, again voting on the side of caution - decided to extend quantitative easing with QE2 and reintroduced a bolus of risk back into the system at a pivotal moment. If Bernanke had consulted with a technical analyst in July of last year - the analyst would have surely told him the market was skating on very thin ice - much thinner than where we sit today.


So what am I getting at?

1. I do not think we will see a likeness of QE(x) tomorrow, because although the Pavlovian modus operandi for traders has been to call for intervention during spells of market weakness - it really is not that bad - both structurally in the economy and in the tape.

2. I believe the fed altered the space-time continuum of the markets natural course lower. Once the market crashed, it shortened the markets resolution of the contraction with its extraordinary stop gap measures. I would argue that from a theoretical perspective we are going through a retest of sorts today - both psychologically and structurally - of the March 2009 lows.

Retests are some of the scariest moments for traders and investors - especially in light of the magnitude of declines in 2008 and 2009.

I believe if you look at the banking sector (BKX) today through a ratio chart with the S&P you can see the clearest evidence of the retest.


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I believe the market will survive the obscure retest because the banking sector will start leading the broader market higher. In the long-term charts below, I boxed the two regions where essentially the banks were not constructively leading the market higher. In the first bear that started with LTCM, they traded sideways for approximately 5 years. It was not until the housing market started inflating that the banks lit a fire under the broader market. This was of course magnified by the cheap capital provided to consumers through the Fed.

In the second region, where it was a true financial crisis - the banking sector has led the market lower for approximately 5 years as well. Assuming the markets inertia survives the latest reverberations from Europe, I believe that dynamic is about to change and it will likely come this time around from the cheap capital provided to corporations from the Fed. How that will reinvigorate banking profits is anyone's guess - but the prospect of an M&A boom in light of very cheap capital and relatively cheap valuations seems highly likely in the coming years.


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As a tie-between, the chart below illustrates the correlation coefficient between the flight to quality (low yields) and the banks. I find it particularly interesting that the closest comparison to the extremely high correlation we have today between the banking index and yields was in late 2002 - right before the banking sector put in a bottom and started inflating the housing boom.

I have yet to purchase any of the banks or ETFs for the sector - but I am actively shopping and will likely acquire them in the coming weeks. From my perspective, the reality for the market is far brighter than what is currently being expressed in investor sentiment and the financial media.


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See - Act I - Perception is Nine Tenths of Reality (Here)

 


 

Erik Swarts

Author: Erik Swarts

Erik Swarts
Market Anthropology

Although I am an active trader, I have always taken a broad perspective when approaching the markets. I respect the Big Picture and attempt to place each piece of information within its appropriate context and timeframe. I have found that without this approach, there is very little understanding of ones expectations in the market and an endless potential for risk.

I am not a stock picker - but trade the broader market itself in varying timeframes. I want to know which way the prevailing wind is blowing, where the doldrums can be expected and where the shoals will likely rise. I will not claim to know which vessel is the fastest or most comfortable for passage - but I can read the charts and know the risks.

I am not a salesperson for the market and its many wares. I observe it, contextualize its moving parts - both visible and discrete - and interpret.

I practice Market Anthropology - Welcome to my notes.

Erik Swarts is not a registered investment advisor. Under no circumstances should any content be used or interpreted as a recommendation for any investment, trade or approach to the markets. Trading and investing can be hazardous to your wealth. Any investment decisions must in all cases be made by the reader or by his or her registered investment advisor. This is strictly for educational and informational purposes only. All opinions expressed by Mr. Swarts are subject to change without notice, and the reader should always obtain current information and perform their own due diligence before making any investment or trading decision.

Copyright © 2011-2014 Erik Swarts

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