The Liquidity Trap
Below is an excerpt from a study that originally appeared at Treasure Chests for the benefit of subscribers on Tuesday, September 5th, 2006.
Process continues to unfold since our last meeting on the subject matter presented below, where market conditions appear to be morphing as expected. There is of course no guarantee this will continue however, which is why it has paid to keep your eye on the ball over the past few years in determining market direction. Of course this is easier said than done, where many a fortune has been lost attempting to short the stock market since 2002. This is why when you find a formula that works, it's as good as gold, especially if works for gold as well. Read on if you are interested in discovering how these abilities can be incorporated into your trading / investing endeavors.
In getting back to the main topic now, and as per above, many are currently asking whether we are finally at that inevitable debt peak, the one where factors like nightmare mortgages put the brakes on the continued expansion of the aggregate credit cycle. Classical economics did not teach bubble dynamics as a matter of course, so to this degree, and from this perspective it appears impossible to answer that question given just when it seems current ballooning experiments are about to implode the system, another one pops up in the distance unexpectedly. In this respect if you remember from past efforts, and given the rather robust echo bubble just witnessed in the stock market over the past four years, it shouldn't be surprising to anyone if at a minimum something similar were to occur in real estate a few years out.
That is to say, it wouldn't be surprising to see real estate in an 'echo bubble' sometime out if market interest rates in the States are allowed to continue falling. What's more, this would also be the period we would expect to see a 'grand bubble' built in precious metals. In this respect it should be understood higher precious metals prices are expected no matter what interest rates do, it's just that the bubble's ultimate size will likely grow bigger the longer general liquidity conditions remain in tact. And given the fragilities now being witnessed in the economy, once some pricing pressure has been removed from the system this fall via falling equity / commodity prices, the process should get started directly afterward, concurrent with Presidential Cycle considerations. This is all speculation however, which as you know is inconsequential in our investment / trading decisions.
Along these lines, and in bringing the timeframe firmly back into this fall and early next year, based on previous work you know we don't like to guess about things like this. And since we've gone to an awful lot of trouble to develop a methodology utilizing open interest put / call ratios on the major US stock market indexes in providing us with a little followed (meaning still effective) means of measuring true market sentiment, where we know above all other factors, sentiment remains the key determinant of price direction in a liquid / efficient environment, we would be foolish not to use this tool in directing our investment policy. As you know, through the continuous monitoring and analysis of sentiment in the broad stock market environment, we have been able to decipher the probability of significant weakness in the equity complex previously quite effectively.
For this reason, there is every reason to believe the predictive nature of this approach will continue to be effective in discerning whether it appears conditions are becoming conducive for the severe weakness many knowledgeable observers are expecting this fall, or not. Again, as practitioners of providing what is expected to be a reasonably educated opinion in this regard, and not just some colorfully worded guessing, it is my opinion such an approach is owed to you. This of course assumes you are in the information market to get a good look down the 'rabbit hole', and not just to listen to fairy tales because they jive with your belief system. To follow such musings has proven to be very expensive for those attempting to short stocks while in the midst of what has proven to be the mother of all echo bubbles. If this is your objective, then you should read on.
In continuing to set the proper context for this exercise, please find a partial reprint of our last effort on the subject below given it still captures the essence of current conditions effectively, as follows:
"In returning to the here and now in monitoring aggregate process, we of course prefer not to simply rely on one simple historical (sentiment related) comparison in determining propensities of possible intermediate degree aspect changes in stocks, where besides cycle related considerations to compliment the mix, a considerable amount of importance is also placed on the measurable internal state of the market as it pertains to sentiment, as well. Here, we are referring to our put / call ratio studies, where it has been my observation throughout the years that as long as liquidity conditions remain fluid, which according to Doug Noland there is no end to the credit bubble in sight, if investors are exhibiting a negative attitude towards stocks as measured by high and rising open interest ratios on major US indexes, no matter how bad things may appear in the news, stocks should remain buoyant set against what for all intents and purposes qualifies as a short squeeze of grand proportions.
And as per the attached detailed study above, we know that based on historical precedent, this measure happens to be 'key' in the overall formula, unquestionably the most important indicator of sentiment available in that one is measuring the very pulse of the market, where participants must pay to vote, meaning because it's costing money, the measure accurately reflects how they actually feel about future prospects. What's more, it's important to recognize we are not talking about volume related put / call ratios here, the ones most traders follow. No, we are talking about 'end of day' ratios, where positions are left on for a period of time because traders are confident they are on the right side of the market, and for this reason willing to let these rapidly depreciating bets ride.
Although we do not have yesterday's numbers available at the time of writing this analysis, I can tell you that Wednesday's numbers showed big jumps higher in put / call ratios on both the S&P 500 (SPX) and S&P 100 (OEX), meaning if this keeps up, we could be looking at a repeat of last month in the end, where yet another squeeze is engineered by the powers that be into expiry. And as you may already know, the Dow's ratio is already above unity, meaning a squeeze remains most probable if history is a good guide. What is interesting to us however is the fact ratios on the NASDAQ have been systematically ratcheting down towards unity over the past few months, lagging the DOW and OEX in this respect, but where if we could just get the SPX doing the same in earnest, the entire group of measures would be signaling a significant sentiment adjustment in total. Therein, then we would be postured similar to the top of the stock market in 2000. I know because I was there trading it. And I made a killing on the short side in the subsequent two years.
And it's not that put / call ratios are not being ratcheted down now either, where it's very important to keep the appropriate perspective, it's just happening very slowly. The next step in this regard, which is essentially the missing element to overall sentiment conditions becoming overtly bearish in terms of the prospects for stocks, would be a snap lower in the SPX's ratio to join the others in proximity to unity, where once this occurs, engineering squeezes higher will begin to prove increasingly futile for authorities in what could be the beginnings of what Keynes termed a liquidity trap. Here, as with Japan in the 90's, no matter how much money was thrown at the problem, prices still declined. This is what happened in the 2000 - 2002 meltdown in stocks around the world, as well. And this is what we are watching for now, where for the most part, all of the writings / observations we currently undertake are in monitoring progress toward the above described eventuality."
In picking things up in terms of process then, it may be appropriate to take a look at some pictures of select open interest put / call ratios at this point given it appears we in fact are potentially developing a 'crash signature'. In this respect, we would be amiss in not talking about the SPX first, where as mentioned above, it's the important one to see falling soon if the whole picture associated with anticipated weaker stock markets is to come together. That is to say, given it appears speculators have largely already reached their maximum 'pain thresholds' for unsuccessfully shorting stocks evidenced in open interest put / call ratios falling into the proximity of unity in measures attributable to the S&P 100 (OEX), Dow, and most recently tech stocks (NDX and QQQQ), once the insurance buyers (think mutual, pension, and hedge funds) slow down purchases of SPX puts as well, the 'big picture' will have come together in a masterpiece of sorts given a high probability for substantially lower major US stock indices would then exist.
To continue past this point in our analysis here today would be a disservice to our subscribers considering they pay for this information. For this reason then, we must cut things off here, but we invite you to visit our site and discover more about how an enlightened approach to market analysis and investing could potentially aid you in protecting your finances and family life into the future. It all depends on how far you are willing to look down that rabbit hole.
And of course if you have any questions 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 all.