A Recipe For Disaster
Below is a commentary that originally appeared at Treasure Chests for the benefit of subscribers on Thursday, August 9th, 2007.
As explained Tuesday, the Fed was not about to give into the mob (in terms of official policy) just yet in consideration of the Presidential Cycle and dollar ($), with the end result being the market thought they were demonstrating the economy is stronger than people think, which turned into a credibility boost as stocks continued to squeeze higher. This of course is really just a bluff on the Fed's part, as the credit cycle is turning down, meaning the economy (all Western economies) is in a great deal of trouble moving forward. Here, as you know, stocks are rising not because they are discounting better times ahead, as price managers would have you believe. No, they are rising because of historically high short positions set against ample liquidity conditions sufficient to spark consecutive short squeezes higher, which is why the stock market never corrects fully.
Additionally, this is why breadth continues to narrow on these rallies, as fewer and fewer stock groups participate, with the most important example at present being financials (including banks). Indeed, key reversals appear to have occurred in the biggest of banks, which again is understandable considering the credit bubble appears to be popped. Enter a potentially rising rate environment brought about by various reasons, and we have a recipe for disaster brewing in the stock market Presidential Cycle or not. This of course is Dave's view, that the S&P 500 (SPX) tops out later this year and corrects right through the election next year. And you know what, if the stock market does rally on deteriorating internals into October, accompanied by the right sentiment conditions (sufficient shorts have been squeezed out of their positions), then, he's most likely correct in his views.
And the market action yesterday certainly bolstered the possibility of such a scenario playing out; where as anticipated, stocks chopped there way higher in another episode of the perpetual short squeeze witnessed these past five years. Remember here the view is stocks should continue to vex the highs as both put / call ratios (note the SPX series has now peaked and is breaking lower) and short positions work lower; which is exactly what is happening. Add into the equation now a Fed that's playing chicken with reality, an increasingly rocky international landscape most recently characterized by the Chinese threatening a disorderly ($) fall, and inflation pressures running rampant, and it should become more apparent to even the staunchest of Neocon types that a recipe for disaster concerning the global economy / markets is coming together - and that the intelligent observer should heed this warning.
Is that it - is that all we should be concerned about with respect to 'factors that matter'? As if that's not enough, how about adding to the list Chinese stocks appear to be putting in a fifth of a fifth wave to complete the larger sequence. Put that together in your head. Let's see now, shipping costs appear to be topping, which when combined with the perspective Chinese stocks (another key barometer of growth in the world) are doing the same, paints a picture of impending deflation in my books. Am I wrong? Am I just seeing things? Will the invisible hand show up again to save the day? One thing is for sure, as professed on these pages many times over the past few weeks; one had better become increasingly defensive with respect to portfolio planning, especially as it pertains to the use of margin. Oh yes, record high margin thresholds, another key ingredient in this recipe for disaster that will undoubtedly play a big role in taking the equity complex down at some point. And that point may be a lot closer than some people think.
What's more scary, at least as far as we are concerned, is that this recipe might also include our precious metals investments, even our junior holdings, some of which have already be beaten badly. An unbiased look at the TSX Venture Composite Index (CDNX), which is the best index related measure of this segment of the sector essentially, appears to be building a top, just like it's big sister, the TSX Composite. (See Figure 1)
And if that's not bad enough, just look at what happened to Harmony shares (a large cap producer) the other day, bombed some 30-percent on earnings concerns. Here, you should find it instructive no less than three high-profile chiefs managing South African operations have now resigned recently, caught monkey in the middle between rising cost pressures and rigged commodity pricing. So you see it's not just the juniors, or one locale being affected by macro-conditions, but the entire sector. (See Figure 2)
In this respect, and in moving our scope out to encompass this view then, it appears the market is quickly coming to the conclusion something must give, and with a possible deflation scare eminent this fall, it's most likely to be prices. And as per above observations, this rout will likely spare no companies, big or small, well run or not. Good examples of this are Etruscan (EET:TSX) which is threatening to break down in a measured move (MM) to $2.30, Orko Silver (OK:TSX-V) which just fell out of a descending / contacting triangle measuring to 50 cents, along with CopperFox Metals (CUU:TSX-V), which is sporting a measure back down into the 50 cent area as well. I own all three of these in size, and I'm not afraid to tell you 'we are not amused'.
Another thing I'm not amused about is how our banker buddies get away with rigging the price of precious metals year in and year out, where again, I'm not afraid to tell you this practice has undoubtedly cost us a great deal in lost opportunity all things considered. And it gets worse, where unfortunately bankers have perpetuated the ultimate 'rig job' on precious metals prices via Exchange Traded Funds (ETF's), where as the stock market falls, stressed players will seek to raise capital to cover margin requirements. So, if a deflation scare were to appear in coming days, it's my opinion gold and silver would properly reflect such a reality by falling.
Deflation scare - what if this turns out to be more than just a deflation scare? Of course this could always be the case, but I don't think our banker buddies are about to give up screwing the system. This means even if it runs the risk of gold escaping the bottle, undoubtedly a hyperinflation agenda will be implemented by the Fed once they realize the game of chicken with reality referred to above is lost, and prices are falling precipitously. What's more, it's important for you to realize that if price managers lose control of the stock market because short sellers are exhausted, then they will need to inflate with abandon, as is the case with all hyperinflationary episodes, where the 2000 - 2002 sequence will appear tame in comparison to what is coming.
Oh - what's this - some of you think hyperinflation in the larger economy is not possible due to the discipline bond markets are suppose to bring into the equation. While you may ultimately be correct, don't be surprised if Da Boyz try anyway, where not only would I expect to see the Chinese spend a great deal of their huge foreign currency reserves supporting US bonds, but more, if you're going to start this kind of thing, one might as well go the full nine-yards and attempt monitizing the bond market too. Just how long these characters think they could get away with this is of course germane, but at this point currency considerations will be secondary. The primary concern will be preserving the asset bubbles, which will be coming apart. This is why the $ could fall, and gold decline right along side until stability in the equity complex is re-established.
While these may not be popular views shared by both you and the investing public at large, we are not in the popularity business. What's more, it should be noted such a scenario developing has always been a real possibility with me, where just the other day we again highlighted parallels with the 70's experience were coming together. Again here, not only is a parallel of the timing associated with the 70's mid-term correction in gold looking more probable every day, but now we also have reason to believe price parallels are also possible, if not in pattern and exacting precision, in scale ultimately. Now wouldn't that shake some trees? (See Figure 4)
Again, this is why we are recommending you get your financial house in order now, because in just a few weeks it could be too late. Once all those short positions are squeezed out of the stock market price managers will lose control of the financial markets, at least for a while, and all hell could break loose.
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Good investing all.