End Game Dynamics
The following is an excerpt from commentary that originally appeared at Treasure Chests for the benefit of subscribers on Wednesday, December 26th, 2007.
Central banks are now showering the economy with accelerating quantities of fiat digits like never before, which is having the effect of extending the current boom cycle even longer in spite of the natural tendency for system failure. Not too long from now however, and in spite of these efforts then, like a game of musical chairs enough participants will be expelled from the festivities in natural process, which is an eventuality that cannot be avoided no matter how much intervention is exercised. Moreover, it's the fact monetary debasement rates need be accelerated to this point that is the signal we are now in the final rounds of the game (end game dynamics), where like in musical chairs, if you are prepared and with a little luck one might be the one left standing at the end. And while this might sound fine for those prepared people, don't kid yourself, what's coming here is not going to be pleasant for anyone, as the hangover from the credit binge we have been on for some 25-years now will not pass in a day or two, meaning living standards are set to decay rapidly.
The musical chairs analogy was used above because quite frankly I could not think of a better one, but at the same time it may not fit the bill in capturing the essence of what could occur as we move into the future either. In this regard, what I am referring to is true on two levels as well, those being this is not a child's game being played; and secondly, I'm not sure if a game of musical chairs captures the essence of an implosion, which is more akin to what is happening to our financial system at present in my opinion. Here, what's happening in the bond insurer arena at present is a good example of just how fast things can change in terms of institutional underpinnings, where all of a sudden investors are waking up to the fact this insurance isn't worth the paper it's written on, and that for this reason neither are the contingent guarantees (credit worthiness) of all the companies being covered. This of course has system wide ramifications as a result, with the primary side effect of the bugaboo being the days of cheap money for corporations have now passed.
One does need wonder just what is going through a rational bond investor's mind now then, where in spite of hot inflation data traders appear sanguine with respect to holding treasuries this year, as evidenced in capped 10-Year Treasury Bond Yields (TNX) and a restrained yield curve. Once we hit January however, things could be very different, which would provide impetus for a resumption of the stock market sell-off with overly optimistic gamers needing to purge stale positions from 2007, along with long-term investors selling profitable positions now that taxes will be deferred until 2009. What's more, at issue here is just how long foreign bondholders will remain sanguine with respect to their holdings, where even if they were to simply continue slowing purchases of US issues this would be enough to push market rates higher at the margin. And one of these days market rates will push past the ability of authorities to keep them contained through monetization efforts, with the season of discontent in this regard now upon us.
Not surprisingly then, the great deflation / hyperinflation debate continues in real time, with forces at opposing ends of the spectrum both intensifying, but with mother nature the sure winner in the end, meaning gravity will eventually prevail. Here, we all know about how monetary authorities are attempting to make it appear 'all is within hand', and that they will paper over whatever comes our way. Unfortunately for them however, history has proven such an attitude naïve in the full measure of time, where other forces, such as changes in speculative tendencies within the investing population, come to light. And while I am not professing to know exactly when a combination of exhausted monetary stimulus efforts combined with altered speculative trends will be sufficient to tip the equity complex over, I can tell you we are getting closer by the day, along with the fact more and more people are beginning to notice.
In this respect then, at present we all know monetary growth rates are through the roof (with growth rates approaching historic highs); and that sentiment, as measured by short sellers, is also at historically high extremes. So, for those observers / investors tuned into this frequency, attitudes remain positive with respect to the future based on these metrics, along with the fact year-end window dressing is surely a concern for distressed money managers. And while others would be quick to point out year-end tax related selling and continued pressure in the credit markets are holding prices back, as you may know we would not agree with such an assessment. In fact, we would tend to view things from the opposite side of the street, where were it not for seasonal / tax related / year-end buying the stock market would be imploding right now. Don't blink however, because as alluded to above once this buying dries up gravity should take hold to bring prices back down to earth. And if observations associated with the charts below are any indication, this could occur anytime after January Effect buying should dry up in the second week of the New Year. (See Figure 1)
And if observations contained in the above have merit, in spite of all the liquidity injections occurring and promised into the future, it appears overall (liquidity) conditions may have already improved as much as can be reasonably expected measured by yield spreads, meaning both the yen (the primary global liquidity measure) and CBOE Volatility Index (VIX) would turn higher if yield curves did the same. What's more in this respect, it should be noted libor rates are now heading lower all right, which is taking pressure off the system temporarily, but that spreads between short and long dated contracts remain high, implying more trouble is on the way. This is why when we isolate our conversation to expectations associated with volatility, and as highlighted in the VIX plot below, while managed efforts to dance prices higher in coming days may continue to be marginally successful, it should be noted most of the gains have already occurred, and that the prudent investor need be more worried about gravity at this time, not hot air. (See Figure 2)
Moreover, and to emphasize this point, it should be noted this volatility will likely not be limited to the equity markets, but to debt markets as well, with seasonal weakness for US Treasuries dead ahead. So, while price managers may have brought the dollar ($) back up (allowing room for it to fall again), which would compensate for rising bond yields somewhat, it should be recognized that the US can ill-afford any disruption to its mushrooming foreign capital needs, even though official statistics continue to do a sorry job of measuring reality in this respect. Here, the true measure as to what is actually happening behind the scene is better monitored in yield spreads for forecasting purposes, where even if rates magically (due to monetization) remain subdued, stress in the system will still be reflected. And again, this also applies to trends in the yen and VIX, as noted above, where as with yield spreads unexpected reversals higher in coming days (after the first week in January) should be anticipated.
Further to this, and in refining comments made the other day in reference to patterning in the Dow, it's not a head and shoulders pattern being traced out, but that of a diamond, considered by some to be the most profound reversal pattern in technical analysis. And just like in the 1999 / 2000 sequence, with all the same timing and Dow Theory considerations confirming this thinking, if history is a good guide, then a top in the blue chips should be expected at options expiry this coming month, with the same for large cap tech heavy indices (think NASDAQ 100) in March. This patterning / timing possibility is reflected in the VIX plot above with a potential triangle (ending diagonal?) being traced out in coming months, but where it should be remembered that history does not always repeat (although it often rhymes), meaning a more extended topping process is not a prerequisite to a meaningful break lower in stocks anytime after early January. This possibility is reflected in potential patterning denoted in the ProShares UltraShort QQQ ETF (QID:AMEX) plot shown below. (See Figure 3)
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Good investing in 2008 all.