How Much Downside Could Still Exist?

 |  Includes: DIA, EEM, QQQ, SPY, XLF
by: Rakesh Saxena

From the prism of facts pertaining to previous recessions, the risks, including systemic risks, within the broad American financial framework are now fully priced. The problem is that, unlike in the case of previous downturns, the American economy today is heavily integrated with the rest of the world and, as a consequence, “extraneous” factors which could drive the major market indices significantly lower from yesterday’s closing levels need to be comprehensively recognized.

Those analysts who are looking for value (buy-and-hold) this week are failing to grasp the potential impact of four compelling developments (briefly outlined only in this article) which are going to shape America’s financial and economic future, specifically the value of American assets, stimulus packages regardless: (a) the crisis in Eastern Europe, (b) the structural collapse, including the meltdown in manufacturing, of the economic fabric in countries like India, China, Brazil, Russia and Turkey, (c) the increasingly unfriendly environment for foreign private capital in South America and (d) the rise of political Islam, beyond Iran, to Pakistan, Bangladesh, Somalia and Central Asia.

Properly considered and fully contextualized, all four factors point to further downside in the S&P 500 (NYSEARCA:SPY), the Dow (NYSEARCA:DIA), the Nasdaq (QQQQ), the emerging markets (NYSEARCA:EEM) and the financials (NYSEARCA:XLF). This writer has exited all short positions on the stated indices and in financials as of today simply to close out a strategy predicated on (a) the S&P 500 reaching 700 and (b) the inherent flaws in bank balance sheets. But the hard facts still make a persuasive case for reinstating shorts on rallies, triggered either by technical considerations or by an abundance of spin (penchant for rosy scenarios) in relation to the succession of rescue and bailout plans.

Any number of fund managers appearing on CNBC, FOX and Bloomberg since last week have been calling a market bottom, without being able to explain, with any acceptable degree of precision, the basis upon which they are forecasting corporate earnings. In fact, most analysts are proving to be hopelessly inadequate in translating today’s multi-faceted investment climate into credible and sustainable trading recommendations.

All former Soviet satellites, without exception, are finally confronting a reality which was more than apparent to this writer shortly after the fall of the Berlin Wall: that the transition from communism to a free market, in economic terms, was never cogently presented, documented, debated or scrutinized. In brief, democracy and freedom were no substitutes for economic imperatives. “The crisis in Eastern Europe is already shaking the foundations of the European Union,” a senior Hungarian cabinet minister told the BBC yesterday. “It is also challenging Washington’s view of post-Cold War Europe, though no politician dare acknowledge this in public.”

The structural collapse in leading emerging markets has its own dimensions. Real unemployment is breaking all historical records, middle-class household balance sheets are in tatters and infrastructure spending is so haphazard that it will do little to boost consumer demand in the foreseeable future. Poverty levels vary from region to region; but, as a rule, the failure to adequately tackle impoverishment, despite all the promises and programmes since the Second World War, is creating a series of well-grounded protest movements which will inevitably result in the legislation of higher subsidies and greater protectionism.

Impoverishment in South America has already led to anti-capitalist governments, usually through electoral mechanisms. As the many protagonists of Bolivarian-style social justice continue to implement their political agenda, it is not too difficult to predict a spate of nationalizations in the food, agricultural, mining and energy sectors.

Finally, there is the issue of failed states, and the scope for substantive instability, and a heightened risk of terrorism, following the growth of Political Islam. While American and NATO forces in the Afghanistan-Pakistan theatre are targeting Al Qaeda and Taliban militants, populous nations like Pakistan and Bangladesh are being torn apart by modern-day fascism. This is not the forum to engage in a detailed analysis of the economic ideology of Political Islam; for trading purposes, it is enough to conclude that religious extremism of the Islamic variety is essentially unfriendly to western capital (e.g. Iran).

So when comparing today to earlier recessions, or even the Great Depression, it is important to understand that the globalization process of the last 60 years has brought with it a unique, and as yet unquantified, risk-reward profile for the American economy. By all accounts, Wall Street has been unable to comprehend the sheer complexity of today’s financial and economic environment. The less said about Washington lawmakers and regulators, the better. And, as far as systemic risk is concerned, Ben Bernanke’s definition is proving to be entirely academic, restricted by numerous, self-serving scholarly texts of the 1929-1939 era.

Stock position: None.