Putting the Stock Rally in Context

I had previously been very bearish on equities, calling for Dow 7500 to be the level to short into. Sure enough, last Thursday the market started rolling over at that level on good volume and my trade thesis for a mini-crash looked good. The rally had all the characteristics of a bear bounce-- bounce from highly oversold conditions, descending volume rallying, lack of confirmation in credit spreads, BS news to qualify it.

Then Treasury Secretary Timothy Geithner announced the Public-Private Investment Program, which expanded the bank rescue to include the sub-AAA and legacy toxic assets everyone was looking to the government for help with. Bernanke and the Federal Reserve announced on March 18 that it would purchase $1.25 trillion in securities, $300 billion of which are long-term Treasury bonds. This quantitative easing was the first step in the United States government's insistence to throw everything it can at the market. Now, the PPIP allows banks to divest their toxic assets to PPIFs. The PPIF is given 14:1 leverage, financed of course by the US taxpayer through (eventually Fed-monetized) FDIC guaranteed loans providing 6:1 debt/equity and the Treasury providing half of the equity. The loans are non-recourse so it's a game of heads PPIF wins, tails taxpayer loses. The toxic assets are purchased at bank book-marked prices, which are ridiculously overvalued relative to market prices, but since the loans are non-recourse, the banks get to divest their toxic assets at a huge premium, the PPIFs are exposed to a very small part of the pricing differential, and the taxpayer has to pay for the depreciation of these toxic assets.

Whatever happens, whoever is left at the end of the game of "hot potato" with these toxic assets is exposed to very little of the losses because of the non-recourse nature of the leverage financing. Since the FDIC is insolvent, it is clear the Federal Reserve will continue to print to soak up the losses. This is a very significant divergence from previous market conditions, as now the toxic asset value depreciation is converted from bank equity depreciation to currency depreciation. If my predictions hold true, essentially what this will amount to is the Federal Reserve mopping up the legacy asset depreciation with printed money. The only question is if the Fed can do it, and I am very certain it can and will, considering foreign creditor nations can't exactly spark an exodus on their massive Treasury positions without killing their own economies. The Cold War taught us that mutually assured destruction leads to a lack of explicit aggression from both parties. We will see how it plays out.

I digress, however, from how this relates to capital markets. The new government backstops amount to Geithner and Bernanke throwing in everything at the market, including the kitchen sink. Since banks are able to divest their toxic mortgage backed securities and loans, they don't have to face further writedowns and losses and have equity left to the attraction of shareholders and investors. Thus far, the bailout ideas are not big enough to soak up all of the toxicity in the system, but with the QE and PPIP of last week, it has become evident that the government is willing to do whatever it takes, a la the Geithner and Bernanke puts. This is the "solution" to the financial crisis, but all it amounts to is its conversion into a monetary crisis. More on that in a minute.

The PPIP news sent the Dow surging through the important 7500 level I had been mentioning and into a confirmed rally. The strength and structure of this rally differentiate it from previous bear market rallies and I think this could hold for longer than ones before. I mentioned the Dow 7800 level as important resistance that this very overbought rally could sell off from, and indeed it has started pulling back. I expect a few more days of pullback before more sustainable upward movement. How this rally tackles index 50DMAs will also provide lots of context. I see lots of broken trendlines everywhere and that is of course bullish.

The rally however did start on news of Citi (C) and JP Morgan (JPM) posting "profits" in the first two months of the quarter. As I mentioned previously, these memos were a load of hot air and that needs to be priced in. The next wave of earnings, around late April-early May, should see huge losses and writedowns that equity markets aren't currently pricing in. Banks will also write down losses in advance of upcoming government stress tests and since the PPIP won't really get going until probably the third quarter of the year, banks will have a bad earnings season and their stocks will drop, bringing the market down with it. However, as more and more PPIFs show interest in the PPIP, the overriding investor sentiment will switch from "how toxic are bank assets right now?" to "how sound are the banks after divestment to PPIP?"

I think it is possible 6500 is the bottom, and I know a lot of perma-bears are calling for that, too. I think a strong move down is still in the cards for the market, probably starting in mid to late April, but the high from where it sells off and the low to which it sells off are anybody's guess. The next wave of selling, presumably in anticipation of and on earnings, could send markets to a higher low, setting in a 2002-like bottom, another deflationary crisis the Fed reflated from. Then again, we may stop rallying at current levels, spend the next couple weeks forming a rising wedge, and sell off to below March 6 lows on earnings. Either way, I think that the nominal bottom in equities comes this year.

What does this mean for the economy? Not as rosy as one may assume. The toxic assets remain toxic and malinvestment still needs to be purged from the system. Also, even though banks may be finding their saving grace in the unwitting US taxpayer (though the efficacy of these government programs can be argued), the same cannot be said about insurers, REITs, airliners, and other heavily indebted industries. At least yet anyway. The Geithner/Bernanke put is leading me to believe everything that needs a bailout will get a bailout. With printed money. There has been a massive expansion in the Federal Reserve's balance sheet (and still expanding) and all of the sequestered liquidity will be released into the economy in this manner.

Back to the monetary crisis I was speaking of. The reflation of assets by the federal government will lead to competitive devaluations by central banks around the world. The problem is, no other nation has the luxury of reserve currency status that America has. The entire world bought into the $13+ trillion Ponzi scheme known as the US Treasury and now that the game is up, they can't leave it without committing economic suicide. This (in my albeit heavily contested opinion) puts the United States in the unique situation of being capable of a lot more quantitative easing than other central banks, as well as forces a large part of the American recovery to be financed by foreign creditor nations as the Fed monetizes the government's exponentially-growing deficit.

Protectionism and trade contraction will undoubtedly take hold and hyperinflation is a very serious threat to the economies of Eastern Europe, Mexico, and ASEAN. The UK and Eurozone should face very bad inflation as they attempt to inflate out of crisis but their government debt isn't met with the same relative immunity as America's so they can't debt inflate the way American can eventually with its external debt. The Euro and Pound should see confidence crises in their currencies as their external debts and budget deficits start appearing unsustainable. Inflation should be bad in the United States, as well, especially once the Treasury market saturates and rates start rising. This should occur in tandem with an exponential rise in gold and silver prices. The US Dollar should make it out of this crisis (years and years from now) on top, however, relative to other currencies (but greatly devalued against hard assets and commodities) and the United States monetary hegemony may actually expand. This is far down the line, however.

Back to the present, gold prices are approaching a breakout at $1000/oz. I am expecting a big move in gold very soon, maybe mid next week, and as more liquidity enters markets from sidelines (the rising silver/gold ratio confirms this), gold stocks should also take off. I have been bullish on oil for a few weeks now and I think it and energy stocks are in buy-the-dip mode.

I would like to state here that I also believe that positions in savings accounts, Treasuries, foreign bonds, corporate bonds, non-commodity based mutual funds, IRAs, pension funds, and any other dollar-denominated assets should be liquidated into the safety of gold as soon as possible. The dollar (and eventually every other major fiat currency) are headed for sharp competitive devaluations against hard assets and as this financial crisis turns into a monetary crisis, it is imperative to keep your wealth preserved in precious metals and keep cash only for the most liquid of positions, such as checking accounts. American Eagle and Canadian Maple coins are my favorite modes of gold to purchase, as FDR's 1933 confiscation of privately-held gold may find relevance again in coming years. Coins (legal tender) are best, followed by bullion and digital currency. Paper gold and ETFs are worst.

The upcoming cataclysm in Eastern Europe and the policy uncertainty of Germany and the ECB should lead to Euro devaluation to follow the Dollar's recent course. A good currency to sell the Euro against is the Australian Dollar, which is heavily linked to commodities. Disclaimer: I am short EUR/AUD from 1.950. Britain, with its massive external debt/GDP (which is certain to grow substantially) faces huge currency devaluation, especially considering it has already started quantitative easing.

From current levels, I expect a pullback/selloff in the stock market, led by financials. I am short Goldman Sachs (GS) from $115 (near its 200DMA) and also own Direxion Financials 3x Bear ETF (FAZ) at 18.72 and ProShares Ultrashort Real Estate ETF (SRS) at 49.80. I will most likely be selling my ultrashort ETF positions in a few days. More stocks should set up for bullish moves if this rally is for real and I will be sure to post what I see.

In a few weeks or whenever I feel like the rally is topping out, I will start loading up big in FAZ and SRS and shorting my go-to bearish stocks for the earnings season sell-off I am expecting. However, it is imperative to remain objective, impartial, and flexible, so I will let the charts dictate my market analysis as events unfold.

I leave you with a sobering quote relevant to the expansion in government spending that is meant to "force" a nominal bottom and will have eventually have to be monetized, being financed by taxpayers, holders of Treasuries and dollars, and future generations of Americans.

No generation has the right to contract debts greater than may be paid during the course of its own existence.

- Thomas Jefferson

Disclosure: Short EUR/AUD, GS. Long FAZ, SRS, GLD.

Comments

[Larry House:]

Thanks for a needed dose of reality. The market bounces and euphoria sets in. It isn't that easy this time. The worst for the US$ is still ahead of us.

Mar 25 10:18 AM

[cash:]

Thanks for a nicely written article and a well explained thesis. Enjoyed reading it

Mar 25 01:26 PM

[Barking:]

nice article with well reasoned arguments.....you sound a lot like bill fleckenstein....

Mar 25 02:29 PM

[robert99:]

Yes, very well written article, and I agree with you on almost every point.

Mar 25 02:33 PM

[riskmgr:]

amazing article, great thought organization Naufal! and i can almost forgive the 10 degree hat tilt hehehe

Mar 25 02:53 PM

[Big-P:]

Nice article, solid advice (for the most part) but while you''re offering all of your advice why don't you also offer the single best piece of advice i.e. avoid taking it from the talking heads on CNBC!

Case in point--and this you cannot dispute--are the terrible calls made for over one full year by Don Luskin while babbling non-stop on Kudlow's show.

Don't take my word for it though, check out these vids for yourself-

donluskinisatool.blogs.../

Mar 26 09:59 PM

[Fish Gone Bad:]

All the problems with the economy did not just go away because Obama and Bernanke were on TV.

This is from: www.marketoracle.co.uk... -
In his speech Geithner admitted that, "In our financial system, 40 percent of consumer lending has historically been available because people buy loans, put them together and sell them. Because this vital source of lending has frozen up, no plan will be successful unless it helps restart securitization markets for sound loans made to consumers and businesses -- large and small.”

40 percent! Think about that. Nearly half the credit pumped into the economy comes from securitization.

In other words, the banks ARE lending; it's just that Wall Street's credit-generating mechanism is kaput. That's why the fall-off in auto sales, consumer spending and foreign trade has been so dramatic, unlike anything anyone has ever seen before. Wall Street's credit model is broken.

Most of the bad paper and non-performing loans appear to be concentrated in the very largest banks. By some estimates Citigroup, Bank of America, JP Morgan-Chase and Wells Fargo are holding two-thirds of all the toxic mortgage-backed paper.

Mar 27 12:40 AM