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The market spiked higher on Friday and it was certainly not what I expected. With stocks indices on a nominal basis at all-time highs as company after company signals trouble on the horizon -- think Caterpillar (NYSE:CAT), Fed Ex (NYSE:FDX), Oracle (NYSE:ORCL) -- I would have expected a little profit taking going into the weekend. Add to that the very real threat that the eurozone could begin to implode next week. Investors are apparently in complete denial.

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Are these stocks anomalies or prescient warnings? Is the economy improving -- as most pundits claim -- and getting ready to confirm that we are now in a secular bull market? Should we heed Chairman Bernanke's claim that 4th-quarter GDP was a fluke and 1st-quarter numbers will show that we are still growing?

I don't think so. How about this excerpt from a news item on my Forex news feed on Friday:

U.S. industrial output was slower in 2012 than initially thought, reflecting slow economic growth last year in the nation's factories, mines and utilities.

Industrial production advanced 2.7% in the fourth quarter of 2012, 0.2 percentage point below its previous estimate, according to annual revisions by the Federal Reserve released Friday. The new figures include additional data not in earlier reports, as well as some recalculations of seasonal factors.

So, are we about to confirm a new secular bull market? I think Doug Short's long-term inflation adjusted chart dating back to 1871 with regression channel included provides a clue. The chart below reflects that the 2009 low just made it back to the long-term regression trend line as Doug points out:

Historically, regression to trend often means overshooting to the other side. The latest monthly average of daily closes is 54% above trend after having fallen only 11% below trend in March of 2009. Previous bottoms were considerably further below trend.

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In my view the chart above suggests we have one more really big leg down. The peak at the high in 2000 was followed by a lower high and lower low. If we do have one more down leg left in the bear market and that takes us to the lower end of the regression channel as we saw in 1921, 1932, 1949 and 1982 then we have a long way to go.

Traders and investors almost always ignore the negative data at market tops and tend to push prices beyond what is rational. Keep in mind that even though there is a decidedly bull side bias to the chart above there is a lot of red on the chart too. In other words, despite popular opinion of late markets do go up and down - not just up.

Greed tends to overcome the rational decision-making process at market tops. That greed is nurtured and fed by a steady dose of optimism in the face of pending doom. Consider the spin this Reuter's author puts on the Cyprus crisis and it is a crisis as we will discuss below:

Wall Street Week Ahead: Cyprus deal could spur S&P 500 to new peak

Stocks could break through to all-time closing highs next week - provided a resolution to the fiscal woes of Cyprus satisfies investors.

The island nation accounts for a fraction of euro zone economic output, and yet the wrangling over a 10 billion euro ($13 billion) bailout package kept markets on edge throughout this past week. The S&P 500 fell for the first time in four weeks, with weakness linked to uncertainty overseas.

I admit to a bit of frustration in that I want to sound a warning yet I don't think anyone will listen until it is too late. My point is a simple one - the stock market is overextended and price matters. Consider these bullet points:

  • We posted negative on GDP in the 4th quarter of 2012 - now adjusted to a .1% positive (that may be revised downward based on the Fed statement above that virtually no one reported).
  • We have some bellwether stocks providing very prescient warnings, i.e., and
  • We have the eurozone in recession and the metrics in that economy are deteriorating at a rapid rate.
  • We have China slowing down and also suggesting the need to battle inflationary forces.

Now we have the very REAL likelihood of a bank run in the eurozone and a flight out of the euro. The list of negatives are too numerous to cover here and we are at all time highs on the stock indices in nominal terms. In other words, if we do crash there will be a lot of reasons the pundits can use for why we did. Of course the one that will get the headlines is the run on the European banks precipitated by the irresponsible decision to tap depositors in Cyprus.

So how does all this play out? Is Cyprus just a no-account economy that makes no difference? Should we just ignore it? Is this another case of "crying wolf"? The relatively miniscule size of the Cyprus economy would suggest that it is indeed rather insignificant in the scheme of things. After all, we are only talking about $6 billion euros. One can argue that there are a good number of private citizens in the world who could just step in and buy the whole country and its banks by themselves.

That's not the point though and if that is how you see it you are seeing it wrong. The point is that Germany drew a line in the sand with this decision. The eurozone banks and sovereigns are in a horrible mess and they need German money to keep the ship afloat and not just in Cyprus. If the depositors in Cyprus can be tapped for bail-out money then depositors in other sovereigns can as well -- at least that is the message.

And the message is getting through to those with funds in the euro system despite the fact that stock investors don't seem to get it -- yet. Consider this excerpt from SA contributor Carlos Alexandre:

Then Cyprus popped out of nowhere, despite the fact that it had been brewing for a while, and the handling of the situation is hard to comprehend. Either they thought that the very small country could be bullied into submission, or they are truly running out of money. Time will tell, but all the money I had in Portugal came home this week in dollar form, and I know plenty of individuals doing the same through electronic transfers, not waiting for the bank to open the door. I was taught that it's better to be safe than sorry.

Here is the message - the decision to tap depositors could set off a firestorm across the eurozone as depositors make a run on the banks and there are more risks here than meet the eye. I will address a few of these in a moment but consider that Cyprus has crossed the line now by approving the use of "capital controls" - a strict taboo based on EU protocol.

To the best of my knowledge at this time we don't know the nature of the "capital controls" but we do know that the Cyprus Parliament authorized their use in a vote Friday night. Suffice it to say that the nature of the controls will not be well received and designed to prevent capital flight out of Cyprus.

If I had funds in the eurozone banks I would be more fearful of "capital controls" that prevent me the freedom to move my money than I would be over the potential loss of a portion of it. It is reasonable to assume that even a modest run on the banks will force other eurozone governments to impose their own "capital controls" even if a bail out is not imminent.

The implications are serious for the euro. Just as Mr. Alexandre states "it's better to be safe than sorry." Isn't it a real possibility that the euro will be dumped in mass as fear and anxiety begin to seep into the psyche of those who hold their wealth in euros?

Right now the only country that will restrict you from moving your euros is Cyprus and maybe that is the only country that will impose such restrictions. On the other hand, it is also possible that the message being sent by the Troika is that future bail outs will require shared risk and if the money isn't there in any other form the depositors will be tapped.

Seriously, just think outside the box for once. Do you really think that politicians and central bankers tell the truth? Wouldn't it be irresponsible to add to a problem by expressing your own fears in public - especially knowing that in doing so you would likely precipitate the crisis yourself?

The EU's problem is that it has a unified monetary system without a unified fiscal system. I suspect that there are more than a few who see it that way as well but don't expect them to announce those feelings. On the other hand, you can read between the lines if you are so inclined.

As a practical matter, the decision to tap the depositors of the Cyprus banks is a decision made by Germany. The truth is that without Germany the funding to support the needed bailouts is not there and Germany is sending a message loud and clear - we won't bear the brunt of the problem ourselves. I made the following statement in response to a readers comment and I think it articulates the situation adequately:

The eurozone - as configured won't last decades. Nobody can even explain why it exists at this point. On the other hand a bad idea takes a long time to die as it requires the admission of failure and few seem willing to do that. Perhaps the Germans are a little more pragmatic on this point.

By the way, that assessment can be applied to the monetary and fiscal policy of Japan and the United States as well. We have attempted to stave off economic collapse resulting from a very irresponsible use of debt by incurring more and more debt and trying our very best to monetize this debt with equally irresponsible monetary policy.

It hasn't worked though - anywhere. Look at Japan's lost decades. Look at GDP, inflation (moving toward deflation), money velocity and unemployment in the U.S. How much has it cost us to get zero GDP growth and 15% unemployment (using the U6 number) in the U.S. since coming out the Great Recession?

The answer -- about $8 trillion -- almost as much in the last five years as we borrowed in all the previous administrations combined going back to the beginning of the Republic. That is the "Law of Diminishing Returns" in full play. Keep in mind our current leaders didn't create these problems - they inherited them. I readily admit they played the hand they were dealt as well as they could and ran a hell of a bluff but in the end you are not likely to win with a pair of deuces.

Here are my concluding thoughts. The decision to tap depositors is not an isolated case but a very deliberate decision intended to send a message and that message is that the German's are no longer willing to subsidize the EU. Don't assume they think everything will be OK either as they know full well the impact of this decision.

Over the next few weeks we can expect a much lower euro dollar, a much higher U.S. dollar, higher bond prices and lower stock prices. My take on gold is not so clear. In one sense the higher dollar should drive gold down but the shock waves could be severe and confidence in all fiat currencies could suffer in a way that drives traders to the metal in droves.

Bottom line - I could see gold moving much higher in the short term but for the wrong reasons. I do see a sharply higher dollar as the euro heads down and much lower equity prices. Don't be surprised if the short end of the yield curve turns negative either. That already happened on the German 2-year - last Thursday I think.

Assuming I am right that the euro dollar plunges precipitated by a mass exodus and a run on the eurozone banks, equities are certain to fall sharply but not all the implications are so self evident. Consider the "carry trade." Pimco announced last week that it had reduced exposure in the euro. The "carry trade" has serious implications going forward.

Those who have exchanged U.S. dollars for euros in order to take advantage of the higher-yielding bonds in the eurozone are fine as long as the two currencies are relatively stable. But what happens if the euro falls in value and the bonds held by the investor also fall in value as they certainly will? The impact can be devastating and a rush to the exit can create a global systemic collapse as traders attempt to unwind these trades and discover that there is no one willing to take them off the hook.

Here is an example of a "carry trade" explained by Investopedia:

A "yen carry trade": a trader borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% as long as the exchange rate between the countries does not change. Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar was to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.

The implications are well beyond the scope of this article. Frankly, I am not sure what happens if the euro dollar has a precipitous fall as I don't have sufficient knowledge of the magnitude of the "carry trade." I do know that those who have exposure will get hammered and those with highly leveraged positions could really get hammered. Longer term, the impact to GDP in the eurozone would be positive as demand for eurozone goods would be greatly enhanced. That of course assumes the eurozone and the Eurodollar survive and there is a least a case to be made for why they won't survive.

One last point - as far as I see it there won't be many places to hide if the euro collapses. U.S. treasuries are a good place but supply is very limited as the Fed has taken a huge position here. The U.S. dollar makes sense but again, dollars are in very limited supply at the moment and I can't imagine anyone wanting to part with their treasuries or dollars in exchange for euros or anything denominated in euros in the scenario I see evolving.

When everyone wants U.S. treasuries and U.S. dollars and no one wants euros the stability of the markets are severely undermined. Price movements can become exaggerated and create a negative feedback loop that recalibrates all assets in rapid fashion. Perhaps this is all just another case of "crying wolf" but I don't think so this time.

Source: A Pending Market Crash Waiting For A Catalyst - The EU Delivers