The Imminent Equity Implosion

Since March 6, the SPDR S&P 500 Index ETF (SPY) is up 28%, driven by the recent surge in financial stocks, quantified by the 80% rally in the SPDR Financials Index ETF (XLF). The rally has left bulls calling bottoms and reverting to familiar long-on-margin methods from bygone bull markets, while leaving bears whipsawed, short squeezed, and scratching their heads.

Yet the state of the economy doesn't justify a sustainable turnaround in equities. Commercial mortgage backed security delinquencies are not only increasing, but still accelerating, as the commercial real estate market heads for implosion. The unemployment rate (as estimated by Shadow Stats by reversing absurd Clinton administration revisions to unemployment data calculations) is at 19.8% and still rising. Taxes are rising to finance massive state and local budget deficits in the midst of underfunded public pension funds and increasing municipal credit risk. The Eastern European crisis is just beginning. The United States Budget Deficit for the first fiscal half year was a staggering $1 trillion. With toxic depreciating assets collateralizing the massive deficit spending and the Fed printing trillions to mop up the damage, gold should be skyrocketing if lending and spending has returned and the economy has turned around. But it isn't.

The fact that the market is rallying while the currency markets show a lack of sovereign credit risk immediately puts me into skeptics' camp. I actually believe a nominal bottom will be reached in equities this year, having full faith in the coordinated powers of Ben Bernanke's printing press (known as the Federal Reserve) and Timothy Geithner's $13 trillion Ponzi scheme (known as the Treasury). But the asset depreciation causing the equity depreciation will not simply disappear: it will be transferred to holders of dollars and Treasuries in the form of currency depreciation. This will be a global phenomenon, as Britain and Japan have entered full-fledged quantitative easing mode as well, with the ECB being pressured away from its anti-inflationist stance with the Eastern European debacle on its heels.

But that is simply not occurring. The markets suggest that all of this government spending (which will eventually all have to be monetized) has magically plugged in all the holes and filled in all the cracks of the financial crisis without even approaching a monetary crisis. This is pure buffoonery. What is occurring is a government-led bear bounce that will lead to a crippling sell-off in equities and an explosion in volatility.

Aside from the absurdity in believing it is commonplace for bank executives to include specific figures on forthcoming earnings in memos, the January and February “profits” announced by the likes of Citi (C), Bank of America (BAC), and JPMorganChase (JPM) are but smoke and mirrors. The revenues are largely due to (absolutely absurd) taxpayer-financed AIG trade unwinds of questionable legality and are announced with no note of the bite write-downs will take out of them. Wells Fargo (WFC) pre-announced an unexpected $3 billion profit for Q1 2009 on March 10, sending the markets soaring on the news. But it was a game of deception: WFC only increased reserves for loan losses by $4.6 billion and expensed charge-offs to the tune of half the (Wells + Wachovia combined) previous quarter as economic conditions worsened.

So why are banks promoting this disinformation in the midst of a credit crisis? Because they want to pass off asset depreciation to the taxpayer by selling equity at inflated prices and they know the government is on their side. Goldman Sachs (GS) is already planning a multi-billion dollar share sale and more and more of these will start popping up on newswires in coming weeks. Banks want to raise cash by issuing equity ahead of non-bank earnings, which will again unmask to the public the abyss known as the current global economy, and around their own earnings, which they have manipulated into being met with temporary optimism with the help of one-time AIG trade unwind profits to amplify otherwise-weak revenues and a clear underestimation of the write-downs that will bite into them. The FASB's easing of mark-to-market accounting also allows for the temporary and artificial perception of stability in banks, only to set up for an even more drastic fall later as toxic assets crash from par to zero. The Treasury's new Public-Private Investment Program is yet another government scam to pass off bank losses to the taxpayer but the news of toxic legacy securities being added to bailout priorities sparked a massive rally. All of this is being done to pass on asset depreciation to the public through equity issuance at inflated prices.

The internals of the rally are where things really get interesting. Volume is nowhere to be found and the rally has been led by a series of overnight gaps up. Short-term liquidity is driving the markets, as last week NYSE program principal trading volume was 21% above its 52 week average while overall NYSE volume was 9% below its own 52 week average.

Sustainable equity market trends are dictated by the long-term directional players, but these market participants are not buying into this rally. The constant overnight gaps higher are being met with low volume action during market hours with no follow-through of price action to rival that of the gaps up. This is indicative of unsustainable behavior, as the core equity market players are decreasing participation while short-term liquidity players like quant funds are massively increasing their participation.

Of utmost relevance is the fact that Goldman Sachs (GS) is behind much of this increase in quant fund trading during this rally. As ZeroHedge notes in a very engaging article about these liquidity disruptions, Goldman's program principal trading accounted for an enormous 5x the volume of its program customer facilitation and agency trading. The over 1 billion shares principal for Goldman last week was more than 3x the next closest firm and is indicative of the government using its girlfriend Goldman Sachs as the intermediary for PPT work.

All of this points to the banks and the government luring in the public to the “bottom” so that it can trade bank equity for cash before the forthcoming avalanche of Alt-A, CRE, and CC resets that will cause more defaults, more write-downs, more deleveraging, and less equity.

As I stated before, the government stimulus/bailout (now extended to legacy securities) will in my opinion be enough to “force” a nominal bottom in equities, mainly because the Fed's printing power is essentially limitless. The FDIC insures all bank deposits up to $250,000 and the over $4 trillion of insured deposits is money that cannot by law leave the money supply. Since the FDIC is currently insolvent (having enough cash to insure about 1.2% of these deposits), the holes will be filled with printed money from the Fed. The existence of the FDIC in itself debunks the risk of long-term deflation. However, the malinvestment still has to be purged (through currency devaluation) and this depreciation risk has not been factored into this market at all, judging by the pullback in precious metals during this massive equity rally. This leads me to believe that this rally is not indicative of an economic turnaround and is unsustainable, meaning more deflation is still at hand.

Banks are merely setting up for a lot more losses they and the government know they will face. The US Treasury is delaying stress test results until after major bank earnings. It wants this rally to continue as long as possible before banks sell equity and pass off losses to a fooled public. Paul Volcker, the man behind the Great Disinflation of the 1980s that saved the US Dollar, is currently being ignored by the Obama administration. He is in place as an advisor for future crippling inflation, as the government fully expects to transfer bank asset losses to the taxpayer through the inflation tax.

Back to the issue of short-term liquidity participants, however, the upcoming quant fund deleveraging will cause an explosion in volatility as market liquidity becomes hard to come by and selling causes more selling and wider bid/ask spreads. The dislocations will in my opinion cause a massive equity sell-off as the game of hot potato ends and the economic fundamentals once again become the topic of news debate (rather than the magical world of Margaritaville Kool-Aid).

The volatility should push gold much higher, as it has recently become the safe haven of choice after the Fed's quantitative easing transferred credit risk from banks to sovereign bonds. The recently increasing gold/silver ratio indicates liquidity is diminishing and also gives support to the idea gold could explode from here. Technically, it is pulling back from importance $1000/oz resistance and if it can take that out, it should begin its dramatic move up that I have been predicting. It is in a falling wedge and bouncing off its 200DMA so it may be on the move very soon.

We are in very overbought conditions (click chart to enlarge), with the McClellan Oscillator in November 2008 and January 2009 territories, adding more pressure to the rally. In a very interesting article, Cobra quoted a Stock Timing report that suggested net institutional buying had a consecutive series of extreme levels seen only twice during the last bull and not once during the last bear. This is not how markets bottom and is clearly suggestive of the “forced” nature of this rally, with full aiding, abetting, and sponsorship from the United States government.

Articles like this are clear contrarian sell signals. As this “irrational exuberance” eventually wears off, look for the news to switch to articles more reminiscent of October 1987, August 1990, August 1998, November 2000, August 2007, January 2008, September 2008, and February 2009.

The coming commercial real estate implosion is going to be disastrous. REITs have announced secondary equity sales and have suspended cash dividend payments, issuing equity instead. The Eastern European crisis is crippling Western European banks and their sovereign central bankers. The muni bond and pension fund crises have yet to surface. The unprecedented deficit is still rising and has started being monetized.

Wealth destruction is still occurring, folks, and is getting much worse by the day. The bottom won't be here until the Dow/gold ratio is at 1, as is historically indicative of a bottom after a major contraction. The Goldman equity sale is going to be an important event in my opinion, since it is largely Goldman's program trading arm that is sustaining this rally. Whenever it does begin, I expect stocks to tank and gold and credit spreads to surge. Tax time is coming up and you can bet the smart non-institutional money will come pouring out of equities into precious metals (cash and government bonds are no longer viable long term safe havens due to the global coordinated quantitative easing, as confirmed by the transfer of credit risk from corporate bonds to sovereign bonds).

I think it is possible we sell off right back to March lows and possibly even break them (with the usual suspects leading the way down-- banks, insurers, REITs). I think it is possible gold trades around $1200/oz once this equity selloff runs its course. But I think it is impossible for the government to magically soak up toxic asset depreciation without devaluing the currency it prints for that purpose.

This is the scam of the century.

Disclosure: Long FAZ, SRS and GLD.

Comments

[mrmillergd]

Well said. Debt doesn't just go away. Even in low/no growth environments, you are still expected to pay it back. Accounting magic can't hide the faults of a stumbling economy.

Agree that things still feel like deflation, especially considering precious metals have yet to make new highs.

2009 Apr 13 11:23 AM

[User 353732]

The common person, when surveying the past several years, might be tempted to conclude that there is a peculiar divergence between financial and real estate markets( on one side) and the real economy.
Financial and real eate markets are, as we all know, far more debt driven than the real economy. The more real estate debt exploded and real eastate related financial technolgy proliferated, the more real eatate began to assume the characteristics of a financial market and the more it too began to diverge from the real economy. This disunity between financial and real markets seems to be still intact.
Indeed, as government debt not merely replaces but actually augemts, aids and abets private debt, financial markets continue to be highly debt driven. In contrast, the real economy faces expensive and tight credit conditions(especially consumers, small and medium businesses). As long as the tremendous concentration of undisciplined debt drives and distorts financial markets(and to a lesser extent its younger sibling, real estate) , I think,as a common person, that this divergence will continue. Not for years, of course....maybe not even for many more months. At the end, the real economy will force convergence.
I think the common person is puzzled by what they see, hear and experience in their daily economic life and what the financial markets are telling them to believe. Maybe the financial markets are just so much smarter and prescient than the common man that they are right and we are plain wrong.

2009 Apr 13 11:38 AM

[pstrusi]

Excellent article, not only cause I could have a short position ( I have not any yet ), but also as technical trader I see very strange signals of this rally.
I'm pretty sure that a lot of people are gonna get caught long on april-final waiting for a May rally to sell, but they'll realize it's late.

Personally I'm studying the best timing to initiate my shorts.

I still think we're gonna have more of this deflation phase, now the most important is to hold but cash.

Good luck

2009 Apr 13 11:38 AM

[ArkansasAngie]

I'm getting a tad bit ticked off. OK ... maybe more than just a tad.

It's time to take mops and brooms and bleach to Washington. They can either come clean or they can go down the drain with the rest of the scum.

They say bankers are leaving -- the brain drain you know.

Super duper! Hot dog!

So ... who is hiring these charlatens? I want to know so I can avoid having anything to do with them. Their new companies will make my list of do not buy stocks.

Actually they've probably all landed jobs with the government.

2009 Apr 13 11:43 AM

[raytayzmd]

...uh. yeah, right!...I seem to recall "Goldman Sachs Is Toast" a few weeks back...more like your short is toast!...LOL!

2009 Apr 13 11:54 AM

[Prospector4]

Thanks for providing a broad synopsis of some strong bearish arguments. Your article (especially the last three lines) may prove to be very prescient with time. Until then, ignorance is bliss and all swans are white.

2009 Apr 13 12:24 PM

[Barking]

He sure makes a hell of alot of sense......EVERYTHING he says is based in common sense and fact....until the day comes that we know exeactly what these banks have on their balance sheets we wont reach a bottom....the major banks are insolvent and corrupt and only still alive because of govt support/collusion ....the are bankrupt and hence, as a country most likely so are we.....gold/silver will EXPLODE in the coming months...

2009 Apr 13 01:09 PM

[Fish Gone Bad]

I have been thinking about how this rally will pan out. Options expiration is this Friday. Maybe FAZ can fall to $5 before this monster dies of a heart attack.

2009 Apr 13 03:05 PM

[doubleguns]

Seems a 50/50 bet at this point. Government manipulations a hard nut to crack. It can drive the market opposite of what we would expect. Gold wins in either direction so make sure you have your 10-20% handy and then place your bets on the rest of the market they way you see it.

Place your bets and lets see where the roulette wheel stops. Just make sure you have some gold chips in your stack.

If none of this interests you sit this one out!!!! Go to cash and wait.

2009 Apr 13 03:17 PM

[Rohan C. Pease]

GS capital raising is being used to buy private equity assets at distressed prices. In my book it looks as if they are capitalizing on an amazing and profitable opportunity. I won't go as far as saying that the rest of the big banks are ok, good trades nontheless, however Nafaul you are so dead wrong on Goldman Sachs. Their earnings tomorrow will crush estimates. People need an example, look at my comment string on "GS is Toast" by Nafaul on March 9th, its embarrasing, I don't know why everyone thinks this 19yr old hot shot has anything good to say, Nafaul you are all smoke and mirrors!

2009 Apr 13 03:34 PM

[Rohan C. Pease]

Also when looking at indicators for economic growth you don't look at precious metals, you pay attention to base (industrial metals) ie copper, platinum, etc.

2009 Apr 13 03:54 PM

[bobby12345321]

but he's probably made more money then you... hehehe

2009 Apr 13 03:57 PM

[Rohan C. Pease]

Doubt it I got long BAC @ 3.07, you do the math, this idiot tried to short GS twice over the last month.

2009 Apr 13 04:05 PM

[Naufal Sanaullah]

i don't suggest precious metals are a barometer for economic growth-- they're a barometer for asset depreciation being socialized into currency depreciation by government spending, however. if we truly are turning around in credit markets, precious metals should be surging because last time i checked, spending money you don't have doesn't bring back real growth, it just transfers losses to other people (taxpayers).

yes, yes, i got stopped out very quickly everytime i tried shorting Goldman. maybe this prediction will make up for it.

2009 Apr 13 04:17 PM

[Bunse]

"for an Arab kid"? Damnnnnnn... Your response could use some work!

I'm surprised that you forgot add: "you are a credit to your race", and "you speak so well for a ...".

No bigoted statement is complete without these two classic chestnuts.

I'm a bit angry that Mr. Sanaullah spends the time to put together such a well reasoned argument, shares it with the rest of us, only to be greeted with such bile.

Full Disclosure: I'm a crooked hat bigot.

(Come correct, son! You aint on "Wildin' Out"!)


On Apr 13 01:09 PM Barking wrote:

> for an Arab kid with moppy hair and a crooked hat he sure makes a
> hell of alot of sense......EVERYTHING he says is based in common
> sense and fact....until the day comes that we know exeactly what
> these banks have on their balance sheets we wont reach a bottom....the
> major banks are insolvent and corrupt and only still alive because
> of govt support/collusion ....the are bankrupt and hence, as a country
> most likely so are we.....gold/silver will EXPLODE in the coming
> months...

2009 Apr 13 05:52 PM

[chux08]

Great article. It's nice to know that being (basically long) in SKF & SRS at their new lows as well as having some long shares in AUY, MFN & MVG and I think I'm on the right track too. 30 ounces of gold and 2500 ounces of silver setting in a GoldMoney account safely overseas doesn't hurt either.

Goldman who??

2009 Apr 13 06:11 PM

[DaveW]

Cetin, you're a kid whose centient awareness of the economy only spans the repeal of the Glass-Steagall act. Our economy was not expanded in any meaningful way, consumerism was expanded in the most meaningful of ways. A house of cards it was and will be if constructed again.
When will people like you learn? It would be better to burn the house of cards and build something meaningful in its place. Sorry, but our standard of living must plummet along with the markets to obtain a more affordable American worker who can be the driving force behind a new industrial and export driven economy. If we get a 'do over' here, let's not do the last 15 years over, let's try something that will work.


On Apr 13 04:27 PM Cetin Hakimoglu wrote:

>
>
> That's not true. The use of debt to
fund
> growth is one of the great economic achievements of recent
history.
> Wasteful deficit spending is bad, but when used on initiates
that
> create value such as tax cuts and stimulus, can expand the economy.
>
>
> On Apr 13 04:17 PM Naufal Sanaullah wrote:
>

2009 Apr 13 06:27 PM

[dcb]

I have reached the same conclusion as this author.

2009 Apr 13 07:40 PM

[The Geoffster]

Excellent article. Thank you.

2009 Apr 13 08:34 PM

[Tmacc]

Brillant Article! Yes debt can provide growth. This Treasury debt is reckless. It is just plugging a hole. Without growth the debt will grow until it is unsustainable.

2009 Apr 14 01:00 AM