Traders Intuition: Market Euphoria About to Come Crashing Down

My trader's intuition is flashing warnings that the stock market might drop off a waterfall starting this week.

Let's start by stipulating if I was actually smart then I'd be rich, and I'm not. Second, let's re-read the HUGE GIANT BIG FAT DISCLAIMER below to refresh our awareness that these are the rantings of an amateur observer, nothing more, posted here for free (Yes, you get what you pay for).

A trader's intuition, eh? Fa, fa, fa. That and $2 will get you a cup of coffee.True. So let's run through some charts.

The MSM is pounding us 24/7 with the "fact" that the GDP will print a rise in the third quarter and hence "the recession is over." Uh, do these charts reflect a growing economy?

Here's the good news: this is the sharpest stock market rally on record:

Nice--but how about jobs?

(Both charts courtesy of The Big Picture blog)

How about the household balance sheet?

How about homeowners' equity?

Gee, is negative equity rising? (homeowners "underwater" on their mortgages)

How about credit card delinquencies?

Don't tax receipts reflect the real economy?

But the American consumer never stops spending, right?

And home prices are rising, right? (Use a magnifying glass as necessary to locate rise)

But all those subprimers are out of the system, right? Their houses have been foreclosed and sold to investors euphoric over "catching the bottom in real estate," right?

Well, sort of, except that the "upper crust" market of prime and jumbo loans is deteriorating faster than an ice cube in the Arabian Sea. (See chart.) Foreclosures in the top tier of homes--those in the highest price range--have almost tripled since 2005 as a percentage of all foreclosures.

And which households were the big spenders? Most likely the ones with the biggest, priciest houses.

This chart alone blows the crowded "recession is over" boat right out of the water. If the households with the biggest mortgages and priciest houses are slipping into foreclosure at a rising clip, then precisely who will be spending at a high enough rate to trigger a sustainable rise in private consumption? (Recall that private consumption is 70% of the U.S. economy.)

So what are households doing with whatever cash comes their way? Paying down debt and saving cold, hard cash (See chart.)

Add these charts up and do you get a solid exit from recession based on growth in employment, household assets, household equity and household spending? No, you do not.

Let's face reality: the Federal government borrowed $1.4 trillion in the 2009 fiscal year (fully 10% of the U.S. GDP) and basically blew it supporting the economy in various ways. The Federal Reserve also funneled hundreds of billions of dollars into the banks and financial sector, creating unprecedented liquidity at near-zero rates.

That hasn't done much for lending (which is falling) or Main Street American business but it sure has handed investment banks plenty of free money for various speculations. (See chart 1.)

So where does this leave us? With a stupendous disconnect between the real economy and the high-flying, euphoric stock market. My intuition is the disconnect is about to resolved in favor of reality.

Take a look at a chart of the VIX--the so-called Fear Index. It is reflecting confidence and complacency--the perfect set-up for a market about to fall screaming off a waterfall. Recall that the VIX moves inverse to the market: if the market is rising, then the VIX is low, and if the market is falling, the VIX is rising.

This is a chart of supreme complacency--except for the indecision of those tall candles of the past few days. The VIX has shot up and fallen back in wild gyrations-- just the sort of action which typically marks tops.

How can we square this swaggering confidence in the stock market's relative safety with the rapidly crumbling real economy?

We can't.

When I worked in the back office of a small quant shop our clients were mutual fund managers--smart guys and gals. Does anyone actually think the smart players believe the Fox news-CNBC shills that the economy is fine now, so buy buy buy? Of course not. They're watching for any weakness to dump. The really smart ones have already hedged or fanned out of their longs. But many are waiting until the party ends, confident that there will be some warning bell that only they will hear.

But it might not work out that way. Perhaps the crowded room which will rise in unison and rush for the exit when the alarm sounds. This feels like the week the crowd rises and suddenly realizes there are thousands of traders and managers all heading for the same little exit. This is intuition, not analysis.

So by way of disclosure: I own calls on inverse ETFs which rise if the market falls, and I advised my sister to sell Monday morning--sell hard, sell fast, and go to cash. Sell the gold funds, the stock funds, sell it all. That is not advice for you, of course, it is only a disclosure. As I write this at 10 p.m. Sunday evening, the Nikkei index is up and the global markets seem poised to continue their giddy eight-month long party.

Time will tell if that long, deep gash left by reality below the waterline has doomed the ship or not. I'm sensing that it's time to grab a lifeboat and leave the milling crowd of party-goers with the unenviable risk of sinking.

Comments

[The Geoffster:]

Don't confuse me with the facts.

Oct 26 03:12 PM

[Mad Hedge F...:]

Nice article. When everything is working, and my portfolio is firing on all 12 cylinders, I pinch myself and ask “Is this real? What can go wrong?” I’m reminded of the slave whose task it was to remind conquering Roman generals “All glory is fleeting.” Virtually all of my recommended core longs in gold, silver, Canadian, New Zealand, and Australian dollars, Brazil, Russia, India, South Korea, Taiwan, Vietnam, and junk bonds are at or near highs for the year. I called the bottom in Natural Gas within 40 cents, and mercifully baled on my one short in US government bonds, the TBT. What we are seeing is a global surge in liquidity as cash emerges from the bomb shelter, squints at the day light, and then rushes to buy the first thing it can find. Everything is going up, regardless of fundamentals. It is the proverbial tide that is lifting all boats. You can make a lot of money in these conditions, but there is no way of knowing if this will last for one week, or another year. But they can go on much longer than you think. In the last two liquidity driven markets I traded, Japan in the eighties and NASDAQ in the nineties, fundamental analysts railed against the tide for years, claiming that stocks were overvalued, each call getting their office moved ever closer to the elevator and men’s bathroom. When someone finally did throw the switch on these markets, it got dark amazingly fast. Tokyo went out at an all time high on the last day of 1989, and then dropped a staggering 45% in January. NASDAQ plunged just as fast from its 2000 top. The one thing we can all be certain about is that the survivors have vastly improved their risk control after our recent crash. Make hay while the sun shines, but keep your finger hovering over that mouse. The level of risk is definitely high than it was in March. When the next real downturn starts, it could resemble a flash fire in a movie theater.

Oct 26 03:18 PM

[enigmaman:]

Ouch!! the truth hurts, I said earlier in another post that the Fed pulled us back from the precipice, but the danger to fall over it still exists, nothing has materially changed except that GS has made a lot of money, banking is the only sector that the Fed can honestly say it saved with its trillion dollar injection of capital, and by saved I mean " For now" the banks smelly toxic paper is buried under all that cash the Fed gave them.

Oct 26 03:21 PM

[JPDX:]

I predict November to be a big pullback, it started several days ago; we are in a correction right now.

Oct 26 03:54 PM

[squark62:]

about to meaning in 6 -10 more weeks. there's a scarcity in unrealized profits. that scarcity will be satisfied toward year end. soon after which is when to look for a "major" sell-off.

Oct 26 04:13 PM

[ryanclarke:]

This rally being "over" is up to Uncle Sam's decision as to whether the big banks should be honest or not with the losses they don't want to take in Q4 2009. I would wait to go all in "short" until the outcome of the upcoming November 3rd Fed meeting. If the Fed continues their easy money policy and leaves monetary policy the same as the last meeting ... look for the S&P 500 to rally into November with the energy sector leading the way and the financials fading. IF the Fed continues to do nothing but "jawbone" about raising short term interest rates ... the broader market won't take a big tumble until summer 2010 followed by more financial "sh** hittin' the fan" in the fall of 2010. Remember, it's not only the housing bust that brought down the consumer ... it took $4 gallon gasoline in the summer of 2008 to bring the consumer to his knees. WAIT FOR THE FED TO SHOW THEIR HAND BEFORE YOU PUT YOUR CARDS ON THE TABLE !!!!!!

Oct 26 04:46 PM

[fleeing omega:]

Very entertaining read!
As for timing the drop, it is hard since the factors underlying the post March rally are not as quite as transparent as some would prefer to represent. As mentioned above, this included a huge load of money that went from bailouts straight into speculation on Wall St. Those same murky forces will likely have at least some say on when the momentum does a 180 for real. Of course there is the case of the one GS mouthpiece who months ago declared SnP at 1100 by years end and we did just clip that rung, so maybe that's why the markets are a bit skittish and fund managers have their finger on the sell trigger?
I think this is a tough call and pulled out a while back and am biding my time.

Oct 26 05:14 PM

[Gary A:]

If we believe that Ben Bernanke is primarily a bond salesman, then we know that he has a boatload of bonds to sell. He doesn't want to continue to buy the bonds, or monetize them. He wants people to buy them and he can scare them out of stocks and into bonds if he needs to by pulling a little bit of liquidity off the table.

Oct 26 08:42 PM

[untrusting ...:]

Good point and yes Bernake and Geitner are the biggest bond salesmen in the galaxy. Note that bond fund purchases are running about 20:1 to stock fund purchases as Morningstar reported a few weeks ago that 2009 stock fund purchases were only about $15 billion but bond fund purchases were over $250 billion. And Bernake and Geitner have only just begun selling bonds, they have years more to go on that program.


On Oct 26 08:42 PM Gary A wrote:

> If we believe that Ben Bernanke is primarily a bond salesman, then
> we know that he has a boatload of bonds to sell. He doesn't want
> to continue to buy the bonds, or monetize them. He wants people to
> buy them and he can scare them out of stocks and into bonds if he
> needs to by pulling a little bit of liquidity off the table.

Oct 26 09:05 PM

[Donald Ingram:]

There is no recovery. Stock market is full of hot stimulus air.
A broken global credit market.
Increasing Federal debt.
Lack of transparency in mortgage backed securities.
Mountains of consumer and corporate debt.
High Federal budget deficit.
Expanding bail outs.
Consumer economy destruction.
Monetization of the National Debt.
Chronic high unemployment.
Hedge funds - borrowed short/lent long at more than $500 billion.
Double wave of mortgage resets.
House prices continue to fall.
Large shadow inventory of foreclosed houses.
Impending collapse of commercial real estate.
Huge crises lurking in over-the-counter derivatives.
Under funded pensions.
Impending municipal bond and municipal bond hedge fund failures.
Increasing number of bank failures.
Insurance company collapses.
Worsening state, county and city budget crises.
No confidence in the US dollar.
Ongoing asset deflation with currency inflation.
A decrepit falling apart infrastructure.

Recovery is here! Spend! Spend! Spend! Buy more everything!
Happy days are here again! Stock market zooming!
Okay fine. Good luck with that.

Oct 26 11:11 PM

[chris coonan:]

Funny, and a good review of the charts.

I think Thursday or Friday may see the big fall....but you never know.

Intuition bolstered by reality.

Oct 27 01:22 AM

[HolySmoke:]

A very good presentation!!! And well thought out.
I agree that a major correction...or even crash...is coming. But I think we are currently seeing a fairly normal, and expected, October pull back. We are entering that period of time when the big Fund and institutional players begin cleaning up their portfolios for fiscal tax reporting and rebalancing. Booking profits, shedding losers, reallocating funds, etc., etc. This sell-off could excelerate for a bit---or not---but I think the rally will again emerge into November and toward year-end into January. Sometime in the 1st QTR / 2nd QTR 2011, however, the REAL sell-off should begin in ernest as the "Recovery Theory" starts falling on deaf ears and the 'smart money' bails. Quickly, too.

Oct 27 02:56 AM

[proudgrampa:]

Nice job. Makes me feel better about my SPY puts and DIA puts. Now if we can just get the market to agree with us!

Oct 27 11:55 AM

[TinyTim:]

Good read.
If your intuition is correct, you will look like a genius (except you have too many disclaimers).

I'd Rather Be Lucky Than Smart
Unfortunately, I'm neither.

I hope this article doesn't turn into a self fulfilling prophesy.
IMHO. the market will hover until the Fed changes QE.
Which isn't to say it won't hover 10-15% below where it is now.

Oct 27 01:51 PM

[rob134:]

Last Wednesday I overheard heard three different couples discussing their stock market purchases, in a restaurant, in one hour. I went short the market Thursday.

Nov 03 07:26 PM