On June 20, I penned my first SA article in a long time. We were at S&P 1280. I concluded:
a. Technically: I don’t see 1250 as a meaningful support. The first Fibonacci retracement at 25% from the July 2010 lows is at 1277; the next one at 38.2% is at 1231. The most likely, should this turn bad, is the 50% retracement at 1190. This also happens to be the 25% retracement from the major March 2009 low. If the driver is Europe, this was obvious on Wednesday: the market reversed Tuesday’s gain of 20 odd points, while the Euro lost 3 cents against the dollar. On Friday, it only regained 10 points of course, while the Euro regained 2 cents. On the upside, the pivot points are 1286 and 1302 but, in the absence of substantial improvement both in Europe and in Washington, I am not willing to consider them until the “hard patch” broadly recover. This was one of the conclusions of my book. For once, politics drive the market.
I was so emboldened by the readership that I went on record with a series of articles titled S&P 500 Target 1190, starting on July 13. We were at S&P 1317. I was calling for some short term supports in the 1260-1280 area, still with a target of 1190. Once we got there on August 4th, I revised it down to 1150.
We almost got there on Friday, when we hit a low of 1168. I wrote this Monday August 8 at 13:25. We have been consolidating in the 1150-1160 area since 10:30 and I don’t recall ever seeing such an advance/decline: 76 to 3056 on NYSE! The numbers and the speed make this feel like a crash, so naturally a flurry of analogies is out there. If we stop at this level, it will have been an extremely painful 15% correction, as its speed made it very difficult, if not impossible, to sell stocks. By the way, the only reason we would stop at this level is because it is the 61.8% Fibonacci retracement level of the 1018 low of July 2010 to the 1364 high of May 2012. As I wrote this, we just broke to 1145 – this is a bad movie, rated NC-35.
So, let’s talk analogies. The first one that comes to mind is 1987. The charts look alike, but the reasons are totally different. There was a housing boom, inflation at 4% had doubled from 1986, industrial production had gone from an annual rate of change of minus 2% to 12%, real GDP was growing at 3.5%. Earnings were constantly being revised upwards, for a P/E of 20, and while the Fed funds rate was increasing from 6 to 7.25%, the market was focusing on growth. It went up 44% to the August high. Valuations were certainly not the same as today: the earnings yield was 5% with the 10-Year TB at 10%.
In the meantime, Greenspan had been appointed and was a relative unknown, to replace famed Paul Volcker. He was fearful of looming inflation because of full employment. On October 18, Treasury Secretary James Baker suggested the dollar was going to weaken further, despite having gone down 50% against the Yen and 30% against the Franc since the Plaza accord in 1985. The next day we had Black Monday – a combination of high valuations, rising rates, prospects of a Fed-induced economic slowdown and Treasury-induced dollar related inflation, some rumblings in the Persian Gulf, and...program trading.
In other words,, this was a crash driven by the economy.
What we have here is a financial crash, hence my analogy with 2008. Simply put, the tip of the Iceberg was the April-July 2010 period, akin to the July-August 2007 period. A year later, we have the real problem. Then it was subprime and CDOs. Now it is Sovereign debt and CDSs.
Is it different this time? Yes, but I am not sure whether this helps. The big difference, certainly with 1987, is that we have already used all the conventional tools in the Fed toolbox, and then “some”, $1.7 trillion. So whereas I am quite sure Greenspan and Baker did not anticipate that their actions would precipitate a crash, they were able to react to it by using the conventional toolbox. We can’t do that. At the same time, there is plenty of liquidity around – that was not the case then. This should buffer the downside.
With regards to 2008, same thing. The liquidity is there. Even though banks hoard it at the Fed, it’s there. $1.7 trillion. That should take care of a few bad loans. Which leads to my next point, which I think is the missing piece of the puzzle.
John Mason, one of my favorite SA contributors, gave me the hint. Foreign banks got $500 billion out of the $600 billion QE2. By now, and I have been vocal on this, everybody should know the EFSF is a Ponzi – see my Charles Dickens quote. The ESM is no better. So I asked myself, why these schemes? Why not the ECB, directly?
The answer is dire. The ECB capital is $11 billion. That’s a trickle.
So we are back to a game of chicken, this time on an international level. What we know is that we printed money, and that Europe took it. Let me venture another thought, this time not emboldened by viewership but by “I can’t take this anymore” ship sh*t. What has to happen next is that Europe prints its own money, and we will take ours back. There is no reason in the world that we should finance Europe – we did this during the wars, a rightful thing to do, and I am not sure we got a thank you note for that. There is no reason they should gloat about their Debt-to-GDP ratio, supposedly lower than the US. What happens if, instead of selling their debt to our Fed, they sell it to their ECB? Oops. Ask S&P…
To conclude, so that I can turn off this screen and maybe enjoy a drink – or five , things are different this time, in terms of policy response. We did our part, and we may have to do some more. The ECB has done a bit of this, a bit of that. The UK, for sure, has done a little bit of this, but none of that.
Well, get off the pot. Recapitalize the ECB, and swallow the paper you’ve issued over the years to be popular and reelected. We know it, you know it. Let me tell you what happens if you don’t. Either the “bad guys” get out of the Euro, back to the recurring “I devalue my currency to be able to borrow”, or the “good guys” get out of the Euro, back to the “you are on your own, guys”. I tell you what, if any of these two scenarios occur, buy. In the meantime, don’t.
What’s in it for us? This is a tough question to answer after these past few days. For a while I thought we would hold the SP 1150 level. Clearly, we tried but we did not succeed. Do not listen to fundamentals; this is the biggest trap when the issue is a financial crisis. In such a crisis, liquidity comes out of the market, indiscriminately. The only thing that can eventually work is Technicals, but even they lose relevance in a crash.
At this point, I have to stick to my previous thought. We decisively broke SP 1150, to close at 1120. The next stop is around 1020. Unless, of course, the Fed and the ECB take my advice – you’ll be the first to know.