There Will Be No European Liquidity Crisis: The Instable Equilibrium (Part IV)

Jul.27.12 | About: SPDR S&P (SPY)

Return to Part III

In a year or so, since I started contributing to SA for fun and fame, I got the fun part. Now it's time to claim my right to fame. It's called "The Instable Equilibrium." To get to it, sorry to say, you'll first have to go through the preamble. When you're done, press whichever button you see fit, to either spread the word or trash me… Of course, if you chose the latter, your computer will self-destroy, but this should not influence your opinion.

Market first. The Dow Model I published two days ago is history. Intraday, I had covered my shorts at DJII 12725 (NYSEARCA:DIA) and S&P 1342 (NYSEARCA:SPY). By the close however, the IShares $ High Yield ETF (NYSEARCA:HYG) was stubbornly behind. This led me to conclude:

The Model looks more positive than in the past three weeks. This begs for a rally [but] HYG is not confirming the trend […] and I cannot ignore this divergence. […] Let's see who wins in the next few days, the Model or the Black Swan.

The Model won, of course, but that's because of the Super Marios -- see the timeline below, in support of my new theory, the "Instable Equilibrium." As far as what this means for the market, I take my cue from the Dow Model. Thirteen stocks have now clearly broken their resistance levels, up from 10 yesterday, most notably Wal-Mart (NYSE:WMT) and ATT (NYSE:T) -- at the time of this writing on Friday. The previous upside target was DJII 13021. For good order's sake, we will probably test 13000 for a bit, but the Model suggests we are going to 13300, which would match the April highs. In terms of the S&P 500, this equates to 1400, and I would push for 1425, on the way to 1600. Needless to say, HYG is fully participating.

Now, here is how we got there.

Out of my 45 articles, the ones that best summarize the timeline of my thought process are a series of four. First, there was S&P 500 Target 1190 -- this is when we were grappling with the prospects of the Greek abyss in mid-2011. In the fall, this turned into "S&P Target 1600", a combination of The P/E Decompression Stampede and Europe Shrugged, Not Atlas, while the perma bears were not yet hibernating.

But the one that got the most attention and controversy was There Will Be No European Liquidity Crisis. How could I dare say this, in the midst of all the haircuts, write-offs, headlines, and claw-backs? Was I impervious to Wall Street and the City's pain and suffering -- and the Greeks, and the Italians, and the Spaniards, and the French? Was I a traitor, some kind of La Fayette, or worse, a Scarlet Pimpernel?

In retrospect, the script followed the timeline. Somewhere, I summarized it this way: guarantee, sanitize, monetize, nationalize, securitize, and ultimately, privatize again. We are three-fifths of the way through the process.

I also cautioned that there was no easy cure, mainly from a socio-economic standpoint. One of my Instablogs of the times is titled, The European Anthem: The Ode to Joy - Nice, But No Lyrics. If Europe cannot sing its anthem in one voice, don't even try to put Humpty Dumpty back together, and certainly do not compare it to the U.S.

The other point I made -- on the concept of a European taxing authority which could in turn issue bonds to fund European needs -- was simple: in our country, whichever state you are from, you pay your share to our military and social system. Over there, the question is as simple: which country will accept to relinquish control over military and social programs, and entrust Brussels or Luxembourg, of all places, to administer them?

This brings me to my new concept, the "Instable Equilibrium". The best example is liquid nitroglycerin. Extremely powerful, it is used to blow mountains, build roads, open tunnels -- but don't shake it. That's what massive monetary stimulus is: the Super Solution, but it can blow up in your face.

Now, why would this be the Super Solution? Simply, because there is no alternative, short term, to massive monetization of the gargantuan debt out there. Remember, it's a process. A short term solution to a generational problem is called a shock. We don't want this. We do not want to either massively raise taxes -- government debt is simply that, deferred taxes -- or massively cut expenses. Both lead to social unrest and, depending on the size of the problem, to war.

Chairman Bernanke has known this all along -- see his speech before the National Economists Club in November 2002, entitled "Deflation: Making Sure It Does Not Happen Here." Trichet was keenly aware of the problem, but as French technocrat, and a low caliber banker, he preferred politics to action -- "Un Euro Fort!"

Mario Draghi, however, is more of the Bernanke school. Actually, he studied under two Nobel prize winners in economics (Modigliani and Solow), held top directorships at the World Bank and the Italian Treasury, was Governor of the Bank of Italy -- and… managing director of Goldman Sachs International in 2002-2005, when the same GS was underwriting European Sovereign bonds left and right. So he knows, too -- and he knows well enough to give the straight talk to the Bundesbank.

The same goes for Mario Monti, former European Commissioner for Financial Markets and Trade. The alternative is simple: on the one hand, the stark reality of a European Depression; on the other, the theoretical risk of hyperinflation.

Here is where the "Instable Equilibrium" comes in. Historically, the Germans are right. But I posit this for one reason only: when this type of monetary and socio-economic problem has occurred, it usually affected one country -- Germany, Mexico, Argentina, Brazil, 14th century France, 15th century Italy, Russia, Japan, the U.S. in the 1920's -- or a group of countries, i.e., the Asian Tigers, etc. These were relative problems, their own "disequilibrium," It affected them relative to the rest of the world. So their solution, too, was relative. Remember the German loaf of bread going from 1 mark in 1919 to 100 billion marks, a round number, by 1923?

In the present case, the problem is worldwide, with a few exceptions. So if every block inflates its monetary base at the same pace relative to the size of its own problem, a loaf of bread will be worth 100 billion euros, 100 billion dollars, and the equivalent in yen. This is no longer a relative shock to be absorbed by one block. It is an absolute shock absorbed by everybody. I call this the "Equilibrium."

It is instable, however, because this would be an historical first, and because the size of the problem is different among the blocks. The end result may be that a loaf of bread would be worth 50 billion yen equivalent in Japan, 100 billion dollars in the U.S., and 250 billion euros in Europe. Still better than Weimar… or a war.

The next step actually comes from the Weimar experience as well. In November 1923, the rentenmark was introduced at the rate of 1 trillion papiermark for one rentenmark. We'll just reset our currencies worldwide, by dividing them by 100 billion. Philippe Le Bel did it -- he just lowered the metal content of the coins in circulation. De Gaulle did it too, when he introduced the "nouveau franc" in 1958.

A year ago, I outlined my Three Little Pigs Scenario -- we were at S&P 1280: either (a) a repeat of the collapse for the straw house, built by the PIIGS Building Company; or (b) hurricane damage to the stick house, built by Fibonacci from Italy, wiping the roof down to the mezzanine level at 1190; or (c) a much higher house, built by Dr. BenBee, "a well-known TV handyman with a bag full of tricks, to include a new structurally engineered material called QE […]. If it worked, he would have repaired the whole system."

The Super Marios are now teaming up with Dr. BenBee, and it looks like it may be working. Whether it's earnings, a P/E stampede, or liquidity, Atlas has not shrugged, it's simply humming along. And Europe is finally listening: a practical solution is better than a theoretical problem. In the meantime, do not watch the euro too closely. Remember, the Equilibrium is Instable, but we are getting there.

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