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Please Don't Shoot The Messenger But The Party Is Over

I have been the bearer of bad news for several weeks now and I am not getting a lot of love. I'm sorry my message is such a downer but recent price action suggests that my message is probably right.

Take a look at the S&P 500 chart below. The high on day 179 (September 14, 2012) was the day after the Federal Reserve announced QE3. Since then we have been moving lower and have come off of the highs by about 50 points as of yesterdays close. This is not a good sign for the bulls who think that the Federal Reserve is big enough and powerful enough to keep the market moving higher in spite of the terrible underlying fundamentals.

My best guess is that the market is currently composed of 20% bulls, 20% bears and 60% bears who think that QE3 will move the market higher in the short term. Those in the 1st category are probably going to consider my argument a lot of nonsense. Those in the second category have probably already moved to cash or taken protection. This message is for those in the 3rd category - those who recognize the serious nature of the underlying fundamentals but still believe there is just a little more upside to this market.

Explaining the chart

My analytical approach is multi-faceted. I am primarily a fundamental analyst and focus heavily on the macro picture. I do look at charts and consider Elliott Wave Theory and Dow Theory primarily so I can understand how other traders might be viewing the markets. I understand chart patterns as well and do pay attention to bull and bear formations and the various continuation patterns that invariably form.

Although I do look at the charts I put very little stock in their predictive value. Nevertheless, I do know that trading stocks off the fundamentals can be a costly undertaking. John Maynard Keynes was not just an economist - he was also a trader of considerable renown. At one point Keynes was forced out of the markets by a margin call leading to his often repeated observation on the risks of trading off the fundamentals:

"The market can stay irrational longer than you can stay solvent."

Understanding the risks inherent in a strict macro approach and having very little faith in the various technical tools others use, I developed a rule based strategy several years back that has proven very reliable as an indicator of trend shifts. The S&P 500 chart above is the product of my work.

You will notice there are 5 bands on the chart above with the closing price for the S&P 500 laid over the top of the structure created by the bands. The bands are based on statistical calculations and establish the outer limits of market price.

The center band is the mean value of all data points. The band above and below the mean represents a one standard deviation shift. The outer bands represent a two standard deviation shift.

Statistical analysis tells us that 65% of the time the next data point (close value) will be contained within the one standard deviation band and 95% of the time the next data point will be contained within the two standard deviation band. A close look at the chart above establishes that this is the case. For your edification I will tell you that this is always the case.

The chart by itself is of little value. It only provides a framework for applying a set of rules for making entry/exit decisions. These rules are discussed more fully in my article on rule based strategy. The strategy has accurately predicted the 3 major moves in the market this year to within one standard deviation of the lows. I have no reason to assume it won't be equally accurate in predicting the next major move which is back down to the lower band at two standard deviations below mean. The signal is not generated until market momentum is sufficient to move the market a full standard deviation in the direction opposite the trend. That value for the S&P 500 is 1419.

What the macro view tells us

As a fundamental analyst I prefer to consider the big picture first. I use the chart above and specific rules to make entry/exit decisions but I never feel comfortable in the markets unless I have a thorough understanding of the macro picture. I have written extensively on the macro view and it is not good. There is really no logical reason to assume that the markets will not move much lower from these price levels.

Quantitative easing has not produced the intended results and you need to understand that fact. I strongly encourage you to read my articles on fractional banking and the liquidity trap.

These articles set forth the truth about QE and support my premise with factual data. My position is that analysts who support a bull market perspective based on expectations of inflation and monetary expansion are leading investors down the wrong path.

A third article that I encourage you to take a look at gives you my take on what is likely to occur in the coming months. It is a pretty specific call on the direction and the magnitude of the next major market move.

I have been an investor and an analyst for over 40 years and I rarely make major fundamental market calls. I have made just 4 such calls in the last 20 years. I have been correct in each instance as my calls were based on strongly compelling fundamental data that showed current price levels were dramatically distorted. It is very rare to see the markets set up like this and so it is very rare that a macro analyst will be in a position to make a call with certainty on a major market move.

Most of the time the market has already priced in the fundamentals and therefore is already priced at reasonable levels. The situation today is different. Reality is not being priced in and in fact I have never seen the markets price and the underlying fundamentals so dramatically distorted.

What should you do?

I will tell you I am not a "permabear" as some like to refer to those with a bearish take on the market. I am a macro analyst and put great stock in the economic metrics that we use to measure economic health and the effectiveness of monetary and fiscal policy. As a Keynesian it is hard for me to conclude that Keynesian theory has failed to steer our economic recovery in the desired direction.

I believe in Keynesian theory just as Ben Bernanke does but I don't have a vested stake in perpetuating a failed policy as Bernanke does. My reputation is not at stake and I refuse to take a stubborn view of the situation by going all in on a bad hand. The truth is that we are not expanding money supply; inflation is not at all imminent; we are not growing GDP and we are not making headway on the unemployment issue. A deflationary spiral is the more likely outcome at this point and commodity prices are already signaling just such an outcome.

So what do you do from here? We are still in a safe zone on stock prices and there is still time to take profits. I advise you do that and go to cash. The idea that you must be invested to beat inflation assumes that inflation is imminent. It is not and all the data points to the opposite - deflation. Again, please take a look at some of the work I have done on this subject. It is an eye opener.

As I have said repeatedly cash is actually an investment asset. Its value moves inversely and in direct proportion to the asset you are currently holding or considering buying. In other words if you go to cash and the stock you sold goes down in value by 50% the value of your cash relative to that stock goes up by 100%. Those who would tell you that you have to be invested in something to protect against the impact of inflation assume inflation is a foregone conclusion.

The inflation chart suggests that deflation is just as likely as inflation. We can see that despite all the fiscal stimulus and the various easing initiatives inflation has been a particularly stubborn problem for the Fed. Keep in mind that inflation is what they are trying to create with QE. What is actually occurring is disinflation - a decrease in the rate of inflation.

Stock analysts are employed by company's that sell stocks. A bearish view that advocates going to cash is simply not acceptable. Who is going to talk themselves out of business? The same applies to business journalists. They too rely on investor's participation in the markets for their livelihood.

I don't see it that way at all. I think the best approach is to recognize where we are and take positive action to capitalize on the next major leg in the market. Today we have a number of ways to capitalize on a downturn in the market. Bear ETF's can be traded in every major sector. In addition, the options markets offer vehicles that you can use to protect long term positions without selling your stocks. The VIX is another way of protecting against downside risk.

I am not a dooms day prophet and I don't have a crystal ball but I believe that we have interfered with the natural cycles that markets go through and the result of that interference is a more protracted contraction and of longer duration than we would have if we had just let the market rapidly complete the deleveraging process at the start of the recession. If we had done that we would now be on our way to a recovery that might look similar to the boom period from 1980 to 2000.

Those good times will return but we have some work to do first. Irresponsible fiscal policy that has operated on a buy now, pay later approach for decades means that we finally have to pay the piper. We must attack our deficit spending with a renewed vigor and bring our debt to GDP ratio back in line. We have reached a day of reckoning and we must now accept the fact that we have dug ourselves a huge hole and there is no easy way out.

Nobody wants to concede that we are going to have to finish the deleveraging process that was started back in 2008 but the truth is we will have to deal with it sooner or later so why not get started now and be done with. We can continue on the current path for a while longer but inevitably we will find ourselves in a situation that is completely unsustainable much like Greece is today.

Yes, it will put us into a recession but I am reminded of a time 32 years ago when President Reagan and Paul Volcker were confronted with a similar situation. Volcker raised interest rates to 20% and rapidly flushed out the weak elements of the economy. A lot of bankruptcies were the result but in a matter of a year rates started back down, confidence in the future was restored and we launched a recovery of unprecedented magnitude and duration.

That era launched by Reagan and Volcker ended in 2000, largely as a result of returning to the easy money days of the 70's. The sooner we conclude that a Reagan/Volcker approach is the only way out of this mess the sooner we can start back on a path of growth and regain our confidence in the future.

In the meantime I suggest you protect yourself. These artificially inflated stock prices won't continue for much longer and the risk relative to the potential gain is wholly unjustified.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short tech stocks, financial stocks and crude oil. I am long the dollar index futures contract.