28 February 2013

Chris Martenson: A Steep Stock Market Decline Is Coming - Ritholtz On Risk On/Risk Off

'Life is a school of probabilities.'

Walter Bagehot

...and the tuition is paid in their miscalculation, especially through unintended consequences.

I had this from Adam Taggart this morning.  This is in no way an endorsement of Chris' conclusion, since I am loathe to make predictions rather than forecasts.  But I respect his work, so I thought I would pass it along to see how it plays out.

Quite a bit of his analysis is correct and I cite him often.  I find this market to be 'thinly bought' with steady rises on fairly cynical buying, with declines that are steep and sharp.  

The fundamentals are very wobbly both in US but especially in Europe.  China is unstable and Japan is in transition.  Political leadership is bad to say the least.

So I would say that the right trigger event to a market correction is something that I can see playing out.  However I would add the caveat that the nature of the trigger event will shape that correction, especially in the inter-market relationships and actions.  This includes type of event and location.

Chris' scenario works well with a supply/price shock in energy, or a new sovereign financial failure in Europe.

It does not play out as well with a US based trigger event, a trade war, or some stronger erosion with confidence in the dollar reserve currency system, or a civil dislocation.  Odds-wise Europe and China are better bets for the locus of the next crisis than the US.

Will the next crisis spring from a private financial occurrence like a bank failure, or a sovereign failure?  Will the unholy Trinity of Fed-Banks-Government falter?  Or will it be more political than financial, although the two are remarkably intertwined in this corporatist world of ours.

Note the time frame which is reasonably broad enough to encompass any number of events.  I would add another month or two, although I would expect that the signs of trouble would be pretty apparent by August, even to the extent of a bubble like environment more obvious than today.

And of course we cannot dismiss the possibility that nothing dramatic will happen, and things will stumble along as they have been, from small crisis to ray of hope, and back.  But with increasing levels of background hysteria as I have said we would see.  This could get a bit ugly before it is over.

I do think the monied interests are looting, on a somewhat wider than normal scale, and some recent market action is the buying up of lifeboats at artificially low prices by given the appearance of normalcy. But really, who can say what will happen?  In a market where stocks trade on their own supply and demand like commodities, rather than their underying fundamentals, the very act of betting against such manipulation creates the opportunity for insiders to manipulate even more. And this applies to all financial paper assets, including highly leveraged paper commodities with serious real world consequences, as we had seen in Enron's egregious manipulation of the energy markets.

I am not faulting Chris' analysis in any way.  I am just loath to stick myself to a forecast of a less probable event, given the wide number of variables that can take the storm in this direction or that.   With regard to the intensity of the storm,  as the unknown aphorist once said:
"Great designs have linear consequences.  Bad designs have exponential consequences." 

Have I given you enough possibilities to effectively make no firm prediction, thereby stressing the need for portfolio diversity and flexibility? I hope so.  I would rather make money than be 'right,' except for the longest term wager of all, which too many neglect.

However I am on alert, and will try to get to know what to watch, and then watch it.

I have lost quite a bit of money underestimating the willingness of frightened men in positions of power to engage in financial shenanigans, outright fraud, and seemingly irrational support for the rationally unsustainable. And I hope never to forget that lesson.  Fiat is a powerful drug.

But there will be no sustained recovery until the financial system is reformed, and so we will continue on in a state of fragility, as so eloquently expounded upon by Taleb.

La voilà.

"Chris Martenson is issuing an official warning of a major stock market correction within the next few months. He's only done this once before in 2008.

He's seeing a convergence of both technical and fundamental data that are flashing oversized risks to the downside for asset prices, despite the Federal Reserve's money printing mania which is showing signs of hitting diminishing returns.

He expects the fall in equity prices to happen within the May-September window.

This downdraft will be characterized by lots of volatility, formed by market routs and Fed-inspired rescues, alternating until some form of bottom is reached. Along the way there will likely be a flight for "safety" into the dollar and Treasury paper, but only during the first stage of this crisis.

Once a bottom is reached -- he expects anywhere from 40% to 60% lower than the current ~1500 level on the S&P 500 -- the process will begin to be dominated by rising government borrowing which will cause interest rates to begin to rise.

When that happens, expect capital to flee the paper market for hard assets. In particular, that's when the upwards price revolution in the gold and silver markets will kick into high gear."

Warning: Stocks Likely to Crater From Here

In a related vein, Barry Ritholtz has posted this very illustrative 'risk-on, risk-off' chart. As the 'risk-on' phase continues, the pricing of risk becomes increasing divergent from reality.

I would like to add the obvious that gold tends to move inverse to this, except when 'risk on' is being fomented by a general increase in liquidity that is causing most asset prices to rise. Then we have that odd phenomenon when gold and stocks move in a correlated manner. And similarly, when there is a general liquidation gold falls with stocks.

Gold often moves most strongly higher in a 'risk off' trade not driven by panic selling of everything, and moves lower in a 'risk on' trade driven by a mispricing of risk. I know that this may seem like thin beer, but it is what it is, and it explains why gold acts as a safe haven, but sometimes does not. Bonds have exhibited similarly odd behaviour.

As for stocks, it depends on the character of the market and the nature of the trigger event, to say whether we might have a crash, or just one hell of a correction, within some longer term trend.

So in other words, not all selling, like risk, is of the same character. You have to know the market behind the price, especially when price is used to mislead. If markets were rational and efficient, Wall Street would not have to cheat so much to win so often. Much financial innovation is merely engaged in the increasingly elaborate mispricing of risk in the service of fraudulent outcomes.
“Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design ... The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”

John Kenneth Galbraith
Politicians, like financiers, can make great personal progress towards power and wealth during new eras of innovation like supply side economics, privatization, globalization, and deregulation. What is particularly damaging is when the government, through monetary actions and/or regulatory inaction, extend and pretend if you will, supports this divergence between the promise, the risk, and the reality for its own ends.

The resulting reversion to the norm can have the impact of a thunderclap. So government becomes complicit in the control fraud which it abets, perhaps for certain policy ends, so that finally only those without conscience can abide it. And that is the genesis of the credibility trap, and the ascent of the careerists, and white collar sociopaths.
"All the truth of my position came flashing on me; and its disappointments, dangers, disgraces, consequences of all kinds, rushed in in such a multitude that I was borne down by them and had to struggle for every breath I drew."

Charles Dickens