While You Were Sleeping

Another disappointing GDP print, and the markets seem to be reacting with a shrug.

Look closer, though, and it’s apparent the markets are teetering.  Many currencies and equities reached the point where they should correct yesterday, and now appear to be tipping over the edge.

The magnitude of the correction is still a question, but it should start either today or Monday — as long as central bankers don’t do anything to upset the bears’ apple cart.  But, they wouldn’t do that, right?

In one of the more disturbing videos I’ve seen in a while, Goldman Sachs Jim O’Neill came on CNBC [watch HERE] and said he thought it was just great that 23% of central bankers recently surveyed were either buying stocks with their reserves or will be soon.

The top reasons given include diversification and yields on government bonds that are too low.  One fellow interviewed for the Bloomberg article remarked that it was a “very logical move” given that stock dividends [at 2.2%] were higher than bond yields [1.69%.]

I could devote today’s entire post to the idiocy of this train of thought.  Thankfully, 70% of central bankers agree with me and still consider investing in equities “beyond the pale.” But, many of these same bankers probably never thought they’d be locked in a defacto currency war, printing currency non-stop to “stimulate” their economies.

Global central bank currency reserves currently total about $11 trillion.  This compares to the S&P 500’s market cap of $13 trillion, or the DJIA’s of $4.3 trillion.  But, of course, a market can be stabilized with the timely purchase of a handful of key components, as we have seen many times when the Plunge Protection Team swings into action.

While many have characterized the PPT as the imaginings of the tin foil hat-wearing fringe, it’s easier to accept the concept and envision the construct given these survey results.  This survey merely brings one element out of the shadows and into the light.

If central banks feel free to buy stocks, is it much of a leap to think they might time those purchases to “help” the markets in times of need?  I don’t think it’s a leap at all; it’s more of a foregone conclusion.  But, the terms and mechanisms used obscure what’s really going on.

The Bloomberg article points out the Fed and the Bank of England have “no mandate to buy stocks directly” — which is a little different from saying they have no hand whatsoever in buying stocks.  By providing virtually unlimited and free cash directly and indirectly to banks — the Fed most certainly supports stocks.

For example, when Goldman Sachs — which in 2012 had $47 trillion in derivatives exposure against $20 billion in tier one capital — sees a swap going against them, they can tap their rich uncle for a low interest loan to help prop up the underlying [see: The Wipeout Ratio.]  We frequently see this in the futures markets — especially overnight in what are known as “ramp jobs.”

Some might wonder whether a caring and benevolent government that steps in to avoid market meltdowns is such a bad thing.  We want our banks, insurance companies, pension plans and trading partners to stay solvent, right?

There’s no question that we do.  But, stock prices are supposed to be driven by the “free hand” of the market, where values are driven by widely divergent views on opportunity and risk.  Should participants come to believe there is no longer any risk, prices will move even further out of line with the fundamental drivers of value.

When inevitable black swan events come along (an earthquake, a Lehman, an AIG, a sovereign downgrading, a tweet, etc.) they could overwhelm the support structure in place, triggering an even bigger financial calamity than would have taken place in a normalized market.

And, what about the misallocation of capital?  Why should banks, which can and do play the markets with all that free cash, risk even a penny of it on your new consulting firm or dry cleaning business — especially when the government is backstopping their trading activities?

Ben Bernanke has been quoted as saying:

“I want to be very, very clear: too big to fail is one of the biggest problems we face in this country, and we must take action to eliminate too big to fail.”

That quote was taken from his 2009 Time Magazine’s Man of the Year interview, and the problem is even worse now than it was then.

If we believe the market is rigged, or a casino, or has lost touch with reality…should we stay away?  I believe there is ample opportunity for those who understand how the game is being played to profit from it.  The analysis I use to decide when to go long or short is exactly the same analysis I would use if the PPT hired me to alert them to potential dangers.

We’ve all heard the axiom “the trend is your friend.”  But, what about market reversals that lead to 10-20% downdrafts?  Much of my work is dedicated to finding inflection points where markets are poised to reverse.  Rather than riding them out, we are often able to position ourselves ahead of and capitalize on the coming move.

Equally important, these inflection points provide a discreet price point with which we can determine if our outlook and current stance is correct.  Typically, if a pattern calls for a reversal at X but prices exceed X, I know what the next reversal point Y will be and whether to change from a long position to short, or vice versa.  This is infinitely harder to accomplish by studying a balance sheet.

It doesn’t always work, and it’s rarely as easy as I’d like it to be, but it’s been fairly effective.  And, because I usually know when to pull the plug, I believe it really helps mitigate risk.

So, rather than complain about the market being rigged (okay, I still do sometimes) I’ll devote my energy to understanding how it’s being run and how to profit from it — and, try to sock enough away just in case it all comes crashing down.

*  *  *  *  *  *  *  *

We’ll start with developments in the currency markets last night…

The USDJPY broke the trend line and Fib Fan line I charted yesterday – indicating a continued decline to at least the 96.25 level.

The EURUSD has broken beneath the channel yet again, but is backtesting it from below this time.

And, the USD is finding support (a second time) at an important channel line.

Yesterday, SPX reached our .786 target of 1584.23, then spurted higher to tag our alternate target of 1590.36.  We closed our long position and shorted @ 1584.80, then rode an interim long position up to 1590 where we closed it as well.  So, we’re short from about 1588, net.

This isn’t the sort of market to let bears off easy, though. SPX ran up to 1592.64 — a nervous moment for those shorting into a rapidly rising market at 1590.  As I posted when SPX pushed through 1587:

I wouldn’t start getting nervous about the short position until around 1594 — the trend line (red, dashed) that extends from the 2000 and 2007 peaks.

Market makers watch Fib levels, too.  So, when we muppets take positions at important inflection points, they like to inflict just enough uncertainty to shake out weak players — those lacking the conviction to hang in there when their position is slightly underwater or who set tight stops at obvious levels.

UPDATE:  1:05 PM

SPX is off about 6 points, but seems to be catching some support here. It looks like backtest support, but we’ll keep an eye on the strength of the move.  We’ve technically come far enough to have a right shoulder to go with the left for the Inverted Head & Shoulders pattern we’ve been tracking.

Any move back through the .786 at 1584.23 (now resistance) would represent more than just a backtest and would be cause to suspect the pattern is ready to complete.

A close-up of the proposed falling channel…

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