Global Financial Stability risk at 13 month High

by the trader

Some risk recap, courtesey of Capital Context.

After a turbulent week or two in global financial markets, as reality turned to relief and then back to a more ruinous reality among European sovereigns and their contagiousness, we note that the risk of the 30 most systemically important financial entities in the world has risen to a 13 month high. Let us see if some kind of intervention brings risk down from these elevated levels, like it has in the past.

As we would expect, European financials have the highest risk but it is noteworthy to see how rapidly the risk of Asian financials has run up over the last few months.

A little difficult to see but we note that Aussie banks (overlaid into the chart but not specirfically members of the FSB30) have risen very notably.

When broken down into region it is clear that Europe is the critical area for now as the rest remain further away from recent wides but this is more relative-value driven in our view as we see US financials heading into a tough earnings season that will suirely bring the realization that borrowing from LLPs will no longer be believed.

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Equities: A Floor Has Been Set

by Guy Lerner

The oversold bounce that occurred 3 weeks ago when investor sentiment was extremely bearish did one very important thing: it put a floor under this market.

Figure 1 is a weekly chart of the SP500 with the red dots serving as key pivot points. Key pivot points are the best areas of support and resistance. The bottom that was carved out 3 weeks ago has put in a key pivot point at SP500 1267.71 (see blue up arrows on chart ). This is support. Back testing on this asset and on multiple assets shows that breaks of support levels generally are an ominous sign. Therefore, I would view a weekly close below SP500 1267.71 as a bad sign. Why? Because the definition of a down trend is lower highs and lower lows, and support levels that fail lead to lower lows.

Figure 1. SP500/ weekly

Does it always work out that way? Of course not. Last August, there was a close below a key pivot level or support level (see black up arrows on chart), and the market situation was dire until Ben Bernanke announced QE2. The market reversed and never looked back.

SP500 1267.71 is the line in the sand. Closes below this level would have me very cautious. A close below this level and a close back above this level would be bullish. Of course, we will see how the market action unfolds and allocate accordingly.

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U.S. Default? Why Are We Surprised?

By Jeff Harding

I didn’t want to let pass the warnings by Moody’s and others on U.S. credit ratings as a result of a potential default because the borrowing limit may not be increased to meet debt commitments. This is nothing new from Moody’s or S&P; they’ve been issuing warnings for some time; now they are stating the obvious about such a default.

The market has taken slight interest in the political wrangling other than to note that credit default swaps have increased slightly. What that means is that it now costs €58,000 to insure €10 million of Treasurys, an 8% increase in cost. Put in perspective the odds are 0.12% for default versus 14.04% for Greece. What this means in that the market believes they will increase the debt limit.

It always takes a crisis for politicians to act. Years of reckless spending are starting to run into a wall of huge debt, voter resistance to new taxes, and the realities of the bond markets.

Which leads to one obvious conclusion brought to my attention by Cato’s Jagadeesh Gokhale: the U.S. credit rating probably already is de facto downgraded. The reason the rating agencies haven’t already done it is because the role the U.S.’s debt and currency represents in international finance. If we were a smaller country spending 45% more than we took in, I am sure our rating wouldn’t be blue chip. The reason is hasn’t happened yet is because our house isn’t as bad as Europe, China, Russia, Brazil, or any other region or country, incredible as that may seem. As a result market dynamics keep Treasury rates low even at the same time as the dollar is devalued. That may not last.

What would happen if we defaulted? Financially probably nothing in the short-term. Debt would be paid on August 15, and at that point the rating agencies won’t downgrade. What would happen, at least according to the articles I have read, is that the government would have to start prioritizing expenditures. Here is a great graphic from the Wall Street Journal:

Tough on “other.”

Moody’s economist Mark Zandi says a default will result in higher interest rates, stock prices will fall, and we will go into recession. He also believes that government spending cuts will also result in a recession. In one sense he’s right (not on government spending), a downgrade in Treasurys would cause substantial financial repercussions. Since I believe we are still in a recession, things would get worse until the markets found some equilibrium. My guess it wouldn’t take very long to find equilibrium, but Treasury holders would take a big hit. There are plenty of ramifications here, none good. I don’t mean to sound callous, but perhaps this could be the best result. It could give rise to spending reform sooner rather than later. Our current course is unsustainable and it is only a matter of time before we are forced to deal with these serious issues. That could be now, but I doubt it.

Politics is always theater. In a nutshell, the economy is bad, voters will blame the incumbent if it’s still bad during the elections, and each side is trying to pin the blame on each other. The budget is just a tool the Republicans are trying to use to get concessions on taxes from Obama and the Democrats. The Democrats are queasy about the fallout either way. The just-as-bad Republicans were huge spenders on guns and butter during Bush II. They approved a brand new expensive entitlement for prescription drugs. And now they protest t0o loudly. My guess: the Republicans will cave. 

Mark Twain said, “Suppose you were an idiot. And suppose you were a member of Congress. But then I repeat myself.”

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Sovereign Debt Blows Big Holes in Big Banks

By: John_Browne

The past few days have been very bad for the world's largest banks. American behemoths Citigroup and Bank of America are down about 7% each. Across the Atlantic, things are far worse. BNP Paribas, Barclays, and Banco Santander are all down 13% or more... and Société Générale is down an astounding 16%!

Some pundits warn of an overreaction and suggest this is a buying opportunity for the beat-up financials. I disagree. Rather, I think the financials should now be considered toxic assets. Caution is justified.

It was only a week ago that markets were preoccupied by a downgrade of Portuguese sovereign debt and renewed concerns that Greece will need about $100 billion by year's end to remain solvent. Now, as eyes are quickly shifting towards the first tremors of financial crisis in Italy, concerns over Greece and Portugal seem rather quaint. With an economy roughly 7 times larger than that of Greece, Italy is simply too big to bail out. Its collapse, like the sinking of a great ship, could create a vortex that drowns Europe's major banks in red ink.

In addition to exposure to sovereign debt from insolvent nations like Greece, Italy, Spain, and Portugal, major US and EU banks are also massively exposed to toxic mortgage debts, the value of which continues to be eroded by crumbling real estate markets across the West. Meanwhile, at the least opportune moment, the banks are being besieged by ill-targeted regulations devised by vindictive politicians. Finally, banks' balance sheets are skewed by ultra-low interest rates and new rules that shield them from pricing their assets to market. Beneath a thin veneer of smoke and mirrors, serious risks remain.

Intractable budget negotiations in Washington and Rome have significantly increased the likelihood of default by the West's two major economic blocs. It could be reasonably inferred that we are entering a new phase of sovereign decline: the US is within weeks of temporary default; Italy is teetering; and the consensus on Greece is shifting toward the 'German fix' of bondholder haircuts. What's worse, there are no long-term solutions readily apparent. The EU is so rigid that it's only option is to break into pieces, while the US is so pliant that its main political parties are allowed to waste precious time scoring political points at the expense of the greater good.

Since the EU does not have a formal mechanism for handling default, large European banks have been 'persuaded' for many months by the ECB and national governments to invest in the debt of financially challenged nations within the EU, most importantly that of Portugal, Ireland, Italy, Greece and Spain (PIIGS). This approach was considered more politically viable than direct investment by the ECB. Now, these European banks are left holding the bag. Since there is still no viable mechanism to deal with this debt at the sovereign level, it's no surprise that EU banks are being hit hardest in this correction. The question remains: what were they promised in exchange for 'walking the plank' into the debt abyss?

American banks have a lesser exposure to sovereign debt of the European PIIGS, but many of these institutions have made massive profits by selling insurance derivatives known as credit default swaps to their European counterparts. This is the same strategy that brought down insurance behemoth AIG in the wake of the 2008 Credit Crunch. Therefore, major American banks are far more heavily exposed to PIIGS debt than first appears. It's as if they have learned nothing. Even conservative, and supposedly bulletproof, money market funds have exposure to EU bank debt.

I do not expect all of these banks' shares to go to zero. Powerful governments are likely to resort to almost any means to salvage their grotesque central-banking/fiat-money system. Likely, that will include eventually forcing their citizens to rescue their banks again -- but this time from even larger losses. However, in the meantime, the financials' earnings and share prices could suffer dramatically.

Moreover, Italy's situation brings some larger questions to the forefront: what happens when the next round of bank bailouts bring major sovereigns to their knees? Where will you want to have your assets positioned if the EU comes apart at the seams, or the US stops paying its soldiers and seniors? What's your plan if the central banks flood the market with even more cheap money?

Readers are strongly encouraged not to waste time gambling on shaky financials, but rather to build themselves an ark of hard assets and start rowing away from the sinking great ships of state. You don't want to be caught in the vortex when they go down.

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Stock Market Inflection Point

By: Tony_Caldaro

For those new to the blog we would like to restate something we did during the last bull market. The SPX/NDX can offer confusing patterns. Their futures contracts are heavily traded which causes volatility. In fact, occassionally a wave does not appear where it should, or a wave occurs that shouldn’t. How do we know? The DOW. 

The DOW is, and has been, the key index for the US stock market. Yes, it has become more of an international index, but as the world’s largest consumer/innovator so has the US. For the past six years or so the SPX/DOW have remained in sync, wave for wave. So this fact is easy to forget. My point is this: When analyzing the US market the DOW should be reviewed first. Let’s look at the last nine years, starting in Oct 2002.

From Oct02 to early ’05 the DOW rallied in what could have been counted as five waves. The market was even threatening to break down as the weekly MACD hit neutral. After a small correction the DOW rallied to a new high around Mar05 and then broke to a lower low. Notice the MACD again went to neutral threatening to fall into bear market territory. The key level to watch was what we had marked as Major wave 4, around 9,700. The market had to make a decision: bull or bear, an inflection point. It chose bull.

Flash ahead to today. From Mar09 to present we can again count a potential five waves up in the DOW: 

Apr10, Jly10, Feb11, Mar11 and Apr11. After a minor correction we are now uptrending again. Notice where the MACD is this time. No threat of a breakdown.

If we count five waves up, the recent correction and current uptrend would be part of the next bear market. If we use the count posted, we’re looking for a significant uptrend to clear the bull market highs and allow enough room for a correction without an overlap. Notice the big difference in price between the Mar11 low and the Jun11 low. This can not be counted as a flat. These are separate waves. Also, it would be quite unusual to count it as a part of a triangle since the rally above Major 1 was quite high. This leaves us with two counts. The original one posted and the alternate count.

Should the DOW break down below the Mar11 low (11,555) the alternate count comes into play. Until then the market suggests it’s going higher.

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The Greater Economic Depression Is Upon Us

By: David_Galland

The phrase “Greater Depression” was coined by Doug Casey a decade or so back as a way of describing the economic crisis he foresaw as inevitable, and which is now materializing.

Because I think it is important for every organization to constantly challenge its own assumptions, I’ve long acted as something of a devil’s advocate here at Casey Research. By constantly pushing our analysts to revisit their assumptions and calculations, it is my firm intention for us to spot the fork in the road that indicates it is time to shift strategies away from investments designed to do well in the face of a currency debasement and to something else.

Being attentive to that fork in the road is hugely important, because even though we urge our subscribers not to overdo their exposure to inflation hedges, we recognize that many do. Many a good person had their clocks cleaned in the early 1980s solely because they had become overly enamored of their precious metals – so much so that they stopped thinking of them as an asset class and began thinking of them more in the terms one might associate with an amorous dinner date. Thus these investors were utterly unprepared when said date stood up and broke a dinner plate over their heads.

With that brief setup, I want to make our views clear: While we correctly anticipated the recent correction in precious metals, this correction is but a blip in a secular bull market that is very much intact.

Doug Casey has often said that the unfolding crisis is going to be even worse than he expects (which is saying something), and the longer the rest of us at Casey Research study the tea leaves, it is hard to disagree that the Greater Depression is still ahead.

Consider:

• The eurozone is growing increasingly desperate. Watching the heads of Europe dither and debate over further bailouts to the unhappy Greeks and other troubled PIIGS – before ultimately reaching back into the pockets of the equally unhappy citizens in Germany and the decreasing number of still-functioning economies in the eurozone – reminds me of a down-on-his-luck blackjack player. He’s mortgaged his home to play the game but is now down to his last chips. He doesn’t want to risk his remaining resources but has no choice, because to walk away now will mean taking up residence in a cardboard box. And so, reluctantly, he shoves across another pile. The problem is that the game is rigged – and not in his favor. As the PIIGS start to default and either leave the eurozone entirely or are shunted off into some sort of sidecar organization, there will be great volatility in the euro and in the European markets.
• The U.S. debt situation is far worse than anyone in Washington is willing to admit. We keep hearing calls for more, not less debt creation. But if people would stop kidding themselves and tally up all the many demands the U.S. government has against it, the actual debt-to-GDP ratio rises to something on the order of 400% – and even that is likely understating things. The fundamental flaws in the U.S. monetary system – flaws that have given license to the bureaucrats to smash the limousine of state straight into a wall – have required a remaking every 20 to 30 years or so. The problem is that there is pretty much nothing else that can be done to save the status quo at this point, and so the monetary system is likely to collapse. That means big changes ahead, including – or perhaps starting with – a poisonous ratcheting up of interest rates.
• China’s miracle mirage. While having aspects of a free market, the hard truth is that China is run as a command economy by a cadre of communist holdovers. This is apparent in the cities that have been built for no purpose other than creating jobs and boosting GDP. It is also apparent in the growing inflation in China – the inevitable knock-on of the government’s decision to yank on the levers of money creation harder than any other nation at the onset of the Greater Depression. Meanwhile, signs of social unrest crop up here and there. Though so far they have been swiftly put down, there is no question that the ruling elite has to walk a very fine line. If the Chinese economy stumbles seriously, all bets are off. That we are talking about the world’s second-largest economy means this is not of small consequence.
• Japan is essentially offline. Reports from friends in Japan – including one who was initially skeptical about the scale of the problems at Fukushima – have now changed in tone by 180 degrees. You can almost feel the growing sense of desperation as the already massively indebted nation begins to slide toward an abyss. There is little standing in the way of the world’s third-largest economy’s slide. 
• The Middle East is in flames. This, too, is far from settled. As usual, the U.S. government has been hopping here and there in an attempt to maintain its influence, but at this point pretty much everything is up for grabs. The odds of the U.S. retaining the same level of influence in the region that it has enjoyed over the last century are slim to none, especially now that even the Saudis are shipping more of their oil to China than to the U.S. Again, big changes are ahead.

I’m convinced that nearly everything about today’s world is going to change over the coming decade… much of it for the worse.

But that doesn’t mean that people – you – can’t come through this in more or less good shape, just as our parents and grandparents made it intact through the last Great Depression. Pay attention and take action, and you’ll do far, far better than most.

Some investment ideas…

First and foremost, protect yourself against the collapse of the U.S. monetary system. It is not as simple as ducking into the nearest coin store and loading up, though that should certainly be one part of your strategy. 

Between now and the endgame that leads into what we can only hope will be a new money based on something tangible, there will periodically be opportunities to make big moves with your portfolio.

As Doug also likes to say, you should do whatever you want in this world, as long as you are willing to accept the consequences. If you are willing to risk going down with the ship, then do nothing.

Some other investible ideas…

* Everyday essentials. Energy is the classic essential. Sure, energy use and prices will ebb and flow with the economy, but ultimately everyone uses energy every day, and the people in emerging markets want to use a lot more of it. Carefully thought-out investments in energy, ideally bought on the dips, belong in everyone’s long-term portfolio.

* Breakthroughs to a brighter future. Throughout modern history, companies that make significant technological advances transcend bad economic times. Do you think that the company that finds a cure for a common variety of cancer will be weighed down, even by a stock market crash? Hardly. In cautious amounts, these sorts of potential breakthrough stocks belong in your portfolio.

* Investing in the inevitable. A ton of charts and data point to just how unusual and unsustainable today's low, low U.S. interest rates are. When these sorts of baseline trends eventually change direction, they tend to move in the new direction for years, and even decades. No one can pick the bottom, but anyone who is paying even a little attention can and should be getting positioned to profit from a sea change in U.S. interest rates while they still can.

* One foot over the border. History has shown that having even one foot over the border can make the difference between losing everything and coming out just fine. Internationalizing your assets is not always easy or convenient, but that doesn't make it any less urgent that you do so.

As for crisis investments, no one has been focused on that longer or better than Doug Casey and the team here.

The bottom line is that while the scale of the crisis is beginning to become more widely apparent, and reading and thinking about it can become fatiguing for those of us who have been on this story from the beginning, the base case for a Greater Depression is fully intact. We need to gird our loins and continue to take active measures to prepare – with the caveat that even in this base case, there are prudent measures you can take to ensure that not all your eggs are in one basket.

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