Europe’s sovereign debt crisis is unraveling in the same manner as the American sub-prime debt crisis from 2007 to 2008. That is to say, a credit driven event has blown up instead of being kicked down the road due to missteps and mismanagement of policy. How do credit events blow up? A psychological shift happens. Keynesian economists believe you can just pile debt on more debt, but there comes a time as in 2008 and 2011 where confidence is lost and panic ensues in a liquidity trap. Also, with electronic trading and massive leverage, it can happen really fast. Just as confidence was lost in September of 2008, when Congress failed to pass a stimulus package on the first go-around, confidence was lost in the ECB and EU’s willingness to backstop debt last week. A waterfall correction ensued. "All the king's horses and all the king's men couldn't put Humpty together again."
That takes us into the title of this paper and a look forward to guide you, the reader. As in 2008, a credit event will eventually filter through the economy to become an economic event. That is to say, while P/E ratios look incredibly attractive here, and value investors are salivating over this dip, the economy is rolling over. Earnings are a look back in the rear view mirror and the P/E ratio can rise (become more expensive) should earnings drop, not necessarily from a rise in price. Jim, Chris, and I have been discussing and watching the LEIs (leading economic indicators) roll over since March this year. Due to recent events, consumer sentiment is dropping fast as well as business owners' outlook on the economy. As conditions worsen, consumers and business owners contract their spending and it becomes a positive feedback loop on the economy until steps are taken by monetary and fiscal policy to change that sentiment.
The Value Trap
So prepare for a dead cat bounce. P/E ratios have dropped. Hot stocks of 2010 and 2011 have fallen 15-30% or more. These will likely fair better than out-of-favor companies in a rally. This would include energy stocks (especially refiners) and large-cap technology stocks. Have you been waiting patiently to buy into Apple, Chipotle, or Netflix for the past year? Well that’s the same feeling many have had and will finally put down some cash to pick up a few shares in a bounce. We’ll get a technical bounce. Here are some reasons why:
- The market is oversold and basing above 1120 for the S&P 500.
- P/E’s look cheap given the upbeat earnings season we just went through.
- Huge buying this week as seen in the up volume of the NYSE on Tuesday. It hasn’t been this high since late May 2010.
- Bottomed out breadth indicators this week (see picture below)
- Reversion to the mean
(From Tuesday morning: Shows 99.8% of stocks in the S&P 500 were below the 10-day moving average, 99% were below the 50-day moving average, and 89.76% of the S&P 500 were below the 200-day moving average.)
TradeStation Quotes - Indicators
A few more finishing comments on the subject of a dead cat bounce. If you went 100% cash in this correction, a dead cat bounce is going to hurt. Cash is yielding a negative return; however, sleep at night is a priceless commodity we all can understand. Renting the market in an ETF for more agile traders makes sense here. This bounce, if purely based on technical reasons, will be a value trap as earnings are a lagging indicator. For the bounce to be meaningful, we’ll need clear and concise steps collectively from all of the major economic regions. We need China, the U.S., AND Europe to be on the same page. We can’t have Europe dilly dallying with stimulus or no stimulus. The market needs to see leadership of one accord as we saw by the Treasury and the Federal Reserve between October 2008 and March 2009—at that point, all-in on gold.
The worst-case-scenario I see going forward is true austerity across the board to deleverage the global debt burden; however, I don’t believe politicians have the stomach for it. Not with elections around the corner and the prospect of social unrest in the streets such as we see in nations that have taken the austerity route. I believe you get the economy on its feet first, drive revenues, and then tighten the belt. Austerity measures have proven they don’t work to get a country out of a recession when creating a positive feedback loop in the economy often leading to unrest.
The problem with juicing things up now and tightening later, is typically the refusal to cut back spending after government and entitlements keep growing. The U.S. government continues to grow. If you look at net job creation, the only area that has grown is public employment over the past 10 years. Stating fact and not conspiracy here: our government continues to march down the socialist path of the European model. The Greeks tried it and failed. Any time a society has tried it, it eventually fails as the working few get fed up paying for the non working entitlement many. Looking at Europe, we’re telling Germany and France to foot the bill for the peripheral nations, but they don’t seem to like that idea. That’s socialism of epic proportions.
Parabolic Gold
Gold has been the bullish momentum trade it is supposed to be in times of crisis, panic, and credit fear these past couple of weeks. Because it is no longer rising at a steady pace, but a parabolic one, puts us into the uncomfortable position we saw in silver last spring. I do not want to go into great detail about parabolic moves because I did as much on April 21st, “Bulls, Do Not Lower Your Guard”. I’ve been doing some technical work on gold for my office over the last two days and will point out some “issues”. One of those issues we discussed was margin requirements. Interestingly enough, we saw margins hiked last night. One won’t break the trend, but a few could. I won’t debate the reasons for the hike, because it makes no sense to fight the tape. You can blame the referee or play a different game. The other issue we discussed was its parabolic overbought condition.
- Yesterday the put to call ratio was near 2/3 on GLD, which is to say that’s overly bullish and from a contrarian prospective, leaves room for a correction in sentiment alone.
- I noticed a spike in put activity in the September 165 and 170 strikes for GLD yesterday which told me hedges were being placed.
- Our proprietary Intermediate Term indicators were red flagging gold for an intermediate-term top (see below)
- Volume in April pointed towards accumulation (volume after the correction) whereas current volume is pointing at distribution (see below)
- As I write here today, the gold futures are down . As I wrote and warned my colleagues yesterday, when gold breaks down from its parabolic move, we could see a - 0 move.
- Today’s move down appears to be an engulfing candlestick, wiping away yesterday’s gains (bearish).
GLD Daily [ARCX] SPDR Gold Trust
As long as gold trades above its second standard deviation away from the 50-day moving average (upper band), then gold can continue the momentum higher for a short while; however, the chances for more margin hikes are likely. The more crowded the trade will get at the top, the steeper a correction. Like a baseball game, some people will filter out at the 7th inning stretch and miss the traffic, but after the 9th inning and the game ends those exits get crowded and you’re stuck in traffic. Case in point: Silver’s steep correction from $50 to $32. That exit got crowded.
If you don’t believe that the global economy is rolling over, then by all means, continue to hold your gold. But if you believe as I do, that the credit event will permeate into the economy and become an economic event, then recall the behavior we saw in gold in 2008. GLD dropped from $99 down to $69. That’s a 30% correction. Technically, I’m looking at $153 as intermediate support. The rest depends on the economy and policy makers. Policy makers will drive this economy to the precipice; with two front tires over the edge before they throw everything and the kitchen sink at the credit crisis to stimulate growth. At that point, as in 2009, gold miners will outperform bullion due to the value created. So consider hedging, or cutting back your gold bullion exposure so you have room to buy the trodden miners when all is said and done.
