Sunday, October 30, 2011

Why The Melt Up?

Last week I was travelling through parts of interior India and one thing lacking was decent internet connection. As a result I could not post my regular market comments for almost 10 days. I should have purchased and carried the portable internet connection from Mumbai but silly me.  Anyway, lessons learned.

Last week we saw melt up and SPX was almost touching 1300 level. Is this the beginning of a new Bull market?  I am waiting on the sideline for many months now, waiting to get a sense of direction. We were close to 1050 in SPX and while many were expecting a re-run of the 2008, I said many times that we are not going to fall though the crack as yet. We might see one more selling pressure next week before we can have a tradable bottom.

So what is the reason for this melt-up? Have Europe solved its problem for good? Are the PIIGS really flying?  We must be delusional to think so for even a moment. European Union faces a risk of tsunami of fiscal and banking crisis. EFSF cannot solve this problem.  The problem is of solvency of all Euro zone financial institutions and banks and ECB and the Governments are trying to cure it by injecting liquidity. Of course if you give free money to the insolvent banks, it might keep them alive for a longer period but in the process create some Zombie banks which will drag the economy down for ever. If you don’t believe me, ask Japan!
The Europeans agreed for 1Trillion Euro for EFSF but where this money will come from is not explained. And they will use leverage to reach this magic number. And even that number is not sufficient to shore up the fortunes of the PIIGS countries. We are told that the banks have agreed for a voluntary haircut of 50% on the Greek bond holding and yet there can never be a greater lie. Because team Merkozy told them that the other alternative is 100% haircut. There is nothing voluntary about this agreement. The banks have been forced to accept this 50% write down with great deal of arm twisting and the next question is whether they will get the protection from the CDS they purchased. If it is voluntary, then there is no compensation from the CDS they purchased and that will effectively kill the CDS market.  So what happens when Ireland comes calling next about its due 50% write down or when Portugal comes with its share of write down? Will it be a voluntary event as well? What happens when Spain or Italy goes down? Already the yield of Italian Bonds are close to 6 % vs 2.5% of German bond yields.

"Data released by the European Central Bank show that real M1 deposits in Portugal have fallen at an annualized rate of 21pc over the past six months, buckling violently in September.
" ‘Portugal appears to have entered a Grecian vortex and monetary trends have deteriorated sharply in Spain, with a decline of 8.4pc,' said Simon Ward, from Henderson Global Investors.

Given this situation, when things are far from normal why this massive stock market melt up? What gives?  Because they changed the rules of the game. As simple as that. Because the haircut was voluntary, it did not trigger the CDS payouts. That took away the risk factor the financials who wrote the CDS.  As there is no risk, it is time to cover for those who were short the markets.  The HFT algos saw the short covering and they joined the trade. So did the momentum traders. And the run up continues. This is a very simplified version or explanation of the run up.

Just remember nothing has changed and when other PIIGS come calling, there would not be enough money in the world for voluntary haircut. Not even China can save Europe.

Coming back to the stock market, what can we expect next? Because everything is so overbought for now, we can expect a pullback next week. For traders that will be an opportunity to go long. I think it will be safer now to buy the dip till December. For investors, it will be another opportunity to liquidate and go out of equities.

For precious metals, the Bull Run will continue for the next six to eight months. I plan to go long gold in the next two weeks time. But I am hoping for a lower entry point. If we close below $1700 in gold that would mean that the corrections in gold is not over yet.

The year 2011 will possibly end in positive territory but I am very skeptical about 2012. Combined with the solvency problem in the Euro Zone, we shall be facing a very nasty Presidential election in the USA. The end of the debt super cycle is upon us. We are just missing the woods for the trees. The risk is actually increasing.