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That statement is an idea I read from one of Ayn Rand’s works. It may not be an exact quote but the sentiment is accurate. Another concept that has served me in good stead is: “(Whenever in doubt), check your premise”.

I have often found that when events are not unfolding as I imagined, the error has lain in  one or more of my assumptions underlining the analyis.

I mention this because from the time I first identified the high in the US Stock Market, my underlining assumption has been: we are forming a scenario akin to 1966 to 1982 - a period when an irregular correction formed. It was irregular in the sense that it formed a broadening sideways congestion (similar to a broadening top except that it broke to the up side). 

Notice that the market would break to new highs and fail, break to new lows and fail. By fail I mean the breakout would result in a return to congestion. This persisted until 1982 when the 1982 to 1999/2000 secular bull market began.

Figure 1 shows the pattern.

FIGURE 1 12-M DJIA

So, why am I starting to sense that this market may be a different animal?

The first source of the unease is the fact that 30-Year Bonds have given a 12-M sell signal. However since I have long held the view that some time next year, we’ll see a sharp rise in inflation, this could not be the answer.

The questions I pose are: if my assumptions were wrong, what could the market be doing this time? And, if this alternative scenario were correct, what would have to happen to prove it right?

The main alternative scenario is that the commodity complex is not forming a 12-M correction but has entered into a new 12-M bear market. A bear market in the commodity complex at the same time as the stock market would suggest this is not a recession but a deflation/depression. Since the commodity complex currently is led by Crude Oil and Gold, their respective positions would be important.

Figure 2 is a 12-M swing of Crude Oil basis CSI’s Perpetual Contract. On Oct 19,  there was about a 200 pip difference between it and the Dec contract (Perpetual closed 88.86, Dec closed 86.62). The key level on a monthly close basis is the 66.67% retracement at 84.59 (about 81.39 basis Dec).  A monthly close below this level suggests at least a 12-M congestion between 145.63 and 54.08 (basis Perpetual Contract); it can also indicate a bear market.

FIGURE 2 12-M Crude Oil

Figure 3 is the 12-M Gold basis the Perpetual Contract in the 1966 to 1982 era. Notice that Gold topped out in 1980 and in 1982 the DJIA bottomed. In my view, this is what should happen in a ‘normal’ recession. Should gold also form a top at the same time as the DJIA, we are more likely to be experiencing a deflation/depression rather than a recession. In such a situation, all asset classes will form bear markets.

FIGURE 3 Gold 12-M 1966 - 1982  

The key level for Gold is the $640.00 (50% retracement) basis the Perpetual Contract. While theoretically Gold has to accept below the 66.67% ($512), acceptance below $640.00, will suggest acceptance below the 66.67% because of Gold’s affinity to the 50% support/resistance. Figure 4 shows the levels.

FIGURE 4 12-M Gold 50%

So, now I have three benchmarks: the Maximum Extension on the 12-M DJIA, Gold’s 50% and Crude’s 84.60.

Figure 5 shows the 12-M S&P.  I have included it to show its Maximum Extension. Its chart is more bearish than the 12-M DJIA: if a top has formed, the latter will probably form a V-top while the S&P has signaled an Upthrust Change in Trend. The Upthrust is the more reliable of the two change in trend patterns.

FIGURE 5 12-M S&P

If we are to see a deflation, how does this reconcile with my inflation view in 2009 and beyond? It’s a question of sequencing: the inflationary pressures will be dealt with too late by the FED - a case of too much, too late. Like the sub-prime, the FED’s actions will lead to the very event Bernanke fears most.

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I was waiting for the last bullet in the Central Banks’ guns to be fired: a concerted rate cut. They did that tonight. As a result, the ES gyrated up and down, and the 30-Year Bonds tanked. For the first time, I am starting to feel that the word recession is too weak to describe the coming events.

For some time now, some commentators I respect have been suggesting we shall be entering a deflationary/stagflationary phase where stocks, commodities, and real estate drop while interest rates rise. Initially I gave the deflation scenario low probability occurrence - recession yes, deflation, unlikely.

But the FED performance has been so inept that I am starting to have second thoughts. I was looking for a repeat of the 1966 to 1982 scenario rather than the 1929 to 1936 one. Now I think the 1929 scenario is at least possible.

I think the jury is still out but I have to admit the ‘D’ phase has become more probable.  Still we still have some bright spots.

One bright spot on the horizon has been gold. If it can continue to rally, then we may just get away with a recession. The other bright spot has been the ability of Crude Oil to hold above 82 to 85. As long as the levels hold, this may still be a 12-month (yearly trend) correction.

If Gold and Crude Oil can rally, then the deflation scenario becomes less likely.

By the way, don’t you find it interesting that rates are cut and the 30-year Bonds tank? What is the bond market telling us about the prospect of inflation in the months to come?

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Sometimes it is appropriate to take a step back just to see what the larger picture looks like. Certainly the last few days have been heady enough for most traders. I am sitting from the sidelines taking a spectator’s role. The volatility as measured by the Average True Range is still too large for my blood.

That however does not mean I am not preparing myself for a possible trade.

There are 3 chief factors influencing my thinking:

1. The seasonal pattern that shows lows in the 2nd to 3rd week of September and 2nd to 3rd week of October. Following the October low we see a strong directional tendency terminating end December to mid-January
2. The 12-month swing (yearly trend) has given a confirmed Upthrust Change in Trend Sell signal that projects a minimum target of 867 to 768 basis cash. (Figure 1).
3. The 13-week swing (quarterly trend) has probably met a time and price swing target. If so we should see a 13-w line turn. Minimum price for the line turn is 133.82 but this will change week-to-week in the coming weeks.

The shorter timeframes show 3 sideways markets:

• Figure 2 shows  two of the longer-term profiles of the sideways price action. Basis Dec, we have targets for the upmove at 1301 to 1313.
• Figure 3 shows the sideways market that began September 17. Acceptance above 1265 projects a target to at least 1303 basis December.

When I examine the charts, I see the immediate bullish factor as being the decrease in volume on Monday’s low when compared to the low on September 17; I see the immediate bearish factor as being the rally last night that progressed on declining volume (except for the last 60-minute rally) - suggesting all we saw was a short-covering rally.

Here’s my best guess on the structure:

1. We’ll be seeing choppy price action leading to higher prices AFTER a re-test of the 1106 lows (basis cash) as the 13-w endeavours to turn its line up. The target for this move basis December is 1300 to 1328. I expect to see a 12-m probe above 1290 but not see acceptance above it - certainly I would not expect to see monthly bar acceptance above 1328.
2. I expect to see these targets meet near the end of December 2008.
3. I expect volatility to shrink as the market heads north in December.
4. Acceptance below 1106 would suggest the seasonal tendencies are absent this year - such acceptance would paint a very bearish picture. I’d expect volatility to remain the same as the present one or increase on such acceptance.

Figure 1 12-M Swing S&P Cash

Figure 2 Market Profile Daily S&P Cash

Figure 3 Market Profile 30-minutes Sept 17 to Date

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I received a few e-mails asking if I could explain in layman’s language:

• what this crisis is all about and
• my stance.

I can certainly explain my stance; the first part of the question may be a little more difficult. Sure, I have my views, but like the Elliott Wave, if we put a number of practitioners in a room, they all will have different ideas about ‘what the crisis is all about”. OK, then, here comes my reply - ready or not:

This problem began with over-leveraged, poorly managed risk among some larger US financial institutions, It then very rapidly became a world wide problem. To understand why, we need to trace three factors:

1. The bursting bubble in the housing and credit markets
2. The role of the Internet in the creation and demise of the bubble; and its role in the world crisis
3. Globalization of world markets.

I won’t go into why the bubbles occurred - there is little argument that they did happen. But in Wall Street’s drive to secure greater profit, they created securitization of debt. The good news about this is  it enabled successful start-ups that normally would not have a look-in at a bank loan, that could obtain financing. But the problem is this:

these loans lack transparency, few understand their intricacies and they divorce the lender from the risk of lending.

What happens in securitization is lenders placed their investment assets into a group. They then sub-divide the package into multiple income streams and sell each stream as an asset-backed security.

When the US housing boom ended, the invalid (pie-in-the- sky) assumptions underlining the sub-prime mortgages caused above normal defaults and foreclosures. This caused larger than greater normal losses firstly with hedge funds and then with banks. These institutions were not only US based but were located world-wide.

Securitized sub-prime loans have been aptly described as ‘toxic waste’. Now here’s why the problem grew exponentially - no one knew who had how much of the ‘toxic waste’ and how to value the ‘waste’.

As a result two things occurred:

1. Investors started to withdraw from any institution that ’smelt’ like having ‘toxic waste’ exposure. This caused the share prices to fall, thereby affecting the ability of the institution to borrow money. This was a crisis of cash.
2. The problem grew so large that banks were reluctant to lend whether or not the counter-party was tainted. This was a crisis not of cash but of confidence.

This is where the problem stands at the moment.

The US bailout is an attempt to solve the problem of cash - but like many short-term solutions, the US authorities, like Wall Street in the bubble years, are ignoring the consequences of their actions: the spurt of growth in M3, a growth divorced from productivity, will cause massive inflation. This rise will start being reflected in the inflation numbers in the next 3 to 18 months.

At that point, the FED will ultimately be forced to raise rates or face hyperinflation. You can use your imagination what would happen to an already fragile US economy when that happens.

Here’s the sad part. It’s not clear that solving the cash problem will solve the confidence dilemma. As I write, the Asian markets have reacted positively to the bailout but I’ll reserve judgment about its effectiveness to restore confidence until end of trading today.

In any event, whether or not, the bailout will help confidence in the short-term, I take the view that in the longer-term other measures are necessary i.e. greater transparency on securitized assets and some means of valuing the ‘toxic waste’.

In ‘The World is Curved’, David Smick said (page 45):

“..securitization, even though essential to wealth creation, is so arcane that few people can understand its workings…..the industrialized world has surrendered control of its financial system to a tiny group of five thousand or so technical market specialists….These insiders are the rare few who know how the securitization process works..And even they at times are dubious that the securitized assets reflect the value stated. But you want a scarier thought? Picture the US Congress trying to effectively legislate the regulation of something as complicated as the securitization process” (without causing even more financial carnage).

Amen

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First off my apologies for failing to make the pre-open comment on the ES as promised in my blog yesterday. Something came up that prevented it.

Here are my thoughts for today.

I was watching CNBC the other day and someone was congratulating the FED for acting more effectively and promptly than the Japanese Central Bank did when the Japanese crisis first broke. He also said that ‘the US experience was different this time’.

It’s always different - humans have a tendency to substitute fact for wishful thinking. Remember Dow 36,000? So what are the facts regarding the Japansese and current crises?

In Volume 4, Issue 47, John Mauldin’s ‘Outside the Box‘, the guest author, ‘The Absolute Return Letter’ provides some facts.

1. This crisis began with housing and will not end until housing prices return to the mean of housing prices relative to the disposable income. Currently in the US, prices are 2 standard deviations away from their mean. For this to happen, we need to see housing prices fall precipitously or remain flat for around 4 years; and the excess supply of housing must be eliminated. There is a 10 months supply overhanging the market, the greatest it has been since 1984.
2. All countries of the world face inflationary pressures - the emerging countries - Russia, India, China etc more so than the developing ones.
3. US housing prices in 2006 rose more than the housing prices in Japan in the 1980s and the Japanese decreased the cost of money more quickly than the FED has done.  
4. The US advice to the Japanese was ‘let the weak banks fail’. I quote the observation about the US practice today: “(The US ) are now at risk of making exactly the same mistake as the Japanese. A number of U.S. banks have capitulated over the past year, and both Fannie Mae and Freddie Mac are in pretty serious trouble at the moment. What do the Americans do? They spend tax payers’ money to try and fix something which is unfixable, not at all dissimilar to the policy mistakes made in Japan 10-15 years ago. This could have quite severe implications for U.S. GDP growth for years to come”

 If this is so, the FED remedial action is little different to that of the failed policies of the 1980s to 2000. It didn’t work then and it won’t work now. So, guys and gals, gird your loins for a bumpy 2009 and beyond.

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