Crossroads

Richard Russell has recently made somewhat opposing remarks regarding the current juncture of the market. Specifically, he has noted that the DJ Transportation Avg. did not confirm the recent selloff by hitting a new intermediate-term low like the Dow Industrials did. I have two comments to make, one fundamental and one technical.

First, fundamentally, what appears to be occurring to my untrained eyes is the deleveraging of the entire US financial system (and thereby the entire global financial system, since US credit is at the heart of global flows). This deleveraging has already revealed that virtually all large banking institutions, and many non-bank financial institutions are insolvent. The authorities refuse to ALLOW this to be recognized and are, in fact, working to PREVENT this recognition from occurring. This effort means that they are trying to use INCREASED leverage to reflate the system. The results are mixed. The private sector is still largely retrenching, while the government, especially Freddie, Fannie (and Sallie too?) are doubling down. The complaints are that this will be inflationary. Will it? While it could IF continued, at this point in July 2010, the Fed has "only" printed $1 Trillion. While it sounds like a lot, when you consider that total US $ denominated debt is in the range of $15 - 50T, conservatively, this $1T is only a small fraction of what would be needed to turn inflation positive. A number another order of magnitude higher would probably ultimately be necessary. The Fed has supposedly been discussing this, with balance sheet estimates of $5T, increased from the current $2.4?T, being thrown out. Personally, I think that they are testing the waters, floating ideas and watching the reaction, but the Fed may do it, if they think it is necessary. But notice the geometric nature to the increase. Before 2008, the Fed balance sheet was under $1T. During the crisis, they expanded that to over $2T. Now they are discussing $5T. If they did that and it did not work, the next step would have to be to $10T. It is hard to imagine the bond market sitting still while the Fed destroys the few shreds of credibility it has left. The final item to ponder is what will happen if and when the banks (and I mean ALL of the banks, including the Fed, which is simply the biggest of the big with special powers) are forced to recognize the losses on the "assets" they have on their balance sheets (not to mention the ones they hold in "Special Purpose Vehicles", like Maiden Lane, etc.). The adjustment could be instantaneous and catastrophic. The "flash crash" would be a picnic as markets could cease to function for an unknown period of time. Therefore, I see two alternatives. Either the Fed attempts to lever its balance sheet to the hilt in one big step, which would result in a melt-up in certain markets followed by a cataclysmic crash or they will be forced to muddle along with occasional bouts of intervention to keep the declines muted. Thereby, the banks can use the clock to their advantage and continue to pocket the spread while slowly, but steadily writing off bad assets to rebuild their balance sheets. I lean toward the latter, which will take much longer, at least another 5 years, probably longer.

This brings me to the technical side of the equation and Russell's comments. He has suggested that more aggressive traders consider taking long positions in the DIA, Diamonds ETF, which tracks the Dow. This recommendation is due to the non-confirmation of the recent Feb. low being broken by the DJIA, but not the DJTA. While I certainly see his point, up until now he has been firmly stating that all of the action since March 2009 has been a rally in a bear market and as such the best course of action is to be out of stocks, including shorts, during a bear market. While those who have a high risk tolerance and are nimble traders can and should take any short-term position, "investors" should steer clear of this market. First, this rally has only brought the averages 2% or so above the Feb. lows, so it is a little early to declare the correction over. Secondly, the averages are largely still below their 200 day moving average (NDX and DJIA are right on the average, SPX is below, while the Trannies are slightly above). We still have lower lows on most of the major averages, which seems to be the definition of the downtrend. This could change, ideally with a decline which holds above recent lows and rallies back, but at the moment, we are still below the waterline, even if we are no longer sinking. As such, the odds favor sinking. Finally, due the above comments about the INCREASED leverage in the system, accompanied by markets which are not as deep (fewer real bids), the risk that one could wake up with a long ETF position of any kind which cannot be closed at a reasonable price is significant, if not high. Therefore, it is more prudent to be short a long ETF (e.g., QLD) if you are bearish, than long a short ETF (e.g. QID), since in the case of any market disclocation, you should be able to bid to cover yours shorts. Indeed, in case of a market dislocation, anyone who is short and trying to cover may be THE market for that security as there is a rush for the exits. We live and trade in dangerous times.