Wednesday, July 15, 2009

The Two Headed Monster

What an interesting day today folks.

One of the first thoughts that I had at the end of trading today was remembering an article that I had read recently around the market action seen during the late 1970's stock market.

There were a series of inflationary and deflationary panics that rattled the nerves of investors during this time. 10%+ moves in gold in either direction were not uncommon as the market worried about the prospects of both economic monsters. This period of destabilization was finally cured when Volker took interest rates into the teens in order to kill inflation.

I am starting to wonder if this is what we may be starting to see in today's market. The one key difference seen today versus the 1970's market is the volatility in equities. Perhaps we should expect this in today's market that's filled with hedge funds, day traders, and speculators?

There are two trading trends that have clearly developed over the past two months: The deflation trade and the inflation trade.

The deflation trade(which we saw last week) is dominated by rising treasuries(lower yields), falling stock prices, and sharp sell offs in things like the metals and other commodities. You also tend to see a stronger US dollar.

The inflation trade that we are seeing this week is a complete inverse of the deflation trade. Treasuries tend to crash(yields up), stocks soar, and commodities flourish. The US dollar tends to remain weak.

Which trade is correct? The market hasn't decided in my view. Its very apparent that Wall St is divided on how this all plays out. Inflation appears to be the big worry if the economy recovers because there are too many dollars floating in the system as a result of the reckless bailouts.

All of this spending makes the bond market very nervous. Take a look at the 10-year today:



My Take:

You can look at this in two different ways. The bulls will say yields always rise when the market soars in order to make bonds attractive vs. stocks. The bears would say that our national debt is spiralling out of control, and the bond market is in the process of making money more expensive in an attempt to put an end to our ridiculous spending.

I think there is a compelling arguement for the bearish explanation. Look at the news that has come out this week in terms of spending: Obama appears hell bent on ramming through the $1 trillion healthcare legislation. The US deficit just hit $1 trillion for the first time in history. Finally, the bailouts continue to flow out of the Fed like water.

Our government has shown ZERO fiscal responsibility.

Bottom Line:

I think that treasuries have sold off much harder during the move higher this week then they should have relative to stocks in a normal market. The resulting higher yields are catastrophic for the housing market.

This could stop any recovery(COUGH) in its track.

My only advice in this type of market is to make sure you are diversified! I own treasury shorts and metals as a hedge against my short positions in stocks. Going long equities is still too risky for my taste.

All it will take is one large financial time bomb and the longs will run for cover because there is no fundemental reason to be long!

We might have seen that financial time bomb tonight with the CIT news after hours:

"WASHINGTON (Reuters) - U.S. officials are still exploring providing government assistance to CIT Group, but are increasingly concerned that conditions at the lender have deteriorated too far, according to a source familiar with government talks.

The source said Treasury Department officials are concerned that CIT's liquidity crunch has worsened over the past few days and that government aid would not effectively put the lender on a path to recovery.

A resolution for the lender's liquidity problems is expected in the next 24 hours and could end in a bankruptcy filing, the source said, speaking anonymously because the situation is still fluid."

Uh oh.

That's really ugly. 1 million small businesses depend on this firm for liquidity.

BE CAREFUL and stay nimble folks. This is an extremely dangerous market that can change on a dime.

18 comments:

getyourselfconnected said...

What bothers me about the defaltion/inflation trades is that they seem to "set in place". Stepping back, when the government needs to have a good bond auction, the "deflation" trade button gets punched. When the indices are nearing short term suppport lines with a break lower seemingly imminent, the "inflation" trade is put in place.

I agree this market is no place for an avargae person looking to get return OF capital, never mind return ON capital. Wild times indeed.

Also from last thread comments:
Jeff,
Glad your piece was in the Seeking Alpha article. They do not always pick up every article I blog, nor every section. SA usually will add some reasonable traffic to my site, hope it does for you. I may exceprt the "Running of the Bulls" article as well this evening. Great blog.

Jeff said...

Get

Yeah its crazy isn't it?

Capital preservation is about all you can do in a market like this.

Regarding SA, great article and thanks for the support.

I just linked your site up to my blog. Great stuff!

getyourselfconnected said...

I am "going to press" as I am writing tonights article as I comment here. Glad you like what you have read. I think this is an important juncture and level headed voices are in short order. Thanks for your work.

CT-Hilltopper said...

As far as the market goes, it's manipulated beyond belief.

The bulls are ignoring a lot of really bad news on their run for the top. I really don't see what this rally is based on. It certainly isn't based on fundamentals. The banks still have the bad assets on their books. But wait, they're not bad anymore, because somehow, someway, someday, they might get something more than a dime to a dollar on these clunkers. Jeez. So for the time being, everyone is ignoring all this crap when they report.

Excuse me while I gag.

All around me all I see is pain. No one I know has a 40 hour work week anymore. Most people have been cut back to 34 or 35 hours. Because of the nature of my job, they can't cut my hours and they don't mess with me much, for which I am extremely grateful.

I don't see any green shoots. I don't see any reason for this remarkable recovery in the stock market.

So what am I missing here?

On a more personal note, congrats to you Jeff, on making "Seeking Alpha". I'd give you a hug...but this is the internet so just accept my sincere congratulations. ;)

I hope you get more hits out of it. :)

Anonymous said...

Jeff,

After doing some research with Robert Prechter and Vox Day, this is my conclusion: deflation will rule the day... at least for the next 2-3 years.

See these links:
http://voxday.blogspot.com/2009/07/prechter-lecture.html

http://www.wnd.com/index.php?pageId=103763

Debt must deleverage and deflate. It must! Available credit must shrink after a period of expansion.

Jeff said...

Get

Looking forward to reading it!

I agree.

The financial media has totally sold out to Wall St so blogs offer an important alternative.

I think its interesting how Dennis Kneale has gone after the financial blogs. I think its a sign of how much of a threat they are to their "green shoots" network.

Lets all continue to get the word out and offer an alternative to all of this hogwash.

Jeff said...

CT

CIT's immenent failure is a big blow to the bulls. The treasury finally said no to a bailout.
What a shocker!

I agree nothing' changed but the accounting standards:)

I am glad your job is safe and thanks for the props!

Jeff said...

Anon

Don't disagree with you. Just hedging my bets.

Prechter is brilliant and I love his work.

Inflation will most likely be a problem down the road versus the near term. My fear is the pressure the government is putting on the currency which makes it vulnerable to a collapse.

I just can't have all of my assets in US dollars. It's too risky in my view.

This is uncharted territory and its unclear as to how it plays out.

Great links.

Thanks!

getyourselfconnected said...

My post is on cue with yours but you beat me to the puch tonight! Good stuff.

Jeff said...

Good stuff

Gotta love Goldman Sachs.

The biggest suckers on the planet are their clients.

They will advise them to go long and then use their own capital to short the same position.

What a bunch of slime.

housingtimebombfan said...

I have been reading your blog for a long time and am a huge fan. I mostly agree with you but would like to point out some observations. you have pointed out several times in the past that the equity market rally does not make sense because credit markets were doing poorly and that credit guys are smarter etc. I am a credit guy (and I believe you when you say I am smarter ;)) and my problem is that credit markets have tightened way too much vs. equities in the recent rally. It is the same whether you look at IG, HY, asset backed, CMBX, ABX and the degree of credit vs. equity outperformance is huge. I think the credit guys are getting it wrong this time but there is a huge risk equities plays catch up and kills my shorts. What do you think?

Disclosure - Have been short equities for 5 years now using put options, was down in 05, 06, flat in 07 and more than recovered in 08. Still short and bleeding and can still come out fine and up significantly if I take all my losses. I will likely stick it out irrespective of what you say but would love to hear your opinion.

snood said...

Bernake is no Volker.

Anonymous said...

to housingtimebombfan : i beleived that you are smarter until you mentioned that you were short last 5 years! boy, you are patient!

Jeff said...

Fan

Thanks!

Glad you are enjoying the blog.

I gotta admit that long term my favorite trade is to short treasuries. I am in total agreement with you.

The spreads on CMBX make zero sense given the problems in commercial.

I think the reason yields continue to collapse is many traders are using the Japan deflation scenario to trade treasuries.

Japan saw yields collapse to 1-2%( I am sure you know all this being a credit guy) as demand collapsed.

This is a different situation because our economies are totally different. Exporter economy(Japan) vs. importer. We have much larger deficits.

I am totally in your camp. I think this multi trillion dollar debt issuance is unsustainable and yields will reflect this down the road.

Julian Roberts who I have a great deal of respect for expects yields to soar up to at least 6% and as high as 18%.

My disclosure:

I bought TBT at $44 and more at $51. Didn't even think of covering when it got up to 58.

I plan on jumping into TLT PUTS on any sharp pullback following a sell off.

This is a trade of patience which is why I continue to hold TBT despite the slippage.

I will jump into longer term PUTS when I jump into TLT.

I am on the same page although many deflationists will disagree.

GL

Jeff said...

Snood

Thats what scares me.

Treasuries could very well do worse with ignorant fiscal discipline versus taking yields higher and being responsible.

We will know the answer in a few years.

Jeff said...

Anon

Agreed.

Patience is a virtue!

Thats why he trades in Chicago versus NY.

He actually understands the underlying issues versus trading like a pump monkey on Wall St.

Anonymous said...

Nice Little Yahoo (Us news feed)article sometimes even they see fit in reporting the gravity of the situation. Typically celebrity fluff and UFC crap for the most part on their homepage.


http://finance.yahoo.com/news/Nine-Reasons-the-Economy-is-usnews-1021116601.html?x=0&.v=1

Alex

Another optimistic day on the markets, oh I think we've turned the corner. Ha

Jeff said...

Alex

Nice article.

Watching the markets is almost humurous at this point.

At some point really will kick in.