Stocks: Crisis Still To Come

My last update on the stock market was at the end of August (Article: Stocks: More Selling To Come). Recently, the blog has mainly focused towards currencies and credit market movements - and rightfully so. It seems majority of the fast passed action is currently there. We have seen credit markets across the globe signal warning signs: crisis ahead! That usually gives boost to the almighty King Dollar (source: CNBC), the worlds greatest currency (sarcasm all around).

Greenback has spiked in the insane fashion against global currencies like Mexican Peso, Turkish Lira, Polish Zloty, South African Rand, Singapore Dollar, Korean Won, Russian Rubble, Indian Rupee, Brazilian Real and many others. It is not just the majors like Euro or Pound that are weak. Generally speaking, a broad Dollar strength is signalling unwinding of carry trade of positions. These investments, that are now being reversed, usually bet on global growth outside of US or Japan. Obviously a global slowdown is now being priced in. Therefore, investors should understand the warning signals of both credit and currency markets: there is more selling to come.

Why do I say that? I'll give just a few main reasons for today.

1. This crisis is to do with EU Debt and we still haven't had any defaults - just can kicking. Therefore, once we see Greece default and the market test many other PIIGS countries as well as the whole Union, than we can know if they have or have not passed the test. My opinion is that defaults in the EU will lead to further Dollar rally, at which point I plan to buy all the Euro and short all the Dollars that I can - the US crisis will be up next!

2. A lot of has been made about bearish investor sentiment this week, as we can see in the chart above. Sentiment in the chart above tells us that we should have a contrarian point of view and not overact to the current fear, however bearish sentiment can stay extremely bearish for a prolonged period of time during bear markets. From a contrarian point of view I am very bullish in opinion, as I do not think we are repeating 2008 like some ultra bearish deflationists, but nonetheless I remain 96% in cash and 4% short with high leverage.

3. Instead, I think that we are on the road to capitulation and most likely closer to the bottom than most think. I wrote about contrarian signals in a Two Part write up (Articles: Stocks: Contrarian Signals Part I & Stocks: Contrarian Signals Part II). These unorthodox tools are not used for timing perfect bottoms, but do let us now that over the next month, two or three a great buying opportunity is going to present itself, similar to that of October 2002 and March 2009.

However, the road to final capitulation is always mixed, as we can see from the chart above of my own Crash Analogue. VIX spikes to extreme levels usually occur during the later phases of a crisis and signal the start of the end. I like to call this a lead up to final capitulation. Usually you have minor or a major crisis capitulation, and currently we are at the crossroads. However, my opinion is that  global central banks as well as governments have learned a lot since 2008. Therefore, I wouldn't get too bearish as we are going to see them print, print and print so more until they run out of trees.

4. Global economy is weakening. Leading indicators everywhere are now showing what the stock markets have already been discounting for months now. The biggest optimism, which needs to be shaken out, is the analysts outlook towards earnings. As we can see from the chart above, S&P reported earnings and US Consumer Sentiment are at a huge discount. I do acknowledge that larger and larger portion of S&P 500 companies earn their profits in the Emerging World, but nonetheless, analysts are still overly bullish.

Summary: More weak hands have to be shaken out, EU default is on its way, more GDP revisions are to come as global growth slows, more earnings downgrades are needed, more job losses are coming, more of this and more of that... etc etc etc, you get the point. However, as the market goes lower, less and less individual components of the index are making new lows signalling breadth divergence has started. That is not a good time to be adding shorts or even opening new ones.

On top of that, I personally would not listen to the current super bearish opera of deflationists who state that the current sell off is just the beginning as the stocks will crash below March 2009 lows. I read newsletters of very smart bears which I respect a lot, but it is difficult for me to get bearish on equities when I see the 10 Yr Yield at 1.7% and true old statistical CPI, not BLS fraudulent figures, north of 10%!

Besides, these super bears usually get louder and louder as we approach the bottom and their arguments of fear, deflation or world coming to an end, start to sink with the publics opinion - in other words their view becomes consensus. Having said that, one would not be too smart to buy any risk asset right now, if history is any guide. The default in EU is still to come so our fund remains 96% cash, with some slight short positions.