Fin/Inv

The clash of the titans is upon us. Make no mistake – it’s make or break time for the bears as they are running out of time as well as wave sub divisions here. Emotionally everyone has been ripped to pieces, but from a technical perspective things could not be much clearer. Either the bears close the deal right here and now or they will be squashed and again be relegated to watching the bulls take their lunch money and fuck their prom queen.

The financial establishment is fighting for its survival – with tooth and nails – as it has been for the past two years. They have used every trick in the book and some unprecedented ones that hadn’t been written yet. They’ve gotten every break and get out of jail pass one can possibly imagine – but despite having the wind in their backs the upside momentum has stalled for about one year now. But don’t underestimate them for a second – until the fat lady sings the incumbents will continue to do exactly what they have been doing and they will never ever give up.

For their survival depends on it.

We now find ourselves at a major inflection point and the big question that remains now is whether the deflationists or the inflationists will win the war. Robert Prechter and friends insist the Fed can’t possible stem the bursting of the credit bubble through continued quantitative easing initiatives. I used to be convinced of that – but having seen what I have seen for the past two years I’m not so sure anymore. I’m also now mindful of various and concerted currency games which seem to provide almost infinite support and thus a permanent floor to equities.

So perhaps the combined forces of banksters worldwide may somehow get the job done and simply socialize those losses to the rest of us – thus in the process finally destroying what ever remains of our teetering middle class. We shall see – either way we’ll probably see some fireworks before it’s all said and done – and I’m not talking about hypothetical ones.

Whatever we’ll get – I’m dressed for the occasion (yes, I’m almost that handsome – well, almost). Now, that I’ve set the stage for you guys (and have the attention of the girls), let’s look at some charts:

The least important chart today is our wave count. Quite frankly – it’s quite clear at this stage that we are in a downtrend that either resolves itself or may paint a bottom and turn into something else.

Clockwork Orange keeps us locked in that current down channel. Which means we may pop a little on Monday morning but then reverse and paint new lows later in the week.

Soylent Green territory begins after 1070 – if we push much above that we will see many funds throw their weight behind a wonderful short squeeze opportunity. Either bears or the bulls are getting squeezed next week. The bears most likely early in the week and if we push higher quite possibly the bulls. I may however point out that if we don’t turn around at the 1100 mark then we’re talking about something completely different. But we’re not there – so let’s not worry about that yet.

But those are just the current high probability scenarios going out for a week or two – what’s a lot more important here is that the current count does not leave much more room for further sub divisions – at some point this bitch has to drop like a rock. After all this is what should be happening around here. In 2008 we had a similar situation and it was driving everyone nuts. I was telling Berk how the slide was overdue and that it simply wasn’t happening. Then it happened – suddenly – without warning – fast and hard. By the time everyone realized what was happening it was pretty much over.

So, when I say that it needs to happen now then it doesn’t mean that I can’t happen. What I’m saying is that it needs to happen by early October – and by that time it should be almost over. So, that leaves us with a very narrow window for a big slide. It has happened before – and there is no doubt that it can happen. But the important message to take away here is that the whole ‘waiting for Godot game’ we had to put up with will come to an end in early fall.

Now that I have shown you the least important chart let’s look at the most important chart for next week. I posted this one last week while we were hovering around that equilibrium center line of that one year channel I suggested. And sure enough we reversed right at the 25% mark – which coincides with that magic 1040 level the funds have been having fun with for the past few months now. Buying the dip here has been a literal gold mine and like Pavlov’s dogs they will continue to do it until they get their ass spanked in a serious way.

The higher we climb in this chart the less credible the short/medium bearish scenario. At the center point the odds are about 50/50. If we push to 1100 the bears have one last opportunity to squeeze the bulls and turn this market to the downside. At the top line around 1130 the odds for the bulls will have increased significantly compared with the odds around 1140.

We need to clear this channel – one way or the other. If we push above it the bears will be in a world of hurt as the ensuing feedback loop will bring buyers back to the table. I’m not sure that’s what the Fed wants – after all a climb in equities supports rising yields in treasuries. But their game may be something completely different and I’m not putting any of my coin on anyone’s interpretation of the Fed’s game. If we breach 1130 I will anticipate further upside and will trade accordingly. Unless of course my momos scream sell sell sell at me. If that happens – well, I will be here to tell you all about it.

If we finally breach 1040 and then 1020 it will be a starting signal for what Primary {3} – there is very little doubt about that. The majority of the longs will draw their line in the sand right there and should we breach it will most likely head for cover. Maybe politics and the November election make this scenario questionable – at least that’s what some claim. Then again – it happened in 2008, didn’t it?

The daily Zero has been pretty lackluster as of late. Just compare the magnitude of spikes we saw early in the year with the snooze fest we had to put up with since mid of July. Yes, that may have been merely seasonal, and if that’s true then it gives additional credence to my perspective that September will be the make or break point for the bears. The big boys are returning now and we should see considerable increase in volume and participation.

The last buy signal we got (see dotted line) was pretty weak and it was only good for a moderate bounce. Thus far we did not see a new low accompanied by a major divergence. But then again, we did not see a big spike down either that would signal that bearish momentum was on the rise. So, I’m split here and thus the odds are split in my mind as well.

Copper started to point up last week and – to no surprise – equities followed suit. Note however, how equities have lagged in comparison with similar levels in copper. This suggests that bullish moves in equities are lagging those we see in copper – a bearish indication. Nevertheless, we are also at a pretty important level for copper – which I have tried to highlight via a blue rectangle on the lower panel. But it’s actually a lot more clear on the point and figure chart:

See, isn’t that so much nicer? I love P&Fs for support/resistance lines. And copper just touched the 340 mark which should pose quite some resistance. If it breaks above then the bearish price objective of 296 may have been revised. Maybe some P&F aficionados can chime in here as well. I have the rules somewhere but don’t have the time to dig them up tonight.

The message to take away here is to watch copper like an eagle. A breach higher would be another ace in the sleeves of the bulls.

My gold:silver ratio chart plotted against the SPX also has touched my one year sell line. Usually bearish things happen at this lower diagonal and this time should not be any exception. Again, a breach here may greatly weaken the short to medium term bearish scenario in equities – so I will be keeping an eye on it.

Currencies is really where the game is being played these days. The AUD/JPY has seemingly been set up with a turbo charger running on high explosive mix of nitro, fuel and oxygen. Seems that the BOJ has had it with lagging exports and is putting the squeeze on the Yen longs by buying the Australian Dollar. Maybe some FX traders could shed a bit more light on this for the benefit of us all.

We are close to the breaching the upper line on my stochastic but that doesn’t mean much. We may push above and become embedded after all – so who knows how high this thing may climb. And that is probably the most worrisome chart for the bears – if equities follow suit here then we’ll see 1100 on the SPX in a very short order. But if it lags then it will give the bears additional ammunition for a long squeeze once the AUD/JPY rolls over.

The DXY is clinging to 82.87 – and not seeing the Dollar getting killed is a plus for the bears. After all, the 18 month climb in equities has been greatly fueld by stomping on the Dollar in the process. You may remember the chart I posted last week which showed the SPX valued in Gold.

Bottom Line:

It’s now or at least not for quite a while for the bears. I won’t say never of course. But the wave count does not give us too many wiggles to postpone the grand finale here. If this is a Minor 3 of Intermediate (1) then it needs to start showing its colors. And the A/D ratio of 5.0+ we saw on Friday should be an anomaly that cannot be followed up – otherwise we have to concede that something else is going on. That simple.

Public Service Announcement:

In the past month I have again put additional emphasis on refining some of my automated trading strategies, with quite some success if I may say. A major reason for my revived focus is a growing realization that the retail trader is slowly going the way of the dodo. I love you guys but just don’t think there will be many of you left in one or two years from now. The market simply has become to complex, narrow, and brutal. And as the old saying goes:

If you can’t beat them – join them.

Now, I have been blessed with some pretty considerable programming experience – after all I used to be a software engineer for 15 years until I decided to retire and focus exclusively on my trading. That however doesn’t mean that I stopped hacking code – quite on the contrary: I merely had become tired of working on other people’s projects and quickly found that my skills were a lot better used working on trading strategies. I seem to have a knack for seeing patterns and putting my observations into code and thus working strategies is a very rewarding endeavor for me – mentally as well as monetary.

Incidentally, the strategies I am testing and continue to optimize until I am ready all have been back tested starting January 2007 to the present. The reason for that is that I believe that any strategy which was able to survive the past four years should at least have a fighting chance moving forward. After all, we are talking about some very dynamic and contrasting market conditions here.

There will be several announcements in the next few weeks – and I believe you will appreciate the kind of stuff I have been cooking up. And over the next few months you may see a slow shift towards automated trading. Some of it in the same fashion as Geronimo or evil.rat – which means via email or SMS notifications. But I may also finally hook into Collective2 or a similar service and thus give you guys the opportunity to trade various strategies through an automated framework.

What concerns me a bit is that Collective2 takes a big chunk out of my profits and being the greedy market megalomaniac that I am it would be preferable to find a different solution. So, if you are reading this and know of a better framework please let me know – I’m open to anything as long as it represents a viable and secure solution.

See you on the other side, folks.

Cheers,

Mole

I think we should just feed some artifical A.I. with a bunch of Socrates quotes and then let it loose on the market. Looks like the old robe donning Greek nailed the support line he proposed yesterday spot on. I can tell you, Plato is in a bad mood right now as he was on the other side of that trade. But he should have known better as he himself said:

I have hardly ever known a mathematician who was capable of reasoning.

Someone should pass that quote on to the respective originators of various toxic assets that pushed our financial markets toward complete melt down – i.e. MBS, CDOs, CDSs, etc.) – most of which are still traded over the counter to this day I may add.

Plato pondering about Mousaka Baked Sedatives.

So, let’s revisit yesterday’s chart and then look at where we are in the ole’ wave count:

Charts and commentary below for anyone donning a secret decoder ring. The rest of you guys will have to wait until tomorrow – sorry. If you are interested in becoming a Gold member then don’t waste time and sign up here. And if you are a Zero subscriber it includes access to all Gold posts, so you actually get double the bang for your buck.

Please login or register for Zero Data Feed or Evil Speculator Gold or geronimo/ES or evil.rat/ES to view this content.

Just reported the other day on the outflows of equity funds and into bond funds that were hitting dangerous levels. The New York Times reported over the weekend about how small investors continue to make the wrong move. This time its the movement into bonds even as corporations continue to recover. Some $33B has exited equity mutual funds at a time that billions should be flowing into the funds.

Many are talking about the bond market being the latest bubble. But it looks more like the press is just seeing bubbles everywhere. To me a bubble happens when everyone starts believing something that probably is not true. For example in the 1990's investors started thinking that the long term earnings growth of the S&P 500 was shifting up from its long term 7% growth rate. So they believed that the market was worth more than historic valuations implied and the market PE rose to the 25 to 30 level.

In the 2000's bankers and home owners came to believe that housing prices could never fall so that homeowners could always refinance their mortgages. Consequently, lenders did not have to worry about credit risk.


So for the bond market to be a "bubble" investors would have to start thinking they can make unusually large capital gains in the bond market. But everyone knows that if you buy a 10 year bond that at the end of 10 years all you will get back is your original investment. In the meantime you will get the coupon and what you can earn by reinvesting that coupon. Yes, if rates continue to fall in the short run you will be able to sell the bond for more than you paid, but you total return has to remain limited because in 10 years the possibility of capital gains must converge on zero. As long as this is true the possibility of a bond bubble must remain something reporters and pundits can pontificate on but nothing more than that.

See figure 1 a weekly price chart. The 40 week moving average (i.e, red line) is heading higher, and prices are trading above key pivot points, which are areas of support (buying) and resistance (selling). In essence, this is a "beautiful" chart with lots of momentum (i.e., note the breakout gaps). If this were a stock, the analysts and pundits would be all over the "breakout" ---blah, blah, blah.

It seems that the big unraveling in equities has switched into second gear.

If you are still positioned to the long side I have two charts you should see:

Exhibit A: The AUD/JPY against the spoos. The AUD/JPY has been leading equities in the past few months, however lately a new trend has emerged in which equities (and thus the ES futures) completely started fading any downside in the AUD/JPY. Today this apparent unraveling has kicked into second gear as the two are now moving completely against each other.

Exhibit B: 10-year treasury bonds against the spoos – the former here shown as its inverse moving yield (TNX). In general (and some will argue this point) equities and the TNX move in tandem. This more long term chart shows a distinct detachment by equities (and index futures) traders as of late. However, today’s respective moves tops the all time charts – and someone has to explain to me how/if that makes sense.

The big unraveling that I expect to ensue in the near future won’t be kind to anyone with long exposure in equities. I strongly recommend that look for exit signs near you. You have been briefed.

Cheers,

Mole

I put "Fraud" in quotation marks because, legally, it's not - even though it should be:

By acquiring about a quarter of home-loan bonds with government-backed guarantees to bolster housing prices and the U.S. economy, the Fed helped make some securities so hard to find that Wall Street has been unable to complete an unprecedented amount of trades. Failures to deliver or receive mortgage debt totaled $1.34 trillion in the week ended July 21, compared with a weekly average of $150 billion in the five years through 2009, according to Fed data.

Note that the total amount of Fannie and Freddie paper outstanding is about $5 trillion - so we've got what - about a quarter of it that's currently subject to a fail-to-deliver?

Gee, that's nice.  Isn't that kinda like a naked short?  Selling that which you don't own, eh?

Now the bond dealers will tell you that this sort of thing is "normal' and "happens all the time."  And they're right, after a fashion - kinda.

When traders don’t deliver bonds to their counterparties, they don’t receive cash they could be earning interest on. With the federal funds target rate in a range of zero to 0.25 percent since December 2008, the amount of foregone earnings is almost nothing.

Yeah, the bigger issue isn't there.  The bigger issue is this:

“What they’re doing is after-the-fact saying, ‘We bought more than existed, so we’re going to try to alleviate those problems,’” said Scott Buchta, head of investment strategy at New York-based Braver Stern Securities LLC.

Let me restate that in English: Someone sold us more than existed - that is, they naked shorted the bonds to us.

Now naked shorting is supposed to be illegal.  Especially when it's intentional naked shorting - not an "accident."

One can hardly argue that 25% of the float being sold naked short is an "accident."  Rather, it sure looks like an intentional act of selling that which you do not own and cannot (reasonably) acquire, fueled by the fact that failing to deliver is, at present, "reasonably cheap."

But it's only reasonably cheap because we have this special class of people in NY that can sell things they don't have, with no reasonable expectation of being able to deliver within the agreed terms.  In the "real world" of commerce such an act is called "fraud" when practiced intentionally and on a grand scale.

Oh sure, occasionally every businessman sells something he is unable to deliver on the original agreed terms.  We accept this, and while there is occasionally some sort of penalty or sanction, it's part of business.  You say you're going to deliver 10,000 Widgets on June 1st, and come June 1st you only have 9,500, because you were a bit too optimistic in terms of how quickly you could manufacture them.  Perhaps you pay a penalty for that, perhaps not, but it's not an intentional act.

That argument - that it's all an "accident" - is darn hard to sustain when the amount of product that is sold short without the ability to deliver is some twenty five percent of the total float outstanding.

Where are the cops?

We have seen the argument from some commission participants (Peterson for one) that Social Security is too expensive for those who need it and pay for it because it is an 'entitlement'. We also have read from some Congress members (Senators Kyl and McConnel) that tax cut extensions of the Bush presidency are not deficit producing and need not be part of pay go.

The Fiscal Times has an article on considerations being undertaken by the Commission for Deficit Reduction. (H/t coberly).

The main theme in this article is that the "tax expenditures" home mortgage deduction and health insurance premium deductions are actually government spending (I assume in relation to the deficit) and thereby letting these taxpayers keep their money is bad. (Because these are "tax expenditures" and not "tax cuts"?)

I see a pattern here unfolding in this series of electioneering statements. Maybe politicians can put it altogether for us before the elections so we know who should pay and who should not in a less confusing way.

Quote is below the fold, bolding is mine:

As the 18-member bipartisan panel met in public for the fifth time, it was becoming clear that the tax system is under its microscope and there are many ideas under review for the long term. The commission's success has always hinged on whether its leaders could muster support among Republicans for changes to the tax system, and agree to major spending cuts and changes in Social Security, Medicare and other entitlement programs that dominate the budget. So far, the GOP members are still at the table.

The most obvious target is recovering the huge amounts of revenue lost to federal tax loopholes known as “tax expenditures,” which include the home mortgage interest deduction and tax-free health premiums for employees. Proponents of rolling back these breaks say they are essentially government spending via the tax code. But health care premiums and mortgage deductions have long histories and are considered untouchable by some.

Erskine Bowles, one of the commission's co-chairmen, pointed out that these loopholes cost the Treasury as much as $1.3 trillion per year, which is larger than total tax revenue. Bowles, citing an op-ed by Reagan White House economist Martin Feldstein, suggested that tax expenditures must be part of any serious attempt to limit spending.

Maya MacGuineas, president of the Committee for a Responsible Federal Budget, told the commission that the current system of tax expenditures is "one of the most detrimental things to the country." But she also pointed out that they would be among the more difficult programs to touch.

Senate Budget Committee chairman Kent Conrad, D-N.D., who leads the commission's working group on taxes, said that he has become convinced that more comprehensive tax reform is necessary to update a system that was built for an era in which the United States did not face global competition. "My own conclusion from this [working group review] is that we really have a tax system that is badly outdated," he said. "It no longer relates to a world that we are in today."

In addition to massive lost revenue through tax expenditures, the Treasury loses another $340 billion or so each year in taxes that people owe but simply do not pay, Conrad pointed out. "These are things that require a focus in our work."

“This, in the long run, will be inflationary so I would rather play the short side of the bond market one year out than the long side.”

Marc Faber is an international investor known for his uncanny predictions of the stock market and futures markets around the world.

Amazing stuff here...

The new law (financial reform) will make ratings firms liable for the quality of their ratings decisions, effective immediately. The companies say that, until they get a better understanding of their legal exposure, they are refusing to let bond issuers use their ratings.

So let me see if I get this right.

The Ratings Agencies get "privileged" access to deal information.  Individual loan data, aggregates, all sorts of stuff that is not released to the potential buyers of a particular issue.

They then issue a rating based on both the known-to-all and the known-to-only-them data.

But they refuse to take responsibility for that rating.

Well now isn't that special.  The issuers, of course, are unhappy:

Several companies are shelving their bond offerings "indefinitely," according to Tom Deutsch, executive director of the American Securitization Forum, which represents the market for bonds backed by assets such as auto loans and credit cards. He said he knew of three offerings scheduled for coming weeks that are now on hold.

So these issues are unmarketable without a rating, but the rating has no meaning because the agencies won't stand behind it - particularly, if it is found that they were negligent in some fashion down the road.

If you think this is the worst bit of circular logic you've heard in a while, you're not alone.  A thing that is only marketable with a rating is obviously only marketable if the rating actually means something. 

If nobody will stand behind their "rating" then in fact there is no rating at all and the issue is unmarketable in the first instance.

I offer my congratulations to the ratings agencies for finally bringing this little inconvenient fact into full public view, and defining themselves not as "ratings agencies" but rather as advertising departments for the major banks, puffery and all.

May they rest in peace.

Amazing stuff here...

The new law (financial reform) will make ratings firms liable for the quality of their ratings decisions, effective immediately. The companies say that, until they get a better understanding of their legal exposure, they are refusing to let bond issuers use their ratings.

So let me see if I get this right.

The Ratings Agencies get "privileged" access to deal information.  Individual loan data, aggregates, all sorts of stuff that is not released to the potential buyers of a particular issue.

They then issue a rating based on both the known-to-all and the known-to-only-them data.

But they refuse to take responsibility for that rating.

Well now isn't that special.  The issuers, of course, are unhappy:

Several companies are shelving their bond offerings "indefinitely," according to Tom Deutsch, executive director of the American Securitization Forum, which represents the market for bonds backed by assets such as auto loans and credit cards. He said he knew of three offerings scheduled for coming weeks that are now on hold.

So these issues are unmarketable without a rating, but the rating has no meaning because the agencies won't stand behind it - particularly, if it is found that they were negligent in some fashion down the road.

If you think this is the worst bit of circular logic you've heard in a while, you're not alone.  A thing that is only marketable with a rating is obviously only marketable if the rating actually means something. 

If nobody will stand behind their "rating" then in fact there is no rating at all and the issue is unmarketable in the first instance.

I offer my congratulations to the ratings agencies for finally bringing this little inconvenient fact into full public view, and defining themselves not as "ratings agencies" but rather as advertising departments for the major banks, puffery and all.

May they rest in peace.

Over the past couple of months I have made the technical case for being long Treasury bonds. Below is a list of articles chronicling my analysis.

Treasury Bonds: The Correct Play Is To Be Long (February 23, 2010)

What I Am Watching (Part 1): TBT and TLT (April 13, 2010)

Bonds Look Attractive (June 24, 2010)

The Case For Treasury Bonds (July 8, 2010)

My description of the equity market is that it is one good banana peel from sliding down that slippery slope into what could be a waterfall decline. That is the implication of all these failed signals that I have been writing about for weeks now. Equities should go higher from these levels, but they aren't as buyers are not materializing, and this is troubling for the bullish case. At best, the equity markets are just hanging on by its finger tips.

Similarly, Treasury bonds have yet to bust out, or conversely, Treasury yields are just hanging on by their finger tips as well. This can be seen in the weekly chart of the Ultra Short 20 + Year Treasury ProShares (symbol:TBT). See figure 1. This is a 2x leveraged ETF product that tracks inversely to the daily performance of the Barclays Capital 20+ Year U.S. Treasury index. The black dots are key pivot points.

Figure 1. TBT/ weekly

TBT is sitting right at support of 36.26. A definitive close below these levels would likely lead to much lower yields and a flush in the equity markets as well. It is no coincidence that Treasury yields are in lock step with equities. This would be a continuation of the secular move in Treasury bonds that started several months ago.

With the economy softening and the Federal Reserve unable to provide a positive catalyst in the form of lower rates, the bond market has taken up of the slack producing lower yields. For example, mortgage rates have dropped over the past month enticing homeowners to refinance. It may not clear the glut of homes on the market or get us back to the old days of your house as an ATM machine, but lower rates do help. This appears to be a trend that will continue especially since Washington and the Fed no longer have the political will to expand the deficit.

Bonds are not a good place to invest in. You should own commodities because that’s your only refuge whether it’s silver or rice.

in Kuala Lumpur

Related ETFs: iShares Silver Trust (ETF) (Public, NYSE:SLV), PowerShares DB Agriculture Fund (Public, NYSE:DBA)

Jim Rogers is an author, financial commentator and successful international investor. He has been frequently featured in Time, The New York Times, Barron’s, Forbes, Fortune, The Wall Street Journal, The Financial Times and is a regular guest on Bloomberg and CNBC.

It’s Primary {3} and we need a new label for those wave counts – so let’s give a warm (and long overdue) welcome to Clockwork Orange. The bearish scenario the bears have been patiently waiting to see for almost a year now. And one that Wall Street has its unique way of welcoming:

That’s right, the bears are back – like it or not. There will be a lot of pain – there will be blood – and there will be a lots of ass kicking mixed with generous helpings of bitch slapping. My advice to the bulls: Wear a cup – this will get ugly. To celebrate this occasion the Evil Lair has now officially been set into extra evil mode – which is one step below the max setting of turbo evil. Expect the worst – and if you’re a stainless steel rat – expect to profit.

Let me celebrate the occasion by sharing this little gem that’s starting to make the rounds:

This is right out of the Book Of The Dead [Markets] – on the left you see the 1987 crash which was preceded by a fractal pattern. One that is repeating itself right now. I sent it to Chris Carolan a few days ago and he came back with the little (but most important) tidbit about the Lunar Eclipse – again the timing is spot on. Mmmmhhh.. I wonder how it all ends this time – anyone buying the dip?

Yes, Soylent Green is dead – we could see a little bounce here near term but medium term I think this market is going to fall off the plate. That is based on the level of bearish sentiment I see out there – and remember large scale drops happen in oversold conditions. Quite frankly I think we are heading into a perfect storm – bring a sweater.

That’s what I’m seeing on the Dow medium term. By the time Minor 3 of Intermediate (1) concludes I expect the Dow to trade in the 8000 range. That is probably when we’ll cover and wait for instructions – of course it’ll all depend on the wave pattern and I will keep everyone in the loop (no bi-monthly vacation for this blog host – ahem…).

Here is something I don’t see anyone talking about. Look at where medium/long term yields are at right now – the 10-year (TNX) is basically where it was at the end of Primary {1} in March of 2009. The 30-year (TYX) is trading slight above but is sinking quickly. What does that tell you about the medium term risk assessment of bond traders? And we have not even dropped yet! Admittedly I am not a bond trader, so if someone with a clue can chime in on this subject I would appreciate it.

Cheers,

Mole

There are two trades in this market: the risk trade and the non-risk trade. The risk trade is in equities and all the other assets, like commodities, real estate and emerging markets, that have become highly correlated to equities. The non-risk trade is in bonds. This works when equities don't. With the bounce in equities sputtering (but not having rolled over yet), Treasury bonds are looking attractive.

"Cash and bonds will be very dangerous in the next 10 years as governments increase money supply to cover fiscal deficits."

in Business Week

Marc Faber is an international investor known for his uncanny predictions of the stock market and futures markets around the world.

Oh oh....

April 9 (Bloomberg) -- China’s finance ministry failed to draw enough demand at sales of 273-day and 91-day treasury bills today after the central bank tightened control on money supply to restrain inflation, according to traders at two banks.

On the short end too!

Why?  Because they're trying to get suckers, er, investors, to loan the government money at a below market rate.

Expectations are of course that the yields will rise - that is, the government simply wasn't offering enough interest.  We shall see.

Bubble bubble toil and trouble.....

So spaketh Goldman

Goldman Sachs Group Inc. is recommending high-yield, high- risk bonds with rankings in the BB tier, the first below investment grade on the Standard & Poor’s scale. Pioneer Investment Management Inc. favors BB and B bonds, the next lowest bracket, while saying the riskiest debt is overvalued. Debt ranked in the BB category gained 39.1 percent in the past 12 months, underperforming the CCC tier by 66 percentage points, according to Bank of America Merrill Lynch index data.

This sort of "advice" reminds me of Alan Greenspan telling people to go get adjustable rate mortgages when rates were at generational lows.

Bond values, assuming you don't intend to hold to maturity, move inversely to rates.  The more duration you take on, the more they move.

So if you hold a long-duration "junk" bond with a very nice coupon and rates go higher, I hope you like holding that trash until it matures, because if you try to sell it you're going to get an ugly surprise.

The real screw job in all of this is that it's entirely possible you could buy a Treasury in the next few years for close to what BBs provide in terms of coupon now!

Spreads on BB ranked debt have fallen 0.66 percentage point to 4.07 percentage points since the start of the year, the Bank of America Merrill Lynch index shows.

4.07% spreads eh?  So assuming we have a 10 year instrument the current yield would be about 8%, which sounds awfully good - until the 10 year goes to 6% in a year or two.

Then it looks like hell, and as borrowing costs go up default rates will too, which means that "BB" rated debt might have realized credit risk embedded in there (but heh, you were "paid" for it, right?)

I want to own bonds in a falling rate environment.  Not only do I get an outsized coupon for the duration should I choose to hold to maturity I in addition get capital gains if I decide to sell early.  Finally, credit risk is diminished as rollover and/or issue is easier (cheaper in terms of interest cost) into a falling rate environment.

I most certainly do not wish to hold bonds in a rising rate environment.  Not only do I get a diminished coupon relative to new issues of th same credit quality if I decide to hold to maturity but if I have to sell early I'm going to get positively hammered on the net-present-value of those instruments.  Worse, whatever alleged credit risk that is embedded in those instruments has an increasing probability of turning into realized credit risk resulting in not only a mark-to-market loss due to the rising rates but an actual capital loss due to default.

Of course there's no mention of these facts in the so-called "free press."

I wonder why?

I also wonder if someone proffering these "ideas" has a lot of "BB" rated bonds they need to sell, or a bunch of companies that would like to issue at that credit quality they underwrite for......

Borrowing costs are going up, and this chart says they're going up a lot - like 200 basis points within the next year or so on mortgages and 10yr Treasuries.

Key to the thesis of Bernanke (and essentially everyone else) that this "V-shaped" recovery could take hold and be sustainable - instead of being a false dawn - is the premise that mortgage rates would behave.

Bernanke's thesis, in fact was that he could cap 30 year money at 4% or less to prevent home price devaluation.

Well, now the 10 year bond is back where it was before the collapse.  That's good, right?  Well, not really - because it means that 30 year money (mortgages) will start backing up shortly and prices on existing Fannie and Freddie (along with other long-duration) paper will start falling.

The target on this breakout of the inverted head-and-shoulders is 6% on the ten year treasury, and approximately 7% on 30 year mortgages.  As of today's pricing (about 5% on that same money) we can back into the home price impact quite simply; the hypothetical $200,000 house will be devalued to $161,644.55.

That is, the same payment that today pays down a $200,000 mortgage will only pay down a $161,644.55 one.

The time on the full expression of this target is one to two years hence, although it can occur sooner.  The reliability of this sort of pattern is extremely high, and remains valid conditionally even with a drop back to 3%, and is not invalidated unless the ten year were to get down to 2.03%.  Neither is likely.

The entire premise of the so-called "recovery" not only requires stabilization of the housing market but a resumption in home price appreciation.  With the cost of mortgage money nearly-certain to rise toward the 7% range over the next year this is simply impossible.

The market will not ignore this for long, once it begins to express itself in actual rates and prices - and it will. 

If you're one of the trapped underwater homeowners who as of today has an opportunity to short-sale your house, take it - while it still is available. 

Consider that The Fed is holding a literal trillion of this paper which is likely to come under extreme valuation pressures as rates back up.

Additionally, the sentiment in the market today is positively giddy - those who claim that retail is "not in" need to look at the ISE index, which hit an all time high today.  That's all retail call buyers - they sure are "in", and now the shears can come out of the drawer.

Parabolic moves like this always go further than you'd expect or believe possible.  But the math always wins, and the sort of rate environment we're seeing now is quite similar to what happened in 1987.

No, this is not predicting a 1987-style crash - at least not today or tomorrow.  But with both rates and oil headed up hard the effective tax this presents to the economy is going to hit home immediately and hard, with no evidence that this very same backup in oil is in commodities generally (look at wheat lately?)

That's not inflation, it's financial speculation in a blow-off top.

Real job creation and a healthier economy?  We'll see.

Our composite indicator that assesses the strength in the trends of gold, 10 year Treasury yields, and crude oil will remain in the extreme zone by the end of the week. This represents a headwind for equities.

For the longest while, my mind set has been to expect higher yields accompanied by higher equity prices. After all, wouldn't higher yields be a sign that the economy is expanding and on the track to recovery? Or to put the relationship between bonds and equity prices in another light: if the equity markets would ever sell off, wouldn't bonds catch a bid as there is a flight to safety? But the technicals have me rethinking these relationships. Is it possible that we could have higher yields and lower equities?

Now we're going to have to threaten to use them....

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

Got that one?

The Market has now called the bluff of Obama and the rest of the government: go ahead and keep deficit spending, and there will be private companies that are safer - in terms of credit risk - than the United States Government.

This is not "exceedingly rare", it is a warning. 

A strong, clear warning.

It's one I expect the administration to ignore, but sticking one's head in the sand on this issue is extremely dangerous.  Doing so could easily lead to the government winding up with a spiral going the wrong way - and fast.

Don't expect Obama and Geithner to "get it" until it's too late... but as I pointed out this weekend we are rapidly approaching the point where all this arm-waving simply won't matter.

I finally had some time to update my BAA-TYX spread chart this afternoon and, like many of my other indicators, the results are not very inspiring for any remaining bears:

As you can see we had a promising upswing during the drop but since the ramp up any loss of appetite for corporate junk bonds has quickly faded. Risk is still in and bearish sentiment is out.

For the noobs: Bonds are generally classified into two groups - “investment grade” bonds and “junk” bonds. Investment grade bonds include those assigned to the top four quality categories by either Standard & Poor’s (AAA, AA, A, BBB) or Moody’s (Aaa, Aa, A, Baa).

The term “junk” is reserved for all bonds with Standard & Poor’s ratings below BBB and/or Moody’s ratings below Baa. Investment grade bonds are generally legal for purchase by banks; junk bonds are not.

The specific definitions assigned to junk bond ratings by the services help define the magnitude of the risk associated with them. Because Standard & Poor’s definitions are somewhat more comprehensive, they are quoted here:

BB, B, CCC, CC, C: Debt rated BB, B, CCC, CC, and C is regarded, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. BB indicates the lowest degree of speculation and C the highest degree of speculation. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions.

BB: Debt rated BB has less near-term vulnerability to default than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to inadequate capacity to meet timely interest and principal payments.

B: Debt rated B has a greater vulnerability to default but currently has the capacity to meet interest payments and principal repayments. Adverse business, financial, or economic conditions will likely impair capacity or willingness to pay interest and repay principal.

Because a B rating is the single most common rating found in a junk bond portfolio, Moody’s definition of its B rating follows:

Bonds which are rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small.

To resume with Standard & Poor’s:

CCC: Debt rated CCC has a currently identifiable vulnerability to default, and is dependent upon favorable business, financial, and economic conditions to meet timely payment of interest and repayment of principal. In the event of adverse business, financial, or economic conditions, it is not likely to have the capacity to pay interest and repay principal.

D: Debt rated D is in payment default.

I guess I should explain how this affects us equities/options traders.The BAA-TYX chart measures the yield spread between bonds rated one step above junk versus the yield of the supposedly most reliable and safe bond there is, the U.S. 30-year treasury bond. In the past it has been observed that a narrowing of the spread often precedes a rise in equities and inversely that a widening of the spread may be a sign of trouble ahead. Is a big drop in equities always preceded by a widening of the BAA-TYX spread? Well - sometimes it is - but if you parse through this chart you’ll also notice that it doesn’t always pan out this way and that it sometimes lags behind a little. Still, it’s something we want to be on the lookout for in case it does occur.

What does it all mean? What it means is that QE sponsored bullishness continued unmitigated and in full blast. Bond traders are usually a lot smarter than equity traders (let’s face it - most of us are small timers without much of a clue) and I do not see any indication that this trend is about to change any time soon. The BAA-TYX spread keeps narrowing further and further and it’s a visual representation of how quantitative easing is attempting to re-inflate our credit bubble just one last time.

Let’s have one for the road, shall we? Tomorrow we all dine in hell.

Cheers,

Mole

One of the frustrating aspects about this market environment is that all assets look like the same trade. Betting on equities is a bet against bonds or vice a versa, betting on bonds is a bet against equities. It is that simple. Consequently, using a tactical asset allocation strategy makes it hard to diversify away my risk as I end up being all in on essentially what has become the same trade.

There are several commentators on the web that I read consistently, and John Hussman of Hussman Funds is one of them. I always take great comfort when my analysis rhymes with his because like myself I know he does his homework too.

If you look at market history since 1940, this condition has been in effect nearly 20% of the time. Yet this set of factors alone has made an enormous difference in the returns achieved by the market. When the above conditions have been in effect at the same time, the S&P 500 has actually lost ground on a price basis, and has delivered an annualized return of just 0.28%. In contrast, when those conditions have not been in effect, the market has advanced at an average annualized rate of 14.94%. Of course, these averages mask a lot of volatility, but it is clear that even the most basic combination of low stock yields and rising yield pressures is hostile to total returns.

To the above conditions, if Treasury bill yields are also higher than 6 months earlier (again, regardless of the absolute level of yields), the annualized return drops to -0.83%. Add a discount rate higher than 6 months earlier, and the annualized return drops to -2.22%.

Now this is interesting...

March 5 (Bloomberg) -- Fannie Mae and Freddie Mac bondholders shouldn’t assume the government will make them whole on their investments as Congress retools the companies, House Financial Services Committee Chairman Barney Frank said.

Heh, who's the biggest individual bondholder?

Mr. Bernanke, the bond market is on line #1!

Frank continues:

A “whole range” of options is being considered for investors in the two government-seized companies, “from paying nothing to a haircut to whatever,” said Frank, whose committee oversees Fannie Mae and Freddie Mac.

Nothing?  You mean zero, zilch, bupkis? 

That would be rich.  After Bernanke stepped in and bought some $200 billion of their debt, to have it "marked to zero" would be the ultimate slap in The Fed's face for buying that which I have argued is impermissible under the law.

What an elegant solution to a difficult problem - "oops - tear 'em up jackass - you should have known better than to buy something that you weren't allowed to and was patently worthless!"

The irony of that outcome would be delicious.  Yes, I know I'm dreaming here - or am I?

“Please don’t think this is federally guaranteed, I don’t think it is, I don’t think it should be, I don’t feel any obligation to bail you out,” Frank said. Congress will “certainly not” extend any new protections to bond and mortgage-security investors beyond what exists, Frank said.

Oh.  You mean that the face of those prospectuses mean what they say?  You mean this is real?

Uh, the market is kinda ignoring that right now, isn't it? 

Yes, I think it is.

How about this for a clear statement?

“We’re not remaking Fannie and Freddie,” Frank said. “We’re going to start from scratch and do housing finance.”

Go ahead folks, keep buying.  This is spelled "opportunity", thank you very much.  Now please excuse me while I go put a few chips on "red."

PS: Why are these stocks still listed again?

I feel like the robot in the television show, "Lost In Space". Investor sentiment remains bullish and trends in gold, crude oil, and yields on the 10 year Treasury bond are collectively becoming extreme as well. This combination has me thinking: "Danger, Danger Will Robinson".

Our composite indicator that assesses the strength in the trends of gold, 10 year Treasury yields, and crude oil is likely to be back in the extreme zone by the end of the week. This represents a headwind for equities.

Over the past many months, I have spent much time on this blog writing about US Treasury bonds. Treasury bonds have become a tale of two diverse stories, and both stories have the potential to be secular or generational in nature.