KRUGER INSIGHTS FRIDAY, OCTOBER 11, 2013

By: Joel Kruger

DISASTERS NARROWLY AVERTED - So it looks like the drama of the government shutdown and debt ceiling are practically behind us, and shockingly (joking), the government is going to reopen and the US will be able to pay its bills!! Who could have seen that coming? Yet the stock markets are once again enamored with the development as if it has come out of nowhere and we are once again near the recently established record highs. Such euphoria over something that was far from unpredictable (sarcasm). Throughout the week I have said multiple times that these short-term distractions mean nothing in the medium-term and should ultimately only weigh on risk assets, rather than meaningfully support them (given the very real medium and longer term structural concerns associated with the US debt crisis). There is no debating that this latest surge in risk assets has been driven off of the prospective resolution in Washington. But how much longer can risk assets remain supported on bad things that didn’t end up happening? Over the course of the past several weeks, all we have seen to support risk assets have been disasters narrowly averted. No Syria, no taper, no Summers, no debt limit. If I were a conspiracy theorist, I might say that it almost seems as though the US administration has created a ton problems that it knows will be resolved in an effort to deceive the public into believing that the government is doing a great job and everything is just peachy.

DISCONNECT -And yet, this is not the case, and the real issue for the US and global economy is monetary policy, and the implications of Fed exit over the coming months. Risk assets have been artificially support by ultra-accomodative Fed policy for several years and this support has propped up the entire global economy. The trouble is, the US and global economy are still far from recovered and these excessively unusual monetary policy measures are now fully extended. There is simply nothing left in the tank. So what now? Well…some necessary realities need to set in, and market participants need to understand that whether it starts in a few weeks or few months, the Fed will be forced to start the reversal (taper). As this happens, the incentive to be in risk assets will become severely compromised. Right now, the disconnect between the real economy and financial markets is staggering. And why such a disconnect? Perhaps one of the big problems has been that the rewards in the financial markets from monetary policy incentive have not trickled into the real economy. Even though money is historically cheap, it doesn’t mean a whole lot if it can’t be accessed.  

THE LIQUIDITY TRAP – This is what is described as a liquidity trap, and this can be a very dangerous thing. Simply put, those with the benefit of having cash, have been able to borrow at nothing and put that money to work in equities (nowhere else to put money to work). Yet those with nothing, still have nothing and have no real means to take advantage of the free money. Though money is cheap, it is simply too difficult to get approved for access to this money. So presumably, with nothing left in the Fed’s bag and monetary policy as extended as it can be, it stands to reason that these artificially supported risk assets could be quite vulnerable in the weeks ahead. Those with cash will liquidate their positions and drive stock prices lower, and those without cash will be in an even more difficult position as money becomes more expensive. So right now, the markets have chosen to disregard these concerns, as we apparently live in a time where the mentality has defaulted to always pushing off the longer-term risks and only dealing with the problems of today. At one time, this strategy seemed to be somewhat justified, but now what was once the exception has become the rule. This is very disturbing. So I hold onto my bearish risk outlook in these very dark days and maintain my convictions.

TECHNICALLY SPEAKING – Aside for the compelling fundamental rationale, the technical picture is also very supportive. Technically, most risk correlated assets appear to be trading by cyclical highs, and are now slowly in the process of topping out. Though the Thursday jacknife reversal in US equities was an intraday stomach turner, if we look at the weekly US indices charts, these major indices have still managed to put in fresh weekly lower highs and lower lows (heading into Friday). The case for a meaningful top is still highly compelling, and should stocks close lower on Friday (I know this is a big IF), this topping structure will still be very much intact. This extends to risk correlated currencies as well, and even though we have seen currencies like the New Zealand Dollar well supported in recent sessions, there is still evidence of the formation of a major longer-term top in this market against the US Dollar. Though I am a currency guy, right now my focus is on the US equity market and I am looking for any signs that these investors are finally ready to wake up to the reality that at a minimum, a very healthy corrective pullback is on the horizon. One final thought – I have found throughout my career that some of the biggest trend reversals have occurred when those fighting the trends have given up and thrown in the towel. After putting in a major fight, they are exhausted and finally concede defeat. Quite often, when you least expect it is exactly when these reversals happen. Perhaps now is when a bearish reversal is least expected.