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Pending Market Liquidations

 

By Chris Laird             Printer Friendly Version

August 8, 2006

www.prudentsquirrel.com

This is an excerpt from this week’s PS newsletter, an 18 page special report on coming market liquidations.
                                       
Gold is at 650 ish but I don’t think this is going to last. The recent oil pipeline issue should have gold above 700 now, particularly with the unresolved Mid East situation. This is not the case, and so, I talk about why markets are set up for big liquidations. Geopolitical events combined with the latest pipeline problems in Alaska should have gold over 700, but gold is 50$ lower. That is a very big signal that gold is going lower in a few weeks at the outside. The geopolitical situation and the oil prices should have gold way up but gold has not reacted like it should, ie rising over 700 in my estimation, therefore, there are gigantic gold bearish forces short term ( less than 3 mos).

Please do not interpret this article to mean that you should sell bullion. I have just bought gold bullion at 635 spot this last week. I believe in buy and hold, and I do this personally. This viewpoint on gold is a short term view- that I see huge bearish forces.

By far the biggest overhang on commodities is pending financial market liquidations. I still firmly believe that world markets are set up for big liquidations. The fact that gold is at $645 now is mostly because of the Mid East turmoil. If that situation were either to stabilize or calm significantly, gold could go below $600. Believe it or not, markets are set up for huge liquidations within two months, and gold is going to take some of that too. The latest PS newsletter talks about why. This public article is only some excerpts. It is not the whole picture.

The latest Fed move will likely be a raise in rates as well. I know there is a lot of speculation that the Fed will raise or not raise. I give a raise better than a 50% probability.

Hedge funds ready to front run market drops

Hedge funds are going to front run any coming market liquidations, if these are in the cards, as I suspect.

The reasons again for coming market liquidations are:

Rising interest rates
Slowing economies
Profit taking coming after record bull markets overseas – to include commodities

Oil is an exception.

Gold’s recent drop to 601 Monday suggests to me that we are right at the cusp of significant market liquidations. I look at gold as a telegraph. Gold’s action last Monday indicates to me that Hedge funds are just about to start betting on dropping markets.

If Gold was in a large bull trend, hedge funds would not have bid gold down then up again so fast.  Since they are really swinging markets now, and gold dropped and recovered so fast last week, I think hedge funds are just about to get into downward market bets in earnest. This is based on the overall market sentiment that I see for financial markets in general.

Last Monday’s gold action, a rapid drop and recovery, shows that gold is in a short term pause overall. I think gold is indicating a coming market liquidation situation world wide. My reasoning for gold to be in a pause is that gold should now be over 700 – due to geopolitical and oil issues, but even Mid East war and a leaking oil pipeline in Alaska is not sending gold to that level, meaning there are large gold bearish forces overhanging this market.

Inflation or stagflation?

I would think that with inflation rearing its head everywhere that gold would find this consistently bullish. But perhaps, gold is also looking into the future and thinking that cooling economies and rising interest rates are going to override gold bullish forces like inflation. The fact is that there is a lot of weakness and strength combined in the world economy. Employment is down but consumer confidence is up. Etc.

And the Mid East tension is gold bullish, but gold is only $10 higher than a week or so ago from 635 Friday before last. If inflation was really the monster coming out of the lagoon now, why hasn’t the Mid East strife caused gold to go over $700 already, particularly with stronger inflation numbers here, in the EU and Japan????

Let’s talk about some of the long term macro trends, and this is not your usual gold bull take on this issue.

Stagflation?

World central banks are caught in a situation where, if they don’t raise interest rates, inflation will get out of control. But then economic activity will be suppressed if they do raise. Meaning? Possible stagflation, (inflation and economic stagnation). If they get it wrong, we get severe recession at the minimum and deflation at the worst.

To be honest, I think the deflationary forces are going to be more of an issue. The US accounts for the vast majority of world economic demand. China is up there, but aside from commodities, does not really create demand for manufactured goods near the US or Japan, or the EU.

China and India not ready to replace US and Japanese consumer demand

Frankly, the theory that demand for manufactured goods from China and India is going to lead soon to real consumer bull forces there is about one recession ahead of itself. In other words, they are not quite mature enough economically to be able to replace the US, and the West’s consumer demand. There will be at least one major recession or depression before China and India can replace the demand for manufactured goods from the West, that is, The US, Japan and the EU.

Interpretation? The world would see a synchronized recession at the least, or a synchronized depression at worst, before China and India can self propel themselves with consumer demand.

China and India to become the Next economic miracle like the US?

This gets to another issue. Suppose that, even though China and India are growing so fast, that, if there was a really severe economic downturn, their economic momentum were to stop cold, and the weight of their now much poorer populations just drags them downward, and the US is unable to get its massive consumer demand going until our debts are washed out.

You know, the world had the great depression in the 1930’s. It is widely believed that, had World War 2 not happened, the world would have had another ten years of great depression. In other words, who is to say that a depression always naturally leads to an economic resurgence? Who is to say that if the world enters a severe recession that China and India are ready to take over the West consumer demand?

The US won WW2, and started a world wide economic boom in the West, and did it with cheap energy and incredible technical advance. Who is to say that, with out cheap energy now, and after the world enters a severe recession, that another period of great prosperity would occur?

Might it not occur? Particularly with nations like China and India supposedly to be the new drivers of world economic prosperity?

What I am saying is, perhaps China and India will become so entangled in domestic issues with their massive populations that any so called economic rejuvenation would be stopped cold by chaos, starvation, regime change, war or who knows what?

After the great depression, the US had very cheap and abundant energy, a stable population situation, and had just won a great war. The baby boom was created.

But in the case of China and India, the last thing they need is a baby boom. They are not looking at a cheap abundant energy future. They do not have the natural resources other than oil that the US has, i.e. they all have to be imported- bought at high prices. China in particular, has severe social strife about industrialization and the confiscation of farms for plants.

China has very little rule of law to prevent unscrupulous local officials and businessmen from raping the countryside.

In other words, China and India just do not have the kind of factors that led to US economic dominance after WW2- Rule of law, a stable and advanced financial system, cheap natural resources and energy, stable population.

Rather, China in particular has:

-Severe social strife driven by their economic development
-Costly energy demands
-No real rule of law
-A very unstable financial sector that is not sophisticated. It is consistently bailed out with their excess foreign reserves.

In short, China is out of control. The US was, on the other hand, very much under control and stable for its unparalleled economic boom after WW2. China has repeatedly tried to reign in their economy though increasing reserve requirements for their banks to 8%. Increasing their interest rates by 1.5%. Nothing is slowing their economic growth. But a lot of this is creating over capacity. And a very serious real estate bubble that is collapsing as we speak in Shanghai.

Is all the economic personal reporting by the usual gold bulls here going to China and writing glowing reports about the China economic juggernaut perhaps about one major depression ahead of itself? Because China is about to have a gigantic manufacturing, speculation and real estate bubble collapse? And how likely is China -an economic wild west- to survive the long ten years of economic collapse that happens during a depression, if things get that bad????

What I really see for China is: economic strife, internal rebellions, international energy wars, financial chaos. They are really set up for a big economic fall if the world were to have any real economic decline.

So, all this talk about China being the next US could be very overrated. The forces of chaos are far stronger than the forces of economic prosperity which require a lot of stability.

And this all is not to mention the fact that the world has been preparing for a great energy war centered on the Middle East. No nation can now afford to be without the essential energy that drives their economies. The alternative, not having enough energy, is economic collapse.

World Bankers Fear Global Financial Meltdown

“Hedge funds still make lots of profits, and by the spring of 2006 they were worth about $1.2 trillion worldwide, but they are increasingly dangerous. More than half of them give preferential treatment to certain big at this time of easy liquidity.” Low-interest rates, Avinash Persaud, one of the gurus of finance concluded, had led investors to use borrowed money to play the markets, and “a painful deleveraging is as inevitable as night follows day…. The only question is its timing.” There was no way that hedge funds, which had become precociously intricate in seeking safety, could avoid a reckoning and “forced to sell their most liquid investments.” “I will not bet on that happy outcome,” the Financial Times’ chief expert concluded in surveying some belated attempts to redeem the hedge funds from their own follies.

A great deal of money went from investors in rich nations into emerging market stocks, which have been especially hard-hit in the past weeks, and if they (leave then the financial shock will be great -- the dangers of a meltdown exist there too.investors, and the U.S. Security and Exchange Commission has since mid-June 2006 openly deplored the practice because the panic, if not chaos, potential in such favoritism is now too obvious to ignore. The practice is “a ticking time bomb,” one industry lawyer described it. These credit risks – risks that exist in other forms as well – seemed ready to materialize when the Financial Times’ Tett reported at the end of June that an unnamed investment bank was trying to unload “several billion dollars” in loans it had made to hedge funds. If true, “this marks a startling watershed for the financial system.” Bankers had become “ultracreative… in their efforts to slice, dice and redistribute risk, …”

http://counterpunch.org/kolko07262006.html

We keep getting peppered with headlines such as this one above. One or two points:
With the incredible complexity of derivatives and such, it is common that:

  • Huge deals are made with even mere scraps of paper, the Fed itself has tried to deal with back office backlogs of over a month.
  • The slicing and dispersion of risk has created a situation where no one knows the real liabilities of companies using derivatives, so it is impossible to know who has what exposure. This is a huge problem. This means that know one can foresee who will fail if there is an derivatives problem, or how many counterparties will fall together, even in a partial derivatives crisis. Once again, financial ‘innovation’ has created a wild west financial world that is so complex it will probably fail merely due to complexity alone if nothing is done.
  • Liquidity problems. Many derivatives are highly illiquid. Many times, over the counter derivatives have to be sold between two parties in huge chunks. Also the complexity requires a counter party to be able to assess the complexity before they make a trade. The OTC derivatives market is the majority of the derivatives trade. OTC is not like a stock market per se, where securities of known companies are bought and sold in a large dispersed market. When problems arise in OTC derivatives, liquidity dries up instantly to zero. This happened in the LTCM crisis, and prevented any rational unwinding of bad trades, and led rapidly to cascading defaults of many LTCM partners/counterparties. (counter parties hold offsetting derivatives positions).

Now that I outlined how hedge funds account for an incredible 50% of market volatility, I think the reality is it is all just a matter of time till they lead to world stock markets imploding. This will be due to a panic of de-leveraging and short selling by hedge funds.

I have stated previously that a changing world interest rate environment, particularly surprises, can just kill derivatives bets. Derivatives are now used in every financial and quasi financial market. They are also now used on every commodity. In short, every market that the normal public has their retirement funds invested in now has a huge unpredictable overhang of derivatives contracts with leverage over 100 to 1. Even a normal person knows that only 2 to 1 leverage can rapidly kill you.

If you are heavily invested in any paper market, maybe you don’t quite realize that with hedge funds now accounting for 50% of market volumes, and derivatives ballooning from 20 to 300 plus trillion dollars since 1990, that this is just not the same market you have grown up investing in. In reality, financial markets are total crap shoots now.

To have these financial markets continue going horizontal, like the US stock market for the last few years, the following will have to happen:

First, no surprises. No surprise interest rate hikes. No surprise hedge fund collapse on some bet no one knew about, like the LTCM crisis that emerged when the Yen carry trade unwound after Russia defaulted on their bonds. No war that sends oil prices and gold into the stratosphere. And so on.

Second, the PPT in Japan and the US performs with out error in any financial or market accident. So far they have been able to create relatively horizontal US markets for the last few years, the biggest test being just after 911. Such luck will have to hold.

Third, No Middle East war that sends oil to 200$. That would just collapse the world economies. It might lead to a panic resource war involving the US, China and Russia.

Fourth, no USD crisis. We have already talked at length about that.

Fifth, no ten sigma event (super surprise).Like a big financial hit by some insane terrorist on another major financial center that causes cascading selling and market liquidations.

Sixth, the chaos in the derivatives market does not fly off into an uncontrolled financial meltdown and liquidity crisis with counter parties acting faster than the Fed, Japan and any other CB trying to control it.

Seventh: No major economic decline world wide that tanks markets.

And so on. If I listed all of these, there would be more than 20.

20th, 21st, 22cnd, 23rd…. 45th 46th…. Etc.

Added together, the odds of any one of these scenarios not happening is low.

Or, put another way, the odds of any one or more of these happening is high.

I think hedge funds are one of the greatest risks on this list. For one thing, they are definitely going to be shorting stock markets soon. It is only a question if the PPT can stay ahead of them. The fact that they (hedges) account for 50% of stock market volume kind of speaks for itself.

Up to this year, hedge funds rode markets up. Well, many markets have dropped a great deal this year, and it’s just a matter of time for the hedge funds to front run the markets down. I think gold is suggesting this already. Gold is showing weakness, it should be over 700 right now due to the Middle East situation, and the only reason it didn’t go below 601 last week is because of the Middle East. If gold was looking at more normal financial markets, it would already be over 700 today because of the present Mid East war. There is therefore a 50$ discount on gold even now,(at 650) based on rising interest rates and coming financial liquidations due to years of bull markets overseas that are crashing and are going to spill over into the US.

This means that there are large market liquidations on the horizon. They are waiting till the Middle East settles into a predictable pattern/resolution. Then look out. I give markets right now a high crash alert assessment, several weeks after the Mid East settles down, if it does at all.

Typically in currency crises, the nations involved CB’s find that they can not stay ahead of speculators. They have to vigilantly watch these guys, who use leverage from 20 to 100 times their capital. If there was a speculator ‘bum rush’ in the US or Tokyo stock market, it is very possible the CB’s will not be able to stop them. They would have to print about ten trillion dollars in one day to cash all those shorts out.

I think that just might not happen fast enough, or there would be a rumor that the CBs are monetizing the markets, at that level, and they would end up having to buy half the total value of the markets to get ahead of the liquidations….At least all the investors with stocks, like mutual funds, would have to get out fast to avoid being creamed with 20, 30, 50% losses in a week’s time.

Frankly, friends, I don’t think we have even seen what can happen, how fast a panic can spread in this internet world, and spill over into the USD and Yen (they will fall together) and so on. One thing you should know is that the Yen and the USD are like sister currencies. If Japan were to see the USD fall drastically, they will print so many Yen to support the USD that the Yen will fall too in a real panic. This kind of thing happened in 2004, when Japan bought about $250 billion worth of USD instruments and supported the USD virtually alone.

Anyway, go read the piece linked above, from a respected international banker- about the risk of the new financial wild west that emerged after all the deregulation! This is NOT the financial market that you grew up with! Danger!

And remember that this writer worked as a systems engineer for Oracle Corporation on some of the largest commercial computer systems in the world. I know how vast and fast the electronic world is. If I say the USD could crash in a day to half its value- that is my informed opinion. It’s not coming out of the blue. I have good reasons for this view of how fast a USD collapse could happen.

Of course, this does not mean is must happen. Only that it is very possible according to me.

The Prudent Squirrel Newsletter is one of the few macro economic gold newsletters.
We try to give a big gold picture that takes in many factors. We also strive to talk about personal financial and physical survival.

The latest newsletter is an 18 page special report on coming market liquidations and the reasons I see for this. Stop by and have a look.

Christopher Laird
Editor-in-Chief
www.PrudentSquirrel.com

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The Prudent Squirrel newsletter is a gold and economic commentary. It is a big picture analysis of markets and gold that looks for new strategic trends. It is more sector analysis than stock specific. It is a commentary and is not investment advice specifically.