Weekly View 9 26 2011

Here They Be Dragons

The previous week was a doozy and will I believe mark a sea change in financial markets. Clearly the FOMC meeting was expected by global market participants to provide some solace or solution to the European crisis. But the Wizard of Fed was unable to provide any magic potion, whereupon the global marketplace paused briefly, sighed and then plunged headlong off a cliff.

We are officially in Here they be Dragons territory now. ( or maybe Bears)

Msci world free and Emerging Markets above, Europe and Latin America below.

Pretty complete rout of the equity markets (those are weekly 5 yr lognormal charts) but the carnage included commodities and non-dollar currencies and most surprisingly the precious metals. As Jim ONeill of BRICS fame put it For many weeks, investors and journalists have been asking for my views on the next safe havens. My usual response, especially since the bold actions of the Swiss National Bank, is that such things dont really exist. Many instruments and currencies especially, can

sometimes appear as safe havens, but as we have seen with the CHF, once policymakers choose to pursue certain policies, any notion of safe haven rightly vanishes. The decline of the Swiss Franc immediately after the SNBs move to announce a floor under the EUR/CHF at 1.20 was probably the fastest and largest single currency move in the history of major currency movements since floating. This should make all market participants think long and hard about safe havens. In this past week, the decline in gold prices has been dramatic, exhibiting the largest weekly fall since 1983. Not bad for a safe haven? Following the reversal of the Swiss Francs strength, it is tempting to explore the idea that the crisis might be coming to an end and, indeed, when one looks at the value on offer in equity markets and the inevitability of some major G20 policy response, it is not just idle temptation. For now, it is perhaps wiser to assume the gold decline is a savage correction, but it could be the end of its rally. It certainly has experienced some damage to many chart technicians views. I am never entirely convinced about the idea of a persistent safe haven as it really depends on the economic and policy circumstances.

Lower charts are copper and Brent crude weekly 5yr log charts also. Gold above. The chart following on the next page is the JPMorgan Asia Dollar Index which had relentlessly advanced till this recent washout. The previously stalwart Asian economies were suddenly seen as vulnerable to the evaporation of growth in Europe and the US.

A quick glance at the curve moves in Brent crude, CBOT corn and soybeans shows price drops across the board were almost parallel indicating little change in the supply but universal expectation of slower growth and weaker demand pressure.

So, what provoked this generalized regurgitation of market positions ? Three things in particular stand out for me. 1. US political leaders are campaigning for office, especially the executive branch, placing the entire responsibility on the central bank. The FOMC comes up with Operation twist to lower long rates in order to help homeowners refinance and improve free cash flow. They got some action look at the curve move in the 2yr 10yr spread.

Almost back to the end of the world prints in Dec 08. Unfortunately there are some undesirable consequences to 10 yr yields under 1.8 called negative real returns. What does a pension manager with an 8% return assumption do to meet his actuarial requirements? He cannot do anything but gamble or become even more underfunded than he probably is already. That means the municipality or corporation must increase their contributions accordingly. Those contributions in the case of corporations come right out of earnings and the bottom line. Earnings already

threatened by the lower growth now being forecast. This is not good for the equity markets and partially explains why so few have stepped up to buy this sell off so far. 2. The problems facing Europe are existential and the aristocratic leaders have stood up and --- and --- done nothing, but point fingers and meet at $1500 per night resort hotels.

3. China and emerging Asia, the exemplars of mercantilist growth and export driven subsidized economies have realized that recession and disintegration in Euroland and threat of recession in the US means they have no consumer of last resort. Markets are repricing based on much less rapid growth. Equities , commodities, and currencies all plunged this week. So, What Do We Do On Monday? George Goodman writing as Adam Smith related the story of his days as a young analyst at Fidelity when after a review and planning session following a harrowing week the founder Mr. Johnson said So, what do we do on Monday? My answer is wait and see. A very dissatisfying answer but there it is. Friday Art Cashin outlined the famous Thursday Monday crash scenario in his last morning note. The most famous of these was in 29 but, the 87 crash followed the same pattern. Horrible Thursday, choppy Friday and bottom falls out Monday. The crash scenario is very unlikely, but the seriousness of such an event makes it important to avoid vulnerability by utilizing fixed risk where possible. (long premium ) More likely is market action very much resembling the last 4 weeks with same uncertainty and nervousness. The weekend news seems to indicate hope that some European action can be configured and initiated by the G20 meeting in November, six

weeks away. Six weeks, some sense of urgency there, why not Christmas or May Day? Literally nothing has happened to improve the psychology of market participants. A weak opening would not be surprising. The past week saw liquidation of all kinds of speculative positions wich may have a bit more to run. I believe the gold and silver sell off us is a correction but even at this corrected price we have only pulled back to about July when this would have been the highest price ever. Does not seem like a popped bubble just a thinning of the herd. I still am interested in mining stocks hedged with metal calls. I believe commodities can continue to show weakness, and equities to grind lower till we have some action by Europe which sounds positive and can be spun into hope. Equity seasonality turns sharply positive in November. I still favor Asian area investments when some sense of calm is restored because that is the part of the world with well financed governments and growth driven by the rising middle class. A comedian once offered this solution for the problem of starving people in Biafra move where the food is. Well I say invest where the growth is. In the mean time Europe must act or devolve into financial chaos and soon. That is the driver for capital movement this coming week.

I have attached two pdfs both excellent and both long. I will put out a summary tomorrow but they are worth reading. One is Russell Napier and the other Donald Coxe.