Today's reality: Potential systemic failure or system failed?

Which came first, the chicken or the egg?

Apply that puzzle of philosophy as metaphor to global economics and financial markets, and we all wonder whether equities truly move in advance of economic fundamentals or react to them. Too many swings and oscillations occur to name this or that price swing as distinct from any large economic or financial news item.

In today's speed-of-light world, grave concerns increase re the sanctity of markets and economies, and markets react immediately, devastatingly. Or do markets' renewed declines anticipate follow-on weakness? The economic and financial problems the world faces are no secret; we all know them. What we do not not know, yet, is the fallout from all our past misguided policies and pursuits (by both business and government) and the maladroit attempt to control, top down, the consequences of past bad decisions and actions.

In The Lessons of '92, I alluded that bad decisions beget bad actions, which often create negative consequences. Market speculators smelled blood as a result of the bad policies and actions made by the Bank of England and the UK government, and dove in to the banquet. In The True Objective of All That Money I pointed out how welfare nations everywhere find themselves on a cliff's edge, with one foot dangling and the other sliding toward doom. And now the world finds itself on the cusp of a crack-up boom. (This article ably explains Ludwig von Mises' notion, and the terrifying nature of its consequences.) In essence, not good.

I, and other commentators, could argue (winningly) that the global financial system does not face possible systemic failure; in fact, the system already has failed. You need look no farther than last week's embrace by the EU of the detested nuclear option: the European Central Bank's (ECB) decision to purchase government bonds issued by euro zone members, thus abandoning their long-held resistance to such a move. And which action follows on our (the USA's) many bailouts of the past 2+ years, from which directives, policies, actions, and bailouts the Europeans recoiled with shuddering horror. "Welcome to the (debt) party, Europe! By the way, the hangover is a bitch."

What the Western world attempts today is as misguided as it is noble: to spend money it does not have, to create from thin air the paper necessary to 'cover' the new deficits, to paper over past errors with more paper, to issue more debt to fund existing debt. Oh, and to give to everyone everything he or she wants: jobs, holidays, health care, a car in every garage and a chicken in every pot. (NB: the protests in Greece will come soon enough to a piazza or square, or street, near you.)

For various reasons, parts of the world are immune to this outbreak of the debt contagion: the Middle East (for reasons cultural and religious) and South East Asia (because those nations endured their own version of this financial mess in 1997/1998, and came out for the better). China remains a question mark; the nation has gazillions of liquid reserves, but most of those reserves are in US$ denominated assets (Treasuries, the $ itself), which could wither to zero in an all-out financial storm. The Chinese know and fear this possibility, so the nation hastily diversifies into real assets -- which satisfies one step of Mises' crack up boom: "Everybody is anxious to swap his money against 'real' goods..." Pay attention to what China does with its excess reserves, continues to do, now and in the future.

Global markets reflect this concern, amid mounting doubts as to how governments regard their sovereign debt, and treat their debt-holders. (Servicing debt, especially with more debt, is a bitch!) China's markets peaked months ago, as did the European markets; they all are in the throes of their price corrections. The US markets... well, let's just say the rally since March 2009 is suspect. Chart below is of the S&P 500:

Note a trend that loses upside momentum; note, too, a possible head & shoulders top. (I ignored the integral component of volume, largely because volume has diminished throughout the recovery rally.) This particular, and potentially powerful, pattern remains a work-in-process, so its realization remains anticipatory; it requires a right shoulder (arguably complete) and a breach of the neckline (identified) to confirm. The double-arrowed line measures the potential for the pattern, ~160 S&P points from the breach, a potential decline to ~910-870. (The same level I pointed to for the past several months, well before this pattern showed up on the chart!) Several stair-steps lower must occur first, though, to validate the bearish scenario: 1125, 1110, 1100, the identified neckline, and the 6 May low of 1065.

What could go wrong with the bearish expectation...?
● No right shoulder forms;
● No breach of the neckline (~1070-1065);
● An accelerated rise from a pattern failure. (No pattern is as bullish as a failed H&S top!)

I could argue that the 6 May low represents a climactic low, which would put paid to the entire expected decline (albeit that expectation was for 900-870, not 1065); certainly the data reached oversold levels. Even were that the case, however, climactic lows typically are tested, sometimes repeatedly. Worse, US equity markets trade 'heavy' and a decline of one week, however seemingly climactic, is insufficient to erase all the technical divergences and negatives built up over the past 6 and 15 months. One possible scenario, of which I could limn many, is a sideways range between 1175 and 1075 that endures for several weeks or months -- before the breach beneath the neckline finally occurs in late-summer (August/September time frame). Only time, and the accumulation of new data, will tell the true tale.

Please recall again the post, The Lessons of '92: speculators will sell short an item they deem has a lesser value than its prevailing price. This means speculators could, would, and do sell short sovereign debt, sovereign currencies, even sovereign governments. (Oh, hello, Goldman Sachs -- arguably today's equivalent of Switzerland during WW2; purportedly neutral, but if they can make a buck, then Grandma also is for sale...) The intent of the new positions that occurred on Thursday and Friday of last week could be to test the EU's mettle and intentions. (viz, the EU's $1 trillion commitment of paper and jawboning.) I know not what actions governments will effect in the attempt to bind, or even banish, speculators. Not difficult, though, to imagine a future in which governments impose confiscatory taxes against 'evil' investors (of all types and time frames), which begets more selling to pay the tax. Until resolute action of some form occurs (best would be reining in our individual and collective expectations), currencies weaken, debt prices decline, and investors (even investors!) sell equities. Actions, reactions; sequences, consequences; selling... and more selling? Perhaps the sudden vacuum of no bids on 6 May will soon reoccur, regularly so. Caveat emptor. The game of musical chairs continues. Fun, eh?

The markets finally will break, up or down. What occurs today, before the break, is the usual comparative and relative swapping vs absolute sales (or buys): trading this weaker currency for that stronger currency one (say, the arguably devolving Euro for the strengthening US$), selling short this sovereign debt and going long that sovereign debt, selling short this or that equity or equity market and going long another equity or equity market. This all is the province of hedge funds in their original form (short this/long that), and bespeaks an ongoing process of correction, not bear market; nor the end of days. The bottom could drop out, though, at any moment; certainly the warning signs, economically and financially, begin to dot and dominate the landscape (charts).

I predict nothing. My role as portfolio manager and market commentator is to lessen risk and increase reward. So I seek the new investment themes and the new leaders: those sectors, groups, and companies that not only will ride out the (coming) storm but should succeed, if not excel. Of course, between then and now lies the Land of Uncertainty, and the possibility of lower share prices.

Fascinating topics (global economics / finances, and markets), to be sure; I could continue for a good while longer. Frankly, it all is rank speculation; at least, at this moment. Will the world muddle through (again)? Will markets stabilize, and rise? Will Charon still demand his fee for ferrying us to there from here? In what form will that coin be?

It pays to be ready for all contingencies:
1) Equity markets stabilize, and then rise anew
2) Equity markets plummet, but recover
3) The world (as we know it) ends

I prefer to focus my attention on items 1 and 2 for the obvious reason. I will do just that on InvestmentPoetry, with specific recommendations, in addition to a deeper discussion of the topics I presented above. As always, your comments and insights are welcomed and appreciated.
-- David M Gordon / The Deipnosophist