What Next? - A Damage Assessment

Long-term EPJ readers should have not been surprised by yesterday's activities in the markets.

I have been highlighting the PIIGS crisis for months.

In my view, the current crisis is a continuation of the crisis started in the summer of 2008, when Bernanke stopped printing money. When you have a plan and understand Austrian business cycle theory, slowing money supply growth, indeed, stopping it, is a good thing. However, when you don't have a plan and slow the growth for whatever reason, I consider you a madman.

The September 2008 government panic caused Bernanke to reverse engines and print money at double-digit rates for approximately six months. It was this money printing, in addition to the normal dead cat bounce off of crisis lows, that caused the strong rebound in stocks. Those rebound days, however, now appear to be over. The Fed is simply not printing any money, and neither is the ECB.

The initial 2008 slowdown in money supply resulted in a drain that developed in the hottest sectors where money flowed the fastest: real estate and the stock market. This second leg of the crisis is developing in a more complex manner. The drain is coming from what was the booming government sector. Unlike the real estate market and stock market, the government has huge tentacles to grab at money from various directions, still when narrowed down the money grab generally comes from only two methods, borrowing and taxes. 

Governments throughout the world structured their taxes by attempting to catch a part of the inflationary flow. It's easier to tax a part of the inflationary flow then by just raising, on a per capita basis, an absolute dollar amount of taxes. The ease of taxing the inflationary flow comes in hiding some of the burden of  the tax,sincde people don't mind taxes as much as their incomes go up (even if it is only an inflationary advance). The problem for governments with this type of tax method, though, is that if the inflationary flow stops, tax revenues stop. Further, because the money flow is slowing during such a period, the money isn't out there to buy the government bonds that various jurisdictions want to issue . It is a situation where government gets squeezed from both sizes, less revenue and less ability to borrow.

This is impacting Greece. Portugal, Los Angeles, Florida, Nevada and Arizona, among many other national and local governments. It will not stop. Basic math says there is no way ten trillion dollars in debt can be paid off when a combination of tax revenues and further borrowings gets you only to seven trfillion dollars.

There for sure can be short-term patch jobs and the taxpayer can be squeezed a bit more. But if you try and squeeze too much you could have Greek riot reactions around the world. Thus, the basic math combined with the political environment suggests only two possible solutions, either defaults by governments or massive inflation. There is no other way out. Either the banksters take the hit, or it will be the mother of all global inflations.

Given the power and influence of the banksters, one would think the inflation option, the so-called nuclear option, is what will ultimately arise out of this crisis, but that money printing hasn't started just yet.

Thus, things get tricky from an investment perspective. The stock market is the most obvious to get a handle on at this point. With the massive down action of recent days, there are most assuredly  firms, hedge funds and the like, that are severely damaged. It may take days, or more, before we learn who they are, but they will be facing meet huge margin calls.  Some of them won't survive.

On a longer-term basis, the slowed money growth suggests that there is little liquidity to take the market higher. Indeed , even what carry trade activity that was going on is also over, as anonymous trader wrote ina post below:

You relate a very important point that the liquidity to support this market is simply not there. The liquidity came from investment banks going long and from yen carry traders who borrowed at 0.25% from the Bank of Japan and its proxy lenders.

There was a violent exit from yen carry trades, including but not limited to the Aussie, the Loonie, the Peso, the Rand, the Ruble, and the Rupe, as investors bought the Yen, FXY, which rose a spectacular 3.8% to close at 109.77. The Euro, FXE, fell to 125.96. The US Dollar, $USD, rose to a 14 month high to close at 84.85. Currency traders sought safety, if it be called that, in the US Dollar.

This one day violent extinguishment of carry trades was a repudiation of investment risk. The Aussie Yen carry trade, FXA:FXY, fell to its 250 day moving average. In one day, currency carry trade investment fell back seven months, to the early October level when gold broke out. This extinguishment of carry trades represents a "vaporization of investment liquidity" which places one's investment capital at risk: further declines in the stock market may trade in an illiquid manner, meaning that there may not be buyers for securities: one may not be able to obtain one's funds in brokerage accounts and at money market accounts...

Bottom line, other than special situations, this is not the time to be in the stock market

The gold market is most tricky. My gold bug friends think gold only goes up, and have forgotten that during the Paul Volcker tight money period, gold dropped by near 70%, and then continued trading around the lows in a trading channel for basically a decade, which is not surprising activity for gold in a tight money period such as we have now. The one caveat to this down trending gold scenario is that the EuroZone panic is causing a flight away from the euro, normally you see the opposite during tight money periods. This flight away from the euro is obviously quite strong, but the longer the ECB stays tight with money, the more this flight from the euro will slow. There simply won't be enough euros around for all current demands for the currency. At such time, gold could break downward violently.

On the otherhand, and this is why gold is tricky, once those monetary floodgates open, gold is going to rocket. $5,000 an ounce gold wouldn't surprise me. The thing is those monetary floodgates aren't open yet.

Thus, the gold play has to be to accumulate for the long term, but be aware their could be some huge downside swings. This means you shouldn't be long gold for short-term trades, only for "tuck away" gold.

The best spot for speculative money right now is German bunds. Germany is going to survive this crisis. If the euro collapses, all the better for bunds. The bund debt would be repaid in a new strong German mark. The one caveat with the bunds is if the ECB chooses the nuclear option and decides to print its way immediately out of the PIIGS crisis. If there is any strong indication that this is going to occur, you need to be out of bunds fast.

The other speculative trade to be put on here is a short of long-term U.S. bonds, at some point the demand to raise money will soar and all U.S. bonds will see major declines. Somewhere after this bond squeeze begins, we may see the nuclear option used, not by the ECB, but by the Fed, as they fight crises in the municipal bond markets and the Treasury security markets.