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SPX Update: Things Aren’t as Bad as You Think! They’re Worse.

Before I get into the charts, indulge me a bit of a rant regarding some of the systemic fundamental problems facing the world. 

By now, everyone (with the possible exception of those guys who live under rocks in the Geico commercials) understands that Europe is in trouble.  However, not everyone understands why Europe’s troubles should impact American stock markets.  I’m going to try to explain why in very simple terms, because the problems facing the world now are so deeply-interconnected that the technicalities quickly become overwhelming to the average person.

It’s a little-known fact that European banks have been bailed out previously by the American taxpayer.  European banks received $30 billion in bailout money, using AIG as a conduit.  A “stealth bailout of Europe,” if you will.  This fact alone would outrage most Americans, but for some reason, it’s not talked about very often. 

And it gets worse. 

After the Federal Reserve opened lending to foreign banks, the Belgian-French bank Dexia alone received $59 billion.  So American taxpayers (and America) are on the hook to Europe.  If Europe falls apart, it will be the shot heard ’round the world, because banks like Dexia in turn owe Goldman Sachs and JP Morgan (and others) substantial debt; so if Europe can’t pay its debts, then our banks will also suffer.  Thus, in a similar way, the European Central Bank’s Long Term Refinancing Operations (LTRO) were a stealth bailout of American banks.

I’ve discussed this before, but many investors mistakenly believe that stocks are driven by fundamentals, such as the economy, the employment rate, etc..  While it’s true that the economy can have an impact on the stock market, it’s not for the reasons most people think.  The only thing that drives stock prices is liquidity.  If there is excess liquidity, some of that cash finds its way into stocks and other assets — so one frequent by-product of a good economy is a liquid market, which means stocks rise.  However, the economy itself is, in reality, only impacting the market indirectly.  The reverse is usually true in a bad economy:  bad economies lead to a liquidity crunch and stocks fall.  But not this time.  In a moment, we’ll discuss why.

To understand the concept of liquidity vs. the economy as a driver of stocks, simply look at the Nasdaq Composite, which is currently trading above its 2007 high.  Then ask yourself:  is the economy as good or better now than it was in 2007?  Obviously not — so if the economy were truly the driver, then the markets would be substantially lower, since things are worse than in 2007.  So why aren’t the markets lower?

Since 2009, the massive money printing from the TARP bailout, the ECB’s LTRO, QE1, QE2, Operation Twist, and others, have provided the liquidity to keep the stock rally going. As far as I can see, this liquidity is virtually the only thing driving stocks higher.  The amount of liquidity injected into the system in recent years is mind boggling, yet stocks have barely reached 2007 levels.

Anyway, that liquidity gets confused with “real” money, and also gets spent as real money — which drives stocks and other assets higher. (“Real” money is money created when an economy produces more than it consumes.  In other words: real money comes from production.)  In this current world, there is limited production:  the prime mover driving asset prices is inflation from the printing presses. 

But this game is not without consequence.

To illustrate a portion of the problems facing the world’s banks and governments, I’m going to draw a simple (and probably illegal, if put into practice) analogy.  Please note that I’m not recommending you try this at home — leave this stuff to the trained professionals at the Fed and ECB.

Let’s imagine that you had three checking accounts, all of which had a real balance of $0.  Now let’s further imagine that you write a check for $1000 to yourself from account #1 to account #2, while simultaneously you write another $1000 check from account #2 to account #3, and another $1000 check from account #3 back to account #1. 

So it looks like this:

Account #1 = $1000 —->  Account #2 = $1000 —-> Account #3 = $1000 —> Account #1

For a brief instant on your balance sheet, it will appear as if you have $3000 — even though, in reality, once all the checks clear against each other, you actually still have a real balance of $0. 

This is not unlike what many of the world’s governments and banks have done for themselves and for each other.  The reason it works better for them is that their “checks” take years, or even decades (with long bonds, for example) before they have to be cashed.  If you could introduce the same long delays into your hypothetical (and illegal) checking account activity, then you could pretend you had $3000 for a while.  And if the checks counted as credits immediately, but weren’t actually debited to the parent accounts for years, then you could even spend the money in each account, just as if you really had $3000.

I realize this is a dramatic over-simplification — what’s really happening, especially when you factor in credit default swaps and everything else, is nearly as complicated as the quantum mechanical concept of paired particles and their ability to communicate across infinite distances at speeds faster than light.  Maybe 8 people on the planet truly understand the complete math behind either concept, and unfortunately, it seems that none of those people are actually in charge.  Which introduces another problem: the massive complexity of the system lends itself to human error.  We all know that the more moving parts something has, the easier it is to break… and the harder it is to fix once it’s broken.

Despite my simplification for purposes of illustration, this checking account analogy is not entirely unlike what’s happening out there in the real world, except out there it’s occurring on a massive scale.  The banks and governments of the world have been spending as if the “checks” they wrote to themselves (and each other) were real money for so long, that at this point, virtually everybody owes everyone else a piece of the Pretend Money Pie.  Eventually, somewhere down the line, one or more accounts are going to need to be debited for the cash. 

And then it all falls apart, because there is no cash. 

This basic issue is the reason why, from a fundamental perspective, I remain bearish. 

Does that mean stocks will collapse this week, this month, or this year?  Possibly; possibly not.  The charts are certainly warning that the potential is there, right here and now.  But these are uncharted waters in a way.  We’ve never seen this level of massive and coordinated intervention in the “free” markets at any prior point in history.  This makes things a bit challenging for an analyst, because we really have nothing to go on except the lessons and patterns of history.  But this is an experiment that has no precedent.

Certain signals that often foreshadowed declines in the past have, in this new world of endless bailouts and the tireless printing press, sometimes simply foreshadowed more intervention — leading the market to rally against the seeming odds. 

So the situation doesn’t preclude stocks from moving higher over the intermediate term.  But it does lead one to wonder how long this massive Ponzi scheme can continue.  Further, there does seem to be a diminishing return to the money printing, if one compares how each successive money launch has yielded smaller and smaller rallies in stocks and bonds.  At some point, one of the links in this massive chain seems almost certain to fail.  And when one link breaks, the whole chain falls apart.

What are the charts telling us?

The charts are telling us that things may be about to get a whole lot worse.  The possibility of a big decline is definitely present right here and now.  As I discussed yesterday, this is a case of potential energy.  The market has wound itself up, and a solid break beneath the key S&P 500 level of 1340 could cause a rapid drop.  I hesitate to use the “c” word (“crash” — get your mind out of the gutter!), but the potential does exist.

Will it come to pass?  I don’t have a crystal ball, but from what I can see, the probability is reasonably high.

Let’s start with an overview of several indices.  This chart shows that virtually all indices have broken, and most have back-tested, their key uptrends off the October 2011 lows.

Below is my “first-stage” chart of the probable decline.  I expect that, if this plays out, it will be only the beginning of a much larger decline.  I currently view this as the most likely outcome over the intermediate term.  Sustained trade and closes north of 1385-1390 would cause me to seriously re-examine this outlook.

Next up is the very short-term chart.  Unfortunately, my confidence in the very short-term patterns is low at the moment.  Red wave ii may have topped already, short of my target zone, since there does appear to be a complete a-b-c fractal in the 1-minute chart.  This could mark ALL OF wave ii, or it could string together a couple more fractals before completing.  I’ve outlined some signals to watch.

A short-term potential that definitely occurs to me is a weekend trap for either bulls or bears. Unfortunately, since the very short-term pattern is unclear as of the time of this writing, I’m uncertain on whom the trap will be sprung.  The two short-term counts both have the potential of a gap open on Monday.  We can see that if wave b plays out into Friday, the trap could be sprung on bears, with a gap up in a c-wave.  If wave ii completed, the trap could be sprung on the bulls, with a gap down in wave iii.  It’s a treacherous market right now.  Hopefully, Friday’s action will convey some signals in this regard and answer the question ahead of time.

And finally, the bearish potential present in the very big picture.  It’s far too early to confirm if this will unfold at this juncture.  The potential is definitely there, however.  Bear in mind that this chart represents a general guideline of how things could unfold — it’s not intended to be an exact prediction, but more of a broad overview.

In conclusion, the bulls have been unable to get much done, and the market presently looks quite weak.  My expectation is that the market is beginning the next wave down (intermediate term), and still in the early phases of a major trend change.  The market is the ultimate authority, however, and what happens over the next couple weeks, and possibly as soon as the next few sessions, appears to be crucial to the bulls maintaining any hopes of a continued long-term rally.  Trade safe.

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