Monday, October 26, 2009

A Trader's Intuition (with Charts)

My trader's intuition is flashing warnings that the stock market might drop off a waterfall starting this week.

Let's start by stipulating if I was actually smart then I'd be rich, and I'm not.Second, let's re-read the HUGE GIANT BIG FAT DISCLAIMER below to refresh our awareness that these are the rantings of an amateur observer, nothing more, posted here for free (Yes, you get what you pay for).

A trader's intuition, eh? Fa, fa, fa. That and $2 will get you a cup of coffee.True. So let's run through some charts.

The MSM is pounding us 24/7 with the "fact" that the GDP will print a rise in the third quarter and hence "the recession is over." Uh, do these charts reflect a growing economy?

Here's the good news: this is the sharpest stock market rally on record:

Nice--but how about jobs?


(Both charts courtesy of The Big Picture blog)

How about the household balance sheet?

How about homeowners' equity?

Gee, is negative equity rising? (homeowners "underwater" on their mortgages)

How about credit card delinquencies?

Don't tax receipts reflect the real economy?

But the American consumer never stops spending, right?

And home prices are rising, right? (Use a magnifying glass as necessary to locate rise)


But all those subprimers are out of the system, right? Their houses have been foreclosed and sold to investors euphoric over "catching the bottom in real estate," right?

Well, sort of, except that the "upper crust" market of prime and jumbo loans is deteriorating faster than an ice cube in the Arabian Sea. (See chart.) Foreclosures in the top tier of homes--those in the highest price range--have almost tripled since 2005 as a percentage of all foreclosures.

And which households were the big spenders? Most likely the ones with the biggest, priciest houses.

This chart alone blows the crowded "recession is over" boat right out of the water. If the households with the biggest mortgages and priciest houses are slipping into foreclosure at a rising clip, then precisely who will be spending at a high enough rate to trigger a sustainable rise in private consumption? (Recall that private consumption is 70% of the U.S. economy.)


So what are households doing with whatever cash comes their way? Paying down debt and saving cold, hard cash (See chart.)

Add these charts up and do you get a solid exit from recession based on growth in employment, household assets, household equity and household spending? No, you do not.

Let's face reality: the Federal government borrowed $1.4 trillion in the 2009 fiscal year (fully 10% of the U.S. GDP) and basically blew it supporting the economy in various ways. The Federal Reserve also funneled hundreds of billions of dollars into the banks and financial sector, creating unprecedented liquidity at near-zero rates.

That hasn't done much for lending (which is falling) or Main Street American business but it sure has handed investment banks plenty of free money for various speculations. (See chart 1.)

So where does this leave us? With a stupendous disconnect between the real economy and the high-flying, euphoric stock market. My intuition is the disconnect is about to resolved in favor of reality.

Take a look at a chart of the VIX--the so-called Fear Index. It is reflecting confidence and complacency--the perfect set-up for a market about to fall screaming off a waterfall. Recall that the VIX moves inverse to the market: if the market is rising, then the VIX is low, and if the market is falling, the VIX is rising.

This is a chart of supreme complacency--except for the indecision of those tall candles of the past few days. The VIX has shot up and fallen back in wild gyrations-- just the sort of action which typically marks tops.

How can we square this swaggering confidence in the stock market's relative safety with the rapidly crumbling real economy?

We can't.

When I worked in the back office of a small quant shop our clients were mutual fund managers--smart guys and gals. Does anyone actually think the smart players believe the Fox news-CNBC shills that the economy is fine now, so buy buy buy? Of course not. They're watching for any weakness to dump. The really smart ones have already hedged or fanned out of their longs. But many are waiting until the party ends, confident that there will be some warning bell that only they will hear.

But it might not work out that way. Perhaps the crowded room which will rise in unison and rush for the exit when the alarm sounds. This feels like the week the crowd rises and suddenly realizes there are thousands of traders and managers all heading for the same little exit. This is intuition, not analysis.

So by way of disclosure: I own calls on inverse ETFs which rise if the market falls, and I advised my sister to sell Monday morning--sell hard, sell fast, and go to cash. Sell the gold funds, the stock funds, sell it all. That is not advice for you, of course, it is only a disclosure. As I write this at 10 p.m. Sunday evening, the Nikkei index is up and the global markets seem poised to continue their giddy eight-month long party.

Time will tell if that long, deep gash left by reality below the waterline has doomed the ship or not. I'm sensing that it's time to grab a lifeboat and leave the milling crowd of party-goers with the unenviable risk of sinking.

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