Smart Money

I do not toss around the idea of a market crash lightly. If you've been following me long enough, you know that only in very rare instances do I issue a cautionary Alert (I've only issued four since my website launched in 2008), and I am generally not given to hyperbole. Let's be clear: I'm not issuing an Alert at this time. But I am concerned that a materially adverse disruption to the financial markets is increasingly likely in the near future. Perhaps a definition will be helpful as we begin. A 'market crash' is an event where there are no bids to meet a wall of selling. The actual amount of the percentage decline is less important to note than the amount of chaos, or loss of control, that a given market experiences. Some like to say that a market downdraft requires a decline of 10%, or maybe even 15% or 20% (or more), in order to qualify as a 'crash.' For me, the key factor is not so much the amount of the decline, but the pace of the decline. With perhaps a quadrillion US dollars of hyper-interconnected derivatives outstanding -- that's the notional value, but who really knows what the real number is? -- an orderly market is essential for knowing whether or not the counterparty to one's trade is solvent. During periods of intense price swings in the market, such things are simply not knowable, and spawn the fear and paralysis that really define a market crash.

The markets are signaling price declines all over the place.  Platinum is trading about $40/ounce below gold. This is anomalous. MIT's Billion Prices Project reported price declines in the U.S. in August (see final chart). The Economic Cycle Research Institute on Friday took the rare step of commenting in print that the stock market is at a significant risk for a further decline. Dangerously, Markit's CMBX index (or, more precisely, some of their constituent indices) that tracks mortgage-backed securities broke Friday to yet another new multi-year low.

Right now, the only investment opportunities I see that are both relatively attractive vis-a-vis the alternatives and offer a likelihood of growing nominal capital are investment grade municipal bonds.

Back in the summer of 2007 two important things happened: the market hit an all time high, and the smart money realized what was about to happen (following the subprime and the Bear hedge fund blow up, it was pretty clear to all but Jim Cramer) and bailed out of stocks and into bonds, with Treasury holdings of Primary Dealers soaring at the fastest pace in history. Well according to the Fed, in the past few months Dealer holdings of Treasurys due in more than a year have soared by a whopping $90 billion, from a $75 billion short on May 6 to a $15.1 billion long on September 7. As Bloomberg reminds us, "the last time dealers bought bonds at such a rapid pace was between July 2007 and September 2007, as losses on subprime mortgages began to infect credit markets and the central bank unexpectedly cut interest rates." Also, as noted above, all hell was about to break loose. So what explains this surge in Dealer bond holdings? Well, expectations for said hell breaking loose all over again is one reason, as is the imminent announcement of Twist, QE3+, and who knows what else Bernanke has up his endless sleeve that will make the 2s10s as close to inverted as possible, putting Bank of America permanently out of business. To quote from Bloomberg again, "The problems are endless” for the economy, William O’Donnell, head U.S. government bond strategist at RBS Securities Inc., a primary dealer, said in a Sept. 13 telephone interview. “What will surprise people is how long this period lasts of very, very low rates.” Judging by leading market indications, perhaps people will not be surprised after all.

Bull versus bear. Greed versus fear. Smart money versus dumb money. Depression versus transitory soft patch. Credit versus equity. In one corner is the credit market, a rather mighty opponent where $1 million defines an odd lot. Credit has spoken loudly. They have priced in a severe recession, depression whatever you want to call it. In the other corner stands the equity market and although fierce is smaller than its opponent where 100 shares defines an odd lot (a mere $700 in the case of BAC). Also known as the contrarian equity has priced in a transitory soft patch, the opposite of credit. Equity hopes to bounce back from a recent loss where they completely failed to price in the 2008 Great Recession. We are now on the eve of yet another showdown. Both corners are far apart and yet only one can be proven correct. The other must accept defeat. The stakes are large and the reward to those on the right side even larger. History will be the judge and time is all it asks.

For those wondering why David Tepper will be strangely missing from CNBC for his annual pre-QE cheerleading appearance, we now have the answer. As Institutional Investor reports, the Appalloosa head man, who was long everything but mostly financials in the form of BofA and Citi last year, and managed to get out just in time before the wipe out which left his colleages at Paulson and Co. dazed following a 34% YTD loss, has decided to invest in a strange asset: cash. "Sources say he has gone 30 percent to 40 percent in cash, which is very high for him. Some of his cash is invested in U.S. Treasuries, which have in turn risen in value in recent weeks." II clarifies: "Keep in mind that Tepper had about 30 percent in cash entering 2009, shortly before he started buying up banks such as Bank of America before anyone else had the guts to do the same and racked up triple-digit gains by the end of the year." And in a very odd development for the man known to take aggressive risks ahead of everyone else, we learn that "he will remain cautious until there is improvement in the European bank crisis. Of course, if the markets tank, you can be sure he’ll be aggressively scouring for bargains." Alas, the markets refuse to tank on generic expectations that the second market start to tank, dip buying materializes on vapor volume and expectations that the Fed will once again kick the middle class in the gonads only to make stock chasers whole. Yet if even Tepper is staying on the sidelines, just what informational advantage does the HFT momentum pursuing crowd have?

Three key metrics which strongly suggest that silver remains far from a bubble if not undervalued. The first is silver’s real price today adjusted for the inflation of the last 31 years. Silver’s real high in 1980 was $130 per ounce – more than double the price today (see chart above). The second is the gold silver ratio which has averaged 15 to 1 throughout history due to geology and the fact that there are 15 parts of silver to every 1 part of gold in the earth’s crust. The third metric is comparing silver’s current bull market to that of the 1970’s. Silver has risen by a factor of 10 in the last 9 years – from near $4 in 2001 to over $41 today. In its bull market from 1971 to 1980, silver rose by over 3,199% or by a factor of more than 32 in just 9 years culminating in the blow off top in 1979. Today, the physical supply of silver bullion is much less than in the 1970’s. Also there is the ‘Asian factor’ and 3 billion people with growing incomes, many of whom see silver as a store of value against currency depreciation. Demand for silver in Asia has been increasing and in China alone silver demand is increasing from a near zero base. The demand was not present in the 1970’s.

As the following update from Goldman's David Kostin demonstrates, after dropping to third place with 173 hedge funds owning AAPL (behind Microsoft at 181 and Citigroup at 178) as of March 31, the company that Steve Jobs built was back at the very top of hedge fund holdings with 181 hedge funds holding on to AAPL. The question is what will they do tomorrow and will the first game theory defection bring an end to the fairytale story?

UBS have raised their 3 month forecast for silver sharply from $30/oz to $50/oz. They suggest that investors are too nervous to short gold and may be preferring to buy silver instead. Silver remains more than 16% below the record nominal high seen in late April 2011 and in January 1980. While gold at $1,888 is now 120% above its nominal 1980 high of $850/oz. The inflation adjusted high for silver is over $130/oz and those who understand the fundamentals of the silver market are positioning themselves for the possibility of a move to these levels in the coming months. Speculative fever in the silver futures market remains muted with COT data showing net longs well below the records seen in April. Silver is volatile but in the current climate what isn’t? Recently, there has been huge volatility in currency and bond markets and entire equity indices have been as volatile as silver. While silver is volatile, what makes silver valuable is the fact that like gold it has no counterparty liability or risk (with silver coins, bars or allocated storage) and therefore cannot go bankrupt unlike banks and sovereign governments. Media coverage of silver remains minimal with big brother gold getting some of the limelight recently.

Bull markets almost always end in a mania phase where there is a near universal belief that an asset class or security is going to rise and there is no risk involved. This has been seen throughout history and was seen with the Nikkei, the Nasdaq and more recently with property markets in Ireland, the UK and the U.S.  It was also seen with gold in the 1970’s when gold increased 128% in 1979 alone. On January 2nd 1979 gold’s London AM Fix was $227/oz. By the 31st of December, gold’s London AM fix was $524/oz. 21 days later gold had increased another 60.9% to $843/oz. This is parabolic. Today’s 27% rise year to date in dollar terms is very tame in comparison.

UBS confirm this morning what we have been experiencing in terms of increased customer demand for gold and an increasing preference for allocated gold. UBS note that “the move to real assets such as gold in physical form signifies the heightened state of risk aversion at present.” “The gold market remains underpinned by the movement to physical gold, which has persisted all week    . . .  European demand for small bars particularly, but also coins, remains very strong. As the week has progressed Asian physical demand, outside India, has been noticeably higher.” The Swiss franc has fallen by another 0.4% against gold today and is down 5.7% week to date against gold.  Pegging the franc to the euro would take time and would face steep legal and political hurdles – a change to the Swiss constitution would be necessary to begin with.

Bild Zeitung, is Germany’s biggest- selling newspaper, is the best-selling newspaper outside Japan and has the sixth-largest circulation worldwide. Bild encouraged German people to invest in gold as the global debt crisis continues to deteriorate and cause turmoil in global markets. “While the companies listed on stock exchanges have lost over the past 14 days, about $8 trillion dollars in value, the price of gold climbed to a record high.” “While money can be printed, gold reserves are limited. To date some 150,000 tonnes of gold have been mined.” Gold “is better than cash,” the newspaper said. “While any amount of money can be printed, gold is limited,” making it “one of the safest investments in crisis times.” The article is interesting as gold has remained taboo is much of the non specialist European press and media and was only briefly covered in recent days due to the deepening crisis and succession of new record nominal highs. German demand for gold has been very robust in recent years and the Germans experience of the Weimar hyperinflation means that they are very aware of the risks posed by today’s excessive money printing and global currency debasement.

Frank Barbera, respected precious metal mining stock expert and editor of the Gold Stock Technician newsletter, has a viewpoint that will likely surprise many. While extremely bullish in the longer term, Frank sees too many risks in the near term and advises smart money to wait. He cautions: "I’ve been watching the mining stocks since 1983 so a fair amount of time that I spent watching the group. I have a wide variety of unique technical indicators on the sector and as I started to see the stock market topping out over the last two to three weeks I wrote my readers a note to say the mining stocks are also very overbought. Mid July we saw one of the second most overbought readings on the XAU, on the arms index in five years. And that kind of reading is a big warning and so I’m not surprised to see them going down. The last letter I put out I told subscribers that I thought the mining stocks could get cut in half in here and I’m going to stick with that. I think we’re looking at a 30 to 50 percent decline over the next six months. The XAU, which recently peaked out at around 220, I think you could see that close to 110 before this decline is complete."

It's getting more confusing by the day. I doubt this is about to change.

And how did Treasury paper do following Standard & Poor’s bombshell downgrade of U.S. debt?  Why, T-Bonds, Bills and Notes came through unscathed, thank you. Actually, they did much better than that, rallying so sharply yesterday that one might have inferred the U.S. was the last citadel against the panic, confusion and fear that rein elsewhere in the world.

260% profits in 48 hours? Global markets in full meltdown mode? Bank runs imminent? Is this an all out collapse or will the global central financial planning cartel reign it in via the bear market rally from hell. Well, here's a few steps to take either way...