Submitted by Nicholas Bucheleres of NJB Deflator blog,
Market-top economics could be an entire university course, if people cared enough about such phenomena. Most only consider the signs of a market top months or years after a crash when some unyielding economics researcher puts the pieces together. As human-beings we have developed an uncanny ability to rationalize what we know to be bad news and convince ourselves, "This time is different," despite the fact that it usually never is.
In a previous article I provided analysis on economic/equity decoupling (cognitive dissonance) and showed that the economy as we know it cannot persist--we are either due for a literal gap-up in leading economic conditions, or we are due for a serious correction in US equities. With today's 5.4% slip in existing home-sales, let's go with the latter.
Velocity of M2 Money Stock (blue) and the S&P500 (red): Inversion in the velocity & SPX correlation led to a market crash in 2000 and 2007. No evidence suggests that we should break that trend this time.
- The revelation of fraud within the financial sector: With more banks being sniffed-out by the day, it would be a crime to call the LIBOR rigging collusion anything less than criminal fraud. Fraud shakes up financial system (and the broader economy) because it redefines what was thought to be growth, revenue, and profitability as lies and untruths, and the market is eventually forced to reprice what was initially priced as success. I have found that markets have a very difficult time retroactively pricing fraud; these are the type of downward corrections that keep on falling, and falling, and falling until they bring down the entire market and forcefully purge the fraudulent behavior. Unfortunately for us law-abiding citizens who get ticketed for going a couple miles over the speed limit, banks currently involved in the LIBOR rigging scandal will likely not get more than a slap on the wrist. I don't care about justice for the sake of justice; I care about confidence within financial markets, and the notion that big banks can do whatever they want makes investors (aptly) think that they don't hold a candle to the big boys that make their own rules. Such loss of confidence is the cause of the exodus of funds from US equity markets, as shown by paltry volume, even by summer standards.
- The collapse of financial institutions under their own weight: When supposedly low-risk financial services institutions like MF Global (collapsed October 2011) and PFGBest (collapsed July 2012) start dropping like flies it makes people wonder: "How is my broker any different than those guys?" Further sucking confidence out of the market, the death of immoral financial institutions is not seen as a beneficial cleanse, but rather it is correctly seen as the tip of an iceberg of more deception. When money was supposed to be in one place, but really wasn't, as in the case of MF Global and PFGBest, investors want to know where that money went. What was financed with that illegal money? Again, markets struggle to price-in fraud because it is unclear what was initially priced with the blood-money.
- Sweeping revenue loss within the financial sector: By today it is clear that financials did not have a good Q2 2012. There were sweeping revenue forecast misses, but conveniently for shareholders, earnings per share (EPS) came in at least right-in-line estimates, and many topped estimates. With almost a dozen banks planning quadruple digit layoffs and salary cuts including Deutsche Bank, Morgan Stanely, and Bank of America it is clear that things are grim and growing darker in Midtown, Manhattan. Even Goldman Sachs is being forced to reign in salaries and bonuses...The fact that these guys aren't winning at their own game should be very alarming to everyone; indicates that there is something going on beneath the surface.
- S&P500 (white) and financials ETF $XLF (white) show that financials have priced in a sliver of what they will be forced to.
- The erection of massive buildings: Tall buildings are a sign of over-ebullience and rampant speculation (hello, market top). The huge buildings are often financed heavily with credit when the market is booming and nobody worries about tomorrow, but once the market slows down a little bit and the reality of a massively over-leveraged, now-considered pile of steel is analyzed mark-to-market the results aren't pretty; the huge building that was meant to elevate society to the skies becomes an anvil on the back of a falling economy. Case and point: The Empire State building of New York City was built in 1929--the height of the pre-Great Depression bubble. "The Shard" just popped out of the ground March 30, 2012 in London and is the tallest building in the European Union. Upon unveiling the building, the architect made it a point to clarify that his creation was not meant to be considered arrogant...If you have to say it, it's probably too late. The chart below says more than I could:
- UK Index Fund $EWU (white): Vertical red line marks the completion of the shard...more to come out of this compression.
Where there is smoke, there is fire; where there is coordinated financial fraud, there are systemic issues. In this case, it seems that the banks involved in LIBOR rigging were attempting to manipulate short-term interest rates in order to literally engineer the price of derivatives contracts. This is a scary notion, and I believe that it is apt to infer that these banks have trillions in losses on shadow derivative contracts that they have been attempting to cover up with interest rate manipulation. It seems that the gaping balance sheet holes are immune to filling and that bank executives have decided to fraudulently cover them up rather than mark them to market (assuming a market exists).
S&P500 (white) and $VIX (blue): True market bottoms are put in place after significant volatility driven capitulation--something that has not happened this summer. We may be gearing up for a 2007-esque double-top sell-off driven by higher-trending volatility coupled with lower lows in the equity markets.
Markets are choosing to hold-off on pricing this negative news and are instead bottling it up to be released in what will surely be a "pop."
Uncle Ben, will you tuck me in and read me a bedtime story?