To the Barricades!

Is today Big Wednesday? Well, if you had to pick a day when the market could blow out — in either direction — you could do worse than today. There are at least two big events that markets will react to (or have already reacted to). First, Germany’s constitutional court will rule on the legality of Germany’s participation in the European Stability Mechanism (ESM). Second, the US Federal Reserve meets on Thursday.

Germany will probably fall on its sword and agree to unlimited liability for Europe’s bottomless government debt pit. The $700 billion ESM is as undemocratic as any bailout fund can be. It bypasses the German parliament and the German voter to give the European Central Bank a vehicle with which to make unlimited purchases of Spanish and Italian government bonds.

With that kind of bizzaro world so tantalisingly close, it’s no wonder the S&P 500 is close to a five-year high. The US blue-chip index closed at 1433 yesterday in New York. That’s the highest close since December 28, 2007, when it closed at 1478. What does it mean?

Overvalued. Over bullish. Overbought. Those are some of the words US fund manager John Hussman uses to describe the S&P 500. For Aussie investors, we turn to our own technical guru, Slipstream Trader Murray Dawes. Our suspicion is that traders have bid up stocks to new highs in anticipation of more money from the Fed and ECB and that no matter what the outcome of the next few days, a correction is in order. Here’s what Murray reckons in a note he sent us this morning:

Since Mario Draghi announced that he was going to do ‘whatever it takes’ to save the euro we have seen risk assets rallying strongly. The DAX (German stock market) is up 24% from the lows reached in early June 2012 and the S+P 500 is up about 13% in that time.

While stocks have been rallying analysts have been paring back their future earnings expectations and global manufacturing data has been decidedly bearish. So much so that 80% of the world’s manufacturing is now in contraction.

This means that P/E’s have been expanding at a rapid pace over the last few months. With earnings expectations going down and stock markets rallying we have now seen a full 2 points of P/E expansion in the states from 12 to 14. Valuations are starting to look stretched when compared to the bearish macro setting of a slowing Europe, China and America.

Either the data needs to make a U-turn in the next few months or the central bankers need to print at a huge scale to keep the rally going.

The technical picture is starting to shape up as a potentially great shorting opportunity. Markets will usually end their rallies with a ‘double top’, or ‘false break of a major high’ as I like to call it.

S+P 500 Daily Chart

The S+P 500 is currently sitting just above the highs reached in April this year of 1422. If you have a close look at the chart you can see there are many instances where the S+P 500 has rallied to retest a previous high, broken out slightly above it, and then failed to hold above the level thus creating a false break of the high. From there the market has nose-dived rapidly over the next few months.

We are now faced with a similar set-up, at a time when central bankers have been inspiring a huge rally in risk assets when most of the actual data coming out is saying to batten down the hatches for a coming recession. The volumes that have been trading are truly woeful and are another reason to be sceptical of this rally.

We have already seen quite clearly that printing money does nothing more than inspire rallies in the equity market. It doesn’t create jobs or fix the underlying problem of too much debt. All it does is stretch valuations further and further from reality.

At some point the rubber band will be stretched too far and it will need to snap back. Any disappointments in the next few days could be the catalyst for that retracement.

While we’re on the subject of retracements, we should point that iron ore actually made a comeback yesterday. Reuters reports that spot import prices in China rose $6 to $95 yesterday. The 6.7% rise, based on data from information provider Steel Index, is the largest one-day gain in iron ore prices since the firm began compiling data in 2008.

Hmm. Did China’s $150 billion stimulus package put a floor under iron ore prices? Was the selling over done? Or is this the proverbial dead cat bounce?

Markets — when they’re working — shoot from overvalued to undervalued and back again. Iron ore was clearly in a bubble. But the floor in the price depends on steel production and consumption in China. And other than last week’s rehash of old announcements and some new ones, there aren’t many clues about what China’s new leaders will do to rev up GDP growth when they assume power next month.

And speaking of those new leaders, one of them has gone missing. The Internet was full of speculation yesterday concerning the whereabouts of Xi Jinping, China’s president-in-waiting. Xi hasn’t been seen in public in about a week. He’s missed some high-profile scheduled meetings. China’s micro blogs are buzzing with rumours.

Some people think he injured his back in a pickup soccer game. Some reckon he hurt himself swimming. And one rumour suggests he’s had a stroke. Mind you these are all rumours and not news. It’s all pure speculation.

Whatever the truth, this isn’t an ideal time for China to contribute uncertainty about its much-anticipated political succession. When your main goal is political stability, a smooth transition of power from one cadre to the next is what you’re after. It raises an obvious but even more speculative question; is there a power struggle going on behind the scenes in China as we speak?

The answer to that question is beyond the scope of our limited knowledge. But if we were writing a screen play for a major motion picture action thriller, we’d somehow incorporate this story into it. China has sent two marine surveillance vessels into the waters surrounding the disputed Senkaku Islands. The dispute is with Japan.

The Japanese have decided to settle the dispute the old fashioned way, by buying the islands from their private owners. The Japanese Cabinet approved the $26.3 million purchase of three of the islands yesterday. That prompted a small but heart-felt protest at the Japanese embassy in Beijing, at which some of the protestors made their sentiments clear.

Source: Zimbio

Other pictures show the protest was quite small. But as Bruce Springsteen says, you can’t start a fire without a spark. Let’s table the possibility that China’s new leadership may wish to be more assertive in a geopolitical sense, especially if it’s trying to distract the public from an economy that can no longer grow at double digit rates. China’s government wouldn’t be the first to direct popular anger at an external enemy. It won’t be the last, either.

Speaking of which, if you’re going to protest properly at an embassy, you should at least tear down the flag and run up your own colours. On the 11th anniversary of 9-11, self-described religious conservatives stormed the wall at the US embassy in Cairo, tore down the flag, and ran up their own black flag bearing the worlds, ‘There is no god but God and Mohammed is his prophet.’

Source: ABC News

The protest was apparently in response to a film, now available on YouTube, depicting the prophet Mohammed in person, having sex, and calling him a fraud. It is apparently offensive to even depict Mohammed in any way in Islam, much less in an insulting way. Religious conservatives would be particularly…upset. Later in the day, the US consulate in Libya was set on fire and one American official was killed.

The day’s events remind us of one of Niall Ferguson’s ‘Six Questions’ at his speech in Vancouver in July. Ferguson asked if the Muslim world can have a Reformation, similar to the European Reformation in which political/secular power replaced religious power as the main authority in public life. It’s a good question.

You’d think, after the last eleven years, that the United States and its allies would see that nation building in faraway places doesn’t work. Democratic ideals are not, as it turns out, universal. People have different aspirations. It’s not the job of the free world to export liberal democracy to places that don’t want it.

On the other hand, it seems pretty clear that any kind of religious fundamentalism is incompatible with secular democracy and the rule of law. Liberal societies allow religious freedom to flourish. That is one of their great achievements. But you can’t be a liberal society that allows for religious intolerance and tyranny. And it’s hard to describe the reaction in Cairo as anything other than intolerance with a veiled threat of violence.

Politicians keep dancing around the issue as if it will go away, but it won’t. Liberal democratic values under the rule of law need robust defending. An open society where individuals enjoy equal protection under the law and where government coercion is constitutionally limited is the historical exception, not the rule.

For most of human history, Might has smashed Right with a boot to the face. That Might can be a bandit, a King, a Prime Minister, or a religious zealot. But in principle, the only thing that stands between civilised society and a war of all against all is the rule of law and people willing to defend it. So we’ll see how that goes…so far it doesn’t look so good.

In the meantime, it’s not like Western liberal democracies are flying the flag for freedom themselves. Stock markets seem to be more about expectations for more money printing from government-controlled central banks than underlying business earnings. Prices are high. Values are absent. It can’t stay that way for much longer, can it?

Of course it could! The US Federal deficit is $16 trillion? Why not $20 trillion? The bond market continues to snap them up as if they were going out of style. Financial markets have been subverted by the Fed and its global cronies. Sooner or later someone’s going to storm their walls too.


Dan Denning
for Markets and Money

From the Archives…

The ECB’s Outright Monetary Madness
07-09-2012 – Greg Canavan

Who Knows What’s Going on in China’s Centrally Planned Economy?
06-09-2012 – Greg Canavan

The Australian Dollar is Not the Euro
05-09-2012 – Dan Denning

Australia’s Unbalanced Boom
04-09-2012 – Dan Denning

Why a Monarchy Beats Modern Democracy
03-09-2012 – Bill Bonner

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3 Comments on "To the Barricades!"

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Thank you Dan for an excellent article, your last sentence the most telling. It has long been my opinion that western countries should butt out of other peoples business. If other nations want to slaughter each other because of religious or political reasons, so be it, it is not our business to ‘come to their aid’, because one faction or other wants it. The result being the loss of ‘our’ young service personnel, and a drain on the taxpayer. As to the market gyrations, well, haven’t we seen this all to often before. Isn’t it all a big con game?,… Read more »


Why do you assert that there is rule of law in the USA…or the west. The whole process: political and financial is rigged. Buy gold and silver; you are going to need it as the US dollar is becoming worthless.

This why judiciaries alone should never again be trusted with interpreting constitutional law. Give the judiciary a constitution and time has proven, in many Western liberal theatres, that expedience takes them every time. Slowly but surely they always group-think their way to destroying the constitution’s legitimacy. According to Bloomberg’s translation and citation ““The relevant factor for adherence to the principles of democracy is whether the Bundestag remains the place in which autonomous decisions on revenue and expenditure are made,” So, apparently, giving away the rights to have unfunded liabilities imposed upon the BundesRepublic is just fine! Legal quackery. “Living… Read more »
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