Monday, November 02, 2009

Crash Potential?

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While the stock market is short-term oversold and ripe for a bounce, there is the potential for a crash somewhere down the line, even without world war three erupting.

In a Financial Times editorial, fellow doomsday economist Nouriel Roubini spells out in explicit detail how the Fed's efforts to reflate the economy have created but another huge asset bubble likely to pop in the near future:

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.


But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

As anticipated in this blog, the stock market appears to have topped out above 10,000 in association with a Spiral Calendar anniversary of the 1987 top before that year's crash.

The 1929-1987-2009 market analogy is continuing to play out suggesting the possibility of a major upset of mass mood into mid-December:

Again, the greatest concern is that any upcoming upset will take the form of war. As overviewed in my thesis and noted recently in this blog, with a reversal from the psychologically important 10,000 mark in the DJIA, one needs to be on the lookout for a historical shock, such as a conflict with Iran (and then Russia).

Here are charts showing why this is so:

The historical pattern above is so obvious that no further elaboration is necessary.

The bottom line is that what we are observing is history repeating itself in a blatant fashion. Man as a species thinks and behaves irrationally and is failing to learn from past mistakes. Hence, human history is doomed to repeat itself.

Only by correcting ourselves by truly believing in God, acknowledging we are creatures accountable to our Creator, and seeking to obey His will as demonstrated by the life of Jesus, can the insane manic-depressive cycles of human history be brought to an end.

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