Dramatic Drops and Short-Covering Rallies Illustrate How Capital Waves Lead to Profits

[Editor's Note: Capital-wave proponent Shah Gilani practices what he preaches. In his new advisory service The Capital Wave Forecast, Gilani notched triple-digit gains in less than two weeks on each of three recommendations to subscribers: a short play on the euro, a long trade on the VIX, and another short trade on Goldman Sachs Group Inc.]

The Greece rescue package is signed and sealed, but is still far from being delivered. It took three tries, but this time global investors believe the EU got it right. Investors celebrated yesterday (Monday) with a relief rally that touched virtually all of the world's key financial markets - and that served as a strident counterpoint to the near-freefall that gripped the U.S. stock market on Thursday.

So is it finally time to shelve our fears of financial contagion, meaning the financial shocks that start with one nation or market and spark a conflagration that spreads through interdependent entities in plague-like fashion?

Definitely not. In fact, hang onto your hats: We have just entered the brave new world where a butterfly flapping its wings in China can fan a market fire on the other side of the world. There are more contagions to come. But because of forces known as "capital waves," the same heat that burns some investors can also generate substantial profits for those who understand how to position themselves.

Riding Capital Waves

Despite yesterday's feel-good rally - which I categorize as nothing more than an institutional short-covering rally of historic proportions - contagions will be part of investors' lives going forward, a situation I refer to as the "new normal." Global investors will increasingly have to watch for these events, since the world's financial markets are more interconnected than ever before.

Thursday's crash - an event, incidentally, that I recently warned was all but a certainty - was symptomatic of what will become known as a "market-centric contagion." Investors were already on edge about Greece's potential for default and U.S. trading volumes were already super low, making this market highly vulnerable to the freefall we saw in U.S. stocks. Fear led to the evaporation of liquidity as high-frequency traders and professional Wall Street pick-off artists folded their tents ... and convincingly proved they are not investors but leeches on our capital markets.

With all that financial kindling in place, it took but a single spark - perhaps just a keystroke error - to start the blaze that nearly caused another U.S. financial crisis.

In fact, don't be surprised if we see a repeat of Thursday's terrifying pattern - perhaps even sooner than you'd like to think.

But here's the real surprise: While it's no time to write any epitaphs for contagions, it's also not time to retire to the sidelines in fear. In fact, smart investors (who increasingly have to act more defensively - in short, more like "long-term traders") should view these flashes of intense volatility as major potential profit opportunities - all because of capital waves.

When we refer to capital waves, we're talking about the massive money flows that move from one geographic market - or one asset class - to another, with major implications for prices as a result.

Whether the infected entity is a sovereign government, global bank, or commodity consumer isn't as important as the potential impact of a virus on our increasingly interconnected world of global producers, consumers and capital investors. Capital waves move into and out of these intertwined asset classes, presenting unprecedented trading and investment opportunities for investors who understand this new world dimension - even with contagion-like conditions as a backdrop.

Since Greece has been "patient one" in the latest contagion scenario, let's start there and see how its illness might have mutated through the world and where the pitfalls and capital-wave profits reside.

A true bailout of Greece would end the potential contagion. But given that this is the third time Greece has supposedly been rescued, this case is a study in why these situations can whipsaw markets - and investors. And the questions we ask here are the same ones to pose in any contagion situation.

Whether or not austerity will or can be enforced is the first question to ask of the patient. If "patient one" isn't able to slim down on its own, its clogged debt arteries will continue to be restricted. So even if bailout medicine is administered, markets are worried that efforts to finance the Greek lifestyle will amount to pouring good money down the drain.

After all, what will happen when the contagion spreads and related markets need their own bailout packages? The contagion fear is that once Greece gets its intravenous lifeline, who will be willing and able to then step up again to give blood to the next infected patient? It's one thing to pledge a pool of bailout money, but quite another to get other infected patients to give real blood when they're being triaged themselves. We'll see how that's really going to work, if it happens at all.

The Domino Effect

Greece's deficit-to-gross domestic product (GDP) ratio is a staggering 13.6%. The European Union requires its members not exceed a deficit of 3% of its GDP. Greece is No. 2 on the list of over-spenders. No. 1 is Ireland, whose deficit-to-GDP ratio is 14.3%. Spain comes in third at 11.2%; and Portugal is fourth at 9.4%.

It's not a stretch to think that when these, or other EU dominos, need bailout money, the sheer borrowing volume from member countries and the IMF will weigh heavily on the EU's currency, the euro. And even if the deal ratchets down the chance of a wildfire-like contagion, there are fears that it shifts so much risk to Germany that a stumble by that EU-stalwart alone could set in motion another global crisis of confidence.

Then there's the euro itself to consider. No euro-member country can "print" euros, like the United States can simply print the dollars that it needs. So whether or not the Union itself decides to print euros to hand out to members, or whether it lets interest rates rise because demand for limited euros will cause rates to spike, either way, the euro is toast.

Flooding the world with euros will eventually be inflationary and immediately undermine the currency's value, almost making any bailout efforts self-defeating. On the other hand, borrowing from a limited supply of euros, which would raise rates, and technically strengthen the euro as a result of the higher return potential of holding that currency, the side effects will end up hurting the euro in the long run. Higher interest rates will choke off a European recovery, lower tax revenues and ultimately divide the Union's members.

The pressure on the euro is tremendous. The primary contagion play is shorting the euro.

The contagion thread is woven more deeply into the fabric of European banks. Not only are all the big European banks huge lenders across the continent and have massive exposure to sovereign borrowers, they are about to extend themselves more, without having fully cleaned up their legacy loans and toxic assets.

While the stability of the euro is front and center, the real fear is that a big bank will teeter or need to be bailed out. Analysts who say that the Sunday's European bailout amounts to a bailout of all Europe's banks aren't exactly correct. The bailout has to do with sovereign governments, not private banks. Any fear of a bank failure will result in another interbank liquidity-and-funding panic. If that happens, the whole banking and credit-crisis-contagion fear within the larger European contagion scenario will sound like the bell to start Round Two of another fight to save the financial systems of the world.

There's plenty of opportunity in shorting some of the big European banks and then getting long them after they've taken their hits and prove they can survive. It might eventually look like March 2009 all over again, at some point. The too-big-to-fail banks will be bargains.

In the "nuclear" contagion scenario, Round Two of anything that remotely smells of bad bank balance sheets rotting in public will freeze up markets and cut off margin to speculators who have bid up commodities and other infrastructure assets. Piercing the speculative bubble in many of the world's commodities would undermine all the stockpilers alongside the speculators. It might look as if we're peering through our rearview mirror at precisely what happened in the summer and fall of 2008.

If commodities crash, the reverberations will be like a tsunami wave spreading across the globe, swamping exporters and deflating the biggest bubble of all, China.

The Negative Feedback Loop

If the bull in the China shop crashes the party in overleveraged domestic real estate and gores the export market simultaneously, the stampede out of China could send the world into a deflationary spiral that would make the Great Depression look like a tea party.

If you see signs of this contagion monster percolating, shorting commodities and China might get you on the Forbes 400 list.

Of course, the contagion-scenario game is itself speculative, but it gives you an idea of how interconnected we all are and how contagion-scenario management could not only protect your investments, but make you realize that there's just as much money to be made when bubbles burst as when they are being inflated.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came Thursday, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. As of Friday morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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