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Global Economic Intersection Article of the Week
Editor's Note: This was originally posted October 30. It is quite interesting to compare this analysis to what has happened in the ensuing week.
John Mauldin, for whom I have a great deal of respect, put forth a very convincing and enlightening argument last weekend in his free Thoughts from the Frontline newsletter. I'm going to try to summarize his argument as succinctly as possible for my readers, but do note that the credit for this information goes to him.
Basically, his argument helps explain what stretched out the historic melt-up rally in equities (the Dow Transportation Average had its best month in 72 years — that's pretty historic). His argument revolves around the announcement which came out of Europe on October 28, and why it impacted the equity markets. As most realize, it had nothing to do with "good news" from Europe. Pretty much anyone with half a brain looked at the European summit and said, "Greek bond holders taking a 50% haircut isn't good news… why is the market rallying like crazy?"
What it boils down to is this: when the banks agreed to a voluntary 50% write off on Greek debt, that agreement caused credit default swap clauses not to be triggered. If the write off is "voluntary," it is not considered a default, so no CDS. Once it became apparent there would be no CDS event, the parties involved no longer needed to hedge their risk on CDS counterparties through short positions.
Imagine you were a big player who sold a CDS on Goldman. You would then short Goldman stock to help hedge your risk exposure, and protect yourself in case you actually had to pay out on that CDS. When the CDS event was voided due to the voluntary write-off agreement, that risk exposure evaporated. And those shorts got covered.
In the interest of brevity, suffice it to say that this "voluntary" agreement out of Europe caused many short position hedges on the SPX and financials to be covered, which then squeezed the short hedge funds and caused them to cover, which then got picked up by the algorithm bots who added more fuel to the fire, followed by momentum traders, followed by John Q. Bear who had his stops hit or his margin squeezed, etc..
Before you know it, the SPX gaps right through the neckline of the old head and shoulders pattern like it isn't even there. I am simplifying things a great deal here, but I think my readers are smart enough to get the basic picture.
The bottom line is: the government changed the rules in the middle of the game. Imagine if you were a football player who returned a kickoff 100 yards all the way to the endzone, then spiked the ball and started celebrating… at which point the officials came running in and said, "Sorry, no touchdown. In fact, it's a fumble. We just moved the endzone out to the parking lot. By the way, grab us some hot dogs on your way back." That's basically what happened to the credit default swap players. Changing those rules had a major impact on the "private" equity markets, and caused the melt-up.
This is another thing that always interests me about Elliott Wave: had the rules of the game not been changed, it seems more likely that the counts I posted on Wednesday might have panned out better. The market sometimes forms patterns which "keep their options open." The patterns can, in essense, morph into something different if influenced enough by an outside force. This is another reason no analyst can be right 100% of the time — you make a call based on your best analysis at the moment, but outside events can transform a pattern from something that appears to be a low probability potential, into a reality.
I have sometimes compared trading to poker. You might have a very strong hand (i.e.- a high probability pattern), but that strong hand can always get cracked by some long-shot hand that hits a miracle card on the river (i.e.- a low probability pattern).
Nothing is guaranteed — the best we can hope to work with are probabilities. I get my money in when I've got the odds on my side, and I get it out when I don't.
The situation in Europe is still far from bullish. There is simply too much debt in Greece, Italy, Ireland, Spain, France, and Portugal for the Eurozone to recover from unscathed. Meanwhile, the United States is running into debt problems of its own. The U.S treasury market is deeply dependent on foreign central banks (FCBs) for support… and lately the bids on U.S. debt are drying up. My associate Lee Adler at the Wall Street Examiner compiles one of the most comprehensive reports available on the Fed and US Treasuries. The data and analysis he provides is incredibly comprehensive and useful. Put simply, it's a champagne report for beer money.