Saturday, November 29, 2008

Death By Numbers

Tuesday, November 25th, 2008.

WARNING: If you cannot stand the sight of nuclear explosions, people being pulled limb from limb, or dogs sleeping with cats, then please read no further as the math you are about to see is extremely graphic in nature.

That’s right, death by numbers – as in fiscal suicide – hence forth to be known as committing a “Paulson” (I only wish I could commit Paulson!). You see, math, unlike Freidman economics, is extremely unforgiving. Simply put, MATH IS A BITCH when the numbers work against you! We’re not even talking about upper level algebra here, just plain old simple math. But for this math, ladies & gentlemen, you will need to put your pocket calculator away and tap into your latest Pentium Processor as your little TI-1785 will run out of digits before we even get half way to entering in our first denominator.

First a little flavor…

Yesterday’s close saw the largest two day point gain in history. It left all of my short term stochastic indicators very over bought – usually a good entry point to go short, but I was careful knowing full well that we may be entering a more positive time frame, the ever elusive eye of the storm, a.k.a. Elliott Wave B up/sideways. The stochastic oscillator was overbought on the 5 minute, 15 minute, 30 minute, and 60 minute time frames, perfect for at least a scalp on the short side – so I took a poke at it just before the close. By the time I went to bed the futures were down more than 100 points – Booya baby, bread AND butter!

Oh, I can hear all of you 7th Day Economists thinking, “Evil short seller! Evil short seller!” But, frankly Scarlet… only Chris Cox gives a damn.

Then this morning I eagerly arose, spun up all three computers (now completely necessary to handle the math) and my jaw dropped to the floor with a THUNK when I saw the latest $800 billion headline! WTF, OVER? I regained my composure, and promptly sold my short positions. Now, normally I don’t just fold like a cheap suit, but come on, $800 billion? More?? This left me with only two options; attempt to trade this frenetic market – and probably give back some of my yearly gains, or sit on my hands and spend the day educating people about the horror show that is our economy… So here you go – Death By Numbers!

The latest $800 billion announcement created a new acronym to be added to the alphabet soup… you know, the TAF, the TARP, and now the TALF is the latest to be added in with all the other CRAP.

Here’s what the old ticker machine spat out about the TALF this morning:

*TREASURY SAYS AUTO, STUDENT, CREDIT CARD, SBA LOANS ELIGIBLE
*TREASURY SAYS CONSUMER ABS MARKET `ESSENTIALLY' STOPPED
*TREASURY SAYS TALF WILL IMPROVE ABS MARKET CONDITIONS
*TREASURY SAYS TALF MAY BE EXPANDED TO INCLUDE OTHER ASSETS
*TREASURY PROVIDES $20 BLN FOR CONSUMER ABS LENDING FACILITY
*NEW TALF FACILITY TO AID CONSUMER, SMALL BUSINESS LENDING
*TREASURY ALLOCATES FUNDS FROM TARP FOR NEW FACILITY
BULLET: FED: Federal Reserve says it will initiate program...
*FED TO LEND UP TO $200 BLN TO INVESTORS IN ABS :FNM US, FRE US
*FED SETS UP TERM ASSET BACKED SECURITIES LOAN FACILITY :FNM US
*FED TO BUY MBS THROUGH ASSET MANAGERS, STARTING BY YEAR-END
*FED TO START BUYING GSE OBLIGATIONS NEXT WEEK :FNM US, FRE US
*FED TO BUY DIRECT GSE OBLIGATIONS THROUGH PRIMARY DEALERS
*FED PURCHASES OF GSE SECURITIES TO BE OVER `SEVERAL QUARTERS'
*FED SAYS SPREADS ON GSE DEBT HAVE `WIDENED APPRECIABLY'
*NATE SAYS PAULSON IS AN IDIOT, DOESN’T KNOW MATH – OCCAM’S RAZOR
*NATE SAYS PAULSON AND CENTRAL BANKERS COMMIT LARGEST HEIST IN THE HISTORY OF MANKIND – ZEITGEIST

So, I get to THANK HANK for ruining what was probably the perfect short entry. Thanks Hank, you’re a true… ahhh, patriot! Yeah, that’s the ticket… a patriot who is actually a traitor who deserves to be swinging from the yardarm! But I digress; we are here to talk about math. Let’s start by wrapping our minds around a trillion dollars… Rev up those Pentiums!

A TRILLION DOLLARS: $1,000,000,000,000

That’s twelve, count them, twelve zeros! Move your cursor over the little Microsoft flag, select All Programs, Accessories, then Calculator if you want to play along. It’s easy, just type in a 1 and then count to twelve while you pound the shit out of the zero key! That’s it, calming isn’t it?

Okay, let’s go through a little math exercise: Let’s say that you are standing next to a huge pile of dollars bills ($1 trillion) and in front of you is a bonfire. Now let’s say that you are going to reach over to that pile and throw a dollar bill into that fire at the rate of $1 per second. How long do you imagine that you’ll be standing there throwing dollar bills into that fire? Five years? Ten years? Thirty years? Will you get done before you die? How about before your kids die? Their kids?

To calculate an answer, let’s start by determining how many seconds there are in a year, that will tell us how many dollars per year get tossed into the fire and then we can divide a trillion by that number to come up with the number of years. Sound simple? It is truly easy math, you just need a calculator large enough!

There are 60 seconds in a minute = 60

There are 60 minutes in an hour… 60 x 60 = 3,600 seconds per hour

There are 24 hours in a day… 24 x 3,600 = 86,400 seconds per day

There are 365 days per year… 365 x 86,400 = 31,536,000 seconds per year

Okay, now we’re getting somewhere! Now we take 1,000,000,000,000 and divide by 31,536,000 to come up with… 31,709.79 YEARS!

That’s right; you would be standing there for nearly 32,000 years tossing bills into the fire.

Now, if you are being charged interest at the rate of 5% per year, you will need 1,585 of your friends standing by your side tossing bills in with you for ETERNITY, JUST TO PAY FOR THE INTEREST.
Oh yeah, sure… we could stack ‘em to the moon, drive 100 miles by a stack of dollar bills 4 feet high, etc., but you get the idea. It’s an enormous amount of money.

This is where the 7th Day Economists jump in to remind us all that, “They said the same doomish stuff about a billion dollars 20 years ago, and when you compare it as a percentage of GDP it’s not that bad!”

Seriously, someone in this conversation has an Alice in Wonderland fantasy in their head – and guess what? IT’S NOT ME. How long ago was it that the entire world was making fun of how much money our military spent on the B-2 bomber? Remember that? The joke was that it stood for the $2 billion bomber! We couldn’t afford them then and now $2 billion sounds like a JOKE compared to the type of figures we’re throwing around just a few relative years later. That type of number growth – from talking billions, to talking trillions – is HUGE. It’s GIGANTIC, in that it shows that the number game of money has truly gone PARABOLIC. If you follow my writings, then you know what happens to all parabolic curves (they collapse under their own weight).

So, yesterday the media finally added up all the money and guarantees promised in all the alphabet soup programs in the past year. The tally? More than $7.7 trillion! And this morning we learn we get to add another $800 billion for a new total of $8.5 trillion!

$8.5 trillion! How much money is that? Well, the 7th Day Economists say, “it’s only a little more than half a year’s GDP!”

And here’s my response to that: Yes, but let’s get out our calculators, shall we? Let’s divide $8.5 trillion by the size of the entire population of the United States…

$8.5 trillion divided by 305,160,073 (current as of today) = $27,854 FOR EVERY MAN, WOMAN AND CHILD IN THE UNITED STATES.

For my family of four? That’s $111,416! Let me ask you this? Can the average family support that debt? If the answer is no, where do you think this all ends? But wait, that’s just the debts and obligations of the recent alphabet soup.

And before I get too far, I want to remind people that when it comes to comparisons to GDP, my bullshit flag is flying a mile high! WHAT DOES DEBT HAVE TO DO WITH GDP ANYWAY? The answer is NOT A DAMN THING! There is NO relationship, no tie whatsoever between debts and GDP and to make that comparison is pure ALICE IN WONDERLAND.

Here’s the same Alice in Wonderland argument, but in a different way: Let’s say that you live in a neighborhood of 100 homes. You and your spouse earn $100K per year (which is way above average). In addition to the $500k you owe on your house, you owe another $1,000,000 on credit cards! But you say, “in comparison to the GDP of my entire neighborhood, that $1 million is just a drop in the bucket so it doesn’t matter!

HUH? You owe a million bucks in unsecured debt but only earn one tenth that? How does that compare to the output of your neighborhood? It doesn’t!

Now let’s go back to the U.S. and our debt to GDP comparisons. Our nation’s businesses and people, NOT OUR GOVERNMENT, create about $13.5 trillion per year in economic activity (as measured by phony government statistics). But our government only takes in about $2.7 trillion per year in taxes or INCOME. Thus, Paulson and company have just committed the people of the United States to 3.14 years (Oooo, Pi) of INCOME down the drain, and that’s without interest.

Back to our neighborhood… if your personal debts exceed your ability to service those debts, there’s a term for that, it’s called BANKRUPT. It certainly doesn’t matter how much your neighbors PRODUCE, or even how much they EARN, it is YOU who is responsible for your debts. What matters is DEBT to INCOME, not DEBT to PRODUCTIVITY.

Did I mention that there are TWO and only TWO ways to pay back debt? That’s right, you can pay it back (with interest) or you can DEFAULT. That’s it.

Now, let’s really get into the scary math. No, we don’t want to talk about derivatives yet, we have to work our way up to that! Let’s continue to talk about debt.

ADDING UP THE DEBTS:

The following site keeps track of the nation’s CURRENT account deficit.

http://www.brillig.com/debt_clock/

This is the number that is NOT based on GAAP accounting standards. You know, Generally Accepted Accounting Principles… the ones that your government requires you to adhere to but refuse to use themselves? Yep, that’s that one. GAAP accounting includes ACCOUNTS PAYABLE. For the U.S. that would include little things like Social Security and Medicare, but we’ll get to that in a minute. Here’s the latest from the debt clock site:

U.S. NATIONAL DEBT CLOCK
The Outstanding Public Debt as of 25 Nov 2008 at 08:12:50 PM GMT is:

The estimated population of the United States is 305,160,294
so each citizen's share of this debt is $34,968.08.


(NOTE: *this is the current figure above. When this article was written it was roughly $10 Trillion. At $12T the amount per capita is more than $40,000)

Uh, huh. Count the digits, there’s twelve of them following that 10! And, as you can see, the CURRENT account deficit is now up to basically $35,000 per man, woman, and child. When you add that debt to the debt that was just produced by all the alphabet soup programs (yes, a little of it is already in this number, but not much), the total is now up to $62,822 per man, woman, and child, or $251,288 for my family of four.

If you prefer to see the debt in chart form, here it is in all its beauty directly from the Fed:



Can you say, “parabolic?” Yes, I thought you could!

Oh, here’s a good one… note what’s been happening to the Federal Debt held by the pigmen (oops, did I use that term? I meant to say the banks that are actually privately owned, and not actually owned by the Fed. They are Fed in name only).



Federal Debt Held by Federal Reserve Banks: Hmmm… their Federal debts are going down while the nation’s debts are going up. Hmmm…

Okay, well our own Federal banks hold a half trillion in debt… gee, I wonder how much foreigners hold of our debt?



Ah ha! Foreigners hold nearly SIX TIMES the debt as our own “Federal” banks – niiice. So, we’ve established that this curve shape is parabolic, what happens to parabolic curves? Uh huh, that’s right! And what do you think will happen when this parabolic curve collapses? Think about it.

But I digress.

Now it’s time to talk about the future obligations of Medicare and Social Security. Before I get into the numbers, YES, WE CAN simply eliminate those programs and make them go away. WILL WE? YES, WE CAN cut our military spending in half to get back within some level of sanity… after all, we do spend MORE MONEY ON OUR MILITARY THAN THE REST OF THE WORLD COMBINED. But WILL WE? And again, who is the insane one in this fantasy that, unfortunately, is no fantasy at all?

Conservatively our own government admits that the obligations of Medicare and Social Security add up to about $56 TRILLION with Social Security being the much smaller problem of the two at “only” about $10 Trillion. Heck, President Bush spent more than $13 trillion with one signature when he signed Medicare Part D into law! By the way, when others calculate these obligations, they come up with numbers as high as $100 trillion, but let’s stick to the more conservative $56 trillion number, okay?

Now we’re talking some serious numbers, 56 followed by twelve zeros. Do the math, that adds another $183,510 for every man, woman, and child in the United States!!

Add that figure to the previous and now we are up to $246,332 for every person or $985,328 for my family of four.

Guess what? We have yet to even discuss personal or corporate debts. Do we want to go there? Okay, what the heck, I’m a glutton for punishment, let’s go…

Here’s a chart showing the liabilities of the household sector. In other words, personal debts. Note the little hook at the end, this figure just stopped growing.



Gee, that’s a BIG number and yet another parabolic chart! That would be about $14,000,000,000,000! Count the zeros, YEP, that’s 14 more trillion that the people of the United States are obligated for. Guess what, it’s the same 305 million people who owe it all. That’s another $45,901 for every person, bringing the total now to $292,233 per person.

Now, let’s talk about corporate debt. Yes, the same 305 million people are ultimately responsible for corporate debt too. Their debts, like all debts can be repaid in two and only two ways.

Below is the latest chart from the Fed… oops, they stopped keeping track of the number back in 2002, gee, I wonder why? And note that it doesn’t include the debts of the financial sector!! What is the shape of that chart? Oh yeah, it’s parabolic too!



Let’s just be ultra-conservative and go with the figure on the chart. That’s another $3.3 trillion in debts or about $10,820 per person.

This brings the total debt in America up to an astonishing $303,053 per person, or $1,212,212 for my family and every other family of four in America.

Guess what? We still have yet to consider debts owed by our state and local governments! And yes, the same 305 million people owe that debt too. Can the average American family support all this debt AND continue to produce enough to make headway?

The answer is clearly NO! The average American family cannot even service the INTEREST on their portion of the debt, let alone pay for food and clothing on top of it.

Now, you will say that there may be overlapping debts in there and that, ha ha, we might even “make money” on the crap the Fed is taking in (ha, ha, good one), and you say that that figure includes future obligations that the government will simply choose not to pay at some point? Okay, cut the figure in half… it’s still completely unmanageable! The math simply doesn’t work.

You can argue that we can grow our way out of it all you want, but math does not lie. The rules of economics are immutable, same as are the rules of physics and math. Now, let’s talk about the really GIANT numbers, the numbers of the shadow banking system.

DERIVATIVES:

Three decades ago modern derivatives did not exist. By 2006 the notional value of the world’s derivatives had grown to over $500 trillion and the highest report just prior to the latest collapse put the world’s notional value of derivatives at an astounding $1.4 QUADRILLION.

Now, just for comparison, the total output of all men and women of the entire globe last year was a GDP of a little over $60 trillion. $1.4 quadrillion is approximately 23 times global GDP! This is a very squishy number and is most likely much smaller now that the financial system is imploding, but it is still an unfathomably large number, in the many hundreds of trillions.

There is a notion going around that there are two parties, one on each side of the “bet,” and that those bets cancel each other out. That is true only to a limited extent. As all the bets unwind there will ultimately people who were not completely neutral and we WILL eventually find out who they are.

You see, not knowing who they are is one of the root causes of our financial problems, unserviceable debt being another.

As far as I’m concerned, there is NO LEGITAMATE reason for modern derivatives of any kind. In fact, 90% of our entire financial system provides NO service to society. My trading certainly doesn’t. Heck, writing this article is a FAR greater service to our society than my trading, that’s why I’m taking the time to write it. How many people do you think made it this far reading it?

Three years ago I gave our country a chance. We still had the option to do the right things that could have turned the math around. I no longer believe that option exists. Thus, OUR CURRENT FINANCIAL SYSTEM IS DOOMED. The debt will be defaulted and now that it has been transferred onto the taxpayer, you and me, we will default together, as in our entire nation. How long will it be? Let’s put it this way; you are not going to be passing these debts onto your grandchildren.

The people who know me, know that I am NO gold bug. Gold historically gets slammed during credit collapses as it has been during the first phase of this collapse, BUT our government’s actions are placing concrete boots on our currency and Paulson/Bernanke have thrown our currency overboard. That makes this a collapse something that’s on a higher level. I am now accumulating gold and silver and I’m going to give you one more reason why, just in case the above math doesn’t convince you…

In my last article I mentioned the mixed signals I’m seeing from my market indicators. Those mixed signals continue to indicate that the Fed could be buying up their own treasuries, in effect a stealth form of printing large sums. This is referred to as “quantitative easing,” which is just another way to say printing. Today saw a resumption of the 10 year bond moving down in yield while the dollar moved down and gold held on to its past two day’s of gains. Meanwhile the overall market treaded water and is working off short term overbought conditions. I am suspicious and am currently watching the markets from a safe distance.

I love America – it pains me greatly to see it and everyone suffer. I certainly do not enjoy passing along such gloom, but until we remove our collective brains from the Alice in Wonderland world in which we are currently living, real change cannot come. It is those who falsely claim to love her while they simultaneously rape and rob her that deserve your ire.

Nate

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Half Way to Zero

Saturday, November 22, 2008.

At the close on Thursday, and through most of the day Friday, the S&P 500 was down more than 50% from its October 2007 high. This is a technical milestone that I consider an important juncture so I wanted to jot down my thoughts as doing so helps gives me clarity and hopefully will help others understand what may lay ahead.

When reviewing the big picture, I like to break the market down into its three components; Fundamental, Technical, and Psychological. I will review all three below but would first like to discuss some anecdotal thoughts/observations.

Last night was our wedding anniversary so my wife and I went to one of our favorite restaurants in Tacoma, WA, called Stanley & Seaforts. We have been going there for about 20 years now. On the way there I-5 was as busy as ever and it took about 20 minutes longer than the no traffic driving time, about 5 to 10 minutes longer than I expected. Gas is back below $2.00 in our area after all! Upon arrival the parking lot was overflowing and both the restaurant and bar were also packed to capacity. As we waited for our table I watched the kitchen workers prepare meals… about 10 of them, all males who appeared to be mid-twenties to about 40 at the oldest, and of varying ethnic backgrounds. It’s kind of fun watching them work, but since I’ve been going there for over 20 years, I started to wonder where are the chefs who used to work there and how come none of them are even close to my age (upper 40’s)? This is, after all, one of the nicest restaurants in the area. Is the pay not enough to keep workers for the long term? I don’t know.

My wife and I then sat down to our meal, had a drink each and skipped the appetizers. We both passed on the steak and had mid priced meals w/salads. We shared a single dessert. We noted the little differences in the meal and that the past few years it seemed that the quality was diminishing. The tab? One Hundred and fifteen dollars! Seven or eight years ago that same tab would have been in the $60 range. My points? While I see that the cost of living has far outstripped wage growth and we all know the devastation that has occurred in our economy, the streets were still packed, and the restaurant was able to fill itself to capacity while producing a mediocre product at a very high cost. People here are evidently still spending. Sure, they were probably spending money they don’t actually have, but there were a lot of them. I started wondering what all these people do for a living – after all, Tacoma isn’t exactly the center of high finance – but to be fair the Seattle/Tacoma area has fared much better than most of the country although our economy tends to lag by about a year or 18 months. What I saw last night leads me to think over the fundamentals as I view them.

FUNDAMENTALS

In a nutshell, the securitization of debt process got completely out of control and produced the greatest boom in the history of mankind. The leveraged derivatives are collectively referred to as the shadow banking system. The shadow banking system is multiples larger than what most people know as the traditional banking system. That system was completely untracked and unregulated. The process of debt securitization is now completely broken and frozen, thus the growth that was occurring has stopped cold, and the creation of money from thin air has slowed dramatically. For growth to continue, the creation of money must be larger and larger each year. Remember that government statistics do not track this money creation nor do they control it. I would contend that the vast majority of them still do not recognize just how large and out-of-control this became. Also keep in mind that comparisons of current government statistics are COMPLETELY MEANINGLESS WITH THE PAST. The methods used are different than the past and they do not reflect the shadow banking system and are subject to manipulations. Thus the data now breeds a lack of confidence in the system.

Ludwig Von Mises noted that the size of the bust is commensurate with the size of the boom and it was Hyman Minsky who accurately described the seven bubble stages (the following excerpt is from my book Flight to Financial Freedom – Fasten Your Finances, written during 2005/2006):

HYMAN MINSKY’S SEVEN BUBBLE STAGES
The late Hyman Minsky, Ph.D., was a famous economist who taught for Washington University’s Economics department for more than 25 years prior to his death in 1996. He studied recurring instability of markets and developed the idea that there are seven stages in any economic bubble:

Stage One – Disturbance:
Every financial bubble begins with a disturbance. It could be the invention of a new technology, such as the Internet. It may be a shift in laws or economic policy. The creation of ERISA or unexpected reductions of interest rates are examples. No matter what the cause, the outlook changes for one sector of the economy.

Stage Two – Expansion/Prices Start to Increase:
Following the disturbance, prices in that sector start to rise. Initially, the increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, more people start to notice.

Stage Three – Euphoria/Easy Credit:
Increasing prices do not, by themselves, create a bubble. Every financial bubble needs fuel; cheap and easy credit is, in most cases, that fuel. Without it, there can’t be speculation. Without it, the consequences of the disturbance die down and the sector returns to a normal state within the bounds of “historical” ratios or measurements. When a bubble starts, that sector is inundated by outsiders; people who normally would not be there. Without cheap and easy credit, the outsiders can’t participate.

The rise in cheap and easy credit is often associated with financial innovation. Many times, a new way of financing is developed that does not reflect the risk involved. In 1929, stock prices were propelled into the stratosphere with the ability to trade via a margin account. Housing prices today skyrocketed as interest-only, variable rate, and reverse amortization mortgages emerged as a viable means for financing overpriced real estate purchases. The latest financing strategy is 40, or even 50 year mortgages.

Stage Four – Over-trading/Prices Reach a Peak:
As the effects of cheap and easy credit digs deeper, the market begins to accelerate. Overtrading lifts up volumes and spot shortages emerge. Prices start to zoom, and easy profits are made. This brings in more outsiders, and prices run out of control. This is the point that amateurs, the foolish, the greedy, and the desperate enter the market. Just as a fire is fed by more fuel, a financial bubble needs cheap and easy credit and more outsiders.

Stage Five – Market Reversal/Insider Profit Taking:
Some wise voices will stand up and say that the bubble can no longer continue. They argue that long run fundamentals, the ratios and measurements, defy sound economic practices. In the bubble, these arguments disappear within one over-riding fact – the price is still rising. The voices of the wise are ignored by the greedy who justify the now insane prices with the euphoric claim that the world has fundamentally changed and this new world means higher prices. Then along comes the cruelest lie of them all, “There will most likely be a ‘soft’ landing!”

Stage Five is where the real estate industry is today [2005/2006]. This stage can be cruel, as the very people who shouldn’t be buying are. They are the ones who will be hurt the most. The true professionals have found their ‘greater fool’ and are well on their way to the next ‘hot’ sector, like the transition from real estate to commodities now.Those who did not enter the market are caught in a dilemma. They know that they have missed the beginning of the bubble (gold, silver, and oil today [2005/2006]). They are bombarded daily with stories of easy riches and friends who are amassing great wealth. The strong will not enter at stage five and reconcile themselves to the missed opportunity. The ‘fool’ may even realize that prices can’t keep rising forever… however, they just can’t act on their knowledge. Everything appears safe as long as they quit at least one day before the bubble bursts. The weak provide the final fuel for the fire and eventually get burned late in stage six or seven.

Stage Six – Financial Crisis/Panic:
A bubble requires many people who believe in a bright future, and so long as the euphoria continues, the bubble is sustained. Just as the euphoria takes hold of the outsiders, the insiders remember what’s real. They lose their faith and begin to sneak out the exit. They understand their segment, and they recognize that it has all gone too far. The savvy are long gone, while those who understand the possible outcome begin to slowly cash out. Typically, the insiders try to sneak away unnoticed, and sometimes they get away without notice. Whether the outsiders see the insiders leave or not, insider profit taking signals the beginning of the end (remember who has sold their rental properties?).

Stage seven – Revulsion/Lender of Last Resort:
Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap and easy credit or some unanticipated piece of news. But whatever it is, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in, prices start to tumble downwards, credit dries up, and losses start to accumulate.

This is where you may see the “lender of last resort” who is usually the government. The government, although they were talking up a soft landing, are now forced to step in to prevent the crises from spreading to other sectors. Ironically, this is where the savvy investor who profited before, really profits now. With government backing, they are asked to step in and return “normalcy” to a now damaged sector.

The government’s attempt to “put out the fire” usually works. However, the conditions beyond the year 2010 will require oceans of water that the government does not posses. You must be ready!

We are obviously in stage seven now. The lender of last resort has stepped in on multiple occasions. Savvy investors like Bill Gross (oink, oink) are stepping in to take advantage and are attempting to restore “normalcy.” And as I stated when I wrote that, “conditions will require oceans of water they do not have to put out the fire,” I still believe that more than ever, 3 years after I first wrote those words.

To date more than $8.4 trillion has been lost in the stock market. Untold trillions have been lost in real estate and commodities. As those prices have come down they have overwhelmed our government’s attempts to smooth out the business cycle and to maintain a constant rate of monetary inflation. Yes, THEIR figures show(ed) inflation, but they have NEVER accounted for all the money/debt created by the shadow banking system. Their efforts have been and will be overwhelmed until the deflationary forces have run their course. THEN, once deflation has rooted out the malinvestment, the government’s reinflation will take over. THEY HOPE, like all government attempts throughout history, that their efforts will be just right – just enough to overpower deflation, but not enough to cause hyperinflation. Unfortunately, my view is that our monetary system makes that perfect combination impossible. All fiat currencies have failed throughout history and this latest monetary EXPERIMENT that is the U.S. Dollar will also eventually fail.

There is another truth/absolute regarding all interest bearing money systems, and that is that all money is debt, and all debts get repaid WITH INTEREST in one way or the other! There are TWO and only TWO ways to pay back debt; one is to simply pay it back (with interest), and the other is to DEFAULT. The notion of “inflating debt away” is a myth – attempting to do so simply results in paying the debt and interest back in “other ways,” such as by losing purchasing power with the dollars you hold.

The Central Bankers in America and throughout the world hold much of the debt and they are asking/forcing the taxpayers to take their debts from them so that THEY do not have to default. The problem here is that there is not enough income to service all the debt that’s been created, thus someone has to and is going to default. Our politicians had a choice – the pigmen or the taxpayers. They chose us, the taxpayer. And thus, at some point in the future the debt WILL BE defaulted on by our government. The math simply no longer works. That’s what happens when the system is designed for never ending growth. Never ending growth turns parabolic and subsequently collapses in on itself.

That’s where we are from a fundamental perspective. Of course there are many, many factors at play throughout the world, but that’s the over-arching concept. Unfortunately, since this crisis began, the actions of our government and Central Bankers have caused the problems to get worse, not better. For growth to occur again, THE DEBTS MUST GO AWAY, not simply transferred from one bag holder to the next. Until that happens, the fundamental prospects for future growth of our economy will not be there.

That said, it certainly is mathematically possible for the government to “print” enough “money” to create monetary inflation. The numbers to do so ARE OVERWHELMINGLY HUGE at the outset, but get SMALLER as more and more of the debt and fiat money return to the ether from which it came. At some point the forces will be momentarily in balance, but only as we swing from monetary deflation back to monetary inflation. When will that occur? It’s hard to say, but we can look to history and to some signals/signs that the deflationary trend has reversed.

From a historical perspective, the equity dislocation of 1929 to 1932 lasted about 2.5 years as did the crash of the Nikkei index in 1990 and our own NASDAQ in the year 2000. It is said that the length of the boom is also commensurate with the length of the bust, but that is not entirely true. If you look back through history, you will find that in “free” market economies the time span of deflationary busts tend to run about two to three and a half years (2.5 yrs average), but the bust does tend to return equity prices back to the point where the parabolic growth phase began. In our current case, some say that our parabolic growth phase began after the 2003 bottom while others contend that it began in the 1990’s or even the early/mid 1980’s. In our technical discussion I will present charts that show my belief that it began in the 1980’s and that prices are most likely headed back to that timeframe. Our equity markets topped in October of 2007, thus if the deflationary phase of the equity markets takes the average 2.5 years, stocks would bottom in April of the year 2010. This will NOT be the average deflationary cycle, thus calling a bottom prior to seeing technical confirmation is simply a fool’s errand.

LONG TERM TECHNICALS

I have attached four long term charts. The first is an 80 year view of the SPX (S&P 500 Index).

This is a logarithmic chart that adjusts to percentages, so the recent moves look relatively small in relation to the entire chart.

The second chart is the same chart but is not a logarithmic chart just so you can see how dramatic the raw number changes are. It is this non-log chart that clearly shows three phases of growth transition; the phase up until the early 80’s is marked by slow and steady growth; it then accelerates into a steeper climb that lasts until about 1995; at which point it goes parabolic and ends in a double top. Why did it end? All parabolic growth ends, it collapses under its own weight as the math is simply no longer able to sustain the rate of growth.

This is a typical curve as found in all of nature. Most people are taught in school that curves have a nice rounded bell shape. That is very rare in nature and NEVER seen in the market place. As Martin Armstrong demonstrated, curves in the marketplace go through a slow growth phase, begin to grow more rapidly, then go through a phase-transition where they turn parabolic. This phase-transition occurs throughout nature, it is akin to the process of boiling water where a liquid state transitions to a vapor as the energy levels reach the boiling point. The backsides of these curves are not the same as the front side as a bell curve would be. The back side is marked by a steep decline as can be seen by looking at any historical long term market chart. This backside of the parabolic curve is typically marked by either 3 waves or 5 waves down. Armstrong prognosticates that we are currently at the place in time where the first wave down transitions to a short up phase which will be followed by another declining phase into the eventual bottom. This is exactly what Elliott Wave prescribes – an A-B-C move into the eventual bottom. Most EW experts believe that we are very near or at the end of the A wave down and that we are about to begin a 2 to 4 month period of up to sideways market action that will be followed by the C wave down into the eventual bottom.

Of course everyone wants to know where and when will it bottom (except all the “experts” on television who think the bottom is today… no wait, today… no wait, today). Well, let’s start by looking at the 80 year logarithmic SPX chart. The red line is a 100+ year trendline. If the market were to drop straight down today it would intersect that line at about the 550 level. If you extend that line out to April of 2010, it will be very close to the 600 level (the same line will be about the 6,000 level on the DOW). That has been my target since the beginning and I have said that once we reach that level betting the market short will be almost pointless and may be unprofitable from my perspective. My experience has shown that making money short by using leverage requires crisp and sharp moves over a short period of time. Thus it’s difficult to make money at the beginning of moves and will likely be difficult to make it towards the end of the move as well, with the most profit coming from the meat in the middle. Although no two crashes are identical, if one examines a chart of the 1929 to 1932 time frame they will find that following the steep and sharp decline the market retraces a large percentage of that decline and then spend a long time period in a slow grind back and forth working its way to the eventual bottom. That could happen here, or we may decline more sharply. I believe the fundamentals are WORSE than that time period so we could decline more sharply. Yes, we have more meddling and interventions, but those occur during all deflationary collapses (governments must “do something”).

Now let’s examine the 20 year SPX chart (this is a logarithmic chart).

It clearly shows a near perfect double top. Breaking the valley floor which was produced at the 2002/2003 bottom was a technically significant event in that it is required to technically verify that a double top formation is in play. It has been broken on a DAILY closing basis, having closed in the 750 area. The candlesticks on the chart are monthly and you can see that we closed at 800 this Friday.

This new lower low means to the Elliott Wave experts that this decline is on the HIGHEST ORDER of magnitude. It marks the end of the 5th and final wave up of the Grand Supercycle and that we are now in an A-B-C correction of the entire cycle. Think about what that means! If you look at the turmoil that surrounded the lower level corrections like during 1929-1932, you get a sense for how large and deep this correction can go. I am not exaggerating when I say that it is likely to be life altering.

Another characteristic of a double top is that the volume should be heaviest on the first ascent and diminish on the second. In this case the volume is much heavier on the second, but they are so removed in time and circumstance that I’m not sure volume is a valid indicator as the overall market volume also went parabolic with the rise of the shadow banking system.

The question then is how do you determine the target for a double top formation? The general saying is that the wider the top, the further down the target. In this case, I have not ever seen an example of a wider top, thus we can expect a target that is way down there. One way is to measure the distance between the peaks and assume that the price will move the same distance down from the peak. In this case that distance produces a target where the twin red lines are on the right, about 475. I note that level is beneath the 100 year uptrend line. Now, the most widely accepted way to calculate a double top target is the same as with a H&S pattern (I note that double top patterns are less reliable than Head & Shoulder patterns). Thus, you would take the height from the peak to the valley and then subtract that height from the floor of the valley. In this case, it produces a NEGATIVE VALUE as the valley floor is greater than 50% from the peak. NOT GOOD. Thus, according to this analysis we truly are HALF WAY TO ZERO.

Where do I think we’re headed? I think it depends on our government’s actions. I will most likely stop playing the short side at 600 regardless and will be a spectator from that point until all the bricks land. You see, I don’t believe in standing under falling bricks and trying to catch them, I’d much rather stand aside, watch them land, and then walk over and pick them up! I think any outcome is POSSIBLE. I try to deal with the odds the way I see the fundamentals, technicals, and market psychology line up. I do not rule out actually going to zero as that would indicate a complete failure of our financial system, and I do not rule out the fed’s ability to create inflation and move nothing but up from here to eternity. I do, however, place the odds of either of those outcomes as low. My personal gut feeling is that our government’s actions combined with how the Obama Administration is looking make a figure below the 100 year trendline more likely.

Now let’s look at the DOW 20 year chart.

I include this chart to illustrate a point about survivor bias. The DOW is comprised of only 30 stocks and thus as a measure of the market is not as good as using the S&P 500 or even a more broad index. Survivor bias artificially inflates the value of the index. This is true for all the indices, not just the DOW, but it is easy to see the influence in the DOW because there are so few stocks. As a company dies, it drops in value below that necessary to be in the index. Once that happens the index drops the loser and puts in a winner. Thus, the index over time does not reflect the true market! Had you invested in the original DOW 30 companies and held until today, you would posses FAR less cash than if you bought the index and held (another reason why index funds outperform). Note that the second peak on the DOW is higher than the first and not as clean a double top as the S&P. I believe that survivor bias is largely responsible for extra inflation of the right peak.

MARKET PSYCHOLOGY:

When I first began talking of the bubble and coming events several years ago, no one would listen, they didn’t believe it and certainly didn’t want to hear it. Now everybody is talking about it, it is the focus of media attention and was the center of political debate. Thus the negative news is now a part of the psyche. The technical measurements, the VIX, VXO, TRIN, Put/Call ratios, and other indicators indeed reflect a high level of volatility and fear. The question is have we reached a level that will produce a sustainable bottom at least in the medium term?

Answering this question was a lot easier a couple months ago before the VIX got above 60 and stayed there. I always go back to my 10 people locked in a room analogy. If they each have 100 dollars, and they are the entire market (with no new money available), and someone believes the market is going to go up, they put in a few dollars… The other people in the room see the market go up and likewise “believe” so they, too, put in a few of their dollars. Well the first guy now sees the market really take off and so he puts his entire 100 bucks in the market. It zooms and soon everyone in the room believes the market only goes up and they all put in their $100. At that point it is a mathematical impossibility for the market to go higher no matter what the participants in the room believe!

Now reverse that example and the same thing is true on the way down. Of course in the real world not every dollar is ever in or out, but EVERY WILLING dollar for that point in time can be. Of course, the truth is that stocks don’t even have to be sold for the value of the stock to go down. All that is required is the perception of a lower value and ALL the stock is instantly worth less. So, are we at that point? My take would be that we are much closer to that point than before. One thing everyone seems to be looking for is “capitulation.” You know, a very high volume sell off and a V bottom with horrid market internals. I don’t know if that HAS to happen, I tend to think that measurements of psychology when they hit extremes can show short term bottoms or tops, but knowing if they mark THE bottom or top is very difficult.

What I saw at dinner last night and on the freeway sure didn’t look like capitulation to me, but what I see in the media does somewhat. I also see the market react to the Geithner nomination and read Obama’s latest plan and can imagine that we could go through a period of HOPE. It will be a false hope as Geithner is a POOR CHOICE, someone who has already played a large part in creating, not solving, the mess we’re in. His actions are the exact opposite of transparent.

So, from a psychological standpoint I see a mixed picture. The people I see in the Great Northwet have yet to truly capitulate with their spending habbits while at the same time the “fear” indicators and media attention argue that this might be a place where people believe that we’ve seen THE bottom since the DOW didn’t break those 2002 lows? Again, I believe that had it not been for survival bias that those lows would have also been broken on the DOW.

MIXED SIGNALS:

I do see something that is sending me mixed signals at this point in time. The ten year bond is dropping to new lows in yield as are the very short term yields. This is signaling a deflationary credit collapse which is in concert with the collapse of the shadow banking system and collapse of commodities. However, it is obvious that the Fed and Treasury have reached the end of their normal policy tools – they are out of their normal bullets. I think it’s ominous that we are asking the Arabs for money… it shows desperation. Then there’s the rumor that we are buying our own treasuries – in effect printing. That would be BAD, and they certainly won’t tell us when they do this but we can look for signs. What would those signs be? How about a sharply falling 10 year? How about sharply spiking gold? This past Thursday we saw a collapsing 10 year yield and we saw gold hold up pretty well while equities crashed. Then on Friday gold shot higher right from the get go and the again the 10 year fell… then the Geithner news and another short covering rally.

These signals are definitely saying something, but is it deflationary credit collapse or is it now saying that the government is buying up their own treasuries? It’s an important question because it will influence the outcome greatly. If they are buying up treasuries another clue will come from the dollar and the currency markets. That’s why I’m watching closely and am pretty much ready for anything at this point.

Unlike the beginning of Elliott Wave 3 of 3 down, the signals are mixed and for me that means putting less of my money at risk while assuming nothing until more clear signals are in place. Protecting hard earned profits and CASH is paramount. That said, I won’t hesitate to jump on a clean move in either direction, but I am very protective and will not let a position run from me nor will I “buy down” a losing position.

There is a good argument to be made that we go higher from here which I am open to on a psychological basis but any such rally will be counter-trend and based on HOPE that will eventually run into the wall that is based upon math.

In regards to trading in this environment I want to note a couple of things. In prior bear markets using the VIX or VXO for entry and exit worked pretty reliably. The formula was simple – buy puts when the VXO was less than 30, sell them when it was above 40 in the early stages, or above 45 to 50 in the later stages. Now we have a VIX and VXO that have gone above 45 and have stayed there since the beginning of October. This is uncharted territory in that regard, but I would offer up the possibility that we are likely to stay above the 45 range for quite some time and that the formula may just have to occur at a higher level… at any rate, buying puts to HOLD for any length of time when the VIX is above 60 just doesn’t seem smart. With the IV as high as it is, using calls as a hedge for any length of time also seems risky and even if you’re right may not be as rewarding as you might otherwise expect. For me, as we are probably nearing the end of the A wave down, I think it’s time to be protective and to not give back anything earned earlier in the year.

OTHER EVENTS:

I have often talked of the other “events” that tend to follow economic events of this magnitude. Those events are much harder to predict than the stock market as they are not based upon underlying math (at least not directly). The truth is that the population of the world exploded on the back of cheap energy and easy credit. That population curve is a parabolic curve also. Nature has a way of placing limits on growth. While mankind has the power of reason on an individual basis, it would seem that making sound judgments about our collective futures is very difficult indeed. I am yet an optimist but I am also aware of history and long term cycles.

Unlike the market, I will not make specific calls about “other” future events. I will simply point you to history and ask that you look at the “events” that have followed within a decade of other times of major economic upheaval. Most people alive today have lived through a relatively peaceful time of unprecedented economic expansion and therefore have difficulty envisioning otherwise. While these events are not within our control, being prepared mentally, physically, and financially is at least somewhat within your control. These “other events” are likely coming and while I’m not saying that your entire life should revolve around this crisis, I am saying that you, your family, and your business need to be prepared for any eventual outcome.

Nate