28 May
2012

Do NOT be COMPLACENT!

Categories: Asian View

Financial institutions such as JP Morgan love to buy derivatives because they are opaque, create fictional income that leads to real bonuses and when (not if) they suffer losses so large that they would cause the bank to fail, they will be bailed out.
-William K. Black

The Godfather of newsletter writers, Richard Russell, warned his readers in the Dow Theory Letters that “something BIG is heading our way,” and wondered “how much longer the decline will continue to be orderly.”

Here is Russell’s reaction after the market close on May 23, 2012, which was published on King World News:

As of today’s closing, Dow down 14 out of 16 sessions! This is one you can tell your kids about. And still no collapse in breadth, and still no crash. The only thing I can make out of it is that a lot of people are standing their ground.

Maybe it’s just the Dow that is dying, and the rest of the market is OK. But don’t you believe it. The Dow represents the manufacturing capabilities of the United States, and when you see the Dow doing what it’s doing, you can be sure that somewhere ahead business is going to take it on the chin.

By the way, on May 1st, the Dow recorded a high, but that high was not confirmed by the Transports. The two averages then plunged below their April lows, delivering a bona fide Dow Theory bear signal. So yes, this is a continuation of the bear market. But it’s starting out in a stranger way than any bear market I’ve ever seen. Maybe the experts are so fascinated with the Dow and Facebook that they’re not taking in what’s happening.

Stay in cash, because I intuit that something BIG is heading our way … I believe the proper position is to be on the sidelines with zero stock holdings. We are entering the second half of the bear market … After all these years following markets, sometimes I have the feeling that I’ve seen everything. But not this time. Hey, would you believe the Dow could go down 14 out of 16 sessions, and people would still be complacent?

There are so many potentially bearish scenarios in the wind that my head is spinning. Last night, I noted that the Dow futures were down 55 points. I can’t remember ever seeing a series like this in my lifetime. As a loyal American, I’d feel better if people were scared out of their wits. What’s it going to take to scare people – the Dow going down to 4000?

I have a great deal of respect for this gentleman, because he has been writing his newsletter for more than half a century – since 1958 – so he definitely knows what he’s talking about. My advice: listen carefully to what he has to say and act accordingly.

After being severely oversold, the S&P 500 got a bit of a relief rally last week. As you can see on the daily chart above, the RSI or Relative Strength Index just went on a buy signal 5 trading days ago.

An RSI buy signal is when the indicator moves below 30 and then moves back above 30. Meanwhile the candlestick chart printed an almost perfect bullish engulfing, which could indicate a potential reversal in the near term.

Should the S&P 500 extend its bounce this week, look for first resistance from broken support in the 1355 area. But I have to repeat again this is most likely ONLY an oversold bounce, and not the start of a new uptrend.

So any rallies should be sharp and swift, but quickly retraced. Also the fact that we are probably going to form wave 4 in the next few days means that we still have one more wave down (wave 5).

If you consider seeking shorting opportunities, and avoiding long trades for the time being, you’d better have a look at the weekly chart below. Possible downside targets are around 1248 and 1207, which are respectively the 50% and 61.8% fibonacci retracements of the previous uptrend.

As promised, here is the second part of the article about DERIVATIVES from Eric J. Fry who made this brilliant piece of writing for The Daily Reckoning. Once more, all credits go to him.

Let’s pick up the story where we left last Friday, namely with the question ‘What could possibly go wrong?’

To begin answering that question, let’s take a closer peek at JP Morgan’s exposure – specifically, the calculation of its “Derivative Receivables” relative to its tangible equity capital (TEC).

“Derivative Receivables” represents the money other folks owe to JP Morgan, based on the current pricing of the derivatives on JP Morgan’s books. These are Morgan’s “winning bets” in other words. But as every gambler knows, a winning bet is not automatically a moneymaker. You must also collect the bet from the loser. Thus, the “Receivables” line item on the balance sheet represents uncollected bets.

So, what would happen if a couple of the losers didn’t pay … just like Lehman Brothers didn’t pay its bets a few years ago? Would that be a problem? In a word: yes.

Obviously, the size of the problem would depend upon the size of the reneged bet or bets. So just for kicks, let’s imagine that almost everyone made good on their bets with JP Morgan. Let’s say that 19 out of 20 repaid their bets, while only one out of 20 refused to answer his phone.

If something like that occurred, Morgan would be short roughly $90 billion – a shortfall that would completely wipe out Morgan’s tangible equity capital. In other words, just one deadbeat gambler out of 20 could imperil the bank’s very existence. Morgan would be insolvent … at least until the Treasury and the Fed flew in their “financial medevac” choppers to airdrop billions of dollars onto the disaster scene.

We aren’t saying a disaster is likely to strike. We are merely saying that it is not unimaginable.

And here’s the really crazy thing; there aren’t even 20 gamblers in the derivatives markets to diversify the risks, there are only four that matter – all four of whom are also “the House.” In other words, because only four big banks hold 94% of the derivatives, they all owe money to each other in virtually incalculable ways.

Yes, they can each count the actual receivables and payables, but they still cannot quantify the “what ifs” they could ensue if one piece of this multi-trillion daisy-chain breaks down. “The high concentration of derivatives among the top four players,” warns Reggie Middleton of the Boombustblog, “strongly suggest that they may be subject to extreme levels of counterparty risk towards each other. JPM is the largest player in derivative markets accounting for approximately 40% of total notional value of derivatives in the US. JPM’s notional value of derivatives as of March 31, 2009 stood at 39.0 times its total assets and 959 times its tangible equity.

These spectacularly large data points concern us. Enormous, opaque and illiquid risk exposure is rarely a good thing.

That said, we would quickly add that we have no axe to grind with JP Morgan … or any of the other big banks. Maybe they are great banks in every way, maybe they aren’t. We have no idea. We are all about hating the sins, not the sinners. And we are concerned about the sizeable risks that linger just beneath the surface of the world’s financial markets.

Any fool can see that the four big derivatives banks should be dialing back their exposures before the next credit crisis, rather than necessitating the next mega-bailout. But Fed Chairman Bernanke is no fool. He’s got enough education and advanced degrees to understand that two drunks leaning against one another are actually “net sober.”

“We aren’t that smart … and probably never will be.”

Last Tuesday (22 May) Nigel Farage, MEP and Leader of the UK Independence Party gave another passionate speech in the European Parliament. And he always does it so eloquently and full of vigor, don’t you think so?

Anyway thanks God for people like him. There should be more brave souls indeed who are straightforward and don’t talk around the bush all the time. Here are some of his comments:

President, we’re in the midst of an economic and increasingly humanitarian crisis and yet Commission president Barroso is not here. Indeed, Herman van Rompuy is not here either. Not that it really matters, because they’re not prepared to listen to any debate or any argument. They’re intent on pursuing their political dream of a United States of Europe. They’re prepared to commit economic suicide for an entire continent.

Tomorrow night, Mr. van Rompuy has called yet another summit at which he’s going to present a strategy for growth and jobs. Elected MEPs, representatives of the people of Europe from left and right – we’ve heard it all before – remember the euro itself was supposed to create growth and jobs and yet it is actively destroying both of those things.

The remedy we’re being offered is more of the same. I would suggest that the medicine is killing the patient, and to increase the dosage is madness.

And don’t listen to those who will tell you that the only alternative is for Greece to stay in the euro. Everyone’s pushing this. David Cameron, all the other leaders are saying, we must keep Greece in the euro, if she leaves the sky will fall in.

It won’t! There’ll be a few difficult weeks and then things will settle down. There’ll be a boom in tourism, investment will start to come back into Greece, innovation will start to come back into Greece as people start making products to beat expensive imports.

Indeed Greece outside of the euro zone may well provide to be an inspiration for Spain, for Portugal and many other countries. We need to recognize that a terrible mistake has been made. We must resolve to put it right. We’ve got to give people hope because out there now is absolute despair.

And please have a look at the chart below from JP Morgan Chase titled “European Exposure”, that shows which regions in the world will be potentially impacted the most if things start getting really messy in Europe. Also pay attention to the region that will experience the least damage, namely the Asian emerging markets. This is one more reason, I would say, to seriously consider Indonesia – which is the biggest country in Southeast Asia – as your next investment destination in the future.

Posted by Nico Omer Jonckheere | VP Research and Analysis, PT. Valbury Asia Futures