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Understanding Recent Equity Market Mayhem: A Tidal Wave of Liquidity Creation Meets a Cavernous Trench of Debt

Over the last couple of weeks we have witnessed a series of conflicting reports from all over the media complex as to why equity markets are under pressure. Predictably, as soon as the markets recover a bit these same pundits come up with all sorts of reasons to cheer.  Needless to say these hysterical reports, bullish or bearish, are entirely worthless.  CNBC, with its ridiculous “fat finger” report, has proved its irrelevance as a financial news source. In fact, this embarrassing story (released with less than an 1/2 hour to go in the trading session) stinks of manipulation and seems to implicate CNBC as a pawn in a propaganda ring.

But I digress, my purpose today is to offer a little clarity to the situation. So without any further ado, let’s map the market developments and see what, if any, conclusions may be reached.

Support:

Government support is the primary reason equity markets have traded higher over the last year. That support has taken the form of, to name a few, ‘cash for clunkers’, foreclosure prevention, home buyer credits and a myriad of Fed liquidity programs.

The result of this support has been the release of government supplied economic numbers that appear promising and suggest GDP expansion (Did you pick up the sarcasm in that sentence? Sorry!).

To sum up, large quantities of Fed-provided quantitative easing and rosy economic numbers are the fuel driving markets higher.

Now Europe and the European Central Bank (ECB) have joined the fray. Supposedly close to $1trillion of liquidity will be thrown into the gaping mouth of the debt monster.

Pressure:

Abysmal – as in the size of an abyss – amounts of world debt are swallowing up prodigious amounts of liquidity.

China - China’s equity markets have for some time been a leading indicator for US markets and risk assets in general.  Recently, the Shanghai Index reached into bear market territory with a 20% decline from the highs of the year.  This is not a good omen.  Moreover, China’s economic expansion could be labeled the lynchpin of world economic growth and the recent measures by China’s central bank to tighten liquidity is, to say the least, problematic for a world drowning in debt. The recent increase in consumer prices of 2.8% in China only exacerbate the problem as it would appear inflation is accelerating.

GS – Common knowledge suggests the markets swooned because of violence in Greece. This is absolutely not the case.  We can draw a direct line to the beginning of this most recent market drop and the day Goldman Sachs faced the Senate tribunal.  Government crucifying of the financial space is heating up and will only get worse as senators fight for re election this November.  GS is the undisputed heavyweight champ of the financial space and if they fall the financials as a whole will experience painful P.E. multiple contraction.  In the last few weeks GS’s credit curve has inverted. Credit protection on GS cost more for 1 year than 5 years. If this trend persists a debt downgrade for GS could be in the offing which would in turn send financial shares tumbling.

This Just In: As I write this the “Senate Finance Committee votes on amendment to create a new ratings agency; yay’s have it 64-35, amendment agreed to…” Can you hear that? That’s the sound of a GS debt downgrade being written. The congressionally approved ratings body will likely remove the conflict of interest inherent in the current private rating agencies business model. Hence, we would not be surprised to see Moody/Fitch/S&P make a preemptive downgrade.

Financial Group (FINs) – FINs have always been a leading indicator for overall market direction. If GS drags the FINs down the rest of the market will suffer. Make no mistake, as the volume of negative news and behavior towards the FINs grows louder the equity markets will suffer.

Andrew Cuomo Investigating Whether Banks Duped Rating Agencies – Huffington Post

Senators Seek Proprietary Trading Ban for Big Banks – WSJ

Greece – I would be remiss if I didn’t include this component as part of the pressure on the markets. The proposed Trillion $ bailout seems dubious at best.  Lest we forget weeks were required to raise just $30 billion and now somehow the finance ministers got together over the weekend and $700 billion was pledged?! Now these ministers must go back to their respective countries and try to get funding. This funding request should be a tough sell. After all, the German people recently voted the ruling party out of one house after the first 40 bil Euro bailout.  In fact, rumor has it a reintroduction of the German Mark may be in the offing. How about England? They have yet to participate in any bailout and now elections have created a coalition (read: do nothing) government.

The simple fact remains that all this talk of bailouts is actually missing the real point: Greece has a solvency issue not a liquidity issue.

Conclusions/Questions:

Q: Will liquidity expansion trump debt implosion?

Q: Will excess liquidity continue to find its way into the equity markets?

Q: Will Chinese tightening and supposed European austerity plans actually drain marginal liquidity?

C: As my mom would say, “we must live the questions and the answers will reveal themselves.” So, remain vigilant, defend principal and let the markets be your guide. Don’t force your will on the market and avoid complacency at all costs.

C: No matter which is the victor, the Tidal Wave of Liquidity or the Trench of Debt, one asset class will not only survive but flourish.  The precious metals, Gold and Silver, are now advancing to new highs against all fiat currencies. I have written repeatedly over the last few years that the true inflection point for Gold and Silver will arrive when their values increase even in the face of a rising US$.  The time is now.  Please hold on to the Bar!

About Bret Rosenthal

Interpreting the news that moves markets. Principal of RCM, LLC, and founding partner of the Fortune's Favor Family of Funds
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