For a picture of what a grizzly looks like please see the chart below. I emphasized the importance of the NYSE Composite in Part 4 of this series. We believe the NYSE Comp. experiences less interference (manipulation) from futures and ETF derivatives than does the big three (DOW, S&P500, NASD Comp), hence offering better insight into true direction. True to form, the NYSE Comp. (depicted below/each bar = 60 minutes) led on the downside dropping 16.2% and remains weaker than the big three trading firmly below the 200-day moving average…. 

The debate now rages about whether this selloff is simply a correction in a Bull market or the return of the Bear. I have made my opinion abundantly clear over the last 2 months. However, I will offer up the following two charts as an exclamation point.

Both charts focus our attention on the credit markets. For some time now, credit markets have been leading equity. I dedicated Part1 of the ‘Stalking’ series to this basic credit leads equity theory. To place a finer point on it, if credit markets are relatively stable then equity selloffs can be viewed as merely necessary pullbacks in ongoing Bull markets. However, if credit market volatility explodes, CDS spreads widen dramatically, interbank lending rates skyrocket, etc., then something more sinister is afoot. And no doubt that foot is covered in fur and has claws.  

So, what is credit telling us now? Well, on May 24th our favorite credit Guru, Michael Johnson of M.S. Howells, had this to say, “CDS spreads are today as bad as they were in Sept. ‘08.” That’s certainly not a good sign. How about the interbank lending market? LIBOR rates in ‘08 spike higher offering an early warning sign of big trouble to come. The chart of today’s LIBOR rate (shown below) offers a classic example of the proverbial picture that is worth…

In conclusion, I am posting a chart of  high yield bond spreads. This chart is indicative of the destruction occurring across the spectrum of corporate and sovereign credit…

Bottomline: Rates are rising at an aggressive pace and unless or until this trend dissipates equity will have a hard time sustaining a rally. Expect volatility to remain elevated. Remember, the biggest up days on record occurred during Bear markets. Please don’t allow the cheerleaders in the financial media to confuse you on these up days. Instead, view them as you would the little guy in the Lotto commercials. He grabs the microphone and screams about the possibilities. Do you really want to be the type that runs with the mob to buy a ticket?

Below you will find five paw prints, I mean charts, that crystallize the market breakdown.  All charts have 60 minute intervals meaning each bar represents 1hour of trading.  We place the highest degree of emphasis on the first two charts for the following reasons:

– We believe the NYSE Composite is a leading indicator of market weakness due to its relative lack of futures and ETF interference.  While the  NASD, Dow and S&P 500 appear to be routinely manipulated through the futures market the NYSE Comp. seems to enjoy relative anonymity.  Average volume of the ETFs, DIA, SPY and QQQQ are 9 mil, 185 mil, & 78 mil shares/day respectively. The NYSE ETF, NYC, trades on average only 6 thousand shares/day; my case rests.

-Financial stocks as a group, for decades and this decade in particular, have a tendency to lead the overall market. Goldman Sachs (GS) is the axe in this group so its importance goes without saying.

Development One: Economic numbers that suggest recovery begin to outpace negative economic news. This leads to the perception — or possibly, the reality — that the Fed will reverse its stance on easy credit.

If you are a new reader I strongly advise the perusal of past post before you begin your protest. Those of you who are familiar with my work will know the well documented relationship between bad economic numbers, easy credit, weak US$ and strong equity markets. As long as the Fed remains committed to easy credit in all its forms the bull market can continue.

However, I have witnessed a disturbing trend over the last few weeks. Good news on the economy leads to selling. This suggests to me a real fear pervades the markets with regard to the continuation of easy credit. The equity markets are trading at these lofty levels because of liquidity not reality and if the Fed controlled gravy train of easy credit stops then trouble will ensue. When the gravy stops dog will eat dog. What the distribution of the last few weeks may be telling us is that the big dogs are smelling trouble and are preparing.

Today’s trading offers a perfect illustration of Development One. First, good earnings numbers out of Microsoft & Amazon were not able to move the markets higher. Instead the excitement was used by the big players to distribute their holding. Second, the following “good” economic report hit the news wires this morning, but the equity markets sold off almost immediately after the release:

Existing Home Sales Exceed Expectations
Existing home sales jumped 9.2% to 5.57 million units in September. The increase followed an unexpected decline (-2.9%) of sales in August. The consensus was expecting sales to rise by a much more modest 5.1% to 5.35 million units.

We obviously don’t have the answer to these questions. However, this very real possibility must be respected. There has always been a high correlation between long rates and the equity markets. I can think of no better example than the crash of 1987. For four months the bond market was collapsing (rates rising) before the equity markets infamously followed.

Of course, in ’87 bonds sold off because the Fed was tightening. If, however, bonds sell off even in the face of Fed easy credit policies then I hate to see the ensuing equity market response.

Record Auctions Announced…euro 1.5001…yen 91.5060 (3.411% -07/32)
Treasury will sell a record batch of bonds next week with $44B 2-yrs Tuesday, $41B 5-yrs Wednesday and $31B 7-yrs Thursday. The record levels show an increase of $1B on the 2-and-5s, and $2B on the 7-yrs. There will also be $7B reopened 5-yr TIPS going off Monday along with $29B 3-mos and $30B 6-mos. The market may get some relief as the news is over, but the high end of expectations had been for closer to $115B versus the $116B announced, so any relief may be brief.

Development Three: The high profile SEC take down of Galleon may cause a ripple effect leading to hedge fund unwinds.

Galleon had over $3 billion and now according to DJ-Galleon winding down all hedge funds.

Last year we all witnessed what happens when hedge funds are forced to unwind. Many of the big funds are often involved in the same trades and one unwind leads to another. There will be many denials along the way but the equity markets will speak the truth.

I will also respectfully submit to you, the readers, that the derivatives crisis is far from over. The individuals that created the credit crisis are still running the show. If you believe this statement is incorrect or feel President Obama promised you change so his cabinet must be full of new thinkers, I suggest you view the PBS Frontline documentary entitled The Warning .

The Warning brings to mind two obvious questions:

1- What will cause the next derivatives crisis? Could it be the take down of a major hedge fund that ignites the next collapse?

2- Why isn’t Brooksley Born a major member of the Obama administration? If he was truly an agent for change wouldn’t she be a must in the cabinet?

Development Two: A funding crisis unfolds.
Will the US$ decline in value to a point where long rates must increase aggressively for our government to continue funding its debt? How long will China and others tolerate the ruse of quantitative easing before demanding higher rates?

While this thought has merit I would also point out that the financials will have an almost impossible time leading the market higher. I heard on the financial news networks yesterday the usual hysteria that accompanies any rally. Cheerleaders were blathering on about the rally led by the financials and pundits were picking the oft elusive bottom. What they fail to discuss is the simple fact that this group requires a dramatic infusion of capital. And whether or not this infusion will be government assisted or constant follow-on offerings, the result is the same: endless supply and dilution leading to weak or underperforming equity prices.

And another thing…

Why can’t the Obama administration and Congress devise a stimulus package that will, you know … stimulate the economy? Am I asking too much? Is this concept too difficult to comprehend? Instead of focusing their efforts on the crisis at hand this package appears to have the usual pork barrel spending and handouts to special interest groups. Someone please tell me why ACORN, a group whose activities (while it is not PC to say) are arguably one of the root causes of the banking crisis, is receiving funds from this stimulus bill? Does ACORN’s involvement in the election process – an involvement that some have suggested amounts to voter fraud – have anything to do with this handout? So basically ‘change’ to the Obama team means changing which special interests get the handouts? How should we reconcile the situation? I guess we could say: “the more things change the more they stay the same.”

‘Greenlight Founder Takes Grandfather’s Advice on Gold‘ By Stewart Bailey and Saijel Kishan
Jan. 28 (Bloomberg) — Greenlight Capital Inc. founder David Einhorn is finally taking his grandfather’s advice. The $5.1 billion hedge fund is buying gold for the first time amid the threat of inflation from increased government spending. Since Einhorn was 10 years old, his grandfather has warned him that investing in bullion and gold-mining stocks was the only “sensible” thing to do given the threat of inflation and the risks of so-called fiat currencies, New York-based Greenlight said in a Jan. 20 letter to clients. The firm had never before considered buying bullion or mining-company shares.“To everyone’s dismay, we believe some of Grandpa Ben’s predictions are playing out,” Greenlight said in the letter, a copy of which was obtained by Bloomberg News. “The size of the Fed’s balance sheet is exploding, and the currency is being debased.”Greenlight is turning to the centuries-old currency to mitigate the effects of the economic collapse and government efforts to end it. Bullion gained for the eighth straight year in 2008 as governments in Europe and the U.S. rescued banks from collapse.

RCM Comment: David, I know of a good way for Greenlight to move assets into precious metals: Consider investing in the hedge fund Fortune’s Favor Precious Metals. The fund was up 4.99% net in 2008 even with the collapse of the mining companies and an approximately 24% decline in the price of silver. Plus, I hear the managers have their own money in the Fund and are pretty cagey veterans.