October 23, 2010

Year of the “Noah effect”

Bubbles in Commodities

B waves

According to Charles Evans, President of the Chicago Fed, we’re in a “liquidity trap”, a point where ultra-low interest rates and high savings rates conspire to make monetary policy ineffective. So, it’s not likely that the Fed will be able to get consumers spending and businesses investing like before, sentiment and expectations have undergone a major shift. Yet unless severe spending cuts are enacted right away, the sell-off in the bond markets will be severe, destabilize the economy and drastically increase federal borrowing costs. After all, like Greece was last year, we’re on the brink of bankruptcy. In fact, even when the next crisis erupts, it will be even more important to cut spending to the bone in order to head off a bond market panic.

Meanwhile, Benoît Mandelbrot, the father of fractals passed away at age 85 last week. Mandelbrot was the ultimate interdisciplinary scientist, who applied his findings across a wide array of scientific fields including physics, biology, mathematical finance, chaos theory and markets. A fractal is essentially a structure where the whole is echoed in its parts, and in parts of its parts,while remaining the same no matter how much it is blown up or scaled downat all degrees of trendas in the wave principle. As Mandelbrot pointed out “all charts look alike - without the legend you can’t tell if you’re looking at decade’s worth of data or an hour’s”This principle is inherent in Nature and therefore in Stock Market patterns, which closely model Nature.

Of Mandelbrot’s books, the most celebrated was The Fractal Geometry of Nature published in 1982. During the final decade of his life, he focused his attention on financial mathematics, and in 2004, co-wrote The (Mis)Behavior of Markets: A Fractal View of risk, ruin and rewardwith Richard Hudson. The latter is a sharp criticism on the failure by mainstream economists and mathematicians to understand the likelihood of wild price swings and the risk of financial disaster, so relevant now.

It was Mandelbrot who disproved the Efficient Markets Hypothesis, Modern Portfolio Theory, the Black-Schools Options Pricing Model Marketsand the Capital Assets Pricing Model half a century ago.Most financial equations continue to be based on these defunct theories, since they use the “risk-free rate” as their cornerstone.They neither follow a “random walk” nor do outcomes fall under the “bell-curve”. What’s more,although markets reflect all known informationmuch of the time, as shown in the chart on the right, in actuality, extreme outliers are far more common than a random coin toss would infer. Mandelbrot distinguished between the “Joseph effects” (seven bountiful years followed by seven lean years) and the “Noah effects” – cataclysms like the Great Flood or the Great Crash in the making. While financial models measure the “Joseph effects”,it’s the“Noah effects”which make or brakeinvestors, sincethese outliers are responsible for the bulk of long-term wealth-building– namely yours.

The 20th century saw 48 days in which the Dow swung more than 7% (equivalent a standard deviation greater than 3.5%), while normal statistical modeling predicts such swings would occur every 300,000 years! While mathematical models tend to capture a lot of reality, only a fool believes they capture all of it. Most investors continue to ignore Mandelbrot’s insights by remaining fully invested “long” in stocks at his juncture, and believing bonds are safe long-termin bonds with the excuse that they “can’t time the Market”,or that its “Time in the Market, rather thantiming the Market” that’s responsible for long-term wealth-building. The Market Crash ahead will likely blow the previous extreme standard deviations out of the water and go down as the “Mother of Extreme Outliers”, the proverbial Black Swan. Unlike the first Great Depression, this Supercycle Bear Markethas had to contend with record amounts of fiscal and monetary interventions to postpone and mitigateits unfolding – causing a counter-force of immense proportions to amass.When bacteria are treated indiscriminately with antibioticstheir “natural selection/survival of the fittest”becomeshighly focused and accelerated“what doesn’t kill it makes it stronger”, creating a “super bug”,resistant to all antibiotics.So too this Deflationary Bear Market has been attempting to self-correct for some time, yet fiscal and monetary policies continue to distort and block Nature’s Laws from unfolding.Each time the day of reckoning is put off, increases its eventual severity and enduring effects. We’renow in a “liquidity trap”, where the Fed is “pushing on a string”, so monetary policy no longer works. So desperate is Bernanke that he has resorted tomanipulating “expectations” in hopes it can pull off another series of market manipulations, hoping that additional quantitative easing will be not required, since it is unlikely to achieve the desired effect anyway. In fact our charts clearly indicate it will backfire.

While the previous outdated market theories would infer remaining “long” at all times, the risk of doing at this juncture,as Mandelbrot proved, areimmeasurableunderthe current mathematical paradigm. Most investors continue to believe the Fed is in control and can pull off a slow recovery. Of course this time is different,“we have a Depression Era scholar directing the Fed”.The same “super blip” that will inflictmisery and embarrassing serial downsizing on many, will give new meaning to the concept of an “outlierwindfall – the Noah effect”.

The VIX is one index where the b wave is just a minor transition. What is highly significant is we are beginning a Supercycle wave (3)to the upside, those of you who enjoy a speculation can buy a small amount of VIX futures or VIX options with December expiration, as this graph shows the peak will likely be occurring then as the market troughs. They could not be any cheaper than they are now, from 19 to at least 100 and likely 145 is like winning the lottery. What’s more this chart indicates the “Noah effect” is right upon us!

Given Mandelbrot’s just criticisms, would-beeconomists continue make linear projections at every opportunity. The latest blunder is the calculation of QE2’s potential effect on the dollar. Rather than taking into account that everything including our stocks and bonds has breaking point, where the weight of just a bit more QE will cause these markets to crater, economists assume its all proportional. Christopher Neely, of the St Louis Fed,assumes the second trillion dollars of Quantitative easing will have the same proportional effect as the first trillion. So the prevailing wisdom infers that QE2 will lower 10-year rates by 30-50 basis points, which according to their logic, will in turn reduce the dollar’s value by 2-5%. While bond rates will drop, in the short-term, they will reverse again into a plunge when least expected,while the dollar has bottomed and going much higher, before reverses as well. In essence everything is headed down sharply intermediate-term with the exception of inverse funds. This could only occur with a Crash, as expectations turn progressively more bleak, first stocks crash and bonds surge, then bonds crash and just before the dollar crashes will likely be the opportune time to buy gold at far lower prices than exist today. From 44 to 54 is ~ 25% gain.

Meanwhile, as Charles Evans, President of the Chicago Fed, explains, the results from the initial stimulus have very little relevance to today’s proposed stimulus, since the economy is now in a liquidity trap and numb to stimulusaltogether. While a 6.5% decline in the dollar resulted from the original $1.7 trillion Fed easing programby simple ratios,without taking into account other dynamic variables, Christopher Neely, of the St Louis Fed, assumes a proportional 3.8% decline in the dollar’s value should follow second easing of $1 trillion. What’s Mr.Neely going to do when the dollar strengthens instead, as stocks plummet? Won’t that indicate the Fed has totally lost control?

On the other hand, since the anticipation of the next stimulus wave began with Bernanke’s speech in Jackson Hole at the end of August, the dollar has already declined 5% - without any stimulus at all! As we know markets overshoot in both directions, yet in the intermediate-term the Fed is patting itself on the back for a weaker dollar, by taking credit for 17% in expected growth in the economy. Would the Fed still take the credit for its misguided policies, when it turns out these have shrunk rather than expanded the economy by an incremental 30%? Or that the Fed’s mindless activity will drive thousands of investors to economic ruin, chronic depression and even suicide?

Fed is digging the dollar’s grave as the world’s reserve currency

While investors were driven in droves during September and early October to the risk trade in anticipation of QE2 –that’scapital flight by any other name. In effect, by raising the impact of deflation, rather than reducing it. The Fed is digging the dollar’s grave as the world’s reserve currency. With the raising of Chinese interest rates, the risk trade has again lost its appealtemporarily, but in the meantime despite the appearance of heading marginally higher, the market has traced out a subtle reversal, to the downside. You see in Diag IIs, which indicate the beginning of a long move in inverse funds, waves (ii) (iv) have a deceptive tendency to drop below the origin of wave (i).All the while,the inverse funds have been building a launching pad in preparation for blast-off. As one investor commented, “the dollar is not the same dollar that we used to have. It’s a new world.”

As you see below, the dollar although on the way down, it has now got to retrace intheuppermostDiag II to between 88 and 88.75 visible only on the daily chart below this one.

Although the dollar is headed down, it must first retrace up to 88 in wave (iv) of the Diag >, then drop to a minimum of 72.75, afterwards it’s a long bear market rally concurrent with in stocks, which will unfortunately likely leave Bernanke smelling like a rose.

Like the Plaza accords 25 years ago, which led to concerted currency interventions to weaken the dollar, Forex traders became convinced last week that a sequel was in the offing. The dollar has dropped 5%, as measured against a basket of currencies,since the Open Market committee met on Sept 7, and after months of lip service when the Renminbi hardly budged,it is now up 2.4% against the dollar.The envisioned bilateral deal between China and the US would leave the dollar loosely tied to the renminbi and cause it to fall against other currencies each time the dollar dropped. As I stated last week, this agreement appears to have already been made clandestinely, like market manipulation, in keeping with our Fed Chairman’s underhanded ways.

Fool’s Gold

Private investors hold 30,000 tons of gold, more thanthe holding of entire holding of all central banks on the Planet. In 1980 gold was also in a bubble andpeaked at $850 anounce,only to plummet 60% the following year. The origins of gold’s rise came from Richard Nixon’s removal of the peg on gold in 1971 or $35, which made it much easier to indulge in inflationary policies. By early1980 gold had reached $850 an ounce. Back then there was 13% inflationand short-term rates were above 16%. In current dollars that $850 is over $2200. So what happens when gold loses its glitter? Investor demand has now reached mania levels. Inearly October 3% of futures traders were bullish on the dollar, while 95% were bullish on gold. While the bubble/bust cycle lasted 4 years in 1980, it is now 7 years in themaking. So what happens when the dollar clearly begins rising, and stocks plummet from deflationary Depression expectations, will there be any benefit to gold then? In the aftermath of the credit crunch we have entered into an era where global systemic risk is extremely high and unpredictable. Even seemingly unrelated small occurrencescan trigger a larger financial crisis, but that will not be inflation anytime soon.While there will likely be a time when gold is again a good buy, when daytime television features ads to invest in gold,obviously it’s in a bubble. Gold will likely be the unmaking of John Paulson, the hedge fund manager with the all-time performance record, who offers the option to denominate his funds in gold rather than dollars. Some would conclude that gold is sky high because faith in the central bank is so low, yet a market crash will likely resolve the faith issue in an entirely different manner than what’s expected. The probability of inflation in a deflationary Supercycle is slim and none.

Rather than a low risk asset or insurance, gold is a speculation, since investors are no longer looking at the “underlying value”, but rather the continuation of a price rise, so they can unload it to an even bigger fool. After the peak in 1980 gold went into a slump that lost 82% of its value in real terms and was a dead investment for nearly two decades. Back then there was utter panic about inflation, this time there’s no inflation and market discipline will override the Fed.

If you are foolish enough to believe that the Fed can cause inflation, against all odds, then by all means own gold, since owning gold is a highly optimistic bet that Central Banks will overshoot their inflation targets and actually get stock markets and economies moving again. On the other hand, the forces of Deflation,like Nature, are much stronger and have been building mass and momentum for a major showdown that will likely undo all the Fed’s stimulus and a good bit more, taking us back to 1978 prices in everything. That will make the dollar rise initially, and possibly retain its value for a while. Certainly in real terms, purchasing power will see an enormous surge, yet this is precisely because there will be so little of it left, again deflation. As you see in the weekly dollar chart the dollar is in wave 2 correction of a long-term 5-wavebullish move.


Like gold, silver peaked at $50 an ounce in 1980, after the Hunt brothers cornered the market;they also went bankrupt in the process, and nearly pulled Bache down, their broker, with them. The following year silver dropped to $10. Like gold it is speculative demand that has made the poor man’s gold surge. Here again demand is driven by fear that the QE2,contrary to all logic, could spark asharp jump in inflation. Sales of silver coins are set to a record high this year while investors have snapped up 1,500 tons of silver through exchange-traded fundsin the past two months alone – more than 5% of the total annual silver supplies. Canadian Silver Maple Leafs have sold more than 30% in excess of last year’s record 10m ounces, and the Canadian mint has run out of 2010-dated coins. Meanwhile the US mint has sold 27.5 m ounces of silver American Eagles this year, already within reach of last year’s 28.8m ounces, with the Christmas season still ahead. Silver has rallied 31% to 23.72 an ounce on Wednesday, more than 3 times gold’s 8.9% rise.A bet on Silver is a bet on economic recovery, on an industrialmetal used in jewelry, electronics and photography. While solar power uses silver-containing chemicals to convert sunlight into electricity. However, it’s investment demand that’s driving up prices, with hedge funds beginning to take positions aiming to profit from its higher volatility. Since the silver market ismuch smaller than gold’s, a hefty investment tends tohave a larger impact on prices. Unlike gold mine production, silver is relatively plentiful. Wheninvestors stop accumulating fresh metal to position against market uncertainty, prices will correct sharply below $7, according to our projections. As you see on the Elliott chart on the right below, silver peaked in the orthodox top in 2008, since then we have been in a correction, with the b wave in a final Spike, next is a crash to below $7 an ounce, to retrace the Diag IIin 2005.