Reading Between the Lines Marking Extremes in Volatility ~ The Risk Averse Alert

Saturday, May 31, 2008

Reading Between the Lines Marking Extremes in Volatility

Do you ever give yourself to reading between the lines?

I do it all the time.

I give you the case of Jim Cramer who on Friday said something I quite agree with...

He claimed next week was going to be a "fulcrum week" in the stock market. He was keyed on Toll Brothers and Hovnanian — homebuilders. Both companies are reporting next week.

Cramer was recalling a conversation he had a few weeks ago with Robert Toll. I heard it myself. In no uncertain terms Mr. Toll gave a bleak analysis of the home building market. Cramer was at a loss for words, and let me tell you that says a lot.

So, there he was opening his Mad Money show on Friday pointing to the two major league homebuilders reporting next week, and recalling his conversation with Robert Toll ... reminding viewers how bleak it was ... all in the context of calling for a fulcrum week in the stock market.

And, of course, he did this with all the well-rehearsed red, white and blue spin you come to expect from such a polished outlet of Wall Street hype as CNBC.

Now let's think about this...

Did Jim Cramer just announce his agreement with me the stock market is at risk of cratering? Was he doing the best he could to warn everybody? Could he have been any more convincing about what to expect?

Let me tell you something. Jim Cramer may be a lot of things to a lot of people, but one thing he is not is a knife catcher.

Funny thing, too, he told the story of the worst investment he made for his charitable trust, Action Alerts Plus. It was Charter Communications. The moral of the story? Don't try catching a falling knife. Of course, that's not how he put it, but the conclusion was the same nevertheless.

So, what's he doing, then, by reminding us of Robert Toll's bleak outlook for the homebuilding market? Is he trying to call a bottom or is he revealing the homebuilders are a falling knife?

Well, really, I don't want to read too much into this. I mean, after all, GM, AIG and C — American stalwarts — were each clubbed for some double-digit percentage loss just in the month of May (2008).

Now, I've read a few books on the crash of 1929. Today's breaking companies are much like those that broke in late '28 and then in '29. They created a breading ground for growing volatility, much as I am forecasting dead ahead.

First a meltdown. Then a melt-up. Then Dow 3600.

And can you believe this might all unfold by 2011? Truth is odds are quite good.

Oh, and trust me, I can show you how this would transpire entirely within the realm of all that is quite natural ... all that has happened many times before.

Right now there are more investment banks than you can shake a stick at standing at the very precipice where furious selling would likely carry these firms right over the edge.

Surely, someday, some of these firms, indeed, will be swept away like Bear Stearns. Things like this in the world of finance are as natural as night and day. Furthermore, because problems on Wall Street are man-made, the consequences likewise will be just as natural as peace and war.

Now, let me be clear here. These vital firms control a vast tangle of financial assets at the core of the American economy. The viability of some significant chunk of these is widely being questioned, with many believing the worst of the "credit crisis" is not behind us. However, what's of interest right now is the role financials might play in the stock market's pending meltdown.

Truth is shares of these firms have already arrived at the precipice in a flurry of selling. Look at Lehman Brothers, Merrill Lynch, Morgan Stanley, JP Morgan/Chase, and many other Wall Street houses. The volume of shares traded in financial companies over the past year's "credit crisis" has been quite pronounced, relatively speaking.

FACT: In the past volume spikes have stood as a sign of strong, underlying support. That's why I will assume the worst of the financial stock selling fit has already hit the market (for now). The Washington fix is in, as everyone was assured during the Bear Stearns take down.

This notwithstanding, though, a great deal of tidal turbulence is revealed through the ongoing LIBOR saga. I mentioned the other day the British Bankers' Association's Friday release of its initial report addressing recent turmoil building among financial institutions dependent on the LIBOR system. The one outstanding thing you can see in the reporting of this news (see the IHT and the NYT) is something of a rebellion developing between Mother England and her children on Wall Street. Like a "know-it-all" teenager, Wall Street appears bent on assigning blame for its present problems on a parent who "just doesn't understand."

These are the seeds of Dow 3600.

Wall Street may talk a good game about finding new adoptive parents friendly to its way of thinking, yet the City of London surely will not hesitate reigning in its child with disciplinary measures that threaten a complete withdrawal of support. They did it in 1930 and if need be, they will do it again. The trend is your friend.

So, this in a nutshell summarizes the state of the financial system. Its credibility hangs in precarious balance. Yet, it probably will not soon fall over the edge in spectacular default. Someday, yes. But now? I think not.

What sector(s), then, might lead the stock market lower during its imminent meltdown?

Well, how about those commodities! Energy especially. You'd have to be blind not to see trouble in the present arrangement, no matter how you look at it.

Most disturbing is not inflated prices. Rather, it's that we got here at all. Heck, crude could sink to $90 later this year and this fact would live on. This, in and of itself, is a problem. It stands to affect market psychology for some time to come.

Obviously, pressure is growing to reign this in. Yet, what people generally fail to see is how commodity inflation has bolstered the share prices of many publicly traded companies. It's a significant reason why the stock market remains buoyant, despite the hit financial stocks have taken over the past year.

Seeing clearly the brakes are being applied to the commodities market, the stock market, in its famed capacity to look ahead some months, stands likely to suffer.

I suspect stocks benefiting from commodities inflation will lead the stock market sharply lower over the next few weeks.

Yes, indeed, energy prices are likely peaking ... at least for the time being. Likewise, I believe the same holds true for commodities prices in general.


We've already begun to see over the past couple months action indicative of topping in the Commodities Research Bureau index. This conclusion is evidenced by the divergent relationship forming between the CRB and the two technical measures presented on the above chart.

As an Elliott Wave Guy I would also make the case the CRB's path of least resistance over the months ahead could drag the index to as low as 250.

I'll not go on and on. I just wanted to give you some sense of the dynamics I see at work and hope this perspective provides some insight into why I believe the stock market is likely to become quite volatile over the next few years ... in both directions.

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adan said...

interesting follow ups from earlier this week, thanks!

looking fwd to seeing how cramer's "fulcrum week" comes out, plus your take on all that :-)

Feroz said...

There are three distinct risks you must guard against; they are business risk, valuation risk, and force of sale risk.Investment Risk