Many of you have probably heard that the Dow took a thousand point dive a few weeks ago. You might have also heard that a fat fingered trader might have been responsible for pushing the wrong button and setting the mini-crash in motion. Hopefully you aren't buying the urban legend...
First of all, real life trading doesn't work that way. It is not possible for a single, inadvertent keystroke to set off a market meltdown. Wall Street knows it and the political weenies likely know it as well. However, it does make for a good cover story to distract the masses from a far more worrisome reality - that the market is running on vapors and is increasingly exposed to the reality of an impending worldwide economic slowdown.
The government's search for a fat-fingered trader is a comical and ironic distraction. Of course, it is serving a purpose - keeping the masses entertained while also keeping the public from wondering if perhaps there is a fundamental reason for the market's brief crash. After all, it is far less worrisome to many to pin the meltdown on an "accident" than it is having to acknowledge that perhaps there is a pervasive, deep-seated rot setting in.
But where's the irony? Well, try this on for size. The government's witch hunt is focused on who might have pushed the wrong button to send the Dow careening 600 points lower in a matter of minutes (it was already down 400 points or so as a result of the steady, heavy selling that led up to the meltdown) rather than on who might have ridden to the rescue with heavy blasts of futures buying. Profit seeking traders are not known for a willingness to catch a falling knife, nor are they likely to willing place themselves in the way of a massive market meltdown. Who, then, stepped up and turned the tide with relentless, massive futures buying, even as the Dow's decline accelerated to four-digits? Perhaps the government should look into who jacked the market up 600 points in a matter of minutes? Perhaps the government already knows....
No, Fat-fingered Freddie didn't cause the market to plunge. What did do it was steady, heavy selling from nervous money managers who are beginning to see the writing on the wall. Tops take time to form and we may have started doing just that over the last few months. Sure the S&P 500 exceeded it's January high in April, but it has already retraced that gain and is currently trading below the January high and just above a flattening 200-day moving average. Furthermore, the 20-day has recently dropped below the 50-day moving average, portending continued market weakness, at least for a few more weeks. The 200-day lies in the vicinity of 1100, a big round number in its own right, making that level very important to traders (and that's most everyone these days). Finally, we've had ten days of well above average down volume since the middle of April, a sign that smart money is exiting. All in all the weight of the evidence suggests a very cautious stance is warranted from a technical point of view.
Fundamentally, the picture is even more worrisome. Europe is in trouble and contractionary forces there are likely to intensify in the coming quarters. The effects of the EU's self described Bazooka (the pledge of a 750 billion Euro backstop to Europe's banks) are already fading as the Euro is weakening again and approaching four-year lows, even as sovereign risk spreads have started to widen, despite intervention from the European Central Bank (ECB). The massive rescue package is as ill-conceived as the U.S. TARP effort (which led to a short term bounce in the stock market but saw an eventual 50% additional decline in the S&P 500 after the short-covering rally faded).
The ECB's proposed 750 billion Euro bomb is a declaration that they stand ready to buy almost $1 trillion dollars worth of distressed Euro-area debt in order to preserve the Euro. Of course, they are also on record as stating that they will sterilize the transactions to prevent the Euro from debasement (750 billion Euros let loose in the EU could create inflation on a massive scale if the transactions were left unsterilized). But that means the ECB is planning to, "debase the quality of its balance sheet by exchanging higher quality Euro-area debt with lower-quality debt of countries that are ultimately likely to default," according to Dr. John Hussman.
Now if that M.O. sounds familiar, well it should, since that is exactly what the Federal Reserve has done over the last couple years in the U.S. The Fed has exchanged U.S. Treasuries for the toxic assets residing on U.S. bank balance sheets, prostituting its own balance sheet in the process and setting the U.S. dollar up for a massive decline in value going forward.
But the worldwide debasement of paper currencies and the ultimate high inflation rates that will follow is for later. For now, it is likely that the EU economy will slow and eventually fall back into recession. Likewise, China is showing early warning signs of an impending slowdown. Finally, the U.S. economy is very likely to return to recession within the next quarter or two, based on the ongoing contraction in real money supply that began last December. Which gets us back to a much more reasonable explaination of what caused the Dow's thousand point drop. Rather than pointing to Fat-Fingered Freddie, we should instead be acknowledging that the professional money managers, who have composed the bulk of the historic rally off of the March 2009 lows, are beginning to edge toward the exit, and that their selling temporarily overwhelmed buying from the public. It's well known among traders that when an overcrowded trade reverses it often does so violently and to excess. Prudent investors would do well to heed the warning shot that was fired on 6 May 2010, it quite likely presages more trouble to come....
