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Tuesday November 25, 2008 - 14:01:15 GMT
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Can we muster a 2-day stock rally?

Key News
• The World Bank on Tuesday cut its growth forecast for China next year to 7.5 per cent, the slowest rate of expansion since 1990, and said the impact of the global financial crisis was likely to “intensify”. (FT)
• [UK] Prime Minister Gordon Brown swept aside three decades of economic orthodoxy with tax increases on the rich and plans that will double Britain’s national debt.

Key Reports Due (WSJ):
7:45a.m. ICSC Chain Store Sales Index For Nov 22: Previous: +0.3%.
8:30a.m. 3Q Preliminary GDP: Previous: -0.3%.
8:30a.m. 3Q Preliminary Corporate Profits: Previous: -0.4%.
8:55a.m. Redbook Retail Sales Index For Nov 22: Previous: -1.1%.
9:00a.m. Sep S&P/Case Shiller Home Price Index: Previous: -17.7%.
10:00a.m. Nov Conference Board Consumer Confidence: Expected: 38.5. Previous: 38.0
10:00a.m. Nov Richmond Fed Mfg Survey: Previous: -26.
10:30a.m. Nov Dallas Fed Mfg Production Index: Previous: -13.7.
5:00p.m. ABC/Wash Post Consumer Conf For Nov 22: Previous: -52.

"The government is unresponsive to the needs of the little man. Under 5'7", it is impossible to get your congressman on the phone.”
Woody Allen 

FX Trading – Can we muster a 2-day stock rally?

Yesterday looked like another day foreshadowing a decent dollar correction on the bounce higher in stocks.  This morning we wake to a stronger dollar again….hmmm…and of course “new” concerns about stocks, one story we saw read.  We bit on the dollar move yesterday, expecting at least a 2-day ebb in risk aversion, playing for a short-term correction.  That view isn’t looking as good today as it was yesterday

It all keeps coming back to the stock market—the key risk asset class; currencies are joined at its hip.

(Chart unavailable in text format.)

S&P 500 Index vs. EURUSD 240-min (Nov 3-25):

When I played baseball and was in a batting slump (which was often), I would consider a foul ball and hit-by-pitch (taking one for the team) a hitting streak; but to qualify in my mind as a streak, the sequence had to come after two consecutive plate appearances.  If the stock market could muster two-days higher in a row I’m sure traders would consider that a streak.  I know Tout TV would.  Yikes!

Every seeming glimmer of perceived good news is quickly dashed by more and more bad of late.  But, the question is, and always is, how much of the bad is discounted into the price?  The collective thing we call the market is the arbiter of news and reflects that in price action.  And if Mr. Market perceives bad news as “a little less bad,” that’s all he needs sometime to stage a rally.

Stay tuned.  A streak is on the line. 

Reader Q&A:

Dear Mr. Crooks,

Q: I’ve read all of your articles ...But, I can’t get my arms around your fundamental bullish view of the dollar.

Am I missing something?

There have been 2 real cases of DEFLATION in our lifetimes: 1) US Great Depression.  2) Japan 1990s.  In both instances they were CREDITOR nations.  No MASSIVE interest bill on debt (with declining income to pay).  They had reserves and surplus cash on hand which led to hoarding and deflation.  You can’t hoard (deflate) when you have no savings.

Gold and Silver: This comes down to the inflation/deflation argument.  I do not equate short term liquidation/deleveraging with deflation.  Debtors will always have to print money to pay debt and (sooner or later) increase interest rates and attract purchasers of their debt respectively.  If they don’t print money (inflationary), then they can’t pay the interest on their treasuries.  If the US defaults on its bonds, Gold will go to $3,000/oz+.  Since it is unlikely the US Treasury will default, it simply means they will keep issuing debt (treasuries) to pay the bills and raising interest rates to continue to attract capital (after the ‘flight to safety’ panic mitigates).  With a declining GDP, no matter how much they tax us, they will not raise enough cash to pay interest on the debt.  They will print more money to pay their creditors.  They is hugely inflationary.  In the short term, dollar strengthens only because as people liquidate assets they convert to dollars and treasuries for safety.

Second, as a fed chairman, if people will not spend, how do you get them to in order to stimulate the economy?  You devalue what they are hoarding.  It is very hard to hold onto something that is dropping in value weekly – as we are finding with housing.  Same will hold true for the dollar. 

The fact that the dollar has artificially strengthened dramatically and gold/silver have relatively held their ground (i.e. the dollar has gained more than gold/silver has dropped – percentage wise) means it’s a net move up for gold/silver.  For example:

If two months ago, $2.00 bought 1 British Pound and now $1.50 buys 1 British Pound, this means the dollar has gained 25%.

If GLD and SLV dropped from $85 to $75 and $12 to $10, they have dropped between 12-20%.  This means you gained a relative purchasing power of at least 5%.  i.e. The $75 you would gain today by selling one share of GLD will purchase more than the $85 of two months ago.

Here’s what is interesting.  In the last few days, the dollar has strengthened AND Gold and Silver have moved up.  This is doubly bullish for metals.

Could GLD and SLV go to $60 and $8 per share before increasing to $100+ and $15+ respectively?  Yes.  Do I think they will?  No.

Your comments are appreciated.  I am open to the possibility that I have a big blind spot in my argument…

A: Dear Mr. Reader...

First let me say that no doubt this is an extremely ugly and precarious situation facing the US.  We have no allusion about the danger here, or pretend the US is good shape.  But because our analysis is of the currency, and how to try to profit from it; the economic analysis that we do always has to be a “relative” game.  And we think, despite the problems, the US is relatively better off than its key competitors in the major and emerging currency sphere.  Ultimately the currency game is about trying to determine the underlying flow of global capital.  And in this environment, because of risk and because the US plays the role of reserve currency, it wins in this environment…a deflationary environment.

We don’t quite know why a creditor vs. debtor country matters in a global deflationary environment?  The amount of once “productive capital” in the world that stimulated demand for goods was a big driver in bidding up inflation.  The supply of real stuff lagged as China demand surged. This, coupled with massive dollar-based liquidity thanks to 1% interest rates at the Fed and ECB in 2002 and 0.25% from the BOJ, ensured “free” money and was the key driver of trillions in derivatives, i.e. dollar-based credit. 

We have a situation where this once seemingly “productive” capital, which was really malinvestment (in the Austrian School terminology), is being destroyed—that is deflationary as demand is sagging.  In addition, because this capital (granted—derivative credit) is disappearing around the globe, it reduces the supply of dollars in the system (one can see that by the improvement of the US current account deficit).  And yet the demand for these dollar-based credits is rising a la the emerging economies that have no domestic source of capital funding and were reliant primarily on international banks and foreign direct investment.  We think this great unwind could last years, not months.  If so, that should be a major deflationary event.

We have always looked at gold as another asset class, and do not attribute a great role to gold in a world driven primarily by credit.  We see it as the reflection of the world’s money—the US dollar.  If the dollar weakens, gold must maintain its purchasing power against a real international basket of goods ... as gold does play that role as maintaining its purchasing power against real stuff.  Gold has rallied in this cycle very tightly with the other asset classes that were dollar-based credit driven, i.e. a liquidity move.  So, if we are right on the dollar, we think gold enters a bear market.

As you astutely observe, the correlation between gold and the dollar isn’t always tight; it can decouple.  And gold may start to play the fear role; we are not sure and are very open to that possibility.  If it does finally start playing that role, it will likely go a lot higher.  But it was definitely not the place to be during this near financial Armageddon.  The gold bugs got everything they wanted and yet their strategy of buying gold and selling the dollar has backfired so far.  We think this proves the role the reserve currency plays at times like these, and suggest to us the gold market is a liquidity animal and not very important to the major players around the globe, i.e. those that have to hide big pools of capital. 

We think the dollar strength will surprise, not just because of this fear move. Here are just a couple of reasons. 

1) US is still more flexible in labor.
2) US is still more flexible in monetary and fiscal matters.
3) US will likely emerge from this faster, i.e. Europe is behind on the business cycle standpoint. (This is why the dollar usually does better than the other major currencies during recession -- 4 of the last 5 recessions the dollar has outperformed.)
4) European banking has massive exposure that has not yet “hit the fan” so to speak.  If the emerging markets breakdown in a big way, it could mean players begin to question the European Monetary System.  That would be very bad for the euro, the key dollar competitor.
5) US dollar world reserve currency status has not been challenged in this cycle; that is solidly intact.

We disagree this dollar move is “artificial” in any way.  It is driven by global macro factors and we think the ongoing sea change in the global economy marks the dollar bottom in this cycle. 

Now, all that said is our story.  If risk appetite returns and industrial production ticks higher and China grows rapidly again and emerging economies start exporting again, etc ... then our view will be proven wrong and liquidity returns and liquidity-driven asset classes go higher as dollar-based credit flows again. 

We know WE are missing something. There is much going on under the surface of the economy that we don’t see, i.e. our standard analysis can’t pickup.  So, we are always open to be very wrong no matter how confident we might be about the fundamentals.  Price is the final arbiter that will tell us we are wrong.  So, we watch and constantly ask ourselves that question as we do our homework: Where are we wrong? 

Thank you for your excellent question and hope our response makes some sense.


Jack Crooks
Black Swan Capital LLC


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