Sunday, August 23, 2009

Don't stray too far from the fallout shelter

I've been foolish to try and pick the top in a market that has the tenacity of a drug-enhanced prize-fighter. Closing out some shorts has been the order of the day.

Still, don't confuse price strength in financial assets for a rebound in economic growth. This market has the structural integrity of Chernobyl. That's what comes from a quick build using flimsy materials - and a liquidity driven market is just that.

As Andy Xie puts it..."a pure bubble tied to excess liquidity over financial assets can't last long". The multiplier effects on consumption and production are simply missing. Sprott Asset Management explore a similar theme and come to the same conclusions.

So when will this liquidity deluge come to an end?

The Fed has indicated it will keep spending until October. The fiscal spend is done with tax cuts and transfers already in the system (both in the US and here in Australia). China recently tickled its markets with a move to effectively reign in bank lending (by increasing reserve requirements and requiring new lending to be for productive purposes). Put it all together and it sounds like liquidity could have already have peaked and will tail off through the remainder of the year.

On this basis, it'd be a fair bet that the equities markets will come to understand this before the end of the year. Until then, there is room to boom. This is the happy part of the price cycle where retail merrily piles in and sentiment indicators climb through the roof (have a look at the put/call ratio on the CBOE to see how happy things are getting).

Some indicators that may signal the end is nigh for the liquidity inspired trade:

Credit spreads - See Lehman's junk bond index (an appropriate epitaph to my former roomie). Also, Evil Speculator is tracking Moody's Baa to Treasuries spreads. Both registering tremors on the geiger counter perhaps?

Volume - should see volume tail off as the rally makes new highs if retail is the only buyer.

Chinese and HK markets - have been leading indicators for moves in the US market. XJO should be pretty sensitive to these markets for obvious reasons.

Goldman Sachs - arguably the biggest beneficiary of the US goverment's largesse. Unbiased Trading had an interesting take in recent price action here.

Still, the market is running and it's not going to listen to naysayers. If the XJO breaks its recent high (~4510) then there is nothing to stop it running all the way to 4950 (a 50% retracement of the entire down leg). The 5000 target is what the likes of Macquarie and AMP are calling for by Christmas and the retail market is listening.

The risks of a quick turnaround at any time are real. Friday's move on no news is indicative of the skittish state of the market. On balance, it's cash while awaiting a clear sign of a trend reversal.

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