Monday, February 15, 2010

Market Update 06.10

A week of choppy trading saw the major indices gain about 1 percentage point. There were violent swings in both directions as rumours swirled in Europe of the Greek fiasco. If you've been reading my links on a daily basis, you've probably got a pretty good handle on the issues. I'll summarize the most important points here:

1) The ECB is constitutionally forbidden from acting unilaterally to assist any one nation or group of nations
2) The IMF has a US veto over use of funds and the issue is too large for them to handle
3) Germany and Holland and Scandinavia cannot assist Greece because
i) politics - Germany underwent austerity to facilitate the EU's formation - telling them now to bailout profligate nations is politically impossible
ii) bailing out Greece will immediately lead to eyes laid on Portugal. Then Spain, Ireland, Italy, UK, France, etc.
iii) moral hazard is obvious
iv) adding the debt burdens of Club Med will put Germany's implied debt burden in just as poor shape as Club Med itself. Interest rates on Northern debt would rise
4) Letting Greece fail would cause a cascade of sovereign failures
5) Bank exposure to Greek debts in Germany, France, Switzerland is huge and enough to paralyze their credit markets
6) Nobody can devalue in a monetary union
7) Austerity in Greece, Portugal and Spain is apparently not an option. Workers refuse to accept lower wages. Politicians are resorting to pointing fingers, citing fear mongering and rumour spreading

All routes lead to collapse of the monetary union. Germany bails out one, they must bail out all of them. This will incite political and financial collapse in Germany. Let one fail, the rest will fail by way of precedent and private banks all go down with them. Austerity is politically impossible (unemployment is already sky-high for example). Austerity in socialistically-minded economies will lead to complete depression.

Yet most market analysts continue to believe that "something will get worked out." It is only their optimistic mindset that supports this view, not any kind of sound logic. And the buoyancy of markets is reflective of this. The second leg down in the Great Credit Crisis will be led by the unwind of this baseless optimism toward solutions that don't exist.

See above the multiple 10-15 point swings last week on their way to nowhere. As I often repeat, "oversold conditions can work their way off by either time, price, or both." This week's choppy rise has successfully rooted out many of the oversold readings, and it has done so without inflicting much technical damage to the downtrend.

Also notice the evident complacency among traders, who, despite violent swings in both directions last week put a much lower price on options. Implied option volatilities are worth 23.3% less on the 1075 close friday than they were at about 2:30pm the previous Friday with the S&P at 1044. If that sounds excessive, it's because it is.

We'll see if the greater downtrend prevails this week. Another week of gains would likely put it in jeopardy.

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