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Contrary Signals Clear Way for Crash

The commentary below is for the benefit of our readers from opinion makers and writers not associated with Euro Pacific. We do not guarantee the accuracy and completeness of third-party authored content. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific, or its CEO, Peter Schiff.
Charles Hugh Smith
January 8, 2010
Is the stock market setting up for a sharp decline (a.k.a. crash)? The stupendous disconnect between a V-shaped euphoric market and a disintegrating real economy will be settled sooner or later.

For your consideration on this first day of 2010, two charts: the 10-year chart of the Dow Jones Industrial Average (DJIA) and a one-year chart of the VIX "fear index." (As always, please read the HUGE GIANT BIG FAT DISCLAIMER below to refresh your awareness that this is not investment advice but merely the freely offered musings of an amateur.)

In early December I (along with many others) noted the deteriorating conditions beneath the widely trumpeted "breakout to new highs" of the past few weeks: A Megaphone Announcing Extremes of Sentiment and Indecision (December 3, 2009) and Bearish Cross in NYSE Volume Suggests Rally Will Crumble (December 4, 2009).

If we look at the past decade in the Dow, the steep V-shaped rebound is clearly visible. This sure looks like a market which is absolutely convinced the U.S. economy is not just on the road to recovery but is already "burning rubber" and shifting into second gear.

Compare this classic V-shaped panic drop and surging euphoria with the choppy, 3-year-long "slope of hope" decline exhibited during the 2000-2002 recession.

The disconnect between the reality of a disintegrating economy propped up solely by unprecedented Federal borrowing, spending, subsidies, giveaways, swag, guarantees, secret intervention in the markets, Fed purchase of Treasury bonds, Fed purchases of toxic-trash mortgage-backed securities, etc. etc. and the market's euphoria about the "recovery" could not be sharper.

Beneath the "happy story" propaganda about the "recovery":

  1. employment is still falling
  2. credit/lending is still declining
  3. sales and income taxes are still in free-fall
  4. commercial real estate is about to crash The Gathering Storm in Commercial Real Estate (CRE) (October 21, 2009)
  5. the residential housing market is totally dependent on Federal support of the mortgage market and tax-credit giveaways: The Final Demise of A Speculative Housing Bubble (September 16, 2009)

These are just the highlights of a deteriorating economy propped up by unsustainable Federal stimulus and interventions.

The stock market has priced in a rapid rise in "real growth," i.e. growth which isn't created by/totally dependent on Federal borrowing/ largesse/ guarantees. By any historic measure, it is priced to perfection: the slightest wavering in the "sharp rebound in consumer spending, GDP and profits" story will call into question the 10-month long 60+% rally since early March, 2009.

What is Mr. VIX saying about this euphoric confidence in a V-shaped recovery of the real economy? It seems Mr. VIX is like a nervous suitor, wavering in wild manic-depressive fashion between the absolute euphoria of "she loves me" (the economy tanked, so a sharp rebound is guaranteed!) to the icy fear of "she loves me not" (the economy is still imploding, lending has seized up, banks are actually insolvent, toxic assets are still priced at 100% nominal valuation on the books, Federal borrowing is unsustainable, the consumer is retrenching, everyone is deleveraging, real estate is not reflating, the propaganda isn't taking, it's only fueling populist rage, etc.).

This indecision is reflected in a giant megaphone pattern:

There is a rich trove of irony here: the megaphone pattern began at the very point that the economy was declared "out of recession." It seems Mr. Market is not quite as sure about that as the cheerleaders in the Fed, Treasury, White House and mainstream media.

Like Mr. VIX, Mr. Market wants to believe that the "recovery" is real, but all those nagging facts are triggering anxiety attacks in the VIX as punters rush to buy puts (options) as insurance against a sudden implosion of the "recovery" story.

If everything is truly peachy and stunningly robust growth is just around the corner, then the VIX should trend around 19 or 20. No need for insurance against a market implosion if the entire economy is fundamentally sound, secure, and low-risk.

On the other hand, this is also the perfect set-up for a spike in volatility and a "what goes up must come down" crash back to the March 2009 lows. (A double-bottom /retest would be par for the course.)

A "story" built on lies, prevarications, extend-and-pretend accounting, Federal funding of everything under the sun, bogus statistics (birth-death model of adding millions of phantom jobs, anyone?) and transparent propaganda can come apart with ferocious speed. There are a lot of punters who are long and the exit is the size of a pet door.

Disclosure: I am short the market via puts.

Charles Hugh Smith writes the Of Two Minds blog and is the author of several books, most recently "Survival+: Structuring Prosperity for Yourself and the Nation." To visit his blog, click here.