From PEI. Worth a CLOSE read.
Panic of 1998 &
The Global Liquidation Crisis
Will Euroland be Next?
By Martin A. Armstrong
Princeton Economic Institute
© Copyright November 19th, 1998
The recent movements of world share markets have contributed greatly
to a growing sense of sheer global confusion. What often appears to be a
normal correction is suddenly complicated thanks to the unwinding of
massive arbitrage players within the hedge fund community and the
likes of Long Term Capital Management. The investment houses have
sent their hired guns out to talk up the market in a vain attempt to keep
the business flowing. Others may have a hidden agenda of self-interest
in hopes of bailing out or selling out at the top before somebody starts to
sing.
Global investment today has become far more complicated thanks to
arbitrage traders like Long Term Capital Management. While many
newspapers have asked how two Nobel Prize winners and a
sophisticated computer model could have been so wrong, what is not
being considered is the fact that the basic trades were fundamentally
driven. Every trade that LTCM became involved in was in fact one giant
bet on Euroland. When the European politicians stood up several years
ago and promised to redeem all European bonds at par when they
converted to the Euro on January 1st, 1999, LTCM began to seek pots
of gold at the end of the European rainbow. They began with buying the
discounted bonds of Italy, Spain and others selling them against the
stronger bonds of Germany. Through these trades they gave the idea of
the Euro life while politicians quickly too credit for the miracle
convergence ahead of schedule.
LTCM did not stop with the first round of the Euro timetable. They
began to enter trade for Phase II ending up with the largest position in
the mortgage-backed securities in Denmark. They also ventured into
the British market assuming that ultimately Tony Blair would take
Britain into the furnace of the Euro. LTCM has now sufficient disrupted
the UK bond market to such an extent that interest differentials
between long and short maturities have caused record spread quotes.
Liquidation of these positions will take months and the damaged caused
to the world economy by LTCM has yet to fully surface.
But another problem we are facing is the unwinding of Euroland trades
within the share markets themselves. There is little doubt that the July
20th turning point on our Economic Confidence Model has marked
precisely a significant bubble top in Europe more so than in the United
States. Europe had in effect been transformed into one giant emerging
market attracting capital from around the globe as many argued that the
Euro would displace the dollar itself. Everyone believed in the Euro and
investment acted accordingly. In the end, the dream of Euroland
collapsed and perhaps only the political circles have yet to recognize this
fact. The European share markets outperformed even the US market by
more than doubling the performance of the past year moving into the
high for July 20th. The bubble top has now burst and in the wake we are
facing even more liquidation of arbitrage positions that is causing the
false impression of the future.
As we move into late November, the reaction rally in the US share
market has everyone buzzing around proclaiming that the worst is over
and that new highs are just ahead in the promiseland. Some widely
respected fundamentally based analysts have boldly proclaimed that
whatever happens outside of the US is no longer relevant. It doesn't
matter who crashes and burns, buy stocks forever. Such
prognostications are not only dangerous, they also reveal a degree of
unprofessionalism. If they cannot understand the new complex global
economy, ignore it and go with the trend seems to be the battle cry of
the day. However, if the trend is not what it may seem to be, look out
below for the slaughter may not yet be over.
The strength in the US market is being caused NOT by rate cuts nor by
swarms of unsophisticated investors pouring even more money into the
market. What we are looking out is yet another unwinding of the
Euroland trades. LTCM and others have been buying every aspect of
Euroland. They have turned to every possible instrument into a spread
on Europe. The sharp rise in the S&P 500 futures has taken place due to
the unwinding of major short positions on the US that were spread
against long positions in the DAX and other continental share indices. If
we compare the daily charts of the DAX and the S&P500 futures, you
will quickly see what happened during September. As the DAX began to
cave in you will notice that the S&P500 began to hold and rally. There
was no rally in the DAX because this was the start of unwinding the
Euroland trades. Long positions in the DAX continued to be sold while
short position on the S&P500 needed to be bought back. Thus, the
percentage decline for the European markets quickly surpassed that of
the US market.
The unwinding of Euroland trades has yet to be completed. Here in
November, the worst market to recover remains the German DAX while
the best performer remains the US. Between January 1st and July 20th,
the US market had advanced only 15% due to massive selling short by
these arbitrage players who were buying into the dream of Euroland.
The DAX advance into July 20th had been more than 40% reflecting the
insane expectation of untold profits due to the Euro. Now, these
arbitrage funds have significantly confused most and disrupted the
global economy perhaps far more so than even governmental
intervention. It is one thing to invest or trade. It is entirely a separate
issue when no single trade can be done without spreading the risk
against another market. In this case, they sold US and bought Europe,
which kept the US market from becoming a bubble top while at the same
time pushing the Euroland dream into unsustainable and vulnerable
territory.
Under normal conditions, the US market should not make any new high
based upon the global business cycle. The major resistance stands at
1157.50 on a monthly closing basis and as long as November closes
beneath this area, then new highs are not likely. However, a November
closing ABOVE 1157.50 could lead to the US moving to a new high
without Europe sucking in every last buyer who would then expect
10,000 on the Dow of Xmas. Such a pattern would escalate the volatility
even further and as far as any new highs were concerned, 10,000 would
still not be achievable.
For now, the resistance is still holding and there is no confirming signal
that new highs can be made just yet. The timing still points to this week
or next as the point of maximum strength. A failure to make new highs
beyond November would surely warn of a collapse that is still inevitable.
Both system and technical resistance stands at the 1177-1170 area basis
the S&P 500 Futures. A high during the week of November 23rd, may
yet be followed by a decline into December with high volatility once
again in January. Nevertheless, we do believe that new record highs are
possible for the US and UK markets in the near future whereas the
same cannot be said about continental Europe. The Fed's aggressive
new policy of cutting rates rapidly is a warning that the liquidity crisis is
getting worse among these arbitrage traders. Given the fact that there is
no supporting evidence that the Fed should be lowering rates due to the
domestic economy, we must take pause and realise that the Fed is
risking creating inflation to prevent something far worse and that can be
only the failure of Euroland due to the massive liquidation of the hege
funds that have supported the dream. |
