MARKET NOTES: Sensex may, repeat MAY, see a sharp corrective bear rally
Sensex: The Sensex closed at 17,134 on Friday after having made 4 significant attempts at breaching the floor at 17,000. While that is not a conclusive reason to anticipate a pullback, the 17,000 by itself is not such a crucial level in the context of long term charts for the Index to spend so much time testing it. Therefore, there are probable other factors at work here.
The Sensex is still in the grip of the complex correction unfolding from the top of 21080 in November 2010. From the top of 21080 to the low of 15,135, the Sensex has spent more time correcting downwards than it took from the top in January 2008. Which is not to say the correction is over but to point out that the Sensex has had enough time to discount all possible bad news.
The long-term trend line, spanning from 2920 in May 2003 was tested in November 2008 and then again in March 2009. The same trend line was retested in the current correction on 19th December when Sensex hit the low of 15,135. We are probably going to test this trend line once again before this correction is over. However, the point in time when this might be tested lies somewhere towards the end of this year and the most likely level at which such a test could happen just happens to be around 17,000. That to my mind explains why the market is spending so much time testing this critical level.
On the wave count front, we are in a bear rally starting from 15,135 and in terms of time that’s not yet run its course. All of these factors, combined with the markets reluctance to go below 17,000, indicate a sharp bear rally that could retest 18,500 or even 19,000.
My analysis would be invalidated if 17,000 is breached over the next few trading sessions. In that case, the market could slide to the afore-mentioned long-term trend line to test it in the region of 16,500. But after that what? It would still have to rally from 16,500. So might as well do it from 17,000! But yes, the downside exists. I would give it a 75% probability that we rally from 17,000 rather than 16,500.
See also comments on S&P 500 below the possibility of a new high there.
$-INR: $ closed at 52.54 on Friday. Its first target is now 53.5 followed by the previous high of 54.5. Won’t happen in a week of course but could. A target beyond 55 is not indicated yet on the charts. A lot will depend on the swiftness with which an assault on 53.5 is launched. Expect no corrections save for minor pullbacks. We are about to enter the parabolic phase. What follows 54.5 will be very interesting but by then we will be into uncharted territory.
Euro-$: Euro-$ closed at 1.32520 before making a high of 1.3270 on the same in the current wedge up. Euro has a significant overhead resistance at just less than 1.33 followed by a tougher cap at 1.34, which is unlikely to be breached in a hurry. On a breakdown of the rising wedge, which could be any day next week, the Euro will head back to test the floor at 1.30 again. A lot will depend on what the Euro does around 1.30 this time down. Not a long term Euro bear unless 1.30 is breached.
$-Index: $ closed at 78.757 on Friday which itself is minor floor that held up towards the end of February. If breached, and I am not certain if it will, a more significant floor holds at 76.5. The wave counts indicate a rally of sorts back to 82 levels in case the floor at 78.5 is not taken out. The rally if any will be corrective. Not bearish on the $ in my trading time frame.
Gold: Gold appears to be screwing up its nerves for a plunge below $1600. It has some time to create room for the plunge. In the immediate future, gold could pull up to $1680. But sooner or later the $1600 level has to give way. Further market trajectory will become apparent only after that. Continue to be bearish on gold.
Silver: Silver is in a reactive pullback after having made a low of $30. Silver is well below its golden cross and in a long-term decline. On a breach of the floor at $30 it is likely to head for the next target of $26. Very dismal chart to read for Silver bulls, if any are left, that is.
Crude Oil: No comment.
S&P 500: As indicated in my last blog post, the possibility of S&P 500 to head back to retest the previous high of 1423.73 was always there. Not sure if it will get there though. The tend line through points 1074, 1158, 1202 and 1340 should act as a spoiler to the current pull back. On the oscillator charts the index is in overbought territory.
On the other hand, the index can surprise by making a new high after a short consolidation. There is room for that on the charts but in my opinion that will be an opportunity to sell, not buy. Which of the two trajectories the index follows before going for a full correction depends on the technical strength of the bulls vs bears and is difficult to predict. Investors should ignore the battle and take profits off the table.
Incidentally, the new high hypothesis ties in with the indicated bear rally in the Sensex. Who is learning from whom in managing markets?!
NB: These notes are just personal musings on the world market trends as a sort of reminder to me on what I thought of them at a particular point in time. They are not predictions and none should rely on them for any investment decisions.
Good politics makes for good economics
Economics assumes rational behavior and rational choices made by freely contracting parties meeting to transact business in free and open markets. Abba Lerner, a renowned economist noted, “Economics has gained the title of the Queen of the Social Sciences by choosing solved political problems as its domain.” In other words, economists cleverly assume away all the political problems that come in the way of rational people making rational choices. Free and open markets don’t happen by themselves. It takes a lot of political effort to organize them and keep them open and free. Nor are all the participants in the market rational players. One among them, the State, is the biggest player of all, and its actions may be rational only in the context of its own agenda that has little to do with what economists imagine. It may for instance prefer just to preserve the power of its existing masters rather than maximize utility for themselves or others. How does society arrive at a point where rational people are able to meet freely in free and open markets to transact business? That is in the realm of politics and it is to politics we must turn for answers. Put simply, before you can talk economics you need to get the politics right to set up the institutional framework that free and open markets require to work their magic. How do societies arrive at such a point? That is the key question that economics doesn’t address but we must.
Whether a society arrives at the juncture, where it finds the creation and maintenance of free and open markets imperative, is a complex function of its particular history and the way power is configured among the various players in that society. [I will use State and society interchangeably relying on the context to clear any misunderstanding.] This point is worth examining in detail because it posits two different things. Firstly, all the payers in the society must find it in their interest to let markets intermediate business among them. That presupposes power is more or less evenly dispersed among players and they can agree on a certain set of universal rules, which will then be applied to all in the realm uniformly. Secondly, the path by which a society arrives at such a happy confluence itself shapes the configuration of markets and the rules that govern them. In other words, the particular history of players in their past dealings with each other colors the outcome. Clearly, getting markets right is neither easy nor automatic as we assume. A lot of hard work and trial and error goes into the process before even the most rudimentary of markets becomes functional.
What then are the essential characteristics of a society that lead it to establish free and open markets? In a significant book, “Why Nations Fail” Daran Acemoglu and James A. Robinson argue that Societies which can create institutions to guarantee – [a] reasonably dispersed power among players such that none can dominate all others, [b] a centralized and uniform application of agreed rules of business through out the realm that guarantee equality and fairness and [c] incentives that motivate the masses to contribute openly and freely to the well being of the society or state – are able to arrive at the promised nirvana over time. These three conditions are necessary and usually sufficient. They are not path independent though. The specifics of how society arrives there and what it needs to do depend on their particular history over time. Point to note here is that a functioning democracy more or less corresponds to power being widely dispersed in a society. A constitutional form of governance in turn guarantees both an adequate centralization of rule making and application to governance uniformly. But a democracy by itself doesn’t achieve the third pre-condition that is a fair and equitable system of incentives is in place to motivate people to give off their best.
India commenced its journey in recorded history with a terribly mixed slate. It is therefore not surprising that we are still not at point where we can rely on markets to organize our economy smoothly with its invisible hand producing optimum prosperity for all. We have come a long way but the ultimate goal eludes us. How might we get closer?
Begin by noting that our caste system makes us one of the most unequal, blatantly oppressive, almost predatory societies. The caste system is so ubiquitous and pervasive that those of us brought up in its milieu are almost blind to its inequity. That’s true of even the oppressed. To the oppressed, as Mayawati was prone to remind us, it matters little if the oppressor is a devout caste Hindu or a Muslim invader from distant lands out on a pillaging expedition. To the oppressed they are all the same. Caste has divided us with catastrophic results for our civilization and polity. We have come a long way after independence. But the backlash against affirmative action is worrisome. If we regress on the equality front, all will be lost. On the other hand, our democracy guarantees we will get there eventually through trial and error whether we like it or not. Hence it would be best if we got on with the job anyway. The legacy of caste and tribal exclusion has left us with a large number of people who cannot be easily absorbed into a market-based economy.
With the caste system goes our system of hereditary succession in professions, businesses and politics that militates against a merit based society. The two together present formidable barriers to entry for meritorious people. For every hereditary succession, a hundred otherwise meritorious people are demotivated.
The British gave us two unintended but invaluable gifts. Firstly, they brought about the essential centralization of rule making in a parliament and arranged for an administrative and court system that applied those rules across the realm. Could we ever have done this on our own given our constantly squabbling regional satrapies and 26 different languages? In their knitting together of India we thus have the first of the conditions necessary- a centralized polity with uniform rules. They may not be ideal but they make a great beginning compared to what went before them. The second gift came to us from our constitutional fathers by way of the Constitution itself.
We tend to underestimate the huge step forward that the constitution means. Societies spend hundreds of years trying to shake off rules devised by reference to divinity and substitute them with rules made by mutual consent of the members of the society. The transition from “divine rule” to “constitutional rule” is neither easy nor bloodless. Yet in what must be a remarkable feat in recorded history, we made that transition in 1947-50 and haven’t looked back since. This is not to say our transition is either complete or will be problem free. The debate about secularism is just one of the pointers to such problems. Nevertheless, compared to other contemporary societies, we have accomplished a near miracle whose importance to our eventual success cannot be underestimated.
It is on the design and implementation of incentives that motivate our people to give of their best that we appear to have floundered the most. We have simply not been able to clearly articulate a vision here that is both true to human nature and is able to harnesses individual capabilities to produce prosperity for all. What are we doing wrong?
First off we need to recognize that people work hard and develop ideas for themselves in order to benefit and profit from them. Yes there are saints amongst us but a society has no business demanding humans turn into saints in order to be its members. Humans will be humans and a society must learn to work with what is, not what it considers its ideal. An individual’s responsibility to others ends when her tax dues are paid. To except anything more is to be foolish.
Secondly, if a person works hard, innovates, etc., how does she store the value she creates for herself when she needs it. It is here that a fair, transparent, uniform and inviolable system of property rights becomes critical. If a person earns, but cannot store value safely, free from expropriation or surreptitious stealing by the state, why should she work hard? Yet, India’s record on property rights is simply horrendous. We have expropriated property from businesses, we have denied property rights to tribals, we don’t enforce property rights properly, and worse of all, Government cheats us of our property stored as money by merrily inflating away its value or subjecting it to stealthy taxes. Either way, while we are relatively free in allowing people to earn, we don’t allow them to safely store the value of their labor. Not surprisingly, people hide their wealth, send it abroad or bury it in useless gold. The failure to respect a person’s store of value is our major failure in the schema of incentivizing people to give of their best.
Our politicians have taken the easy way out to reap votes through populism rather the hard way to incentivize people. We have our outliers, who despite all hurdles in the way, have pursued novel ideas, and have created enormous wealth and value for society. But by and large, politicians have chosen to correct our legacy problems of inequality by pulling down outliers rather than giving incentives to underperformers to pull themselves up. The problem is acute because politicians don’t raid your current income as much as your stored wealth – usually surreptitiously.
People work for themselves and their near and dear ones. A state’s role is to enable them to do so without infringing similar rights of others in a free and fair manner. The right to enjoy the fruits of what one creates is at the heart of an individual’s motivation to excel. When we defeat nature’s way of motivating people, we defeat ourselves as a society. India must realize that an unfair and shabby system of property rights and lack of respect therefor is holding back her people.
MARKET NOTES: Critical tests lie ahead over the next two weeks in most markets
NYSE Composite: The NYSE Composite index illustrates the state of play in the US markets better than any of the more narrower cousins that are the subject to much tinkering by authorities every now and then. The picture it shows is considerably more bearish than the other indices. Firstly, on a pullback from 6500 level, the index failed to top 8730, a point that was easily crossed by the narrower indices. That means, as far as the broad mass of stocks in the US were concerned, the rally from 6500 starting in October 2011 was nothing more than a pullback rally. Secondly, the NYSE Composite has now commenced wave III of the down move from April 2011 and the target for this down would at least be a retest 6500.
It is too early to estimate what shape the fall from 8360 will take. The immediate target for the NYSE appears to be test of its 200 DMA currently placed at 7800. It is quietly likely that the index may bounce for a while from its 200 DMA but the bounce is likely to be deceptive. Continue to be bearish on the US equity markets.
Spot Gold: Gold’s price action since the pullback to challenge its overhead resistance of 1800 on 28th February has been very bearish. Note that the fall from 1800 to 1628 was followed by a feeble attempt to pullback. The metal is currently headed for a test of 1630. The resistance is unlikely to hold and the metal could target 1550 after a breach of this resistance. Indeed, the last pullback has been so feeble that one would have to brave to assert that 1550 will hold. Very bad news ahead for gold bugs.
HG Copper: Copper appears to be headed for a test of 3.6 and on a breach of that level to 3.0. The next few trading sessions should help resolve the nature and depth of the ensuing correction for a lot of industrial stocks. Needless to say a breach of 3.6 will be very bearish for the metal and industrial stocks. Would be worth watching this critical metal over the next two weeks.
Silver: 31 is a crucial level for Silver. A bounce from that region over the next two weeks will indicate if the metal is in a normal bullish correction. A decisive breach on the other hand, will point to an impulse wave unfolding from the top of 49.4 making for a target of $20 for the metal within reach over time. A short bounce from 31 will not negate this bearishness. It will only change the nature of the correction unfolding and the ultimate target for the correction.
NYMEX Crude: Crude oil continues to befuddle. In passing one may note that crude has made a double top in the 110 to 115 region and is on its way down. While this price action is indisputable, the long-term wave counts are conflicted. Crude is likely to test $100 in the next few trading sessions before pulling back. Don’t recommend trading in crude due to conflicted wave count.
$-Index: The $ is currently placed at 79.3 and appears headed to test 78.75 in the next few trading sessions. A breach of that level will lead to a test of 78. Bearish action in the $ but a major move isn’t indicated on the charts unless 78 is breached. Expect range bound movement for sometime more.
$-INR: As expected, the $ topped 52 during the week and closed at 52.07. The next overhead resistance for the $ is placed at 52.75 and may be taken out over the next two weeks after a bit of consolidation above 52. Over the longer term, a retest of 54 is surely on the cards by end of May.
Euro-$: Euro pullback from 1.30 is reactive and the crucial level is likely to be retested over the next few weeks. Note the level has been tested three times already and may give way on the 4th. However, on a breach of 1.3 the downside may be limited. It is very unlikely that the floor of 1.26 will be tested in the ensuing move.
Sensex: The Sensex has been testing the floor 17,000 repeatedly; having already done so three times and is now heading for the 4th attempt. The Sensex’s 200 DMA is placed at 17,268 while its 25 DMA is placed at 17,344. A confluence of the two moving averages combined with the critical floor at 17,000 make the next week or two of trading in the Sensex critical for the shape of the correction that will unfold. In my view the 17,000 level is unlikely to hold. A breach of the same will open the way for 15,500 and then 15,000. Bearish on Indian markets even if 17,000 holds up for now.
Shanghai Composite: ShComp turned up from the level of 2240. This point is higher than the low of 2160 made in December 2011, a low that this blog correctly called. On a rally from there, the index made a double top at 2478. Correcting from that level, it made a low of 2240 [higher low] and is currently placed at 2407. A retest of 2476 is almost certainly on the cards.
A break atop 2480 will confirm a bullish intermediate uptrend in the Chinese index and open the way for a test of 2550. A breakout above 2550 is bullish Holy Grail for the index. It is likely that the index may consolidate for a while below 2480 before attempting a break out. The price action bears a close watch.
NB: These notes are just personal musings on the world market trends as a sort of reminder to me on what I thought of them at a particular point in time. They are not predictions and none should rely on them for any investment decisions.
MARKET NOTES: Major markets confirm an intermediate down trend
Spot Gold: After staging a reactive pullback from the $1610 area to $1680, gold has turned down again. Gold’s target for this leg down remains unchanged at $1550. In terms of wave counts, gold has entered the 3rd leg of the downturn that extends the most. The target it achieves in this wave down will tell us if the fall from $1920 was a bull market correction or the start something more fundamental. So the metal’s reaction to the $1550 area should be of great interest to bulls and bears alike. Worth noting the positive correlation between gold and risk assets continues despite the sharp sell off in equities.
Not hopeful of a meaningful gold rally until early July.
HG Copper: Like other risk assets Copper has also turned down after failing to pierce it overhead resistance at 4.0. To my mind, Copper’s correction started way before other risk assets from a level of 4.5 in July 2011 and the present fall is a continuation of the same process. What that means is that Copper fell from a level of 4.5 to 3.1 in the first leg of the fall. The pull back from there was reactive in nature and rose to 4.0. Copper is therefore now experiencing the second leg of a normal bull market correction.
On that reckoning, Copper could retest 3.1 again during the course of this correction and the correction itself would last till about first week of July 2012. Don’t expect a very long bearish spell in Copper though the price drops could be sharp. Also, given that Copper is in a long-term bullish trend, the floor set up at 3.1 is unlikely to be significantly breached. So yes Copper is bearish but the potential downside has a floor.
NYMEX Crude: Am greatly befuddled by the rude behavior of NYMEX crude. One wave count, and it is the one that I have favored so far, projects Crude at $150 by March 2013. That means crude should be going parabolic in prices near about now. In this view Crude is unlikely to dip below $100 for any significant length of time and will soon see a return to the parabolic rise we have seen since the last bottom of $32 in January 2009.
There is an alternative count that would take Crude far beyond $150 but over a longer period of time. In this time frame, Crude could consolidate between $75 and $105 for some more time before moving up from this trading range.
For the present, Crude shows a formidable double top at $110, which must be respected. Hence until that level is taken out decisively, one cannot be bullish in Crude no matter what the geopolitics or fundamentals. On the other hand, why trade in Crude if the picture is not very clear? There is other juicy stuff to nibble at. So am giving Crude a miss until the wave count becomes a little clearer. Don’t expect a prolonged bearish spell in crude though. Much of the price correction is already done.
Silver: I don’t trade Silver. So this is really for gold bugs, that lacking capital for gold, end up punting in Silver. The metal is very bearish. In my view the metal’s target for this correction is $21. From the top made at $37.6 on 28th February, Silver should head down in a gradually downward sloping channel to $21 by end of December this year.
Normally, I prefer to get the direction right and leave price targets for markets to reveal themselves as we go along. Making an exception here because Silver is very volatile and retail participation in Silver tends to be high given a perception of “cheaper price” and lower cost of entry. And many among this class of investors hold on to positions in the hope that things will be all right soon. Never works out in real life.
Expect a test of $20 before the year is out on Silver.
$-Index: $-Index first target down remains at 78. The pull back in the $ on Friday to 80.075 was just a correction to the fall through out the week. Expect the downtrend to resume next week. $ Reaction to the 78 area will offer further clues on whether it intends a test of 0.72 or not before the end of this year. Not bullish on the $.
Euro-$: Euro-$ first target remains at 1.30 a breach of which will open the way for a retest of 1.26 area again. Remain bearish on the Euro for the near term. The month of May may see the Euro decide to move decisively one way or the other.
$-INR: $ has an overhead resistance at 52 against INR. It appears to consolidating just above 51 before making the assault at 52. Just a matter of time before 52 is taken out. Remain bearish on INR.
S&P 500: The S&P 500 Index finally turned around from its overhead resistance at 1420 to close at 1370 for the week. While I have little doubt that the broader markets slipped into an intermediate correction long ago as explained in this blog, the S&P 500 has a trick or two up it sleeves to befuddle investors further.
First off, note that the floor of 1345 hasn’t been tested yet. Until this gives away one really cannot speak of a correction for the full bull wave from the low of 2008 crash. Secondly, the index bounced off the trend line that connects the low of 1075 and the low of 1158 in this rally. So a retest of 1420, or even beyond is not ruled out. In fact if there are enough trapped bears, S&P 500 can well spend sometime here doing nothing all through May.
Nevertheless, maintain my view that we are headed into a full blown correction that will test the strength of the humongous rally that we have seen from the low of 668 in March 2009 to 1420 in March 2012.
Sensex: As mentioned in the previous blog, 17,000 on the Sensex held at the 3rd attempt and is due for a fourth test on Monday. This time the floor at 17,000 may not hold. The Sensex behavior on a breach of 17,000 will be significant. A pull back after breach will signify an oversold market and more volatility. On the other hand a tame passage below 17,000 will indicate a normally correcting market that will give opportunities for accumulation at the lows as the correction proceeds. On a breach of 17,000, the path to 15,000 opens up for the future. However, don’t expect a one-way movement.
NB: These notes are just personal musings on the world market trends as a sort of reminder to me on what I thought of them at a particular point in time. They are not predictions and none should rely on them for any investment decisions.
Overcoming Limits to growth
A vast majority of us assume there is no limit to our growth as a species in terms size, economics, and culture. There is no limit to human ingenuity that we know of. Every generation of Malthusian economist since the original himself has been proved wrong. Our culture, of which science and technology is an integral part, has found solutions to a vast variety of problems that could have finished off a less intelligent species long ago. Techniques of production, problems of attacks by other species on our well being, finding resources to feed, house and clothe increasing numbers, have all yielded to our quest for knowledge and the innovations it brings. In the process we have created a society where our survival depends less on the DNA we inherit than on the acculturation we receive through education in our formative years.
The world in which we live and work is increasingly self-created by our species as opposed to one given us by nature. Indeed individuals not adequately plugged into this self-created environment have very little chance of survival or growth. The means by which we plug individuals, or families, into the world we have created is money. Money is the system’s lifeblood that delivers sustenance and rewards performance. It intermediates almost all our dealings with the rest of the world. Indeed to have no money, or a means of claiming some from others around us, is to die. The life scripts that come to us speak of rights, duties, moral obligations and a variety of other notions that have little meaning unless backed up by money. How money is earned, and who gets how much of it for what, is the key political question asked of economics or culture since we invented the idea of money. Both capitalism and communism have sought to answer that question from differing perspective, in their respective domains of validity.
Capitalism focuses on the processes by which we create value that eventually translates into money for everybody. Wisely, capitalism doesn’t take either innovation or entrepreneurial talent for granted nor does it pretend to know how it happens in individuals randomly dispersed in societies. Yet all value at the margin is created by innovation, our uniquely human gift to apply past knowledge to solve current problems, and to create new knowledge itself. Not all innovation survives. What capitalism tries to ensure is that free and open markets provide the best opportunity to any innovation to attract capital, labor and other resources to create incremental value for all. In the process of doing so, almost incidentally as it were, capitalism also resolves issues related to how the incremental value created should be distributed. This value distribution is also determined by open and free markets that prices all resources. Any surplus left over goes to the innovator who created the means to further that innovation.
Communism takes innovation as given. It starts with a static world in which all people are equal and equally endowed. Therefore, there is no need to prefer one individual over the other. In this view, all capital is saved labor, since labor is all that we are capable of for creating value. Anybody who has a few proprietary rights over saved labor, through capture of one sort or the other, that is to say capital, tries to extract rent from labor for it’s use. This gives rise to social tensions between labor and capital, who then play a zero sum game where one’s gains come at the expense of the other. Since capital has the upper hand to begin with, absent a social revolution, rent to capital adds to capital until one fine day capital has all the money or capital; and labor has none which leads to a collapse of the system itself. Point to note is communism totally ignores the value of innovation and the special effort society needs to make to find innovators and encourage them.
So who is going to solve the problems that we face as a species? Let us just take three. First, consider global warming that the right, so called undisputed champions of capitalism, deny is a problem at all despite all the evidence that continues to accumulate. Who is going to resolve the problem? Second, lets talk shortage of fresh water. The earth as a whole produces only a given amount of fresh water annually that is limited by the solar energy that earth receives on its surface. At 7 billion we are already way behind the fresh water we need. As we approach 9 billion the problem will become unmanageable. Worse, water shortage feeds into the problem of global warming. South east Asia, comprising, Pakistan, India, Bangladesh and China will constitute 30% of the worlds population but have only 12% of the world’s supply of fresh water. Further more, due to global warming, food production in this area will fall by as much as 50% due to warming and desertification by 2060. How is one-third of humanity going to be fed with less than 10% of the world’s food? Lastly, let’s consider energy. Fossil fuel production, oil and coal, has in all probability already peaked. How are we going to meet the shortfalls in future?
Note these not problems of one local society, culture, country or system. We as a species are hitting global constraints imposed by Earth’s ecological and bio-systems that we don’t know how to mitigate or resolve as a species. What’s more challenging is that solutions to these problems, if any exist, will be global across many different cultures, religions, societies, countries and systems. We have never faced problems of such humongous complexities before. Should we thrown in the towel, as Malthusian communists would advocate?
If you are a communist, the answers to the emerging problems are profoundly different from those that one would look for under capitalism. Communists would consider putting an absolute ceiling on population numbers. One child per couple or you are unplugged from the system. A global police state to enforce the rule would be absolutely necessary. A war on those opposed to the rule or dissenters would be mandatory and would help whittle down numbers further. Scarce resources would be rationed out per capita. Incentives for innovation would fall off dramatically. Faith in the future of the species would give way to despair. Exceptions to rationing, restrictions on liberties for the privileged would be eased. Gifted individuals have to be tracked down the hard way and put in special schools with special privileges to find solutions to the problems we have outlined. After an era of absolute darkness, communism itself would be dismantled having decimated a generation or two of the species and we would be back into capitalism once again. If capitalism is cyclic, the bad cycles span years not generations.
Does capitalism have unique solutions to emerging problems that are better than those offered by communism? The answer has to be a resounding no. But what capitalism offers is hope that Malthus would have considered foolhardy given the tyranny of geometrical growth over arithmetical progression. Capitalism guarantees that if there are viable ideas to resolve these emerging global problems then it is best placed to not only find them but also put them into practice. And it does so, not by putting a totalitarian or fascist all knowing omniscient government at the top, but by working through everyday democracy. To my mind that is the crucial difference between the two systems. One views the species positively and has inherent faith in its ability to learn and resolve problems compassionately. The other treats the large mass of general population as untrustworthy, selfish brutes who will behave correctly only when effectively policed. In fact communism creates the very elites it insists do not exist when faced with the need to resolve problems!
It is not the time for despair or even panic. Nevertheless, we have to explicitly recognize that education is the means by which we have always trained and equipped people to live in an environment that we have created for ourselves. The Anthropocene bubble that we live in is not one that Mother Nature equips us to live in through our DNA. It is of our own creation and the only way of making it work is by our own ideas and our own culture. Education of the young is what keeps it going. Absent the acculturation that education offers our bubble would collapse as if pricked. The sad thing is in the crucial neighborhood that we live, education’s true purpose has neither been understood nor the resources necessary to impart it have been found. This is a dreadful weakness that we must address on a war footing. Education is then the only factor limiting our growth.
Rescuing the financial derivatives market from gamblers
Derivatives, more particularly, credit derivatives, were at the heart of the crisis that overwhelmed financial markets in 2007 and triggered the worst ever global recession. Yet efforts to regulate these rather complex financial instruments have met with fierce resistance from Bankers. The Frank-Dodd Act is essentially toothless, as it prescribes no methodology for regulators to use for such regulation. Nor has the Act made it mandatory to clear all derivative trades through a clearinghouse where exposure and risk could be monitored by regulators. Four years after the worst ever crisis, we are still without effective regulation of Credit Derivatives.
Eric A. Posner and E Glen Weyl, at the University of Chicago, have published a seminal paper on the need for, and methodology of, regulation of financial derivatives: Applying the Insurable Interest Doctrine to Twenty-First-Century Financial Markets. The paper is available for download at http://www.law.uchicago.edu/Lawecon/index.html and is very readable without any complicated mathematics and/or jargon. Invoking the principle of “Insurable interest” it sets out a universally valid test to segregate hedging from gambling or speculation in financial transactions. The principle was first invoked in Britain in early 19th Century to curb gambling by the general populace by taking out life insurance policies on the lives of politicians even when they had no direct interest in the outcome. The principle saved the life insurance industry from the infamy of gamblers. Might such a principle save the derivatives market from itself?
The Bankers’ efforts to keep the Credit Derivatives out of clearinghouses, and the purview of regulators, are understandable. Due to deposit insurance, and the reluctance of Governments to let banks fail, the credit risk in banks is effectively transferred onto Governments, and from there, to tax payers. Bank depositors, the main stakeholders in Banks, have no incentive to monitor a Bank’s risk exposure and little expertise in doing so. This sets up an incentive for banks to load up on risk without attracting additional equity capital. Unregulated credit derivatives offer unprecedented leverage. In the absence of a central clearinghouse exposure to them cannot be monitored. Bankers therefore find them ideal instruments to put on risk without having to raise matching capital. The Bankers’ lobby is therefore fighting tooth & nail to avoid any regulation in this area.
Numerical illiteracy has played a crucial role in the history of finance. Moneylenders used the intricacy of the compound interest formula to enslave labor for centuries. Governments have had to ban usury, and slave labor, but the practice surfaces every now and then in a disguised forms. Some of the credit card products are little short of enslavement. Derivatives, and Credit derivatives in particular, carry on the hoary tradition of mesmerization the masses with abstruse mathematics of stochastic equations. Yet the price distributions of the underlying asset on which Black-Scholes, and all other valuation models depend, assume random walk. As any trader will testify, markets as constituted could hardly function if prices were truly randomly dispersed around a mean. The result is that even without any rigging, most models grossly underestimate tail risk and are overwhelmed by black swan events.
It is therefore, truly remarkable that Posner and Weyl have been able to cut through the mathematical clutter to arrive at a set of principles that all can understand. The authors propose, [a] all financial products based on derivatives should be required to demonstrate that their use contributes to overall risk reduction for intended users of the product, and system as a whole [b] that the products actually play a beneficial role in enhancing the efficiency with which financial markets allocate capital and [c] that the products confer no inherent advantage to any one group of participants over others in the market. These three criteria, taken together would eliminate products from the menu that merely permit speculation and add to the overall risk in financial markets by introducing risk for risk’s sake. They would not interfere with normal calls, puts, futures and other derivatives in the market that are used by participants in constructing hedging strategies.
The authors have borrowed from the regulatory model for drugs to propose a regulator, such as the SEC, or the FED, who will examine all derivative products before they are introduced in the marketplace. If that sounds draconian, it is not because the measure is unjustified but because the concept is unfamiliar. Warren Buffett described derivatives as weapon of financial mass destruction and events after 2007 proved him right. The authors have fleshed out well-defined criteria for a regulator to use in examining such new products, and in the hands of experts, these should be easy to apply unambiguously. A case can be made to allow introduction of new products but subject to a mandatory regulatory review in 3 to 6 months after they have been in use. Either way, the case for regulation now has a solid conceptual base thanks to the two authors.
The paper has also examined the 9 broad categories of derivatives in use ranging from simple futures and options to Credit and Statistical derivatives with a view to examining the role they play in capital allocation, net contribution to reduction of overall risk in the system and the manner of their use. The examination is rigorous and fair. Clearly, credit derivatives and some statistical derivatives have almost no role to play either in enhancing the efficiency of the capital allocation process or in risk mitigation. It may be noted that credit derivatives come into play on existing debt instruments and hence do little to ease the manner in which debt is raised in markets. On the other hand, they have been the main conduits used by bankers to inject risk into the system to aid heuristic speculation by holders of traditional debt instruments. Mortgage based securities could never have been sold in such large quantities to such risk averse investors such as insurance companies without Bankers specifically constructing Credit Default Derivatives that they knew would fail in distress.
Financial markets are a mirror to the real economy. They are a consequence of the real economy and have a profound effect on what the real economy does. Speculation is at the heart of the financial markets. No mechanism for price discovery can work without an element of speculation as its basic mechanism. There has always been a realization that excessive speculation is bad for the markets and results in less than optimal, distorted prices. However, efforts to distinguish between healthy speculations from its price-distorting cousin have proved exceedingly difficult. As a result, the regulatory pendulum has tended to swing from one extreme to the other with changing fortunes in the financial markets. In the process it exaggerates the boom bust cycles inherent in financial markets.
The paper by Posner and Weyl does seminal work in laying out the conceptual basis for distinguishing the good sort of speculation from the bad with a clearly defined set of criterion. An expert regulatory body working with these tools could easily weed out products, which are nothing but vehicles for gambling, while retaining those that contribute towards efficiency in the real economy. The authors have chosen not to focus on the absence of a clearinghouse for all derivatives traded in markets, especially the over-the-counter market, which allows bankers to escape regulatory scrutiny and margining provisions. That aspect, while relevant to the regulation of derivatives, was clearly not the focus of this paper. Nevertheless, I don’t think any regulation of the derivatives market could work without a strong mandatory clearing mechanism that provides raw data on exposure and use to regulators in policing the markets for misuse and containing associated credit, market and other risks. Perhaps the authors themselves would not insist on prior scrutiny of products by regulators if such a clearing mechanism were in place.
Posner and Weyl paper is truly ground breaking on par with Black-Scholes-Merton model that set off the derivatives revolution. What’s more, it is easily accessible free of esoteric mathematics. If it reignites interest in derivatives regulation after the Dodd-Frank Act fiasco, so much the better.
MARKET NOTES: NYSE Composite shows the US markets have also turned down.
Spot Gold: Gold took an awful tumble from the near $1700 levels, to make a low of $1612. It has since tried to recoup some losses and could reach up to $1640 on the reactive up move. If this is wave 3 of the impulse move down, a retest of $1500 level could easily be on the cards over the next few weeks. Gold next target is $1550, and the metal’s reaction to this area will offer clues to gold’s long-term intentions. For now, there is nothing bullish about the metal on the charts.
$1550 is an inflexion point for gold. It has been tested twice before and such important levels do not give way till the 3rd or the 4th attempt. Hence a failure to immediately break the $1550 floor will not make gold bullish in my view.
$-Index: As if to taunt $ bears, and the crowd crying hoarse about currency debasement, $ again turned up well above the 78 level, and is currently placed just above 80. $ could well head for the 82 mark again over the next few weeks. It first immediate target is 80.5, and once atop that, a fresh assault at 82 appears likely.
One may note in passing that the $ rally here is rather counter-intuitive. $ has been correcting from 88.75 level last seen in June 2010 and we are nearing the end of that correction. Going by the wave counts, $ should be heading for a retest of 72 instead of 82. However, strong violent bear rallies are common in Wave 5 of a bearish correction and the $ rally should be seen as a part of that process. What this means is that [a] 82 may not be breached and [b] the rally could terminate abruptly. Expect lots of volatility in the $ going forward.
Euro-$: The Euro turned down sharply from 1.34 levels to test 1.30. Euro has been in a downward correction since the 1.4950 top formed in May 2011. On turning down from 1.34, the Euro confirmed that this correction is not yet over. On a breach of 1.30, a retest of 1.26 is again likely though I expect the floor to hold up. On the other hand, an upturn from 1.30 will show Euro is triangulating between 1.26 and 1.36 for an explosive breakout, most probably to the topside.
Euro’s reaction to 1.30 bears watching for further clues.
$-INR: The $ has been consolidating between 50.5 and 51.5 against the Indian Rupee. As mentioned the last blog post, the next target for the $ is 52 followed by a test of the recent highs. It is just a matter of time before we get there.
NYMEX Crude: Crude Oil has an important overhead resistance at $110 that it tested in late February. Crude has since been correcting and is currently placed at $101, a crucial floor. A decisive breach of the floor would invalidate my working wave count prompting a complete reassessment of charts. However, I don’t see Crude breaching this level easily.
Barring a breach of $101 decisively, I expect Crude to head back to $110 or even $115. In fact Oil should continue to consolidate above $101 for some more time before it eventually breaks atop $110-115. Not bearish on Crude but keep tight stop losses under $97. [Or $94 if you prefer!]
NYSE Composite: The main indices of the US market, DJIA and SPX continued to drag out their top formation as expected. That could go on a week or two more but should not concern us. The NYA’s corresponding pattern at the recent top is interesting and shows a top at 8329.37 on 19th march followed by two lower tops on 26th March and 2nd April. Between these tops, it made a series of 3 lower lows, the most recent of which was 8055 on 5th April. That series of lower tops and lower bottoms confirms that the overall US market is turning down. The main indices will in all probability soon follow the broader market.
It is too early to say how the coming reaction will shape out in depth and duration. It is possible that initially, the declines could be small and shallow, followed by a deeper correction since the previous major correction was sharp impulsive move down. Either way, NYA shows the correction may have already started in the broader market.
The major European markets have all begun their respective corrections.
Sensex: The Sensex has an inflection point at 17,000. It is a crucial level that cannot be expected to give way on the first two or three attempts. During the week, the index rallied sharply from just this level to 17,665 before turning down again. I expect the 17,000 levels to be tested again and even breached at the 4th attempt if not the next. Nothing looks remotely bullish about the Sensex on the charts.
Shanghai Composite: It is too early to say if China is headed for a Japanese style deflation though I have long argued that China’s growth over the last 4/5 years has primarily came from Government induced, bank financed investment and inventory build up boom that can’t be inflated any more. I have also argued that land sales artificially inflate Chinese GDP numbers [relative to say a typical OECD country] by as much as 2% per annum. So a prolonged period of slow growth will not surprise me at all.
No, this blog hasn’t gone fundamentalist. I mention this because in keeping with my view, Shanghai Composite has been correcting continuously and consistently over the last 4 years without any of the fanfare and drama that we see in Indian or US markets. This is obvious from the fact that while US markets are reaching for previous tops Shanghai is barely 35% of it peak at 6,200 now placed at 2302.
In short, much of the doom and gloom that the press has now started reporting is ALREADY in the price.
Still maintain my original working wave count that says the Chinese market made a bottom at 2134 on 28th December last year and is now in an intermediate uptrend. In my view the correction from 2480 is reactive and could continue for a few weeks more.
My wave count will be negated if the index breaches 2160 which would correct 100% of the rise from last low to 2480, an unlikely event.
MARKET NOTES: Early signs of trend reversal in US Markets
Gold: After a minor pull back to $1680, Gold resumed its fall and is currently placed at $1665. There is nothing to indicate a trend shift in Gold. It could test $1620 level during the ensuing week before a reactive pullback of some significance. Continue to be bearish on gold.
$-Index: $ looks all set to test 78 level in the coming weeks. It is currently positioned at 79.1380. $ may have resumed its intermediate down trend from the top of 82 in January 2012. A break below 78 would confirm this prognosis.
Euro-$: The Euro-$ is currently placed at 1.33430. Euro-$ could come back to test the 1.30 level in the next few weeks. On the other hand, it could reach for 1.35 before doing so; or after doing so! The exact trajectory of the Euro-$ is rather indeterminate as it compresses between 1.30 and 1.35 before an eventual break out to the upside. This compression could take several weeks to come.
$-INR: The $ closed a shade below 51 at 50.87 last week after having pierced through 51 during the week. The next target for the $ is 51.8 followed by 52.4. $ may spend the next week consolidating above 51 before moving higher. A retest of the recent highs at 54 before the end of May this year is likely. News flow for the INR is likely to turn adverse as we go forward.
NYMEX Crude: Crude fell sharply last week to test its major support at $103, which it successfully held. Still maintain my short-term bullish view on crude. Having successfully tested $103, Crude could flare up to $110 or more before the end of April. Crude appears oversold on the charts.
NYSE Composite: NYA made a top of 8330.32 on 19th March. After making low of 8115 on 22nd March, NYA rallied to 8288.82, failing to reach its previous top. It then fell to 8083 making a lower low than on 22nd March. It has since rallied to close at 8207 on Friday.
A lower top followed by a lower low from the top of 8330.32 on 19th March indicates a correction has set in. The low on 29th March also violated the trend line through points 6898 and 7129 on 25th November and 19th December respectively. Both these indicate the ensuing correction may last a while though it is still too early to confirm a full trend reversal.
The first target for the move down is 7900 on the NYA. The market’s reaction to that area will reveal which way the market wants to go.
S&P 500: Not so obvious on the daily charts, but fairly clear from 10 day, 15 min intraday charts, the S&P 500 index could be in the process of forming an inverted Shoulder-Head-Shoulder pattern. The left shoulder stands at 1414; the head at 1419 and the right shoulder could be forming at 1411.
Too early to say if the pattern will complete and prove out. Nevertheless, taken in conjunction with the pattern on NYA that more clearly reveals the onset of a correction, the possible inverted S-H-S is another cautionary signal from the markets.
Sensex: The Sensex pulled back smartly from the 17,000 on Friday, to close at 30th March. The pull back was reactive though sharp.
17,000 on the Sensex has emerged as a major support having been successfully tested 3 times in the recent past. Near term, Sensex is oversold. So the Sensex could spend some more time above 17,000 before attempting an assault at the support again.
There is nothing in the charts to indicate that the bearish trend in play in the Sensex has reversed. Expect another assault on 17,000 after a few days of consolidation.
Shanghai Composite: After having made a double top at 2480, the Chinese Index has been in a correction and is currently placed at 2263. The index is in oversold territory and could consolidate before moving down again. My wave count still indicates the pull back from 2480 is in the nature of a correction.
The floor 2200 follows the next target on the downside for the index at 2110, which could also be tested. Those stopped out at 2350 should wait to see how the index reacts to the 2200 area. A violation there could call my entire wave count into question. So caution is indicated.