Featured Trades: (IS QE3 BACK FROM THE DEAD?)

2) Is QE3 Back From the Dead? When I went to bed late last night, the (SPX) was trading down 30 points, and I was thinking 'here we go again'. When I woke up, the market was up 30 points, and I had to blink hard. The overnight range was an unprecedented 60 points, or 560 Dow points. From the July high to the Asian low, the (SPX) has fallen 23% in 12 trading days.

When QE2 ended on June 30th, I argued that there was zero chance of Ben Bernanke moving straight into another quantitative easing program. But as my recent performance has convincingly testified, I can be wrong. Will the market swan dive cause the Federal Reserve to change its mind? Will QE3 come back from the dead?

I still think it unlikely. Remember that a substantial number of Fed hawks, like Richard Fisher, were opposed to QE2, and are even less likely to vote for a QE3. All of the $2.8 trillion in QE1 and QE2 is still out there. The problem is that it is not being used at all. So there is no point in pumping more liquidity into an economy that clearly doesn't want it.

The Fed has a few other tools on its belt that can be put to work. The most obvious one is keep rolling over the existing quantitative easing by taking the proceeds from maturing Treasury bonds and using them to buy new ones. That postpones any Fed tightening. Call this QE2.1.

The Fed can also cut the interest rate that the Fed pays banks for reserve deposits from the current 25 basis points to zero. I am surprised that the Fed hasn't done this already. Of course, this would take away the free lunch that the banks have been feasting on for the last three years.

This is one of the reasons why I recommended that readers short Bank of America (BAC) at $12.31 in my April 22 Fox Business Interview (click here for the link). Yesterday, it hit $6.40. By the way, in that interview, I predict a four month sell off in all risk assets that bottoms in August.

Next, the Fed can massage the language in its statements to indicate that it will maintain its accommodative policy for an extended period of time. This could deliver a zero cost confidence boost the markets need. This could happen as early as today.

More extreme measures are unlikely. It could announce that it was buying $1 trillion in mortgage securities to boost the housing market. It could peg the yield for five and ten year Treasury bonds a low level. This is what the ten year Treasury yield at 2.30% is hinting at.

The Fed could also buy equities. I convinced the Hong Kong monetary authorities to do this during the Asian financial crisis in 1998, back when the Hang Seng was trading at 4,000. It was hugely successful, and the government ended up making a huge killing in the market. A similar effort in Japan, which I had nothing to do with, failed.

But the political firestorm this would ignite makes this an outlier. I can already hear the 'government picking winners and losers' arguments. In fact, there is a risk that extreme measures of any kind would signal to the markets that the economy is far worse than it actually is, sending the markets back into free fall.

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Is QE3 Back from the Dead?

1) The Second Shoe Falls in the Downgrade Crisis. Today, Standard and Poor's fired the second barrel of its shotgun at the credit worthiness of the US with its downgrade of Fannie Mae debt from triple 'A' to AA+. Other government-backed securities are soon expected to suffer a similar fate.

The move snuffed out a nascent rally in stocks, sending them into a new tailspin, with the (SPX) ticking as low as 1,110. Gold renewed its high, tacking on a breathtaking $60 from the Friday lows. Copper really took it on the chin, trading as low as $3.91. Even corn was seeing some serious selling, dropping 10% in a handful of sessions. These are moves you will tell your grandchildren about. These days, you don't sell what you want to, you sell what you can.

As of today, the market has given up all of the positive impact QE2 had on stock prices since it was launched last November. The S&P 500 is now down 12.8% year to date and up only 2.7% YOY.

There had been hope in the overnight session that buying of Italian and Spanish bonds by the European Central Bank, which caused yields there to crash more than 100 basis points, would put a floor under market. Standard and Poor's thought otherwise. The disgraced rating agency is now hinting that it may purse a second downgrade of Treasury bonds as early as November.

Reading the downgrade report over the weekend, it's clear why Standard and Poor's acted when it did. The refusal of the House Republicans to raise taxes under any circumstances was a major consideration in its decision. Standard and Poor's has pored over the figures for federal income and expenditure. as I have and have, and reached the same conclusion: that any balancing of the budget without tax hikes is a mathematical impossibility. This condition may continue until well after the next election and beyond.

The agency is also deeply concerned about the willingness of many members of congress to push the US into default for political reasons, even though it has the resources to avoid it. Political risk is now being ascribed to US government securities for the first time ever.

Don't overweight the importance of Standard and Poor's move. At the end of the day, this is just one private research boutique's opinion. The other two ratings agencies have disagreed. I get a ton a research sent to me every day by similar organizations, and most of it is garbage. Is America's credit worthiness really just one notch above Slovenia's?

I was a regular follower of the sovereign debt default scene during the seventies and eighties, when Argentina, Brazil, and sub Saharan Africa were regular miscreants. The International Monetary Fund would read them the riot act, withholding bail out money until it obtained commitments on huge spending cuts and tax increases from the offending government. Painful declines in the standard of living always followed.

It is somewhat humorous to see Standard and Poor's force feed the same medicine to the US. It's proof that if you live long enough, you see everything.

Please don't confuse Monday's cataclysmic market action, down 604 Dow points at its worst, with the downgrade or the debt ceiling compromise. These are distractions. The real driver here is fear about the long term future of the US economy, and those fears are valid.

I don't believe we are imminently going into recession, and I expect the risk markets to have a rapid bounce back almost as ferocious as the decline. Watch for gold and the VIX to top soon to prove that I'm right.

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Get Ready to Swallow Hard

Featured Trades: (WHY I'VE BEEN WRONG ON THE MARKET), (SPX)

3) Why I've Been Wrong About the Market. On Friday I was fairly convinced that we are close to a bottom in the market at 1,166. As I write this the next day, I am staring at the (SPX) futures ticking down to 1,114.60.

I have been following global financial markets since the late sixties, and at my current advanced age, I don't get surprised very often. But I have to tell you that the 20.4%, 235 point plunge over the last two weeks has been a shocker. It is one of the most out of the blue moves that I have every seen, like the Kennedy assassination in 1963, Japan's overnight rebalancing of 50% of the Nikkei Index in 2,000, or 9-11 in 2001.

The recent market action reminds me of the mathematics of wave action in an Oceanography class that I took long ago. Several random, independent events coming from different sources a combining to amplify each other. The end result is a selling tsunami.

Of course, the finger prints of the high frequency traders are all over this move. Their computer algorithms flick billions in capital around to take profits measured in pennies and held for microseconds, arbitraging between exchange mainframes. The wider the spreads, the more of this kind of capital gets sucked into the market, the bigger and more violent the market moves. Spreads are now at 2 ? year highs, hence the 600 point daily ranges.

I have been warning readers all year that the risk of a flash crash was high. There is a reason why the flash crashes are always to the downside. We don't see flash melt ups. After a doubling of the equity indexes since 2009, it is the only natural move from a purely mathematical point of view.

The problem for you and I is that this kind of trading renders traditional market tools useless, like fundamental technical analysis useless, at least for the short term. You might as well take your income and balance sheet analysis, McClellan oscillators, and RSI's and throw them in the garbage can.

A rogue computer doesn't care that the price earnings multiple for the S&P 500 is a bargain at 12 times, and that you should get some sort of support at appropriate Fibonacci levels. While you usually see a battle fought around a 50 and 200 day moving averages that can last days or weeks, the market this time traded like they weren't there at all.

The only protection from this is to completely bail on the market and go into cash. This is why my cash positions have been running at the 80%-90% level in recent months, versus a 150% long portfolio last November. It is also why I have not been doubling up on the downside. Better to live to fight another day than lean against the Titanic.

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There Goes My Research

Featured Trades: (RIP FOR AMERICA'S TRIPPLE A RATING), (TLT), (TBT)

2) RIP for America's Triple A Rating. At long last, after months of warnings, leaks, hand wringing, and speculation, Standard and Poor's has at last downgraded US Treasury bonds a notch to AA+. The change was the most telegraphed ratings change in history.

You can bet this weekend saw a flurry of emergency board meetings across the country. Many institutions are only permitted to own AAA debt securities, and rules will need to be changed quickly to permit their continued residence in institutional portfolios.

I don't expect to see any major market impact, beyond a day or two. The fact is that America's financial health has been sliding down hill for the last 30 years. Standard & Poor's should have made the downgrade during 1980-82, when Ronald Reagans quadrupled the national debt, from $1 trillion to $4 trillion.

It should have downgraded Uncle Sam's debt a second time when George W. Bush doubled it again from $5 trillion to $10.5 trillion. It turns out that cutting taxes while starting two new wars is not a great budget balancing strategy. If any other country were issuing bonds with this balance sheet, I reckon they would catch a single 'A' rating at best.

I suspect that the timing of the downgrade now was more of a political than analytical decision. It's not that Standard & Poor's has any great credibility here. It totally missed the 2008 financial collapse. During the credit boom, it handed out triple 'A' ratings with reckless abandon to subprime securities that were clearly junk. To this day, I am amazed that the shoddy practices of the ratings agencies didn't get the principals sued out of existence or put in jail.

Sovereign debt downgrades from triple 'A' are not without precedent. In every case the change turned out to be a deep lagging indicator, a classic case of closing the barn door after the horses have bolted. One need look no further than Japan, whose downgrade was greeted with no more than a yawn.

Today, the Japanese government can borrow all it wants at 1.01% for ten years, and a pitiful 1.90% for 30 years, less than half of what the US government currently pays. The true irony here is that Standard & Poor's made its move the day after ten year Treasury bond yields matched a 40 year low at 2.35%.

It may turn out that America's long heralded debt downgrade is the first boring thing that happened this month.

Present Japanese Yield Curve

Debt Downgrade? No Problem Here

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An AA+ Rating? Really!

Only Treasury securities provided a safe haven, with overnight paper briefly showing negative interest rates. The yield on ten year Treasury bonds plummeted to 2.42%, nearly matching its 30 year low set last year.

Global contagion was back on the table, with credit default swaps for France blasting through to all-time highs. The European Central Bank's folly of raising interest rates in the face of a weak economy is now bearing its bitter fruit.

The confirmation of the 'head and shoulders' formation on the charts has triggered a an entire new round of selling by technically driven programs, clearly putting the 1,160 target on the downside in play. Margin clerks on Wall Street and the futures markets in Chicago were having a field day.

US stocks have lost $1.3 trillion in market cap in two weeks. This is on the coattails of the government sucking $2.4 trillion out of the global economy in the debt ceiling compromise. Gee, do you think there is a connection?

Here is where to watch for the next major turn in the markets. The traditional safe havens of gold, the Swiss franc, the yen, and Treasury bonds, have all posted hyperbolic moves to the upside over the past two weeks.

Now gold is making topping noises, the yen has seen a major reversal, and the Swiss franc has stalled. The fact that this is all happening in August makes all of these big moves suspect.

We may be seeing the first cracks in this monolithic 'RISK OFF' trade in the Japanese yen today. The Bank of Japan finally awoke from its long slumber, moving into the foreign exchange markets with a major intervention, gapping the yen down three and a half handles against the dollar. The leveraged short yen ETF (YCS) soared.

Further hope was engendered by the weekly jobless claims, which showed a loss of only 1,000. This is the second week in a row at the 400,000 level. Talk about being stuck on the 50 yard line.

JP Morgan dramatically ratcheted down its forecast for Q3 from 2.50% to 1.50%. Q4 was chopped from 3% to 2.5%. It now believes that we can expect no more than 2% growth in the first half of next year. Unemployment will stay at 9% through the end of 2012. It expects no movement by the Federal Reserves on interest rates until 2013.

I can't tell you how many people tried to get me to buy today. The fact that I ignored them is the only reason I still have ten fingers, as catching a falling knife did not appeal. If you believe that this is just a correction in a bull market, then this is a fantastic place to buy, and the rout will be over in a few days.

If, in fact, the next recession has already begun, then we have just seen the first 12% of a 50% move down that will last three years. That is because there will be no safety net in the next crash in the form of TARP, supplementary budgets, or QE3. The Tea Party wouldn't hear of it. I thought this worst case scenario wouldn't start until next year, but I could be wrong.

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