The Unexpected

June 16th, 2014
in contributors

X-factor Report 15 June 2014

by Lance Roberts, Streetalk Live

I have often written in the past that the thing that will influence the markets the most will be something that is totally unexpected. Things that we know about, such as the Chinese economic slowdown, deflationary pressures in the Eurozone or weak domestic economic data is primarily already factored into current market psychology.

Follow up:

Currently, those "knowns" are believed to be directly countered by the Federal Reserve's continued accommodative policy. Investors have now been "conditioned" and the "fear" of missing out on a possible market advance overwhelms basic investment logic and discipline.

However, at some point, an event will arise that is both surprising and shocking enough that it begins a "rush for the exits." It is this sudden and dramatic shift in investor attitudes that leads to sharp market reversions that occur so quickly that most individuals become "paralyzed" from taking action. This is the focus for today.

A few weeks ago we were discussing the rising geopolitical tensions between the Ukraine and Russia. However, those hostilities were soon incorporated by investors and determined not to be a threat to the financial markets to any great degree. A previously "unknown" is now "known" and has been "weighed and measured."

This past week, market volatility rose as a new "unknown" was introduced. The invasion of Iraq by ISIS (Islamic State Of Iraq And Syria), or ISIL, (Islamic State In Iraq And The Levant), has now sent jitters through the financial markets and oil prices surging toward our previous price target of $106/bbl to wit:

"Oil prices have settled back to moving average support as the news flow from Russia has slowed. However, with oil prices in an uptrend, and not overbought as of yet, the most likely direction for oil is higher to a target of $106. If actions flare up over the Ukraine in the days ahead this is the most likely outcome."


The problem with spiking oil prices is the negative impact to consumption due to rising prices. With Iraq ranking near the top of the world's oil production and reserves the potential economic impact of the invasion is real. It is currently estimated that oil prices could spike significantly higher if ISIS gains control of the country.

As of Sunday morning here are the latest updates:

  • Obama said Friday that ground forces are off the table but his national security team will present him with other options 'in the days ahead'
  • The possible breakup of Iraq into feuding ethnic and sectarian bastions accelerated Friday as Iraq's senior Shiite Muslim cleric broke years of support for the central government and decreed that every able-bodied Shiite man has a religious obligation to defend the sect's holy sites from rebellious Sunni Muslims led by fighters from the extremist Islamic State of Iraq and Syria.
  • The new reality is the biggest threat to Iraq's stability since the U.S. withdrawal at the end of 2011, and it has pushed the nation closer to the precipice that would partition it into Sunni, Shiite and Kurdish zones.
  • Republicans in Congress insist that waiting shouldn't be an option: 'We need to be hitting these columns of terrorists marching on Baghdad with drones now'
  • A senior Air Force official in Afghanistan said air bases there and across the Middle East expect 'contingency plans' in the next 72 hours
  • Obama could have airstrikes underway in 24 hours, according to one retired general. His authorization from Congress for military force in Iraq has never expired, so he could legally do it without approval from Capitol Hill
  • When Abu Bakr al-Baghdadi walked away from a U.S. detention camp in 2009, the future leader of ISIS, who is now considered the most dangerous man in the world, issued some chilling final words to reservists from Long Island. "He said, 'I'll see you guys in New York,'" recalls Army Col. Kenneth King, then the commanding officer of Camp Bucca.
  • Abu Bakr al-Baghdadi is the leader of ISIS, the ultra-extremist army, which is currently sweeping through Iraq towards Baghdad.

While there is a fairly spirited defense of Baghdad currently underway, if Baghdad falls under the control of ISIS oil prices between $110 and $120/bbl would not be out of the question. Such a spike in oil prices would have a negative impact on the economy.

The charts below show inflation adjusted (real) oil prices as compared to consumer confidence, the employment to population ratio and the economy as a whole.

Gradual increases in oil prices do not have a "shock" on confidence as consumers can adjust for rising oil prices by curtailing spending elsewhere or borrowing on credit to maintain the current standard of living. However, sharp spikes, as seen in 2011, for example, translated into an immediate contraction of confidence.


While there are many explanations about "why" the employment to population ratio has not risen since the financial crisis, the fact is simply due to the lack of economic recovery. As shown below, a sharp increase in oil prices has been coincident with not only declines in the employment to population ratio, but also have led to the onset of economic recession. The reason that the rise in oil prices has not triggered a recession in since the financial crisis, although we were indeed on the verge of one in 2011, has been primarily due to the ongoing massive infusions of liquidity by the Federal Reserve.


The chart below shows spikes in oil prices versus economic activity.


What happens over the next couple of weeks in Iraq will be important. However, it is important not to take your eyes off of what is happening elsewhere in the world either. The problem with China's rehypothecation fraud is systemic and is a potential lynchpin to another financial crisis as in 2008.

"According to the 21st Century Business Herald, at least 17 financial institutions involved in copper, aluminum and other nonferrous metals financing business face losses of almost 15 billion Yuan (not including the contagious rehypothecated collateral chains involved) due to the over-invoicing of the Qingdao port. Crucially, it appears that the evaporation of collateral (i.e. multiple loans secured by the same collateral) has been confirmed officially, and banks such as Standard Chartered have already ceased any new business via this supposedly secured channel."

Furthermore, there are increasing tensions in the Ukraine as a Ukrainian military transport was shot down killing all 49 Ukrainian service personnel on board. Via AFP:

"'On the night of June 13-14, the terrorists...fired from an anti-aircraft weapon and a large calibre machine gun, shooting down military transport aircraft...IL-76 as it was about to land,' the ministry said in a statement, offering its condolences to the victims' families.

Forty-nine military personnel were killed in the incident, according to military spokesman Vladislav Seleznov. Luhansk lies near Ukraine's border with Russia, an area where separatists have seized government buildings and declared independence after holding disputed referendums.

An estimated 270 people have been killed in the violence over the past two months."

Also, the New York Times reported that Russia has been assisting those "terrorists," actually the "separatists," in the Ukraine:

"The State Department said Friday that Russia had sent tanks and other heavy weapons to separatists in Ukraine, supporting accusations Thursday by the Ukrainian government.

A convoy of three T-64 tanks, several BM-21 multiple rocket launchers and other military vehicles crossed the border near the Ukrainian town of Snizhne, State Department officials said. The Ukrainian Army reported Friday that it had destroyed two of the tanks and several other vehicles in the convoy.

'This is unacceptable,' said Marie Harf, the deputy State Department spokeswoman. 'A failure by Russia to de-escalate this situation will lead to additional costs.'"

The geopolitical instability is growing and, while mostly ignored by the markets currently, could lead to a rapid dislocation in the financial markets if any of these events accelerate rapidly.

Overly Optimistic

Spiking oil prices, geopoltical unrest, or "something else" presents an even larger problem when markets are extremely extended and overly optimistic.

As I discussed last week in "More Signs Of Excess Bullishness."

"The chart below shows that while the current bull market trend remains in place, the recent 'consolidation' failed to reduce the overbought, overly bullish, conditions in the market.


"While the promise of a continued bull market is very enticing it is important to remember, as investors, that we have only one job: 'Buy Low/Sell High.' It is a simple rule that is more often than not forgotten as 'greed' replaces 'logic.' However, it is also that simple emotion of greed that tends to lead to devastating losses. Therefore, if your portfolio, and ultimately your retirement, is dependent upon the thesis of a 'never ending bull market' you should at least consider the following charts.

Bob Farrell's rule #9 states that when everyone agrees; something else is bound to happen. The next three charts show the level of 'bullishness' of both individual investors (AAII Survey) and professional money managers (INVI Survey).


A look at just 'professional' investors shows an extreme level of bullishness only seen at major market peaks.


It is interesting to note that the 8-week moving average of bullish sentiment for individuals has declined prior to the ultimate peak in the market.


"Stocks have not 'reached a permanently high plateau' nor will 'this time be different.' As with all late cycle bull markets, irrationality by investors in the financial markets is not new nor will it end any differently than it has in the past. However, it is also important to realize that these late cycle stages of bull markets can last longer, and become even more irrational, than logic would dictate."

There is rising signs of "strain" in the overall market as exuberance has reached levels that far exceed the underlying fundamentals. What will the actual "catalyst" be that trips up the market? I don't have a clue and neither does anyone else. However, what I do now is that it will happen and it is only a question of when. This is why it is critical that we pay attention to "cards that are being dealt" rather than the "hand we just won."

No Changes To Model...Yet

When I discuss the potential risks that exist in the markets, I get one of two responses.

1) You are just being "bearish," or;

2) Does this mean I should sell everything and go to cash?

The answer to both is simply, "No."

No, I am not bearish. However, my job as an advisor is to not only utilize the markets to make money, but also to preserve the gains, and investment capital, as much as possible. That is why I focus on the "risks" contained in the markets.

Currently, the market remains well confined to its current bullish market uptrend. While there are MANY things to worry about in the market currently, NOTHING has happened that would dictate the need to reduce our portfolio allocation model.


The market is extremely overbought on an intermediate term basis and is pushing a rather substantial divergence from its long term moving average. However, nothing has broken as of yet to suggest any significant portfolio actions.

This is what separates long term investment success from most individuals. Emotionally speaking there are plenty of reasons to sell positions and raise cash. While doing so may provide some short term satisfaction, if the market continues to increase your "emotions" are likely going to force you to buy back in at an even higher price because you "feel like you are missing out." However, by allowing the markets to "tell" you when to sell by looking for a change in the direction of price, will allow you to raise cash at the appropriate time and protect the underlying capital.

Because the portfolio model remains fully invested in the markets, as shown below, and; therefore, there is no need to focus on what is going "right" for the markets. By only focusing on what is going "right," I run the risk of missing what just went "wrong" that cost me a significant portion of my investment capital.


Think about it this way. If I am driving a car on a very straight road, I could close my eyes and probably drive for quite a ways without incident. However, by doing so I run the risk of missing the unseen curve in the road ahead which would lead to a disastrous outcome. Therefore, it is in my best interest to stay on alert for the potential dangers that may appear in front of us.

Understanding the bullish arguments is unquestionably significant, however, the risk to investors is not a continued increase in price, but the eventual reversion that will occur. Unfortunately, since most individuals are only told to consider the "bull case," they never see the "train coming."

Remember, every professional poker player knows how to spot a "pigeon at the table." Make sure it is not you.

Hope all you Dads had a very happy and enjoyable Father's Day.

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