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European Dominos Turn Into Global Cascade

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The rest of the world's financial markets will fall. Question is, when will it hit the US?

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I'll start out by getting right to the point: I'm incredibly bearish right now.

The jitteriness in the markets over the last two weeks has been more than obvious. Traders and portfolio managers are jockeying for position as they try to extrapolate the ramifications of Europe's actions. Is it Euro-TARP? Will it have the same effect? What is austerity exactly? And on and on and on.

Let me try to give you an idea of what I think and try to lay out a plan of how the globalized economy could play out.

I think Europe could very well destroy any hope of a recovery that we thought we might see. Not only that, I think it could push the world off of a precipice of debt that, if it were to occur, would create something resembling outright disaster. Austerity combined with savage debt service issues and crushing currency devaluation is impacting the entire world, and we're now starting to see the economic domino theory I wrote about a month ago. Frankly, I'm nothing short of terrified. These aren't words I use lightly. In fact, the last time I uttered them was July 2008 in an email to my closest friends warning them of an impending crash. Is that what we face now? Let's take it in pieces and see what we come up with.

1. What's wrong with Europe exactly?

  • Massive amounts of sovereign and corporate debt.
    This has been beaten to death by numerous people, including myself, but it simply can't be overlooked now. There's too much debt around the world and in numbers (size) that just boggle the minds of regular people. How is all of that money going to be paid back? Do governments realize that it must, in fact, be paid back? Where is the economic growth going to come from? Tax hikes will only serve to slow recovery even more.

  • Rampant unemployment.
    Spain is the standard bearer here with 20%+ general unemployment and near 45% unemployment for those under 25. How can a society survive when the youth have no hope and no future? Greece is no better and the backroom dealings and corruption add a seedy and impossible layer to the whole system.

  • No commonalities in tax system, retirement, social ideology, etc.
    This is a key reason why the currency was doomed from the start. Everyone has different ideas about what life should be like and how their country should be managed. Greece has no effective tax collection system making it impossible to properly fund the government, France works 35 hours a week, punishing those who are more industrious, and Germany is continually forced to play big brother to all of them. Without commonality in retirement age, work hours, how taxes are both assessed and collected, and more, the EMU will fall. The differences are just too great.


2. As Greece was the first domino in Europe, Europe will be the first domino for the rest of the world.

  • Europe is China's biggest customer.
    With Europe forcing austerity, their economies will forcibly slow... and dramatically at that. Slowing economies mean more unemployed, less business spending, probably more government/entitlement spending, and all of that means lower spending on imported goods from both China and the US.

  • The first sovereign default will set off a debt devaluation that will rock the continent and more.
    This goes beyond 2010, but it could certainly happen in 2011 as just Europe and the US have between $7 trillion and $8 trillion in debt to roll over by the end of this year, not to mention all of the corporate debt. Someone will be left holding the bag and it won't be filled with cash.


  • Slower China will reduce demand for hard commodities.
    Reduced demand plus a higher dollar equals lower prices for crude, copper, cement, steel, etc. These sectors are by far the most dangerous right now.

  • Collapsing Euro will eliminate any chance for a Yuan revaluation.
    There's no way the Chinese will revalue the Yuan to make it even more expensive for Europeans to import their goods. This is completely off the table now, in my opinion.

  • Slowing Europe and continental Asia will also hit Japan.
    Demographically, Japan is a titanic mess with debt problems that are actually worse than everyone else's. (Is the common theme emerging now?) A lower Euro and slower China makes it tougher on export-oriented Japan. Its answer will be to devalue faster than everyone else. Couple that with its soon-to-be need to go to foreigners in its debt issuance (probably the next three to five years) and its rates will necessarily balloon to 3%-5% or more. That will make its debt service unbearable, causing a true collapse in the Yen and a possibly even default for Japan. The Yen could see 120+ in a few years. That is staggering.


3. With the rest of the world in turmoil, can America really continue on a positive path? The dominoes will hit American shores -- the question is when.

  • Revisit the first two parts of section 1 and the last part of section 2.
    Sound familiar? Right now the USD and USTs are flying as people are fleeing Europe, the UK, and other questionable areas around the world. But, have you noticed how Gold has been soaring along with the dollar? That isn't supposed to happen, but it is and everyone should be paying attention. After the German's agreed to the bailout, one Austrian mint practically sold out of gold and, according to one report, sold more gold in a two-week span than they did in the entire first quarter. People are voting with their feet in the only way they know how.

  • If a debt-laden Europe is seeing these kinds of problems, the US will eventually see them as well.
    Yes, the US can print money at will, but that is as much of a negative as it is a positive. We still sell bonds, and at some point velocity will catch up with us, driving down the value of the dollar and driving up interest rates. When this occurs, demand for our debt will slow until rates match investor requirements. What happens when our debt levels break 100% to GDP (or maybe even start to match Japan's) and the cost to service our debt exceeds our tax revenues? What do you think will happen to interest rates then? What level that is can't be answered, but I find it hard to believe it won't be like the Carter days again by the time it comes around. Right now, Greece should be paying at least 15% on its sovereign debt. When trouble finally gets to us, imagine how bad it will be for everyone else. The Fed won't raise rates here for many years, but the market will do it for them.


  • Inflation will eventually trump deflation.
    What we're seeing now is a battle royale between inflation and deflation, which is why we aren't seeing significant price changes. Deflation coming from stagnant wages, tight consumer credit, and economic slack is being offset by rising prices in the cost of government, medicine, education, and other things we "need" versus things we "want", plus the massive amount of money that has been printed to date (and is sitting on bank balance sheets).

  • Austerity will be welcomed by many in America.
    Some think I'm crazy, but the Tea Party movement didn't just arise out of thin air. These people are hard-working taxpayers that make up much more of the country than many people think. They want to do whatever is necessary to save our country. Sacrifice is a word that no longer exists in Europe. Let's see if it still exists in America.

  • Precious metals will reign.
    I'm a genius, right? There's a reason why metals are doing well. Gold can't be whipped up on a printing press and they aren't making any more of it. Currency debasement will continue to push gold (and silver) higher as it becomes the reserve currency it was hundreds of years ago. The big misnomer is that gold is over-owned. I beg to differ. Other than a few publicly followed hedge funds, hardly anyone owns it or owns much in relation to their portfolio.


So, what does this all mean for the markets?

Europe has already been shut down due to volcanic eruptions (twice, the first time for about 10 days), austerity protests, and electoral tumult. That is only just now being factored into second-quarter numbers. So, their decline is well on its way. If things move as fast as they have on other issues this year, it means that we could see declines of perhaps 15%-25% in the second half alone. 850 on the S&P is roughly 25% down from here. While some will certainly chew me up, I think that it's certainly possible. I have stated for months on end that the economy is, in fact, not doing that well. Remove the massive government intervention and we'd certainly be far lower now than we are. It's obvious to me that the public won't tolerate more indebtedness by the government. Rand Paul's runaway victory in Kentucky is proof, along with many other elections we've had so far this year (strong fiscal conservatives are winning in landslide victories) and through the current administration's low approval ratings.

For the last two weeks, I've been slowly selling my long positions, or hedging them while opening new short positions in line with the macro thesis I've laid out here. I think it's possible we try to make one more stab at 1150/1200 (though we may have just seen it last week), but any move higher is an opportunity to sell. Toddo has a great credo that I've utilized for many years: Opportunities are easier to make up than losses. This environment embodies just that ideology. To me, there's no reason to be in stocks right now. You will definitely get another opportunity, but that opportunity won't be there if you're out of capital.

I certainly hope that I'm wrong, but I'm incredibly bearish over the intermediate term (with no real opinion short term). Without drastic and immediate changes in fiscal policy both domestically and abroad, we're in for a heap of trouble.

See what inverse ETFs Ron Coby & Denny Lamson are using to play the global markets with a FREE 14 day trial to the Grail ETF & Equity Investor newsletter on Minyanville. Learn more.

Position in PHYS, SPY, FXE, FXY, FXB

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