Big Blows to the Market Optimists

As somebody once told me, "Nobody likes a negative person," which is undeniably true. The problem is, with markets, sometimes you have to be negative -- and right now this market looks terrible.

The major indices have now entered downtrends, major leading industrial stocks such as Caterpillar (NYSE: CAT) have been breaking down, and global economic data is weakening. It is a time for major caution -- don't try to be a hero.

Caterpillar digs a hole

Earlier in the week, I noted I had been perusing some stocks that had already discounted a lot of economic problems and gotten very cheap, and I was thinking about some buys. But the catch is: What are these stocks thinking? Global slowdown. We have had more economic data confirming what the commodities markets already knew. Yesterday, the Chicago PMI manufacturing indicator came in much weaker than expected. Last night, the Chinese PMI printed its lowest reading in a year. Today, another lukewarm employment report from the Feds confirmed that our economy is sliding back into a "soft patch."

These data points do not bode well for an immediate market recovery. In fact, if anything, we are sticking to our "groundhog day" model of last year, in which markets peaked in the April/May timeframe, and then declined on rolling, volatile "financial crises" into the summer, with some sort of resolution -- either in the form of a market crash or massive global bailout -- arriving by September.

The problem is, the results are pretty much impossible to know, unless you have the secret playbook that tells you how they will toggle between the options of "insolvent global banking system" and "coordinated central-bank bailout." Yesterday, the market spiked on one rumor that the IMF was going to bail out Spain. But what's the IMF, after all, but a puny $400 billion appendage to our own central banking system? The IMF is located in New York and its biggest patron is the United States government. The US banking bailout cost a couple trillion in 2008, and you think $400 billion is enough for the bottomless pit of bailouts? A few hundred billion is just starting table stakes here in 2012.

Maybe we need the Avengers.

The volatility embedded in the global banking system is unprecedented and not easy to fix because it is linked to trillions of dollars in derivatives contracts. As we recently saw with JP Morgan's massive losses -- and this is one of the better banks -- there is no way to know which way these banks' highly levered trading positions will go. JP Morgan had a "hedge" that turned into billions of dollars of losses -- the total amount is yet unknown but is estimated to ranges as high as $5 billion. Imagine what could be hiding in the ghastly balance sheets of some European banks.

I have mentioned derivatives before -- they are the global banking fission material, the core of the financial crisis. These leveraged contracts are what banks use to "hedge" their investments, but more often you read about derivatives contracts as the sources of massive losses.

Let me boil it down to you in simple terms. A derivatives contract is leveraged. If I have a net worth of $100 and I have made a $10 bet, I can only lose only 10% of my money. But if that $10 bet is leveraged 25-to-1, I can lose $250 and have my entire net worth wiped out overnight. For whatever reason, our diabolical system, with the global banking system levered 25-to-1, still cannot understand this.

Feeling masochistic, I recently looked over the latest derivatives numbers from the Bank of International Settlements (BIS). According to the BIS, the gross market value of over-the-counter derivatives contracts has grown from $21 trillion in December, 2009, to $27 trillion in November/December 2011. If you look at the notional amounts of these contracts they have grown from $603 trillion to $647 trillion.

Banking leverage near all-time high

Gulp.

So back to the casino, where making simple investments is tougher than ever. It would be nice to be in a normal world where you could buy Cliffs Natural Resources Inc. (NYSE: CLF) trading with a P/E of 5, or even Microsoft Corp. (Nasdaq: MSFT) with a 3% yield and a P/E of 10, knowing these were relatively safe bets. In simpler times, these would be no-brainers. But we do not live in simpler times. We live in a world with hundreds of trillions of derivatives contracts linked to a world banking system teetering on the brink, when any morning you could wake up to learn that some stupid trader at a bank in France, Britain, or America hit the nuclear trigger.

The market could bounce potentially here on some sort of new banking rescue plan of the hour, or then again it might not. I confess I don't have a lot of confidence in knowing what a roulette-wheel market is doing from day-to-day. But I do know it's not a time for bold moves. It's time to wait and monitor and stay protected with cash positions and a a core gold position which I still advocate -- and see what the central bankers do next.

Our model portfolio reflects in general what I'm doing on a personal level -- high levels of cash, gold, and some conservative low P/E stocks. This is the only way forward, I believe.

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