October 24, 2012

Relativity and Dollars

How do you prove relativity?

When Einstein proffered the preposterous suggestion that all motion is relative including time, people clearly had not yet seen Usain Bolt. Or what happens to stocks after options-expirations when the spread between the dollar and equity indexes is at a relative post-crisis zenith.

Let me rephrase that.

As you know if you get analytics from us, we warned more than a week ago that a reset loomed in equities. Forget the pillars on which we lean – Behavior and Sentiment. Yes, Sentiment was vastly neutral. Behavior showed weak investment and declining speculation –signs of dying demand – all the way back in mid-August.

Let’s talk about the dollar – as I’m wont to do.

There is a prevailing sense in markets that stocks are down because earnings are bad. No doubt that contributes. But it’s like saying your car stopped moving because the engine died, when a glance earlier at the fuel gauge on empty would have offered a transcendent and predictive indicator.

Stocks are down because money long ago looked a data abounding around us. From Europe clinging together through printed Euros, to steadily falling GDP indicators in the US and China, to the workforce-participation line in US employment data nose-down like it is when economies are contracting not recovering, there were signs, much the way a piercing shriek follows when you accidentally press the panic button on your car’s key fob, that stuff didn’t look great.

We know institutional money didn’t wake up yesterday, rub its eyes, and go, “Shazzam! Earnings are going to be bad!”

Statistically, here is a fact. Tracing back before the Financial Crisis, one can track the US dollar index (DXY) relative to major equity indexes including the S&P 500. Each time the spread between the two widens more than 10%, a reset follows. It’ true 100% of the time. The Fed, try as it might, cannot change that, no matter the trillions it flings at the global financial system.

Why? All market activity on a fiat-currency planet, one way or another, involves assets and hedges. Just as balance sheets turn on debits and credits.

At some point the value of assets into which money is deployed will exceed protective hedges. The providers of hedges – banks behind puts and calls and swaps – likewise will only take on so much risk before revising exposure. Either move, or both, will reset equity values and hedge values. The rule of thumb throughout human history, from markets to the weekly vig on your hard money from Vinny the Face, is 10%.

The same microcosm occurs in your shares. Both it and the macrocosm are mathematically observable.

And we’ve just demonstrated the Theory of General Relativity in Equities and Dollars. Defying it is unwise and costly.

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