Remember back in 2007 after the collapse of the Bear Stearns funds and everyone was told "Don't worry. We have it contained."
We all know how bad that ended even if it took a year and a half to come to fruition.
The situation here is similar in Europe. The intent is to create a controlled default in which Greek debt is swapped, the market feels much better, and everyone can move forward instead of worrying about a Greek default or bank failure.
Why is the bank failure a major fear? Look back at my article on Amagerbanken earlier this year. European regulations require bondholders to take immediate write downs which would cause a ripple effect across the European banking sector.
Meanwhile the Greek government hopes to buy enough time to implement reforms but as we have seen so far this is much more difficult than anyone expected.
When new taxes were suggested the population protested and when the tax collectors found out the new real estate tax was to be collected via electricity bills rather than the tax office they protested.
In the U.S. we have questions surrounding the entire "super-committee" and their ability to actually come to an agreement after participants sit entrenched in their ideological silos. Given the difficulties in coming to an agreement after missing the April deadline to extend the debt ceiling, I have serious doubts.
There is a very good chance that the automatic cuts will kick in due to the inability of both sides to come to an agreement.
So where do we stand right now? The Greek government wants to stay in the EU but there are rumblings across Europe about kicking out a government who falsified documents to enter, continued their spending ways, got bailed out, refused to make structural changes to the economy, and is at the table looking for another bailout.
While the politicians attempt to muddle through without touching their sacred cows the markets will likely have other ideas. The muddle through scenario carries the most risk as the markets will be asked to accept lower return on the risk that Greece and the U.S. cannot pass the necessary structural reforms to reform their economies.
The $2 billion forex loss by UBS (UBS) was just the beginning. We saw similar losses in 2007 and 2008 after the blowup of Bear Stearns leverages hedge funds. Morgan Stanley then lost $9 billion dollars to CDS trades and Societe Generale (SCGLF.PK) lost $7.22 billion on bad European Index trades.
While the markets look oversold and gold and silver look overbought one should exercise extreme caution as we move into the fourth quarter.
In terms of gold (GLD), (DGP) and silver (SLV), (AGQ), tops remain in place but when earnings season rolls around, companies will be asked about the global slowdown and how they expect sales and earnings to slow in the fourth quarter and 2012.
At this point in time investors would be well advised to reduce their risk and leverage to the markets. Leverage within the system is being reduced all year long as sovereign risk in the U.S. and Europe increases.
The greatest risk within the system is the stock market going back to highs made earlier this year which the sovereign problems remain unresolved. Much like 2007 and 2008 as we approached the U.S. elections, risk and fear increased greatly and we paid a significant price.
As unemployment hiring continues to remain stagnant we are likely to see stagnant consumer spending. As the Christmas shopping season approaches it will be interesting to see the hiring patterns of large chain stores.
This coming week will see an engaging debate within the Federal Reserve concerning QE3 and the Twist strategy. With some members are openly calling for additional stimulus others are have come to the realization that the Federal Reserve has done enough and changes to fiscal policy should push the economy forward. The bulk of the response from the Federal Reserve coming out of the meeting will likely focus on support for the EU during its time of crisis.
I have my doubts about a full blown equities crash but investors should prepare themselves for this possibility by reducing leverage, tightening stops, and considering the possibility of using short ETF’s (QID), (PSQ), (DOG), (DXD), (SH), (SDS) as a hedge to their portfolio with stops in place.
Disclosure: I am long AGQ, DGP.
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