Why some believe a crash is imminent

December 2nd, 2007

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In this week alone, after hearing hints that the Federal Reserve will be cutting interest rates, the Dow Jones index shot up several hundred points. In two days alone, it rose more than 500 points, which had not happened before for many years. Back in October, in Drugged up stock market, we remarked that

Ever since Ben Bernanke cut interest rates, the US stock market had been surging, even hitting another record high.

To an outside observer who is only allowed to look at the stock market in isolation, his/her conclusion must be that the economy must be booming. After all, as we said before in Drugged up stock market,

… the stock market is an early indicator of the health of the economy. It is very much like the radar of an aeroplane, telling the pilot what dangers are ahead. In fact, the stock market is such a sensitive indicator that its alarms of economic slowdowns often turns out unfounded.

But when that outside observer looks at the US economy, he/she will see a completely different picture. Bad news after bad news on the US economy has been piling up. Even mainstream news media has been chattering recession in the US (see Mainstream chatter about recession in the US). The credit crunch is getting worse (see Tightening noose around business?s neck). US Treasury bond prices have been rising (i.e. long term interest rates has been falling).

Meanwhile, despite economists downgrading their forecasts for global growth in 2008 (due to the economic malaise in the US), the general belief is that China and India will save the rest of the world. As contrarians, we are very sceptical of this belief (see Is Chinese growth ?de-coupled? from the US economy? and Contradictions in the red hot Chinese economy).

This is a very surreal situation. How is it possible to have,

  1. Bear market for the economy (which is fundamentally bad).
  2. Bear market for the credit market (which will worsen the already bad economic fundamentals).
  3. Bull market for Treasury bonds (which tells us that the bond market believes that it the economic fundamentals will be bad)

… and have a bull market for stocks (which tells us that the stock market believes that the economic fundamentals will be very good) at the same time?

Isn’t this a strange contradiction? It is very obvious that something have to give way eventually. Chances are, the stock market will have to give way to the economy, credit market and bond market. When that happens, it is called a “crash.” This is why there is a lot of volatility and skittishness in the stock market. And by the way, just prior to the Great Crash of 1929, there was a lot of volatility in the stock market too (see The Great Crash of 1929).

So, how should we understand this anomaly? For those who are struggling to comprehend this strange situation, we will provide the perspectives for you to see what on earth is going on.

Meanwhile, for the adventurous, here are some of our thoughts on how to profit from a possible stock market crash.