(09/24/13) Bearish CrossCurrents

In theory, derivatives are said to aid economic growth and are responsible for economic growth that would otherwise be difficult to achieve. Wrong, asserts Alan Newman, editor of CrossCurrents.

The theory that derivatives are responsible for economic growth have long ignored the obvious; they do not provide better economic growth. In fact, they hamper economic growth.

Over the last few years, we have been acutely aware of what we see as irresponsible stances of the financial industry, those committed to protect investors (such as the SEC) and by the Federal Reserve Board to hide all the facts.

Over time, more leverage, more credit, and methods to accommodate leverage and credit, have proliferated. We are now a society living, not only on borrowed money, but very likely on borrowed time as well.

While we have no doubt that derivatives, and especially leverage, have potential to temporarily boost economic growth, the attendant risks are gigantic.

The banks, exchanges, and the brokerage industry, have completely transformed the capital raising functions of the equity market, by reducing the long-term to microseconds.

The proliferation of high frequency trading has afforded privileges in which the public cannot participate, and which favors institutions, to the detriment of the public.

Derivatives have also favored institutions to the detriment of the public, by having the very substantial advantage of bailout possibilities.

In fact, at this point in time, it is clear that the situation has become so onerous that there is no doubt that way too many institutions are, indeed, too big to fail.

If one goes down, the potential harm to the remainder of the system is too great and, thus, another plunge into the chasm will be fixed the same way as before.

The banks and broker know this. The exchanges know this. There is no impetus to change or ameliorate the same kind of risks that placed the nation on the verge of the abyss in 2008. Thus, the public will again be punished, as the worst of double standards is allowed to endure.

For a stock market again so close to major index highs, there seems to be a perilous helping of deteriorating technical indicators that suggest very high odds for substantial weakness in the weeks to come.

Ten-day new highs minus new lows is diverging horribly, despite an awesome week for the major averages. What's wrong? What's wrong is that fewer strong issues are driving the indexes. The analogy of the troops deserting the Generals is apt.

As to sentiment, nothing scares this market. Truth be told, pessimism is out of vogue. In 49 years of observation, we've never seen a market so completely devoid of concern for what can go wrong. Given so much complacency, a rousing wake-up call is in order.

We have yet to see the high volume necessary for a substantial corrective wave to unfold. Stocks remain primarily and almost exclusively driven by mechanical factors, chiefly high frequency trading.

Despite the latest rally, the bulls are still losing control one foot at a time. There is not enough interest or liquidity at this time for money managers to commit big time to stocks.

With mutual fund cash remaining at extremely low levels, and margin debt in the stratosphere, the current environment is as dangerous as any this observer has ever seen.

The August 28 Dow mini-correction low of 14,760 seems far less important than the June 24 low of 14,551, the level at which we would expect the downside to accelerate. We are convinced a major top is brewing.

We see strong support in the Dow at 12,471; the worst case scenario of a smash to Dow 10,404 is still possible. The only good news is we don't think there is any way the March 2009 lows will ever be taken out.