The Mounting Case for a New Bear Market (by Retracement Levels)

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It is ironic that right when most Bears where capitulating, a geopolitical event in a small country far away from the US started something that may potentially lead to the next Bear Market and actually trigger a global meltdown that could make the 2008 crisis look like a small correction.


First of all, Retracement Levels is not part of the bears bunch, we do not have a bias in that regard. We use quantitative methods to assess the probability of long/short trend changes and we do not care  about the WHYs of the market volatility, we only care about the HOW MUCH, WHERE and WHEN.

However, what is happening currently in Italy (Europe) is a fundamental curveball that is too significant to be ignored.

As we
explained in some of our latest Daily commentaries, the political
instability in Europe (more precisely: in Italy) may lead to potentially
catastrophic events, mostly because the new emerging political force of
Italy (the M5S led by former comedian Beppe Grillo) has in its
political agenda the 'restructuring' of the 2 trillion euros italian sovereign
debt (read: default) and a 'referendum to let italians decide if they
want to stay or not in the euro currency bloc' (read: exit).

In our view, the above facts lead to a
simple conclusion: instability for markets in the next few
months and potentially a serious global meltdown if Italy defaults on
its debt and exits the euro currency bloc.

The main issue with this
curveball in our view is that most global investors at this stage do
not have a clear understanding of what is happening in Italy (we do,
because we have a highly privileged observation point on it).

Last week
Credit Suisse has published a report where it made an analysis of the
italian situation, concluding that most probably, given the local
elections results, the European Central Bank will end up cutting deeply
the euro interest rates and flooding the euro-system with long-term liquidity, following the
Bernanke model (opposite to what german hawks wanted so far), to
guarantee that Italy does not go into default.

Goldman Sachs' Jim O'Neill
recently expressed a similar view,
saying that what is happening now in Italy is 'exciting' and hopefully
will push away the european austerity measures (wanted by Germany) that so far
have badly hurt the european PIIGS sending them into a recession spiral.

What is all the above telling us?

Very simple: the global banking
gotha thinks that the italian elections outcome is
actually paving the way for massive liquidity injections into
the european financial system and this is seen as a positive event. To let you understand better their thinking: imagine that Occupy Wall Street has now become the first political party in the US and has a very large number of senators and representatives in Congress and Senate and it's able to gridlock everything and the global bankers think that this will force Bernanke to ease more (assuming it was even possible) to improve the country's economy.

The main concern we have with the bankers' vision is this: what if Italy votes to exit from the euro currency bloc and go back to their local currency?

The
bankers seem to miss that key point in their analysis: it is a big
mistake, they are failing to understand the scope of the revolution that
is happening in Italy (and also they fail to understand that it may
spread to other european countries). If you think about the last crisis,
2008, most bank analysts completely missed and underestimated the
magnitude of what was about to happen. This time they are failing to
understand that Beppe Grillo and Italy are taking the same path as
Iceland
: they are chasing the "bankrupt yourself to recovery" model,
praised also by Nobel laureate Paul Krugman. The problem lies in the
scalability of that model: Iceland defaulted on 85 billions euros. Italy
will default on > 2 trillions euros.

In
conclusion, based on our current reading of the italian/european
political and economical crisis, we are sure that there is currently a huge risk looming on the entire global financial system: the risk that Italy leaves the euro bloc and defaults on its sovereign debt and if that happens the whole global financial system will crash very badly.

The purpose of this post is to make a case for a possible Bear Market in 2013-2014. Be prepared for the worst. However, we must also say that it
is not possible to predict for sure if and when there will be an actual
crisis (Mr. Bernanke showed us that systemic crisis may be artificially postponed for a long time).

Too many factors affect
these type of crisis and the 2009-2012 Bull run should have taught several big lessons to all fundamental and technical analysts when it comes to market timing.

In conclusion, we think that a long-term bearish bias from here is justified, a Bear Market is possible (not sure, but possible) in the next 2 years and it may be a devastating one if Italy leaves the euro, defaults on its debt and if other euro PIIGS countries decide to follow that model.

In the next few weeks, keep an eye on the 'Italy vs. Europe' unfolding drama: that is the telltale that will show you the direction of the wind: according to some economists Italy is expected to become insolvent (unable to pay its debt and public workers) in no later than 6 months from now. Boom!

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