Is Today’s Recovery the Biggest Headfake Since 1931?

Stocks are stalling. So says today’s Financial Times… “Major equity markets came under pressure yesterday and initial gains for commodities eroded as investors cast doubt over the global economic outlook.”

We see red on our Google Finance screen. And nasty little minus signs. The Dow closed down -1.25% yesterday. The S&P 500 fared worse. It ended the day down -1.27%. The yield on 10-year T-bonds dropped too, signaling increased demand for safer havens than the notoriously capricious stock market.

What’s there to doubt? We were under the impression here at our Notes bunker that the global economy was awash with “green shoots.” Investors have been piling into junk stocks since March. US equity markets are up 37% in just under four months. Why stop now?

The bulls’ answer is that the recent flagging in stocks is a necessary “consolidation” – a “breather” on the way to the moon. But concern is growing that the rally may not have the staying power the green shoots brigade has been touting.

Here at Notes we’ll be watching closely as the end of the month – and this quarter – draws to a close. This is when companies often put out profit warnings. We’ll also be keeping a beady eye on those 200-day moving averages. If the Dow and the S&P 500 break below these magic lines there could be trouble.

Underground investor Karim Rahemtulla, investment director of the Smart Profits Report has been warning investors about overheating stocks for the past couple of months.

He’s also been warning investors not to get suckered by the short sell. According to Karim, if you’re not careful this can lead to a nightmare scenario: the short squeeze.

You short an asset that you’re convinced is about to decline, but it turns the tables on you and rises instead. You’re now on the hook to buy the shares at a higher price than you borrowed them – and you’re on the wrong end of a short squeeze.A short squeeze puts short sellers in a losing position, faced with the prospect of unlimited losses as the asset rises. The more people who went short, the more severe the reaction will be.

In a panic, they all pile into the stock at the same time, trying to buy back the shares to cover their trades and get out of them. This is known as short covering - and the buying demand, coupled with the lack of sellers drives the price up even more, thus adding to your unlimited losses.

For example, let’s say you shorted 1,000 shares of Boeing (NYSE: BA) at $35 where it was three months ago. That would have given you $35,000. But you’d still have to replace those shares eventually because you only borrowed them.

But Boeing has performed very well over the past three months and is trading around $50 today, so if you hadn’t covered your shares till now, you’re forced to buy them back for $50,000 – a loss of $15,000. And the more the stock rises, the more you lose on your original investment.

Bill Bonner reckons the rally is a head fake – just like the ‘recovery’ of 1931. Readers with even a passing knowledge of history will know that the Great Crash of 1929 was just the beginning of the Great Depression.

The rise in stocks in 1931 was nothing more than a cruel joke, a bull trap that lured hungry investors back into stocks only to drag them down to a new bottom on July 8 1932. This was the day the Dow finally bottomed out at a puny 41 points – a mere tenth of its September 1929 high.

Of course, Team Obama is now in charge. And student of the Great Depression Ben Bernanke is heading up the Fed. What can go wrong? More than you think, says underground investor Rick Ackerman, a veteran market maker on the floor of the Pacific Market Exchange (hat tip the Daily Reckoning)…

Bailing out the economy and the banking system has been such a brazenly corrupt, mendacious and, ultimately, doomed enterprise that one could almost forget for a moment how very clever the perpetrators are. If we needed proof that these guys are the slickest behind-the-scenes spin-doctors around, consider the following two headlines that ran on successive days atop the Wall Street Journal’s front page. “Rate Rise Clouds Recovery” was the grim news that greeted us last Thursday, on day one. The article described how, despite the Federal Reserve’s explicit strategy of buying as much Treasury paper as it takes to hold market rates down, particularly in the mortgage sector, rates are rising anyway, and steeply. In fact, 30-year fixeds climbed to 5.79% from 5.00% just two weeks earlier, suggesting that market demand for mortgage paper is drying up despite the Fed’s strategy of direct monetization of Treasury debt (a.k.a. “quantitative easing”).

But get this: On day two, as if to reassure us that [the] Treasury’s borrowing is well under control despite the fact that the opposite is true, the spinmeisters co-opted the Journal’s front page with this well-timed policy leak: “Fed to Keep Lid on Bond Buys.” Are we actually being asked to believe that, absent the acceleration of direct purchases of Treasury paper by the central bank, demand from other sources will suffice to keep rates from rising further?