http://seekingalpha.com/article/240674-beware-the-market-s-rip-currents?source=dashboard_macro-view

by Jack Sparrow

On U.S. beaches, rip currents (also known as rip tides) are responsible for 80% of lifeguard rescues. They are hard to spot (especially if you aren’t looking) and potentially fatal.

In an ocean or large lake, a rip current is “a strong channel of water flowing seaward from near the shore.”

In markets, a rip current could be classified as a submerged theme or trend the market is ignoring, that yet could suddenly and violently return to the fore.

Just as ocean rip currents can drown careless or inexperienced swimmers, so too can market rip currents drown careless or inexperienced investors.

At the moment the “rip current” potential for this market is very, very high, due to all the developing themes the market has chosen to (temporarily) dismiss out of hand:

• China inflation pressures out of control
  
• The potential for a global E.M. hiking cycle
• The blowback potential of rising energy costs
  
• The blowback potential of rising U.S. interest rates
• A brewing state budget crisis
  
• Europe’s steady slide into monetization oblivion

We maintain that 2010 markets have been excellent for traders, but hazardous to those without fluid timing and a strong handle on risk control.

As Jon Kabat-Zinn observes, “You can’t stop the waves, but you can learn how to surf”…

We’ll dive in with a look at the S&P. What you see above is an S&P weekly chart (click to enlarge), inlaid with a one day 5 minute chart.

Given the positive developments of recent weeks, the bulls have largely assumed they are home free, with growing expectations of a rally that extends well into 2011. This remains a dangerous assumption.

On Tuesday (December 7th), U.S. equities roared at the open on news of an Obama-GOP tax cut deal. But after sending the S&P to fresh 2 year highs, the rally fizzled (as you can see from the 5 minute chart).

Major new highs and lows, especially in conjunction with support or resistance on the weekly charts, have a good track record as potential inflection points. To be turned back here would be an ominous sign.The bulls need to clear this hurdle, and they need to do it soon.

If the S&P can pick itself up and grind higher in short order, then perhaps all will be well. But if not, the threat of a weekly double top still looms, underscored by the implied failure of bulls to carry through on excellent news (the likelihood of tax extensions).

On the strategic side of things, it is further interesting to note the growing divide between President Obama and his political power base. Many Democrats were infuriated by Obama’s willingness to “sell out” to Republicans, particularly on estate tax details, and are whispering of revolt. More rip current potential there, especially if priced-in tax cut expectations are suddenly reversed.

Winston Churchill: “There is no worse mistake in public leadership than to hold out false hopes soon to be swept away.”

Another reason for Tuesday’s disconcerting equity fade — the horror show in bonds (click on chart to enlarge).

U.S. treasuries plummeted on renewed concerns over government debt levels. 10-year yields rose the most in 18 months, and long bonds were similarly crushed.

Between tax cuts and open-ended hints at more QE, bonds are in a terrible position. And of course, as treasuries fall, interest rates rise, putting further pressure on the anemic-at-best recovery.

We were short USTs prior to Tuesday’s meltdown, having made the call last week.

Another notable aspect of Tuesday’s action was the big reversal in precious metal miners (click on charts to enlarge). After pushing $30 an ounce, silver futures saw a blood-red turnaround on the day, and PM names followed suit.

In the Mercenary portfolios, we were fortunate to have booked half profits on two of our open gold and silver positions (GDXJ and SSRI as shown) on Monday and Tuesday. The timing was most fortuitous, though not explicitly planned to catch the top. It is standard practice for us to take half profits at pre-established volatility targets.

This half profit target (HPT) practice has many benefits: It helps smooth the equity curve via more routine profit distribution, frees up incremental capital for new positions, and creates a psychological cushion for our second half long-term trend positions.

The GDXJ pyramid point was mentioned in the public post stream. All trades are documented by third-party executing broker and also in theLive Feed archives.

We remain long the $USD (via UUP) from significantly lower levels and short China (via FXI) from significantly higher levels (click on charts to enlarge).

The $USD and China trades are a powerful illustration of half profit target (HPT) logic at work. Had we not taken partial profits on these positions, it would have been psychologically much harder to endure the volatility of recent weeks (and the risk of giving profits back).

Now the $USD and China are both setting up for fresh pyramid opportunities. (To pyramid is simply to add to an existing position, sometimes in size.) The $USD chart is not registering a traditionally bullish pattern, but one must consider what is happening in Europe.

In a nutshell, it is slowly dawning on investors that Europe has no way out of its current mess other than mass-monetization of EU periphery debt. Germany may talk of walking away, but that isn’t a truly palatable option for multiple reasons. Nor is a single-country periphery default, as if one goes down the others follow like dominos.

Default and departure options blocked, that leaves monetization — a path that lets the euro survive as a currency, but only at the cost of violent devaluation. EUO, the ultra-short Euro ETF, is another potential way to play this trade (for those not inclined to futures or forex).

And as for China, we have already made that case — nothing has really changed there, other than Mr. Market temporarily focusing more on “Bernanke” than “Beijing.” (Perhaps the first official rate hike will change that?)

Keep an eye on China, the $USD, precious metals and the S&P. And by all means, don’t be complacent about risk — not now, especially not now. If markets roll over, the bears could strike fast and hard (and we will be among their number).

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.