For now, I’m sticking with my prediction of a tediously bullish summer, but there are some unmistakable warning signs that suggest stocks could fall over the near-term, perhaps sharply. Below is a chart that I published intraday that shows an incipiently bearish arc developing in the Dow Average’s daily-bar stochastic. While it would require only a modest rally over the next couple of days to render this pattern docile, a mild decline could just as easily turn it savage, setting up a downdraft of perhaps 300-500 points.

If so, the reversal will have begun from a logical place, since it was just a few days ago that I signaled a potentially important high in the S&P cash index. The analysis was as follows:  “Heads-up: The S&P cash index has stalled today within an inch of a fairly important hidden-pivot resistance. I hadn't noticed it earlier, but when a friend with whom I talk regularly asked for a reading on the S&Ps, my calculations produced a hitherto unobserved hidden swing point at 1205.61. Since the actual high was at 1205.64, we should be alert to the possibility of a substantial pullback from these levels, or perhaps even a major top. Please note, however, that a two-day close above the pivot, or an intraday move exceeding it by more than a point or so, would signal additional upside potential to as high as 1275.”

Considering the foregoing, as well the possibility that long term-yields may have bottomed for a while, we should be extremely cautious about taking on any new long-stock positions right now. Meanwhile, we are prepared for the worst by way of QQQ puts we’ve been accumulating, most recently June 39s for 0.65. We also hold a substantial number of June 34 puts as part of a rolling short position intended to provide a hedge against the unthinkable.

***

In a chat group that I frequent someone suggested that it might be a good time to short dollars and buy yen. “Not so fast,”  came an illuminating response, which I reprint with the author’s permission:

 That's a bold play, and I certainly hope just a trade -- one based on the relative currency strength of the dollar, and the euro-versus-yen. But from a macro standpoint Japan is a disaster. The Liberal Democratic Party (LDP) still maintains too much control of the Diet and thus the government. It is still a one-party system even though the LDP has experienced a substantial reduction in power in the last decade.

Ironically it is western money that is helping to prop up their economy and financial system. The Fed-induced stimulus in the U.S. drove up the Japanese and German stocks and saved the banking system in each from an almost inevitable liquidity collapse just a few years ago. Both were both approaching BIS reserve limits as share prices fell. Western investment banks have also been positioning themselves in Japan as providers of liquidity by slowly buying up non-performing loans. This allows for the illusion of a strengthening banking system there. Greenspan also knows this, and one of his principal reasons (although unspoken because of mandate concerns) in wanting to get the fed funds rate back to a around 5% is so that the U.S. Fed has the ability to stimulate the world again if need be.

Fed Out of Ammo

Meanwhile, concerns that the fed is targeting housing is unfounded. Their recent advice to banks to tighten up on residential underwriting of second trusts was begun by the banks at least six months ago and has already resulted in a rapid reduction in the growth of revolving home equity loans in the US -- to the point that the slowdown should be of more concern than the imprudent underwriting. Europe can do nothing to stop it, and with China attempting to slow imports from Japan, the specter of deflation accelerating in Japan has returned. This time, though, their savings have been collateralized, their sovereign debt is twice their GDP and the U.S. Fed has only been able to get fed funds back to 3%. Which is to say, the Fed does not have the ammunition to thwart another round of slowing global growth, falling share prices etc.

I don't know if it is going to happen, but if it does, the potential for a real banking crisis in Europe and Asia is far greater today than it was a few years ago. And that may very well be what Japan and Europe need to break their political and social stalemate over real reform and deregulation. Both Schroeder and Koizumi have failed to get reform through – Schroeder’s 2010 agenda is in a shambles and Koizumi’s postal savings reform is due for a critical vote within the next few weeks. If postal privatization in Japan fails, Koizumi will almost certainly step down -- and there is no apparent heir to take up the charge of deregulation.