first majestic silver

The Steve Puetz Letter

April 15, 1997

Dear Fellow Thinker:

The stock market crash is progressing mostly as expected. The outline was detailed in last month's letter. Today, I will update those projections.

First, however, some preliminary information will help you appreciate the selling potential facing the marketplace in the coming days and weeks. Armed with this information, you will better understand why the present stock market decline must end with a crash.


Model risk. That's the name given to the nonhedged risk of option strategies designed into computer programs. These computer programs constantly crank out their estimates of a fair price for various options as the markets trade during the day. Virtually all of the major banks and brokerage firms have designed their own option pricing models. And traders at these firms use these computer models in making their hedging and trading decisions.

Model risk is making news these days. That's not surprising, though. We have been warning for quite some time that derivative open-interest has exploded upward. The growth has been particularly hectic in unlisted derivatives. And it's in the unlisted derivatives where problems are now beginning to surface.

On April 11th, Knight-Ridder reported: "Model risk is said to be behind recent hefty losses made by NatWest and Bank of Tokyo-Mitsubishi in their options businesses, and it is expected to claim more victims before the year is out. James McNabb, director of trading risk management at consultants Capital Markets Risk Advisors, and a former options trader, said: '...We think 1997 is the year of model risk. Our thinking is there are going to be a lot more of them, along the lines of the losses announced already this year. Some people are looking closely at their models, but others are still leaving themselves open to surprises.' ... NatWest is believed, by traders who prefer to stay off the record, to have used simplistic models that mispriced the caps by marking them to a flat volatility for each maturity. Also, instead of working out the skew volatility properly by taking into account the increased volatility of out-of-the-money caps in a rising -compared to a docile falling -- rate environment, they allegedly ignored complexities and stuck with an inflexible model. One key risk for options traders is technological. Pricing systems that were state-of-the-art three years ago, may now have dangerous inadequacies.... Another big risk, according to senior options traders, lies in the pricing of more exotic options. These infinitely complex creations rely heavily on assumptions -- including constant volatility - and a number of banks have come unstuck by bidding aggressively for exotic deals, only to find the assumptions used are too inflexible, and thus, inaccurate."

In particular, increased volatility is the one factor that could, and probably will, cause all of these option models to blow up. To track stock market volatility, watch the VIX index. VIX is reported every week in Barron's. For anyone who has a DTN machine, VIX is constantly updated during trading hours.

During October and November 1996, VIX traded in a range between 16 and 20. After Alan Greenspan's Irrational-Exuberance speech during early December, the VIX volatility jumped to a trading range of 19 to 23. Since the March 11th peak in the Dow Industrials, VIX volatility has increased further -- to a range of 20 to 25.

Should the VIX increase to 30 or higher, which I believe it will, then the situation will begin to mirror the panic days of October 1987. That's when you should expect the pricing-value of these widely used option models to blow up. When the models blow up, so will the balance sheets of many of the large institutions that are heavily involved in options trading. The leverage is there, the only remaining mystery involves naming names. That will follow.

Global derivative contracts are estimated at
around $58.4 trillion, which, he reports,
is nearly twice the world gross domestic
product. A loss of 2% of the contract
value would be, he reckons, roughly equal
to the total capital of all the world's banks.

Citing an article by British securities analyst Andrew Smithers, Alan Abelson explains model risk in different terms in the April 14th issue of Barron's: "The [option] investor can lay off his risk only if someone assumes it. The someone happens to be the banks that deal in options. A key question in Andrew's mind is whether the banks are charging enough to assume that risk. Since the future is unknowable, he observes, the only reasonable guide to whether or not options are adequately priced is the past. But that raises a second problem: What is an accurate measure of past experience? If you take as a guide the past 10 years, a period marked by mostly booming stock markets, then prices of market options are reasonable. But, if you take the past 30 years, which included much more varied kinds of stock markets, then options, Andrew insists, are much too cheap. 'The relative youth of the traders has been the subject of widespread comment,' Andrew comments shrewdly, 'but it is the relative youth of the databases which poses the more serious problem.' Global derivative contracts are estimated at around $58.4 trillion, which, he reports, is nearly twice the world gross domestic product. A loss of 2% of the contract value would be, he reckons, roughly equal to the total capital of all the world's banks. Studies of this global banking exposure, Andrew recounts, have sought to reassure us Nervous Nellies by arguing that banks run matched books. Snorts Andrew: 'if this means that bank profits will not be hit by a stock-market crash, this borders on the incredible."

While leverage is excessive, and thus troubling, in traditional measures (such as NYSE margin debt), the greatest leverage, by far, is in new types of financial derivatives. At the time of the 1987 stock market crash, many of these derivatives were either just beginning to be used or had not yet been invented. Now, their open interest stands at staggering levels. Derivatives permeate the investment scene. It remains to be seen how this massive leveraging will affect the stock market in a severe downturn. Because of inadequate volatility assumptions, I expect derivatives to accentuate the crash once it begins. The end result is likely to be a crash of historic proportions -- sending the Dow Industrials to 3000 or lower before the end of May. We shall soon find out.


It's the stock market and the economy that makes the President, not the other way around. That's the theme in Robert Prechter's March 27, 1997 issue of The Elliott Wave Theorist (P.O. Box 1618, Gainesville, GA 30503). Prechter made this bold prediction: "On the exact day of the March 11 [stock market] high, the Senate shocked reporters. The next morning, front page articles exclaimed, 'in an abrupt change of course, the Senate on Tuesday unanimously approved a much broader investigation into the White House and Congressional fund-raising practices.' The Senate's abrupt change of mind, we believe, mirrored an equally abrupt shift insocial mood from long term bull to bear. Clinton has suddenly come under fire from liberal journalists, some of whom are beginning to say that they have had enough and are 'bailing out.' Evidence that mood change is the primary force behind the shift is that the Clintons' latest apparent crime isn't on the scale of misusing Federally insured funds, employing drug users at the White House, laundering money in a commodities account, using FBI and IRS files illegally, demanding sexual favors from employees, or even obstructing investigations of dead bodies in the park. It is just influence-peddling and lying about it (i.e., business as usual in Little Rock and Washington D.C.). The ultimate result may be like getting Al Capone for tax evasion: It's the least of his suspected crimes but the only thing authorities will be able to prove. Just watch how Clinton's 'Teflon' of the past four years changes to Velcro when the stock market begins dropping in earnest. Because of the degree of the emerging shift in social mood, we continue to believe that Clinton's approval rating, which, remember, was at an all-time high in January, the month the NASDAQ index peaked, will ultimately fall to nonexistent and that he will not serve his full term."

Always remember that investing usually has a strong social component. In the present case, friends, neighbors, and relatives telling each other of their success with mutual-funds has been a powerful influence during the bull market of the 1990s. Newspaper articles and the majority of investment advisors have reinforced the belief in mutual funds. During the past couple of years, that belief has been focused on equity mutualfunds.

The Federal Reserve, headed by Alan Greenspan, provided an easy-credit environment for anyone who wanted a loan during the 1990s. One way or another, either directly or indirectly, much of the money borrowed during the 1990s found its way into the stock market.

History shows that once a financial mania collapses, the public seeks out scapegoats. The scapegoats are typically the leaders of the mania.

During 1720, angry mobs chased John Law out of France after the Mississippi Bubble collapsed. After the 1929 crash, the two public leaders of the bull market -- Charles Mitchell (president of National City Bank) and Richard Whitney (president of the New York Stock Exchange) - were both sentenced to prison. After the 1980 silver crash, Bunker Hunt, reported to be the wealthiest man in America, declared bankruptcy a few years later. After the 1990 collapse of the junk-bond market, junk-bond king, Michael Milken, spent time in prison. The list goes on and on.

In the present case, President Clinton and Alan Greenspan are the obvious leaders, and, hence, the most likely scapegoats. Expect public outrage to be directed toward these two individuals once the crash unfolds.


My new book revolves around the theme of a total collapse of our financial system and our government. In the March 24th issue of The Intemational Harry Schultz Letter, (P.O. Box 622, CH-1001 Lausanne, Switzerland), Schultz discusses a recent total collapse overseas, and questions about the possibility here. Schultz wrote: "A government (Albania) was brought down because a nationwide investment plan collapsed and many lost their life savings. Could it happen in the West? ...

Look at these facts: People in every nation are heavily into mutual funds and unit trusts. In the US, many millions have their life savings socked into mutual funds. [in recent years] Americans are fast to complain, emotional, and less stoic.... When the selling hits the fan and the mutual-fund bubble bursts, and tens of millions are wiped out or lose oniv 50%, will Americans do nothing? ... Will Americans hire their eager and able lawyers to represent them in the mother of all class action suits for compensation? ... Is that impossible? Or likely? This isn't 1929 when people took responsibility for their actions. Today it's always someone else's fault."

The seeds for a total collapse in the United States are greater than ever. Not only do Americans fail to accept responsibility as they should, the whole structure of the US economy is heavily indebted. Once the crash begins, the credit-worthiness of individuals, corporations, and even the US government will become hot topics. And without new credit, all of these sectors will collapse economically.


The expected stock market crash is progressing almost exactly as outlined in last month's letter. Because all of the great market crashes of the past have had similar topping patterns, I have been predicting that the bull market of the 1990s would peak, and then crash, in a similar fashion. That's not just a hunch. It's an observation based on patterns of crowd psychology and knowledge of the mental anguish involved whenspeculators face repeated margin calls.

Some margin calls have already been issued. However, the number has been relatively small up to this point. It will take a decline below Dow 6350 to trigger a volume of margin calls significant enough to precipitate panic on Wall Street.

The Dow Industrials all-time high occurred on March 11th at 7085. A 10% downward move then took the Dow to 6392 on April 11th. The following Monday, April 14th, the Dow sank to 6350 during the morning before making a nice comeback and closing higher in the afternoon. Right now, the final rally of the topping process is in progress. If history repeats, that rally should last 5-to-7 trading days. Hence, the final rally should stall out on either April 18th, April 21st, or April 22nd. Then the crash should begin.

There are several indicators worth watching during this final rally. Here is - what I'd expect: The number of advancing issues will barely beat out the number of declining issues (that is, market breadth will be poor), call option volume should remain high relative to put option volume (as it has during the past two weeks), bond market and utility stock strength during the rally should be either non-existent or lackluster, NYSE volume should be relatively low. During this rally, the Dow Industrials could easily advance to the 6600-to-6800 range.

Also, as a market mania traces out a top during the typical six-week topping pattern, some subcomponents of the market often record an all time high six weeks after the primary peak.

In 1929, the primary peak was the first trading day of September. However, during mid October 1929, when other stocks had been beaten up, the Dow Utilities were still very close to their record high. Then all stocks crashed during the last two weeks of October 1929.

For the precious metals in 1980, the primary peak occurred on January 21st -- when gold and silver made their all-time highs. Platinum, however, recorded its peak price six weeks later - during the early days of March. Then, all three of the precious metals crashed for the remainder of March 1980.

In 1987, the primary peak took place during late August. By early October, however, the NASDAQ 0-T-C Index came all the way back up to its August high to form a double-top. Then, all stocks collapsed for the next two weeks.

This time, the Dow Transports are the component of the market showing superior strength during the debacle. The Transports are so close to their record high that it appears likely that they will do so. When it does, the bulls (as they have done in the past) will cling to this divergent high as proof that the market is strong. The high mark for the Dow Transports is 2470. If and when the Transports exceed that mark, use it as a powerful divergent sell-signal, not as a positive signal -- as the bulls are sure to claim.

The behavior of the next decline, however, is more important than any other indicator. By the end of April (or the first day or two of May at the latest), the Dow should break below the recent support established in the 6350-to-6400 range. When that happens, the decline will have enough momentum to develop into a full-scale panic similar to prior crashes.


Because stocks are more over-valued now than any other time in history, and because the amount of leverage involved is unprecedented, the percentage losses should be greater than either 1929 or 1987. Expect the Dow Industrials to fall to 3000 or lower before finding a temporary bottom. And look for the debacle to take place in the relatively short time-span of 2 to 3 weeks.


During the past three weeks, the bears have again clobbered gold and silver. The reason given for the most recent sell-off is the Fed's tough stance against inflation. Hence, inflation hedgers have been getting rid of the precious metals.

Furthermore, as the stock market began to recover some of its losses on April 14th and 15th, the precious metal sell-off intensified. To gold and silver investors, years of repeated down-trends have discouraged them to the point where not too many even care about the precious metals anymore.

However, my argument for owning gold and silver has little to do with inflation. During the past 15 years, the Federal Reserve has fueled inflation through massive credit to the financial markets. Much of that paper is about to go bad. Credit difficulties and bankruptcies continue to rise to new records.

Ownership of gold and silver is a vote of collapsing no confidence in the present financial system. It's an action that involves the removal of money out of a system and into time-tested money (gold and silver). It will take a full fledged financial panic to finally turn the precious metals around. But it will happen.


A combination of factors are working to intensify the selling pressure that began over one month ago. These factors include over-valuation, excessive leveraging, derivative risk, margin calls, a changing social mood, and declining confidence. Now, one factor feeds on the other, creating a "snowball effect."

Selling pressure builds with each passing day. Soon, this pressure will reach the bursting point. Then, panic will spread. Stocks will crash. And a "run on the mutual funds" will spring, up overnight.

For the majority of investors, hope remains. But, it's wearing thin. The securities industry mantras of Buy all dips and Hold for the long-term are soon to be discredited. As any bull market makes the transformation to a bear market, hope always turns to fear. As a nation, we are very close to that critical point.

When the Dow Industrials break below the April 11th closing low of 6392, it will signal confirmation of the beginning of the panic-phase of the expected crash. Watch closely. Once the 6350-to-6400 support area is penetrated to the downside, a tremendous crash to 3000 or lower should follow within 10 to 15 trading days.

Put options and modest amounts of short positions on stock indices are recommended. Otherwise, hold 100% of your assets in money external to the collapsing global financial system -- that is: fiercely hold onto gold and silver coins.

If the Dow Industrials close over 7085, the crash pattern is aborted. The Dow must start moving sharply lower during the next 3 days to get back on course. During the past 2 weeks, the Dow has rallied 8.9%, however, the advance-decline line (for the NYSE, OTC, Amex, and Bonds) has gone nowhere -- a very bearish divergence that has always preceded downturns in the Dow Industrials in the past. The advance-decline line is one of the important indicators that expose the narrowness and the fragileness of the recent upmove. Watch closely the next few days.

  Sirens screech. Horns blow. Whistles tweet. This is a full-scale crash alert!

Gold is still being mined and refined at the rate of almost 2,600 tonnes per year.
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