Thursday, October 9, 2008

Lehman CDS Pricing on Friday

It appears that today’s collapse was the result of fear over who has exposure to the Lehman Credit Default Swaps (which settle tomorrow (Friday).

Here is the timeline for how the settlement will play out tomorrow (Friday) –

What is means in English is the companies which sold insurance policies on the bonds of Lehman Brothers will know how much they will have to pay up tomorrow. $400 billion in Credit Default Swaps were written on Lehman Bonds! The fear is that the companies who sold the insurance will not have the money to pay up on October 21st. That would lead to several companies potentially going out of business this month and then all kinds of new risks enter the system.

I would not be surprised to see the tradable bottom show up tomorrow as the news of the Lehman CDS pricing evolves tomorrow. I will be looking for a capitulation tomorrow morning. If it shows up, then I may put some money to work. If it does not show up, then I stay in cash and wait for Monday…

970 Broke, Leading to Another Leg Down

I noted the following yesterday –

“The S&P tried to find support the last two days at 970. That level had better hold, or the markets will start yet another leg down”

Here is the chart from yesterday, updated for today’s action. 970 got taken out and the S&P 500 did a nosedive into the close, falling about 60 points (-6.2%) in the last 90 minutes of trading.

I also noted the following yesterday –

“Sellers continue to swamp buyers and the markets continue to sell off hard into the close each day as mutual funds sell to cover what are no doubt massive redemptions.”

This is classic Bear Market action. I think we are in the “capitulation” stage, where people wake up at night in cold sweats and sell because they just can’t take it any more. The last few days of selling are always nose dives. So it can be so very costly if you are even just a few days early. That is why I want to only buy on a low risk set up.

You will not want to buy at the end of a Bear Market or a selling panic. It is human nature. My goal with this blog is to get a continuous commentary going to let you know how the markets evolve and how those internal changes in the markets will tell you when it is time to be buying and not selling.

As the markets were topping last year, I went through the changes with clients in great detail and we were able to take defensive measures to protect capital. Some chose not to sell. I am sure that they will listen next time...

I can now buy the markets at a 37% discount to a year ago. Are you kidding me? Those who raised cash in late 2007 and the first half of 2008 are now years ahead of the game. Those who didn’t may have to delay retirement for a few years.

I think people grasp onto the “buy and hold” mantra because they have not found how to determine when it is time to be buying and time to be selling. Just as the markets gave a lot of clues as they topped, they will also give lots of clues as they bottom. My goal is to keep you informed, so that you are interested in buying what big money is buying, even though the idiots on TV are telling you to sell – just as they were telling you to buy the first 4,000 points down on the Dow! Remember, “Buy low and sell high”.

I did zero trades today. Then I went home and took a long nap. I am exhausted. Interpreting this intra-day volatility is hard work. Even with the hard work, I may still miss the low and not be able to trade whatever bounce we get. My concern now is that the next rally may only carry up to 970 on the S&P 500.

Wednesday, October 8, 2008

This Bear Market is of Epic Proportions

I figured that we had a decent chance of a crash on Monday, but this is getting ridiculous.

I only have reliable charts back to 1980, but I can tell you that since 1980, there are only 3 occasions where the markets got to this level of extreme selling – October 1987, July 2002 and this crash.

Today, the markets had an excuse to rally, with several Central Banks cutting interest rates over night and Wal-Mart being less bearish than expected, but the markets cut through support like it wasn’t even there. Sellers continue to swamp buyers and the markets continue to sell off hard into the close each day as mutual funds sell to cover what are no doubt massive redemptions.

Here is the market today

Here is The Crash of 1987

As you can see, The Crash stopped below the -25% band (Black Line). I have no clue where the market bottoms on this leg down. Anybody who tells you they know where things will bottom is making it up and you don’t need to bother listening to that nonsense.

But I can use past market moves to see how the market reacted once the selling stopped. In 1987, the S&P 500 fell below -25%, reversed for a few days, then retested the -25% band (2nd Black Arrow), then rallied back to the -15% band (Blue Arrow), then retested the -25% band again, before reverting back into the Mean (Green Arrow).

So the odds are high that after this selling panic stops, the markets will rally and then retest the lows for a while before they make their move back into the Green Line.

The same thing occurred in late 2002, as the S&P 500 spiked below -25%, then rallied, retested the Bear Market Low of July (Red Arrow), then tested the Green Line on several occasions, retested the July and October 2002 lows one more time in March 2003 (Red Arrow) and then started a new Bull Market.

The 1987 bottom took several weeks and the 2002 bottom took over 8 months to form. So I expect this market to see a bottom form over time. There might be a HUGE short term rally once the bottom is reached, but there will most likely be a retest of the lows after this rally.

The other issue I have noticed is that while the market was in these bottoming processes, the Green Line was falling. So when the market finally does revert back into the Mean, the Mean will be a lot lower than it is today. In 1987, the Mean fell 11.5% from the day the market bottomed, until the day the market finally touched the Green Line again.

Today, the Green Line is at 1300. 1300! While the S&P 500 is at 986…
It is just a guess, but my guess is that price and the Green Line end up meeting in the 1150 – 1200 range.

I expect the next rally to be highly shortable.

Today I moved some of my 401k money from cash into the S&P 500 Index Fund. I did not buy a share of anything for my clients. I did the 401k purchase, because I can only buy mutual funds at the close and it is more profitable to be a day early than it is to buy at the end of the day of the bottom.
The S&P tried to find support the last two days at 970. That level had better hold, or the markets will start yet another leg down. IF 970 holds, then I will consider buying it, because the first real resistance is at 1100. That is 14.4% from 970. If 970 fails, then I will wait for the market to try and build a bottom at some lower level and then look to buy a reliable set up.

Did I mention that 976 is the -25% band on the S&P 500 and 1103 is the -15% band? You can’t make this stuff up.

One of these bottoms is going to work. I’m just not sure which one. But I have to treat every attempt with the potential to be a bottom. I hope the bottom arrives soon, because I am exhausted.
The charts of the NASDAQ and the Dow Jones both have similar potential bottoms to the S&P 500. They will most likely all bottom in unison.

Sunday, October 5, 2008

Potential Bear Market Rally Near

There are two absolutes in the markets –

Emotions will take prices to irrational extremes
Prices always revert back to the mean

Over the years, I have discovered that irrational extremes are quantifiable on a pretty consistent basis. If you can identify likely extremes to which prices normally go in times of extreme emotion, you can put yourself in a position to be making decisions at high probability turning points. This can prove to be very valuable.

I want to define a couple of things before I get into detailed analysis of where we are in relation to what has occurred in the past.

The Mean in statistical terms, is the average of a set of numbers. For the markets, I use the average value for the last 30 weeks. If you plot this average every week on the chart, you get what is called the 30-week moving average (Green Line).

Over time, price moves back to the 30-week moving average, or “reverts” back to the mean.

You can quantify the emotional over-reactions as price moves a specific percentage away from the 30-week moving average. Historically, in a panic, prices move 15% or even 20% below the 30-week average. That range of 15-20% below the 30-week average tends to be a very good place from which to look for reversals up in stock price.

If you haven’t yet figured it out, I love managing money. I love the combination of mathematics, emotions and psychology. Knowledge gives me an edge and an intense work ethic allows me to build up an extensive knowledge of historical price movement. Moreover, it is of paramount importance to know how to protect assets when risk increases and opportunity diminishes.

Again, I made it real clear in early 2008 that we were now in a Bear Market for stock markets. I went on defense. My gameplan shifted from buying dips to shorting rallies. It has proven to be very successful this year.

Using the last 12 year of market activity, I figured that I would get chances to buy stocks on extreme moves down in price. I even sent the following chart to clients on several occasions to give them insight into how I was making decisions.

In 1998, the markets were in turmoil as the Long Term Capital hedge fund got over-leveraged and collapsed. This caused a meltdown in the derivative markets and the markets crashed. This panic only took the S&P 500 15% below (Blue Line) its mean (Yellow Arrow).

The Bear Market from 2000-2003 saw the markets fall to 20% below the mean on several occasions (Black Arrows). The markets did not have a weekly close below the Red Line, so any selloff below those levels was immediately rewarded if bought.

In early 2008 (Green Arrow), the markets again were stretched to the Blue Line. At the time I had to analyze the markets and determine if we were replaying 1998, and would rally to new highs, or replaying something similar to 2000-2003 and would find the markets at much lower prices over the next year or two. I thought we were replaying the 2000-2003 market and chose to short the early 2008 rally. History has proven me to be right.

I have expressed a lot of frustration during this Bear Market of not being able to buy extreme moves in price. This is because we have not yet seen the markets get to the Blue Line. Every time the markets get close to cracking, the Fed steps in with some new intervention scheme and the markets bounce a little and I am unable to get a decent risk reward to buy any bounce.

Rallies from this extreme condition have proven to be very profitable. During the 2000-2003 Bear Market, there were four such rallies (Black Arrows) -

Low Date High Date Low Price High Price Return
3/19/2002 5/21/2001 1081 1315 21.6%
9/17/2001 12/03/2001 944 1173 24.3%
7/22/2002 8/19/2002 775 965 24.5%
10/07/2002 12/02/2002 768 954 24.2%

The returns are uniform, because the market tends to rally from 20% below Mean, and then rallies to a few percentage points above the Mean before topping and starting another leg down.

I took a look at the daily charts of each of these legs down and what I noticed was that the trends accelerated down into the lows as panic selling took hold and people sold out at any price.

Final Selloff Numbers (all daily measures are trading days, not calendar days)
Start Price Bottom Duration Loss
1. 1260 1080 10 Days -14.3%
2. 1130 944 8 Days -16.4%
3. 990 775 12 Days -21.7%
4. 850 770 7 Days -9.4%

Amazingly enough, the top of this current leg down is 1265.12 and Monday will be Day 10 of the crash. That is 5 points from the top of the first crash in 2001. I would not be surprised to see the price decline stop between 1080 and 1040 in the next few days.

Sentiment, Momentum and Market Internals
When I start to hear guys like Jim Cramer who have been wrong the whole way down tell me how to play the next 3,000 point drop, I recognize that sentiment may have changed and I may get a chance to buy an extreme selloff in stocks for a bounce that very few are expecting.

Here is a chart of the S&P 500 with several indicators to show just how extreme the current price move is when compared to normal market conditions –

The Top Box is the price of the S&P 500

The Second Box shows the Bullish Percent Indicator ($BPSPX). This indicator measures the percent of stock which are in uptrends. A reading at or below 20 has been seen on 5 occasions in the past 11 years. It has proven to be a good to buy stocks.

The Third Box shows momentum (RSI (14)). Think of momentum as the strength of the trend. A reading below 30 indicates that there is incredibly strong selling - think panic. This low reading has occurred 5 times in 11 years.

The Fourth Box measures volatility in options contracts ($VIX). Think of this as the price of insurance on stocks. The higher the reading, the more people are willing to pay to insure their stock portfolios. So an extremely high reading indicates panic by market participants. An extreme reading of over 40 has occurred only 5 times in 11 years.

So all the things I look for at a tradable bottom in a Bear Market are lining up. I am seeing panic, broad-based selling. I am seeing panic activity in the options market and the perma-bulls have thrown in the towel.

I will come out with a list of potential set ups in the next few days. For the first time in 10 months, I want in.