Thursday, October 16, 2008

Follow Through Day, Warts and All

Today we got what may have been a successful retest of last Friday's lows. The markets rallied and finished up on decent volume, so the big boys may have been spending some money today.

My big concerns are that the markets started rallying off the lows on the back of a rumor (Microsoft is looking at buying Yahoo again...). My other big concern is that tomorrow is options expiration and the Fed has been very active in goosing the markets on the Thrusday and Friday of options expiration week.

In 1929, the markets rallied for 2 days, then cracked for a few days, then rallied for a day of two and then tanked hard for a few more days. The action after the market crash in 1987 was similar. So we may just bounce tomorrow and sell off again.

I think whatever rally we get is not the end of the Bear Market. Stocks will need a lot of time to repair. It normally takes about 9 months of test and retesting a low before a new Bull Market starts.

I am most interested in the areas which benefit most from a rapid decline in systemic risk as the Lehman CDS drama settles next week. The safe havens during this panic has been the US Dollar, the Japanese Yen and short-term US Treasuries. They have benefitted as investors have sold the Euro, Commodities, Emerging Markets and Corporate Bonds.

I am not sure that a tradable low is in, but I now have definable levels of risk here. I may get stopped out of what I buy as early as tomorrow. But I will try and start to scale into positions tomorrow. I am looking to trade only. I do not expect to take any positions that I buy in October into 2009.

Wednesday, October 15, 2008

The Derivative Endgame

I think the end game is for the remaining 9 banks with big derivative exposure -

Suntrust
PNC
Northern Trust
Keycorp
National City
US Bank
Regions
BB&T
Fifth Third

Is for them to be taken over by the large banks to which the Central Banks of the World are giving cash -

JPMorgan/Chase/Bear Stearns
Bank of America/Merrill Lynch/LaSalle
Citibank/Smith Barney
Wells Fargo/Wachovia
HSBC
Bank of New York/Mellon
RBS/Citizens
Mitsubishi/Morgan Stanley/Union Bank
UBS/Paine Webber
Barclays/Lehman Brothers
Deutsche Bank
Credit Suisse
Goldman Sachs

I’ve spent a lot of time letting my mind wander on this topic and I think this is the Grand Strategy.

The goal of the Fed is to move all of the credit derivative exposure into a handful of banks (about a dozen). Once they get the derivatives all gathered up, they are going to sit down with the banks and start figuring out how to zero out derivative positions.

Think of it like a giant game of “Go Fish”, where everybody shows their cards – “you have a two and a three? I have a two and a three. I’ll trade you a two for your three…”

But it will be “you have risk on Bank A’s Bonds? I bought the insurance from you on Bank A’s bonds. I have risk on Bank B’s bonds because you bought the insurance on Bank B from me. I’ll trade you my insurance on Bank A for your insurance on Bank B and we can zero out the risk of both positions.”

The Fed will make up the difference to make sure that both parties have no net economic loss from the removal of derivative risk from the system. The banks are being compelled to do this, because the only way they can win is to play and get the Fed to cover your losses.

So Step One is to consolidate all the derivatives into a manageable number of banks.
Step Two is to zero out derivative losses and gains across these banks.
Step Three should go something like this –

Once the banks have removed the easy leverage in Step 2, their risk will then be in their portfolios of loans.

Think about all the loans you have. Each one may be with a different bank – 1st Mortgage, 2nd Mortgage, HELOC, Car Loan A, Car Loan B, Credit Card A, Credit Card B, Student Loan, other consumer loans…

I think Step 3 is to have the banks rip apart all the securitized debt instruments they issued and then reconstruct the credit picture for each individual (very Orwellian). These banks will trade pieces amongst one another to allow each bank to own all the debts of one person. The bank will then have the capability to go to the individual and offer them a standard rate on all their debt, which will be low enough to allow them to pay off all their debts over the next 30 years.

The people will feel like they have been saved!
The banks will make a fortune!!
The taxpayer will bankroll the whole thing and get back half or less of all the money paid in.

Actually, the taxpayer won’t get anything but a $4 trillion bill, because you know damn well that whatever money the government gets back from the banks will be spent by the government and not returned to the tax payer or used to pay down the soon to be $12 trillion National Debt.

Let’s see how it plays out, but those are my thoughts.

My guess is that we rally beginning on or about October 21st and then sell off again at some point in Early 2009. That sell off will be the point when the 9 remaining banks are taken over by The Chosen Banks. I may have to start buying banks on that last round of consolidation. We will see.

I’d love some feedback on this. Post a reply or email me at nbcharts@yahoo.com

That Was a Nasty Day

On Monday the markets had enormous rallies and I wrote the following post –

http://nbcharts.blogspot.com/2008/10/i-cant-find-crash-without-retest.html

In the post I looked at the Crashes of 1929, 1946, 1987, 2001, 2001, 2002 and 2002 and came to this conclusion –

“The biggest rallies have come in Bear Markets. Bear Market rallies make you feel good, scare you about being in cash, suck you in and then crush you. Buyer Beware!! (Gary Kaltbaum taught me this)
I actually started shorting some this afternoon. I expect a retest of Friday's lows.
I can't find a crash that didn't have a retest!”

“I am not interested in buying a spike down, and I am not interested in buying a spike up. I want to wait for a decent entry point, with definite risk.”

“The most painful scenario right now is a sharp selloff to retrace some of the massive gains of the last few hours of trading.
That would be enough to scare some more people into selling their stock before a more meaningful rally. Remember, the average rally from these emotional extremes is 24% over 8 weeks.”

“History tells me that there will be a retest of the recent lows, or at least a decent retracement of the first rally off the lows. It is at that time that I will be able to determine if I should be buying and how much risk I may be taking.”

I covered my shorts today when the Dow was down about 550 points. I am no longer interested in shorting.

A two-day moonshot up into the 10-day moving average, followed by an implosion. That was the expected action and that is what occurred.

This is not rocket science. I simply looked at how the markets reacted at the last emotional extremes and stated that I expected the same to occur on this crash.

I am not brilliant. I JUST DID MY HOMEWORK!!

I am WAY ahead of the markets this year and that allows me to be patient and wait for the low-risk entry points.

I am now going to do a lot of homework and try and figure out how to participate in the rally that I feel is going to show up in the not too distant future.

Now let’s see if the markets give me a Follow Through Day

http://www.investors.com/yahoofinance/2006w24/storyC03.asp

Tuesday, October 14, 2008

Final Lehman CDS Settlement on October 21

It is becoming clear to me what is going on with $700 billion TARP/Paulson Plan. It has nothing do with mortgages, “distressed assets”, home owners, small businesses, LIBOR, Treasury Yields, “Main Street” or any other canard the media tries to throw up.

What it is about is that governments are terrified that banks are overleveraged in derivatives. They see the settlement of the Lehman Brothers Credit Default Swaps (CDS) on October 21 as a potential back-breaker for the banking system. You can review the Lehman CDS pricing here –

http://nbcharts.blogspot.com/2008/10/lehman-cds-settlement-on-friday.html

The estimates are that the settlement of all Lehman CDS could cost $300 billion for the banks who wrote the insurance.

Here is a list of the 25 largest players in the Derivative Market. Lehman was #25! If the #25 going under costs $300 billion then what would happen if JPMorgan, with 3,250 times the exposure of Lehman were to go under?


Look at how the money being given to banks will be disbursed –

$25 billion each to – JPMorgan (ranked #1), Bank of America (#2), Citibank (#3), Wells Fargo/Wachovia (#4)
$2.5 billion each to – Bank of New York (#6) and State Street (#7)

$10 billion each to – Goldman Sachs (Hank Paulson’s company) and Morgan Stanley

#5 HSBC is getting handed a big pile of money by the UK government

The entire process of bank consolidation the last 18 months has been designed to manage the impact of derivative losses on the banking system.

JPMorgan (#1) bought Bear Sterns (former #5 on the list), because they would have taken a $30 billion hit if Bear went under

Bank of America (#2) has now bought Merrill Lynch (# 18) and Lasalle (#22)
Wells Fargo (#6) bought Wachovia (#4) and the other bidder for Wachovia was Citibank (#3)

Bank of New York (#7) bought Mellon (#12)

RBS (#19) has been nationalize by the UK
Deutsche Bank (#24) has been bailed out by Germany
UBS (#23) will get some cash from Switzerland
Union Bank (#21) was bought by Mitsubishi – gee, that name sounds familiar…

This leaves but a few stragglers –
Suntrust (#9), PNC Financial (#10), Northern Trust (#11), Keycorp (#13), National City (#14), US Bank (#15), Regions Bank (#16), BB&T (#17) and Fifth Third (#20)

I am not sure whether or not they will survive, but my guess is that these banks will not be bought out at premiums.

Then there is that little company called AIG which wrote the most CDS insurance. The initial bailout for AIG was $87 billion. Then last week, the Fed announced another infusion of $25 billion. My guess is that the government is funding AIG to make sure that they are able to make good on the CDS insurance they wrote. If AIG did not pay, then I am all but certain that several banks and hedge funds would become insolvent and that would lead to more problems in the financial system.

No doubt Morgan and Goldman are being given the money to cover any losses sustained by the hedge funds with which they trade. I am not sure if the Fed gave the money to the other banks to help them cover CDS insurance they wrote, or to cover them if some of the banks which sold them CDS insurance will not be able to pay.

So October 21 is the key date. If things don’t blow up, then we may be okay for a while. I am going to operate under the assumption that the best buying opportunity will a retest of last week’s lows between now and October 21.

Monday, October 13, 2008

I Can't Find a Crash without a Retest

For those of you who have been fully, or even partially invested the entire way down, I am sincerely happy that you were able to make back some serious money the last few days.

That said, there was plenty of evidence in 2007 and early 2008 to tell you that it was time to get out of stocks and protect the hard-earned gains of the 2003-2007 Bull Market.

The biggest rallies have come in Bear Markets. Bear Market rallies make you feel good, scare you about being in cash, suck you in and then crush you. Buyer Beware!!

I actually started shorting some this afternoon. I expect a retest of Friday's lows.
I can't find a crash that didn't have a retest!
Look at the 2-day rally following the Crash in 1929. See how the market sold off and actually undercut the initial low?

The same thing happened in 1946. The Dow crashed and then put in a series of sharp rallies and retests. September - November 1946 looked like a really frustrating and unproductive time to own anything.

The Crash of 1987 looks a whole lot like the Crash of 1929. The crash was followed by a sharp, 2-day rally. Then the index tested the lows over the next week or so.
In 2001, the S&P 500 had two major selloffs (crashes). In the first (Green Box), the S&P rallied sharply for a few days and then retested the low of the crash.

In the second (Black Box), the S&P rallied for a few days and then sat around for 3 days (Black Arrow). While sitting around, price corrected 30% of the first move up, and support was easily defined for a clear stop point on any buys.
I am not interested in buying a spike down, and I am not interested in buying a spike up. I want to wait for a decent entry point, with definite risk.

There were also two crashes in 2002. The first had a 1-day pullback (Red Arrow), which retraced about half of the first-day's gains. A few days later, there was a nasty 3-day selloff which retraced a big chunk of the first rally.
After several weeks of rallying, the market rolled over and ultimately undercut the lows of July (Black Arrow). This testing and retesting is a part of the bottoming process.
My brother once told me that the markets go to the most obvious place in the most painful manner possible.
The most painful scenario right now is a sharp selloff to retrace some of the massive gains of the last few hours of trading.
That would be enough to scare some more people into selling their stock before a more meaningful rally. Remember, the average rally from these emotional extremes is 24% over 8 weeks.
This is an emotional time. The more information you have about historical precedent, the better you should be able to navigate the current market.
I think we are in a Bear Market rally of unknown price and duration. History tells me that there will be a retest of the recent lows, or at least a decent retracement of the first rally off the lows. It is at that time that I will be able to determine if I should be buying and how much risk I may be taking.
Clients know that I have been heavy in cash the last 12 months and that affords me the ability to pick my spots.

A Bad Year for the US Taxpayer

I just did the math on all the bailouts and such, to see how much the government has spent in the last 12 months to bailout the banks and the economy and the total is about $2.036 trillion..............

Bailouts -

Bear Sterns $30 billion (we will be lucky to get back 6 cents on the dollar)
AIG $85 billion
AIG part 2 (after the swanky party) $25 billion
Freddie Mac $100 billion so far
Fannie Mae $100 billion so far (the "Bazooka")
The TARP $700 billion so far (Germany's version of the TARP is $630 billion, so to match that amount on a GDP adjusted basis, the US TARP would (may) end up costing $2.7 trillion)

Assorted Loans and Credits $631 billion
Securities "loaned" to banks (and never to be seen again) $299 billion
Stimulus Package I $165 billion

For a grand total of $2.036 trillion.

Thanks Washington and Wall Street, you done good.

Here is an explaination of how the Fed "invented" all this new money -

http://www.econbrowser.com/archives/2008/10/balance_sheet_o.html

Sunday, October 12, 2008

The Casino Was Open on Friday. Now What?

On Thursday evening I wrote the following -

"I would not be surprised to see the tradable bottom show up tomorrow as the news of the Lehman CDS settlement evolves tomorrow. I will be looking for a capitulation tomorrow morning. If it shows up, then I may put some money to work."

Oh, where to begin…
On Wednesday, the S&P 500 took out 970 and tanked 130 points in about 90 minutes of trading. That’s like a point a minute or 13.4%! Brutal! That’s 53.6 years of returns in the current 3-month US Treasury…

Here’s a chart of the Dow Jones Industrial Average on Friday. Each red and black bar represents on minute of trading.
Down about 700 points in 8 minutes
Up 500 points in 8 minutes
Up about 850 points in 30 minutes
Down 450 points in 5 minutes

The casino is open! I am not interested in gambling, so I sat on my hands on Friday.

A tradable low may now be in. If it is, then I will wait for sound entry points to buy. I am not real keen on buying into this news-driven environment, especially ahead of a weekend.

The S&P 500 spiked down to the -35% level. I think it would be natural for the S&P to spike up into the last breakdown point (970), before rolling back down to retest Friday’s lows. Of course, that is on the assumption that 908 can be cleared. A successful retest is what I am interested in buying.
I am trying to carefully measure how I write the next sentence. If (IF) in the next few days, the S&P 500 takes out the lows of Friday (840) and cracks hard like it did from 970, then it is my opinion that the Fed will call a “Banking Holiday” and close the banks for a few days. During the time the banks are closed, I would expect the Fed to nationalize the banking system and offer existing shareholders of bank stocks warrants in these banks for some point in the future when they are sold back into the markets as public companies again.

I would also expect the Fed to guarantee all bank balances to convince individuals and institutions to not take their money out of the banks. We really are at that stage right now where the system is on the brink of breaking and that is why I am looking for opportunity.

On the 30-minute chart I show each 5% band (black dashed lines). The lows band (840) is -35%. The top band is -15% (1100).
For now, the S&P is merely trying to find a bottom in the 840 – 910 range. If this level holds, then I would expect the first real resistance to come in at 970 – 1020. If the 840 low holds, then we could see the rally in the S&P work its way up into the 1100 range over the next 8 weeks or so. The weaker the bounce, the worse the next leg down will be.

One thing I am always interested in is determining what is acting stronger than the overall market. Take a look at how Apple and Deere have traded the last week. Both were able to hold up rather well for the entire week, even while the S&P 500 was breaking to lower and lower lows. That is a potential positive for these two companies. I own neither and sold Apple at $184 on May 5, 2008.