Wednesday, July 28, 2010

S(tuff) Off The Bottom

The general rule is that when the laggards stop falling, the markets can bounce. Laggards have been Retail, Housing, Energy, Financials, Materials and Biotech to name a few. The junk has bounced and now we are entering another one of those times for a potential reversal of trend.

A move above 1,130 by SPX sets up another one of those triangle patterns that have worked so well in Energy in June and SPX in July. SPX is now about 2% below that 1,130 -1,140 zone. The key over the next few days is a pop into the 1,130 – 1,140 range for SPX.

If the SPX consolidates in this 1094 – 1115 zone for the next 5-8 days and works off any Short Term -Overbought condition, then it is possible that the SPX could trade higher into the Sept period before a significant reversal, but that is the least likely scenario.

The potential reversal pattern is setting up for the S&P 500, Dow Jones Industrial Average, S&P Mid Cap 400, Russell 2000 Small Cap indexes. It has already set up for Transports (IYT), Materials (IYM), REITs (IYR) and Consumer Staples.

GE, JPMorgan and Wells Fargo also have the setup forming.

I am not telling you that the market has topped. I am not telling you to go sell or short a bunch of anything. I am simply showing you what I see and what I look for.

Here is resistance and support, with key dates on the S&P 500 Futures. Resistance clusters in the 1,122 – 1,134 range.

I mentioned a few weeks ago that it looked like Gold was topping. Gold, Gold Stocks and Silver have all had a rough few days, but Gold is now into support ranging from 1,156 – 1,133. Maybe we are setting up for a Long Gold/ Short Stocks trade. We’ll see how things turn out.

European "Stress Test", Basel III and Euribor

We all know by now that the European “Stress Test” was a scam of the highest order. This is obvious because a few days after the release of the “results”, the Basel III Accord was rewritten to lower the capital requirements for banks.

No Sovereign Debt Default Calculations
First, the entire reason for fear in the European Banks was exposure by the banks to the debts of countries who may default. So the stress test did not take into consideration the possibility that a country could default. Sovereign Debt was not even used in the calculations of the Stress Test. Amazing…

Clearly if the Stress Test affirmed the fact that a Euro Country could default, then the Euro is by definition defunct. So we all pretend that they are infinitely solvent… until the next crisis arises.

Hold to Maturity at Par

Have you ever wondered why banks are so reluctant to foreclose on properties? It is because the rules were rewritten last year so that a bank would not have to realize a loss on a Mortgage Bond until there was a material event like a foreclosure that forced them to do so.

The rules made it so that the banks can price nonperforming loans at 100% of their maturity value as long as they can expect these Mortgages to one day get repaid. This was the whole “Marked to Market” pricing discussion of last year. The banks use these mispriced Mortgage Bonds in their calculations for how much “Capital” they have and for how much they can pay out in bonuses. The higher the values, the higher the bonuses and the less Capital the banks need to go raise through stock and bond offerings.

These accounting rule changes have allowed banks to lower the reserves they have to keep for nonperforming loans. The decrease in these reserves are added directly to the Net Income the banks show at the end of each Quarter and have been used to pad their Earnings numbers.

It Gets Better
The series of Basel Accords were put in place to standardize the rules and laws of international banking, focusing a significant amount of time on accounting practices and Capital Requirements. The Basel III Accord was set to increase Capital requirements by the end of 2012 and the banks were terrified that it would force them to raise more Capital and lower their Profits, by lowering their leverage – with the definition of leverage being how many times you can relend the same Dollar over and over and over again.

The European Stress Test was run with the assumption that the net Capital Banks needed to hold would have to be 6% of the value of their good assets (Level I). Under this test, 7 banks failed. However, under the new Basel III rules, the minimum requirement for banks would have been 8% and under that standard, 39 European Banks would have failed the “Stress Test”.

If the rules had gone unchanged, then the estimate from Credit Suisse is that European Banks would have to raise another $1.3 trillion in new Capital. That money simply does not exist. So the rules were rewritten and released yesterday to great Bullish fanfare on the stock exchanges.

Capital Ratio Requirements were lowered, some down to 3%. More assets are now going to be allowed to move “Off Balance Sheet” (think Enron) to Level II and Level III. And the newly watered down, but stricter Net Capital Requirements will not go into effect until at least 2018.
Remember how Lehman actually failed?
One day, one of the banks Lehman was borrowing money from came back to Lehman and told them that the Collateral Lehman gave them was not worth enough to back the loan. Lehman came back to the bank and told them that they had no more Collateral of any value. The bank pulled the loan, word got out that Lehman had no more Collateral of value and 4 days later, Lehman was out of business.

The same thing is going on again. Banks are reluctant to lend to one another because they know that the bank that is borrowing from them is lying about the value of their collateral they would use to back the loan. So very little lending is getting done.

You can see this via the Euribor Rate (the Interest Rate at which European Banks lend to one another). The 3-month Euribor has continued to climb, even after the stress test results were released. My fear is that banks know the guys on the other side of the loan are insolvent and that they will one day not be able to repay their loans with mispriced Collateral.

The same thing is happening here. New home starts are at their lowest level since 1963 (when the data started). There are over 18 million vacant homes in the USA (versus 111 million households). 51 million of those homes currently have mortgages on them. How many of those mortgages are underwater and how many are delinquent?

What happens if there is another leg down in Real Estate prices? Asset prices have fallen substantially and the economy seemed to grind to a halt once the Fed’s Quantitative Easing program ended in March. The prospect of another leg down in housing prices (and Commercial Real Estate for that matter) has Bernanke talking about another round of Quantitative Easing. I think it is a given that it will occur and that the markets are currently vacillating between the fear that it won’t (Europe says they won’t do it) and the hope that they will (Bernanke’s testimony last week).