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Market Wrap

Contained vs. Contagion

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One of the reasons the equity futures sold off so hard last night is because of the after-hours report that surfaced concerning the Bear Stearns (BSC) hedge funds involved in the subprime mortgage market. The fact that BSC is declaring their hedge funds that are involved in subprime mortgages as worthless or near worthless, has everyone wondering if this subprime problem is really contained or is it going to turn into some kind of contagion that takes down the big banks (and hundreds if not thousands of other funds).

There are two funds that BSC is dealing with at the moment and if they were the only ones then we could certainly say the subprime mortgages and mortgage backed securities (MBS) problems will be easily contained. But is it logical to think that BSC is the only one who owned this kind of hedge fund? I think not.

For a quick recap on the hedge funds in question, BSC had two of them, one more highly leveraged than the other. The more leveraged one is called the High-Grade Structured Credit Strategies Enhanced Leverage Fund (High Grade?) and the slightly less leveraged one is called the High Grade Structured Credit Strategies fund. On June 15th Moody's Investor Service, one of the rating agencies, downgraded some bonds that were backed by speculative subprime mortgages. This affected about $3B worth of bounds, which represents about 1% of the $400B in mortgage-backed bonds that have been issued just since 2006. Some ratings were cut to "junk" from "investment-grade". Ouch, and that requires investors like pension funds to sell them.

Selling these bonds is what forces other owners to change the valuation on their books from "mark-to-[computer] model" to "mark-to-market" and that's where the problems are cropping up. Many investors, BSC being one of them, are finding their valuations are way off the mark and they're lucky to get 10 cents on the dollar for these investments (it's an illiquid market and when there are no buyers of this toxic waste--a Wall Street name for these--the value goes to zero). And this is what has happened to the BSC funds.

The rating agencies have decided to close the barn door after the horses are long gone and somewhere in the north 40. But better late than never and they've started downgrading these MBS to take into account the fact that the foreclosure rate is at historic highs and still climbing. They've been saying they're waiting for proof of a problem before speculating on where the market might go. I guess they got their proof when BSC said their hedge funds went poof!

The bigger question of course is how the ratings agencies (Standard & Poors, Fitch Ratings and Moody's) could have ever imagined repackaging subprime mortgages, which everyone knows are inherently more risky, makes them less risky. By splitting apart the subprime mortgages into separate packages called tranches, saying some magic words over them and sprinkling them with fairy dust, they were magically transformed into AAA-rated bonds, good enough to sell to pension funds who are required by their charters to invest only in investment grade bonds. The trouble is the clock struck midnight and Cinderella's carriage just turned into a massive pumpkin. And it's sitting at the corner of Broad and Wall and starting to rot.


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So the more speculative hedge fund for BSC turned to dust and they've had to notify their investors that, well, sorry, "you know those millions of dollars you gave us? The dog ate them." When this problem came to light in June, BSC said they would inject $3.2B on their own capital to save the funds. Later reports said they had injected about $1.2B and some reports that they decided not to throw any good money after bad and just take their (or their investors') lumps.

BSC started with $638M of investor capital (now gone) and had leveraged it up to a total of $11.15B in long positions. This is 17.5:1 leverage and in the example I gave in last night's Wrap, a 20:1 leverage means the fund's value only needs to drop by 5% and the entire invested capital is wiped out. There are many many hedge funds with similarly leveraged investments in similarly risky junk bonds.

BSC's less leveraged fund had $925M and leveraged it up to $9.682B in long positions, for a much more "conservative" 10.5:1 leverage ratio. So it only took a 10% decline to wipe out investors' money. Merrill Lynch proved that kind of drop the minute they tried to sell off some of BSC's assets to get their $800M back--the best stuff wasn't even getting 90 cents on the dollar. That $800M? It's gone. Oh, my mistake, BSC says that fund is worth 9 cents on the dollar. So thanks for the $800M, here's $72M back. Have a nice day and don't forget to invest with us again!

The SEC has decided to step in now so that they can investigate how this could have happened. Helloo! Where have you been Mr. Cox (SEC Chairman)? What do we pay you for anyway? Post-event analysis? Silly me for thinking the SEC was set up to protect the investor and curtailing things like repackaging garbage, tying a pretty bow on it and calling it investment grade material. A pig in lipstick is still a pig. And I could say the same thing about the SEC (and the Fed), but I won't. Get out of bed with the investment banks and do your job! And with that I'll relinquish my soap box.

These repackaged loans also provided the capital that's been used in all the LBOs (leveraged buy-outs) this year. They're just as stinky and they're just as dangerous to own. The credit derivatives market expanded about 15 times since 2003, in an exponential increase, to about $50T (that's a 'T'). About $7T is in these mortgage-related bonds. Much of this is in the same category as the subprime and LBO funding and therefore much of it will need to be unwound. How quickly it unwinds (not if) will obviously have an impact on our market.

The ABX index, which tracks the performance of various classes of subprime-related bonds, is hitting new lows. The spread between junk bonds and U.S. Treasuries had shrunk to near record lows recently but have made a big jump in the last month. That's understandable. The very low spread was a warning that investors had become entirely too complacent. Now portions of the index that track the safer mortgage bonds, with ratings of AAA and AA, are also falling, down about 5% in the last week. The portion of the index that tracks lower-rated BBB bonds is down more than 50% (and very likely headed much lower as the ratings agencies get busy with their downgrades). So the ramifications of this subprime problem are starting to spread out to other investments.

Contained or Contagion? I hope I've made my opinion clear on the answer to that question. And it's also why I think the Fed engineered last week's Super Thursday rally. The Working Group (PPT) decided to get proactive and knock the shorts out of the market before they could do some real damage. The trouble is their footprint was all over that rally (lack of breadth, negative TICK readings, lack of institutional involvement, etc.) and that is likely to only embolden smart money to really load up short. In fact put options far exceed call options on the S&P 500 and 100. This is usually smart money bets on these indices and they've been very good predictors. Many are saying they expect a 10% correction very soon. I'll say that'll be just the start of it. The PPT will become a bystander very soon, throwing good money after bad.

I've been saying there were clear indications that institutions were not participating in last Super Thursday's rally (lack of program trading being one indication). One reason is the historically low cash levels in mutual funds' coffers. Here's a chart showing cash levels as a percent of assets:

Mutual Fund Cash Levels

As you can see, cash levels are below where they were in 2000 at the previous market peak. We've now had a correction of the 2000-2002 decline and fund managers are so convinced of the strength of the current rally that they've thrown everything they can into this rally (and then some, called margin which is at a record high level). From a contrarian perspective, this raises a big red flag. Obviously that red flag has only made the bull charge even harder but the danger is the sword from the bull fighter (otherwise known as the market). Are you going to be the thrustee (and take the sword) or are you going to parry?

There were a couple of economic reports this morning that did not affect the market. Essentially there were no surprises.

Economic reports
This morning's reports included CPI and Core CPI, Housing Starts and Permits and Crude Inventories.

CPI and Core CPI
There was no surprise as the numbers came in as expected--CPI was up +0.2%, helped by energy prices falling -0.5%. Food prices were up +0.5% thanks mostly to dairy and poultry as the higher corn prices work their way through the system. Thank you Uncle Sam for making our food more expensive while forcing us to burn less efficient ethanol fuel. Only our economically illiterate Congress could come up with such a plan. CPI is up +2.7% for the past 12 months while core CPI is up +2.2% for the past year.

June Housing Starts and Building Permits
It was a good news, bad news day for home builders. Housing starts rose +2.3% while building permits declined -7.5%. June's housing starts were nearly 20% lower than June 2006. David Seiders, the NAHB (National Association of Home Builders) chief economist, said the single-family housing market remains in a "correction process".

Crude Inventories
Crude popped above $75 for the first time in almost 11 months after traders reacted to a report showing crude supplies fell. Rising refinery capacity (91% vs. last week's 90.2%) is credited with drawing down crude inventories which dropped 500K barrels to 352.1M. Gasoline supplies were also down due to large demand, dropping 2.3M barrels to 203.3M which is 4.5% below the year-ago level. Distillate inventories were also down, dropping 200K barrels to 122.2M. That's down -8.3% from a year ago.

While not an economic report, Bernanke's speech and Q&A session in front of the House Financial Services Committee today provided some entertainment for the market. Congress is criticizing the Fed for the mortgage crisis that's developing, particularly the subprime mortgage mess. Congress needs to look in the mirror and accept much of the responsibility here. In fact there's enough blame to spread around to most of the participants, including those who took mortgages with no intention of making payments on them.

Bernanke assured the Committee that he will tighten consumer protections by writing new mortgage rules. One thing you have to remember about the Fed--their charter is to protect the banking system and not the public. Whatever they do they're doing to protect the banks. The public is obviously served by this endeavor but as far as rewriting mortgage rules, it's for the benefit of the banks and not the little guy. The subprime mess will take a lot of banks and lenders down so that's why the Fed is stepping in.

And now let's take a look at the charts to see what today's pullback accomplished. Obviously there's not much of a change to the daily charts that I showed in last night's Wrap.

DOW chart, Daily

It's possible today's dip is all we'll see for the small 4th wave correction (green wave-iv on the chart) and now we'll get the next leg up to finish the rally. We could see further consolidation with another relatively small decline below today's low or more of a sideways consolidation. Or it might tank straight from here. A drop below 13670 would support the "tanking" scenario.

I show an upside Fib target at 14184 which is where the 5th wave in the rally from March will equal 162% of the 1st wave. The most common Fib relationships between these two waves are 62%, 100% and 162%. Not shown on the chart but assuming the end of wave-iv on the chart finished at today's low then wave-v projects to 14077 for 62% of wave-i and then 14234 for 100%. So those two projections bracket the 14184 projection which I continue to like for an upside target (as long as the market doesn't tank from here).

DOW chart, 60-min

The 60-min chart shows the possibility for another leg down for a slightly larger 4th wave correction. I don't like that interpretation because it would have SPX violating an important support level. Not shown on this chart, but I do show it on the NDX 60-min chart, is a sideways triangle consolidation that takes up the rest of this week. But if we get the next and final rally leg started from here then it's possible we'll see the high for the market get put in by Friday which is a Fibonacci turn date (a Fibonacci 89 days from the March low). Plus or minus one day gives a potential turn window of tomorrow through Monday.

SPX chart, Daily

Overall, SPX is maintaining an ascending wedge look to the final stages of its rally, with the bearish divergences to go with it. It's possible we'll get one more small rally leg up to the 1563 Fib target area which will finish off the entire bull market rally. A slightly more bullish price path would be for price to stair-step higher into early August as it makes its way up towards the 1570 area, maybe even as high as the 1600 area. But if price turns around and heads south again, breaking today's low, then that would make for a strong argument that we've already seen the high. A break below 1506 would confirm that.

SPX chart, 60-min

The downtrend line from June 1st provided support today, as did the previous high on July 9th. Price actually dipped slightly below the June 9th high and by strict definition of the EW rules that's a no-no since a 4th wave pullback can't overlap the 1st wave high. It either means we have a very bullish setup (two sets of 1st and 2nd waves to the upside) or the high could already be in. Since it was a minor overlap and not confirmed by the DOW or NDX, I'm withholding judgment on this overlap. On small time frames I've found the rules need to be subject to interpretation, like any other technical indicator. But a break back below today's low would be a clear violation of the July 9 high and that would negate the bullish wave count, so that's a key level to watch.

My preferred wave count is the bullish one which shows another leg up to finish the entire rally, potentially topping out in the 1560-1570 area. It could stair-step higher into August but that won't become more obvious until the pullback following a new high.

Nasdaq-100 (NDX) chart, Daily

NDX has either topped or it will give us one more new high (with perhaps another few days of consolidation first). Upside potential is as close at 2050 and then up to about 2070, depending on how long it waits to rally again and how much resistance is offered by the tops of its channels. It has to drop below 1970 to give us a heads up that something more bearish is happening, with confirmation by a break below 1948.

Nasdaq-100 (NDX) chart, 60-min

The one-day pullback seems too short in time when I compare to the general size of the rally and the size of the previous 2nd wave correction (not shown on the chart) which was a little more than 5 days. Very often the 4th wave correction takes the same amount of time. That would mean a consolidation that takes us into early next week. I show the possibility for a sideways triangle which is a very common 4th wave pattern.

These triangles are good patterns to trade because there's a high probability that the previous trend (up in this case) will continue so you can play the next leg up. More importantly for where we are in the pattern it also points to the last leg of the move (the 5th wave). You will rarely see a triangle in the 2nd wave position.

So we'll see if this plays out over the next few days and if it does then we're probably looking for a high in NDX sometime towards the end of next week at the earliest.

Russell-2000 (RUT) chart, Daily

The RUT made a big move down this morning, just barely missing the previous low which would have negated the bullish wave count on this chart, and then a big recovery. Like the other indices, this count calls for one more new high. I like the 860 area now for a potential high if it hits it this week. Otherwise a further consolidation would have it on a path similar to what I discussed for NDX.

Russell-2000 (RUT) chart, 60-min

If the RUT immediately turns back down on Thursday and breaks today's low then the bearish wave count will be looking much more likely. Assuming we'll see price either consolidate further or rally to a new high, this rally may chop its way higher into the end of the month or it could be over this week.

BIX banking index, Daily chart

The banks are getting downright volatile lately. Every piece of subprime news is met with either "whew" or "oh sh.." and traders react accordingly. The bullish wave count calls for a rally out of here to new highs. A break above 398 would tell us to look for new highs. The more immediately bearish wave count (dark red) calls for an immediate decline to new lows. In between (light red) we could see another leg up as part of a larger bounce from the July low before it tips back over and heads for new lows. Considering my expectation for another leg up for the broader market I'm thinking we could see another bounce in the banks before it tips back over.

But when I look at Mother Merrill (MER) I get a real bad feeling about the banks, as though the other shoe is about to drop.

Merrill Lynch (MER), Daily chart

I have a slightly different wave count on MER than on the BIX and it could be a significant difference. The wave count on this chart says get ready for a strong 3rd of a 3rd wave down. These usually start with a gap down (see what happened today?) and then run lower from there. If we get a strong breakdown in the banks I'm not so sure the broader market will be able to rally in the face of that. Very definitely worth keeping an eye on Mother here. If she says get out of the shark-infested waters, you'd best listen.

U.S. Home Construction Index chart, DJUSHB, Daily

The light red wave count says we'll get another leg up before tipping back over whereas the dark red count says look lower from here. Common theme is look lower.

Oil chart, August contract (CL07Q), Daily

Oil got a nice lift today on the oil inventory numbers so the rally continues. Short term it's looking a little tired so we should see a pullback/consolidation starting soon. But this should stair-step higher to the $80 area.

Oil Index chart, Daily

Oil stocks got a lift back up with the price of oil taking a jump of more than a dollar. I changed the parallel channel from the chart I posted last night (for those who notice such things). I think this better reflects where support will be, assuming the decline continues, and where a breakdown will tell us the rally from March is finished. It's still in an uptrend and I'm trying to pick a top here, which I think was last Friday's high (Friday the 13th). But that means the oil stocks have to turn right back down tomorrow. No more rally otherwise we haven't seen the highs yet.

Transportation Index chart, TRAN, Daily

Nice stop run this morning! The Trannies gapped up and spiked higher this morning, gave it all back and then recovered about 38% of the drop by the time it closed. That was either an exhaustion gap to finish the rally or else we haven't seen the highs yet. A drop below today's low at 5393 would tell me we've seen the highs.

U.S. Dollar chart, Daily

Still probing for that bottom. We've got hints of MACD turning at its uptrend line that goes back to the beginning of the bullish descending wedge in May 2006. The dollar should come bounding out of here but obviously not until a bottom is found. Even the shorter term charts are saying it's found its bottom (I hate it when it gets lost):

U.S. Dollar chart, 60-min

New lows are being met with bullish divergences on the 60-min chart and that suggests we're about to see a turn back up. The bearish sentiment on the dollar and headlines talking about the demise of the US dollar are enough, from a contrarian standpoint, to say we're ripe for a rally.

Gold chart, August contract (GC), Daily

If the US dollar is close to finding a bottom, is gold close to finding a top in its bounce? I say yes. While much of my opinion on gold has to do with my expectations for the dollar, I'm also biased against gold because I think it will join all asset classes in being sold off as the credit bubble collapses. Inflation fears are not driving the price of gold.

The other reason I'm thinking the current bounce will finish soon (could first get as high as the 62% retracement at 682) is because of the EW pattern. I've highlighted the June 20-27 leg down because I wanted to show its form--it's a 3-wave move. Declines or rallies don't finish with a 3-wave move but instead it indicates it's the middle of a larger move. In this case I'm calling it the middle of an a-b-c bounce off the June 13th low (called an irregular, or expanded, flat correction). I've got wave-1 down to the June 13 low, the current leg up is wave-c of the a-b-c correction for wave-2 and the next move will be a strong decline in wave-3.

If we instead get a pullback followed by new highs (shown in green) then my interpretation is wrong and it will be time to get long gold for what should be a run to new highs (in which case the stock market will also probably still be rallying). But it will have to prove itself to me first. In the meantime I'm looking at the current bounce in gold as an excellent shorting opportunity. Gold should be headed for $500 or lower before the bull market in gold is ready to resume.

Results of today's economic reports and tomorrow's reports include the following:

Unless the LEI (Leading Economic Indicators) come in with a nasty surprise, I don't see tomorrow's reports as being market moving. Sometimes the FOMC minutes can disrupt the market but I don't think the Fed has been saying much that would surprise the market.

SPX chart, Weekly

There's not much to add to last night's commentary on this SPX weekly chart which I used in my top-down analysis of SPX and why I'm looking for a top very soon. I still like the 1563 area for a potential high and depending on how long we consolidate this week, or not, we could see that level hit tomorrow or Friday. The kind of top I'm looking for here is a MOAP (Mother of All Puts) opportunity so look to be testing the next high since it could be a real winner.

The closer we get to August in this rally the closer we complete the same pattern as 1929 and 1987. And the 1929 rally through the summer was all about mergers and buyouts while the economy slowed (sound familiar?). Patterns repeat and it's looking more and more like this one will repeat on us. Get your Tums ready.

Thursday and Friday of opex week have generally been slow trading days as most of the opex squaring is finished. People are waiting for next week to place new bets. This supports the idea that we could consolidate into early next week as I discussed on the NDX 60-min chart. If we do consolidate then it will likely be a choppy mess with no follow through to the moves. But if we see the market break to new highs then I'd be real careful about chasing this one. Instead look for negative divergences as clues to try shorting it.

If you are unable to watch the market during the day then you'll have plenty of time to catch a bounce after an initial decline. I like hunting for tops and bottoms. It's what I do. But many don't like trying to catch turns but instead prefer momentum runs. Momentum to the upside is clearly waning and obviously we have no momentum to the downside so you should be flat and waiting, or have your stops on long positions pulled up closer now.

As always I'll try to catch the tops and bottoms of the moves on the Market Monitor and show the setups to identify and trade them (had a beautiful setup that I showed on SPX at this morning's low--a real pretty bottom and we like pretty bottoms). I'll see you there or back here next week. Good luck in your trading.

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