The markets raced back to resistance on Wednesday and then stalled once the buy programs and short covering ran its course. Traders turned back into cliff dwellers on Friday as the markets edged closer to the edge of the abyss. With a Grand Canyon sized cliff potential looming traders quickly took their rebound profits off the table fearing a repeat of last weekend's global implosion.
Dow Chart - Daily
Nasdaq Chart - Daily
There were no economic reports of note on Friday and we were left to trade based on the earnings news for the week. This was a very light week on the economic calendar but next week will be exactly the opposite. The week starts out with the State of the Union where President Bush will use the pulpit to lobby for a new round of tax cuts and economic stimulus. The markets will be paying close attention to see what the last year of the Bush presidency may hold. On Tuesday we get the latest Durable Goods report and expectations are for an increase of 1.6% and that would be a sharp departure from four months of flat to significantly lower orders. Why analysts think orders picked up in December is unclear. All other indicators suggest the economy was slowing significantly in December.
On Wednesday we will get the first look at Q4-GDP and current estimates are something in the 1% range. That compares to the 4.9% reading we saw in Q3. This report will be one of the key reports for the week. Also on Wednesday the Fed will conclude their 2-day FOMC meeting and odds are still very strong they will cut rates again. Currently the Fed Funds Futures are showing a 305% chance of a 25-point cut and an 86% chance of a 50-point cut. Either would be an amazing development given their 75-point cut early last week. I believe the market is setting up for a disappointment from the Fed for reasons most people don't understand.
You may have heard of the massive $7.15 billion trading loss at French bank Societe Generale last week. A 31-year-old futures trader made massive unapproved bets on Eurostox equity futures heading into 2008. When the positions went against him he compounded the bets by increasing the positions in a "huge scheme of elaborate fictitious transactions" according to Societe Generale. As the markets continued to decline his positions were increased until the fraud was initially uncovered around Tuesday the 15th but the full scope was not known until Friday the 18th. After dissecting the positions over the weekend the bank frantically unloaded the futures on Monday and Tuesday of last week (21/22nd).
Eurostoxx 50 ETF
The actual value of the positions is still unknown but it is believed to have been in the tens of billions and according to AFX News was in excess of the $70 billion market cap of SocGen. Reportedly the trader had amassed a long position of more than 1.5 million Eurostoxx 50 futures contracts and an undisclosed number of DAX Futures. Another news source claimed the total position was worth more than $103 billion. If you are long futures you are long the market. If you sell those long futures you are putting pressure on the market and that is exactly what happened last week. Selling $100 billion in the global futures market would be a monster crush of equities. The U.S. markets were closed on Monday and that put additional pressure on the more thinly traded futures markets. Traders could not look at the U.S. markets for reassurance that the bottom was not falling out. With Societe Generale in panic mode after realizing they were massively positioned on the wrong side of the market they were dumping positions on a massive scale. They probably decided not to follow in the footsteps of Barings and try to negotiate their way out of trouble. When Barings did it in 1995 the news leaked and the market went against them nearly doubling the loss.
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The trader, Jerome Kerviel, helped them unwind the positions because the complexity astounded the bank. He then disappeared along with many of his bosses. Reportedly the trader did not profit from the scheme and was trading for the benefit of the bank. The trader vanished on Tuesday and is only speaking through his lawyer. The bosses were fired for letting it happen. SocGen has filed charges against the trader. The $7.15 billion loss ranks as the largest ever to be suffered by a bank in a fraudulent trading scheme. The next largest was the $1.38 billion loss that bankrupted Barings in 1995. Amazingly SocGen still expects to post a profit for the quarter despite the $7.15 billion loss and another $2.5 billion loss in subprime mortgages. They are going to raise $8 billion in emergency capital in an offering underwritten by JP Morgan and Morgan Stanley.
Eurostoxx 50 Index
The Fed reacted in part to the massive sell off in global equities last Mon/Tue when they cut rates by 75-points at the open of the U.S. markets on Tuesday. Since a major factor in that sell off was Societe General dumping tens of billions in equity futures and not recession fears as previously thought this suggests the Fed may not want to follow that ill-timed rate cut with another cut that may not be needed. The Fed released a statement on Friday saying they were unaware of the SocGen trades when they cut rates on Tuesday but were comfortable with their decision. What are they going to say? Oops, we screwed up and will fix it next week by raising rates. Most people are completely unaware of the impact of the Societe Generale disaster on the global equity markets and are still expecting the Fed to pull another rabbit out of their hat on Wednesday. To say the announcement will be extremely important would be an understatement.
On Thursday there are ten economic reports with the headliner the Chicago PMI with expectations for a drop from 56.4 to 52.0 and possible under 50 and into contraction territory. On Friday the two biggest reports for the week could be the Non-farm Payrolls and the ISM Index. The payroll report is expected to show a gain of 57,000 jobs in January compared to only 18,000 in December. There are whisper numbers suggesting we could even see a negative number. If this jobs number is going to be negative it could push the Fed to act again on Wednesday. They will have an advance look and will be taking the payrolls into account when making their decision.
The ISM Index for January is expected to decline to 47.0 from 47.7 in December. That drop to 47.7 was the sixth consecutive month of decline and the first time that has happened since the decline into the 2001 recession. The 47.7 level is also the lowest reading since the 2001 recession. The ISM is probably our best indicator of the U.S. economy on a current basis and the Fed will also have this data before their Wednesday decision. If the economy is as bad as people claim we could see a number as low as 45 and clear recession territory.
Last week was a big week for earnings but next week will be even bigger. We can't match the star power of Intel, Microsoft or Apple but there are some big names led by YHOO, AMZN and Google from the Internet sector and OXY, CVX and XOM from the energy sector. Of particular note are the MBI earnings on Thursday. There are considerable fears of another rating downgrade and a cut to less than AAA could put them out of business. If their credit rating falls the rates on tens of billions in bonds they insured will rocket higher and force many firms to take additional write downs. This is a key earnings event for the week.
Amazon estimates are weakening on fears that they could warn for Q2 due to slowing consumer sales. Yahoo has already disclosed they are feeling the pain and will be cutting employees to reduce costs. Google has been sinking on fears they will spend billions on the discarded broadcast spectrums that the government is putting up for sale. If they win the bids for billions they will have to spend billions more putting a product on those airwaves. Eventually earnings will rise but fears of over aggressive goals have been depressing the stock price.
So far with one-third of the S&P already reported the earnings for Q4 have fallen -19% over the same period in 2006. It is primarily due to the carnage in the banking industry and the sudden explosion of subprime problems. Many of the tech companies that reported last week beat estimates and guided higher. That has not helped their stock prices. Microsoft reported sales that soared +81% over the comparison quarter and after opening 5% higher at $35 declined to close with a loss at $32.94. Apple reported strong earnings and was promptly knocked for a $30 loss on weak guidance. The good and the bad still lost ground. More than 633 companies will report next week and by far the busiest week of the quarter.
Earnings Calendar - Selected Companies
Gold prices hit a new record high at $924.20 after news broke that power outages in South Africa had shutdown some of the countries mines. Rolling power outages have been hitting various parts of the country over the past few weeks with power going out for up to five hours at a time as demand exceeds supply. AngloGold Ashanti (AU), Harmony Gold (HMY) and Gold Fields (GV) have all announced shutdowns or curtailment of underground mining and some above ground processing. Mining and smelting requires a lot of continuous power and they can't afford for the power to keep dropping unexpectedly. For those miners underground it is a major hazard knocking out lights and ventilation. The problem is not expected to be solved for up to 3-years when new plants come online. It is worse this month because of recent heavy rains. The coal used for power is low quality and when wet it produces even less heat and therefore less electricity.
February Gold Chart - Daily
Elsewhere on the energy front crude rebounded +1.30 to $91 and well off the panic lows of $85.42 we saw last Monday. Crude prices were depressed by the implosion in the European equity markets and the unwinding of the SocGen trades. When the liquidity lake is drained all the boats settle to the bottom. Next Friday OPEC meets again to discuss production levels. Short of somebody pointing a nuke at Saudi Arabia and blackmailing them to produce more oil there will not be a production increase. The drop to $85 last week sealed that fate and two weeks of inventory gains in the U.S. for 6.6 million barrels was another nail in the coffin. There will be a lot of conciliatory sound bites from the meeting but OPEC will not likely raise production rates.
I believe the markets rallied this week mainly on the possibility for a bailout of the monoline bond insurers Ambac (ABK), MBIA (MBI) and ACA Capital (ACA). Ambac rallied +67% for the week to close Friday at $11.31. That is impressive but it was well off the $16.45 high for the week. That was a +143% rebound off the prior Thursday's low of $6.76. The rebound was on news that Wilbur Ross a billionaire investor might take a run at buying them. He specializes in distressed companies but before the week was out the rumor was quashed by the Financial Times saying he would rather start a new company than take over the many problems of Ambac. Ambac's problems increased on Friday with the filing of multiple suits against them with one being a class action suit. Furthermore Ambac said it will no longer disclose any future filings of additional suits. That is not a good sign.
Ambac Chart - 45 min
I reported on this last Sunday and despite the +100% bounce on these stocks the situation has not changed. Ambac has insured $556 billion in debt from 137,000 customers. MBIA insured $31 billion including $8.14 billion in CDOs that were made up of other CDOs. These have nearly a zero chance of paying off or being able to claim on the insurance. ACA Capital has insured $69 billion and after taking monster losses only has about $425 million in capital left and has already been placed into receivership by the State of Maryland. That is a total of $656 billion in insured bonds that will eventually be revalued with monster write-downs. Banks and brokers have already written off nearly $100 billion and most analysts are now talking about another $200 million to go over the next few quarters. If you expand the scope to the bonds, CDOs and credit default swaps (a $45 trillion market) held by funds, hedge funds, banks, institutions and sovereign funds that could add up to another $2 trillion at risk.
Since they will all end with some value the risk is only in the short-term mark-to-market losses but many will require significant recapitalization. New York's Insurance Superintendent is trying to arrange a bank led bailout of those three firms rather than suffer the trillion dollar consequences of all three going under. He is having trouble since the main banks are all having capital problems of their own. Should the bond insurers fail, which is extremely likely, it would cast a pall over the entire sector and cause untold damage to the financial system in the process. Barclays said this week the stink is spreading to formerly pristine firms and even Financial Guaranty Insurance Company is likely to be downgraded. They insured $315 billion in bonds. Barclays also said banks will have to raise another $143 billion in capital to offset further write-downs as bond insurers begin to fail.
The key here is the downgrades and their impact on the banking system. John Mauldin said banks will suffer $22 billion in write-downs for every notch of credit downgrade on the insurers. ACA is already at junk (CCC) and Ambac and MBIA are just starting to crack below the investment grade rating of AAA on their way to junk status. Everyone in the business agrees that the three firms are going to fail. It is just a matter of time. Regulators, banking officials and some elected officials are pleading with the rating agencies to delay any downgrade on the group to give them time to sculpt a bailout plan rather than have the sector crumble to dust. So far the agencies have appeared willing to wait but time is growing short. A failure to downgrade when justified would subject the rating agencies to legal attack. Another domino fell on Thursday when Security Capital (SCA) was cut from AAA to A by Fitch. Traders immediately reported that they were unable to sell debt insured by Security Capital.
Citigroup said last week that it reserved another $900 million to cover exposure to bond insurers. The Louisville Arena Authority said it was going to drop Ambac as an insurer for their $340 million in bonds now that Ambac has lost its AAA rating. They had previously committed to pay $11.4 million to Ambac for insurance for those bonds. As more companies flee the insurer the company will have less money to pay claims and continue operations. Any rating below AAA effectively prevents the company from writing new business. ACA is already CCC, SCA was just cut to A, Ambac was cut to AA by Fitch. Ambac premiums written fell by 78% in Q4 as customers fled to more stable alternatives.
Bond Rating Scale
The problem for the markets was the news on Friday that no bailout is coming. Hopes were high for a Wilbur Ross takeover or a bank consortium bailout. Those options died on the vine and we can expect those stocks to return to $5 very quickly. The major financial stocks that rallied on hope last week will decline with them as that hope fades. This is going to be a major problem long-term and with financials the largest sector in the market they will cause a lot of damage.
The Dow fell to 11634 on Wednesday and repeated that decline with a touch of 11645 on Wednesday. The rebound was triggered by a monster buy program and some serious short covering on the potential bail out of the bond insurers. Once that completed the Dow was at 12325 and holding. It held for nearly two days at that 12325 level before the bailout hopes began to fade. Friday closed with a -171 point loss. We have already had more triple digit days in 2008 than we had in the first 3-months of 2007. The volatility is huge with the VIX closing just below 30 on Friday. Unfortunately I believe the volatility is going to continue.
I believe we have risk due to the continuing financial problem, economic numbers due out next week and a possible disappointment by the Fed. I already discussed the problem with the banks/insurers. The economics could be ugly with challenges in the Durable Goods, GDP, PMI, Jobs and the ISM Index. The potential for recessionary news is very high. The Fed, whether they admit it or not, was fooled by the SocGen futures dumping into a history making 75-point inter-meeting rate cut. Now they are faced with either admitting it (zero chance) or trying to bluff their way through with only a 25-point cut on Wednesday. If they don't cut at all with the market expecting 50-points it would be a disaster. They can't take a pass because that would be admitting they were fooled and caved in to market pressures. That means they have to cut and 25-points is the minimum they can get by with. The market will not be happy with 25-points.
There is another scenario that should be mentioned. If the Fed does cut 50-points even after realizing they were fooled by the SocGen trades then there is an even bigger problem ahead. It will suggest the Fed knows something we don't and whatever it is could be dangerous. It would be completely ignoring the inflation monster that they were so careful to guard against just a short time ago. It could mean the economy was even worse off than we thought.
OR, it could mean the Fed is aware of the mounting problems in the bond sector and is trying to head off a calamity in advance. The best thing the Fed could do for the economy today is to bring back housing inflation. By cutting the rates in half they could rekindle real estate demand within a couple months. No big bailout, no billions in support for mortgage companies, just quickly cut rates to the bone. Once the bottom appears to be behind us in the housing sector and with Fed rates around 2.0% those wanting to make a purchase would be racing to make a deal. Home inventories would shrink substantially by summer. This is also an ideal way to head off the 1.2 million foreclosures expected in 2008. Rekindle the housing bubble and suddenly those underwater could escape economic ruin with the help of a rush of buyers. Mortgage backed CDOs would no longer be plunging in value. Mortgage companies would be recovering and new loans being written. Add in the proposed economic stimulus package and we could be back to 5% GDP by year-end. The Fed could then pull back on the reins a little slower and let the inflation heat bleed off the economy over time instead of the implode track we are on today. The Fed wanted to deflate the housing bubble but they did not expect the entire global financial system to crash in the process. The Fed should see the beauty of a quick re-injection of liquidity into the housing sector but then again they are the Fed. They are always behind the curve and this crisis is no different.
For next week I think the odds are good we are going to see the indexes return to some lower levels. I know some analysts are expecting a retest of the lows at 11640 but my crystal ball does not see that clearly. Based strictly on the charts we still have risk to 10700 but that won't happen next week. I do believe we are going to see a couple down days with high volatility but there are far too events impacting sentiment to just roll over and drop back to 11640 without another SocGen futures program. That was a once in a decade type of event and I think it did flush out a lot of weak holders. Unfortunately the Fed made the surprise rate announcement on Tuesday morning before the U.S. markets really had a chance to duplicate the overseas losses. Many traders ready to pull the exit trigger heard the Fed news and decided to hold on. That limited the damage even though we had another margin call plunge on Wednesday morning.
S&P-500 Chart - Daily
The index I am going to use this weekend is the S&P-500. The S&P closed at 1330
on Friday after plunging to 1271 on Wednesday and rebounding to 1368 on Friday.
That 100-point range is probably going to be the range for next week as well.
1350 is currently initial resistance and 1330 initial support. That gives us our
trigger points. I would short a failure at 1330 and go long on a breakout over
1350. If we do get a dip back to the 1270 range I would reverse to a long around
I used a 5-point cushion there to avoid the rush of traders wanting to buy
a purely technical dip to 1271 and jumping the gun. I spent a long time trying
to analyze the known events on the calendar and the combination of events and
decipher their potential impact on the markets. The only one that fit the
scenario for a serious market drop was the Fed. The rest are just additional
chapters to a book where we already know the ending. The Fed is the wild card
that could really sour
the markets. That makes Wednesday D-day or drop-day if it
is really going to happen. If this is really a bear market and last week's
bounce just a bear market rally then the reasons for a continued drop are
meaningless. It will happen regardless of the news. There will be several short
squeezes along the way and every one will be assigned an excuse in the press.
The key for me is to simply trade what the market gives us. I know the impulse
is to buy Google or short Amazon ahead of
their earnings but the key is to
always trade in the direction of the market if a direction is present. If we are
in a consolidation phase then trade anything you want. Otherwise turn (trade) in
the direction of the skid. You always have three choices. Stay on the sidelines,
trade what you want or trade what is right. The decision you make determines
your long-term profitability. For me that means enter shorts of your choice on a
failure of SPX 1330, enter longs over 1350 and buy a
dip to 1275. All the rest
is just noise.