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Market Wrap

(De)Investment Banks--And Then There Were None

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Admin note: I (Keene) will be taking Robert's newsletter tonight, he will take Jim's tomorrow. Wednesday and Thursday will be Jeff and Keene as normal and then Linda will take the weekend newsletter.

First there were five and then there were none. The big investment banks that is. I call them Deinvestment banks because they've successfully lost an enormous amount of money over the last two years. I thought that would be kinder than calling them Loser Banks (with big 'L's on their foreheads. SEC's rule change in 2004 helped to destroy the investment banking industry when the investment banks were allowed to increase their use of leverage. From a maximum leverage of 12:1 they were now allowed to use 30:1 and even 40:1. To give you a sense of what 40:1 leverage can do, buying something with a 5% annual return suddenly gives you a 200% return on your money.

This huge increase in leverage (and risk) is the reason these banks were making obscene amounts of money in the years since 2004, and richly rewarding themselves in the process. And then when fortunes were reversed these fat cats believed it was important for the taxpayer to bail them out so that they could keep their big homes, yachts, jets and extravagant lifestyle. Hank Paulson is a Goldman Sachs graduate and don't believe for a second he's forgotten his roots.

Cartoonists have an uncanny ability to capture national mood and I thought this one was particularly spot on:

Robbing the Bank, courtesy slate.com

But I digress. Back to leverage, when you buy a $300,000 house with $30,000 down you're leveraging your money 10:1 and that's reasonable in real estate. The nice thing about real estate is that it is extremely unlikely that the value will drop to zero and very unlikely it will drop by even 50% (although many areas will see that kind of drop). But these big investment banks weren't investing in real estate. They were instead investing in derivatives of derivatives of real estate. That 40:1 leverage that makes you so much money on the upside can destroy you in a heartbeat on the downside. A 2.5% decline in value of the asset will completely wipe out your investment if leveraged 40:1. All your money, gone. Poof. Money heaven.

And that's what's been happening to these big banks. They've been forced to write down the value of their holdings based on what the assets have been selling for on the open market. They might be carrying full value on their books (mark-to-model) but once a sale completes they have to then mark-to-market and take the loss. This is what killed Bear Stearns, Lehman Brothers, and Merrill Lynch. And then AIG was insuring all these losses and did not have nearly enough assets to cover what they were insuring (again, they leverage their assets to insure a much greater amount of assets). So now the five big investment banks are down to two survivors, Goldman Sachs and Morgan Stanley. But they are in the same boat and rumors are they're also very close to insolvency. I'll come back to these two and why today's change of bank "status" saves them.

Back in the early 1980s we had the S&L bank crisis. One cause, if not the primary cause, was due to loans made to Latin American countries. Bad real estate loans were blamed when in fact they were only a contributory cause. When Latin America defaulted on their loans it essentially broke the banks in the U.S. They would have had to declare bankruptcy had not the Fed stepped in to help. The Fed allowed the banks to carry the defaulted loans on the books as "long term investments". That enabled the banks to slowly work off those bad debts as income allowed. The regulators looked the other way, for a long time, while the banks worked these bad loans off the books.

This "privilege" offered to the commercial banks is not something the investment banks are allowed to do. Hence the change of status today for Goldman and Morgan Stanley. Had they been required to write down their bad debts to the point where they would no longer be able to recapitalize, which is what happened to BSC, LEH and MER, we'd have five out of five investment bank failures (thanks to the SEC rule change in 2004, among other things). Becoming commercial banks requires them to live with all the regulations that go with that distinction and it significantly lowers their profitability (they will no longer be able to leverage their assets like they're used to doing). On the face of it one wonders why they would subject themselves to this change.

There will likely be very little public disclosure about this but I'll bet you my last dollar the government regulatory bodies made this switch to allow GS and MS to now carry all that toxic debt on their books and not have to mark it to market. They'll now carry it on their books as "long term investments". I wouldn't touch these banks as an investment with a 10-foot pole.

What this solution does not fix is the credit problem that is the underlying cause. SEC's Cox can blame the shorts all he wants but the real problem is the weakness in these companies because of bad debts and the inability to raise more capital and/or obtain loans at a reasonable cost. The credit market will remain moribund if not frozen. The TED spread (spread between the 3-month T-bill rate and the LIBOR, or interbank rate) had spiked up from near 1.0 in August to just over 3.1 last Thursday. This was clear evidence that banks did not want to lend to each other and it's what frightened government officials. The following chart shows graphically what was happening in a very short period of time (from early September):

TED Spread, Daily chart, courtesy bloomberg.com

Since last Thursday's high the TED spread has dropped back down to 2.3 today. But notice that it has not dropped below the spread seen back in December and March of this year. This is significant since a massive bailout by the Fed and Treasury has not fixed the problem with banks not lending (either they're unable to lend because of low capital assets or they're unwilling to lend for fear of not getting it back). In other words the problem is still out there. The fundamental problem with our market today is a lack of credibility and trust and those are the underpinnings of a credit market. Take away trust and you take away credit. Take away credit and you take away the economic grease required to lubricate the wheels of the economy.

So why did the market rally so strong last week? Well we know the Fed, Treasury and SEC hate short players. They clearly blame the shorts for the bad performance of the banks. They got caught mismanaging the nation's money and are now trying to blame it on someone else. It's just more of the same victim mentality that seems to plague us. Those who were short the financials, and there were many, had to cover their short positions or face retributions from the SEC. The rest of the stock market followed along as shorts covered en masse. I'm sure opex Thursday/Friday had nothing to do with their timing (cough). Friday morning's settlement price that was 50 points higher (after the strong Thursday rally) absolutely fried the shorts.


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The question I have now is what happens with these financial stocks (and we can add GE and GM to "thou shall not short" list today) when real selling hits? Those who are long the financials (to which I ask why) may look at this gift handed to them and decide to unload while the unloading is good. If the holders of these stocks start unloading and the selling accelerates everyone will know it's real selling and not the shorts doing it. That could scare them even more and pretty soon the selling avalanches out of control. And guess what? There are no shorts with profits to lift the sector back up, only wiped out long players. It's the law of unintended consequences whenever you're dealing with the government making panicked decisions (the government is the epitome of herd mentality and makes these kinds of decisions at the worst possible time).

We live in interesting times and we'll have some stories to tell our grandchildren about being there when the house of cards came down. I've said it many times and I'll say it again--the credit contraction will happen mind-numbingly fast and we're probably not even half way through the "correction". Hang onto your hats because things are happening fast now. And with that let's move to today's charts to see what the pullback could mean.

S&P 500, SPX, Weekly chart

Last week's candle was a very bullish dragonfly doji at the long-term uptrend line from 1990. The market was very close to a severe breakdown (crash?) last week before it was rescued. So now the question is what was today. Today's weekly candle is obviously today's price action only and we have another 4 days before we'll know how the week will close but so far it doesn't look like a good follow through to last Thursday's and Friday's rally. This longer-term uptrend line is very important and the market is paying attention to it.

S&P 500, SPX, Daily chart

The daily chart is crowded with everything I'm trying to show. Price closed back below the long-term uptrend line from 1990 as well as the 1225 level where price found support and resistance in 2005 and 2006. You can see this price level acted as support in July and September. A break below 1162 would be a significant break of all Fib levels and price level support near 1170. But until that happens we have to respect the possibility we'll see the bounce off last week's low make it up to 1315 if not all the way up to 1360. Above 1360 would be very bullish.

The significance of this chart is the dark red wave count that still shows the market vulnerable to a strong selloff. I'm tempted to recommend looking for a buying opportunity for a run higher in the bounce but just can't myself to do it. Risks and surprises are to the downside (although I'd say bears would disagree with that statement after last week's opex jam job).

For those who are studying EW (Elliott Wave) analysis, the wave count for the move since July could be an a-b-c expanded flat correction where last week's rally was the c-wave. It achieved equality with the 1st leg up (July-August rally leg) at 1246 and therefore could be considered complete. However it's more typical to see the c-wave achieve 162% of the a-wave. That projection is shown at 1315.86 which would coincide with a retest of the broken uptrend line from July (green line). A little higher is the downtrend line from October 2007. The pink wave count would actually be an ideal longer-term short play setup.

Key Levels for SPX:
- cautiously bullish above 1265 and bullish above 1360
- bearish below 1162

S&P 500, SPX, 120-min chart

Friday's high is the key level to the upside and the 78.6% retracement is the key level to the downside (1162). Follow the direction of the break.

Dow Industrials, INDU, Daily chart

The DOW's rally on Friday stopped just shy of the downtrend line from May and also just shy of the Fib projection at 11499 where last week's rally would have equaled the leg up from July to August (for a possible completion to an a-b-c rally off the July low). There are a couple of other levels to watch if we see more rally this week: the broken uptrend line from July and price level resistance, both at 11750; the Fib projection at 12141 where the leg up from last week's low would equal 162% of the July-August leg up. It's also the location of the 200-dma. Again, if the DOW rallies up to that upper level I would consider it an ideal short play setup.

Key Levels for DOW:
- cautiously bullish above 11483 and bullish above 12230
- bearish below 10700

Dow Industrials, INDU, 120-min chart

This chart looks very similar to the SPX chart except that price stopped on Friday at the top of a parallel down-channel that was created from the first two lows from August 20th. This chart also shows one other level of interest if we see an immediate turn back up tomorrow. Two equal legs up from last Thursday would be at 12018. This is a very challenging market to figure out right now so I'm trying to show some potential trading levels--trade the market now (if you dare) and be quick to take profits. Only if the key levels on the daily chart are broken would I then be willing to risk and overnight trade in that direction.

Nasdaq-100, NDX, Daily chart

I have felt the price pattern for NDX is a little clearer for some time and I was expecting a bounce following the 5-wave move down from August. The rally from Thursday's low should be a correction of that decline and the only question in my mind is how big the correction will get. It could be already over, as labeled in dark red, and we're about to see one of the strongest selloffs in the market that any of us has ever seen (multiple degrees of 3rd wave declines about to kick off).

But the correction may not be finished yet and another leg up could tag the broken uptrend line from October 2002, shown in pink, before heading lower again.

Key Levels for NDX:
- cautiously bullish above 1774 and bullish above 1895
- bearish below 1640

Nasdaq-100, NDX, 120-min chart

NDX dropped back inside the parallel down-channel that it had been in since the August high (not bullish). A break below 1640, the 78.6% retracement of last week's rally would be bearish. But if a rally starts right away tomorrow notice that two equal legs up projects to 1832.94 which is right on top of the 62% retracement of the August-September decline. I like that setup in pink but I'm not sure we'll get it.

Russell-2000, RUT, Weekly chart

The price pattern of the RUT has left me scratching my head for a while now and therefore I've moved out to the weekly chart in hopes the larger pattern might make some sense and ignore the daily flopping around. First thing to notice is that the market is paying attention to the longer-term uptrend line from October 2002--the RUT has bounced off it three times now and a 4th touch (near the key level shown at 678) would very likely result in failure of that support level. If the bulls can get this back to the upside I see upside potential to 841. I don't know if it will be able to get there but that's the potential and as depicted it could be a choppy ride up that takes us into the new year. I am having trouble correlating this with other indices but sometimes that's a good heads up.

Key Levels for RUT:
- cautiously bullish above 768
- bearish below 678

NYSE Composite, NYA, Daily chart

Considering the differences I'm seeing in the above four major averages I like to see what the bigger index is telling us. Last Friday's rally stopped at its downtrend line from May which is also near its 50-dma. It could certainly be pulling back in preparation for a break of its downtrend. But at this point that would be pure speculation. In the meantime this one is as clear as a bell--the trend is your friend and it's obviously down. A break back below 7500, by the dark red wave count, suggests we'll see price break below the down-channel as it drops in a 3rd wave.

Banking index, BIX, Daily chart

I snapped another parallel channel line (top blue one) equal in distance to the others and notice where price stopped. This shows that even in a situation like last week that we still see symmetry in the market. There's a Fib projection for two equal legs up from July at 254 but I always pay attention to trend and channel lines. These parallel channels can be powerful technical indicators to watch and based on this I'm thinking the banks are ready to turn right back down.

The dark red EW count calls for a 3rd wave decline which will make the May-July decline look mild. The government actions to save the market could very well backfire on them by leaving the banking sector more vulnerable than ever to selling (taking the shorts out of the market and leaving no one else to buy in a decline). Back below 173 would suggest you do not want to be long the broader market.

With all the attention on the brokers I thought it would be good to take another look at their chart:

Brokers index, XBD, Daily chart

Textbook retest. Last week's bounce took the broker index back up to the bottom of the previous triangle pattern and the top of its down-channel in place since October 2007. Once again the trend is down and you should be trading that way until it's broken. If the wave count is correct we're about to see a 3rd wave down and strong selling.

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

Nice bear flag. The choppy price action for the home builders index is indicative of a correction. Tagging the top of the channel was a good finish to the bear flag correction pattern. While price could continue to work its way higher, as shown in pink, tagging the upper side of the flag was a good setup for the short side. It has to break below 281 though to confirm the bearish setup here.

Transportation Index, TRAN, Daily chart

The transportation average continues to look like a mess. It could go up (pink) or down (dark red) or sideways (not shown). Follow the key level break, with the lower one at 4727 getting close now.

U.S. Dollar, DXY, Daily chart

All this talk about a couple hundred billion dollars here, a couple hundred billion there and pretty soon we're talking some serious money. Estimates range from about $1T to $2T in debt that the government will have to fund if they want to do everything they've promised to do. Obviously they'll have to create the money out of thin air since it will all be debt and that has many worrying about skyrocketing inflation as a result. While that's a very legitimate concern at the moment I believe we'll be talking about deflation next year.

In the meantime the price pattern called for a correction to the July-September rally and I was calling for one once the dollar tagged the December 2004 low. The pullback is sharp so that raises the possibility we'll see the dollar work its way lower into next year and make a new low below the March low (dark red). But at this point it's equally possible the current pullback will lead to another rally leg that tests or exceeds the September high. A break below 74.30 would negate the bullish wave count and strongly suggest new lows will be seen by early next year.

With the strong drop in the dollar (and strong rally in the euro) commodities have been getting a big boost. October oil (expiring contract) got a huge short squeeze of a rally today but the November and December contracts did not. Therefore the headline number for the jump in oil is not entirely accurate. It wasn't really the $25 jump that's all over the headlines. For example, the December contract was up $5.48. USO also reflects a less exuberant rally today although it bullishly leaped out of its down-channel:

Oil Fund, USO, Daily chart

USO gapped above its parallel down-channel today and rallied up to its 200-dma before pulling back some. I see more upside potential for oil, either continuing higher and eventually breaking to a new high (especially if the dollar breaks down) or else a 3-wave bounce, shown in dark red, into November before heading lower again.

Oil Index, OIX, Daily chart

Oil stocks almost made it out of its down-channel today but closed back below its downtrend line and 50-dma. It's only a marginal break so a continuation higher tomorrow should see at least a test of its 200-dma near 855. However I think we'll see either a continuation lower from here (pink) or a choppy pullback before another leg up in a larger 3-wave bounce (dark red) which would then be followed by a turn back down into 2009.

Gold Fund, GLD, Daily chart

Gold has been struggling with its 50-dma at 84.48, 200-dma at 87.81 and its broken uptrend line from July 2005, which coincides with the 200-dma. Bullishly it closed above all those resistance levels today. I see upside potential to 93.27 before either pulling back to correct the September rally or starting a new leg down.

Economic reports, summary and Key Trading Levels

It's a relatively quiet week for economic reports and nothing for today or tomorrow.

As a summary of tonight's charts, if I go with the major indices I could argue equally strongly for an upside resolution following today's pullback or for a continuation lower, perhaps after a bounce to correct today's decline. But when I look at some of the other sectors, particularly the banks and brokers and even the home builders, I get a much more immediate bearish feeling about their price patterns. And if we follow the money and they head south in a hurry I think we'll want to follow their lead. Eventually the financial sector will hit a bottom and start recovering before the broader market but I don't see that as ready to happen yet.

I wanted to see how today and tomorrow play out before committing any serious money to this market. We had a wild week last week and today's "minor" 372-point decline for the DOW easily fits in the correction category, as in a correction of last week's rally. Pretty amazing volatility when you think about it. Great trading if you can catch those swings. My preference is not to day trade but to instead look for swing trade setups. I'll wait days for it and then take a couple of swings at it and hope it works for a day or two or three (after that I start getting real nervous that I've overstayed my welcome in the trade).

After Friday's highs and looking at potential support areas, I've identified what I think are key levels now for the market. Follow the break of those levels as I think they'll be good for a nice run. If that happens to be to the upside I would keep one foot holding open the exit door (meaning keep a close eye on your trade and especially don't get complacent about holding it overnight--preferably keep a hedge in place during the overnight hours). If the trade is to the downside we already know what the market can do to shorts. The smell of burnt bear hide (mine included) hung over the market on Thursday and Friday and it wasn't pleasant.

It's a wild one out there so be careful this week. Good luck and I'll be back with you on Thursday.

Key Levels for SPX:
- cautiously bullish above 1265 and bullish above 1360
- bearish below 1162

Key Levels for DOW:
- cautiously bullish above 11483 and bullish above 12230
- bearish below 10700

Key Levels for NDX:
- cautiously bullish above 1774 and bullish above 1895
- bearish below 1640

Key Levels for RUT:
- cautiously bullish above 768
- bearish below 678

Keene H. Little, CMT
Chartered Market Technician

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