Central banks across the globe injected billions into the banking systems early Friday, hoping to boost liquidity and stem concerns about the stability of financial markets. In Asia, central banks might also have hoped to impede the rise of the yen and other Asian currencies against currencies such as the euro and the U.S. dollar.
Articles and CNBC commentators noted that this was the first time that central banks had acted in such a concerted effort since soon after the 9/11 terrorist attacks. The LONDON TIMES reported that the ECB's injections this week have exceeded those made after the 9/11 attacks. That LONDON TIMES article noted that central banks had collectively injected $120 billion of extra liquidity into the financial markets, but the number may have risen even higher after that article was published online. Our central bank added liquidity at least three times today, for example.
Friday, the European Central Bank added another 61 billion euros, worth about $84 billion dollars, after Thursday's 95 billion. The Bank of Japan reportedly added 1 trillion yen into money markets during the overnight session Friday. Central banks in Canada, Hong Kong and Australia also reportedly injected liquidity into their banking systems.
Our Federal Reserve announced this morning that it was "providing liquidity to facilitate the orderly functioning of financial markets." Our Fed first added $19 billion in addition to Thursday's $24 billion addition. Even that wasn't enough for European market watchers who had hoped to see our Fed inject more since dollars were desperately needed, but their hopes were to be somewhat met by the afternoon. By that time, the Fed had injected funds two more times, bringing its total injection for the day up to $38 billion at the last count that I saw. As a CNBC commentator noted, it was only with the third injection that the Fed was able to meet its goal for injecting the funds.
What was that goal? Those injections were made necessary by overnight lending rates that were jumping above the various governments' target rates. As the LONDON TIMES article noted, the globe's banks reported difficulties securing financing for the corporate loans they have on their books and they needed help from their central banks. Dollars and euros were especially needed.
In a press release published on its site (http://www.federalreserve.gov) early Friday morning and released near the cash market open, the Federal Reserve promised that it would utilize its open market operations "to facilitate the orderly functioning of financial markets." The stated goal was to "promote trading in the federal funds markets at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent." Dislocations in credit and money markets could cause depository institutions to "experience unusual funding needs," the Federal Reserve further noted.
Initially, the reassurances and actual monies being offered by our central banks and others exacerbated concerns, however, especially amidst a Chapter 11 bankruptcy filing by HomeBanc Corp. (HMBN) and an SEC filing by Countrywide Financial (CFC) that detailed significant threats to the company's balance sheet. Articles specifying the additions made by the globe's central banks also detailed the strong demand for that money, with demand for funds "far exceeding supply," according to that Dow Jones article published online early Friday morning.
Rumors about the need for our FOMC to hold an emergency meeting to lower rates again circulated, as they had late last week and at various times during the week. A Merrill Lynch strategist was quoted in a MarketWatch.com article early Friday morning as saying that such a meeting would be needed within a week.
Would get-me-out-at-any-cost hysteria rein or would some of that money be put to work buying equities or at least staunching the bleeding? All held their breath as the cash market open approached Friday morning. We were about to find out, and find out in a day that would produce phenomenal volume, in excess of 10,000,000 shares traded. Although my sources for volume figures have produced sketchy numbers lately, I compared volume numbers to those provided by the NYSE and Nasdaq, which reported 5,236,859,000 and 3,104,953,600, respectively. With AMEX volume added in, that 10,000,000+ figure looks accurate.
Analysts such as one who mentioned the "beginning" of a credit crunch, as quoted in a Dow Jones article, and those that affirmed that the ECB and other central banks would probably need to add liquidity next week also heightened the worry. Equities headed sharply lower at the open. If conditions haven't improved by next week, it will be necessary for our Fed and other central banks to continue injecting liquidity as this week's tenders come due and need to be rolled over again. Further injections are needed in that case just to maintain the status quo and wouldn't necessarily imply worsening conditions, however reassuring that might be.
Countrywide Financial (CFC), our largest U.S. home lender, added to that early morning worry, however. In a filing that was part of the company's regular quarterly financial report with the SEC, CFC revealed that the company foresees a serious threat to its financial condition and earnings due to the problems in the U.S. mortgage market. Jim and Keene have both previously discussed the repackaging of loans by U.S. lenders to resell, and it's CFC's inability to resell those loans that's of particular concern. Current conditions dictate that the company must now retain more of those loans than it's selling.
Reassurances about CFC were offered by analysts at Merrill Lynch, noting that CFC's management talent and financial strength would ensure that the company would pull through this difficult time. The firm claimed that when CFC disclosed just last Monday that the company intended to buy a small lender's retail branches, that disclosure proved that neither CFC's management nor its financial means had been overwhelmed by the current conditions.
However, others not speaking for CFC apparently remembered that just last week French bank BNP Paribas assured investors that its exposure to the U.S. subprime problems was negligible. That was just days before the company was telling the world this week that its exposure was negatively impacting it and forcing it to stop withdrawals from three of its funds, since it couldn't accurately value them. The risks BNP Paribas (BNPQY) faced due to the U.S. mortgage market was amplified Friday when Atlanta-based HomeBanc Corp. (HMBN) filed for Chapter 11 bankruptcy. BNPQY is one of HMBN's creditors, as is Commerzbank AG (CRZBY).
CFC was driven lower during pre-market trading, and the revelation added to the early morning concern, even while MER analysts were commenting that the pre-market downturn in the stock was an overreaction. MER analysts were advocating buying on weakness. Apparently some did, as CFC never hit the 8/06 low and closed well off Friday's $24.71 low, closing at $27.86. Volume was strong, although not quite as strong as it had been as CFC was sinking into that 8/06 low.
The credit crunch impacted companies in other ways. According to a LONDON TIMES article, Fortis, the bank that plans to buy ABN Amro, has admitted that it may have to delay selling bonds needed to finance the takeover. An AP article quoted Fortis' chief executive as saying that he was "very confident" that the deal could be made, with Fortis' bid one of two competing bids for ABN Amro. Jim Brown has been warning for some time in his weekend Wraps that M&A deals would be impacted by the credit crunch, and that's playing out to some degree. The problem is that no one knows to what degree these M&A deals will be affected.
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News that the SEC was diligently searching the books of Wall Street's investment banks, including the largest and supposedly most stable, for hidden losses from subprime mortgages and collateralized-debt obligations (CDOs) also increased the fear. The search, reported by Reuters, involved a topic discussed on these pages by other writers: the way that mortgage-backed assets are valued. According to that article, the books of GS and MER will be among those scoured for hidden losses. As has been discussed by people more experienced than I am, those assets can be assigned a book value, but once the holder is forced to sell them, especially in the current illiquid environment, a market value is assigned that might be quite different and much lower than the book value. The SEC wants to see if hedge funds are reporting their losses accurately to investors.
Although this news was reported Friday, some industry spokespersons say that such SEC study is routine. Indeed, the SEC had already announced in late June that it was scrutinizing a number of CDOs. The information today was more volatile, however, in a climate that includes confessions or actual fund closures by the likes of Bear Stearns, UBS AG and BNP Paribas. In addition, CNBC reported during the middle of the day that the respected Renaissance hedge fund was telling investors that it had lost 8.7 percent in August. Earlier in the day, a commentator on CNBC was wondering out loud whether funds would report losses before they measured 10 percent or so, at which point they would be morally obligated to do so.
These aren't fly-by-night organizations with names we scarcely recognize, but instead are names recognized and respected by the world's citizens. What's safe, mom and pop investor were asking on Friday, with moms and pops all over the world doing the asking. Central banks worked behind the scenes and analysts worked in front of the camera assuring those moms and pops that the world's economies were not, indeed, falling apart. Still, rumors continued to circulate that a big hedge fund was being forced to liquidate positions, so little comfort could be obtained during earliest trading.
The concern doesn't stop with these institutions, either, as market watchers speculate and come to wildly different conclusions about the exposure of Japanese banks to the subprime difficulties. These institutions, among the largest in the world, have variously been characterized as probably too stodgy to delve into the mortgage-backed asset vehicles and perhaps too dodgy to admit their exposure if they had. A LONDON TIMES article quotes a Deutsche Bank analyst who notes that the language Japanese banks are using to describe their exposure is reminiscent of that they used during the 2001-2003 banking crisis is Japan, while other interviewed analysts asserted that the Japanese banks were in a far better position to ride out the difficulties caused by the subprime problem than were European and U.S. financial institutions.
It sounds dire, doesn't it? Comparisons with 9/11, 1998 and other crises didn't help. Let's look at charts and see what they're telling us, if anything, and whether matters as seen on the charts are really that dire.
The SPX's chart was not particularly dire although it's not offering many comforts, either.
Annotated Daily Chart of the SPX:
A strong spring off support, such as today's, is typically a sign of short-term bullishness, but short-term bullishness was short-term indeed when a similar spring was produced on 8/01. Consider that when deciding on how bullish this spring and the resultant doji at support might be.
As noted on the chart, I believe that prices may chop around, hopefully with the amplifications of each wave tamping down somewhat until a recognizable triangle or flag is formed. We can then watch for a breakout or breakdown, being always cognizant until then that markets look and feel vulnerable now, and any strong push through this tentative support level being established could wipe out confidence and prompt a rout.
Right now, however, all we have is a chop zone with nothing recognizable to guide us. Shortest-term (early Monday) sentiment may, with emphasis on "may," be bullish, but that sentiment won't last through a single press conference by a large hedge fund or bank or central bank that damages sentiment.
If short-term bullish sentiment survives through to Monday morning and if indices climb, protect short-term bullish profits at each red trendline and especially at the influential (for the SPX) aqua-colored 72-ema.
I haven't shown the RSI on this chart as there's just too much else to show. Because so much happened Friday and so many charts need to be included, this article will already be far longer than is optimal. However, RSI has been climbing as prices churn. That's not usually a bullish sign, so that information should be factored into other conclusions.
Annotated Daily Chart of the Dow:
The Dow also sprang off support, although "support" appears to be hanging in space or along a megaphone support line in this chart. When looking at a daily nested Keltner chart, which I'm not including here in the interests of keeping this article no longer than is necessary, the support becomes more obvious. Currently that support is at about 13,181.40 on daily closes, with next support below that near 12,990-13,026 on daily closes. The Dow punched down toward that lower support and closed above the stronger daily support. The danger is if the Dow begins producing daily closes beneath the line currently at about 13,181.40. For those who want to watch the changes in this dynamic Keltner line, it is the 120-ema. Some might prefer to watch the band between the 100- and 130-ema's.
It should be noted that the Dow's shape is anything but bullish. It's forming a head-and-shoulder shape at the top of its climb. I don't believe that these formations are trustworthy any longer, but it should be noted that daily closes beneath the 120-ema that I've mentioned would constitute a confirmation of the head-and-shoulder formation. While I might not trust these head-and-shoulders formations any longer, I certainly do watch them for the information they can give us about bullishness or bearishness.
Annotated Daily Chart of the Nasdaq:
Annotated Daily Chart of the SOX:
The Russell 2000 also performed rather well on Friday, managing a relatively sedate trading day. The 200-sma and -ema's continue to provide resistance, so the trading can not yet be considered bullish, but "sedate" almost substitutes for bullish these days, doesn't it?
Annotated Daily Chart of the RUT:
If, as Jim Brown has long noted, the fate of the small caps helps us measure how willing market participants and funds are to step into the riskier instruments, the chart of the USD/yen helps us predict or corroborate that tendency. The RUT followed the USD/yen pair lower, falling to and through 200-sma as it did and predicting the 200-sma tests to occur on other indices.
Annotated Daily Chart of the USD/yen:
I would have been more alarmed by Friday's actions, even early Friday, if the USD/yen pair had dropped significantly lower. I would have been more comforted if it had closed above its 10-sma. Neither happened.
Friday's and Last Week's Developments
Friday featured the release of July's Import and Export Prices at 8:30. Petroleum-related costs drove import costs higher by 1.5 percent for the month, the sixth straight month that import costs have risen. I don't need to tell subscribers that this is not good news, especially with all the calls for an emergency rate reduction by the Fed, a Fed that's put all on notice that it's still watching for inflationary pressures. Import prices, ex-oil, rose 0.2 percent, up from the prior 0.1 percent. Export prices, ex-agricultural products, were flat.
That release was followed by July's Treasury Budget at 2:00. The Treasury Department reported that both receipts and outlays for July hit record numbers, with the monthly deficit amounting to $36.3 billion. This was roughly in line with expectations, edging just lower than the expected $37.0 billion. For the first ten months of this fiscal year, the federal deficit has mounted to $157 billion, with last year's deficit at $248 billion for the year.
None of these Friday releases was expected to be market moving unless the trade balance was deemed to be so far from expectations that it impacted GDP estimates. That didn't appear to happen.
If rising crude costs pushed the import prices higher, the sharp decline in crude costs during the week ameliorated some of the concerns that rising crude costs would contribute inflationary pressures. With the hurricane season not yet producing hurricanes that harmed production and with the credit crunch instead producing fears that demand will weaken, crude and some other commodities weakened along with equities earlier in the week. Keene Little has been predicting this effect.
I don't want to delve too deeply into the energy complex, as Jim Brown provides the expert analysis in his Leaps and other columns, but I did want to note that on Friday, the International Energy Agency reiterated its estimates of demand for oil for this year and 2008. Although the IEA revised lower its estimates for China and the former Soviet Union, the organization noted a strong increase in demand from Japan that offset the weakening demand in the other areas. Slowing U.S. demand did cause the IEA to trim its estimate for the fourth quarter of this year by 100,000 barrels a day, but estimates for overall demand for 2008 remained essentially the same.
The week had been light on economic releases or events other than the FOMC meeting. Did our Fed get it wrong at that meeting? By Thursday, when central banks across the globe injected money into the system to maintain liquidity, pundits already questioned whether our FOMC had missed an important opportunity at that meeting and whether other countries' central banks were wrong, too. Various pundits called for an emergency meeting here in the U.S. to cut rates, and some pointed to action in the Fed fund rates or to the Fed's injections of cash as signs that such an emergency meeting was needed or would occur. Some claimed that the FOMC's bias should have been shifted more toward neutral at least, with stronger acknowledgement of the risks due to the subprime meltdown.
Some asked how Japan could move to a tightening bias if the central bank was busy flooding the markets with yen late in the week. How could the ECB inject money to support liquidity on the same day that it was employing language that typically signaled a near-term rate hike, as happened Thursday? A Merrill Lynch analyst was telling his clients late Thursday that our Federal Reserve might be required to cut rates in an emergency inter-meeting move within a week, before the September 18 FOMC meeting. According to an AP article this afternoon, the president of Yardeni Research was saying the same thing, as presumably many others are doing.
Others, such as Merrill Lynch's David Rosenberg, warned in a Dow Jones article this morning that the Fed's injections of funds this week did not signal that they would move to ease rates. Added to his voice were others who claim that a rate cut wouldn't be effective anyway. These included economists at JP Morgan Chase and JVB Financial, according to a MarketWatch.com article. In the Market Monitor, the live portion of our site, Keene Little on Friday compared such action to pushing against a string, and those economists quoted in the MarketWatch.com article appeared to agree. If the problem is in determining a correct price for mortgage-backed assets, how would easing help, JVB Financial's chief economist questioned.
Other economists and analysts noted other times that such lowering of rates had helped. They pointed to such action in crises that they deem similar, such as during the implosion of Long-Term Capital Management, a hedge fund that imploded during the 1998 Russian debt crisis. Whether or not the Fed heeds increasing cries to lower rates or whether such action ultimately helps, if it does occur, a few analysts at least gave the Fed credit for being responsive to the current crisis when they injected funds Friday. Those analysts felt that the Fed had not ignored the crisis while keeping their focus entirely on inflation concerns, as some were afraid they might do.
Next Week's Economic and Earnings Releases
If this week's slate of releases was tame, next week's will be anything but tame. Tuesday's I; Wednesday's CPI, NY Empire State Index and Industrial Production; and Thursday's Housing Starts, Building Permits and Philly Fed Survey all could impact trading. In particular, most consider the CPI one of the most important inflation gauges, and the FOMC reminded us this week that it remains vigilant, watching for increasing inflation pressures.
EcEconomic Releases for Next Week:
Earnings reports from the majors begin to slow next week. Tuesday features reports from MAT, HD, UBS and WMT. Thursday, BEAS, HPQ, KSS and JWN report.
WWe probably have more to fear from rumors or hard news of other hedge-fund or bank problems or deal failures than from a reporting company. Perhaps UBS, because of its already mentioned connection, has the potential to roil markets.
What about Monday and the Rest of Next Week?
Thursday, I wrote about "spooky action at a distance," a term that Einstein used to describe his objection to some of the implications of the quantum theory that he helped usher into being. I noted then that we were seeing some "spooky action at a distance" of our own, with what was done or not done by the world's global banks immediately impacting what happened at a distance: namely, in our equity markets. If anything, Friday heightened that impression. Many people expressed the belief that, without those infusions of cash by our central banks, the carnage on Friday would have been extensive.
Is that true? Let's take a breath and look at what charts were showing us Thursday afternoon, via a 15-minute Keltner chart that I posted in Thursday evening's Wrap. I'm going to include it as it was set up Thursday, complete with the original annotations, so please do note that the prices here are not accurate as of Friday's close.
AAnnotated 15-Minute Minute Chart of the SPX:
Obviously, the 1449 area did not prompt a bounce, with the SPX gapping down into that zone and diving from there. But did the eltner target and likely support factor into Friday's trading, trading? Let's look at an updated chart. I'll leave the arrow but change the annotations.
AAnnotated 15-Minute Chart of the SPX:
Either all that collective knowledge reputedly reflected in charts already knew that the globe's central banks were going to step in Friday and support markets or else markets were generally just doing their thing anyway, falling to a technical target that had been set and then bouncing from it. eltner targets serve as both targets and likely support or resistance, depending whether they're downside or upside channel lines.
What comes next for earliest trading on Monday morning? I wish I could tell you, but this time, charts are unclear. Unlike Thursday evening, no new target has been set on the SPX or on many other charts. Resistance appeared to hold again on the SPX's second test, which normally suggests that at least a slight pullback is needed to gather energy for another test. In addition, the lower black channel line still slants lower, indicating that support is not yet firming, as prices sometimes slide down a descending-lower Keltner line. However, RSI (not shown) had not yet risen into an extreme level, indicating that the current upward push could still have a little "uumph" left.
It's uncertain, unclear, but as the chart notes, those who hope for stabilization would like to see any pullback stop at the black channel line.
AAnnotated 15-Minute Chart of the Dow:
Annotated 15-Minute Chart of the Nasdaq:
Annotated 15-Minute Chart of the Russell 2000:
I'm not an economist. I consider myself a financial writer, one with a bent
toward technical analysis. When writing this article, I must be considered only
a reporter. Analyzing the effectiveness of a rate cut, ernanke's effectiveness
in his stiffest test yet as our Fed head or the exposure that Japan's banks,
among the biggest in the world, have to the credit mess is beyond my
capabilities. I defer to the charts, and they're telling me that the volatility
could likely continue until
we know more. If what we find out is damaging, the
volatility will likely resolve with a downside move. If we can weather the
further damaging announcements that will surely occur, the markets may churn out
support levels that lead to tentative buying at least. I don't think direction
is resolved yet, but it could be at any time if the news is negative enough. As
painful as it is to endure the current chop, it's my opinion that the best
scenario would be to continue to chop out a
support zone until it's well formed,
perhaps some time from now, and then to break to the upside.
Play Editor's Note: The markets have been exceptionally volatile lately. Sometimes the best play is to actually sit out and not trade. We are adding a few bullish positions because the markets, and these stocks, look poised to bounce. However, they are all more aggressive, higher-risk plays. We picked stocks that should not have any exposure to the weakness in financials and sub-prime fears.
Cleveland Cliffs - CLF - close: 67.30 chg: +4.18 stop: 61.45
Why We Like It:
BUY CALL SEP 65.00 CLF-IM open interest= 147 current ask $6.30
Picked on August 12 at $ 67.30
Chevron - CVX - cls: 83.42 change: +2.31 stop: 79.35
Why We Like It:
BUY CALL SEP 80.00 CVX-IP open interest=10044 current ask $6.20
Picked on August 12 at $ 83.42
Fluor - FLR - clse: 121.00 change: +0.68 stop: 114.99
Why We Like It:
BUY CALL SEP 120 FLR-ID open interest=216 current ask $7.60
Picked on August xx at $ xx.xx <-- see TRIGGER
XTO Energy - XTO - cls: 57.08 change: +1.84 stop: 54.45
Why We Like It:
BUY CALL SEP 55.00 XTO-IK open interest=1521 current ask $4.20
Picked on August xx at $ xx.xx <-- see TRIGGER
Penn National Gaming - PENN - cls: 56.05 chg: -0.78 stop: n/a
Our speculative, high-risk play in PENN has not panned out. PENN failed to find any new bidders to raise the buyout price. Meanwhile the credit market has collapsed and shares of PENN are trading significantly under the $67 buyout price announced back in June. This weakness is suggesting that the market doesn't believe the deal will get done in its current form or price. We are not suggesting new positions at this time. However, it's worth noting that on a technical basis Friday's intraday rebound almost looks like the second half to a bullish double-bottom pattern. Unfortunately, technicals become less reliable when we're dealing with a stock in a post-merger or post-buyout announcement. FYI: We'll be dropping this stock at August option expiration.
Picked on June 17 at $ 62.12
Sears Holding - SHLD - cls: 133.10 chg: +3.20 stop: 127.49
We are issuing another reversal alert for SHLD. This time the stock has produced a bullish reversal with Friday's bullish engulfing candlestick pattern. The stock dipped to $128.00 on Friday morning and rebounded to a 2.4% gain. This is a new bullish entry point to buy calls. Our short-term target is the $139.50-140.00 range. We plan to exit ahead of the August 30th (unconfirmed) earnings report. More aggressive traders may want to aim higher. The $145-150 zone looks like a tempting target. FYI: We noticed a large number of calls were traded at the September $140 strike on Friday.
BUY CALL SEP 130 KTQ-IY open interest= 520 current ask $10.80
Picked on August 3 at $133.00
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
Daimler-Benz AG - DAI - cls: 83.84 chg: -0.51 stop: n/a
Intraday weakness pushed DAI (new symbol) to $81.85 before the stock bounced back into the close. This pushed the August $85 puts to an intraday high of $3.90. We are not suggesting new strangles on DCX at this time. The options in our suggested strangle were the August $95 calls (DAI-HS) and the August $85 puts (DAI-TQ). Our estimated cost was $3.70. Please note that we're running out of time. August options expire in five trading days. Therefore we're adjusting our target to sell the winning side of this strangle to $5.55, which would be a 50% gain.
Picked on July 22 at $ 89.75
ITT Educ. - ESI - cls: 108.29 change: +9.65 stop: 105.05
Shares of ESI hit our stop loss at $105.05 on Friday. Why did the stock spike 10% on Friday when most of the market was flat to down? Normal news channels don't say why ESI was so strong. You can see the sharp rally in the morning and then the huge spike higher midday shortly after twelve noon. Evidently the catalyst behind Friday's spike was news that Goldman Sachs (GS) has upped (or announced) their stake in ESI is now at 10.1%. This was revealed in an SEC disclosure filed on Friday. Click on the link here for details. Look down to page 1 of 7 and then look at line 9 and line 10. This event is another good example of why we have to play with stop losses. An unexpected event can always push stocks in the opposite direction.
Picked on August 05 at $102.22
These days, everyone wants to know where the equity markets are going. Is the outlook at ugly as it has been?
Equity traders turn on CNBC before they have their first cups of coffee. If futures are higher, bulls preen in this mirror that they believe gives a glimpse of the earliest trades, although they haven't been doing much preening of late, unfortunately. If futures are lower, bears are the ones preening in front of that mirror.
Both bulls and bears could be looking at distorted images, though, unless they're also looking at fair values. Turns out, the mirror can lie. Of course, on days like Friday, when the SPX futures were down in the range of 15-25 points, depending on when one first glanced at the television screen or computer monitor, they weren't telling lies. The SPX was going to decline at the open. However, if the S&P 500 futures were down by two points, but the fair value for that index was lower by five, then futures are stronger--prettier, if you want to stretch the mirror analogy--than fair value. The SPX may be moving higher during the earliest trading, not lower.
I'm reprising a previous article on fair value for the benefit of new subscribers or for those who might have forgotten the definitions. They're easy to forget. Just as beauty is in the eye of the beholder, so is "fair" when it's applied to fair value.
If you're not quite sure about what the terms means, you're not alone. According to H.L. Camp and Company in a statement made several years ago, more callers to CNBC's Squawk Box asked about fair value than any other topic. Some people wouldn't approach CNBC for a definition, perhaps unfairly believing that the CNBC version of fair value differs from the strictest interpretation of that term.
So, let's get to definitions. According to Investopedia, the CNBC-type meaning references the difference between the actual cash value of an index and the futures contract on that index. More specifically, Herb Greenberg, Senior Columnist for TheStreet.com several years ago defined the CNBC-type term as the difference between the closing price of each of the component stocks of an index and the closing price of the futures contract.
That type of fair-value calculation, whether or not CNBC employs it, will garner complaints from purists, however. It did for Herb Greenberg back in 1998 when he briefly answered a reader's question about fair value. One correspondent to his column wanted to redefine that "CNBC-type" fair value, as many sources tagged it, as the "the closing spread," a different value entirely from the more respected fair-value meaning. Greenberg's next column was comprised of a number of excerpts from readers who wanted to expound upon or argue against Greenberg's brief answer, but none contested Greenberg's characterization of CNBC's use of fair value.
Maybe they should have contested that unfair characterization. An article written by Mark Hanes and contributed first to CNBC.com and then reprinted on another source comports with the more traditional definition of fair value, as it turns out. So, let's get to that one.
Investopedia offers another definition in addition to the "CNBC type" one. That second definition notes that fair value is calculated by figuring in spot price, compounded interest paid and dividends lost until the expiration of a futures contract. Futures owners do not collect dividends, as do owners of the actual stocks.
Index arbitrage traders may be more interested in that traditional computation than in a closing spread. Here's how it works. If futures are priced at fair value, then they're theoretically at the same value that cash indices are in the absence of transaction costs. To calculate fair value, financing charges, a function of interest rates, would be added to the spot prices, and dividends would be subtracted to account for those transactions costs. The Chicago Mercantile Exchange's Rule 813.D sets forth the calculation and rules for fair value. HL Camp & Company uses the following formula:
FV = S[1 + (I - D)], where "FV" is fair value, "I" is the interest a trader would pay to borrow enough money to buy all the SPX stocks, and "D" is the dividend that would have been collected if the stocks had been owned instead of futures.
There's a time factor applied to the calculation of the interest, as the interest must be calculated from the date of the FV calculation until the expiration of March, June, September or December expiration of a futures contract. Carrying costs will drop as a futures contract draws nearer to its settlement day, so the fair value will more closely approach the actual spot price of the index in question. Those interested in following an exact computation of fair value, an exercise that might be useful for all to follow at least once, can find such a sample computation at http://www.cme.com/trading/prd/equity/fairvalue.html on the Chicago Mercantile site. Following such a computation provides a greater grasp of how fair value might change as interest rates or dividends change.
Hanes' article makes note of the same computations in the CNBC's version of fair value. At the time his article was written, CNBC was receiving fair values from Prudential Securities, and Hanes noted that the formula used was as follows:
F = S[1 + (I-D)t/365], where F is the fair value for futures; S, the spot index price; I, the interest rate, expressed as a money market yield; D, the dividend rate, expressed as a money market yield; and t, the number of days from the spot value date until the settlement of the futures contract. That formula argues against detractors who claim that the "CNBC type" fair value is a less useful measure of closing spread.
Useful or less useful to index arbitragers, that is, although many everyday traders might be interested in the times when futures and index values get so out of synch that program buying or selling programs are likely to be triggered.
For that reason, the discussion of fair value probably wouldn't be complete without a discussion of premium. One of Greenberg's correspondents described premium as a threshold amount above or below fair value, at which buy or sell programs might be triggered.
If futures contracts are trading at fair value, big funds or institutions don't care whether they own stocks or futures. Arbitrageurs aren't going to find an opportunity to exploit the difference. If futures are trading at a threshold amount above fair value--if it would cost a threshold amount more to buy and hold futures until their settlement than to buy the equities and pay the transactions costs until that settlement day--then futures contracts might be sold and equities bought. If equities are trading at a threshold amount above futures, arbitrageurs might take the opposite action. When I first researched this article several years ago, HL Camp and Company claimed that index arbitrage actions then accounted for only about 10 percent of all program trading activity, however, and I read recently that advances in electronic trading has further diminished opportunities for arbitrage trades. I can't verify that as being true, however.
For those interested in watching for program trading activity, premium value should also be understood. Premium values are spreads that measure the arithmetic difference between futures and spot index values. So there's that plain old spread showing up again, rather than the more complicated formulas for fair value. Hanes says that CNBC defines "premium" just as it's defined here. Premium value can be monitored on many charting or quote services. Traders should check the symbol help section on their services to find the appropriate levels.
So how is that spread or premium used on CNBC or elsewhere? HL Camp & Company provides program selling levels each day for those traders interested in setting alerts for potential program selling or buying signals. The various companies issuing these program trading signals might offer slightly different results because they're the ones calculating what they think that threshold level will be.
While these sources include premium, as defined as that spread, in their decisions as to where program buying or selling might occur, they do not use premium alone. Rather, they include proprietary studies on where program selling is most likely to occur with respect to the fair value and the premium of the futures to the cash index. They're making proprietary guesses, if computer-assisted and sophisticated ones, as to the probability that a buy or sell program would be triggered at a certain premium level. Hanes' article indicates one reason that some buy or sell programs might not be triggered when expected and why those proprietary studies might be needed. Because arbitrageurs use borrowed money and since each might have a slightly different interest rate, not all arbitrageurs might act at the same premium level.
HL Camp and Company describes premium as the spread between the most active of the available S&P 500 futures contract, usually the front-month contract, and the actual cash index value, with the cash index value subtracted from the futures contract. Most times, the spread varies between +/-$5.00, the site notes. This company's numbers are projections for the amounts at which they believe program trading will kick in and index stocks might be bought or sold as a result. The company corroborates that premium values cannot be used as a pure indicator of when a buy or sell program might kick in, as the company's extensive research has shown some occasions when PREM signaled that a buy or sell program should occur but didn't.
Some traders find it helpful to monitor premium values and match that to a preferred source's projections of when buy or sell programs might be hit, to gauge their own buy or sell decisions on these best guesses. However, as Hanes himself cautioned, the action of buying stocks when futures are a certain threshold above fair value helps to narrow that spread. That action brings futures closer to fair value. The narrowing can happen quickly, as it can when futures might have been at a discount to the indices, and equity selling occurs. My recent reading, since this material on fair value and premium was first presented, suggests that the narrowing occurs faster now than it previously did in this age of electronic trading.
Those who have seen pre-cash-market futures values far above or below fair value are often surprised to see action at the open. That upward or downward bias sometimes doesn't last long, sometimes not even until the cash open. Use those comparisons as one tool only.
If Hanes' characterization is correct, it turns out that those who disparage "CNBC type" fair value might need to be a little fairer in their criticisms.
This article was intended to provide an overview of these often-confused terms
rather than to promote a trading style based on potential program selling or
buying points. Some find such tactics useful; others, less so. Traders should
monitor premium and expected buy or sell programs for a time to determine
applicability to their trading styles before basing decisions on those signals.
Today's Newsletter Notes: Market Wrap and Trader's Corner by Linda Piazza and all other plays and content by the Option Investor staff.
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