Friday started off negative after JP Morgan confessed a $2 billion loss for a trade gone bad. After a brief rebound the indexes finished in the red once again.
While we don't as yet know the specific details of the JP Morgan trades that have cost the company $2 billion through last week we do know what happened in a generic sense. JPM had a portfolio of $379 billion in bonds at the end of March. Only 30% of those were guaranteed by a government agency. That was down from 42% at the end of 2010. This compares to the $293 billion bond book at Bank of America that is 87% in agency guaranteed securities.
JP Morgan wanted to hedge this bond risk and the Chief Investment Office (CIO) attempted to hedge the risk by buying/selling credit default swaps. Those swaps would have allowed JPM to profit if the bond holdings went against them.
However, a trader in the Europe office leveraged up these swaps to the point where hedge funds and other institutions figured out what they were doing. Bloomberg did articles on these monster trades in March and April and Jamie Dimon blew it off then as a "tempest in a teapot." That article alerted even more hedge funds to the enormous positions and everyone started betting against the JPM hedges.
The bank did not realize it was in serious trouble because they had moved to a new software program for calculating the daily "value at risk" or VAR. In theory that is the amount of money a bank can lose on any day based on their positions. The new program did not accurately value the CDS positions. When they saw they were losing money in excess of the VAR estimates they went back to the old program and suddenly the VAR doubled. This set off alarm bells at the highest levels of JPM and they immediately began to try and close the positions. However, since the hedge fund community had caught on and were betting against JPM they began taking huge losses in closing the CDS positions. At one point they had to quit trading because the market deck was stacked against them so heavily.
The CDS market is extremely thin and with JPM trying to exit billions in positions all at once the bids went significantly against them. In fact JPM is still exposed. Dimon said it could take a couple of quarters to completely unwind the positions. That means there is not enough liquidity to close the swaps at a reasonable price. JPM will have to hold the remaining positions until they can find willing buyers and that could take some time. Dimon said the $2 billion loss was a starting point.
However, despite the magnitude of the trades and the loss the bank is in no trouble. Even with the loss they will still post a profit in Q2 and for the full year. They expect to produce revenue of more than $90 billion in 2012 and earnings before share buybacks of more than $15 billion. Losing $2 billion is a blow but relatively speaking the bank is still very profitable.
The biggest blow came to the rock star status of Jamie Dimon. He was widely regarded as the best CEO in the megabank world but having to admit this kind of problem is a serious black eye. He admitted the hedge was "complex, flawed, poorly executed, poorly reviewed and poorly monitored". He said the trade was structured wrong and managed terribly. In an interview he gave late Friday for Sunday's Meet the Press he said "We were sloppy, we were stupid and we know we exercised bad judgment." He said "we should have paid more attention to the news reports."
The trader responsible for constructing the "synthetic credit portfolio" was Bruno Iksil otherwise known as "the London Whale" and as "Voldemort" the villain in the Harry potter series. At one time he said he could walk on water, referring to his skill at constructing elaborate portfolios producing large profits. He had attracted market attention in early April with "epic" sized market moving trades in the CDS market. The face value of the position was in excess of $100 billion. The size and quantity of these trades had garnered some serious attention in the community and in the press. A Bloomberg reporter and former trader who covered hedge funds for 14 years, Stephanie Ruhle, began writing about the mysterious whale trades back in early April.
It was clear JPM shares were going to take a serious hit on Friday after the confession late Thursday night. With JPM a Dow component this was a direct influence on the Dow. JPM shares declined -9.3% to close near the lows of the day. This knocked 29 points off the Dow.
Once this news blows over and the trade liability ends we know JPM will come back strong. That may be months from now but you can bet Dimon will put controls in place to make sure this type of event does not happen again. JPM shares hit a low of $28 last year and closed at $37 on Friday. If we get a drop back to that $28 range I would be a buyer for a long term hold.
The S&P futures were severely negative on Thursday night based on the cockroach theory. If JPM had trading problems then the other major banks probably had them as well. By Friday morning this theory had been discounted and the bad news was pretty much a JPM only story. The Dow opened negative about -75 points. It quickly rebounded +139 to test resistance at 12,920 from the prior four days and then the sellers took over and it was a long slow slide into the close. The JPM news did not accelerate the decline for the week but merely confirmed it.
Dow Chart - 15 Min
The economic news helped to relieve some of the gloom and doom at the open. The Consumer Sentiment for May rebounded sharply to 77.8 and a four year high! The April number was 76.4 and expectations were for a small decline to 76.0. This surprise gain stretched the streak of consecutive monthly gains to nine months.
The present conditions component spiked sharply from 82.9 to 87.3 to provide all the momentum to the headline number. The future expectations component declined to 71.7 from 72.3. The recent decline in gasoline prices from $3.92 to $3.73 was credited with the majority of the improvement. Back in April all the news headlines were predicting $4 gasoline and once that daily price hike stalled and started moving lower it was a relief to consumers.
The stabilization in the labor market may also have helped. The Nonfarm Payrolls for April remained level with March and did not continue their steep decline. The jobless claims have also returned to prior 2012 levels and the three weeks of spikes to 390,000 have ended. Claims returned to 367,000 last week.
However, the decline in the stock market could weigh on the next sentiment release. The declines have been minimal at about -4% but the streaks of losing days will cause sentiment to decline.
Consumer Sentiment Chart
Jobless Claims Chart
The Producer Price Index (PPI) declined -0.2% for April as inflation pressures eased. The year over year rate declined for the seventh consecutive month to +1.9%. Prices for finished goods fell -1.4% and the biggest drop since October thanks to the falling gasoline prices.
The core rate, excluding food and energy, saw prices rise +0.2% and slightly less than the +0.3% rate in March. Prices for products made with crude oil fell by -4.4%. Commodities declined and that helped push many of the prices lower. Cotton prices fell to a five year low after India ended an export ban. Copper prices are also declining because of slower manufacturing in China.
The economic calendar for next week is highlighted by the FOMC minutes on Wednesday and the Philly Fed Manufacturing Survey on Thursday. The FOMC minutes are going to be the key event for the week. We already know there is dissension within the Fed but the minutes will give us a clue as to how heated the discussions were and to some extent what options were discussed.
The Facebook IPO is tentatively scheduled for Friday. However, late Friday CNBC said it could be delayed because the SEC has not yet approved the latest filing. Rumors are claiming it is oversubscribed by a factor of 10. However, Bloomberg said institutional investors are shying away from it because they are skeptical about the company's prospects since ad revenue has not kept pace with user growth. Facebook amended its S-1 form on Wednesday to show the number of ads per daily average user is falling. Q1 revenue declined -6% from Q4. Bloomberg cited "people with knowledge of the matter" saying the institutional demand was much weaker than expected. Retail investors still appear to be excited but they will each buy far fewer shares than institutions would normally.
An investor poll found that 79% of investors, analysts and traders who subscribe to Bloomberg thought the $96 billion valuation was too high.
Several top name investors and analysts have said Zuckerberg's decision to wear his trademark hoodie to the road show events was a mark of immaturity. As a hedge fund manager contemplating investing millions of dollars in a company they would like to feel confident the management is professional and competent. Zuckerberg controls 57% of the voting shares.
Quite a few analysts expect a huge pop on the open and then a quick fade. Almost nobody in the analyst community is recommending buying the shares in the open market. The consensus appears to be "if you can get them in the IPO then sell them at the open."
I am worried about the amount of cash the IPO will take out of the market. The official price range is $28 to $35 but they could easily raise that to $40 based on the excessive retail demand. Just using a $40 price and the 185 million shares Facebook is selling, assuming an overallotment, and the 157 million shares being sold by existing shareholders you get roughly $14 billion. That means investors will have to sell billions of dollars in shares of other companies in order to have the cash available in their account when the IPO prices. That suggests there could be an underlying cash drain in the market early in the week.
The number I will be interested in is the number of shares traded on the first day. With 342 million shares available to trade on the first day I would not be surprised to see one billion shares trade as the churning begins.
In stock news embattled energy company Chesapeake (CHK) announced after the close it had received an emergency bridge loan from Goldman Sachs and Jefferies Group of $3 billion. The short term loan will be used to repay part of its existing $4 billion revolving credit facility. CHK has been in a cash squeeze as gas prices plummeted and the company was forced to curtail production. The company said earlier in the day it may have to delay asset sales in order to preserve cash flow to remain within its banking covenants. Selling producing assets reduces reserves and cash flows and impacts your balance sheet. That also reduces the amount of collateral held by secured creditors.
Chesapeake has been under fire because of news events surrounding its high profile CEO Aubrey McClendon. The new loan will allow CHK breathing room while it tries to sell up to $14 billion in assets in 2012. The company needs to sell assets to raise cash because of its high debt load and falling revenue. The new debt facility matures in 2017 and carries an interest rate of 8.5%. The rate is high but the loan is "unsecured."
Fitch Ratings estimates CHK was facing a funding gap as high as $10 billion in 2012. Between now and the end of 2013 CHK is facing required capex spending of as much as $23 billion. In most cases CHK has to drill wells on new leases in order to hold them with production. That means they have to drill wells that are currently unprofitable in order to preserve the leases until gas prices rise again.
Shares of CHK plunged to a new multiyear low.
The dollar rallied for its ninth day and closed at a two month high as the worries in Europe increased. Greece failed to form a coalition government for the third time as each of the three major parties exhausted their three days each in an attempt to head off new elections. There is only one more event that could avoid those elections and that is a meeting with the country's president. The socialist party leader, Evangelos Wenizelos, the third party leader to fail the coalition effort, said he would hand the mantle back to the president on Saturday. The president will bring all party leaders together for one last attempt to find common ground before the mandated elections, which would occur in June.
While the parties could not form a coalition they did seem united in not wanting to follow through on the bailout terms. Austerity was voted down and now the people will have to find a way to vote in a coalition that will follow their wishes.
Greece leaving the euro currency was a topic in nearly every piece of analysis I read this weekend. This seems to be a done deal even though the public is going to be crushed when it happens. Banks are going to fail. Businesses are going to fail. Savings will be cut in half. In the beginning it will be ugly but a year from now the results for Greece will probably be better conditions. With ultra cheap money their products will be cheap and tourism will probably double or triple.
In Spain the banks have been given 15 days to raise 30 billion euros in new capital or be nationalized. This is on top of a 54 billion euro plan ordered in December. They have to raise loan loss reserves from 7% to 30% on real estate loans. They have 15 days to either come up with the cash or present plans on how they will raise it or be forced to take government loans in the form of convertible bonds with an interest rate of 10%.
Unfortunately there is an estimated 180 billion euros of toxic real estate loans on the books of Spanish banks. Nonperforming loans are in excess of 20%, some claim it is more than 25%. The banks will require an additional 200-250 billion euros in new capital to reach the level required by the EU later this year. Basically the Spanish government is going to have to create new debt amounting to roughly 25% of its GDP before the end of 2012 in order to keep the banks afloat. Those same banks borrowed roughly 332 billion euros from the ECB in the one trillion euro handout six months ago. I would bet against that money being paid back to the ECB when the three years are up.
On Friday Art Cashin reiterated the problem with bank runs in Europe. Citizens who don't want to end up with drachmas or lira in their account some morning in the near future will be withdrawing euros in cash to stash under their mattress. This has already been underway for the last several months but with Spain talking nationalism it is sure to accelerate. The faster the withdrawals the quicker the banks will fail.
On Saturday more than 100,000 demonstrators gathered across Spain to protest the austerity program. They are demanding repeal of the current austerity programs.
Spain's Puerta del Sol Plaza
Ireland will vote on austerity on May 31st and analysts are worried they will vote against the current leaders after Greece voted their leaders out. Austerity is not fun but most citizens don't understand the alternatives. Ireland is widely expected to default on its debt but elect to remain in the euro.
European economics are worsening along with the political outlooks. There were even people talking on Friday about Germany pulling out of the euro because of the coming QE programs by the ECB in order to rescue the debtor nations, which is rapidly becoming all of them. If Germany withdrew the rest of the euro would collapse.
Over the weekend there was an article in the main German paper that appeared to acknowledge the need for further QE by the ECB. Germany had been strongly against debasing the currency through multiple QE programs like the LTRO because they have suffered through unbelievable inflation in the 1920s. Paper money was so worthless it was cheaper to burn for heat instead of using it to buy firewood. They actually had one trillion mark notes. The one below is a 20 billion Mark note.
German 20 Billion Mark Note
Burning German Notes for Heat
If Germany is now relenting on additional ECB QE then it will probably take the form of new LTRO programs. Banks can buy sovereign debt like Spain's at 5%, use it as collateral in LTRO offerings to borrow more money at 1% interest and then buy more sovereign debt to use as collateral in the next LTRO, etc, etc. In this way the sovereign yields are kept artificially low while the banks pocket a fat 4% spread on what will end up being trillions in quantitative easing. The entire house of cards will eventually collapse when the countries default on their debt but that "can" will have been kicked three years down the road by the LTRO. There is no solution to this problem. Spain will likely default followed by Italy and then France. French debt to GDP is over 140% when guarantees to the EU bailout programs are included. Downgrades to their credit rating could come any day now that Hollande has been elected.
The problem is the common euro currency but no common government or common budget. The individual countries can't print their own euros so they are forced to live on a budget only they have been exceeding that budget by taking on excess debt when they have no hopes of ever paying it back. There is no easy solution and the Greek domino is only the first one to fall.
The growing problems in Europe have pushed the euro to a four month low while the dollar broke out to a two month high. Because of the scenario laid out above the euro is going to continue lower in the long run and that supports the dollar. This dollar strength along with economic weakness in Europe and China has pushed commodities to multi week lows.
Dollar Index Chart
Gold prices broke below $1600 and below next level support at $1581. It would appear a test of $1550 is guaranteed because I don't see any dollar weakness in the near future.
Gold bulls are still predicting $2000 by year end. Eric Sprott, Citigroup and Morgan Stanley are in that camp. Goldman is predicting $1840 by year end. They base this on the economic cliff facing the U.S. in January. There are $1.2 billion in mandatory spending cuts. There are more than a dozen tax increases plus another $1.3 trillion budget deficit. Regardless of whom wins the election the next 60 days after the November ballot will be very hectic and outgoing lawmakers don't have the best record for governing responsibly.
Crude oil continues to fall in lock step with the dollar's gains. Helping push it lower is the turmoil in Europe and the calming words coming out of Saudi Arabia. Iran has started to increase its bluster over the scheduled May 23rd meeting but Saudi is repeating to anyone who will listen that they have 2.5 mbpd of spare capacity and more than 80 million barrels in storage. Whether either claim is valid we may never know but the repeated claim and the rising dollar has pushed WTI down to just over $95.
Crude Oil Chart
The S&P declined to 1343 on Wednesday and the support of the 100-day average at 1353. Both levels need to hold if there is going to be any hope of a return to a bullish trend. That 1340 support dates back to February and a break below that level is going to set off alarm bells at every trading desk in the country. The combination of a break of 1340 and the 100-day average is double trouble.
The banks are supposed to be major contributors to S&P earnings in the second half of the year. If the JPM problem forces new regulations or a cutback on current operations at the major banks then those earnings could be in jeopardy.
Similarly if oil prices decline below $95 the earnings in the energy sector will decline and that was also a major component of the S&P earnings for the rest of the year. Once analysts start cutting estimates on entire sectors the outlook could quickly dim.
We have had a decent bout of profit taking but it only equates to about 4% on the S&P. That is barely a thunderstorm for the markets. However, after watching the entire month of April in a consolidation pattern with a month end rebound that failed, we could be looking at a change in investor sentiment.
Fortunately that 1340 support level is very clear on the chart so there will be no ambiguity about when to go short. If 1340 breaks it could be a quick ride to -10% at 1275 and the 200-day average.
S&P-500 Chart - Daily
The Dow chart has the same clear cut chart pattern with the 100-day average and strong support at 12,750 just ahead. A break of both would target the 200-day average at 12,180.
JP Morgan knocked about 29 points off the Dow on Friday but the Dow finished -99 points off its highs. The rebound failed about as quickly as it started but it was a summer Friday. Volume was light at 6.4 billion shares and declining volume was 2:1 over advancing. New 52-week lows at 186 outnumbered new highs at 146.
We have returned to the "sell the close" pattern. Morning rebounds are sold in the afternoon as longs run to the safety of cash rather than face the overnight darkness.
Until this pattern changes and we start seeing rallies into the close you can bet there are lower lows ahead. This is a sign of a lack of conviction by the longs.
Target a break under 12,750 to be flat or short.
The Dow Transports have declined for two weeks despite falling oil prices for the last nine days. In theory this should have been positive for the transports but the weakening economics proved to be a bigger drag. The transports have strong support at 5050 and the 300-day average. For some reason that average has a strong influence on the transports. As long as the transports are declining the Dow Industrials are not going to mount a big rally.
Dow Transports Chart
The Nasdaq Composite is also teetering on the brink with the 100-day average at 2910 just slightly over psychological support at 2900. Google, Apple, Priceline and other large tech stocks are still trending lower.
Apple is weak after analysts predicted the carrier subsidies for the iPhone were going to be cut. When only one or two carriers had the iPhone they were forced to pay huge subsidies to offset the $649 cost of the phone. Now that basically all carriers have the phone and acceptance of the phone itself is worldwide there is no reason to pay such large upfront fees. If a user is upgrading from one iPhone to another they don't need to be subsidized. They want the iPhone. AT&T is currently paying about $265 per phone to Apple and then recovering that money with the two year contract to the user. If AT&T and others decided to cut that subsidy to $200 per phone the number of sales might drop slightly given the number of other touch screen smartphones available now. AT&T and Verizon beat estimates for Q1 because the number of iPhones they sold were lower than estimates and that means less money put out for subsidy payments. The carriers are dealing from a position of strength in the quarters ahead and while Apple will continue to make great products and sell a lot of phones the newness has worn off the iPhone and profits may begin to slow. Of course that has been the claim for several quarters and it has not happened yet.
Cracks are beginning to form in several of the big cap tech stocks. Google has patent problems and institutional investors seem concerned the company may be devoting too much money in non core areas like the self driving car, solar energy and the race to space. Priceline declined nearly $100 over the last two weeks on earnings problems. Oracle declined -10% over the last eight days. Cisco is down -10%. The last week was not kind to big cap techs.
Eventually this negativity will end but it may not be this week. The 2900 support level will be critical. If investors are content to buy that dip then maybe the tide will turn. However, a break there could quickly target 2735.
The small cap Russell 2000 could be ready to lead us lower. The Russell did not rebound as high as the other indexes in late April and the Russell has already broken below the 100-day average. A break below 785 is going to target 750 and the 200-day average.
The Russell chart looks like a textbook head and shoulders formation. A break below the neckline at 785 should produce significant technical selling.
Russell 2000 Chart
On Saturday China cut the reserve requirement ratio (RRR) for banks by 50 basis points. That action freed up 400 billion yuan ($63.5 billion) for lending in an effort to reduce the risk of a further economic slowdown. It is effective as of May 18th. This is the third RRR cut in the last six months. Data out of China on Friday showed the economy continuing to weaken rather than recovering. Industrial production rose at 9.3% and the lowest rate since April 2009. April retail sales rose only +14.1% compared to estimates of 15.1% and a reading of 15.2% in March. The RRR cut was expected after the bad economic numbers on Friday. However, it should still be market positive for Monday at least in Asia.
I am neutral on the market for next week. A -4% decline to date is just moderate profit taking and the indexes are at decent support levels. We could see a minor rebound but I think the cash drain from the FaceBook IPO will offset any dip buying. Until current support fails this is just a garden variety pullback. Once that support fails (12,750, 2900, 1340, 785) traders will start factoring in a bigger -10% correction act accordingly.
The FOMC minutes is the biggest hurdle for the week but should support break before Wednesday afternoon they will likely be ignored.
Enter passively, exit aggressively!
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