Once again this past week the markets ricocheted
like a hard whacked racket ball in a telephone booth—
AND WE LEARNED A VERY VALUABLE LESSON IN THE
PROCESS
Even though the day after we took our bearish
position on RCI the stock plunged almost three dollars our April 35 puts
barely nudged higher!
Why? Because of an obnoxiously fat bid/ask spread
that wasn’t readily apparent when we recommended the play last Sunday.
In other words the stock headed in the direction we thought it would but
because the bid/ask spread is so wide we didn’t see anywhere near the
gains we should have.
The problem was even more exaggerated on SCRC—on
that play we were stopped out just slightly below our entry point when
the stock suddenly reversed lower--which should have resulted in a very
minor loss—instead we lost much more than we should have because once
again the market makers on this particular stock take a gigantic
profit-whacking bite right out of the middle!
The solution? They can keep their thinly traded
stocks to themselves (and hopefully starve to death in the process) and
from now on we’ll ONLY trade stocks with very narrow bid/ask spreads—why
not give every play the best chance to profit possible?
Now this is really a lesson we’ve RELEARNED because
we’ve mentioned it before in our trading package and on the site—but
sometimes on the weekend it’s hard to tell how wide the spread really
is. But in any case if the spread isn’t super reasonable and the stock
doesn’t show a good volume of options open interest we’re just going to
pass—no matter how good the chart looks.
That said this recent explosion of volatility has
created some outrageous opportunities to make our money back plus a
bunch more for good measure—and we’re going to detail two of the best
later in this update. But before we do let’s take a good look at…
WHICH WAY THIS MARKET IS HEADED
As you can see both of these big indices are in
decline and have recently bounced back up toward their
old/support--new/resistance lines. In other words we may be staring at a
super sweet shorting opportunity here.
So far with
one-third of the S&P reporting earnings have fallen -19% over the same
period in 2006----primarily due to the carnage in the financial sector
and the continuing implosion of subprime derivatives.
The good news is
many of the tech companies that reported last week beat estimates and
guided higher—unfortunately that has not helped their stock prices—a
true sign of bear market sentiment.
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 pummeled for a $30 plunge on weak
guidance. Remember it’s not the news that counts—it’s the market’s
reaction to the news—and last week’s reaction tells us the profits in
this market is on the downside.
More than 633
companies report this week---by far the busiest week of the
quarter--with some big names led by YHOO, AMZN and Google from the
Internet sector and OXY, CVX and XOM from the energy sector.
Then Thursday the
markets get hit with ten economic reports with the headliner the Chicago
PMI with expectations for a drop from 56.4 to 52.0---and possibly under
50 into the dreaded contraction territory. On Friday we get the Non-farm
Payrolls and the ISM Index.
But the big news
this week is the Fed FOMC meeting and the possibility of another rate
cut on Wednesday--on top of the three-quarter point cut last Tuesday.
That big surprise
Fed cut before the open Tuesday was triggered by a very unusual event. A
massive $7.15 billion trading loss at French bank Societe Generale
caused a huge gap down when our markets reopened on Tuesday morning
prompting the Fed to try and hold back the tide with a pre-emptive rate
cut.
Apparently 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 plunge he increased his positions in an attempt to
‘average down’ 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 under mounting panic the bank frantically
unloaded the futures on Monday and Tuesday of last week. 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 Societe Generale.
One news source
claimed the total position was worth more than $103 billion. Selling
$100 billion in the global futures market created a monster crush on
stock markets around the world. The U.S. markets were closed on Monday
and that put additional pressure on the more thinly traded world-wide
futures markets. With Societe Generale in panic mode after realizing
they were massively positioned on the wrong side of the market they were
dumping on a huge scale.
The Fed reacted to
the massive sell-off in global equities last Monday and Tuesday 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 this week. The Fed released a statement on Friday
saying they were unaware of the SocGen trades when they cut rates on
Tuesday but that statement is a little hard to believe.
The problem is most
retail traders 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—and if they
don’t—look out below!
Another big concern
right now is the plight of the bond insurers. We’ll get earnings out of
MBIA (MBI) on Thursday that should shed more light on the subject but
it’s not likely to be good news. Fears of another ratings downgrade and
a cut to less than AAA could put the bond insurers out of business. If
their credit ratings fall 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.
Despite the bounce
on these bond insurance stocks the situation has not changed one bit. 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 devastating losses—this is the ‘other shoe’ to drop in the
subprime meltdown.
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 held by
funds, hedge funds, banks, institutions and sovereign funds that could
add up to another $2 trillion at risk.
New York's
Insurance Superintendent is trying to arrange a bank led bailout of
those MBIA, Ambac and ACA Capital rather than suffer the trillion dollar
consequences of all three going under—the problem is the banks are all
having capital problems of their own.
Should the bond
insurers fail---which is extremely likely---it would cause untold
additional damage to the financial system. Barclays said this week the
fear is spreading to formerly ‘safe’ firms and even Financial Guaranty
Insurance Company is likely to be downgraded with a current insured
portfolio of $315 billion in bonds. Barclays also said banks will have
to raise another $143 billion in capital to offset further losses as
bond insurers begin to fail.
Citigroup warned 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.
These troubled
insurers bounced on the belief a bail out was coming—but none
materialized by Friday and probably won’t anytime soon. 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 it will cause a lot of
damage.
The Dow fell to 11634 on Tuesday and repeated that decline with a touch
of 11645 on Wednesday. Wednesday’s rebound was triggered by a huge buy
program and some heavy short covering on the potential bail out of the
bond insurers. Once that hope dissipated the markets began to rollover
with Friday closing with a -171 point loss. We have already had more
triple digit days on the Dow in 2008 than we had in the first 3-months
of 2007. Volatility is spiking with the VIX closing just below 30 on
Friday and that volatility is likely to continue.
This market has huge risk due to continuing financial problems, economic
numbers due out next week and a possible disappointment by the Fed
almost no matter what they do. In addition to the serious credit market
problems incurred by the bond insurers the economic reports could be
nasty with challenges in the Durable Goods, GDP, PMI, Jobs and the ISM
Index. The potential for recessionary news is very high. After a three
quarter point cut last week the Fed is likely to cut only .25 basis
points at most this week—and the market may not be happy with 25-points.
Even if the Fed cuts .50 it means they know something we don't---and
whatever it is could be dangerous enough for them to completely ignore
the inflation monster they were so worried about just a short time ago.
In other words a .50 point cut could be interpreted as the economy being
even worse off than originally thought.
The bottom line is
this market is probably heading south in a big way—and the kickoff is
likely to begin this week. The question is…
HOW DO WE MAKE
MONEY ON IT?
We’ve got two
outstanding looking plays lined up this week and as you may have guessed
they are both bearish.
Our first is on an
index that can really move when it wants to—and this index is especially
susceptible to bad news. It climbs higher than the rest of the markets
during good times but really falls off a cliff when growth starts to
slow. This Wednesday we get the first look at Q4-GDP and current
estimates are for something in the 1% range--- compared to the 4.9%
reading we saw in Q3. When growth slows this index traditionally
plummets off a cliff—a dive we’ll be cashing in on with some well placed
puts this week!
Our next play is on
a stock that is completely in the consumer discretionary sector—a sector
that has been getting hit hard lately as consumers struggle to pay their
bills and fill their tanks with gasoline. This stock turned south Friday
in a classic bearish reversal with the potential for huge follow-up to
the downside this week—a move we’ll be positioning ourselves for first
thing Monday morning!
We’ve got two big
movers lined up this week with a market teetering on the abyss—so let’s
get started…
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