This past week the markets tumbled hard adding some
good value to our bearish plays…
BETWEEN MONDAY’S OPEN AND FRIDAY’S CLOSE HARLEY
DAVIDSON (HOG) DROPPED OVER FOUR DOLLARS BOOSTING THE VALUE OF OUR HOG
FEBRUARY 37.50 PUTS BY A WHOPPING FOUR-HUNDRED-TWENTY PERCENT!
In addition to Harley Davidson (HOG) our put plays
on the IWM and RCI benefited as well, but Thursday’s extreme volatility
triggered our trailing stops on both HOG and the IWM. Fortunately we
benefited from four days of added value to both positions, and RCI is
still open which should provide a nice profit on its next plunge lower.
Both our new bullish plays were stopped out fast
last week which is what you want on a sudden change in market
direction—it’s better to get out quick at a small loss than linger for a
larger one. We always want profits on our plays and taking losses is
never fun—but unfortunately it does happen. The good news is most of the
time there are bigger winnings waiting around the bend.
This market is churning fast trying to find a
sustainable direction—to help get a handle on it let’s take a good look
at…
WHICH WAY THIS MARKET IS HEADED
This past week the SP-500 gave back almost exactly
what it had gained the previous week—down 64 points versus up 65 the
week before. The Nasdaq fared a little worse down 109 last week while up
87 the week before. Meanwhile the Dow
lost 561 points chalking up the worst week since March 2003 for a 4.4%
drop. This past week’s performance underscored the risk of bear market
rallies—they may be powerful but they don’t last as traders pile on the
moment the indices begin to roll-over causing the classic bear market
pattern of lower highs and lower lows.
The two best
performing sectors from the previous week fell the most with banking
down 8% and the homebuilders off by 11%. Those two sectors were
responsible for the majority of the market’s losses. The biggest
economic news sparking last week’s sell-off was the ISM report coming
in at 41.9% in January from 54.4% in December—this is a drastically
lower reading than expected and confirmed a contracting economy.
Trimtabs.com—a
company that tracks mutual fund flows---reported $9.2 billion withdrawn
from mutual funds over the past week compared to $1.5 billion in inflows
the prior week. Investors are starting to believe the economy is
skidding toward a recession and money is fleeing stocks toward safer
havens.
In the past ten
days we’ve had warnings from huge industry giants including the
homebuilders, suppliers like Weyerhaeuser, freight companies like YRC
Worldwide and now Cisco telling us that the future still looks weak
casting a blow to the tech sector. It’s one thing to see it in an
economic report—it’s another to have the CEO of a major corporation
confirm it. The charts are reflecting this bearish action as volume
surges on the dips instead of the spikes—a bearish sign.
There may also be
more bearish news in the coming week with the retail sales report on
Wednesday. We’ve already seen chain-store sales record their weakest
January in decades, and auto sales fell 6.3% to the second lowest level
in 10 years so economists are not hopeful for the retail report this
coming week. With the consumer responsible for 70% of the economy a
slowdown in spending will guarantee a contraction--and the markets will
likely follow.
For the past month
oil has been trading lower giving a small boost to the markets but crude
exploded for a gain of +3.78 to close the week at $91.89 from news of
constricting supplies. Shell warned oil exports from Nigeria could fall
by as much as a million barrels per day in February and March due to a
deteriorating security situation and planned maintenance. That is
130,000 bpd less than prior outage levels.
In addition to
supply problems in Nigeria production from the North Sea decreased by
280,000 bpd due to technical problems. Plus output from a Russian field
was predicted to fall sharply due to rising depletion rates. With the
summer driving season build-up beginning any constriction in supplies
drives up prices and we’re likely to see a further uptrend in the coming
weeks.
The earnings parade
will slow this week with only 341 companies reporting compared to more
than 700 last week. There are only a couple of big names that most
traders would recognize so the vast majority of fourth quarter earnings
are now behind us. At this point the markets are moving away from
earnings to focus on two key issues—the potential for further rate cuts
by the Fed and the bond insurance dilemma.
Bernanke and
Paulson have been summoned to the hill for testimony next Thursday along
with rest of the President's Working Group on Financial Markets. They
will be grilled on the economy and the health of the banking system but
we may be able to get some advance clues from the various regional Fed
speeches this past week.
San Francisco Fed
President Janet Yellin hinted in a speech on Friday that there could be
more rate cuts ahead. She said the U.S. may avoid a recession but more
cuts could be necessary. Cleveland Fed President Sandra Pianalto said
the "economy is in the midst of some very difficult times."
Fed funds futures
are pricing in a .50 basis point cut at the next FOMC meeting on March
18th—the closer we get to that date the more influence a
potential rate cut will have on the markets--but as we just saw a rate
cut does not guarantee a new lasting trend to the upside. Investors need
to see a bounce in some key economic indicators and they need to be
convinced the sub-prime problem is behind us. The second half of the
subprime damage potential lies with the bond insurers—and if they go
sideways we’ll see another round of huge losses for the banks.
The fuse is growing
shorter on negotiations to bail out the bond insurers and there is a
good chance we could see an explosion one way or the other this coming
week. There has been no bailout announced yet and while there is still
hope everyone concedes the discussions could fall apart at any time. The
rating agencies like Standard and Poor’s and Fitch’s are crushing the
life out of the discussions with almost daily press releases about the
impending downgrade of the bond insurance companies which would in turn
downgrade the bonds they insure. This was a major factor in the weakness
of the financials over the last week.
Analysts are afraid
a deal will not get done or that the banks in desperation will do
anything to shore up the insurers to avoid another write-down cycle.
MBIA managed to float one billion in new stock at $12.15 on the hopes a
deal is going to get done. MBIA closed up slightly on the news at 14.60.
This coming week is
critical for the three bond insurers with the most immediate risk—MBIC (MBI),
Ambac (ABK) and Financial Guaranty (FGIC). If a deal is not completed
the rating agencies are expected to drastically lower their ratings on
the three and force write-downs on hundreds of billions in bond/CDO
debt. With $2 trillion of this debt as a foundation under the major
banks any downgrade will crumble the financials with massive new losses.
Goldman Sachs
estimates the total write-down exposure at over $400 billion. Fitch
warned in the Wall Street Journal Friday that there could be $139
billion in additional losses from individuals walking away from
mortgages even before foreclosure because the homes have dropped below
loan value. Fitch now expects 26% losses on all subprime loans written
in 2007.
Defaults on credit
cards rose to 7.6% in December and credit card debt is bundled and sold
in CDOs just like mortgages so it all get rated together by the bond
insurers—if insurers themselves are downgraded the debt will be also. At
this point the $2 trillion CDO market is frozen with very little trading
as no one wants the risk. What little is trading recently changed hands
at .14 cents on the dollar.
The companies with
the largest exposure to CDO debt include Morgan Stanley, JP Morgan,
Merrill Lynch, Bear Stearns, Carrington, Citigroup and others. The
possibility of massive additional write-downs is guaranteed unless a
major deal occurs to rescue the bond insurers and buoy the CDO market.
The problem is no one wants to take on the risk of further CDO
write-downs which is making a bond insurer bail-out even tougher.
This is a huge
issue and it will massively move the markets when the outcome is
known—one direction or the other. Several high profile government
agencies are involved so a bailout may be mandated to head off a further
implosion of the financials but at this point it could go either way.
The bond rating agencies have waited about as long as they can so this
week may tell the tale.
This CDO and bond rating problem is huge and mainly dependent on the
quality of debt held by the country’s major financial institutions. The
two biggest components of that debt are bonds and mortgages. A good
indicator of the current quality of mortgage debt can be seen in Fannie
Mae’s (FNM) upcoming report. FNMA is expected to report decaying credit
quality in its mortgage portfolio according to Morgan Stanley.
In November Fannie
said 0.9% of their single family loans were seriously delinquent. That
is expected to climb sharply in Dec/Jan despite falling interest rates.
Fannie Mae has $2.4 trillion in mortgage loans on its books. Morgan
Stanley said delinquency trends and transition rates have deteriorated
over the last several months at an accelerating pace—a further
indication that the mortgage debit meltdown is still with us.
So we’ve got lower
retail sales potentially reported this week, a Fed likely to lower rates
again on March 18, a deteriorating mortgage and credit card situation
and the major bond insurers on the verge of being downgraded—the
question is…
HOW DO WE MAKE
MONEY ON IT?
We’ve got two high
potential plays lined up this week—the first is bearish and the second
one can make money in either direction—it’s a play on exploding
volatility.
Our first play is
bearish and it’s on a major transportation and shipping company. Between
rising oil prices and a declining economy this stock is headed lower—a
fact you’ll really appreciate when you see the chart. This stock hit
resistance a week ago and rolled over to the downside this past week—now
it’s got nothing under it but air and it’s falling—this is a ride we’ll
be jumping aboard with some well placed puts first thing Monday morning.
Our next stock will
be massively affected by any outcome in the bond insurance decision—if a
bailout comes this stock will gap straight-up on huge volume—on the
other hand no bailout and a downgrade could plummet the stock to
oblivion—the key is to we’ll set ourselves up to make money either way.
We’re buying both
puts and calls on this one and in spite of some massive impending
volatility we can still get a reasonable price on both. One great thing
about betting both directions is it doesn’t matter what happens as long
as something does—and it will. The good news is we shouldn’t have to
wait long!
We’ve got two great
new plays lined up and a market on the move so let’s get going…
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