The Insightful Trader

After taking a breather yesterday, the market resumed it’s upward bounce in impressive fashion today. The market opened  with a 6-7 point pullback the first 15min, but from then on it was onward and upward the remainder of the the day so that by 10:30 we were right in the middle of a resistance zone in the 735 area. Pulling back slightly to catch it’s breath, by noon we were in a steady uptrend which gained momentum throughout the rest of the day. The net result was a DOW that closed up an additional 3.5% and a S&P that was up slightly over 4%. This was despite MSFT which didn’t participate at all, though once again the techs and semis were strong across the board.

Oil prices moved higher, above $47, as did gold, while the dollar showed a little weakness. The oil stocks did not really participate today until after lunch and then made a nice catchup move this PM. AG stocks failed to participate at all, trading pretty much mixed throughout the session. Financial Stocks were once again the shining stars today with many, such as COF, JPM and BAC up over 15% today and the BKX being up over 11%. Brokers were also strong. The result is that some of the financials are up 30% the past three days. GE, now considered a hybrid, was up  over 10% again today. Everyone’s favorite 2-1 financial trader SKF dropped a whopping 30 points today so that in 10 days its had a perfect round trip from the 140 range, up to 265ish and back down to 140ish again. Breath taking for those on both sides of the trade.

So where do we go from here. I’ve taken the liberty of drawing in some near term resistance levels in the SPX 60min chart below. Despite over a 500 point move in the DOW the past 3 days, we’re still only barely 1/2 way recovered from our breakdown at the 800 level just a few weeks ago. So even though I’ve been eagerly awaiting this bear market bounce, I think we’ll have some backing and filling as we make our way upward. How far can we go? The pundits are calling anywhere from the 800 level to 900 and even a 1000 on the S&P. We’ll look at some fibonacci levels later, but for now I took a few of my long positions off the table and lightened up a little on some of the others, notably AMZN and the Q’s. I’m still long some XLF calls and some AXP from the 10 area.

We had to wait a few days but finally we had a heck of a short term bounce, over 350 points led by the financials, of all things. But everything was strong with the exception of the metals with gold being off again. Our friends at Sentiment Trader posted this chart late yesterday. What it shows that on a historical basis we could be in for some positive moves over the next few weeks.

Of course all the talking heads led by Cramer who just 2 days ago was saying that after careful study he eas picking 5300 or some such as the bottom. Then last night he was enthusiastic about the rally that it was almost sickening. One area I do agee with him is that the SEC does need to reinstate the uptick rule and yesterday Barney Franks indicated that it could be done within a month. I agree that removing the rule was hurtful for the individual traders.

We do need to be careful here however. Looking at the charts, as you can see we have some gap resistance coming up at the 730-740 area. Plus we went from being oversold to over bought in 1 day on some of our indicators. So a gap up this am that stalls out in this resistance range, means we could see some pullback. So I’d be wary of chasing gaps until we see continued buying coming in.

The NFP came and went with not much reaction initially. Numbers for once were about in-line with what was expected but the big kicker was a revision showing that we had  lost even more jobs than reported from past months by another 160,000. The bulls were determined though, so we initially had a nice surge into positive territory which, surprise, surprise, was immediately sold into so that by 10:30 we were back where we had started and by 11 were definitely in the red. That’s where we remained the rest of the day finally working our way down close to the next support  area before staging a pretty healthy looking rally, on decent volume, the last 30 minutes of the day to barely finish in the green. Not the kind of bottom I was looking for if indeed it was a short term bottom. Flip a coin, not sure anyone knows at this stage.

I have to admit the most encouraging thing I saw all day was Cramer and others picking bottoms a 1000 points or further away. Much as all the pundits were calling for $250 oil and the DOW hitting 16,000 almost exactly at the top, perhaps this is a good sign that maybe we actually are close to a short term bottom. Have to admit, it looks pretty bleak out there. Speaking of pundits and their reporting, the hottest video on the internet right now is John Stewart’s takedown of CNBC on Comedy Central. This is a must see if you haven’t seen it yet.

I’ve got two charts for you to take a look at , the first is the 5min from Friday which looks a little encouraging whereas the following 30min still looks pretty grim.

As long as we hold 645ish area I ‘m still somwhat hopeful that we have the potential to make some type on meaningful bounce here.

  An item on Bloomberg News has pushed me into a reluctant conclusion: credit default swaps (CDS) do more harm than good. We need to find the quickest way to eliminate them without inflicting greater harm. I’m not saying that process will be easy or neat. Only essential.  And yes, a proper unwinding of CDS trades would take time.  Also, banning CDS would mean that the United States would void previously lawful private contracts, something I am not exactly eager to advocate. But as the Naked Capitalism blog has pointed out at least once in its excellent discussions on CDS, we have done lots of things like this under emergency conditions.  I would say our economy is at least approaching an emergency condition now.

        Credit default swaps are contracts that insure the CDS owner against the default or bankruptcy of another entity. Under usual CDS terms you buy protection on $10 million worth of bonds for five years and pay an annual percentage of the insured amount as an insurance premium that is in the low single digits, or in the case of a strong credit, even less than one percent. If however the market begins to worry about a given credit, CDS premiums rise, or in the extreme case, CDS trade on an “upfront” basis, in which CDS protection sellers demand payment upfront for the whole five year term. On some CDS, sellers of CDS protection are required to start posting collateral in the event that the insured credit begins weakening (AIG got into trouble this way).   If you own CDS on a bond you get paid at par, less the recovery value determined at auction when it is determined that the bond has experienced an event of default. If there is no default, you have paid out your premiums over the years and have presumably bought only some piece of mind with your insurance premium.

        Here’s the rub. As Bloomberg notes, bondholders of some weak companies who own CDS protection now have every incentive to push the company to file for bankruptcy rather than work with them to keep the company alive. That stands proper economic incentives on their head in two ways.

        First, before the advent of CDS, smart bond investors had every incentive to do good credit analysis on corporate bonds. In other words, they were paid to do their homework and avoid weak credits or sell their holdings of  bonds of companies that had weakened. Now you have every incentive to buy weak bonds before everyone else realizes they are weak, assuming you can find someone to write CDS protection on them, because if the company goes bankrupt you are going to be made whole, as Bloomberg reports. Or, you buy distressed bonds along with the associated CDS, and depending on the price of the combo trade, you can still make money on subsequent price changes or what you receive in recovery after an event of default is declared. It’s now called, “the basis trade.” So now you have dumb bond buyers not bothering to do their homework because they expect insurers to bail them out — and smart bond buyers sometimes buying weak credits because they can get bailed out, too. Both of which distort the bond pricing system which should give us clues about which companies are sound and which are not.

        Secondly, society benefits when lenders work with borrowers to prevent bankruptcies. That incentive is now being seriously eroded by CDS. Of course some companies are badly managed, overly leveraged, or have poor business models. Those companies should fail, that’s capitalism. The overleveraged ones with good business models should go through reorganization and come out as viable employers — that is the point of Chapter 11. The rest may have to be left to their fate. The point is, we want lenders to be patient with borrowers while we determine which companies would benefit from Chapter 11, which are hopeless, and which just might turn around without going through bankruptcy in the first place. 

        The basis trade also throws a new wrinkle into the profession of credit analysis for distressed bonds, Bloomberg reports. Now you have to go beyond valuing the bonds in the event  bankruptcy for recovery value, and start learning who owns CDS, because holders of bonds and CDS might do even better by forcing bankruptcy rather than trading bonds based on intrinsic value.

         As a daytrader I normally detest the idea of government restricting people’s opportunity to trade. But this might be one of the very rare cases where traders are overplaying their hand by exacerbating the weakness of an economy that is one step from Depression. If some day the boys and girls on some  New York bond desk  push Ford Motor over the edge into bankruptcy, do you think the rest of us traders will escape retribution when  unemployed autoworkers figure that out? Good luck to us.

  So Ken Lewis of Bank of America tells the Financial Times Monday that it was a “tactical mistake” to accept an additional $20 billion in TARP funds in December? According to Lewis in the FT interview, accepting the second round of TARP money made BAC look as weak as other banks, “like Citigroup(C)”.  Funny, but that is not what BAC said in January on  the BAC 2008 fourth quarter earnings conference call.

    On the call BAC said that the additional injection was important because of BAC’s acquisition of Merrill Lynch (MER). Obviously if you are a bank  with  $1.84 trillion in total assets, and you absorb an acquisition with total assets of  $667 billion, you need more capital in order to keep your ratio of capital to assets constant. Which is exactly what BAC said during the call, and I don’t think anyone reading that transcript would have taken BAC’s second TARP injection, in and of itself, as an admission of weakness. It only would have made BAC look weak if people thought that Lewis wanted the funds to shore up weaknesses in the existing assets.

    So why would Lewis say this to the FT? My guess is that he knows that people worry about BAC’s solvency, and he wanted to move the discussion away from that by focusing on one small piece of the federal support BAC needs to keep its doors open, hoping people might think that TARP and the need to meet statutory capital adequacy standards was the whole of BAC’s problem.  As I noted last week Lewis ended up having to disclose in his 2008 10-k that his loan book was valued by the market at $44 billion below its marks on the balance sheet, and that he still had outstanding, albeit reduced, exposure to CDS (credit default swaps). Moreover he had $100 billion or so in off balance sheet assets in SIVs (structured investment vehicles) of undisclosed quality.

    To make the MER acquisition work BAC needed $20 billion more in  TARP money and up to $118 billion in federal guarantees against loss on MER’s weak assets. Not that anyone in their right mind would have bought MER without some sort of support, but wait, there’s more on BAC’s list of federal goodies. That would include the previous $25 billion in TARP funds BAC accepted at TARP’s inception, the $60 billion plus in funds borrowed from the Federal Home Loan Bank System to support its 2007 purchase of Countrywide Financial (where Lewis could have waited for CFC to go bankrupt and then bought the mortgage origination business he was after, minus CFC’s loan portfolio), and  the untold tens of billions BAC has borrowed from the Federal Reserve under the Fed’s recently established credit facilities. In other words, BAC was already weak before taking on MER and when it did so BAC became even more a ward of the state.

    If Lewis eventually pays back $20 billion of the TARP money to the Treasury that would be welcome. But he should not get away with saying, that repaying a mere $20 billion in TARP funds would prove his bank to be a strong firm that poses no risk to US taxpayers. We should be so lucky.

What a week. After a nice little oversold rally yesterday, at least for the first 2/3 of the day, the futures were down overnite, only to come bouncing back the first half hour today. Then reality set in and it was pretty much downhill the rest of the day other than a couple of half-hearted bounce attempts. The net result was we were down about 4% on most the major indexes although tech actually held up quite well today, perhaps helped by ADBE’s  report. And of course tomorrow morning we have the Non-Farm-Payroll. The dollar is already weaker tonight and gold had a nice move up today after being whacked for the past7-8 days. Not that it did me any good after going long early this morning, of course after getting whipsawed a couple of times overnite, had Ed Seykota’s ‘The Whipsaw Song’ on auto replay, I went long at 913 and put my stop too close at 911, which promptly got taken out just minutes before it makes a 25 point move to the upside.

But speaking of NFP, what the heck, who needs jobs anyway? Having a job is way over-rated. With all the other governments around the world cranking up their printing presses, bound to be money for everyone. If not that, then we can all become day traders. What with the VIX back up in the 50 range again, volatility has been crazy in certain stocks this week. Make that most stocks. So what if your life savings are invested in C, which managed to barely escaped closing under $1.00 today or BAC sitting at 3, when you can make 20 points a day on SKF. It’s only up $100 the past week as financials continue to melt away to nothing. Sheesh, just made me wonder what the price does when every financial stock out there goes to 0, does SKF keep going to infinity? 

FAZ, one of the new 3-1 bear ETFs has gone from 48 to 103 high today in the past week. Glad I sold at 74 yesterday. Or you could have traded POT which has fallen from 81 to 69 since yesterday morning or GOOG which is down nearly 40 points this week and had a 20 point range today. Just read some gurus advice earlier in the week to buy GOOG at 340 and sell a march call for $10. He had it worked out to some pheonominal return on an annualized basis. Wonder how all the people that followed him into that trade are feeling tonight? So anyway, I say, to heck with jobs, and bailouts, we just need Uncle Sam to send all of us $25k to open  a day trading account and we’ll all be filthy rich in just weeks.

On a serious note, the market  still continues to hunt for the ever elusive bottom as the news just continues to overwhelm us. Between GM’s auditors warning, like where have they been hiding for the past 2 years, must have been stock analysts prior to becoming auditors; GE continuing to come under pressure despite denying they need money, does anyone believe any corporate CEO these days; and Moody’s finally waking up and threatening to cut bank ratings even more, they were playing golf with GM auditors I suppose, the market is like the fighter in the ring who has already been hit a few times to many. Every time it even thinks about standing up, it gets punched again. Our next support zone is coming up quickly in the 645-660 area. I’ve been joined on the potential bounce side by Doug Kass and then today money manger Steve Leuthold, who earned Grizzly Short Fund investors 74% last year by shorting stocks says now is the time to buy(moneynews.com). Of course a recent article on the businessinsider.com site has Robert Shiller’s cyclical P/E analysis which is interesting reading if you feel like being depressed. I actually agree with a lot of it, that we could see valuations must lower in the longer term, just hopefully not in the next week or two.

Before we get into our charts, a couple of interesting articles you may want to take a look at. The first by Larry Edelson from Money and Markets has a good discussion about the water crisis, which has been one of my pet concerns for awhile now, along with a few recommendations of water related stocks that may be of interest to you as  a longer term investment. In my opinion I truly feel that water may be the major causes for war at some point in the future. According to his article and I’ve heard similar numbers elsewhere, 10,000 children/day are dying due to water problems on our planet. Kind of puts a weak market in perspective doesn’t it.

The other article I read with interest since I trade currencies also, is Tom Dyson’s article yesterday in Daily Wealthregarding the Yen. He makes a good argument that Japan could be the first major sovereign bankruptcy.

I’m way behind on getting some new posts into the Trade of the Day area and we’ve had some really good ones both in stocks and currency. I will try to get those caught up this weekend. I’m still long some real small positions in Q, AMZN, and XLF calls and will probably add to the position if we get down into the 660 area with fairly tight stops at that point.

Here are several charts for today. First is a 16 year S&P showing support areas and the next two are the NASI and NAMO which are conflicting, although the NAMO is the more sensitive of the two.

Despite a couple of attempts at a decent rally yesterday, the market still finished slightly negative for the day bringing us to an unbelievable 11 days out of 12 that we’ve finished down for the day in the S&P. It also brought us to a close below 700, but we remain in the 685-700 support range with the intraday low hitting 692ish. The economic reports remain frightening. Automakers reported horrendous results again for February, down anywhere from the 35-50% range, depending on manufacturer. We had Bernacke making comments, trying to put on a positive spin to the stimulus package while Geithner was testifying most the day, which of course was cheap filler for CNBC listening to our leaders asking dumb questions for the most part. I could only take so much and had to shut off the sound after awhile.

Gold remained under pressure most the day before finally climbing some towards the end of the day although gold stocks did a little better. Overnite so far it has been trading in a narrow range in the low 900s. The dollar continued its climb albeit a little slower. Tech stocks which acted pretty well most the day, got hit hard in the late afternoon, while energy stocks were mixed with the exception of FSLR which had a great day despite some late day profit taking.

So the question remains, where do we go from here. Personally I feel like that we may be closer to a short term bottom, although it does bother me that a lot of others seem to feel that way also, which typically doesn’t make for good bottoms. Looking at it from a historical standpoint, we typically have decent corrective rallies, even in extremely weak markets, sometimes as much as a 50% retracement. I’d settle for 25%.  We haven’t in this sell-off yet, so though I feel like that we may have another 5% risk to the downside in the short term, I feel we may have more potential to the upside. Because of that I started nibbling at a few long positions, primarily with options and picking up a few shares of some of the safer high yield stocks. But notice I emphasize small here.

Take a look at the BPENER chart below. This has been a consistently reliable indicator on oil stocks and as you can see, we’re definitely getting into an oversold position here.
Positions held- long XLF,NLY, QQQQ, AMZN

What a month. Febuary, which started with a small promising bounce, turned into a disaster month for the market. We’ve now had 6 straight months that the market has been down with 8 out the past ten months being negative. Be sure to notice the volume level on the charts below. On top of that we start out the month of March with numerous economic reports which may not help the bullish cause. We have both the ISM index and services report Monday, Tuesday, we have pending home sales which could continue to remain ugly, Wednesday the Fed Beige Book comes out, Thursday we have January factoy orders and last but not least Friday we have N0n-farm payrolls. If expectations are in line, than we will have over one million less jobs than we had just 2 months ago. It will be an interesting week to say the least. Our technical indicators are oversold, but nothing says they can’t become more so. At some point I still feel we’ll have a bounce, but I’m still waiting for the market to tell us when and not venturing a bottom feeding guess. If you’re short then trailing your stops is probably your most prudent action.

            “Bank of America [BAC] probably needs $100 billion of equity in the next 100 days,” said credit expert Sean Egan this past Friday on CNBC. Referring to the Treasury Department’s bank “stress tests,” Egan also stated that under a severe scenario any of the major banks would end up needing more money from us taxpayers. It so happened that BAC filed its year-end 10-k that same day, and your humble blogger couldn’t resist a peek. (Today, on Sunday, Institutional Risk Analytics scored BAC as second weakest of the big four banks, but gave BAC an A, its second strongest grade in its stress testing scale.)  

Our analysis has one major caveat, and that is, BAC’s 10-k is as opaque as those of many financial institutions. Many key numbers are not fully explained. Warren Buffett says he has to “reach for aspirin” when trying to make sense of the banks’ SEC filings. Portfolio manager Bill Fleckenstein agrees, deriding financials as “black boxes.”

            In our reading, BAC has a horse race going on between the bank’s continuing capacity to generate operating earnings, and the likelihood of additional credit losses driven by our weakening economy.

BAC provided a $26.8 billion allowance for credit losses in 2008, up from $8.39 billion in 2007.  On the other hand, even after the loss provision BAC had $139.4 billion in common equity and $57.5 billion in tangible equity to support total assets of $1.82 trillion as of year-end 2008. In other words, with its tangible equity to assets ratio over 3%, and a Tier 1 capital to assets ratio above the required levels regulators say BAC is “well capitalized.”  So far so good. In addition, the bank earned $32.5 billion in pretax operating income before credit losses in 2008.

We further suspect that low short term interest rates are good for BAC in two ways. First, they give BAC a low cost of funds and thereby keep the net interest margin healthy. In 2008 BAC’s interest earning assets yielded 5.56%, and its interest bearing liabilities cost 2.88%. Second, low rates are good for those homeowners who can afford to refinance, assuming they have enough equity. That ought to be especially good for the mortgage origination business BAC obtained when it bought Countrywide Financial. So BAC has adequate capital for now and if it can continue generating operating earnings as it did in 2008, it might well survive.

For the moment we have decided to simplify our analysis by neglecting the effect of the Merrill Lynch (MER) acquisition on BAC’s future earnings. The acquisition closed this past January 1, so BAC has not yet accounted for MER in its annual report. More to the point, BAC received a government guarantee against losses on the newly acquired Merrill assets of up to $118 billion, as against MER’s total assets of $667 billion. If that doesn’t buy BAC time to liquidate MER’s dodgy assets, nothing will. With these government guarantees BAC got MER on a heads we win, tails the taxpayer loses basis. On the other hand, MER seems to have lost some of its earnings power. We are not sure when MER’s business will contribute to BAC’s profits; assuming BAC is cleaning house we think that BAC might get the MER business close to breakeven for 2009 rather than absorb the kind of losses MER recorded in 2008. Eventually, though, MER could generate material profits for BAC. Of course the addition of MER’s assets will reduce the ratios of capital to assets but the company offset this in large part with an additional $20 billion of TARP funds from the Treasury.

Here’s the rub, though. If credit losses accelerate, they could overwhelm the capacity of the bank to generate operating earnings and BAC would need more government funds.

Banks often make their big loan loss provisions at year-end and we suspect BAC wanted to set forth the cleanest year-end balance sheet it could. As far as existing balance sheet items go, we focus most on the $44 billion discount between stated loan values and market values. The bank claims it will hold these to maturity and therefore they intend to carry the loans at stated value rather than market value. We suspect that since the market is marking these loans down the market smells some sort of impairment, a likelihood that BAC won’t be paid back on these loans at 100 cents on the dollar. If we assume for the sake of argument that BAC eventually has to charge off half this amount, $22 billion, that would not exactly be welcome news. If BAC needs to take large charge-offs, they no doubt hope to postpone them until the bank can earn enough profit to offset them. As for other balance sheet wildcards: BAC seems to have done a good job in reducing its exposure to derivatives such as credit default swaps since year-end 2007. On the other hand, we wonder about exposure to European banks, whose difficulties have exploded into view during the last several weeks.

Regarding possible problems down the road, the Case-Shiller Home Price Index says that housing prices are still 10-20% overvalued according to the Calculated Risk blog posts of February 27, and weak conditions in the housing market point to further price drops. Home inventory for sale stands at a record 13 months’ supply. In addition, many homeowners still have adjustable rate mortgages that allow the borrower to pay low, introductory, “teaser” rates. The schedule of homeowners slated to experience the shock of having their mortgages reset to market rate tails off in 2011 so we have trouble imagining that house prices will bottom before then.  On the employment front, businesses continue cut jobs at the rate of 500,000 per month. These factors will affect BAC’s home mortgages, commercial loans, and commercial real estate loans.

We conclude that BAC is rather too close to call. BAC can afford around $20-25 billion in credit losses per year without eating into its capital, assuming no change in pretax earnings. If the economy rebounds more quickly than we expect BAC could prove to be a profitable investment. Should the economy continue to worsen, however, (and we suspect it might) we are not sure BAC can escape. The combination of deteriorating earnings and increased credit losses might then be just enough to push them into receivership – unless Treasury chooses to put them on life support.