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Where is our Santa Claus rally?

We usually have one. Even last year the Dow went from 8,149 on Dec 1st to finish at 8,776 on Dec 31st. This year, we’re lower than we were on Thanksgiving and challenging the 10,200 line, the lowest we’ve been since Nov 9th. Why has Santa Claus forsaken us? Most likely, it’s because we already got our Christmas present in November, when the Dow ran from 9,712 on the 2nd to 10,406 on the 16th. That was when we threw in our bullish towel as it was way over our 2009 target (9,850), which is based on fundamental market valuations, rather than Christmas wishes.

We still face serious headwinds in the economy and, as I’ve said many times this year, the current market valuations are ignoring the risk factors of owning equities - an amazing thing considering how recently those risk factors showed up and bit people’s faces off both last fall and this spring. For example, according to the NYTimes this morning, American International Group (NYSE:AIG), Fannie Mae (FNM), Freddie Mac (FRE) and GMAC are not only unable to repay the government, they are in need of continuing infusions that make them look increasingly like long-term wards of the state. The total risk they pose to the taxpayer far exceeds that of the big banks. Fannie and Freddie, in the final days of the year, are even said to be negotiating with the Treasury about greatly expanding the money available to them.

While some banks are repaying TARP funds, these wards of the state need MORE money or we are right back to the default risk that sent the market plunging last year. What else sent the market plunging last year? Oh yes, it was credit default swaps. We still have many hundreds of Trillions of those nasty little suckers outstanding and now the cost of insuring sovereign debt against default in Europe is right back to where it was in March, when we thought the World was ending. “It’s going to prove extraordinarily difficult for countries to cut back on budget deficits,” said Ciaran O’Hagan, a fixed-income strategist at Societe Generale SA in Paris. “Many countries are facing severe difficulties in coping with the economic downturn.”

Credit-default swaps on Portugal’s debt jumped 6.5 basis points to 80 today, CMA prices show. Hungary climbed 13 basis points to 243, Spain increased 5 to 98 and Germany rose 1 to 23. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to debt agreements. An increase signals deterioration in perceptions of credit quality. The cost of default protection on corporate bonds also rose with contracts on the Markit iTraxx Crossover Index of 50 companies with mostly high-yield credit ratings climbing 4 basis points to 475, according to JPM. The Markit iTraxx Europe Index of 125 companies with investment-grade ratings rose 1 basis point to 80.5, JPM prices show. A basis point on a contract protecting 10 million euros ($14.4 million) of debt from default for five years is equivalent to 1,000 euros a year. THIS IS NOT GOOD, PEOPLE, THIS IS THE OPPOSITE OF GOOD, ie. BAD!

Here’s a nice case study of how Credit Default Swaps caused a crisis at Harvard last year as JPM and GS were able to put the squeeze on the university for a cool Billion as swap rates spiked. That is how quickly things can get out of control again because NOTHING has been done to fix this problem - all we have done is concentrate the risk in fewer and fewer banks that are now WAY too big to fail!

Not only are we no better off than we were last year but, should any of these potentially catastrophic events turn out to be an actual problem, our government will have to deal with them from a position of being 33% more in debt than we were last November - think we can make it 50%? How long before CDS bets begin to rise on a US default? Germany went up 5% yesterday - do we really think we’re stronger than them?

Obviously Main Street America doesn’t think so as Obama’s approval rating is plunging as our citizens are sick and tired of hearing about how the Wall Street economy is improving while the average American sinks further and further into debt. The LAST thing people want to hear as they cut back on their holiday shopping budgets is that the Banks have paid back TARP so they can all get their massive bonuses this year.

I know you want to think this is just me ranting and ignore all these worries and try to have a nice Christmas but I feel it is imperative to at least get you thinking about moving to more cash. I want you to go into the last 7 days before Christmas either in cash or well protected or even (dare I say it?) short on the market (see last Wednesday’s Hedging for Disaster article) so that you CAN have a merry little Christmas, without worrying about the silly thin-market trading we’ll have in the last 2 weeks of the year.

Because it’s not just me. Bill Gross, who runs the world’s biggest bond fund ($200Bn), cut government debt holdings and boosted cash to the most since Lehman Brothers Holdings Inc. collapsed in 2008 amid increasing speculation that interest rates will rise (see our 150% return TBT play at the end of yesterday’s Member chat). Gross also reduced government-related securities to 51 percent from a five-year high of 63 percent in October. Gross also cut holdings of mortgage securities to 12 percent, the lowest since Pimco’s figures started in 2000, from 16 percent, according to the Web site. Are you starting to get the picture?

As I said in yesterday’s post, I hate to be Chicken Little but I would also hate to be a media sell-out who tells you what you want to hear instead of what you need to hear. Yes, there are good things going on in the markets. Companies are figuring out how to make more money on less revenues but that doesn’t solve the global problem that can still drag down the good with the bad.

If we don’t plunge into January earnings and we do finally break over our levels, I’d be thrilled to buy some things but, for now, cash is much more comfortable, wifh a few short plays - just in case... Asia pulled back this morning as the Nikkei failed to retake 10,200 despite the BOJ leaving rates at 0.1% and a huge run into the close. The Hang Seng fell another 171 points, all the way down to 21,175 and looking very weak as the Markit iTraxx Australia index of credit- default swaps jumped 4.5 basis points to 91 basis points (the 5% rule!). “This correction mode may last until the end of the year,” said Lim Chang Gue, a fund manager at Samsung Investment Trust Management Co. in Seoul, which manages $42 billion. “Investors expect the recovery in consumption to take a while and the U.S. job market data has reaffirmed it’s a tough road.”

“China’s asset markets are a Ponzi scheme,” according to former Morgan Stanley Chief Asian Economist Andy Xie, now an independent economist based in Shanghai, “Property is heading for one huge bust that will take a year and a half to unfold.” China’s property and stock markets are a “bubble” that will burst when inflation accelerates in 2011. “It’s a less glamorous version of the Greenspan bubble and the story will end with inflation,” Xie said. Hong Kong stocks are also about 30 percent “overvalued” and may face a “major correction” in the next four to five months as the market factors in a possible stimulus exit by the Fed. The market may recover in the second half, he predicted.

Europe got a big boost early this morning but gave back most of those gains by 9am. German Business Confidence rose to the higherst level in 17 months but investors are following Bill Gross’ lead and cashing in their chips. “Prospects for the euro-zone economy are growing murky, given sovereign debt woes and banking sector issues,” said Keiji Matsumoto, a currency strategist in Tokyo at Nikko Cordial Securities Inc. “The euro may stretch its decline both against the dollar and the yen.”

Spanish Credit Default Swaps jumped 20% to 103.5 this month while the UK was up 20%, climbing 14 points to 84 and Greek bonds have jumped 130% since August. “There is definitely a potential danger to credit in sovereign CDS,” said Martin at Bank of America. “When sovereign CDS spreads widen, they act as a lower boundary for credit spreads.” That, in turn, puts pressure on corporate bond rates, which have been trading this year at about 3.8%, down from 6.97% last year. Low borrowing costs account for pretty much ALL of this year’s increased corporate profits with favorable exchange rates accounting for the rest. As we learned last Fall - all those factors can pretty much reverse overnight. “Our key risk for markets next year is higher bond yields,” said Jim Reid, head of strategy at Deutsche Bank AG in London. That may be “due to government supply starting to overwhelm demand, or because of inflation fears starting to mount,” he said.

Oil is being boosted this morning by RUMORS that Iranian forces have occupied an oil well site in Iraq. The timing of this is absolutely amazing as it’s coming on the day before NYMEX contracts have to be rolled over so the nice $2 boost we’re seeing in oil, back to $75.50, is saving NYMEX traders billions of dollars today as they roll the contracts they pretended they wanted for January delivery into contracts they will pretend to want for February delivery. Keep in mind that in order to create this kind of "news" and make Billions, all you have to do is give $100 each to 5 guys with a jeep and some guns in Iran and tell them to drive 5 miles over the border to the closest oil field, fire a few shots in the air and raise a flag. It may not be legal but it happens every time the commodity crooks need a boost, yet our government does nothing to rein in the speculators. We are speculating oil short at $75.50, in futures and with USO puts.

So play at your own risk. We’ll be mostly watching from the sidelines as we roast our chestnuts on an open fire and maybe even do some last-minute shopping - doing our part to boost the struggling economy.

Have a great weekend,

- Phil

Source: Friday Outlook: Scroogy Swap Prices Darken Christmas