Options Trader: Monday Morning Ideas

by: Philip Davis

Do we have a pulse?

Of course we do - the market isn’t dead, just wounded. I am, in fact, thrilled with the recent correction as it is exactly what I expected as I made my Dow predictions for 2007. Back on 12/24 I said: "If, in the macro picture, we are truly in the early stage of a major advance, then we would expect any pullback here not to violate 11,500, a 50% retracement of our recent gain. I know, ouch! That does sound like a lot, but it is good and natural if it happens."

I concluded that article with this statement: "The top of the range is 12,967 so that will be our break-out target but we need to be mindful the big picture retracement of 11,500 if we stray below 12,350." We only made it to 12,800 so I was a bit too optimistic, but I think I still like the logic of my 12,350 target so we’ll look for that as our primary recovery point for the week. If we establish a new channel here, between 12,000 and 12,300, I will have to sadly point out that 12,300 is EXACTLY 500 points below our top of 12,800 and 12,000 is EXACTLY 500 points above my downside target of 11,500 - a little too symmetrical for coincidence!

It also should be pointed out that the center of this range, 12,150, is almost exactly (10 points off) the 5% rule down from 12,800 while 12,075 is 5% over 11,500. Let’s split the difference and call 12,112.50 our Maginot Line for the week, keeping in mind that that particular strategy did not go well for the French…

But before we discuss the CAC 40, let’s check in on Asia where they’re having a real party today with the Hang Seng jumping 313 points on a China Central Bank .27% rate HIKE to 6.39%. Hong Liang, a Goldman Sachs economist, said this in a statement that welcomed the move as "positive:" "In our view, raising both the deposit (2.79%) and lending rates is a much more efficient and effective measure of monetary tightening than a reserve requirement ratio hike or intensive moral suasion on bank lending."

The Nikkei saw it as positive as well and broke back over 17,000 on a very, very, very strong looking day led by blue-chips. India gained 1.7% as well and a lot of this was a "buy on the news" situation as the BOC had long telegraphed the hike, which was relatively mild.

I don’t mind a market rally as long as it doesn’t spark a commodity rally which, as I said in the weekend article, must end in order for us to start making real progress in equities.

Europe is chipper but cautious with half-point gains across the board. There’s plenty of M&A activity to feed the bulls this morning but, as is often the case, Europe is reluctant to make a commitment until they see how our markets open. I’m thinking of looking into EU ETF’s on this basis as it’s easier to play their market direction than ours much of the time.

Before we get too excited I will point out that this is approximately a 50% bounce off an awful week that is doing very little so far to catch us up from our longer-term fall, so let’s watch our 20% and 38.2% levels before we get all excited again:

Phil\'s US Markets

US Markets

I’m very pleased with the Transports getting over the hump so we’ll follow those and, of course, the SOX as our early indicators today. We REALLY don’t want to see the SOX give anything back so we will consider 469 to be a very bad sign if we fall under it. It’s all about the Dow since the Asian blue chips are getting attention. A lack of similar flows on this side would indicate extreme disfavor in the US markets.

Top subprime mortgage lenders
Rank Lender Location Q4 2006 originations, in billions
1 HSBC Finance (HBC) Prospect Heights, IL $12.3
2 New Century Financial Irvine, CA $12.2
3 Countrywide Financial Calabasas, CA $10.1
4 WMC Mortgage (NYSE:GE) Burbank, CA $9.0
5 First Franklin (Merrill Lynch) San Jose, CA $7.8
6 Wells Fargo Home Mortgage San Francisco, CA $7.4
7 Option One (H&R Block) Irvine, CA $6.1
8 Fremont Investment  & Loan* Santa Monica, CA $6.0
9 Washington Mutual* Seattle, WA $5.7
10 CitiFinancial (Citigroup)* Baltimore, MD $5.0
  Data: National Mortgage News

Just in case you’ve forgotten over the weekend, we are still in the first stage of a mortgage crisis that threatens to rip the financial sector to shreds and we have a Fed meeting this week where any single word could spart a 500-point sell-off. While that’s easy to envision, as an exercise - try to envision what will spart a 500-point rally. If you are having trouble then perhaps it is not time to jump in front of the bear train just yet.

Here’s a nice chart from National Mortgage News detailing the top subprime mortgage originators of Q4. Like true addicts, these are the people who just could not stop themselves, despite the warning signs and these companies should all be watched very closely for signs of trouble.

These are the numbers for just one quarter, and while big boys like HSBC Holdings plc (HBC) may be able to ride out the storm as a 20% default rate represents only a fraction of their market cap - lenders like New Century Financial Corporation (NEWC.pk) and Fremont General Corporation (FMT) may be hopelessly under water. New Century alone wrote $52Bn worth of subprime loans in 2006 (8% of the market) while Countrywide Financial Corporation (CFC) hardly seems out of the woods with $40Bn worth of subprime origination against a $20Bn market cap.

The total "B&C" originations in 2006 alone were $640bn and ARMs are just starting to reset this year, so the Fed’s next move is critical in this chess game but a 20% default rate means someone is going to lose some money somewhere - so caveat emptor when jumping into this market.

That being said, I’m picking up a position on Wells Fargo & Company (NYSE:WFC) $35s for .45 as they grossly overstated their subprime originations because they included co-issue loans in their numbers, which means their exposure is possibly far less than currently estimated and I think the sell-off may have been a bit overdone for the month. Inside B&C Lending lists them as having $83Bn worth of subprime loans in ‘06 yet the above chart shows "just" $7.4Bn worth of loans so either the initial report is, indeed, WAY OFF or they’ve made tremendous progress to kicking their habit - either way that’s a buy to me!

Oil will hopefully stay below $57.50 but we have two wild trading days ahead of us on the NYMEX as they reposition for the May contracts. April contracts have been pared down to 84Mb on order so they need to dump about 44MB in the next two days, while May is already swelling with 344Mb. But they did get April as high as 400Mb last month so once again, there is room for shenanigans (although those who pumped the April contract up to $62 early in the month took a nice hit for their troubles).

We need a dollar recovery to spark a real rally and that’s going to be tough with the BOC tightening a quarter point. Will Bernanke have the guts to do what it takes and tighten U.S. rates, facing the wrath of Wall Street? Tough language is not going to cut it over the long haul,G but a surprise rate hike will shock and then reassure the markets. Until we get past this Fed meeting, I’m not too keen on making big moves.

Gold has to hold $650 to show that it’s serious but I doubt there will be much from them ahead of the Fed either. We want gold to fail but, more importantly, we need copper to fall back below $265 but it may take a rejection off the 200 dma at $315 to make that happen.

Oil and Dollar

Let’s be very careful out there today. I still like our General Electric (GE) play from Friday, though, and the new WFC play, for those of you who insist on getting in on the early action.