Markets were way down to start the week, with the Dow Jones (NYSEARCA:DIA) dropping as much as 400 points and the other indices down even more on a percentage basis in Monday afternoon trading. As has often been happening lately, with an hour left in the day, the market turned on a dime, and by the close had erased half the day's losses.
I've been calling for a market bottom for several weeks now. At about 2:30 p.m. ET, it wasn't looking good for my call. However, markets did in fact bounce from a level well above the January low.
From here, there's two possible directions. One, that was a higher low and markets can now make another bullish move. The other possibility is that the market is heading for new lows, and that the afternoon rally was just a bit of relief before the next slump. As of this hour, futures are down big again Monday evening.
However, 1,810 is the do or die line for bulls on the S&P 500 (NYSEARCA:SPY). That was the flash crash low in August, and it was hit again dead-on in January. 1,828 was the low Monday. Hold that level tomorrow and the market is still in okay shape. Between 1,810 and 1,828 would be a yellow light, and a close below 1,810 would be a cause for great concern.
As to my prediction of where the market will go? Honestly, I don't know now. There's so many cross-currents in play now, this isn't just a China and oil story anymore. Let's run through what else to be watching this week.
European Banking Problems
Deutsche Bank (NYSE:DB) for better or worse has become Europe's example bank. The continent is sorely in need of a bank to lead the Eurozone's struggling economy forward. However, its recent efforts are going poorly:
DB data by YCharts
That's another 8% down just on Monday. At proximate fault are the bank's "CoCo" bonds that have collapsed in value in recent weeks.
I urge everyone to watch this video. Credit expert Peter Tchir explains the details on these bonds, and how the market may be taking things out of proportion:
So we're all talking about these CoCo bonds, and the reality is they're much more like preferred equity. I think that got lost in the shuffle. We've gone through two years of the ECB being supportive of this chase for yield [...] something with a 7.5% coupon, which these Deutsche Bank CoCo bonds have looks attractive, so it got bought as a bond. [...] The [CoCo bonds] do count as Tier 1 capital, so they are equity capital for the banks.
The coupon can be shut off, it doesn't cause a credit event. So shutting the coupon off is not a default, that can be done at the option of Deutsche Bank [...] We're now lost in a shuffle of a lack of liquidity and a scary headline.
Tchir goes on to say that the ECB has many policy options to backstop the banks and support the actual bonds. Letting the CoCo bonds - preferred equity by another name - convert to equity might make for ugly headlines. But it's not a bond default.
People are thrown off because the word bond is in the name. But it's more like a bank choosing to stop payment on its preferred dividend. That's not a good thing, but it's less bad than perhaps the market is thinking.
The market is certainly pricing Deutsche's CDS poorly:
Whether or not Deutsche has severe long-term solvency issues, I couldn't say. In the short run, the current level of panic seems a bit overdone.
Some European banks are in deep trouble, and deserve the pain they're taking. Witness Santander (NYSE:SAN), which is getting taken to the woodshed:
SAN data by YCharts
However, Santander has major problems in Brazil, its home Spanish market is facing political unease, and the US Santander Consumer (NYSE:SC) unit is looking like a basket case:
SC data by YCharts
All is not well with European banks, however, it is too early to say the whole sector is rotten. Watch how these stocks trade, but don't panic just yet.
Chesapeake: Going, Going...
I've been vocally, aggressively, and unrepentantly short the natural gas producers ETF (NYSEARCA:FCG). My thesis all along has been that roughly half of the companies that are in the ETF are insolvent, and that until Chesapeake (NYSE:CHK) croaks, investors are remaining too bullish on the space. It's been - to put it modestly - a good trade:
FCG data by YCharts
However, the main event, the big thud I've been waiting for, now appears to be almost here. Chesapeake Energy, on Monday, was forced to deny that it is about to file for bankruptcy.
Shares were down as much as 50% on the day at one point as rumors flew, before closing with "only" a 33% loss following its denial of the bankruptcy claim.
CHK Price data by YCharts
Regardless of whether it files tomorrow or in a few months, the outcome seems almost inevitable. I've been patiently waiting for it, letting the FCG short position's profits continue to accrue.
As fellow SA author Scott Fearon puts it in his book Dead Companies Walking, companies listed on US exchanges tend to remain way overvalued even when it is already 95% likely that they will end up in bankruptcy. Due to aversion to taking losses, naive optimism, or some other psychological quirk, investors are far too prone to holding onto or buying "cheap" stocks that are almost certainly worthless when you examine their balance sheet.
Chesapeake - and the broader wildcat energy space - was an example of a dead company walking that remained grossly overvalued long after it was clear their business model had gone kaput.
Once Chesapeake goes bust and the other nat gas producers see the remaining excess optimism wrung out of their share prices, I will finally cover my short FCG position. People have been saying the whole way down: "Ian, it's too late to short." To which I say, it's never too late to short something that's about to go bankrupt.
As for the broader market impact, it will be good once these companies have gone bust. The market is so fearful of a broader debt contagion; however, most of the independent energy companies don't have large enough debtloads to really shake the banking system. Defaulting and seeing the banks write down the bad debt will clarify a lot of risk that is hard to properly account for at this point.
The truly important coming energy bankruptcy - Petrobras (NYSE:PBR) - is likely still a few quarters off. That is the one that could cause global mayhem. Chesapeake, by contrast, can and should be allowed to fail without it triggering a domino effect on the broader market.
Tech Stocks Continue To Plummet
Monday's Briefing was titled: Tech Stocks Implode. One clever reader suggested today's Briefing should be entitled: "Tech Stocks Implode Again." And I can't really argue.
The Nasdaq got shellacked again, taking a worse beating than the other indices. The usual suspects were again to blame. Biotech is a dead horse (NYSEARCA:XBI) that short sellers are beating for fun at this point:
XBI data by YCharts
This last drop has gone from 70 to 45 without a single decent upmove. The one plus in this huge decline is that few people are arguing that biotech isn't a popped bubble anymore. I follow many biotech investors on Twitter, and a good number of them have gone radio silent over the past month. If you're looking to play a bounce, this might be the moment to take a shot, as the bulls are finally giving up (or have run out of money).
The FANG stocks continue to sink. Amazon (NASDAQ:AMZN) closed well under 500 on Monday. Facebook (NASDAQ:FB), congrats on beating earnings, but we're still going to take back your whole earnings pop anyway:
FB data by YCharts
Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) spells out a similar tale. Despite all that, the FANGs have been holding up better than the so-called CULT stocks. These sorry four - Chipotle (NYSE:CMG), Under Armour (NYSE:UA), Lululemon (NASDAQ:LULU), and Tesla (NASDAQ:TSLA) - were down 4%, 9%, 7%, and 9% respectively at one point in the afternoon. Particularly for Tesla, it's been a real drain recently:
TSLA data by YCharts
That's almost 40% down YTD for Tesla! Pretty amazing stuff. Everyone loves momo stocks on the way up, but this is the sickening reminder of what happens if you overstay the party. As for me, my top tech holding is Texas Instruments (NYSE:TXN). Call me an old man if you wish, but I enjoy my holdings not to be prone to near-overnight 50% sell-offs:
TXN data by YCharts
Any tech company is likely to sell off with the market. Tech is known for being high beta. But there's a big difference between buying low to no profit, shoot-the-moon type stocks, and buying wide moat defensive tech like Texas Instruments, as you can see from the respective charts.
If you want to own momo tech, and can handle the risk, that's great! I certainly wouldn't tell you to do otherwise. But let this be a reminder that there's good reason that many people, myself included, avoid these stocks. Just like in 1999, you heard a deafening chorus that you had to own FANG, you had to own biotech, and so on.
Particularly for young investors, we would supposedly be left behind if we didn't get some hot biotech or cloud company into our portfolios. Like all popular market stories, the truth wasn't quite that simple.
Disclosure: I am/we are long TXN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am short FCG.
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