What's Behind the Market's Instability?

by: Jim Kingsland

The two primary reasons for the recent stock market drop are the carry trade, and the junk bond market.

The carry trade:

At the beginning of last week, this blog warned you about the carry trade. Don't underestimate the damage that is done when unwinding occurs. The carry trade has funded all strata of speculative activity that has helped the stock market to rise this year. Oh, the carry trade recognition wasn't anything special, no fortune cookie to direct me to look, just the ability to break away from drinking the Kool-Aid of the parabolic lines on the S&P 500 chart.

In a basic sense, the carry trade didn't start to matter until November of last year when it became fully apparent that the Japanese economy was finally starting to climb out of the deflation hole. The rally in the yen ($XJY on stockcharts, JPY on Bloomberg) during mid November led to a drop in the stock market Thanksgiving week, and choppy trading in December. But as the yen slid back to 82 (a very key number) by late January, U.S. stocks were on their way back up. Then in early February the yen became very volatile as speculation mounted that the BOJ would hike their overnight call rate by 100% to .5% which they did on Feb 21st.

In combination with tightened banking reserves announced the following weekend in China, the yen soared, the Shanghai market plunged, and February 27th resulted on Wall Street. But things simmered down again, and the yen was allowed to sink all the way to a low of 80.75 by late June, but then began to rebound in July as talk increased that the BOJ could again increase rates in August, or September. An 82 on the chart below was the inflection point for trouble again. The 82 had been an important floor for the yen earlier in the year and once broken in June became an important resistance level which was broken just as the Dow, interestingly enough, hit 14,000. The rest is recent history.

Carry Trade

On Friday, however, the yen was flat to a smidgen lower. So why did the stock market swoon in the final hour? Part of it was nervousness about holding ahead of the weekend, but the bigger factor was rapid deterioration on Friday in the....

The Junk Bond Market:

Bonds 101 states that trouble in one part of the market leads to trouble in the rest of the market. Many an arrogant nit wit said subprime didn't matter. That sort of ignorance had to be born in a pompous 'let them eat cake' mentality where only the little people of the subprime world would be getting their just desserts. That's a quick lesson in Social Equity 101 where the weakest rungs of the food chain can still impact the upper rungs. So two lessons for the price of one out of the School of Hard Knocks for the investment intelligentsia of the world who preached with Elmer Gantry-like verve that subprime didn't matter.

Subprime has now seized up the "junk bond" market. Yes, subprime has always mattered. I even wondered with tongue in cheek a few weeks ago: Should I Even Bother To Write About ABX?. I got the timing wrong on how quickly problems would show up in earnings (the Countrywide earnings, illustrate this point), but at least I was on the right track, but took the slower train.

An even tougher lesson will come as those who now spout that the economy won't be hurt by these credit market woes. They fail to connect the dots and realize that the junk bonk market has funded more than just LBOs - it's the economic engine of the great majority of public companies who use money they raise through the sale of below investment grade debt to buy things... capital spending, is I think what they call it.

If you've been paying attention to put buying in the options market, you'll notice that here and there, but with increasing frequency, January options are picking up in volume on the realization that crimped capital spending will make for tough times around Christmas, and going into next year.

Also helping to grease the skids on Friday, was the Cadbury (NYSE:CSG) news: Cadbury's Not for Sale -Just Yet. Ouch.

The general assumption is that no deal reached during the LBO boom will be scuttled by syndicate banks due to contractual obligations, breakup fees, potential litigation, etc. But with nearly $200 bln in U.S. deals yet to be syndicated, and around $40 bln in European deals in waiting, good luck with the "no deal will be scuttled theory." You can bet that bankers are looking at everything they committed to with eye toward 'what if we walk away and just eat the costs?' That perhaps is a very long shot, but previously viewed long shots have been coming to pass, so it's something to be aware of.

Thus far options speculation in the deal names has been quiet on the put side. It's a good idea to keep track of put activity from the very long list, which includes names such as Sallie Mae (NYSE:SLM), First Data (NYSE:FDC), and Bell Canada (NYSE:BCE).

All I can say is that this reminds me of Ford (NYSE:F) and exploding gas tanks. Ford knew they would explode and result in some deaths and costly litigation, but also determined that the litigation costs would be small in comparison to impeding their ability to make money by selling the defective cars. If syndicate bankers come to a point of realizing it's better in some cases to walk in order to protect their ultimate self interest of making money by not damaging their balance sheets - they'll pull some deals. Again, perhaps draconian and a long shot, but I'm not willing to rule it out.

As for the condition of junk bond market, it's ugly, but from a historical perspective, it's starting to get back to where it should be spread-wise. The fear is whether it overshoots and for how long the 'closed' sign stays up. My guess is for as long as the LBO overhang remains and that's likely to mean a seized up junk bond market going into September.

The biggest fright for the market Friday was the further slide in junk. LCDX, which is one example plunged over 2 points Friday with its spread widening by almost 50 BASIS POINTS IN A DAY!

LCDX Chart

So it makes sense, as Bill Luby pointed out on Vix and More, that the Vix swung up to over 24 after the bell. I think as word quickly spread on where LCDX closed and where other junk benchmark spreads finished some folks jumped in to further protect themselves.

This almost has a Black Monday in-the-making-feel to it, but very Blue Monday is more like it. Any sort of stabilization in the junk market, and the carry trade situation will give the stock market some quick relief; further deterioration and we're in for more pounding. I doubt we will see any blockbuster LBOs announced on Monday. I imagine that anything over $10 bln is off the table. But, we could see corporate to corporate buyouts which could give the market some support.

As I mentioned in my post late in the day on Friday, I think we've got a good chance to see the 200 DMA tested in the S&P next week down at 1448, and that could lead to a extreme oversold bounce opportunity. If that doesn't hold then the next area of support has to be March lows, and that would certainly leave a mark.