Thursday Was Reversal Day

“What is the problem ???”

On Friday we will learn what “caused” the rapid selloff that turned a triple digit gain on the Dow into a significant loss in just over an hour. While the indexes rallied toward the close to put on a good face, the damage is likely done as far as sentiment is concerned. To get a better grip on where we stand, lets take a stroll down memory lane to figure out how we got here.

Back in August as the wheels were falling off the wagon, investors began to panic. Credit was no longer being extended even to the most worthy of borrowers and the ramifications were far reaching. As investors balked at purchasing MBS assets, mortgage companies were unable to securitize loans and get them off their balance sheets. The disconnect between supply (way too much) and demand (non existent) for these securities pushed prices down. This was a major concern for financial companies such as Merrill (MER), Bear Stearns (BSC), and Lehman Brothers (LEH) who were carrying these securities with incredible size on their balance sheets. One can also point to asset managers (Hedge funds got most of the headlines) who owned these securities with extreme leverage.

Once prices started dropping, margin calls were issued and firms had to sell whatever assets they could at whatever prices they could simply to liquidate enough merchandise to meet the calls. This is one of the main reasons we saw selling in cyclicals, consumer stocks, technology issues, and healthcare names. All sectors that one might not expect to be directly related to mortgage backed securities.

As panic began to ensue, the sound of helicopters was heard as Bernanke rushed in to save the day on the morning before options expiration. The decision to cut rates on the discount window and to encourage banks to use this vehicle as a means to borrow for non-emergency liquidity caused a massive shock to the system. Those who had positioned themselves short to take advantage of a financial crisis (which is not an evil practice in and of itself) were trapped and vulnerable and as they scrambled to cover, option traders had to step in and buy themselves as there appeared to be a good bit of short out of the money calls which became liabilities with higher market prices.

The liquidity infusion was effective and stabilized the overall market for the time being as lenders slowly began opening their coffers, and transactions began to pick up a bit with asset backed securities. While there were still imbalances to work through, and still concerns that consumers had overextended in home purchases, it appeared the overall economy was working through the painful process of weeding out excesses and establishing the beginning of some solutions for our long-term problems.

Things became dramatically different on September 18, as the Federal Open Market Committee released the statement regarding their decision to cut the overnight rate by 50 basis points. This had the general effect of lowering interest rates for many of the benchmark indices and the added stimulus from the fed ignited a massive move in the equity markets. The move also touched off criticism as the fed appears to have created a moral hazard (see my article titled “moral hazard“) whereby conservative institutions are punished for not participating in risky behavior while those who lent recklessly are now given an easy out. The rate cut would likely have a negative effect on an already weakening dollar (printing money to inject into the system simply makes the money less valuable compared to other currencies).

After spending a few weeks digesting the rate cuts and moving to new highs, we find ourselves at the current juncture. Nothing has changed structurally. We still have a leveraged consumer that will have trouble with adjustable interest rates on exorbitant mortgages. We still have a trade deficit that leaves foreign powers holding incredible amounts of dollar denominated securities. We still have leverage in the system with many off-balance sheet positions that have yet to be uncovered. And now we have a market that reversed sharply in the afternoon with only guesses as to what set it off (yes I’ve heard about the futures trading error - and the ECB members statements). The point is, we are in a market that has wrung out much of the short interest, has become extended, and we still have significant structural issues that need to be dealt with.

I’m not necessarily calling for a meltdown from here.

But I did spend most of the afternoon lightening up on positions and buying some index puts as insurance.

I believe this market has a good bit of vulnerability at this level. While one must respect the herd mentality and the tendency for managers to chase performance into year end, I believe there could be a sharp “air pocket” surprise as investors who have finally capitulated and bought into the new market highs are shaken out of positions.

This year has been frustrating and full of volatility. Managers who have controlled their risk and protected capital are likely popular with their investors. Those who do not have a sound discipline may quickly find themselves giving up hard earned gains. The financial markets warrant caution at this time and investors who trade with sound rules and damage control stand to reap the spoils.

Disclosure: Author does not have a position in any stocks mentioned.

Comments

[Solution:]

I smell a lot of fear in this artical and others published at this site. That is good for the market.

2007 Oct 12 02:40 PM

[razormd:]

I have to agree with "Tintin Dong"...all I see are negatives headlines about upcoming earnings, real estate, etc...I can find a bunch of dire market forecasts but nary a single full blown "buy now" recommendation...if everybody already knows how bad things are and already know how overpriced everything is, how many "sellers" are left?...at this point I would be looking to trade the long side more than the short.

2007 Oct 13 08:54 AM

[sharkboy:]

These are scary times, but after all, investing is always scary to some extent. I have been out of everything except energy for a year now. I am a doom&gloom-this-ho... some-point type and as such have missed some huge moves up. But this is October after all, the next hiccup in equities could easily become the next tsunami. I'm taking the advice and buying some index puts first thing in the a.m.

2007 Oct 14 10:43 AM

[gordon:]

I thought SPY short positions are still at an all time high, and Profunds said just last week 80% of their etf volume is on the short side.

2007 Oct 14 01:46 PM