Bank Stocks: Another Day Through The Looking Glass

 Alice laughed. "There's not use trying," she said: "one can't believe impossible things."

"I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for half-an-hour a day. Why, sometimes I've believed as many as six impossible things before breakfast."

-- Lewis Carroll, Through the Looking-Glass

It's easy to grin / When your ship comes in / And you've got the stock market beat. / But the man worthwhile, / Is the man who can smile, / When his shorts are too tight in the seat.

-- Judge Smails, Caddyshack 

There they go again...

Once again, financials seemed poised to collapse, threatening to send bits of pulverized dollars and faith in the banking system hurtling into the ether. The cheap government champagne of mid-July had already gone flat, and left Mr Market with a nasty hangover and a worse disposition.

This was hardly the best backdrop for Merrill Lynch (MER) to demonstrate their ability to withstand brutal self inflicted pain, while simultaneously treating shareholders to the prospect of enduring $8.5 billion worth of dilution. Nor, apparently for Hank Paulson and his All Stars to introduce their latest in their fully-clothed line for Fall 08: Rescue II the Sequel: Covered Bonds issued by the very banks which some might say, ungraciously, are hardly the best candidates to inspire trust. (Harvey, my cat, informs me that Covered Bonds, touted as 'innovative financing' by Mr Pauslon - are a space age innovation of 1850s Europe, and could actually be considered less safe than SIVs, because at least SIVs are contained, and nothing else affects their value than the collateral, but I digress)

Admittedly, bonds - covered or exposed - are hardly as sexy as the image of a besieged Fannie in distress being rescued from the cliff's edge, or thoughts of hedge fund shorts being forced to don a robe, so as the esteemed Secretary spoke I watched the Financial Sector SPDR ETF (XLF) wilt with every qualifier and repetition of the words "no magic bullets".

XLF ended the day below $20 support, continuing to fall in after hours trading.

Traders, who had wondered all along if the rally in financials was sustainable, or even rational, flocked to defensive positions. Reuters reported that financial options had become a "crowd favorite" and XLF $20 and $18 puts, UltraShort Financial ProShares ETF (SKF) $140 and $180 calls were the flavor of the street. On Monday evening, markets around the world hemorrhaged on MER news as well as the sobering, yet curiously under reported National Australian Bank story. (Naked Capitalism has written some excellent analysis on the subject.)

Most rational traders who had been following the dire developments assumed a rational, if bearish response

You'd think we'd have known better.

Apparently the Red Queen has joined the Market Fairy on the Plunge Protection Team and on Tuesday, U.S. banking stocks made another trip through the looking glass. Incredulous observers, armed with stacks of due diligence, balance sheets and technical analysis, were forced to throw all into the circular file and ask once again ask, "are we taking crazy pills here?"

U.S. investors, at this advanced stage, are a cynical and calloused breed. They are largely inured to market gyrations previously confined to the penny stock world; they yawn at the sight of good stocks brought down after excellent earnings by wandering packs of bear raiders looking for any candidate left trading above the 50 day moving average. They have seen and expect it all.

However, what U.S. investors have NOT been prepared for is the sight of limping, mauled, barely conscious banking intensive care candidates enjoying the kind of marathon sprint into the green usually reserved for well regarded veterans paying impressive dividends, or eye catching newbies with exciting new products, surging revenues, and upgrades.

What gives? Once might seem like an accident...twice more like a planned collision. As I have been saying for several weeks now: it's all about the price of oil. In my opinion, this rally in financials, which sparked a broader relief rally across the board, is less about the fact that MER has finally come clean - (and this time they mean it!) , but rather about crude looking likely to drop below the crucial $120 level....and the implications for hot money flowing out of the energy sectors back into equities.

I had surmised last week that certain big players, including U.S pension and university funds, have been given 'the word' on what behavior is considered acceptable if they want to avoid long visits by SEC regulators, and amassing huge positions in oil is not acceptable. The U.S. Bill to rein in oil speculators won a test vote, and although currently halted, may be having a cooling effect. Naysayers insist that traders were not the cause for the meteoric rise in crude prices this spring, but if not them, then who? Somebody out there was, and now, apparently, they have changed their trade, leaving even the WSJ to speculate that perhaps speculators were to blame, after all.

Are they or aren't they...perhaps we'll never know...and of course, like most truly interesting stories on Wall Street, I doubt the details of what is actually transpiring will ever be released for mainstream public consumption. Rather, we are left to guess the cause by observing its effects through the sharp movement in oil futures and the price of bank stocks. Stories like this one in the FT confirm that more funds than expected were long oil, short banks, and detail the carnage. Worth noting is that, perhaps, the squeeze may continue.

Last, but hardly least, is the fact that Tuesday is when SEC restrictions on shorting were set to expire. Most on Wall Street expected them to be extended and expanded, and that left the more prescient to anticipate a new SEC inspired rally. And indeed, the restrictions were extended for another 15 days, although no new institutions were added to the "No Crappy Bank Left Behind" list.

So, how is a trader to react? I would bet that financials will continue to rally for several days, perhaps into next week. The emergency provisions expire by mid August, which might leave those holding big positions in August financial puts in a tricky situation...do they average lower in what are sure to be bargain hunting days ahead? If so, they could be well rewarded after some sweat-filled hours. No doubt, within the next two weeks markets will be treated to more abysmal banking news from some sector. Even my cat Harvey assumes that.

Unhappy events which could be fly in the ointment include the ongoing tension in the middle east, as I noted last week. Tuesday night, in the midst of market euphoria, Israel reminded the world that they hadn't taken their sights off Iran.

In addition, Sovereign Wealth Funds apparently are not impressed by Hank "No Magic Bullets" Paulson's jaw boning, and we hear that they are continuing to cut their exposure to the U.S. dollar. Fannie (FNM) and Freddie (FRE) have been saved from the prospect of another stock rout for now, but how long can this last? An S&P downgrade of Fannie/Freddie debt has implications which are extremely bearish for equity holders, who already have much to tremble about if they dare look between the sheets.

So in conclusion, in my opinion the possible causes for Tuesday's remarkable rally are:

1. a drop in crude prices
2. funds being forced to alter trading strategy and re-enter equity positions (and the prospect of those billions of dollars of commodity profits entering stocks is an interesting one)
3. extension of the SEC short squeeze policy, er, I mean naked shorting restrictions, which might have caused some banks who had hoped to cover lower after July 28th being forced to cover. Shorts take note that this emergency order cannot be extended again

What could end the rally

1. Any strike by Israel on Iran, which would immediately impact the price of oil, given the Iranian threat to blockade the strait of Hormuz. Apparently, the U.S. was quick to confirm that a strike on Iran is not out of the question, so I personally wouldn't minimize this possibility
2. A serious crisis involving a major broker dealer, on the scale of Bear Sterns. We know that Professor Nouriel Roubini cites Lehman Brothers (LEH) as a possible candidate, but there are so many others, why limit oneself?
3. Of course, the third reason the rally could break is the psilocybin wears off and longs find themselves standing shirtless and dehydrated in the Mirage parking lot as the sun comes up, left with nothing but a comp card, a hand covered with stamps and $14 dollars in quarters.  They then have to cash in their UYG calls so they can buy airfare home (not cheap!) and pay for the tattoo removal.

But for today, expect meteorologists to report more sightings of flying pigs, and traders who can stomach the trade, should see nice profits by going long on XLF, Ultra Financial ProShares ETF (UYG), Wachovia Bank (WB), Citi (C) and others that logically should not be enjoying double digit gains. Airlines may already have priced in all the decrease in oil prices, but given the artificial supports skewing trading patterns, especially in bank stocks, it is too quick to jump to conclusions.

Where to next? I can only imagine that Act IV, Scene IV of this particular show includes a stage littered with groaning and expiring players. However, for now, its certainly behaving more like a comedy.

Cue the music...and make it something snappy, something we can all sing along with...an old favorite like 'Happy Days are Here Again'

For now...

Disclosure: the author holds both calls and puts on XLF, SKF and puts on WM, MER and WB

Comments

[peterthepai...:]

I was sure it was 5 but you're right - its 6! wait until after the election and maybe even Santa clause. Then it really will be impossible.

2008 Jul 31 08:31 AM

[Alan Young:]

Right on. Love your literary style!

2008 Jul 31 10:18 AM

[junebug:]

Thanks for sorting this all out! I used to think that I'm nauseous from the vertigo and gyrations of this market. Now I realize it's because I'm on LSD! I hope that when my stomach clears, the usual fundamentals and TA will work again. Until then, follow the White Rabbit to where the Mad Hatter is setting legislation ("Eat me!") and openning the Fed windows to all comers ("Drink me!").

Heh...I thought they said that this time on Wall St. it was different because the windows don't open... --juneBug

2008 Jul 31 10:21 AM

[Lilliana:]

Didnt "W "wish that Social Security enter Wall Street with its funds...only a few short months ago.?
How bright does this sound now.???"
So much for the boy wonder.

2008 Jul 31 11:00 AM

[msgtb:]

Remember the only people on earth that would buy financial stocks at this time, would be the Plunge Protection Team (PPT). People need to write their US Representatives and US Senators and remind them that they are the elected officials, and we will have our revenge on them. We may not be able to get to Paulson and Bernake but if they continue to send good money after bad and rob our children and grandchildren the wealth earned by previous generations of Americans as well as our own.

The lack of honesty is a beacon to the would that American can't be trusted. Free markets? Who would believe that now.

Please Vote!

2008 Jul 31 02:18 PM

[BGnyc:]

You are almost as cool as my favourite Todd Harrison. And anybody who quotes Lewis Carroll (a fave too) so aptly is worth a good read.

2008 Jul 31 02:57 PM

[Contrarian ...:]

A classic contrarian play...

www.contrarianprofits....

2008 Aug 01 03:12 PM