Short Squeeze Triggers Sharp Volatility in Stocks

For the first time since March 2003, the Dow Jones Industrial Average broke 8000 at the open of the US markets. However just as quickly as stocks dropped 600 points, it recovered more than half of its losses in the first 15 minutes of trading and actually moved into positive territory 35 minutes into the trading session. The capitulation followed by the major short squeeze suggests that we may have seen a near term bottom. This type of volatility drove the VIX index to a record high of 70.

Currency Traders Waiting for the Buying Opportunity

Interestingly enough, we have not seen much of a reaction in the currency market. This suggests that the capitulation is only in stocks and traders are waiting for the bounce to get in. The day is early so many things can change and equities could sell off again, but for the time being, it appears that the buyers of EUR/USD, GBP/USD and USD/JPY are sitting on the sidelines waiting to get in. If stocks start bottoming out, carry trades could actually bounce today. No one will want to be short carry ahead of the G7 and G20 meeting this weekend – we expect a bounce.

Pessimism in Uncharted Territories

Pessimism in the market has hit uncharted territories with the TED spread reaching another record high. This indicates that liquidity remains a problem and unfortunately confidence in the markets is tied to liquidity. Lehman has a CDS auction today and the rumor in the markets is that governments could resort to temporarily shutting down equity trading. This seems nearly impossible by theory, but it is certainly becoming a growing possibility. There is nothing more coveted than cash right now and the continued hemorrhaging will force the G7 and G20 into action. It will be another long weekend for US Treasury Secretary Paulson and Federal Reserve Chairman Ben Bernanke. There is even talk that the US is considering a guarantee of bank debt.

G7 Meeting – Most Significant Since 1985 Plaza Accord

Finance Ministers have arrived in Washington for the G7 meeting while the G20 meeting is scheduled for the weekend. This will be the most significant G7 / G20 meeting since the 1985 Plaza Accord which marked a major turning point for the US dollar. The consequences of inaction are severe, so we expect a big announcement this weekend if not sooner.

In 1985, the 5 nations attending the event agreed to intervene in the currency markets and to sell US dollars to reduce the US current account deficit and to pull the US economy out of a serious recession. FX intervention is still on the table, but it remains to be seen whether even that step will enough to surprise the markets.

How Low Can Stocks Go?

The Dow Jones Industrial Average has fallen to the lowest level in 5 years. Since its peak in October 2007, the Dow has fallen close to 40 percent. The worst financial crisis prior to the current one was the Wall Street Crash of 1929, which led to the Great Depression. Stocks started selling off in October 1929 with the big crash happening on October 29th of that year. Equities did not bottom out until July 1932, after the Dow lost 89 percent of its value. These are scary figures but it provides a perspective on how bad things have gotten in the past. We sincerely hope that this doesn’t happen, but the lower equities fall, the greater the decline in USD/JPY and carry trades.

Comments

[MarvinMBA:]

I've been preaching holding cash but if you still have stock I think its now too late to sell and just hang in there. There could still be pain but I believe the worst is over believe it or not..MarvinMBA

2008 Oct 10 10:46 AM

[peterthepai...:]

how can the worst be over? transparency and trust are missing...credit is contracting...capital is disappearing...

2008 Oct 10 10:59 AM

[phdinsuntan...:]

Japan is still the boss...

2008 Oct 10 11:54 AM

[ThinkRight:]

Domino Toppling is always underestimated by those who do not have idea of big picture and effect it can have in other branches (other markets). That's most of us :-( Elephant is in the room. Takes days to make an arrangement and takes minutes to fall. (Takes a week to lose what was gained in five years.) Each end of domino is marked with a number of spots (also called pips - hum ). Short squeeze is one of the reasons....cause or effect we don't know.

2008 Oct 10 12:39 PM

[Smarty_Pants:]

The trend is down. Expect more of the same until it stops.

2008 Oct 10 02:52 PM

[jasonjim:]

One type of solution which would aid immensely in settling the stock markets of the world into a more normal state of affairs would be to ban worldwide every type of short selling of stocks in a coordinated effort by every country for perhaps six months or so, maybe longer. This would go a long way in removing the volatility in the markets and get things back to being more normal. This would eliminate in the short term attacks by short sellers with big money on perceived weak stocks while the ban remained in place----big money would have to look elsewhere to find a place for their megabucks, and hopefully that would mean they'd go long in depressed stocks that they helped depress in the first place----this would go a long way to help the market recover in an upward direction.

2008 Oct 10 05:00 PM

[Richard Col...:]

The latest report is that both Harvard and Yale endowment funds have both been shorting the market. I still maintain you buy good companies that are reasonably priced and expect to hold them till the market rebounds which might be sooner if there are good things coming out of the G-7 and G-20 meetings.
Daniel Kowkabany

2008 Oct 11 12:21 PM

[NOWHEREMAN:]

Short Squeeze, I don't think so. I think the shorts have a new tactic. In a Forced Sale environment, the shorts can step in to the void, buy up and start bailing out at the end of the day. Stocks are now low enough where this is feasible.

Monday's morning selloff will let you know if the unwinding of Friday's purchases continues. It will also let you know, in the next few days, where they feel a new rally point or possibly Bottom is in place, possibly 7,000.

2008 Oct 11 12:49 PM

[bill d:]

1. Declare war on Japan.
2. Surrender.
3. Let them rebuild us.

2008 Oct 11 01:38 PM

[NOWHEREMAN:]

They would have to destroy something first, how about a few million foreclosed homes. Burn all of them to the ground, Have insurers foot the bill, when they fail, bail them out. Housing glut over.

2008 Oct 11 02:21 PM

[bill d:]

Or they could bomb Pearl Harbor - maybe they could get it right this time (of course I'm happy that they screwed it up).

2008 Oct 11 07:31 PM