Monday's Markets: Missing Momentum?

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Includes: DB, GS, TBT, XOM
by: Philip Davis

"Every civilization," Swiss historian Jacob Burkhardt once wrote, "carries within itself the seeds of its own destruction."

Dr. Hanmer Hill and Josh Bill tell us:

We believe the financial crisis of 2008 exposes a seed that can destroy Western-style free-market capitalism. The name of that seed is the credit default swap, or CDS… A surgeon could not take out a life policy on a patient he or she was about to operate on. You could not take out a fire policy on a home you did not own, and you could not take out more than one policy on a home you did own… It was, and still is, possible to buy an unlimited number of CDSs against any financial instrument, whether one owns that instrument or not. Imagine someone taking out 20 fire policies on his neighbor’s home. Common sense tells you the odds just went up that that house is going to burn, and you have just created a perverse appetite for the homes most likely to burn.

The total amount of subprime mortgages written soon rose to $2 trillion. The total value of the CDSs written against CDOs rose to $65 trillion. That’s right: $65 trillion of insurance against $2 trillion worth of high-risk mortgages. Those who profited the most sought out the worst of the worst mortgages to bet against. One big winner was hedge fund manager John Paulson. In 2006, Paulson convinced Goldman Sachs (NYSE:GS) and Deutsche Bank (NYSE:DB) to create extremely high-risk CDOs and sell them to others, so both he and they could bet against them. Paulson picked the mortgages. He made $15 billion. His friend George Soros (who later said "I’m having a very good crisis") made $5 billion. Deutsche Bank made $25 billion doing this. Goldman Sachs made much, much more.

In 2006, Goldman Sachs and Deutsche Bank underwrote 352 fraudulent mortgages in Sikeston, Mo. In 2009, Goldman Sachs paid Massachusetts $60 million to close an investigation into its role in creating "mortgages designed to fail at the inception."

As I mentioned this weekend in my Davos review, I find it VERY disturbing that we are seeing an extreme uptick in both lending to risky countries and CDS betting that those same countries will fail. This is kind of like playing that carnival game where you squirt water into the clown’s mouth until you pop the balloon while adding bets that the balloon will pop.

Unlike the clown game, your bet doesn’t have to pop first, as long as it pops at some point and, if you keep pouring more and more debt burden onto a sovereign nation, it will, eventually, pop and your CDS bets will far more than offset the capital you stuffed into the clown economy. And what happens if the clown economy stops the game and stops taking on more debt? Well, then you have a sad, deflated balloon and very few politicians have the stomach for that either….

So there is what I called in my Thursday morning post, my "Ball to the Wall" bull market premise as Obama and Bernanke hold hands and do a "Thelma and Louise" with the US economy. In the Weekly Wrap-Up I pointed out that we have not yet broken our tolerance levels on the 5% Rule and we did take our bullish chances into this weekend. I had promised to do more reading to see if I was sure, but after posting many news items in comments and reviewing Davos, I still wasn’t sure.

Updating our Buy List, on the other hand, did make me sure that we’re on the right track as I’m about halfway through and NONE of the 21 hedged plays from Jan 9th that I reviewed are even in trouble, even if we had taken them that day (which we didn’t as we were waiting for this drop). Now we have EVEN BETTER entries and an EVEN HIGHER VIX to give us EVEN BETTER spreads as entry positions on some very, very good stocks that we were worried were getting away for us on the 9th.

Hell, even the Google (NASDAQ:GOOG) spread is in good shape and that’s pretty good as they’ve dropped $70 since I first laid out the trade idea. We have 17 more trades to go through but we already executed many of those last week in Member Chat as our bottom fishing expedition gave us plays on XOM, WFR, PCS, S and ORCL as they got nice and cheap. As we expected, Rent-A-Rebel came to the rescue of oil this weekend with Shell (NYSE:RDS.A), halting production after a pipeline was sabotaged. That got oil off the $72.50 mark and now $73.50 at 8am, a bonus profit of $86M on today’s Global oil sales in year 5 of being unable to thwart a few dozen teenagers with guns and an outboard motorboat - curses, foiled again!

That’s why we didn’t short oil (or gold) last week (we did that already at $84). We didn’t go long, other than Exxon (NYSE:XOM) - who came through for us on earnings this morning - because we still think oil is overpriced but that doesn’t mean a little rebel action here, and some GS upgrades and JPM buying another dozen tankers and sending them off on an extended cruise, can’t sqeeze another couple of Billion a week out of the wallets of already struggling global citizens. Ah capitalism - no wonder John Maynard Keynes said: "Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone."

Of course it was Lenin (Vlad not John) who said: "The best way to destroy the Capitalist system is to debauch the currency," so perhaps Obama, Bernanke, Blankfein et al are doing more Lenin’s work than God’s. Wasn’t it Lenin who said they were bigger than Jesus anyway (or was that John)? Of course we all know that Capitalism is nothing but Man exploiting Man while Communism is the exact opposite so we will not get into an idealistic debate on the subject - not until next weekend anyway!

Speaking of Communism, it was pretty clear who the new Global boss is in Davos as our Chinese masters demanded that there be no discussion of Google and censorship - so there wasn’t! The reluctance of companies to talk about China illustrates the pressure on them to protect their business in the country, while the U.S. government doesn’t want to upset Chinese investors, the biggest holders of U.S. debt, said Andy Mok, president of consulting firm Red Pagoda Concepts LLC. China held $789.6 billion in U.S. Treasuries in November, or 22% of debt held by foreign investors. “Chinese Internet policies are sensible, rational and legitimate,” said Wang Baodong, a spokesman for the embassy. “People there enjoy sufficient access to both the Internet itself and the content.”

Meanwhile, that little Communist growth engine is just chugging along with China’s Manufacturing Purchasing Managers Index rising to a record high of 57.4 in January from 56.1 in December, marking the fourth straight month that the index’s reading has risen. Businesses reported more orders at home and abroad. A PMI level above 50 indicates growth in manufacturing from the previous month. Unfortunately, there was also a great deal of inflationary price pressure, and fears of additional government tightening dropped the Shanghai Composite 1.6% this morning, to 4-month lows and right to our target 350 line on the DJSH.

Similar indexes for other Asian countries reinforced signs of a broader regional economy. HSBC’s Taiwan purchasing managers index also rose for the 11th consecutive month, while the index for South Korea showed new orders rising at the fastest pace in 25 months. The HSBC PMI for India rose to 57.6 in January from 55.6 in December, the fastest pace in 17 months, as companies increased production to meet rising orders. "Worries about tightening and a sudden slowdown are certainly exaggerated," said Royal Bank of Scotland economist Ben Simpfendorfer. "The economy will continue to grow robustly in the first half of this year."

As I said last week, nothing but a change in sentiment full of fear and panic over a few bad numbers and some political rhetoric. Speaking of fearmongering political rhetoric: U.K. opposition leader George Osborne said this morning that the U.K. risks a “Greek-style budget crisis,” if he is not elected. “Britain, with the largest debts, the largest borrowing of any major economy in the world, has to deal with this problem,” Osborne told the British Broadcasting Corp.’s Sunday AM show today. “If we don’t, we risk a Greek-style budget crisis that will put interest rates up.” Have I mentioned I like TBT lately?

Gordon Brown came back with this zinger: "a return to strong, sustainable global growth remains some way off." OK, maybe not so much of a zinger as getting on his knees and begging for mercy. “I can reassure you that we are not about to jeopardize Britain’s economic future by suddenly pulling the rug from under the recovery,” Brown said. “Only with this radical approach and a plan for prosperity for all can we deliver renewed growth, jobs and opportunities for all.” I guess that’s Brown in the back seat of the car going off the cliff with Obama and Bernanke.

We’ll see how far we can rally this morning. We’ll be looking to add some disaster hedges to protect our bullish profits - very well played last week, it turns out, as we should get a nice pop this morning - but it doesn’t mean anything if we can’t start taking back our levels.

Be careful out there.

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