Options Trader: Thursday Morning Ideas

by: Philip Davis

It’s not a rally if we don’t keep going.

I’m sorry, and I know my readership goes down when I’m bearish (as discussed back in November when I revealed the dirty little financial writing secret) but that’s why you are lucky to be reading a member supported, rather than ad supported, site - I can afford to tell you the truth (or at least my version of it, which is all anyone can really tell you).

So if you are looking for a rah-rah, go markets commentary this morning, you’d better leave now because we’re just not there yet…

I was, as I’m sure you were too, rereading the Fed’s last report (July 19th) to see what has really changed and I noticed that while jobs are up and inflation is down (good things), the outlook on the GDP has dropped from: "3 percent to 3-1/4 percent in 2007" to "2-1/2 to 3% in 2007."

That’s a $140Bn difference on the low end!

The Fed projects unemployment even lower than they did in June and places the slowdown squarely on the shoulders of (and I know you can guess this one) - homebuilders! "This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer."

I wrote back in October about how there is nothing inherently bad about a deflating housing bubble with respect to equities but it’s always a neat trick to get that balance just right - effectively it’s like playing roulette and, given the choice to put our money on a 50/50 bet of red or black, we say "no thanks, I like that green number."

So today and tomorrow we face a real market test. If we do not move UP from here then we can only conclude that we have not really broken orbit yet and will be taking another rangebound pass at market neutrality. If this is a REAL rally, then the Fed, global shenanigans, housing, options scandals etc.. . JUST WON’T MATTER!

Japan got its rally cap on and took the Nikkei to a 7-year high at 17,897, up 15% since Thanksgiving! Also leaving the Dow in the dust is the Hang Seng, which picked up a neat 328 points (I wonder what their VIX looks like?) to finish at 20,538, gaining a neat 70% against the Dow since mid-2004 - if we can’t get it in gear and start catching up to these guys, then we’ve got some serious sentiment problems!

Europe is flat this morning with no real news over there so we’ll move on…

U.S. futures are looking flat (7:30) but we have more bad news on the home loan default front with the WSJ ripping off my "hot potato" analagy and applying it to mortgages. That’s OK, I use their ideas all the time (but at least I give them credit).

The Rising Price of Risk
I wish I had time to explain this (maybe on the weekend) but the chart on the right is like the 7th circle of hell for subprime lenders. The short story is that "Under mortgage contracts, mortgage originators must often repurchase loans that default very early in their term or that come with underwriting mistakes, such as flawed property appraisals." Anyone in the real estate game can tell you that, using the appraisal clause, a big lender can shove a whole portfolio back down someone’s throat in a housing turn-down!

Accredited Home Lenders Holding Co. (LEND) yesterday reported a loss of $37.8M, much of it due to bad loans they were forced to buy back but that was a relief compared to ResMae Mortgage Corp, which is being forced by Merrill Lynch & Co. (MER) to buy back $308M of loans in which borrowers have already defaulted!

ResMae said those demands "crippled" its operations. The Brea, Calif., company said that repurchase requests were "severe and unexpected."

Worry about them (they’re private), but also worry about the banks that lend them money as you can only force someone to buy back so many bad loans before they go bankrupt. MER bought $3.5 in subprime loans last year, and values them based on the premise that they can always get rid of the bad ones… As Blondie once said, "Dreamin’ is Free."

Earnings growth is already slowing down sharply, from 9.5% last Q to 8.5% so far in Q1 with 75% of the stocks reporting. While 8.5% is good, it’s more than 10% off last quarter’s pace and you’ve got to be concerned about ‘08 if this trend continues (the Fed is). I warned you this wasn’t going to be a rah-rah morning but, if we really are finally breaking orbit, then none of that stuff will matter and we will take out my new targets:

• Dow needs to break and hold 12,750!
• Transports need to hold 2,900.
• S&P needs to break 1,460.
• NYSE needs to take out 9,450.
• Nasdaq needs to retake 2,500.
SOX 470 must hold - we shouldn’t go so easy on them but they are just so pathetic!
• Russell 820 will give us a real rally sign.

US Markets

Without the pull of gravity, none of these levels should be a problem but, if these levels can’t be cleared, then any downturn at all is likely to lead us all the way back to where the month started, back at the periapsis (the lowest part of our orbit).

Apoapsis Periapsis

Speaking of orbital lows - how about that oil patch? CNBC (Causing Neophytes to Buy Crude) has pulled out all the stops this morning with incredible (as in not credible) speculation that Al Queda is planning to disrupt the flow of oil to the U.S., that cold weather is going to last, that demand is up, supply is down, ethanol won’t work… If I didn’t know any better I would swear they are nothing more than decrepit mouthpieces for the oil industry but we know that they are simply a fine bastion of unbiased journalistic integrity, just doing their duty by protecting you from thinking that we may not be having an oil crisis.

A 1% drop in US GDP growth is 1.4Mb a week of demand drop, that’s more than double China’s growth scenario and, of course, if we slow down, they slow down so this could get ugly. Ironically, it’s $60 oil that puts a cap on our rallies and I think the Saudis are starting to realize this but the rest of OPEC doesn’t seem very bright.

Baker Hughes Incorporated (BHI) BHI had a nice miss this morning an we’ll do a run-down over the weekend to evaluate our full slate of March oil plays. I’m not ready to dump my protective XOM calls yet but it is very tempting! Picking up those Mar $67.50s for .90 yesterday may turn out to be our trade of the week!

It is the weekend so we don’t get cocky. I will pick up a second round of yesterday’s oil puts if we get a good run (AND a turn signal) but not if oil breaks above $58.50 again.

Downside numbers are real easy as we can pretty much watch $57, $56, $54, $52 and $50 for supports as they psychological out weighs the numerological at this point. With Japan booming up the Yen will gain strength and may push the dollar down further, especially if the Euro stays over $1.30, all of which will lend additional support to crude prices as the long delivery schedule inherently lead to currency hedging in the contract price.


No picks today as it’s time to make a lot of portfolio decisions so expect a lot of intraday moves!

Be careful out there - remember, if it’s a real rally, you won’t have to say - "Is this a real rally?"