The Expanding Menu of Horrors
By Frank Barbera CMT. February 26, 2008
Over the last 20 years, municipal issuers and other investors have utilized auction rate securities (ARS) to meet their financing needs. During that period of time, seldom have these auction rate securities met with insufficient demand. That is, until the last few weeks when concerns about monoline insurer solvency have caused the market to place a huge premium on liquidity, in turn, causing many of the bidders at these auctions to pull out. The result: thousands of auctions have failed, or been priced at huge 20% reset type premiums. Since late January, the "cap" rates for a wide variety of ARS paper have expanded from 4% to as high as 20%, with most notes now at least 15%. The reason, with the monolines under a serious threat of being downgraded, a number of the large brokers who in the past offered a liquidity backstop, have now simply stopped bidding. Under the terms of the arrangements, the auction arrangers are not obligated to repurchase the securities much to the horror of investors who thought these securities were absolutely liquid instruments.
Chalk this up as one more instance of the unwinding of derivatives markets which, week in and week out, has continued unabated in 2008. In fact, last week, according to Bloomberg.com, UBS concluded that mathematical models that traders use to calculate prices in the 2 trillion dollar market for collateralized debt obligations simply don't work anymore. In its commentary, UBS admitted that integral "correlation" models which represent the odds of one default potentially infecting another, and the very fabric of pricing for many of these derivative securities, now show a nearly 100% chance of contagion. As a result, any number of quant funds are already in deep trouble in 2008, some down as much as 15 to 20%.
Across Wall Street and the Financial community, hedge funds are starting to crumble like DB Zwirn & Co., where investors have pulled out 2 billion in the last few weeks, and which on Thursday night sent out a letter to investors outlining plans to liquidate remaining assets, 60% of which were not easily tradable. Of concern here is not the fate of one particular fund, but the downside risk to all markets should the hedge fund industry begin to delever. In our view, aside from the bursting of the bond market bubble, 2008 has an excellent chance of witnessing the bursting of the hedge fund bubble, which in the last decade has seen the industry grown from a small sub-section of speculative capital to perhaps THE dominant force in global finance. While many believe that hedge fund forced liquidations will be orderly as last year's saw several punctuated declines followed by quick recoveries, the odds of that pattern repeating in the weeks ahead seem very distant at this juncture with the kind of damage which has been sustained throughout the credit system. It would seem likely that 2008 will ring down the curtain on leveraged finance for some time to come, perhaps decades.
Of course, on the economic news front, things continue to point the way toward a deepening recession, led by still further weakness in Housing. Earlier today, S&P reported that home prices dropped 8.90% in the final quarter if 2007 versus one year ago, the steepest decline in the 20 year history of its housing index. The S&P/Case-Shiller home price index reflected year-over-year declines in 17 metropolitan areas with double digit declines in eight of them. In addition, the most recent report shows that home prices fell 5.4% from the previous three-month period, by far the largest quarter to quarter decline in the index's history.
Above: the Conference Board Consumer Confidence Survey.
In what cannot seem like anything more then a totally predictable outcome, the result of the onslaught of bearish news and headlines, Consumer Confidence plunged in February. In its monthly report on Consumer Confidence, the Conference Board indicated that overall Consumer Confidence fell to 75 this month, down from a revised 87.30 in January. That marked the lowest reading seen since February 2003, just before the US invaded Iraq. As can be seen in the chart above, readings below 70 on the index have correlated to recessions time and time again. While we are not there yet given this month's reading of 75, considering that the index was as high as 112 as recently as last July (37 point decline in 7 months = 5.28 points per month), we should see "official" recession type readings by either the March or April report. Given the stock market bounce in recent weeks, perhaps March may show a small improvement. However, when you look at the rest of the Conference Board Survey, the news is not at all encouraging. Take, for example, the Forward Expectations Index which casts a spotlight on the path ahead. In today's release, the Forward Expectations component plunged by 11.40 index points from 69.30 to 57.90, with the figure of 57.90 representing a 17 year low.
Simply put, (and as shown on the next chart) there has never -- that's right, never -- been a single instance when the Forward Expectations Index plunged under 70 and the economy failed to record a recession. In fact, at present levels, the reading of 57.90 compares very closely with the readings of deep recession lows seen in 1990 (+55.32) "the Gulf War" and 1982, the Arab Oil Embargo (+49.99). Thus, we are not talking about a "mild" recession but rather leading data pointing the way to a deep and possibly long lasting recession.
Above: the Conference Board Index of Forward Expectations.
And there is still more bad news ahead. As America's mortgage markets continue to unravel, concern is growing centering on the nearly 1 Trillion in credit card debt markets. Across the board, Credit Card issuers are boosting loan loss reserves with anecdotal evidence suggesting that cash strapped mortgagers are using credit cards to make mortgage payments. Already credit card delinquencies are increasing sharply with most analysts expecting that trend to accelerate in coming months.
So what does this all mean for the market? In our view, it translates into a highly unpredictable investment climate, where things can seem OK on one day, and turn out to be "pitch black" the next. As we have done with great success in the recent past, our mantra of the moment is keep an eye on the ball, in this case, the ball being the financial sector. We strongly suspect that within the broad stock market, whether it starts in the near term or later on this year, there is still another "leg" down ahead for the global equity markets. The proverbial Elliot A-B-C decline has probably already seen Wave A down, with Wave B, the counter-trend phase now in force. What could signal the end of the Counter-Trend Bear Market rally phase and the beginning of Wave C to the downside? In our view, we still say the financials are the hot spot to watch and maintain a sharp eye.
Above: S&P 500 with GST Brokerage Stocks lower clip.
Last year, as can be seen in the chart above, the large stock brokerage firms did a good job in foreshadowing the final highs for the S&P. As the stock market surged to new all time highs in Sept-October to the cheers of the bubble heads on CNBC, the financials failed to confirm recording a lower high even amidst the start of a rate easing cycle. This kinda' said "something is wrong" and now we know just how wrong that something was, with Financial Institutions booking over $150 Billion in losses, thus far. Of course, on a nearly daily basis, Larry Kudlow could not help point out how ridiculous all of the bears were for calling for a recession as his work pointed to this economy as the "greatest story never told." Still feel that way, Larry? Really? Oh well, it just goes to show you what happens when some people confuse politics with economics, let alone markets. Perhaps this is why economists in America have such a bad rap, for most of them, with the notable exceptions of Nuriel Rubini and Paul Kasriel, too many other issues contaminate their point of view. In the case of Mr. Rubini and Mr. Kasriel, kudo's to both for "getting it" right time and time again. In any case, getting back to the Broker – Dealer stocks we noted that this group was a crucial leading indicator as far back as February 2007 when we highlighted the sector for FSO readers in "Oh, What a Tangled Web We Weave."
Above: a very long term view of US Brokerage Group showing a complete five wave advance dating back to the late 1970's.
In our Elliott work, we were maintaining that the Financial sector for the US was completing a well defined five wave secular advance in 2007, with the decline of the last few months the early stages of a much larger bear market. Using our own GST Unweighted Brokerage group, we believe that Intermediate Wave (A) of the Bear Market bottomed on August 16th, 2007. Since then, the market has traced out an A-B-C counter-trend rally which when complete, will comprise Intermediate Wave (B) of the ongoing bear.
Above: a much broader version of the Brokerage Group – what I call my GST Unweighted Brokerage Index, which shows an essentially similar pattern peaking in the middle of last year.
Within Intermediate Wave (B), we have so far seen Minor Wave A peak on October 11th, 2007, with Minor Wave B bottoming on January 23rd, 2008. In our work, Minor Wave C to the upside remains in force and so far has lasted 25 trading days. In the prior instance, Minor Wave A lasted a full 41 trading days, and we would not be surprised to see some symmetry in the overall time duration. As a result, we lean toward the idea that Minor Wave C up may last into mid-March 2008 spanning about 41 to 44 days and potentially retracing the sector back up toward the mid-November and mid-December 2007 highs.
Above: Upside target for Minor Wave C of larger "B-Wave" rally on XBD Index
In the case of the widely followed XBD, Amex Broker-Dealer Index, a further price retracement toward the 215 to 220 level would be ideal, and would represent a .618 Fibonacci retracement of the preceding Minor Wave B decline. Should this market manage to "HOLD UP" long enough and far enough into mid-March such that our projections are being met, it would likely play out as another high probability short sale with the larger Intermediate Wave [C] decline very likely to carry prices well below the January lows with longer range Fibonacci relationships ultimately suggesting an eventual return toward par on the XBD.
Above: the Amex Broker-Dealer Index likely about half way through another bear market rally phase... with more larger declines still ahead in 2008 and 2009.
Above: Goldman Sachs (GS)
Of course, within the Brokerage group, we can always find some useful additional clues. To this end, we found it quite interesting that Goldman Sachs (GS), long time market bellwether, has been struggling of late to even match the dismal recovery performance of the XBD. In fact, over the last few days GS has managed to break below its January 23rd lows, quite the difficult task given a substantially rising stock market over the last few days. Could there be serious problems at GS about to be revealed? In our view, the stock is acting like there is serious bad news ahead, and to that end, the $162-$168 range looks like "must hold" support. Any move below that zone on GS could mean that the brokerage stocks as a whole are in even more hot water than we think, and could signal the end of this counter-trend trading rally.
Finally, we just can’tresist taking further note of the miserable chart performance being notched by Fannie Mae (FNM) and Freddie Mac (FRE); both of these seem headed for the Critical Care ward with prices also breaking down within the context of a rising market. This just can't be a sign of better things to come as smart money seems to be heading for the door.
Above: Fannie Mae about to make new lows hard to believe no bounce even with S&P up several days in a row. A sign of bad things ahead? We would not be surprised.
Above: We highlighted these two for you last week, and we highlight them again. The GSE's are not acting well and could be the catalyst for an even larger set of financial problems and shock waves still ahead of us in the weeks to come. WHY? -- WHY? ---WHY are these stocks falling in a rising market?
Finally, the last bellwether we are watching is credit card behemoth Mastercard (MA) whose stock price appears to be putting in a "right shoulder" rally over the last few weeks. As long the price is holding above the $178-$180 level, perhaps there is no cause for alarm. However, any break below that key support would argue another domino is toppling in the ongoing daisy chain that is the credit market deflation unleashed since last August.
Stocks closed higher on the day with the DJIA finishing up 115.11 at 12,685.33, a gain of .92%, with the S&P 500 adding on 9.53 index points to finish at 1381.33, a gain of .70%. Technology stocks also rallied with the NASDAQ Composite up 16.71 index points at 2344.19, for a gain of .72% with the 10 Year Bond yield ending at 3.86%. April Gold finished higher at 950.30/oz, a gain of $9.80. That's all for now,
© 2008 Frank Barbera