Pondering the Last Wrench in the Tool Kit
Will RTC(B) contain CDS? We wonder
By Frank Barbera CMT. September 23, 2008
It is my view today that the state of affairs hangs in a precarious balance. All eyes are on Washington with Senate hearings this morning featuring Mr. Paulson and Mr. Bernanke making their pitch to the Congress that the $700 Billion dollar Resolution Trust Corp (B) be passed with a matter of great urgency.
Last week’s credit market panic ensued following the collapse of Lehman Brothers spilled into the money market fund industry causing the Regions Fund to ‘break the buck.’ Not as heavily discussed, but a cause of grave concern. Behind the scenes remains Lehman’s Credit Default Swap contracts and those of AIG, the insurance giant at the very center of CDS. At the moment, the operating consensus seems to be that while theoretical CDS pricing continues for various institutions and even for Uncle Sam, in reality this pricing is not being determined by any substantial volume, but mostly by purely academic models. Speaking with a block trader who insisted on anonymity at a major New York investment banker last week, the commentary I received suggested that the CDS market has frozen up and was ‘in a shambles,’ with virtually no trading taking place as a forced mark-to–mark outcome at this juncture could spell disaster in the event of real price discovery.
This leads others to wonder about the nature of the current RTC solution as the bill proposed is said to feature a ‘reverse auction mechanism’ in which troubled, opaque paper is sold off to Uncle Sam at the lowest bid, rather then the highest bid. This may be a critical component in the legislation as a Dutch auction mechanism may make it very difficult for bankers to be willing to write off the bad paper. The forced booking of huge losses and a further erosion of what is now virtually irreplaceable capital could throw a monkey wrench in the RTC approach. In addition, while neither political party wants to be seen as holding up a matter of national urgency, there is still substantial risk that a game of political wrangling could end up yielding a prolonged delay. Granted, this seems less likely as last week both Bernanke and Paulson addressed key members of the Banking Committee and made it fundamentally clear that the US stands on the edge of an abyss -- a serious banking crisis and a possible systemic seizure, with Paulson supposedly telling Congress that the RTC solution proposed was the ‘last wrench in the tool kit.” Not a comforting thought to be sure.
Source: FDIC/IRA Bank Monitor Q1 2008
Thus, we wonder, with the problem now passed to the legislature for decisive action. Will Congress get it right? Or will they insist on attaching foreclosure legislation – not needed – to the current bill? Will they use this current point of maximum leverage to extract concessions for more oversight and possible criminal penalties? To be sure, some of these are probably a very good idea, especially those regarding more regulation and oversight, but the real question is, how much time is truly at hand before things accelerate even further off the proverbial cliff. Does the system have the time? In the end, it seems certain that any effort at ‘loading up the bill’ which was originally cast as a three page document, is likely to lead to more delays and will almost certainly wear the stock market's patience thin. As the week began, a sharp unwinding of last week's sharp two day rally makes things even more precarious as an acceleration to new lows in the stock indices could have tremendous negative consequences. In the chart below we see the S&P 500, which has over the last few years broken many rising long term trendlines. This represents a pattern of intensifying selling pressure with the last trendline, a trendline dating all the way back to 1982 violated in recent weeks.
Above: the S&P with long term trend line to 1982.
In my view, if prices do not hold the recent lows, there is a good chance that the stock indices will unwind rapidly back down to the 2002-2003 lows which is the next support. That is essentially crash like action and could be a hammer blow to the system given the precarious state of confidence at the current time. As of this writing, the 20 month lower band closed today at 1214.92, with any sustained move below that likely to be signaling a downside continuation pattern. Mind you, with things in such a perilous state, we are hoping that the market can find its confidence and hold last week's lows, and that the political response to this bail out bill is both sensible and expeditious. The problem is that the market seems to be backed into a real corner. In the stock market anything that can lead to more uncertainty about the resolution of a given problem is bad news, and at the moment the markets stock pile of good will seem about gone. That means for most investors, raising cash and or remaining on the sidelines is a key aspect of self-preservation. It is a function of today’s markets that things happen very quickly and if a panic sell off were to develop, odds are high that a gap down open would be involved.
Above: the S&P 500 with 20 Month Trading Bands
On the NASDAQ, we also see a clear cut warning to go slow. On the chart of the NDX 100 we see a large Head and Shoulder top, which is of the “Diamond” variety. These are top formations with a V shaped neckline. Prices break down below the neckline, and then almost always snap back. The rally seen late last week did precisely that. The next step is normally for prices to break down violently with a top like this easily targeting a full retracement back down to the 2002 lows. In the case of technology, recent channel checks sound bleak with companies like Flextronics issuing a warning over the last few days. In a recession, tech is deeply cyclical and earnings can fall precipitously. Even in the financial sector, if the RTC plan is approved, the hit to forward earnings looks like a nightmare without any visible end. Thus, the market stands at a very difficult juncture.
Notice also that Energy stocks have been unable to rally even given a dynamic move in the price of Oil in yesterday's September contract short squeeze expiration. Why are energy stocks lagging the underlying? Answer: Earnings estimates are still very high for big Oil, and with the price declines seen in energy in recent weeks, those estimates are likely to be ‘too high’ for the final reality where numbers are going to come in light. That’s a ‘sell the news’ situation and argues that perhaps even the robust energy sector should be reduced. Longer range, energy remains atop the list of industries with bright prospects, but the forward comparisons are now at risk in the medium term.
Above: NASDAQ 100 with Head and Shoulder – Diamond Top.
Finally, we note that other markets around the world are continuing to make new lower lows. In Taiwan for example, the Taipei Composite has broken down very sharply in recent weeks. Taiwan is a leading manufacturing center for high tech and tends to lead at important turns. We show a few charts of the Taipei Composite and the NASDAQ Composite going back to 1999-2000, 2002-2003 and the most recent 2007-2008 time period. Taipei led the turns on the downside and the action seen in recent weeks may be suggesting even more weakness ahead. Thus, a maximum defensive posture remains with regard to the outlook for capital markets, where crash risk is very high. In our work, we are constantly watching the action in the financials to see how various institutions are responding to the large moves in the capital markets. To date, JP Morgan (the king of derivatives), Bank America and Wells Fargo have faired well among the majors. Citicorp, Wachovia, and of course, WaMu have been considerably weaker. Unnoticed in recent days we suspect has been the miserable performance at GMAC, the large credit unit of General Motors that is heavily involved in CDS and which seems to be heading for a waterfall style collapse. In my view, GMAC could be yet another major problem directly ahead, and could also trigger major issues at Ford Credit. The CDS market remains the most likely catalyst for a further credit unwinding and one of the largest reasons investors should remain ultra-defensive and not get caught up in any value based analysis. In bear markets, ‘values’ are fluid and what looks like a great bargain one day, is an even better bargain three months down the road.
Above: Taiwan and NASDAQ at the 1999-2000 top, Taiwan turned down first.
Above: Taiwan bottomed ahead of NASDAQ at the 2002-2003 lows.
Above: Taiwan Composite and NASDAQ Composite, Taiwan breaking down sharply in recent weeks.
Above: On the brink ? – GMAC LLC no bounce with the market in recent days, another shoe to fall?
Above: Mastercard (MA) looking very shaky as prices move lower following completion of a major top.
For those looking and trying to find real hints of a turn for the better, (always a good idea to look at both sides) one thought that comes to mind would be to keep a sharp eye on the trend in credit card company shares, the likes of Visa (V), and Capital One and Mastercard (MA). Mastercard, in particular, is the top of the heap and in my view, the down trend in share prices hints strongly at deepening recession. On the positive side, were MA shares able to successfully cross back above the medium term downtrend line, I would suggest that perhaps a measure of stability had been regained. Another bluechip which is also worth watching closely is the price action of Goldman Sachs where the $150 to $158 level is now strong overhead supply. Again, while I do not expect it, any move back above this zone would suggest a turn for the better, while alternatively any move back under $100 would have to be rated as very negative.
Above: Goldman Sachs (GS) has broken down badly below major support, which as a bell wether for the market has to be viewed as a major negative.
In summary, the US seems to be confronted by a massive crisis of confidence with final resolution being temporarily held in abeyance. In my view, the situation is highly charged and for long-term investors, the best place to be at the current time is out of equities, out of bonds and largely in cash. In the past, investors who did not employ risk control on their portfolios end up waiting many years to break even. Given the shaky nature of the current situation, any movement to new lows from here would seem to suggest that a selling panic could ensue, trapping money with even larger losses for some time to come.
At the close, the DJIA ended down 161.52 at 10854.17, the NASDAQ Composite down 25.64 at 2153.34 and the S&P 500 down 18.87 at 1188.22. That’s all for now,
© 2008 Frank Barbera