Sunday, October 12, 2008

Hedge Fund Unwinding Continues

- Massive selling, a reversal, the reversal reverses, then fights back to close out the week.
- Hedge fund unwinding continues, now including Treasuries.
- Treasury Department announces intention to buy equity in financial firms.
- This could be the weekend the various fixes to the world credit chain get linked up.
- Re-entering the market with some buys to play the rebound, the start of a new bottoming attempt.

It's another selloff. No, it's a reversal. No it's a selloff. How about an almost reversal?

There was nothing new and major Friday, but the 'same old, same old' was bad news enough. Foreign markets sported 7% to 10% losses, interbank lending rates spiked again indicating all of the drastic measures by federal governments have yet to break credit free. Hedge funds were liquidating again across the board as the massively overcrowded trades of late 2007 are still unwinding. Oil was clobbered on the weaker world economic assessments and the hedge funds' need for capital, breaking $80/bbl with ease and in doing so blowing out support at $85 (closed at 77.70, -8.90/bbl). Commodities, agriculture as usual, now joined by all other sectors as well. Again, more of the 'same old, same old.'

Stocks gapped much lower than futures suggested and within 10 minutes the Dow fell 697 points, NASDAQ 102, and SP500 70. Hey, they had to keep up with those overseas 7+% losses. They immediately rebounded, however, turning positive within the first 40 minutes of trade. Then the sellers took their shot, selling into a rally as hedge funds used the recovery to once more liquidate and raise capital to cover redemptions and margin calls. That put the kybosh on the upside and the session wandered lower and lower into mid-afternoon, threatening the early lows.

Then the rebound. There is a G7 meeting this weekend (leaders of the largest western economies, though it includes Russia and the judo-video, tiger taming Vladimir Putin so go figure) and even though the participants played down the chance of blanket insurance for interbank loans (what the markets really want and the last link in the chain for credit markets and of course the government takeover of same), the possibility of that brought in the shorts to cover ahead of the weekend meeting. It was quite a rush higher, driving the indices positive with 25 minutes before the bell. The Dow moved positive almost 300 points. It shot its ammunition a bit too early, however, and the Dow fell 430 points off of that late high to close negative though well, well off the lows. Unreal volatility fed by hedge funds that were all into those crowded trades and are still in the process of unwinding. There is some buying by long term players, but it is not enough right now to overcome the massive moves brought about when the hedge funds stampede the market.

TECHNICAL. Unreal volatility even intraday. The massive volatility in the market shows a change trying to move in, and the now intraday volatility underscores that. Early on there was that palpable, sick feeling once more. The reach lower in continuation of the Thursday selling, the bad day on top of a bad day, had that climax air to it. It was Friday, however, and those often cascade into weak Mondays as well. The afternoon recovery may have altered that some though it was driven by short covering ahead of the G7 and possible good news. Of course all rallies start with short covering. Thus if the G7 guys and gals take the final step the late reversal by the shorts to cover could be warranted.

INTERNALS. Impressive once more though by the close the incredibly negative breadth was basically flat. New lows surged to over 2600 on NYSE and 1700 on NASDAQ. Volume exploded to the third highest ever on NYSE (2.9B) and the highest ever on NASDAQ (4.2B). After all of the other indicators (sentiment, internal, technical) hit extremes, this volume is finally the kind of volume you associate with a reversal. Massive trade levels.

CHARTS. The dive lower early Friday pushed the indices lower toward the 2002 lows, the bottom of the prior bear market. DJ30 came within 740 points of that low; with these declines that is just a day's selling. SP500 a mere 80 points. If they hold here, if Friday was the crescendo selloff that starts a new bottom, that is a real positive for the market and the economy. Even if it goes lower to start next week and tests these levels further, that is okay as well. The small cap SP600 undercut the 2004 double bottom in that index and held the Q4 2003 lows, bouncing with fury the other indices did not possess. It covered over 30 points in the session, and 11% move, finishing up 4%. We bought into some IWM positions as it rebounded in what looks to be a very strong, market leading reversal. This is a very important move by the small cap index.

LEADERSHIP. The leader of the day? The dollar. It closed at 1.3410 euros versus 1.3603 euros Thursday. Huge move and it even faded some from an intraday move lower (1.3376). The small caps were popping off of their hard selloff of the past week, providing a lot of upside momentum. Hard to call them leaders just yet, however. There was not much change from Thursday because of that early dump lower. The base metals and large cap techs are still setting up for a turn. We will see if they can make it.


Paulson after hours: US will buy equity in financial institutions.

The $700B socialist program empowers Treasury to give money to financial institutions . . . in exchange for equity. This is a very dangerous provision. US federal government owning equity and potentially calling the shots in financial institutions. Just look at what it does to local schools: they are slaves to the money the state, via federal spending, puts into the system. The result is absurdly bloated administration employees and facilities that are often physically larger in terms of employees and budgets than the actual schools they oversee. Instead of going to the teachers and kids, the money has created a sub-bureaucracy that seeks to grow itself as do all bureaucracies.

Fortunately Paulson still has some living roots to free enterprise and capitalism left. He will use the power to buy non-voting preferred stock. That will give the companies capital in the companies without direct voting control by the feds. It dilutes all shareholders, but it is explained away as benefitting us all through the preferred stock ownership, though we know any gains will go to Treasury to be spent by the feds. What a sweet deal for the government. All we get out of it is, at best, maintaining the status quo with the exception of a hugely expanded federal government. What a deal. It will help solve the current crisis, but down the road it only adds to the problem we will some day be faced with and what our founding fathers said was a good thing: a little revolution now and then never hurt any country. Not necessarily the armed type, just social disobedience and the like. The true test will be how the vastly expanded federal government responds.

G7 set to meet again this weekend to hammer out some details.

Friday the G7 countries met preliminarily ahead of more meetings this weekend. The group issued a 1-page statement, something of a rarity in its brevity. It indicated they would work to secure the system but tended to lean toward individual, case by case fixes versus the blanket proposal to insure all of the interbank loans. Some really smart people, however, say it is going to do otherwise.

Why this move is needed. There is plenty of liquidity in the world. The central banks are pushing money into the system and citizens, thanks to governments guaranteeing their deposits and even before that showing a good sense of calm, keeping their money in the bank. Problem is, because banks cannot be sure which fellow banks are loaded with the crap to the extent they are about to implode they are very reluctant to lend to each other as they typically do freely every day. These loans are not guaranteed and the banks are on their own or have to seek some kind of insurance from collateral default swaps. As discussed three weeks back, the premiums on those policies have shot up ($10M was $14K but rose to over $400K in just a few weeks) and as we have seen may be just worthless paper anyway.

Thus in order to try and protect themselves they charge more for the loans. This is the 'TED' spread you hear about every day. It is the difference between the yield on the 3 month LIBOR (London Interbank Offer Rage) and the yield on the 3 month US Treasury. On Friday that difference was 4.34%. It has bounced between 2% and 6% for more than three weeks. For a reference point, in 2006 (before it started to rise in 2007 as the market started to sense the crisis) it averaged 0.36%. It costs 12 times to borrow funds as it did in 2006 just to do business. Banks cannot afford it.

That creates liquidity squeezes as institutions cannot meet their required ratios of deposits to obligations because they cannot get the cash needed. It sets up a vicious cycle: those institutions struggling and needing liquidity in order to make some money and work things out cannot get funds and their financial condition deteriorates further and further. They will eventually fail and one by one (2 by 2, and 3 by 3, etc. as time goes on) the financial institutions go down.

Thus the call to insure the interbank loans so banks will lend to one another. All other links in the chain are there: commercial paper is backed, depositors are insured, swap facilities are in place around the world, the US is going to (eventually) buy the bad assets and take them off the financial world's balance sheets. That completes the chain of liquidity flow and federal intervention. That provides the needed liquidity so the money can circulate through the system, going where it needs to go and thus avoiding the spiral lower that unnecessarily took down BSC and LEH.

As noted, some very smart economics minds say this will work to fix the system near term. Of course they are not Constitutional scholars and they put the caveat out that it fixes things 'near term.' No one knows specifically what all of this government intervention into historically private areas will cause, but there is general concern that after the crisis is averted for now just how and whether the government will extricate itself and whether this level of intrusion will chill economic risk taking and thus economic output in the future. If Big Brother is involved, potential is rarely met.



VIX: 69.95; +6.03. Hit new 20 year closing high and intraday spike at 76.94, surpassed only by the meltdown in 1987.
VXN: 71.58; +1.92
VXO: 85.99; +10.03

Put/Call Ratio (CBOE): 1.22; -0.13. Three weeks in excess of 1.0 and it spiked intraday. As noted, this indicates plenty of downside speculation and when everyone thinks things are going lower they usually don't.

Bulls versus Bears:

This is a reading of the number of bullish investment advisors versus bearish advisors. The reason you look at this is that it gives you an idea of how bullish investors are. If they are too bullish then everyone is in the market and it is heading for a top: if everyone wants to be in the market then all the money is in and there is no more new cash to drive it higher. On the other side of the spectrum if there are a lot of bears then there is a lot of cash on the sideline, and as the market rallies it drags that cash in as the bears give in. That cash provides the market the fuel to move higher. If bears are low it is the same as a lot of bulls: everyone is in and the market doesn't have the cash to drive it higher.

Bulls: 25.3%. Largest single week drop we have ever seen, down from 33.7% and 37.5% the week before. Well below the 35% threshold considered bullish. Down from 40.7% on the high during the rally off the July 208 lows. Surpassing the 27.8% on the low this round. 30.9% was the March ow. In March the indicator did its job with the dive below 35% and the crossover with the bears. A move into the lower 40's is a decline of significance. A move to 35% is a bullish indicator. This is smashing that. For reference it bottomed in the summer 2006, the last major round of selling ahead of this 2007 top, near 36%, and 35% is considered bullish.

Bears: 53.0%. Surging from 47.2% and 40.9% the week before. Surpassing 50.0%, the high on this move. Well above the 35% threshold so still a bullish indication. This move over 50 takes it to the highest since 1995. Extreme negative sentiment. 35% is the level that historically indicates excessive pessimism. As with the bulls the jump in bears did its job after hitting 44.7% in the third week of March. Bearishness peaked at 37.4% in September 2007. It topped the June 2006 peak (36%) on that run. That June peak eclipsed the March 2006 high (33%) and well above the 2005 highs that spawned new rallies (30% in May 2005, 29.2% in October 2005). This is a huge turn, unlike any seen in recent history.


Stats: +4.39 points (+0.27%) to close at 1649.51
Volume: 4.204B (+40.79%). The highest NASDAQ volume ever. This is the type of volume that you look for to accompany a reversal.

Up Volume: 1.632B (+1.432B)
Down Volume: 2.533B (-243.652M)

A/D and Hi/Lo: Decliners led 1.09 to 1
Previous Session: Decliners led 5.34 to 1

New Highs: 6 (-1)
New Lows: 1709 (+651)


Gapped lower, undercut the mid-2003 consolidation, bottoming just over the late 2002 (1521, 1542 on the Friday low), followed by a big surge back up that made it to positive. Huge intraday volatility but also a huge recovery on tremendous volume that held support on the close. That is reversal quality action. Now it will need to follow through starting Wednesday, looking for a move accompanied by strong breadth as well as volume. Then we look for bases to form on the ensuing bounce and test of the prior low. You have heard it before. The market will go through this until it gets a base of leaders in position along with a base in the indices.

NASDAQ 100 (-0.42%) could not hold the move back to positive. Strong volume, good reversal. Looking for large cap techs to pull some weight on a move this week.

SOX (-0.93%) sold as well, coming within spitting distance of the 2002 low and then reversed, just missing positive on the close. Nice deep doji with tail shows the momentum trying so shift.




Stats: -10.7 points (-1.18%) to close at 899.22
NYSE Volume: 2.929B (+45.46%). As with NASDAQ, this is the kind of volume you look for when the market reverses. Third highest volume of all time.

Up Volume: 1.071B (+976.124M)
Down Volume: 1.854B (-61.647M)

A/D and Hi/Lo: Decliners led 1.95 to 1
Previous Session: Decliners led 10.73 to 1

New Highs: 16 (+10)
New Lows: 2631 (+827). Impressive. And extreme.


Big reach lower, coming close to the March 2003 low that tested the late 2002 double bottom bottom, and then rebounding. Turned positive late but as with DJ30, could not quite hold positive on the close. New lows surged, volume surged, index reversed after massive selling. Short covering yes, but still looking for more upside after this selloff.

SP600 (+3.99%) undercut the 2004 double bottom lows, tapped the bottom of the 2003 Q4 consolidation, and then furiously reversed to lead the market higher. This kind of furious recovery by the economically sensitive stocks suggests the rest of the market will show strength as well if the upside trigger hits over the weekend in the form of a significant G7 agreement.

SP600 Chart:



Same action as SP500, just more points involved. Reached down toward the May 2003 low and then reversed course. Surged positive by 300 points less than a half hour ahead of the close, then just couldn't hold onto it. The moves were huge with 100 point increments reeling off in seconds. Huge volume here as well. By the close it missed the big reach lower and reversal to positive, but with NASDAQ and the SP600 making the reversal they can carry DJ30 and SP500 along with them.

Stats: -128 points (-1.49%) to close at 8451.19
VOLUME: 674M shares Friday versus 436M shares Thursday. Big volume all week as DJ30 sold. Distribution for sure but that is how it gets sold out.



Got another selloff and then a big intraday bounce, but it was not all just huge reversal off the lows. The sellers still took a second bite of the apple before covering late in the session. Thus while there was a big recovery into the close, it was not a clear run by the buyers when the sellers are exhausted. That makes this weekend G7 meeting extremely important as the market wants that last link in the chain forged, yet many of the European nations are against insuring the interbank loans for fear of a failure. Okay; that is what insurance is for. Can't say you want to insure unless you are willing to make it pay. Moreover, what if they do fail if the governments don't step in? They think that won't burden their taxpayers in other ways such as lost jobs, folding businesses, etc.?

The market closed with the rebound both out of fear by the shorts and hope by the longs that the G7 will do the right thing. At this point they have done everything but this last step in completing the 'circle of life' for financials to operate their businesses and fund the world economies. It would be foolish, yea verily stupid, to not go ahead and finish the job. Worries of too much intervention at this point is similar to halting construction of the last mile of a 100 mile road through pristine forest because it will knock down a few more trees. The damage is done. Steve Forbes thinks the G7 will do the right thing, so there you go.

While the rally may not have been of the purest with respect to a turn to long buying, after such an onslaught of selling the market often turns with a spell of massive short covering. Whether it continues depends upon a couple of issues. First, the hedge funds will have to get sold out, i.e. cover the redemptions and margin calls. Second, the credit market has to get the links of the chain forged with a complete bailout package so it can finally function and allow the institutions to conduct business and provide the money the world economies need.

If the latter is accomplished then the hedge funds will be less pressured to liquidate. The economy can start to operate, and while just a functioning credit market won't heal the economy, it will allow it to operate and get on the road to recovery. We have heard predictions that if the credit chain is completed the economies could be back and starting to recover in 6 months.

That would allow the market to start discounting a recovery almost immediately, meaning the reversal Friday could continue with a nice relief bounce from here and go about setting up a bottom, either a less typical 'V' bottom or more likely the usual 'W' bottom with a test of the Friday low.

In that vein we will continue to look for vehicles to ride a recovery bounce higher as we also watch for bases to form in growth stocks so that they can lead the subsequent move higher after the initial rebounding stocks carry the market off the lows. That is how it worked in 2002. The first leg of the bottom had little in the way of leadership bases, but bases formed as the market tested back following the initial surge higher. Those stocks in bases then broke out as the market bounced off the second bottom, leading the way higher through December. Then as the market tested back from January to March, dozens and dozens of growth stocks formed bases and broke out in late March.

We may still be a bit early, but late last week we started buying into stocks in position to bounce that were showing some relative strength along with some index positions with the intention to ride them higher on the first leg of a rebound. We are still looking to do that and add positions as the opportunity presents. Monday will tell much more of the tale as it could be another down session given the history of bottoms. With the massive early selloff and bounce on Friday, however, we felt it worth venturing some buys.

Again, we will continue to do so as the opportunity presents to start the week, adding to current positions and looking at some new plays as well. For now while we wait for bases to form in growth stocks we keep it simple, sticking to strong stocks showing relative strength and in position to bounce as well as indices as they bounce higher.

Support and Resistance

NASDAQ: Closed at 1649.51
1752 from 2004
1782 from August 2004
The 10 day EMA is 1844
1882 from October 2003
1900 is the gap down point in October; from August 2004
1912 from April 2005
1947 is the point where the market gapped down from in October
The 18 day EMA at 1956
2070 from September 2008
2099 is the mid-September closing low
The 50 day EMA at 2144
2155 is the March 2008 low
2167 is the July 2008 low
2202 is the January 2008 low
2261 is a March 2008 interim low
2286 is the first April 2008 gap up point.
2300 is some resistance
The 200 day SMA at 2335
2340 from the March 2007 low

1644 from August 2003
1620 from the early 2001 low
1521 is the late 2002 peak following the bounce off the bear market low
1387 is the 2001 low
1253 is the March 2003 low on the test of the rally off the 2002 bear market low
1108 is the 2002 low

S&P 500: Closed at 899.22
965 is the 2003 consolidation low
995 from June 2003 consolidation peak. Below this level on the Wednesday close.
The 10 day EMA at 1028
1065 is the Q4 2003 level that SP500 started the run to 2007 after the first run in the recovery.
1075 from August 2004.
The 18 day EMA at 1088
1133.50 is the September 2008 low
The 50 day EMA at 1183
1200 is the July 2008 intraday low
1242 is the 2002/2003 up trendline
1244 is an August 2005 peak
The 90 day SMA at 1249
1257 is the March low
1270 is the January low
1285 is the recent July peak
1313.15 is the August 2008 peak
1317 from the February low
The 200 day SMA at 1315
1324 is the April low
1335 is an ancient trendline

889 is an interim 2002 peak
853 is the July 2002 low
800 is the March 2003 post bottom low
768 is the 2002 bear market low

Dow: Closed at 8451.19
8521 is an interim high in March 2003 after the March 2003 low
8626 from December 2002
8985 is the closing low in the mid-2003 consolidation
9200 is the July peak in the 2003 consolidation
9323 From June 2003 peak
9575 from September 2003, May 2001
The 10 day EMA at 9627
9814 from August 2004
9937 from May 2004 low
10,100 to 10,000
The 18 day EMA at 10,106
10,127 is an April 2005 low
10,215 from Q4 2005
10,365 is the new 2008 low
10,459 is a September 2008 low
10,827 is the July 2008 intraday low
The 50 day EMA at 10,834
10,962 is the July closing low
11,061 from February 2006
The 90 day SMA at 11,309
11,317 from March 2006
11,388 is the prior August low

7702 is the July 2002 low
7524 is the March 2002 low to test the move off the October 2002 low
7282 is the October 2002 low

Economic Calendar

These are consensus expectations. Our expectations will vary and are discussed in the 'Economy' section.

October 13 - Monday
September Treasury Budget (2:00)

October 15 - Wednesday
September Core PPI, (8:30): 0.2% expected, 0.2% prior
NY Empire State Index, October (8:30): -10.0% expected, -7.4% prior
PPI, September (8:30): -0.3% expected, -0.9% prior
Retail Sales, September (8:30): -0.4% expected, -0.3% prior
Retail Sales ex-auto, September (8:30): 0.1% expected, -0.7% prior
Business Inventories, August (10:00): 0.4% expected, 1.1% prior
Crude Oil Inventories, 10/11 (10:35): +8.1M prior

October 16 - Thursday
September Core CPI (8:30): 0.2% expected, 0.2% prior
CPI, September (8:30): 0.1% expected, -0.1% prior
Initial Jobless Claims, 10/11 (8:30): 478K prior
Net Foreign Purchases, August (9:00)
Capacity Utilization, September (9:15): 78.0% expected, 78.7% prior
Industrial Production, September (9:15): -0.8% expected, -1.1% prior
Philadelphia Fed, October (10:00): -5.0 expected, 3.8 expected

October 17 - Friday
September Building Permits (8:30): 845K expected, 895K prior
Housing Starts, September (8:30): 880K expected, 895K prior
Michigan Sentiment-Prel., October (10:00): 69.0 expected, 70.3 prior

By: Jon Johnson, Editor
Copyright 2008 | All Rights Reserved

Jon Johnson is the Editor of The Daily at

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