MARKET RECAP: Can’t You Hear Me Knocking

Stocks looked to be on the brink of collapse this week as Wednesday morning, trading below the previous week’s low, the bears had the S&P right where they wanted it, but with so much bad news already discounted, the market could no follow through to the downside. The reversal was sharp and with a benign Fed statement on Thursday, the bulls seemed to trap the shorts yet once again as they were able to push the S&Ps back above the 10 & 40 day moving averages on Friday. Bonds continued their bottoming process grinding higher with a flattening bias pushing the front end back below 5%. The dollar vibrated around new highs v the yen with the euro/yen rebounding nicely indicating the carry trade was not in danger of massive unwinding. Gold remained under pressure as liquidity is ebbing while crude continued higher on geo-political fears.

INTERNATIONAL INTEREST: Don’t You Worry ‘Bout a Thing

Currency markets were relatively quiet this week despite continued fears of risk aversion in stock markets and unwinding of leveraged bets in credit markets. The dollar reversed from a new high v the yen but held the previous high at 122.20. The euro/yen recovered from an impending melt down as the fears of massive carry trade unwinding subsided as stock prices reversed. Sterling traded back above the $2 level but remained just shy of the previous highs at 2.015.

We had been refraining from positions in currencies as we viewed the risks of carry trade unwinding or the opposite a blow off top were not compelling risk/rewards in our eyes. We did mention that sterling was an attractive place to hide as the BOE could be the most hawkish central bank and their rates remain above the Fed funds.

Bottom Line: We continue to monitor the yen for signs of de-leveraging but at this point, despite all the turmoil and warnings in the credit markets, the carry trade remains in tack.

COST OF CAPITAL: On the Sunny Side of the Street

Bonds remained volatile but continued the bottoming process as the curve traded with a flattening bias pushing the 10YR back below 5.10% and the 5YR below 5.00%. Friday, the bond contract bumped up against the initial gap from the Bear Stearns blow up that occurred in mid-June. If the market continues to flatten, closing this gap, it leaves the potential for a short squeeze as those who sold after the gap will be forced to cover or go long duration. Next week will be a thin holiday shortened week with the important ISM manufacturing and services data released earlier, finishing off with non-farm payroll data on Friday. With news of potential downgrades in the CDO market and the margin calls that could accompany we see more potential stress on the sector. We remain cautious on the bond market due to fund liquidity needs and continue to play defense in the front end despite recent flattening, preferring the 5% level on the 5YR to the rest of the coupon curve.

Bottom Line: The bottoming process we suggested needed to occur with the 10YR yield making baby steps 5bps at a time seems to be unfolding. We, however, are wary of the potential for liquidations to meet margin calls and thus prefer to reduce principal exposure by hiding in the front end of a still relatively flat yield curve.

BETA MAXIMUS: Let Me Stand Next to Your Fire

The US stock market was on the brink of collapse this week as the S&P 500 made a lower low Wednesday morning before a hard reversal higher. Tuesday, the 4:00-4:15 late session in the S&P pit at the CME, saw massive selling of contracts by a large dealer which contributed to the Wednesday morning gap but when there was no follow through Wednesday morning, the buyers stepped in. This was impressive considering all the fears in the credit markets and the effects on the private equity “put” that has been such an important underpinning of valuations. Holding the low in the face of so much bad news and with no apparent carry trade unwinding leads to a bullish bias next week with the new high we are looking for within reach barring some unexpected event (like the UK bombing scares).

However, like in bonds we remain cautious and on defense as this leg up could be a final blow off type move which would be difficult to trade and thus continue to stick to the plan of using this rally to peel out of longs. If we are marching to new highs much of the rally could occur during next week’s thin session as money gets put to work at the start of Q3. We will watch the bond market and the economic data as well as our favorite leverage indicator the euro/yen for clues. If the curve maintains its flattening bias and the 10YR can get through the 5% level that would net net provide further bullish underpinnings.

Bottom Line: The plan is working and we will stick to our defensive strategy until proven wrong.

DUKE & DUKE: From a Whisper to a Scream

A couple of weeks back, we pointed out that a potential break out in crude prices could be signaling some “news” and with the contract surpassing $70/brl on the day of a thwarted London bomb attack we must wonder if the boyz knew something was brewing. Nevertheless, we view the rally as an increase in risk premium and not due to demand discount. This is also consistent with the flattening rally in bonds. Gold remained under pressure as it becomes more apparent that liquidity is ebbing. If we are marking a turn in the credit cycle and the excess liquidity that accompanied it, we will look back on the gold contract topping first as a great signal due to gold being arguably the most sensitive commodity to liquidity conditions.

Bottom Line: It now looks like the gold market sniffed out the tightening of liquidity in the CDO market and we recommend investors continue to monitor for direction of overall market liquidity. Gold has had trouble recovering but a bounce is likely. What the market does with the rebound will an important indicator for the direction of all asset classes.

THE EX ANTE FACTOR: The more Wall St changes...

With the SEC investigating the Bear Stearns multi-billion dollar hedge fund collapse and as fears of widespread deep discounting in the collateralized debt market are mounting, I can't help but think about a few other credit "events" in history that bring everything back full circle.

Recall that during this event Bear was having trouble raising funds for a bailout and that Merrill, having no mercy, balked at further loans and took back their $850mm in collateral and liquidated. The media pointed out the irony in that Bear was the only major Wall Street bank that did not participate in the NY Fed's orchestrated LTCM bailout in 1998, the most recent famous credit event.

Due to the fact that Merrill was playing hardball, I was reminded of the even greater irony of another credit event in 1987 when the young mortgage super-star Howie Rubin of Merrill Lynch, (coming from Salomon Brothers) blew up $250mm in mortgage IOs and POs which was the largest single losing trade in the history of Wall Street at the time. Salomon's then star studded bond arbitrage department was making a killing in the liquidity squeeze as they picked up the pieces. They were led by none other than John Meriwether, who of course ran LTCM. When Merrill fired Rubin, who do you think hired him to run their CMO desk? Bear Stearns, practically the next day. (much of this described and in better detail in Michal Lewis' Liar's Poker)

The long term trend line of BSC has held during tumultuous events such as the bond bear market of 1994 (Orange Co blow up), the 1998 de-leveraging of LTCM and the 2000-2002 equity bear market. Bear Stearns has always been a top mortgage bond shop and they are arguably one of the more highly exposed investment banks, hedge fund blow up not withstanding, to the sub-prime and subsequent CDO implosions. Is this an isolated event or the tip of the iceberg? Judging by this chart showing some breaching of the trend line with a deteriorating RSI we would be on the lookout for further troubles in the mortgage/collateralized debt market and the subsequent losses in BSC’s stock price. The XBD is viewed as a leading market index and a breakdown in BSC should be viewed as a warning for the overall market condition. We have been watching the currency markets for signs of de-leveraging but the real culprit might be right under our nose in the price action of the broker dealers.

What is the discount?
This week’s rally in the bond market as stocks finished unchanged, ticked the risk premium 10bps higher. The equity risk premium didn’t fare as well as interim grade corporate debt underperformed high grade and government bonds indicating that risk premiums are still widening. If we are experiencing a larger event in the credit markets as the brokers could be suggesting then we would expect riskier debt to continue to under perform quality. This confirms our month long thesis that investors should seek quality assets and concentrate fixed income allocations in the front end of the yield curve to maintain liquidity in what appears to be a general re-pricing of risk premiums.

Bottom Line: The first week of June we became very defensive and suggested investors rotate into cash and high quality assets. We are sticking to the plan of using rallies to raise cash and would now be using some cash to buy 5YR notes at 5%. The list of indicators is growing as now the XBD and BSC charts are added to gold and the euro/yen. We feel the market is doing its job of providing investors with ample information to guide asset allocation and will continue to heed its recommendations.