Market Recap: Where’s Cpt. Liquidity?

And we thought volatility was high last week? We definitely expected the vol to remain elevated and with continuing problems in the credit markets equities finally gave in and virtually collapsed for -4.9% on the S&P 500 and an astonishing -7.25% in DJU, taking out the previous June low on most indices. Bonds benefited from the classic flight to quality as credit market problems intensified on news JPM would take down part of the Chrysler deal that couldn’t get placed and that more deals would be in jeopardy as evidenced by the postponement of the Cadbury deal. The highly leveraged capital markets are now in a precarious situation as they are dependant on the ability to access more credit to keep the asset appreciation afloat. A liquidation of highly leveraged collateral can have the same affect on the way down as it had on the way up.

International Interest: The Green Phoenix

Despite continued concerns about the dollar meltdown, it bottomed off a new low as the stock market was falling apart on Thursday. We believe this is just a taste of what’s to come and potentially validates our thesis that the unwinding of the credit cycle will be bullish for the greenback. Despite the bounce in DXY some apparent de-leveraging of carry trades was occurring with the stress in credit and equity markets. USD/JPY, EUR/JPY and GBP/JPY all were under pressure and broke trend lines that have been in place since the March low. A major catalyst seemed to be the bank of New Zealand’s rate hike and signaling that would end their tightening cycle drove some selling in NZD possibly the most favorite of carry traders. EUR/JPY and GBP/JPY both lost 4% for the week coming off all time highs. This should be no surprise to our readers as we have been monitoring the speculation and leveraging via carry trades for months. Should selling continue next week in these currency pairs we expect equity and credit markets to remain under pressure. Tonight’s election in Japan could drive some volatility in the yen.

Bottom Line: We are looking for the dollar to be under pressure when the Fed signals an ease but if it holds and we think it will, prepare for strong rally as cash will out perform during the credit cycle reversal.

Cost of Capital: Principal Guardian

The bond market was right on cue during this week’s credit and equity market turmoil as the flight to quality benefited the entire coupon curve driving even long bond yields below 5%. The curve continued to steepen as investors favored the principal safety of the front end and further attempted to re-discount a Fed ease as we suggested last week. The steepening and widening of credit spreads acted as a double whammy on credit deal flow and wacc valuations on leveraged balance sheets (see Ex Ante Factor). Friday’s Q1 preliminary GDP came in slight stronger than expected with inflation measures slightly weaker. Next week’s calendar is full of important data with Chicago PMI and on Friday, ISM and non-farm payrolls data. At this point the credit market seems to be trumping data and earnings but if numbers come in weak, we believe this will validate the market’s ease discount and could be setting the stage for a Sept. ease. As credit tightens and the economy slows the Fed will be forced to lower despite fears of a dollar melt-down. Thee curve should continue to trade with a steeper bias as the long end discounts the inflation pressure from a easing cycle. For this reason, we continue to favor the front end and are buyers of 5YR notes on pullbacks. Should the data come in hot expect the curve to flatten as the market sees the Fed on hold which ironically could benefit credit and stocks as the inflation premium falls.

Bottom Line: We expect credit spreads to continue to widen over the next 24 months, though there will be some pullbacks along the way. The front end will remain our focus as long as risk premiums rise and the curve looks to discount a higher inflation premium due to a future Fed easing campaign.

Beta Maximus: Credit Queen

Stocks finally succumbed to the reality in credit markets and the shifting of momentum as the rising trend line from the March low was broken bringing in further selling as no doubt leveraged players started liquidating collateral. The news of the Chrysler deal failing to be placed and that JPM would take down the loan struck fears in financials and other leveraged sectors such as utilities which were down 7.25% on the week. As readers know we have been anticipating this correction for a couple of months and have been encouraging investors to peel out of their holdings and rotate into 5YR note treasuries. That trade has been prudent and profitable with 5YR note yields falling over 50bps and equity yields on the S&P 500 rising just under 50bps over the past couple of weeks. The widening of the so-called Fed model could drive some relative value buying next week but since corporations don’t borrow in the treasury market, if credit spreads continue to widen the relative value would be muted. We are not panicking at this point and selling into this hole because barring some fat tail 1987 type event, the market should rally/bounce and sticking with out strategy, would rather use the bounce to continue to lighten up. That being said, this could be a major turn and correct a large chunk of the five year-long rally. At a minimum we are looking for a retest of the March low at 1360 SPX or another 6% from current levels. Below that and the 5/06 lows come in to play.

Bottom Line: Our defensive from the beginning of June is now paying off as the markets look to retrace the 2007 rally, having already completed 50% from the March low. The relative value of the risk premium blew out over the past two weeks and we would be looking for a retrace of that spread favoring stocks this week. We reiterate using the rally to unload as we believe the risk in the system is still building not diminishing which will drive risk premiums higher from here.

Duke & Duke: Icarus Getting Close

The wild wild west cowboys were trading crude this week as prices came off last Friday’s $76/brl high, hit $73, rallied to a new high at $77.25, came off $3 in afternoon trading as stocks sold off, only to recover Friday to trade back to the $77 level near the previous high. We have been discussing the rally in crude and pointing to the dollar and risk premium as the main catalysts for the rally as opposed to a supply/demand issue. This week we think that was more evident as momentum seem to be driving all the action. The volatility can be indicative of a turn and with a potential C wave coming, we would not be owners of oil up here even as the market increases the risk premium, which we find impossible to quantify.

Bottom Line: Momentum is driving the price action in crude with traders weighing the dollar and risk premiums which in our opinion are difficult to quantify. Due to our bullish opinion on the DXY and our reluctance to chase the momentum, we are cautious on oil up at these levels.

The Ex Ante Factor: Flight to NDX = Flight to Cash

Last week we identified Dominick’s SPX target of 1556 and while we acknowledged the importance of the market’s recognizing the number we still thought there was potentially more work to do on the upside and cited some catalysts that could drive buying. Obviously those catalysts, the yen, oil, gold/dxy and credit spreads traded counter to the necessary direction to help stock prices as “the dead Italian” became too formidable.

At Trading the Charts one of the charts we follow on the Trend Cycle page, is the relative performance of NDX v SPX. On Tuesday as all markets slid we noticed a very interesting development in that NDX was outperforming many of the major indices and considering the higher beta of NDX v SPX it was even more profound from my perspective. Members must have been sick of my seemingly sarcastic citing of “a flight to NDX”. At the end of the day one of the worst performing sectors were utilities, with UTIL -3.45% for the session while the NDX was -1.75%. For the week the UTIL was -7.25% v NDX -3.9%. Sure, utilities are a carry trade beneficiary due to their yield, but I think there is a bigger picture discount at work.

I have long been pounding the table on the peaking credit cycle and effects of a reversal. Dom’s idea of a big multi-year dollar rally ensuing soon, as the pundits preach about its demise, is perfectly consistent with the relative value of cash and liquidity during the reversal of the credit cycle and the subsequent liquidation of collateral . The breaking down of banks and broker/dealers has been well documented due to their exposure in credit markets, potential negative balance sheet implications of taking down LBO debt and overall market turbulence. This, however, does not explain the relative performance of NDX v the typically conservative and defensive utility sector. It occurred to me that utilities typically operate leveraged capital structures like that of banks and broker/dealers while large cap tech companies have little or no debt on their balance sheets and in fact are sitting on loads of cash. The cost of capital is rising for both equity and debt but with turmoil in the credit markets, risk spreads are rising and thus the weighted average cost of capital is rising more for the leveraged balance sheets. The capital structure arbitrage that had been exploited by issuing debt to buy equity is vanishing.

It is my contention that while large cap tech still got hit, the risk-adjusted out-performance suggests, due to their solid liquid balance sheets, some smart money might be buying this sector as they rotate out of levered sectors. Many of these companies are too large for private equity to LBO, especially with the cost of their leverage rising so fast. A favorite tool of activist hedge funds, the leveraged stock buyback and dividend payment is going away for the same reason (see EXPE and HD buyback news). The seemingly stubborn reluctance for these tech companies to spend their cash ironically may now be catalyst that draws investors seeking liquid balance sheets.

I am not suggesting that tech companies won’t get hit with this market under pressure, but their relative performance, especially considering their beta, is speaking to me. The first name that comes to mind when I think of a liquid cash ginning machine is Berkshire Hathaway which was only down .77% for the week and +.50% on Friday. Hasn’t Mr. Buffet been removing his dollar hedge? I would think the DXY would make a new low when the Fed signals the first ease (possibly by 8/7 meeting). If it doesn’t, the low is probably in and cash will be king.

What is the discount?
Due to the continued flight to quality, the implied risk premium offered by investing in the S&P 500 v 10YR note treasuries blew out another 57bps from last week’s 23bps widening driving stocks to their cheapest relative value since late April when the market was coming out of the March low that saw the spread 333bps v today’s level of 283bps. While the past two weeks have clearly made stocks more appealing and assuming no crash, there should be a rally soon based on this relative value.
Even with the widening of risk credit spreads to the highest of 2007, the implied equity risk premium still favors equities as their yields rose 25bps higher.

Bottom Line: That severe of a sell off is not to be taken lightly as major trend lines were broken on heavy selling. We thought we could tell if the market had really turned when the dip buyers, who have been rewarded for their risk all the way up, would be punished and puke on the way down. That appeared to happen on Thursday and Friday with bounces sold harder than dips bought. This is further evidence to us that the risk has shifted to being long v being short and unless you are short term trader we would not be committing new capital to risk assets until we can determine some stabilization. Like we said at a minimum we believe the March lows will be tested and below that is last summer’s lows which implies 16% further downside from Friday’s closing price on the SPX. If we can muster some stronger than expected economic data this week that drives some unwinding of the flight to quality bid in treasuries, we would advise investors to use the pullbacks to scale into 5YR notes at 4.75% and 5.00% if it can get there.