Market Recap: Pass the Dramamine

Stocks attempted a recovery from recent losses in what proved to be a failed run as credit market turmoil and cautious comments from Bear Stearns took out the previous lows from Monday, closing on the low of the day at 1433 on the SPX cash. Some late day buy programs on Wednesday and Thursday were responsible for most of the upward price movement and it proved to be a dead cat bounce that found little buying support after weak employment data stalled momentum and tape bombs out of credit land were too much for a summer Friday into the close. Bonds continued to grind higher as the turmoil in credit kept the quality bid in tact with the curve trading with a steepening bias. Crude reversed from a new high on bullish inventory news and the yen basically continued it’s carry trade exposure by trading inversely to risky assets closing the week higher.

International Interests: Goodbye Greenback?

Currency pairs were mixed this week as the carry trade exposure drove some volatility as global equity and credit markets continue to re-price risk premium. EURJPY rebounded from the steep sell off while USDJPY remained under pressure as stocks took out their low on Friday with some clear flight from risk taking place. EURUSD rallied back towards recent highs on weak US jobs data which presumably tilts the Fed ease discount while the ECB and BOE (who both held steady on Thursday) remain tight. We believe the risk markets are clearly unwinding leveraged positions and expect the yen to remain strong as spreads widen. With that said we expect next week for the Fed to begin laying the groundwork (drop inflation bias perhaps) for an ease possibly by the following meeting and thus could see further pressure on the dollar as speculators try to push thru the $80 level. We become bullish on a new low that finds support as the tightening credit conditions and collateral liquidations should benefit the greenback.

Bottom Line: The Fed will most certainly need to ease in the coming months as the credit market is drying up fast. While we are skeptical of the Fed’s ability to engineer a soft landing (as many have already declared to have happened) and expect the dollar to make a new low in the coming weeks. Our thesis of a strengthening dollar in the face of a credit cycle reversal remains in tact and we look to buy upon stabilization under 80.

Cost of Capital: Credit Siege

Bonds continued to grind higher this week with a steeper bias as the credit market turmoil kept the flight to quality bid in the front end. News of turmoil in the mortgage and corporate credit markets and that dealers were shutting down and liquidity was drying up sent shockwaves throughout stock and currency markets as investors were flying from risk. The 5YR traded thru 4.50% on Friday and has rallied over 50bps since we began to recommend investors rotate into them. The bond market is clearly discounting an ease and we expect the steepening rally to continue in what we expect to be a coming Fed easing campaign that could be good for at least 100bps according to our model. Credit conditions are rapidly shutting down and nominal GDP has averaged 4.20% for the past two quarters and is trending lower. The seizing up of credit access will only lead to slower than expected growth which is already expected to be below trend. On the back end we expect the market to discount higher inflation risk premium with Helicopter Ben priming the pump and thus our steeper bias. History has shown that with the economy slowing and the Fed pumping (rising Marshallian K), the yield curve steepens to discount the inflationary pressure. We still favor the 5YR and belly of the curve and are looking for 4% yield by Q2 2008. If the Fed does not signal an ease or are continued to worry about inflation pressures, the curve could flatten as the ease discount comes under pressure. In this scenario we would use any pullback to 4.75% to buy the front end. It is our opinion that risk-free treasuries remain a buy as long as the yield exceeds the nominal growth rate of the economy.

Bottom Line: We expect economic growth to continue to decelerate and the bond market to further discount a multi-month Fed easing campaign. We think they are roughly 100bps behind the curve and with nominal growth slowing we may need more than that. We are a buyer of 5YR and belly treasuries on any pullbacks and as long as they yield more than the decelerating nominal GDP growth rate of 4.20%.

Beta Maximus: Drop the Bomb on Me

Stock markets ended the week just how they began, for sale. Volatility continued as indices attempted to retrace previous selling that had the S&P ~8% from high to low. Wednesday and Thursday saw back to back late day buy programs that drove some covering into the close. Unfortunately that is not constructive buying in a distribution phase and with Friday’s weak payroll data coupled with relentless “tape bombs” from BSC and credit market tightening the market rolled over into the afternoon taking out the previous low of 1440 on SPX to close at the low of week at 1433. We have been in the camp that the credit cycle is unwinding and equity valuations are subject to outside forces which are raising the cost of capital and removing the capitalization arbitrage that has supported prices at an alarming pace. Last week we were looking for a bounce but didn’t see as much upside as expected. We think the market could trade higher into Tuesday’s Fed meeting with some dovish talk possibly driving a spike higher. That being said, we see significant resistance around the 1500 ESU7 area at the 50% retrace and would target that area for selling with the idea they could push to 1525 but will have trouble as the market has been selling each bounce. We think the risk has turned and expect to see dip buyers punished while rallies are sold. The amount of leverage in the financial economy (real economy not withstanding) is still elevated and as long as credit spreads are under pressure we think stocks are capped. A Fed ease is not expected to help as the curve likely steepns and puts pressure on risk spreads and the cost of capital. As such we would target liquid balance sheets, low debt/equity and debt/cash ratios.

Bottom Line: Either we are bouncing or crashing. Since we don’t recommend betting on fat tail events we would rather look for a bounce and an opportunity to sell positions when the market is better bid. It is not time to speculate on the long side until the dip buyers prove to be successful. Thus far they remain under water and have not been paid to take the risk.

Duke & Duke: Cowboys Retreat

Crude rallied to a new all time high this week on bullish inventory news only to see a hard reversal. This price action reminds us of the previous high reversal on the seemingly bullish Prudhome Bay pipeline shutdown. We pointed to a potential topping in crude as we can see a large triangle developing (per tip from Dominick). Our thesis on oil is that it was trading on momentum and risk premiums, which are impossible to quantify, rather than fundamental demand and think Wednesday’s reversal was a perfect example of this dynamic. Gold found buyers on dollar and economic weakness this week and we expect it to regain it’s inverse relationship with the dollar and would be cautious buyers here.

Bottom Line: Crude could be reversing some momentum and while we could see one more slight high, with US economic growth slowing and risk aversion leading the trading environment we are defensive on crude and would look to trade back to the lower end of the recent range around $65-$70.

The Ex Ante Factor: BSC – revisited

On July 1 we posted this weekly chart of BSC and made this comment: 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.

Since we published this analysis the stock price of BSC is down 23% and the XBD is down 15%. The credit markets are shutting down anything but prime credit and investment banks reportedly are taking back paper to the tune of roughly $300b, a number that represents approximately 40% of the book value of C JPM BAC WB UBS MS MER GS BSC and LEH combined.

Since the beginning of 2007, Dom had been showing the divergence in the stock prices of Bear and Merrill v the S&P and even as we have been expecting a credit event since last fall when pundits were pounding the table on the excess liquidity, we did not expect credit markets would completely turn off the spigot so soon. Markets are re-pricing risk premiums and price discovery is difficult to obtain with dealers pulling bids.

Markets are a discounting mechanism. Current price reflects the market’s discount of future fundamentals and a risk premium for achieving those fundamentals. Many use technical analysis to scalp or swing trade and I have great admiration for the fortitude required. Having larger time frame, I like to use technical analysis to give me potential market discounts of price, which in turn provide potential discounts of future fundamentals. The BSC chart is a classic example of this type of technical analysis. By identifying the implications of BSC breaking that long trend line and seeing the RSI almost lead the stock price, we concluded that the market would be discounting either a decline in risk premium/valuation or an actual decline in fundamentals. But as we suggested BSC was a leading stock in a leading index. The chart not only provided a window into BSC’s current situation but also suggested trouble in the overall financial economy. While everyone (including myself) has been watching the yen and carry-trade pairs, the evidence of a credit event was right under their nose.
Friday, BSC held a conference call where the CFO commented that "these times are pretty significant in the fixed income market" and "it's as been as bad as I've seen it in 22 years. The fixed income market environment we've seen in the last eight weeks has been pretty extreme.” He also said they would not be buying back stock (book value expected to decline?) and that the appropriate path is to preserve our capital to weather the storm.

I’d say that confirms our thesis.

What is the discount?
It’s truly amazing how long it takes for risk premiums to narrow v how quickly they unwind. The implied risk premium earned by investing in the S&P 500 v 10YR note treasuries has blown out by 100bps since the low just 3 weeks ago to 307bps, now the widest spread since the March low when spreads widened to 333bps. The equity risk premium earned is 50bps up in the past few weeks but is still only half of the level from March when bond spreads were still tight relative to stocks. The total return offered by stocks is the highest level of the year indicating stocks are at their cheapest level from a total return perspective irrespective of bonds. I would like to see that number closer to 10% before rotating back into stocks. 225bps more shouldn’t be too much to ask.

Bottom Line: Stocks have continued their volatile risk aversion ways and while we are expecting a bounce we think the tide has turned for the credit cycle and thus would avoid any asset that has benefited by leveraged speculation. For months we have been recommending 5YR note treasuries and selling the rallies. No strategy employed can match that risk reward as evidenced by our model showing the widening of risk premium spreads and we see no evidence that would have us change plans. Offer us 200bps more in risk premium and we might get interested. Until that happens we are content to sit in short term treasuries and cash as those “real” yield are rising as asset valuations fall.