The Capital Observer Will Return Thursday

The Capital Observer Will Return Thursday

A Quick Note

I just wanted to make a quick statement before I head out for the day. All this talk I keep hearing of a depression is actually making me bullish. I think we are very close to a long side trading opportunity. This is the type of talk you hear at a bottom. I want to hear more depression talk and less bottom talk. The same clowns that told you to buy 30% higher are now saying to sell down here.

Stay In The Game

The first rule of investing is not to lose money. Given that I will be out for the next two days, I was more cautious about starting a position. If we would have melted through the end of the day I would have gotten long regardless. There will be opportunities when I return even if I miss this bottom. Have a good night.

Welcome To A World With No Shorts

Welcome to a world with no short covering.
Panic. Check.
VIX 48. Check.
PutCall. No Check.
I am this close to buying but not there yet. QQQQ will likely be my vehicle of choice

Just What The Doctor Ordered

I come back from the doctor's office to find the market crashing. I bought the other half of my NLY position. We are getting very close to the point where I am willing to get long. I am leaning towards the QQQQ.

Free Falling

I wanted to get a few thoughts out before I head out to a doctor's appointment
  • If I were lucky enough to be short I would surely be covering here (but I am usually a bit early).
  • However it might be a bit early to buy the market as a whole.
  • I am sure there are individual bargains in the midst of this chaos.
  • Apple (AAPL) is starting to get cheap based on forward earnings. Excluding cash they trade at 15 times next years projections. The key is figuring out if people will be willing to pay up for their products in the midst of a recession.
  • The call buying on the ISE is bothering me.
  • Are bulls still holding out hope for the market to rally once the bailout package is passed? Maybe we need that event to pass before we can get true capitulation.
  • Is Hank letting the market fall to pressure Congress into passing the bill?

Bought Some NLY

I bought back half the NLY that I sold at much higher levels. This is not a market call. I would be happy to buy more at lower levels. Just trying to use prices to my advantage.

Quick Note On Call Buying

I am astonished to see that with the S&P 500 down over 40 points there is call buying at the ISE. This is reducing my urge to bottom fish. I want to see panic and put buying. I suspect we need to break to a new 52 week low.

I Can Feel It Coming InThe Air

We are getting closer to a good short term trading opportunity from the long side. I would love to see the following before I bought:
  • A break of the low from 2 weeks ago in the S&P
  • A VIX in the 45 area
  • A low without the government intervening in the market.
Unfortunately I will be out the next 2 days so I might not have the chance to trade this

Warren Buffett Is Human

Warren Buffett is the greatest investor of all time. I am always interested to know his views and read everything I could about him. However, he is not infallible and makes plenty of mistakes. Warren Buffett sold put options on junk bonds and major stock indices very close to the top in both markets. He is probably facing large losses in these positions. Stabilizing Goldman Sachs and his comments about the bailout package last week were self serving. While I have great respect for him, he is human.

The following excerpt is from the Berkshire Hathaway 2007 Letter To Shareholders:

"First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013.At yearend we had received $3.2 billion in premiums on these contracts had paid $472 million in losses and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Ouryearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative ContractLiabilities” on our balance sheet.

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of$4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate,will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period."

Be Careful What You Wish For

Good Morning. On Friday, I thought the most likely scenario was a gap up on the bailout package followed by a drop. However, I began questioning that scenario when everyone I spoke to was expecting the same. The market rarely obliges everyone. Today, we wake up to find the S&P futures down greater than 20 points. That is a scenario I did not hear anyone talking about. That is why this is the greatest game on Earth.
  • Year end redemption notices for many hedge funds are due tomorrow. This can add to volatility, although it has been reported that hedge funds already have record levels of cash on hand.
  • The New York Times reports the average hedge fund is down close to 10% this year. Even SAC is down.
  • The Wall Street Journal reports that steel demand and prices are down. Steel is a leading indicator of industrial activity as it goes into making most industrial products.
  • Do you thin Hank and the Plunge Protection Team will let the market go down today without a fight?
  • I will probably be a spectator today as I am taking the next two days off.

Weekly Strategy

"We have never had the combination of 5.5% inflation and about a 25 multiple on the S&P's trailing earnings. When we talk about a 25 multiple on the S&P, nobody can believe that it's actually the trailing earnings. And then people say, "Well, if that's true, it's only the financial stocks." Well, it's not. It's much more broad-based.

The market is just legitimately expensive, and we are so hesitant to use forward earnings, because analysts haven't revised their estimates downward. So to say the market is selling at 13, 14, 15 times forward earnings is a meaningless statement."

-Richard Bernstein in this weekend's Barrons

Richard Bernstein, one of the few Wall Street strategists worth listening to, explains why despite the large drop in the market, stocks are not cheap. A year ago, market pundits argued that the S&P 500 was cheap based on forward earnings. Since then the S&P 500 has fallen more than 20%, while forward earnings estimates proved overly optimistic. That does not stop many pundits from using the same non rigorous argument again.

The change in earnings for US companies is secular, not cyclical, as profit margins were at unsustainable levels. Please see the chart below showing profit margins going back to 1955, from Hussman Funds. The chart is a bit dated but shows that profit margins have reached record levels in recent years. Profit margins are mean reverting. A basic tenet of capitalism is that high profit margins brings more competition, which in turn reduces profit margins. In addition, we are in the midst of a deleveraging of balance sheets. I believe this is a permanent deleveraging, as foreigners are no longer eager to finance our ballooning current account deficit. This will lead to slower economic activity for many years to come.

However, those arguments are longer term in nature. At the moment, a good case can be made both for the bulls and bears. The short term bull case is that there is a lot of money on the the sidelines, which there undoubtedly is. The bailout package will force a lot of that cash in. Market players will declare we have seen a double bottom and hedge funds will jump aboard a year end rally to try and make their year back. While this might seem implausible right now, it never ceases to amaze me how higher prices make people more bullish.

The short term bear case is that markets have been manipulated higher by the government. The market would undoubtedly be a lot lower if it were not for an assault on short sellers and the bailout package. There is now a small short base and a lot of people pinning their hopes on this package. If a rally should fail to materialize there is no short base to protect the market on the downside and the government's bag of tricks is looking empty. This could be the big one.

I am leaning towards the bear side and am tempted to short a gap up opening on the announcement of the bailout package Monday morning. However, the following is making me hesitant. If I were Hank Paulson and I had a Plunge Protection Team I would not let the market fail the day after the bailout package, which I staked my reputation on, was announced.


  • The greater the number of people that set themselves up for a rally off the bailout package, the less likely a rally is.
  • It is disturbing that people are still more scared to miss a rally than to lose money. That is not the attitude seen at a good bottom.
  • People could have concentrated on who is holding the debt that Washington Mutual just defaulted on or who is holding the debt of the banks that will follow. Instead, they are focusing on what stocks will rally the most after the bailout package is announced.
  • Do you see RIMM down 27%. Momentum cuts both ways. I learned long ago (the hard way) to completely stay away from these type of stocks. Long or short.
  • Have a great weekend.

Political Roulette

  • While it is certainly admirable that the market has had every reason to fall apart today and thus far has not, that is not reason alone to invest. Not with my money.
  • It is now possible to borrow SPY. The other day, when the SPY was higher, I tried to short it but could not borrow it. Interesting?
  • GS, JPM and COF have raised a combined 16 billion dollars this week. In the long term that is a positive as our banking system needs more capital. In the short term that is 16 billion less to fuel a rally.
  • Credit markets are in disarray as a lot of debt got wiped out today. There are certainly casualties. The question is who?
  • If the best of breed want to raise capital, what do you think lesser banks want to do? That should cap any rally.
  • Another reason the sidelines look nice to me is that so much has to do with politics and that is not my expertise.
  • My best guess is that the market will not be able to turn around today without a package announced. No skin in the game though.
  • My posts will be sparse today as I am on the road.

The Surreal Life

Good Morning. It seems like once in a lifetime events now happen on a daily basis. Banking behemoth Washington Mutual is now a relic of history. Common stock holders, preferred stock holders and debt holders have been wiped out. JPMorgan Chase will take over the deposits and some branches. The good news is that this will not cost the FDIC anything.
  • Washington Mutual stock was worth less than 3 billion dollars. I don't believe that will have an effect on the market. However, who holds the preferred stock, bonds and CDS might cause problems. Psychologically, it does not help as people might start questioning everything.
  • It seems the bailout plan is on the rocks. Is this just politics? I don't know, but even as a big believer in free markets I think government action is necessary.
  • The bright spot is that there are no more annoying WhooHoo commercials.
  • The eerie thing is that when I woke S&P futures were only 13 points below fair value. People are becoming numb to this type of news.
  • JPMorgan Chase is raising 9 billion in a secondary offering. More supply.
  • Bloomberg reports that California home prices are now down 41% from a year ago.
  • There will be good times again. There always are. It will just take time.

Dazed and Confused

Just a head's up. JP Morgan Chase has scheduled a conference call for 9:15 tonight without stating a reason. This is highly unusual. Maybe something, maybe nothing but thought I would let everyone know. Here is the link


  • Looks like Research In Motion (symbol:RIMM) is also feeling the slower economy. It was down as much as 15% in after hours on a miss and a warning. The weakness will probably spread to Apple (symbol:AAPL) as their have been rumors recently that iPhone sales have slowed as well.
  • I believe corporate profit estimates are still too high. Today's warnings from GE and RIMM are the tip of the iceberg.
  • If the bailout package produces a rally I believe it should be sold into.
  • Have a good night.

Flight From Safety?

I don't usually trade treasuries but I am strongly considering making an exception. Besides the bulging deficit, the government will now need to raise another 700 billion dollars to fund the bailout. This will be done through the selling of bonds. I am not sure that kind supply has ever been tested and the result can be disastrous. However, I am hesitant to short bonds in what I think will be a deep recession. The jury is still out.

Hurricane Hank

  • Once again the day starts with heavy call buying.
  • Market breadth is excellent as advancing stocks are far outpacing declining stocks. This is a positive change from recent days.
  • I think the market can rally as sentiment is very negative, but I believe the upside is limited.
  • As of now, I am firmly on the sidelines.
  • Capital One (symbol:COF) successfully completed their secondary offering. Expect more of the same from other financial companies if the rally continues. More supply.
  • GE suspended its stock buyback program. Less demand.
  • New unemployment claims were tremendous as the financial crisis spreads further into the real economy.
  • As a value and vulture investor I have great respect for Warren Buffett. However, the fact that he tries to portray himself as some sort of savior saint is a bit annoying. Warren Buffett does not do deals out of the kindness of his heart.
  • This bailout package amounts to $2,000 for every American citizen. For my $2,000, I thought Bush could have put on a better show. He sounded like a second grader reading his homework off of a sheet of paper that he copied from his friend Hank.
  • The fact that the market can ignore GE's warning is definitely a plus. I would be more impressed if the market was ignoring GE without the bailout news.

Buffett Breakfast

Good Morning. In this morning's Wall Street Journal Warren Buffett describes how he decided to invest in Goldman Sachs in a single afternoon, without even reviewing their financial statements and without any due diligence. Considering the sweetheart deal he received, I would have been happy to join him without looking at a financial statement. However, what about all the people who didn't get the same deal, that bought the secondary offering just because Buffett had confidence in Goldman Sachs?
  • Goldman Sachs was suspiciously up $10 the afternoon before the deal was announced even though the market was tanking? According to Buffett, the deal was made that afternoon. It should not be that hard to track how that inside information spread but don't hold your breath.
  • Do you think someone might have known about the GE miss? The stock has been acting like death.
  • How many people are investing based on the rescue package passing?
  • Could traders sell the news?
  • Why do the futures trade up every morning?
  • Do you think a younger Buffett, who was the one that made the spectacular returns, would have invested 5 billion without any due diligence?

Closing Observations

  • The market would be up this week if they closed the market at 3:30. The entire loss for the week has happened between 3:30 and the close.
  • Every day there is a smaller short base in financial stocks as shorts cover but shorts are not added. How much has this aided the market? What happens when this wears off?
  • Yesterday, I asked why Take Two (TTWO), the video game maker, was trading at 8 times next year's earnings estimate, net of cash? The answer I received was that many don't believe that they will earn that much. It seems like there is a reasonable margin for error already baked into the price as competitor, Electronic Arts (ERTS) trades at 15 times next year's earnings estimate, net of cash. Seems like Take Two trades at an attractive price, but I am still looking into it. My biggest issue is that earnings are very inconsistent for video game makers and can swing wildly depending on how hot their games are.
  • What's the most bullish thing about this market? It seems you have to be crazy to buy it.
  • I don't understand politics, so I don't know if all the tough talk from Congress about the bailout package is just a show?
  • I do understand who butters their bread, as the financial industry is the largest lobbyist and campaign donor.
  • Have a good night.

My Bailout Plan

If banks sold their assets to the Treasury at current market prices most banks would be insolvent. Banks don't have to mark loans to market so they are currently solvent. Bernanke suggested paying above market prices for the loans in order to ensure that banks remain solvent. I agree with that premise but believe the banks should be forced to issue equity to the government to make up for the difference between "market" prices and the value they are holding the loans on their books, plus a penalty. Look at what Buffett was able to get from Goldman. Shouldn't the taxpayer's get the same? Do we not work for our money?

I think the idea of allowing defaulted home buyer's to modify loans would be a disaster. It would encourage more people to default on their loans in order to get a modification. This would worsen the problem. Why does someone who put nothing down on their house deserve a break? What did they lose?

Scaredy Cat

  • Once again, there is too much call buying.
  • Once again, there are more stocks declining than advancing, even though the market is flat.
  • Credit spreads are at their widest since the crisis began.
  • Won't more banks issue stock if the market goes up? That is supply.
  • Bloomberg reports that option trading volume has collapsed. That is why I am putting less weight in the high call buying, but I am heeding the signal.
  • Call me too scared to buy, too scared to short.
  • Why too scared to short? Times of turmoil are usually good buying opportunities and a Senate package can be announced at any time.

Covered S&P Short

Yesterday, as documented in these pages, I shorted the S&P in after hours on the Goldman news . I have covered that short at a handsome profit. I still think Goldman ends the day down but I no longer have skin in the game.

Morning News

Yesterday, I said my impression of the Senate hearing was that the Treasury was going to willingly overpay for bank assets. My impression was correct. From Bloomberg, Paulson, Bernanke Put Aiding Banks Ahead of Best Taxpayer Deal:

"Bernanke told lawmakers yesterday the government won't pay ``fire-sale prices'' for the mainly mortgage-related securities Paulson aims to buy in a proposed $700 billion rescue. Instead, officials want to set a long-term value on assets, intending to hold them until they mature or markets improve.

Insisting on paying higher prices may increase complaints from legislators, who will pepper Bernanke and Paulson with questions in a second day of hearings today, that the government is bailing out Wall Street at the expense of Main Street. At the same time, setting values too low may roil financial markets further and tip the economy into a deep recession."

Goldman is using the Buffett induced hype to up their public offering of stock to 5 billion. I think Goldman closes down today. From Bloomberg, Goldman Sachs Said to Double Stock Sale to $5 Billion

"Goldman Sachs Group Inc., the most profitable firm on Wall Street, plans to raise $5 billion in a stock offering, double what the bank had originally sought, two people familiar with the situation said. The bank increased the size in a so-called accelerated book-building, said the people, who declined to be identified because the terms haven't been made public."

Buffet's B@?%ch

  • Goldman is paying between 14%-17% to borrow money from Buffett depending on how you value the stock options. That's good news?
  • Don't you think Buffett should have at least gave them a teaser rate?
  • Capital One (symbol:COF) also announced they are selling 750 million in stock.
  • If the market responds well to these capital raises there will be more as many financial companies need equity. That will put a lid on the market.
  • The market soaring on every piece of news shows that too many people are still scared missing the bottom.

Berkshire Is Now Goldman's Loan Shark

I think the news that Berkshire Hathaway is investing in Goldman Sachs is being misinterpreted. If I was allowed to short Goldman I would be doing it now as it is at $137 on the news. Berkshire Hathaway did not buy common stock. That would have been a vote of confidence. They bought preferred stock. Berkshire Hathaway is lending Goldman Sachs money at 10%. In addition, they are receiving in the money call options on 5 billion in stock. The price Goldman is paying is probably closer to 14%. Whys does Goldman need to pay 14% for capital? Why are they selling an additional 2.5 billion in common. Just last week they said everything was good. This is proof positive that all is not well. I also tried to short SPY but couldn't get a borrow. Just bought SDS, which is the UltraShort S&P.

Closing Observations

  • Some things I would want to see before I get long this market is a down opening in the morning with heavy put buying following.
  • Some Dow 8,000 price targets would be nice as well, but it's not a necessity.
  • Earlier I said "I would love nothing more than to build a portfolio of stocks, collect dividends and watch the portfolio grow. However, we are still in a Bear Market and someone has to pay to keep the lights on." To that I was reminded to add that I need money for shoes and pocketbooks as well.
  • I am happy to see GE down. I think the fact that they asked to be added to the "no short" list was disgraceful. They are supposed to be the top company in the World. Concentrate on running your business properly and the stock price will take care of itself.
  • Have a good night.

Inner Monolgue

I have been debating whether I should get long this market for a trade. We had a huge washout last week, with panic, fear and the VIX over 40. That is usually good for a few weeks of rallying. I still believe we are in a Bear Market but that doesn't mean we can't rally first.

However, many of the shorter term indicators I look at urge caution. There is not enough fear as people are quick to buy call options and market breadth has not been great on advances. I would rather everything line up, as my main goal is to protect my capital. I accept that part of protecting my capital is missing some moves. As such, I am waiting for everything to line up. If I miss the rally there will be others.

Hey Big Spender

  • One of the key takeaways from the Senate panel is that the Treasury is planning on buying the assets from the banks for above market prices. Bernanke called market prices "fire sale" prices. I cringed when I heard that. This guarantees a huge bill to US taxpayers if you ever had a doubt.
  • What will they do if we keep going down? There are no short sellers to blame this time around. There are also no short sellers to start a short covering rally in the financial stocks, which is how previous rallies were started.
  • I guess stocks will need to get to the market clearing price. What a concept?
  • I would love nothing more than to build a portfolio of stocks, collect dividends and watch the portfolio grow. However, we are still in a Bear Market and someone has to pay to keep the lights on.

Midday Observations

  • Call buying is still very high.
  • There are more stocks declining than advancing even though the market is higher.
  • These two indicators support a lower market in the short term.
  • I have been searching far and wide for cheap stocks today. For the most part the cheapest stocks are the more economically sensitive stocks. Since I am bearish on the economy I am not interested. However, I have found a handful of stocks that look good.
  • Take Two (symbol:TTWO), the video game maker trades at a single digit multiple net of cash. If anyone knows about this stock drop me a line.
  • Listening to politicians talk makes me want cry and puke at the same time.

Quick Note On Call Buying

Once again this morning we are seeing heavy call buying. Normally, this is bearish as heavy call buying shows that the crowd is too bullish. Maybe the fact that market makers can't short financial stocks is distorting the reading.
Despite the red warning sign flashing from the options market I feel that the most logical path for the market is up before we go down. However, like a child that burnt his hand on the stove (my upside try in Microsoft yesterday), today I will be a spectator.

Strange Days

Good morning. The only way I could describe yesterday's trading was strange. It was the quietest down 4% day I have ever seen. In addition, investors were buying calls all day despite the lower market. It seems an anti-dollar trade developed as the US Dollar was down the most ever versus the Euro. Gold and commodities were up while bonds were down. Usually on big down days we see a flight to safety in treasuries. It seems foreign investors are voting for the bailout plan with their feet.
  • The changes being made to the bank bailout plan seem logical. The additional oversight is a no brainer. The equity stakes to the government makes sense as companies should have to pay something for being bailed out. That is not a positive for holders of bank shares but better than no bailout plan.
  • Commodities have rallied hard since making their lows. A pullback would seem logical unless we are seeing a full fledged exodus from US Dollar based assets.
  • The futures are pointing to a higher open. After such an ugly day yesterday I would expect a downside test even if we are going to advance today.
  • My plan for today is to do a lot of research and sit on my hands.

Late Day Observations

  • There is persistent call buying even though the market is down a lot. I don't recall any time I have seen this. While I am putting less weight in indicators right now this is worth mentioning.
  • The credit markets have not improved, nor has the preferred market.
  • Oil is now up $20 a barrel. Gold is rallying hard as well.
  • It seems we are getting a hint of what might happen if the bailouts continue. There is no such thing as a free lunch.
  • I said that I expected commodities to outperform. I am now neutral on them. Commodity prices will now be in a tug of war between economic weakness and dollar debasement. Who will win is the billion dollar question.
  • Sold MSFT at a loss.

I added a stop loss to my MSFT Position

  • I put a stop loss on MSFT at around the days lows
  • While I think the stock will outperform as it trades much cheaper than the market the buyback will not be as aggressive as I first thought. The cash on their balance sheet is largely stuck overseas and they will need to generate the cash before they can spend it.
  • The other positives on MSFT is that it seems they are backing off their aggressive acquisition strategy. In addition, they are borrowing to buy back shares and Bill Gates is a smart investor.
  • If you have to own something I think the stock will outperform but I don't have to own anything so I want to limit my loss.

Bought Some MSFT

I bought some MSFT as per my thinking in the prior post. A 40 billion buyback is huge even considering MSFT's size.

MSFT and the 40 Billion Buyback

If I were inclined to play the long side it would be through Microsoft or the QQQQ. Microsoft is cheap and the fact that they are buying back 40 billion in stock puts a floor under the stock price. This should also benefit the QQQQ shorter term as does the weaker dollar.

Morning Capital Observations

  • I view Goldman's conversion to a bank as proof positive that something was/is not well.
  • GS and MS are now allowed not to mark to market. Maybe they will be able to ride out this crisis but due to their status as banks, during the next boom they will face restrictions limiting their profitability.
  • Australia has completely banned short selling.
  • When is the last time government manipulation in markets worked in the long run?
  • Do you see oil at $108? Will this be one of the unintended consequences of the bailout? Everyone is paying to save a few people.
  • Do you see the 10 year rate at 3.9%, up over 50 bps from last week? Another unintended consequence?
  • As Woody Allen likes to say "the most expensive sex is free sex". Ask any married man.
  • Does the same hold true for free money?
  • There is too much call buying for my taste. That does not bode well for a turnaround but the day is still young.

Weekly Strategy

"Deleveraging is a very painful process, and will run longer and deeper than anybody can imagine. I've been fearful of this.
So far, what we're seeing is the pain in the financial system. Later on, we'll see the echo effect of the pain in the real economy. I can't understand economists talking about no recession or mild recession. This is the worst financial crisis since the 1930s. It's different than the '30s, but is the worst since then, and the consequences will be very, very painful for virtually everybody in our economies."

-Felix Zulauf in Barrons this week

Famed investor Felix Zulauf said it best this weekend in Barrons. Even if we can stem the financial crisis the real economy is going to adjust to a new world where leverage is reduced. Periods of adjustment are not good for markets as markets hate uncertainty.

The markets have been distorted by the new short selling rules and the new bailout plan. The short term is very uncertain as the rules of the game have changed. Indicators are useless as market players are in a state of confusion. I don't know where this will lead shorter term but I know where I think we are heading longer term.

My plan is to use any strength in the markets from the new bailout plans to establish short positions. I will give the market some room to rally because we did have a strong washout and that typically leads to rallies. However, above S&P 1300 I will start aggresively shorting the market. During earnings season in October I believe that it will be revealed that this crisis is not contained to financial companies but is spreading to the broader economy.

Highway Robbery

The details of the Treasury Plan have been released and it is scary. The plan will give the Treasury a blank check of 700 billion to spend as it deems necessary on buying mortgages. There will be no process in place to make sure the funds are distributed fairly or that taxpayer money will be protected. Maybe the dollar bill should say "In Hank we trust". From the New York Times:
"The Bush administration on Saturday formally proposed a vast bailout of financial institutions in the United States, requesting unfettered authority for the Treasury Department to buy up to $700 billion in distressed mortgage-related assets from the private firms.
The proposal, not quite three pages long, was stunning for its stark simplicity. It would raise the national debt ceiling to $11.3 trillion. And it would place no restrictions on the administration other than requiring semiannual reports to Congress, granting the Treasury secretary unprecedented power to buy and resell mortgage debt."
The administration has been known to use times of fear to forward its agenda. The people in Treasury will soon be in the private sector and human nature is still human nature. This is insanity.

In addition, this will bring the deficit to over 1 trillion dollars. Foreigners are no longer crazy about funding our excesses. This could have a disastrous effect on interest rates aside from the other unintended consequences. However, all the short term solutions that got us in to this mess were widely cheered and I don't see why this time will be any different. We are mortgaging our future. There is no such thing as a free lunch.

Capitalism Is Dead

This week was bittersweet for me. It was an excellent week for me from a P&L perspective. I took a lot of heat for being conservative the past few weeks. Someone suggested that the Pornographic Observer might be a better idea for me. However, I stayed disciplined and kept my head when the market got crazy. I ran into the fire instead of away from it and I came out with some loot.
However, what the government did this week by taking over a public company, banning short selling and possibly creating a fund to bailout banks has destroyed the market as I have known and loved it. The markets will never be the same again. I will continue to operate with caution as the government has distorted the market and we are dealing with a different animal. I am practicing what I preach and going home in 100% cash again.
  • Do you think Hank just wanted his own Sovereign Wealth Fund?
  • What did Hank know that we don't that made him take such desperate measures?
  • Short sellers actually cushion the market as it goes down. That's why I would be very scared to be long this market once this rally is over.
  • If I told you on Monday after the Lehman bankruptcy that you could get out of the market even would you have taken the opportunity? Did you?
  • What do they do for an encore the next time the market falls.
  • Don't be fooled. Things are more dangerous than ever. I hope we can navigate it together. Have a great weekend.

Midday Observations

  • I sold Puts against my SPY short. Think of me as flat. Nice trade.
  • I thought I was in for some pain before I would be able to cash my chips in on this trade. Doesn't it always work that way?
  • Aren't the trades that seem easy always the worst ones?
  • After a month of sitting at my keyboard disciplined and patient, it finally paid off in the last two days.
  • I would want to short the market if the S&P approached 1300 again. What to do if it goes down is the harder choice.
  • This is a sad day in the history of capitalism
  • Should I change the name of this blog to Socialism Observer?

Call Me Crazy

Call Me Crazy but I shorted the SPY at 128 in the pre market. I am a seller on a scale up. Once this upside panic subsides I will cash in. There will be capital raises if the market holds up. That will bring us right back down. That may mean a few nights of bad sleep but so be it. Bring it on Hank!

Morning Observations

  • Do you really want to buy a market that is being manipulated higher by the government?
  • When's the last time that worked longer term?
  • Did you think they were going to let the market fall before the election, without a fight?
  • The constant government interference distorts markets. One not only needs to focus on fundamentals, economic conditions, crowd psychology but on trying to predict what our socialist government will do next.
  • Who do they blame the next time the market goes down?
  • On one hand I believe we are in a deflationary environment, which is bad for commodities. On the other hand I can hear the US government starting up the US dollar printing press and am tempted to buy Gold.
  • Could they go after gold buyers next?
  • What do you think the P&L of the Plunge Protection Team is going to look like today?
  • Nice Trade Hank!
  • I am trying to figure out if my urge to short this move is rational. If I told you yesterday at noon you could sell the S&P at 1250, would you have taken the offer? Or is it just my anger at the government for trying to manipulate the market?
  • Why doesn't the government just print the stock prices they want to see twice a day and we could all go home?
  • The more I think about the government interfering in markets the more I don't want to be involved.
  • Who am I kidding?

Welcome To The USSA

Yesterday, the VIX went over 40. Panic was in the air. According to plan, I held my nose and bought some stocks. Needless to say it worked out very well but I cashed out completely by the end of the day.The question on everyone's mind is, "Was that the bottom"? My answer would be yes if the rally wasn't spurred by the Europeans banning short selling and talk over here of a new RTC. In addition, the effect of these actions were amplified by being done right before option expiration. I suspect the market would have gone lower if the governments did not interfere. I wish we could see a washout without government interference, then we would see a true bottom.
However, we must deal with the facts and the fact is that the government interfered. So what now? I don't think we have seen the ultimate bottom for this Bear Market but yesterday could have been a short term bottom. We had panic, a VIX over 40 and a strong reversal. However, I don't believe that a rally can go much further than a few percent from here. As we speak the S&P futures are up another 43 points as our country is taking its cues from Pakistan and banning short selling. This is an unprecedented move and I will not chase it. I am very tempted to short it, but will probably just watch as our free markets become socialized. I continue to err on the side of caution.

Sold balance of NLY

Sold the balance of NLY up close to 20% from where I bought it yesterday. I'm 100% cash and will reassess tomorrow.


I just sold the NLY I bought this morning for a greater than 10% profit. In addition, I did not communicate that I also bought a second slug of GS @88.5. I don't know if this is the bottom but the Capital Observer is taking a well deserved afternoon off. My only holding now is NLY. Have a great night. I will have much more in the morning.


SOLD GS at 98.5

Sold SPY

I sold the SPY i bought at break even. Am sitting on GS. Added to NLY.


Bought some GS at 93.5

Bought SPY For A Trade

With the heavy put buying and the VIX nearing 39 I have bought SPY for a trade.

Opening Observations

  • Call buying is low on the ISE for a 18 point up day. This has been the best intraday indicator and I would say it is supportive of a higher market for today
  • I purchased NLY into the muck yesterday. It is up over 5% from my purchase price. I am letting it run
  • Why aren't I getting long? I would rather see the market exhaust itself on the downside and not get saved by liquidity injections.
  • The constant bailouts and government interference got us into this mess. Its not going to get us out. Only time will.
  • My posts will be sparse today as my back is killing me and the doctor wants me completely off the keyboard. Thats not happening but I'm cutting back.
  • Good luck today.

Good Morning Vietnam

Good Morning. During a crash, which I assume we are in right now, statistics don't matter. By definition a crash is an outlier event. However, one indicator has held up through the Russian crisis, Long Term Capital, September 11 and the bursting of the tech bubble. That indicator is the VIX and I continue to use it as my compass. As you can see from the chart I posted last night the VIX has a very hard time going higher than the mid 40's. Does that mean we have to get there? No, but that is what I want to see before I risk my capital. I continue to err on the side of caution.
  • Are short sellers to blame for this mess? How about 0% financing, 106% financing, no money, no job, no problem, off balance sheet, SIV, teaser rates, stated income, adjustable, Flip This House and my favorite The Ninja Loan?
  • The futures are signaling an opening up over 1%. I would expect the market to test the downside at least once.
  • The Feds always bring out surprises before options expiration to get more bang for their buck. Tomorrow is options expiration.
  • It seems to me that everyone is searching for a bottom. Not a good sign.
  • That said I think we are close to a good bottom time wise.


I have been saying that the VIX has room to go up if fear is going to reach levels of past crisises. Here is a chart from Bespoke Investment Group. As you can see the 45 area seems to be the magic number

Getting Closer

  • The VIX closed at 36.22. We are getting closer to other major panic points but are not quite there yet. I will continue to err on the side of caution until then.
  • I have been saying for weeks that in a Bear Market it pays to err on the side of caution. If you got caught in this, remember the lesson.
  • I learned this lesson before, the only way I know how, the hard way.
  • The market can stay irrational longer than you can stay solvent.
  • Have a good night.

Afternoon Observations

  • I nibbled on some NLY. They are a mortgage REIT and were trading below book value. They basically hold Fannie and Freddie bonds. If I could buy a dollar for less than a dollar I'll take it. These guys are very conservative so if they go under there are not many stocks that can be owned. They yield well over 15%. JP Morgan estimates that in the next year they will yield 20% at the current price.
  • The vast majority of my money is still in cash. Yes there is blood in the streets but during the last Bear Market the VIX got over 40 before every major rally. We got to 35.58.
  • If the VIX goes over 40 I am planning on holding my nose and buying.
  • eBay acts like a champ.
  • America is still a great country. We work harder than any other people in the World. However, there are too many imbalances in our economy that need to be repaired. The transition will be tough but the sun will come out again.
  • It's always darkest before dawn.

Midday Observations

  • It seems everyone was looking for a rally at the open today as buying the open has been profitable the past two days. Traders must have been licking their lips when they saw a third big down opening. When something seems too good to be true it probably is.
  • The clue that there was a lot of supply was that the market was down big despite call buying, which I pointed out 20 S&P points ago.
  • The rumor is that Lehman is unwinding positions.
  • The SEC just added restrictions to short selling and the market ignored it.
  • What will the government do next if the market keeps falling?
  • I would much rather see the market go down hard than it saving itself. That will shake out all the weak holders and allow for a better rally.
  • The VIX is at 34. There is still room for that to go up.

Morning Observations

  • On second thought maybe I was wrong about people being bearish. The S&P opened down 20 and calls are being bought. Despite the call buying the market is not rallying. Very troubling.
  • Am I upset I covered my retail shorts? I am never upset about making money. I used to look back and said I should have held on but that is counterproductive.
  • This could get UGLY.
  • That would actually bring us closer to a bottom.
  • The Fed bailed out AIG and is running out of money. The Treasury just announced that they will be injecting funds into the Fed. Is this the beginning of money printing?
  • Stay tuned.

Closed Out Retail Short

Just a quick note. I have covered my short in the retailers. I hope to revisit at a higher price.

Ingredients For A Rally

I am starting to see some of the ingredients necessary for a rally. While I don't think the Bear Market is over by a long shot that does not mean we can't rally from time to time. Sentiment is very negative and that is now seen in every sentiment survey and in put buying. I am not quite ready to get bullish but I am starting to see a light at the end of the tunnel. I think it is a positive that the S&P future are down close to 30 points right now. People are beginning to look at these bailouts with skepticism. That is a big change from a few weeks ago when the market would rally every time a company would fail.

Was that the bottom?

Good morning. The most consistent feedback I have received to date (which I very much appreciate) is that I am not taking a stand on anything and keep showing both sides of the coin. We are in unprecedented times where so much of the movement is dependent on announcements of who's getting bailed out and who's entangled in what web. What's worse is that the information is being leaked to certain market players ahead of time (the market mysteriously goes up before every bailout announcement) and I am not one of them. So I am at an information disadvantage. This is the reason I am sitting in mostly cash. This blog is not the gold mine it may seem to be and in order to make money I need to take a stand and want nothing more but I am not going to force the issue because that is a sure road to losses.
The most important lesson I learned in the twelve years I have been investing was to go to cash when I don't have a strong view. I would consistently make money when I had good ideas with conviction in them and consistently give a lot of it back when I was just taking positions to keep myself busy. Learning to go to cash was not easy as I crave action. CNBC parades a whole list of people everyday that claim to know everything about everything. I am not one of them. I am just a squirrel trying to get a nut and this blog is about my thought process that looks at both sides of the coin.
  • Yesterday had a lot of the hallmarks of a bottom including a turnaround, heavy volume, a VIX at 34, heavy put buying and fear.
  • I would be more impressed if the turnaround did not occur because of a rumor of the Fed bailing out AIG. In addition, it seems that all the bailouts to date have been leaked to selected market players as the market mysteriously goes up right before every bailout announcement. I would have rather seen the market turn around on no news. In that case it would have been much clearer that the sellers exhausted themselves.
  • The corporate and mortgage bond market don't think we are at a bottom as credit spreads are at their widest for this cycle.
  • The treasury market does not think we have seen a bottom as the ten year bond yields 3.5%.
  • I was very impressed with commodities and commodity stocks. No rate cut was bad news for them and they rallied hard. They should continue to outperform.

Shopping List: eBay

I am preparing a shopping list in case the market has a sale in the next few weeks. One of the stocks I am looking at is eBay (symbol:EBAY). While I am concerned about owning a company that's earnings is dependent on consumer spending, I believe the valuation of the stock more than incorporates a negative consumer outlook. Analysts expect eBay to earn $1.94 next year. Including the over $3 a share in cash eBay holds the stock trades at 10 times next years earnings. If one considers the growth valuation Skype and PayPal should receive, the auction business trades at a single digit multiple.

I believe a certain part of eBay's business is vulnerable. There are people that are addicted to eBay just like there are people addicted to the Home Shopping Network. Those people will probably cut back in a bad environment. Additionally, a weaker economy will effect business and lower credit availability will not help, as many use credit cards to purchase on eBay. However, much of eBay's business comes from people trying to save money and many people might look to eBay in tough times as a way of selling some items they don't need to raise cash. Even if one assumes a recession-depression next year, and a 20% earnings miss, eBay still trades at 12 times trough earnings. That's something I could live with. I am not expecting eBay to earn $1.94 next year.

My only hesitation is that according to Barron's, Wedge Partners believes eBay will have an earnings miss this quarter. Wedge Partners is a research firm that does excellent work. If the earnings miss is coming now, I might consider waiting until after earnings. The jury is still out.

Squeeeeeeze Observations

  • That was a sight to be seen. First the Fed didn't cut rates and the Bears attacked taking the S&P down 18. Once the Bears were completely off guard the Fed leaked out the news that they were going to throw a lifeline to AIG, catching the Bears with their pants down. The S&P was up as many as 22 points.
  • A 40 point rally in less than an hour. That's why they say the biggest rallies occur in Bear Markets.
  • I still don't think we are done going down.
  • If only the Fed was as adept at managing the economy as they are in squeezing shorts we wouldn't be in the mess.
  • What am I doing? Nothing. So much rests on who is going to bail out what. I have no edge.
  • Someone needs to inform the Fed that the Bears are not the problem. Its the economy and the mess they helped create.

More More Capital Observations

  • I said earlier that the market looked like it could rally because of the heavy put buying at the open.
  • The S&P is up 9. The ISE Put Call has moved to neutral and the VIX is down. Sentiment is no longer supportive of a further rally. That does not mean it can't happen.
  • Can we be at a good bottom if people are so quick to embrace a rally?
  • Why did the FOMC meeting stop me from playing the rally this morning? I think too many people are pinning their hopes on the FOMC. I like to buy when there is no hope.
  • They say you shouldn't keep all your eggs in one basket.
  • I would rather keep all my eggs in one basket and watch it like a hawk. Right now my basket consists almost entirely of cash.

More Capital Observations

  • The markets opening was met with put buying. That is much better than yesterday when calls were being bought.
  • I was bidding under the market for some Conoco Phillips (COP) but it got away from me.
  • Technology does not want to go down. Looks like I should have held on to eBay.
  • While I don't think this is over we could see a rally today.
  • That said, I am not playing for one.
  • A lot can change after the FOMC meeting.

Morning Observations

  • Isn't it amazing how all the analysts had the foresight to lower Goldman' s earnings estimates in the last few weeks to the exact range where it came out? Its a wonder that they didn't see the credit crisis happening.
  • The market is looking much lower on Goldman's earnings. I would usually love to buy into this kind of mess for a trade but the FOMC meeting later in the day is too much of an unknown.
  • It might seem as if AIG being bailed out or the Federal Reserve lowering rates will cure all that ails us. However, AIG is not the problem, it is a symptom of the problem. If AIG is bailed out another problem will arise.
  • Our Current Account Deficit is 6%. These imbalances grew over a long period of time. They will not be solved in one day.
  • Best Buy missed earnings. It seems that lower gas prices are not the only factor in people buying 60" plasmas. Retail should get hit. As a function of discipline I will probably use the weakness to unwind my retail short.
  • Many are pointing to the positive divergences yesterday. The S&P made a new low while the number of individual stocks making new lows was 792. On July 15 there were 1304 new lows. While I am not ignoring that I would point to the fact that the market is not done going down and new lows can still expand.
  • I am starting to make a shopping list of stocks I want to buy. Im not quite ready to use the list but I'm keeping it handy.
  • Does anyone else think that Greenspan should just keep his mouth shut? Greenspan was to this crisis what Pamela Anderson's chest was to Baywatch.

Animal Spirits

Good Morning. While I don't believe we have seen the end of this decline, I believe that yesterday was the beginning of the end. The final phase of a decline is the capitulation phase. Up until yesterday people were still trying to catch a bottom but by the end of the day they were dialing 1-800-GetMeOut.
Once the capitulation phase begins we are usually a few days to three weeks away from a good bottom. I believe we could get a nice rally into year end. That is the good news. The bad news is that the capitulation phase is not over and a lot of damage can be done in a short period of time during the capitulation phase.
At some point I will start scaling in to some exposure. If the VIX pops over 40 it will be a no brainer but I have no hard and fast rules. In this phase people's animal instincts take over as they are hard wired to run from danger. While our primitive instincts were helpful in the survival of the human species, they are a hinderance in investing. Hopefully, I will be able to ignore mine and run into the fire at the right time.

Closing Observations

  • What were the people buying the market on the Lehman bankruptcy thinking?
  • I suspect it is that type of thinking that caused the Lehman bankruptcy.
  • Once the market starts going down like this it means we are getting close to a good bottom time wise. However, the end of a decline is usually the most severe price wise.
  • The VIX is over 31. Once the VIX reaches 40 it will be very hard to justify not buying stocks for a trade.
  • Now that we have broken every support level we will be able to shake out the weak hands. That will lead to a better rally.
  • The next time I kick myself for missing a trade because I was too cautious, I hope I remember today.
  • My prayers go out to all the families that are suffering from this mess. Good night.

Are We There Yet

There are many Wall Street sayings that advocate buying when times are bad. "Buy when there is blood in the street", " Buy at the sound of canons", "Be greedy when others are fearful and fearful when others are greedy". I live by these sayings, however too many people are trying to catch a bottom. The reason these sayings work is that in bad times, many market participants want out any price. Once the sellers have exhausted themselves the market starts to rise.
In this market people are more scared of missing the bottom than losing money. I heard more talk this morning about what and when to buy than what to sell. I was amazed that the opening was bought aggressively. Last week, the government took over Fannie and Freddie. This week Lehman went under and Washington Mutual and AIG are on their death bed. If I told you a year ago that would happen what would you say would happen to the market? When janitors with bad credit were able to get 106% loans on $700,000 houses I thought I was losing my mind. When I saw the opening bought aggressively today I was sure of it.
I don't think we are close to a bottom. I am in capital preservation mode with only a short on the retailers. Be careful.

Amateur Hour

I used this latest lunch hour dip in SPY to unwind my position. While I succeeded in my original goal this morning of getting out of eBay with minimal damage, I am not proud of the manner in which I did it. In investing the most important thing is the process, not the end result. If you go into enough high probability situations eventually you will make money. At the same time one can make money going into a low probability trade through luck. Today, I made a few low probability trades.
  1. I should not have shorted the S&P opening down over 30 points even if it was a hedge. Big gap down openings should not be chased.
  2. I thought this time was different as surely this would wake everybody up to the severity of the situation. Thinking that this time is different is OK. Betting that way is lethal.
  3. After I unwound eBay, I held on to my hedge even though I did not have an intention of shorting the market. Never let a trade turn into an investment.
Luckily, everything worked out but I feel that my trading today was amateurish. Hopefully, we all can learn from my mistake. I still think everyone is whistling past the graveyard.

Quick Update

While I am shocked that the market is rallying, I am not going to let a position (SPY) that was meant to be a hedge turn into an investment. I put a stop loss in. I am not happy right now!

Quick Note, Part Two

  • Punted eBay at a much smaller loss than I could have imagined
  • holding on to SPY so I am medium net short now
  • People are actually buying more calls than puts at the ISE. Unbelievable! What will it take to scare them?

Quick Note

  • I was net market neutral coming into the day as I was short retail (RTH) and long eBay (EBAY)
  • I shorted some SPY against my eBay position, so I would describe myself as slightly net short

Morning Observations

Good Morning. It is a sad day as Lehman employed 25,000 people with families. We are now facing the realization of what years of excess has brought us. Bailouts, 1% interest rates, 0% financing, no money down, NINJA loans. This is the other side as we now have to pay the piper. However, this is part of the healing process. There will be good times again after we make adjustments. The primary adjustment will be for Americans to live within their means. Our 6% current account deficit must be dealt with. This will be achieved through lower consumption and a reallocation of resources. More Americans will need to work in goods producing sectors that the rest of the world wants instead of in money shuffling sectors. Here are some thoughts for the more immediate future:
  • People were probably positioned for an up day as the Bear Stearns and Fannie weekends brought stock market rallies. This should exacerbate the downside.
  • Many are using S&P 1215 and S&P 1201 as stop loss levels. It could get uglier if we break those levels but it will also get rid of the renters. That should help produce a better rally at some point.
  • "Buy when there is blood in the streets" comes to mind. While these days are usually good times to buy I would prefer if this came after a long decline where we were already oversold.
  • The key will be the debt markets and how it reacts to this.
  • I dont plan to do much trading today but those type of plans have been known to change.
  • Good luck and be careful.

Weekly Strategy

Please note: This weekly strategy is being written Sunday morning without knowledge of how the Lehman situation will evolve but regardless of the outcome it does not change my approach.

I am operating under the assumption that we are still in a Bear Market. It may seem late in the Bear cycle, as consumer weakness, credit card delinquencies and housing problems usually manifest at the bottom of the cycle. However, this time around these problems started before unemployment rose, whereas in a normal cycle they are the result of unemployment. Unemployment is now just starting to accelerate to a recessionary level and these problems are likely to worsen before they get better. In addition, S&P earnings estimates have yet to come down. I believe that once the slowdown in global growth, weaker consumer spending and further credit contraction manifest, estimates will come down in a big way. Anecdotally, I speak to a lot of small business owners and almost all are saying that business is as bad as it has ever been. Smaller companies are leading indicators as they more often deal with the end user and have smaller lead times and backlogs.
However, nothing goes down in a straight line and it is certainly possible that we could witness a Bear Market rally. Sentiment surveys are showing that bearishness is at the higher end, while not yet extreme. Put buying picked up at the end of the week despite the higher market. The energy and materials sector are deeply oversold and certainly have room to rally. In addition, the market ignored bad news at the end of the week and rallied.
While a case can be made for a rally I will take a pass. If I miss it there will be other opportunities. In a Bear Market, I am only willing to get long when the market is severely oversold and sentiment is extreme. By my measures they are not. The surprises in a Bear Market are usually to the downside. If I am going to take that sort of risk I want a fater pitch.

Weekend News

Last week I tried to debunk the myth that Manhattan real estate prices can't go down. Manhattan prices are already down according to the New York Times:

"A review of closing co-op and condominium prices in July and August shows average Manhattan closing prices off 7 percent in the third quarter to date, and median prices off 6 percent, compared with the previous quarter, but above the levels of a year ago. "

The only reason prices are above the level of a year ago is because The Plaza Hotel and 15 Central Park West apartments have been closing this year, skewing the average.

Another New York Times article looks at challenges Manhattan is facing as a result of the chaos on Wall Street:

"Now New York City officials and economists are worrying even more about the future of the city’s financial sector. New York City will surely remain a leading center of global finance when the current crisis is over, they say, but its days as the clear leader may be ending."

On to a different subject. While the stock market has been cheering every government bailout, there is a price tag to them. We are now beholdent to our loan sharks. From the WSJ:

"In an effort to prevent an exodus of foreign investors from the two struggling mortgage titans, a senior U.S. Treasury official made phone calls to large Japanese investors Thursday to explain its latest rescue package for Fannie Mae and Freddie Mac ... The unusual move came after at least one Japanese investor sold a chunk of its investments in debts issued or guaranteed by Fannie and Freddie during recent weeks."

Sold on eBay

  • I have been watching eBay get cheaper and cheaper. It now trades at 11 times earnings net of cash. I finally pulled the trigger and bought some eBay (to be precise I sold puts).
  • That makes me market neutral because I am still short the retailers (RTH)
  • Beside the greater than 3% drop, what made me pull the trigger was this article "Cramer called this company “hapless.” Stay away from eBay."
  • I have nothing against Jim Cramer but he's not the best market timer I have ever seen.
  • Did you notice GE is down 6.3% on no news? Their financing unit has been immune thus far to the financial contagion or has it?
  • Can Hurricane Ike compete with the financial storm that will hit us in the next year?
  • Do you think Hank is counting the hours until he's jobless?
  • Do you think Hank and the Plunge Protection Team have been working overtime lately?
  • This article makes me reconsider my bearish stance. Maybe we do need one more rally to clear out the Bears?
  • Have a great weekend!

Midday Observations

  • Commodity stocks are continuing their rally from their deeply oversold condition. While the old winners, like retail, are lagging.
  • Now that everyone is expecting a Lehman and Washington Mutual resolution over the weekend, will traders sell the news?
  • What if their is no resolution?
  • What if the hurricane hits? What if the hurricane doesn't hit?
  • Get my point? With so many unknowns I'm waiting for a better pitch.
  • Aren't weekends so much better when you don't have big positions on?
  • I mentioned this morning that credit spreads have been widening so its only fair that I mention that they are coming in today and treasury rates are higher.

Party Pooper

Good Morning. While yesterday's turnaround was impressive and the market certainly has room to rally, there were plenty of things wrong with the market. I don't see the value in repeating what everyone else is saying, so while everyone is fawning over the turnaround, here is the other side:
  • As much as everyone hated the market yesterday morning, they loved it by the afternoon. At a good bottom people don't embrace the rally so quickly.
  • While credit spreads came in the day of the bailout they have been steadily widening all week.
  • 10 year yields remain very close to their lows showing that treasury investors believe the economy will continue to weaken. The bond and stock market are telling two different stories. I know who I think has more credit (no pun intended).
  • On the NYSE there were actually more stocks down than up (negative breadth) yesterday. That is amazing considering the market was up 1.5%. I looked back over the past year and found nothing like it. There were a few occurrences where the market was up slightly and breadth was negative. Market action over the next few days was subdued at best.
  • There were 499 new lows on the NYSE yesterday. Last Friday, when we reached the same levels there were 321 new lows. A negative divergence.
That said I am not yet shorting this market. The market certainly has room to rally as sentiment has room to improve and commodity stocks work off their oversold condition. The points I made are not so important in the very short term but speak to the ultimate quality and sustainability of the rally.

Closing Observations

  • Does anyone really think that this mess we are in will get better just because John Mccain gets elected?
  • Isn't Bush a Republican too?
  • Yesterday, stocks widely owned by hedge funds did well for the first time in ages. Today, the outperformance continues with Mastercard up over 5%. Energy and material stocks are up as well.
  • Even more impressive is that energy stocks are up despite oil being down sharply.
  • Does a rally to relieve the oversold condition in hedge fund owned names need to play out before the market can reverse lower?
  • It looks like the game of Jenga we call the stock market is still on.
  • It looks like I still might get my chance to short this market. Have a good night.

Put Your Money Where Your Mouth Is

I have been asked numerous times why I am not heavily short this market given that my big picture view is bearish. There is a saying that in a Bear Market nobody makes money. Not the Bulls and not the Bears. I believe there are a number of reasons why this is the case. The prime reason is that the most vicious rallies occur in Bear Markets. During the 2000-2003 Bear Market there were multiple rallies of over 20%. If one pressed their bets at the wrong time the consequences were disastrous. At the same time a Bear is not immune to the temptation of trying to catch a falling knife or two.

The way I like to play a Bear market is to wait for extremes. During the rally in May everyone got bullish and the Bulls started to overplay their hand. All the indicators showed it whether it be option indicators, overbought/oversold indicators or sentiment surveys. That never happened during the rally we just had off the July lows. While I readily admit that we probably put in a top for this move and are on a new leg down, jumping in here is just not my style. I don't like to chase moves. There will be other opportunities. While I do have a small short position that I put on a few percent higher, it is relatively small. If we do get a rally into the election I will be in a position to use the strength to get short, instead of getting squeezed.

Mr. Brightside

  • S&P 1215 was the closing low for the year and S&P 1201 was the intraday low for the year. I believe that technicians using these levels as a buy point are the Bulls best hope for the day.
  • If I was inclined to play the bounce I would do it through commodity stocks, but I'm not.
  • My sole position is a short on the retailers.
  • Since in my morning piece I gave the dark side, these are the positives I'm seeing:
  • Most sentiment surveys show that market players and advisers are negative on the market. Contrarily, that is a bullish signal.
  • Hedge funds are at a historically low net long exposure. That has been a good contrary indicator in the past but redemptions and large losses might have something to do with it this time around.
  • Even if the S&P makes a new 52 week low today the amount of 52 week lows in individual stocks should contract from the last time we were at these levels. Also, the banks are not making new lows. Both are positive divergences.
  • Do you think Hank and the Plunge Protection Team want the market cratering before the election?

Plunge Protection Team

Last week, in the article Stacked Deck, I alluded to the fact that the government might be intervening in the market privately as well as publicly. I don't want you to think of me as a conspiracy theorist that wears a tin foil hat. There is a "Plunge Protection Team" that intervenes in markets officially called the President's Working Group on Financial Markets. Don't take my word for it. Here is an excerpt from an article in The Telegraph from January, Bush Convenes Plunge Protection Team

"On Friday, Mr Bush convened the so-called Plunge Protection Team for its first known meeting in the Oval Office. The black arts unit - officially the President's Working Group on Financial Markets - was created after the 1987 crash.

It appears to have powers to support the markets in a crisis with a host of instruments, mostly by through buying futures contracts on the stock indexes (DOW, S&P 500, NASDAQ and Russell) and key credit levers. And it has the means to fry "short" traders in the hottest of oils."

What The Put Call Ratio Is Saying About The Market

Below is a graph of the Put Call Ratio(10 Day Moving Average of the CBOE Put Call Ratio). When the line is at the top of the page there is heavy put buying, which indicates fear and is usually seen at market bottoms. I marked the peaks in the ratio with a red X, which roughly coincided with this years major market lows. As you can see we are nowhere near prior peaks of put buying and have probably not put in a good bottom.
The highest peak coincided with the March low, which produced the largest rally this year. The lowest peak coincided with the July 15 low, which produced the weakest major rally this year. In order to get the type of low we had in March there is a long way to go.

Some people are arguing that the option ratios are no longer useful because people now use inverse ETF's to hedge. However, this methodology seems to be working this year. This does not mean the market can't rally. It only means that any rally from these levels is likely to be weak.

On the bright side hedge fund positions saw some relief yesterday. Major hedge fund holdings like MA, V and COP were up after going down mercilessly for weeks. It is possible that funds are done liquidating.

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  • Energy stocks outperformed financial stocks by 5% today. Hedge funds have officially unwound their positions.
  • This market reminds of a game of Jenga.
  • Did you know that Colgate, the toothpaste maker, trades at 24 times earnings? Where's the growth to justify that PE going to come from? Did they figure out a way to make the British brush their teeth?
  • Is it such a sin to hold cash that managers would rather hide from the recession in Colgate?
  • Maybe they should add a .com to the end of their name and do a two for split.
  • Wall Street analysts are very positive on the stock.
  • At the end of a Bear Market even the hiding places get hit.

Midday Observations

  • While the near term direction of the market is tough, I have a hard time seeing how stocks go higher in the longer term.
  • What happens if one morning we wake up and Lehman finds a suitor? Would you want to be short for that?
  • I believe that the trade that has been killing hedge funds is now over (commodity stocks down, financial stocks up). However, I believe hedge fund's troubles are far from over.
  • Technology stocks have been getting killed as hedge funds unwind their positions. It looks like they are getting some breathing room today as well. I believe they should continue to outperform in the short term.
  • Why is it that every small business owner I talk to is having such a hard time but S&P earnings ex financial companies are holding in?
  • Fannie Mae and Freddie Mac are insolvent and in government hands. What can we trust?
  • I think in the next few years there will be a time when bargains are abundant in the stock market. However, no one will want to touch them because they have been burned so bad. The key is to have money when that time comes.

Hedge Fund Woes

According to a Goldman Sachs report released a few weeks ago hedge funds were overweight commodity stocks, while they were short financial stocks. For weeks on end this trade went against hedge funds. The process became self feeding as the more this trade went bad the more hedge funds needed to get out causing the trade to go even worse. For the first time in a long time energy stocks are up while financial stocks are down. It appears the vicious cycle is over, at least for now.
It is hard to know what the effect of the ending of this trade will mean for the broader market. While one source of instability is gone many others are still around. While I have some positions that will benefit if this trade is over my main goal is to protect my capital. There will be times when there will be easier trades.

Preferred Shares

Many banks who needed capital were able to issue new shares in May. However, in June it became a harder sell. Banks that needed capital issued preferred shares.
According to the Treasury plan for Fannie and Freddie the government must first retrieve all of its money before any money goes to preferred shareholders. As a result of the Treasury plan preferred shares in Fannie and Freddie plunged. Issued in May for $25 some are now worth $3. This has led to a large selloff in preferred shares across the board. From Bloomberg:
"Prices of fixed-rate preferred stock fell an average of 9 cents to 71.5 cents on the dollar this week, according to Merrill Lynch & Co. index data, the biggest two-day drop in more than a decade. The 11 percent decline compares with a 1.4 percent drop in the Standard & Poor's 500 index over the same time."
This probably means that the next time a bank needs money preferred shares are no longer an option. A share offering highly disadvantageous to existing shareholders is the most likely outcome if banks can even raise money.

Quick Observations

  • I read the Lehman Brothers Press Release and it seems to me not much is new. That they made such a big stink over this shows that they are desperate. Here is the release
  • A higher open is actually bad for the Bulls. It allows the Bears to get good prices on their shorts. A lower open that flushes out the weak holders and gets the short sellers in at lower prices would bode better for a higher close.
  • While I have no skin in the game yet I believe that oil will reverse higher by tomorrow.
  • Even if the Treasury Plan lowers rates it will not speed up the economy as we have overbuilt. From the Wall Street Journal : Mall Glut To Clog Market For Years. How will lower rates get rid of excess inventory?

Mission Not Accomplished

In a bear market the only time it is safe to buy stocks is when stocks are extremely oversold and sentiment is extremely negative. Right now, stocks are not oversold on a short term or long term basis (Please see charts below). Sentiment is clearly negative but it is not yet extreme. The VIX is under 26 while in the last bear market it was over 40 numerous times.
On the bright side there was a whiff of fear in the air yesterday. We saw the most put buying since March on the equity side of the ISE and CBOE. Although, before the March lows we had numerous days with this level of put buying before a bottom. While we could see a rebound we need to see more days like yesterday to get a lasting bottom.
Oil and material stocks are in complete free fall. I find that this type of action usually happens at the end of a down move. It seems everyone is now bearish on oil and calling for $80 oil. I believe that purchases at these levels will be rewarded when a bounce does arrive.


Today the market did not distinguish between stocks. Everything was down. The scary part is that the VIX is still below 26. During the last Bear Market the VIX would get over 4o before the market would have a good rally. I don't want to imagine where we would need to go for that to happen. If I wanted to look for a glimmer of hope it is that there was heavy put buying today. In addition, oil and material stocks seem like they are in their capitulatory phase. I am staying short retail and long the Euro. Have a good night.

Hedge Fund Woes

Good Morning. I feel like a broken record every day pointing out how fundamentals no longer matter in individual stocks. Whatever hedge funds are overweight goes down and whatever they are underweight goes up. It seems like the mainstream media is finally picking up on this as there were numerous articles in today's papers on hedge fund woes and deleveraging. Once something becomes front page news it is usually late in the trade. I am going to start taking the other side of that trade as I believe we will get a strong snapback once the unwind is done. I took a small short in RTH during the late day strength as a starter position.
  • This morning oil is down $1.50 sitting on heavy support at $105.
  • At the same time we are starting to hear calls for $80 oil. A good contrarian signal.
  • Financials are suspiciously weak in the pre market this morning.
  • Could today be the day the unwind trade finally turns?
  • While I am bearish on the market my biggest reservation is that too many people are in the same camp. That is why I believe that a push higher that makes people more constructive would provide the perfect shorting opportunity.

Credit Spreads Little Changed

The Bull case on the Treasury bailout is that this would relieve the credit crunch. However, the improvement in credit spreads thus far has been mostly limited to the mortgage market. Preferred shares were broadly lower making yields higher. The Wall Street Journal reports that corporate spreads did not fair much better.

"junk-bond spreads remained at their widest levels of the year, at 8.55 percentage points above Treasury bonds, while investment-grade corporate bond spreads rose by 0.01 percentage point to their highs at 3.22 percentage points above Treasury bonds, as concerns about the weak economy linger"

In addition, yields were pretty steady on government bonds signaling that bond investors do not believe that this plan will do much to stimulate the economy. The bond market is more reliable as a barometer of the economy than the stock market.

Have A Good Night

I pointed out the heavy put buying this morning. That was the clue that people did not trust the rally and probably the reason the market was able to hold on. It is hard for me to see how this market can go much higher. There are some shorts to squeeze but with the economy faltering and the cracks in our financial system exposed I can't imagine who would put money into this market other than for a trade.

Everyday seems the same as technology stocks and energy stocks underperform financial stocks and retail. The trade is completely self feeding now as more liquidations in hedge funds cause more hedge funds to unwind the trade. Respecting the fact that these unwinds almost always last longer than anyone can imagine I used the late day strength to begin a short in RTH. I expect RTH to go higher and I will use that strength to build my position. Longer term I believe retail is going lower so I chose to fade that part of the unwind. Going long energy stocks would probably give me the biggest bang for my buck but I believe oil is going lower in the intermediate term. Have a good night. Hopefully this will get easier.

Stacked Deck

It is clear as day that many people had advance information of the Fannie and Freddie bailout. On Friday the market mysteriously started rising in the morning with financial stocks taking the lead. In addition, the government has been intervening in the markets on a regular basis this year both publicly and possibly privately. It is the equivalent of being in a poker game where some of the other players see the cards in advance and the rules can change at any time. I would rather just not play unless I see a situation where I can absolutely not lose.

A few observations
  • I saw preferred shares of FNM trade to 3 from 14. Most preferred shares started the day up but are now down. Banks have been using the preferred market as a source of capital. After the FNM loss I believe that door has shut. Banks will now have to sell common stock and cut dividends in order to raise capital.
  • It seems that fundamentals no longer matter in individual stocks. Whatever hedge funds are overweight goes down and whatever they are underweight goes up. This is causing large disparities in valuations. I will be looking for signs of a turn in that trade.
  • Parents cut back on their kids last. If back to school shopping was weak, how will Christmas look?
  • Then why are retail stocks doing so well? Guess who is underweight.
  • Why is Lehman down? Look what happened to people who put money into FNM. Capital raising might be a little harder and going to the government for help will wipe out shareholders.

Opening Observations

The strong open has been faded by market players. This is what I am seeing:
  • The pattern of out performance of financial stocks and consumer discretionary over commodities and tech is continuing.
  • There are a lot of Puts being bought. While the market fade should be concerning to the Bulls it would be more concerning if there was heavy call buying.
  • What would make for a great shorting opportunity in my opinion?
    • S&P 1320-1350
    • Financial companies using the rise in prices to issue more common stock to the public (ie. not to sovereign wealth funds or private equity)
    • Heavy call buying
There are hard calls and easy calls in the market. I believe right now this is a hard call, especially because the market pulled back already. I want to protect my capital and wait for an easier pitch. If I miss my opportunity to short at least I don't lose any money. Be careful.

Mission Accomplished

Good Morning. Its a bright new day. The S&P Futures are surging as people are equating this event to the Long Term Capital bailout, the Bear Stearns takeover and the surprise Fed rate cuts. While all those events were excellent short term buying opportunities I believe there is a very important distinction between those events and our current situation. All those events happened after a market panic. A large part of those rallies were a result of the cessation of panic and the relieving of the oversold state of the market. Currently, we have not had a market panic and are actually overbought.
There is a large short base in the market that can fuel a market rally. However, I believe that rally would be an excellent short selling opportunity. Fannie Mae and Freddie Mac will not be aggressively expanding lending under the government plan and hence this plan does not change much. As I have previously said it averts a disaster but a disaster was not priced in. Quick and easy solutions will not clear up a decade of excesses. Hope is the enemy in a Bear Market as Bear Markets fall down the slope of hope. While the bulls are now hopeful I don't believe this is the cure to all that ails us.
  • The Bull case is that this will alleviate the credit crunch. Watch corporate and bank spreads to see if the bull case holds any water. While they will rally the question is how much and for how long?
  • The heavily shorted areas of the market, financial stocks and consumer discretionary should be the standouts.
  • There is potential for something special in the financial sector. Many will learn the meaning of the saying "The market can stay irrational for longer than you can stay solvent".
  • Will this bailout help people who can't pay their mortgages? What does this do to bank losses from people who default?
  • Will people charge the US government more to borrow now that they have taken on 5 trillion dollars in obligations? How much will lower spreads be offset by a higher government bond yield?
  • Karl Marx would be smiling.
  • One would have thought that the failure of two institutions that play an integral part in our economy would give people some pause. Does that mean we have not learned anything and have a long way to go in this adjustment period?
  • The fact that the Treasury is actually buying Fannie and Freddie debt is smart. Considering that they are now guaranteeing the debt they might as well earn the higher rate.
  • The preferred shares of Fannie and Freddie will be the equivalent of an option on Fannie and Freddie while the common stock will be more like lottery tickets.
  • As much as I hate to admit it the government actually did well in the structure of the bailout. That said, it is a sorry state of affairs.

Weekly Strategy – Great News

News Friday that two of the largest US Corporations are worthless and that the cleanup bill will be footed by the taxpayers was greeted with a huge rally by financial stocks in after hours trading. While in the short term this news might be viewed positively or cause a massive short squeeze I don't see how this inspires confidence in US stocks longer term.
As I write this the full details of the plan have not been released. It is hard to believe that Fannie and Freddie will be aggressively expanding their book of business now that they are under government control. At best, they will continue what they are doing now which has not been enough to prop up the housing market. While a disaster might have been averted I don't believe a disaster was priced into the market.
There is very high short interest in financial stocks and it is possible that shorts will be squeezed causing a rally. If that rally brings hope of a recovery I believe it will be an excellent short selling opportunity. Ironically, short selling in a Bear Market is very difficult because at times there are vicious short covering rallies. The only time one can short with minimal danger is when the shorts have already been squeezed and market players are positioned for a recovery. While I am not convinced we will get there, a rally into the S&P 1320-1350 range would be a gift. Real Estate and Retail stocks are heavily shorted as well. If they rally hard I will look to put out shorts in those two groups specifically (I will lay out my case for for shorting Real Estate and Retail later in the week).

Manhattan Real Estate Can Withstand Nuclear War

It amazes me that the vast majority of people in New York City I speak to still believe that Manhattan real estate can not go down. Even after seeing the tech bubble, real estate bubble and credit bubble burst they believe that Manhattan is immune.
The main arguments are that there is no more land in Manhattan or that the Europeans are going to buy up everything because its cheap to them. Never mind that most of the people who are buying 1.5 million dollar two bedroom apartments work in finance and will probably get a nice bottle of whisky as a Christmas bonus this year if they are lucky enough to keep their jobs. Or that it is nearly impossible to get a jumbo mortgage. Or that there are over 10,000 apartments in the construction process right now.

In reading the papers today I came across a few article that are exposing cracks in the Manhattan real estate foundation:

From the New York Times, Foreclosure Makes Its Move On Manhattan:

"Jessica Davis, the president of Profiles Publications Inc., which tracks foreclosure filings, has seen a marked increase in Manhattan filings in the last two months — a jump that she saw in Queens and Brooklyn a year ago."

A Barron's article talks about how the largest real estate deal in the history of Manhattan, Stuyvesant Town, might be in trouble, among other high profile deals.

"The foundation is buckling beneath several debt-heavy Manhattan apartment deals. Who will be left holding the bag?"

Since the Europeans are going to save us I thought this article from the New York Times was interesting, As Consumers Buy Less, Europe's Economy Slows :

For the first time in more than a decade, consumers in much of Europe are buying less than they did a year earlier, and that is helping to slow economies that may have fallen into recession."

I take it the Europeans are saving up so they can buy our real estate.

Hanky Panky

A few short hours ago I wrote "Now that the Republican National Convention is over the Treasury might announce their plan for Fannie and Freddie". Little did I realize that we were just a couple of hours away from an announcement. From Bloomberg:

"Treasuries fell amid speculation the U.S. is close to reaching a plan to help troubled mortgage finance companies Fannie Mae and Freddie Mac, easing the haven appeal of government debt."

Here are the first thoughts that come to mind:
  • This is definitely meant to spur the market higher into the election. In the short term the S&P futures are up 15 but will it work longer term?
  • While this does avert a disaster, does it change anything in the real economy?
  • Judging by the market action today some market players had this information in advance. That's wrong.
  • Will this be enough to get the XLF (financial spyder) to break out. In after hours the XLF is at 22.42 and flirting with a breakout.
  • If the XLF breaks out will hedge funds cause a giant short squeeze in the financials? They are very short the sector and don't have a high tolerance for pain right now.
  • Fannie and Freddie's combined market cap is 11 billion dollars. Even if the plan leaves the equity holders of Fannie and Freddie with nothing the positive liquidity effect on the financial system should dwarf the loss to shareholders.
  • The more important thing to look at will be how it effects preferred shareholders as many financial companies hold preffered stock.
  • If this does take the market higher I will want to short the market at some point.
  • The only question is when.

Wrap Up

I am calling it a week. Have a great weekend. Be cautious as there are more unknowns out there than any time I can remember

  • Once again the Financials and Consumer Discretionary were the out performers while Technology and Energy are lagging. Not the best outcome for hedge funds as they are not positioned that way (see my post from earlier in the week on hedge fund positioning).
  • Will there be more hedge fund blow ups next week? What happens if there aren't?
  • A Lehman resolution is possible next week. Being that it is highly anticipated it will be interesting to see if the news is bought or sold.
  • Now that the Republican National Convention is over the Treasury might announce their plan for Fannie and Freddie. Did you really think they were going to upstage themselves?
  • Ever since I started writing this blog I have received more business propositions from people I don't know than a $5 hooker.
  • Somehow all the propositions involve me giving them money.
  • Did it seem crazy when I was considering buying the SPY this morning?