Friday, March 7, 2008

Weekend Weimar and Beagle

Sorry to be so late in posting this. I was in court all day. But anyway .......

The markets are closed (thank god, right?). So it's time to forget about the markets for the rest of the day.

It's the Leverage, Stupid

From the WSJ:

The financial turmoil is taking on a new dimension: Banks that lent money to hedge funds and other big risk-takers are asking for some of it back.

Loans from banks and brokerages had allowed hedge funds, which manage some $1.9 trillion in clients' money, to amass many times that amount in investments. But as the value of mortgage-backed bonds and other investments has dropped in recent weeks, the lenders are demanding that borrowers put up more cash or assets.

This is producing a negative cycle that has policy makers deeply worried. When investors rush to dump assets, prices fall and lenders feel compelled to make further demands, or "margin calls," which cause even more selling.

So far, the turbulence touched off last summer hasn't resulted in many big hedge-fund blowups. If that changes, banks and other financial firms could end up holding even more hard-to-sell securities. Already, their troubled investments, especially in securities tied to mortgages, have cost them some $140 billion in write-downs.


The funds facing the greatest pressure are those that are highly leveraged, meaning they have large borrowings relative to the money entrusted to them. Carlyle Capital managed only $670 million in client money, but used borrowing to boost its portfolio of bonds to $21.7 billion, meaning it was about 32 times leveraged.

Who are these idiot lenders in this deal? Didn't anyone ask about the clients current margin situation? Was there any disclosure in this deal? It's looking more and more like lenders just made loans without even thinking about looking at the client's financial situation at all.

Thursday, March 6, 2008

Why Isn't the Bond Market Selling Off From Inflation Fears?

While the 20+ year end of the Treasury Market has dropped below its year-long trend line, it isn't selling off that hard.

The 7-10 year part of the market is also still clearly in an uptrend.

The short end is still rallying as well.

Let's review what moves the bond market.

1.) Interest rate policy. When the Fed is lowering rates, previously issued bonds (which have a higher coupon) are more valuable. This means investors will buy them, increasing prices.

2.) Safety: In times on uncertainty, investors seek safe havens. That means government bonds.

So -- we have two strong reasons for the Treasury market's rally over the last year. But

3.) Inflation eats away at the interest rate received by bond investors.

Considering we've had some really nasty inflation reports lately, the bond market should be selling off, right?

Maybe not. While I am still extremely worried about inflation, my friend New Deal Democrat is not. He offers the following chart and explanation as to why inflation is not a problem.

Below is a graph showing how inflation tends to play out over economic cycles. The blue line is consumer inflation (cpi). The red line is producer inflation (ppi) which is the rate at which costs are increasing to producers. The green line is household debt.

A regular pattern of cpi vs. ppi inflation unfolds over economic cycles. Consumer inflation is relatively tame, but consumer inflation starts out very low, and considerably less than consumer inflation (the red line is under the blue line). Simply put, producer costs aren't rising as fast as consumer prices can be increased, and increased production and sales leads to increased profits. Over time, both consumer and producer inflation increases. Ultimately, producer prices increase faster than consumer prices.(the red line is over the blue line). Producers aren't able to pass on their increased costs to consumers, and their profits decline. When their profits decline, they cut back and lay off employees. A recession ensues as consumers pull in their belts. Prices, especially producer prices, decline, thus setting off the next cycle.

In the graph above, you can see that just before every single recession, both the red and blue lines are going up, and the red line has overtaken the blue line. In other words, producer prices are rising, and have overtaken consumer prices. When the recession hits (the shaded area) both the red and blue lines decline, meaning that both consumer and producer inflation are decreasing.

Thanks to NDD for letting me use his piece.

A Closer Look at the Consumer Discretionary Sector

This index rose from 2003 to mid-2004. Then it sold off, but rallied again into a trading range for 2005 - 2006. After rallying through resistance in late 2006, the index rose to new highs in 2007, but has since sold-off to 2005 levels.

Since last summer, the index has shows a clear lower low and lower high pattern, indicating the index is in bear market territory.

On the 6 months chart, notice the following about the SMAs:

-- Prices are below the 200 day SMA, indicating the index is in a bear market.

-- The 200 and 50 day SMA are both heading lower.

-- The 10 and 20 day SMA just turned lower as well.

-- Prices are below all the SMAs.

A Closer Look At the Energy Sector

Record gas prices have a way of helping the energy sector

On the 5 year chart, notice we are still in a very strong uptrend. The index rose from 2005-2005, consolidated in 2006 and then continued rallying.

On the 1 year chart notice we have the possibility of a diamond top forming (although the artists skills are very much in question).

On the SMA chart, notice the following:

-- Prices are above the 200 day SMA -- indicating we're in bull market territory.

-- The 200 day SMA is still increasing.

-- The 20 and 20 day SMA are both moving higher and have recently crossed over the 50 day SMA.

My guess is we see energy consolidate but not have much of a sell-off. However, if there is a big drop in oil, all bets are off.

Today's Markets

The markets may be getting ready to break lower. Let's take a look at the charts.

The Russell 2000 has continually led the way lower since the sell-off began in mid-summer. This makes sense. The Russell 2000 is comprised of small companies that don't pay dividends. Therefore, they need a growing economy to increase sales and thereby increase share price. But when the economy is shrinking, the exact opposite happens. So when traders think the economy is going to shrink, they start to sell the higher-risk stocks like those in the Russell 2000. As the chart shows, the index has been breaking lower for the last 4 days and today printed a long downward bar on high volume.

On the 10 day daily chart for the IWMs, note the index has not been able to maintain any upward momentum since last Wednesday. That's a whole lot of negative sentiment. Finally, notice the index broke down hard in the last bar on very heavy volume.

The SPYs also broke below support today. While the volume wasn't of the "break-out" variety, it wasn't weak either.

On the 10-day daily chart, notice that this SPYs have not been able to maintain any upward momentum and are currently at crucial technical support. Also note the high volume, last 5-minute bar today -- it's a big move lower.

The QQQQs -- which have been consolidating in a triangle pattern -- are right at the verge of going lower.

On the daily chart, notice we've got a bit to go before hitting crucial support levels. But there is a ton of negative sentiment in the market right now.

It's the Leverage, Stupid

From the WSJ:

Even as financial firefighters try to douse the flames, the search is under way for the cause of the fire.

How could a mortgage-market meltdown -- losses of perhaps $400 billion, less than 2% of the overall value of the stock market -- cause so much of a disturbance and do so much damage to the U.S. economy? "After all," Federal Reserve governor Frederic Mishkin observed last week, "a 2% decline in stock-market prices sometimes happens on a daily basis, and yet leads to hardly a ripple in the U.S. economy."

And is the fire being fanned by the way commercial banks are required to keep their books and decide how much capital to hold as a cushion against bad times?

The short answer to the first question is leverage. The short answer to the second is yes.

What role do you think leverage and the way banks decide how much capital to hold played in creating the current credit mess? Readers, weigh in.

Leverage is borrowing money to make bigger bets. Invest $1, borrow $9, buy something for $10. If its value rises $2, you've tripled your initial investment. It works great when the market is on the way up. On the way down, it amplifies losses.


With money cheap, banks gorged themselves with leverage in good times, making not only risky mortgages, but increasing leverage by investing in securities that rested on the riskiest slice of those mortgages. Bank balance sheets now are on a forced diet.

"Banks gorged themselves with leverage in good times." Gee Alan, do you think this:

Had anything to do with that?

The US Says It's Supply; OPEC Says Its the Dollar

From the WSJ:

Ministers from the Organization of Petroleum Exporting Countries, meeting in Vienna, blamed surging oil prices on the weak U.S. dollar and "mismanagement" of the U.S. economy. President Bush shot back, telling a renewable-energy conference in Washington that "it should be obvious to all that the demand [for oil] is outstripping supply." The U.S., he said, must change its habits. "We've got to get off oil," he said.

Mr. Bush urged OPEC this week to pump more oil. The cartel supplies just less than 40% of world demand.

OPEC ministers said they see a well-supplied market. OPEC President Chakib Khelil said the oil market is "moving into a new phase" of slower economic growth and ebbing demand.

The oil market is interesting right now. I don't think there s one factor that is pushing prices up, but instead a strong vortex of three events

-- Chine and India and their over 2 billion people have an increased standard of living. That means they want more energy (and food).

-- The dollar is dropping and has been for some time. That means the currency that oil is priced in is dropping which is a de facto increase in the price of oil.

-- There is a flight to the commodities area as an inflation hedge against the dropping dollar. It is also the only market that is rallying right now, so we're getting a number of speculators in the market.

Let's see what the charts say about the oil/dollar price relationship.

Notice the following:

-- The dollar's chart is "down/bear market rally or consolidation/down

-- Oil's chart is up/consolidation/up.

Those charts look pretty "mirror imagey" to me. It's not an exact match, but it's pretty clear that oil and the dollar are clearly linked.

A Closer Look At the Technology Sector

Notice the technology came late to this rally. It spent 2004 - 2006 consolidation in a trading range. However, it made up for lost time after it broke out of this range in 2006 with a strong rally that peaked at the end of 2007. However, the sector has since fallen 20% and is back to early 2006 levels.

The yearly chart shows the index formed a triangle top in late 2007 but has since fallen. Also note that prices are currently in a downward sloping channel.

On the SMA (3 month) chart, notice the following:

-- Prices are below the 200 day SMA by about 12%.

-- The 50 day SMA is heading lower

-- Prices and the SMAs are tightly bunched right now.

-- Prices are in a slightly downward sloping downtrend right now.

A Closer Look at th Health Care Sector

At the beginning of the week, I stated that I was going to look a bit deeper into the market and analyze the charts of the major sectors. Today I'm going to continue by looking at the health care sector.

There are two obvious trends lines with this chart. The first connects a large number of bottoms over the last 5 years, while the second (the lower one) connects the more extreme price fluctuations. While prices have broken through the first trend line, they are resting a bit above the second (see the chart below).

One the yearly chart, there is a pretty clear triangle consolidation which would serve as a reversal formation.

With the SMA chart, notice the following:

-- Prices are below the 200 day SMA, indicating a bear market.

-- The longer SMAs -- the 200 and 50 day SMA -- are moving lower.

-- The shorter SMAs and prices are bunched up together and have been for about a month, indicating a lack of meaningful direction in the market.

-- Price movements have been non-existent for the last month or so.

Wednesday, March 5, 2008

Today's Markets

Hey -- we had another Ambac story today. That was just thrilling. Anyway.....

The short version is the markets remain mired in a trading range.

The SPYs have been trading between roughly 132 and 138 for the last month. Also notice that prices and the short-term SMAs are still bunched up, indicating a lack of overall direction. While we've had some volume increases over the last three days, overall the average volume range has been pretty constant.

The QQQQs are consolidating in a triangle pattern. Prices and the SMAs are jumbled together as well and there hasn't been a big volume move one way or the over for most of this time. Volume has picked up the last two days, but I'm not convinced that is anything more than the "Ambac" effect.

The IWMS have broken below a trend line in a consolidation pattern, but they really haven't meaningfully moved since then. Usually traders would look to a move like this as a shorting opportunity. But this move hasn't impressed at all.

OPEC Squeezing the Last Drops of Profit

From the WSJ:

With oil prices hovering near record highs and inventories flush, OPEC ministers meeting in Vienna today are all but sure to leave output unchanged. But with so much uncertainty facing the market, the group is likely to meet again in the next few months, amid deep-seated concern about the direction the global economy is taking and the implications for oil demand.

The 13-member Organization of Petroleum Exporting Countries, which supplies 40% of the world's crude, faces a tough dilemma. Were it to cut production at a time of high prices, it could get the blame if the world tips into recession. If it raises output as demand weakens, prices could nose-dive, threatening the group's revenue.

The U.S. made a last-ditch appeal to the cartel to raise output. President Bush said it was a "mistake" to have your biggest customers' economies slowing down because of high crude prices, which he warned could cause people "to buy less energy over time." The U.S. Energy Information Agency said OPEC should raise oil-production levels by between 300,000 and 500,000 barrels per day.
Oil rose nearly 20% in less than one month and trading has been volatile after OPEC signaled it would keep output unchanged. Krista Nonnenmacher, an independent market maker with AMEX, discusses the oil market and geo-political influences.

But the group is likely to sit on its hands. "It seems like there will be no change," Iran's oil minister, Gholam Hussein Nozari, said yesterday after a meeting of the committee that recommends policy decisions to OPEC.

The problem with the US' request is we're no longer OPEC's only big customer. Previously the statement from the US would have had weight. But now 1.3 billion people in China and and 1.1 billion people in India have a higher standard of living. Even if their economies slow there is now more wealth in those countries which increases their demand for oil. As a result, we get price charts like this:

And the US will simply have to get use to prices like this:

They Were Warned and Didn't Listen

From the WSJ:

A top Federal Reserve official said the central bank failed to fully appreciate risks that financial institutions were taking before the recent credit problems, and it is reviewing its regulations.

During a sometimes-contentious Senate hearing, Fed Vice Chairman Donald Kohn said the central bank is likely to become "more forceful" with the financial institutions it supervises. Mr. Kohn didn't explain what new actions the Fed might take, but he did warn banks to rely less on the assessments of credit-rating agencies.

After years of watching the banking industry make record profits, regulators are now scrambling to deal with turmoil stemming from problems in the U.S. housing market. Large U.S. banks have had to write down the value of assets by billions of dollars, including slivers of mortgage-backed debt that many believed were almost risk-free.

Mr. Kohn's comments mark one of the few times that a top Fed official has acknowledged shortcomings in regulation as a cause of the mess.

"I don't know that we fully appreciated all the risks out there," he told the Senate Banking Committee. "I'm not sure anybody did, to be perfectly honest." Later, he said the Fed "did not perform flawlessly -- I absolutely agree with that."

Now they admit things got out of hand. Well -- they have been warned. While I've been writing about the negative implications of the massive debt build-up in the US economy, I doubt Fed officials read my stuff on a daily basis -- if at all. But I'm not the only one whose been warning about this stuff by a long shot:

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of “best practices” and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

“He never gave us a good reason, but he didn’t want to do it,” Mr. Gnaizda said last week. “He just wasn’t interested.”

And here's the money quote:

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry’s excesses. Both the Fed and the Bush administration placed a higher priority on promoting “financial innovation” and what President Bush has called the “ownership society.”

On top of that, many Fed officials counted on the housing boom to prop up the economy after the stock market collapsed in 2000.

Mr. Greenspan, in an interview, vigorously defended his actions, saying the Fed was poorly equipped to investigate deceptive lending and that it was not to blame for the housing bubble and bust.

First, I'm pretty sure the standard response was, "you're being a worry wort. Everything will be fine. Self regulation will work out." Seven years later we know that's just not true.

Here's the bottom line: you have to have rules. Left to their own devices, people in powerful positions have a tendency to become greedy which in turn compromises their ethics.

A story from law school comes to mind. One day I was in the student lounge watching the news when a story came across the wire that an executive at a corporation had lied about financial figures. He overstated earnings, which would have boosted the stock price. This in turn would have made his options more valuable.

A person behind me commented, " just lose your ethics when you become an executive?"

Here's my response: excessive virtue is the result of insufficient temptation. Think about this. You're an executive with a large corporation. One day your CFO comes in and says, "we could game the numbers and make the company more profitable on paper. This should increase share value which could increase your net worth by $100 million dollars." What would you do? Anyone who says they wouldn't at least think about it is lying. Figures that large tend to do that. And when you know a whole system is gamed like that (for example, mortgage brokers who don't perform credit checks, banks and ratings agencies barely perform collateral checks) your ethics get squishier. And then you realize that $100 million buys a lot of lawyering to keep you out of jail.

While I am all for capitalism, I also realized that capitalism unleashes greed. Greed must be controlled or it will feed on itself and eventually destroy the system completely. Think I'm wrong? This chart says I'm right:

A Closer Look At Consumer Staples

As with the utility sector, this area of the market is still in an uptrend.

However -- also like the utility sector - this sector is in the middle of a broadening formation which is considered a reversal pattern.

The SMAs tell us:

-- Prices are just below the 200 day SMA, indicating we're in a bear market (but just barely).

-- Three SMAs -- the 10, 20, and 200 -- are nearly horizontal.

-- Prices and the SMAs are tightly packed indicating a clear lack of direction.

A CLoser Look At Utilities

I'm going to continue looking at various sectors of the market with a look at the safer areas -- the utilities.

The 5-year chart chart shows the sector is still clearly in a rally.

Here's a closer look at the last 1 1/2 years. Notice:

-- The average is still above the long term trend line, but

-- There is also a broadening formation occurring which is a reversal pattern.

The SMAs tell us the following:

-- Prices are below the 200 day SMA, which indicates a bear market

-- The longer SMAs (the 50 and 200 day SMA0 are clearly moving lower.

-- The 50 day SMA is about to cross over the 200 day SMA -- a bearish crossover.

-- Prices and the shorter SMAs are wrapped up around the same level, indicating a lack of direction.

Short version: expect more losses.

Tuesday, March 4, 2008

Today's Markets

Ignore the late day rally. We had another "Ambac is close to a bail-out" rumor in the market. Traders can be such lemmings.....

The SPYs, notice we're still "falling down a flight of stairs". I drew arrows from reversal points to prices where the reversal occurred to show that reversals occurred around round numbers. This probably means program trading was kicking at at the reversal levels.

The QQQQs have been in a solid downward sloping channel until today's Amback news. Then it broke through resistance.

As with the SPYs, I drew arrows from reversal points to prices to show where the turnarounds occurred. Notice the reversals occurred at clear price levels once again indicating program trading was kicking in around those levels.

The point of showing where buying is occurring is to indicate that it's not investor excitement about the market that is saving the market from falling; it's computers.

What Inflation?

From IBD:

In nearly every recorded downturn, slower U.S. demand pulled the rug out from commodity prices. Over time, those cheaper prices for inputs like oil, copper and steel provided the needed push to get things roaring again.

This time, it's the opposite. Crude is beyond the $100 mark. Gold is near $1,000 an ounce, while silver broke above $20 for the first time in 27 years. Base metals like copper are red-hot dear.

Cocoa has flown to its highest spot in 24 years, coffee is at a 10-year peak and sugar is flirting with 18-month peaks.

Wheat prices have soared so high that Italy's government has warned its people to brace for big hikes in pasta prices. No kidding.

Thank China and other emerging markets for these sky-high prices, many experts say. So far, most of the U.S. slowdown is staying in the U.S. Construction abroad is booming and factories are humming. All of these efforts need energy and metals.

Wealth is growing where once there was just poverty. Those seeing some money for the first time in their lives are enjoying better diets.

The Chinese and others are buying more meat, sharply boosting demand for feeds like corn.

They also are driving gas-guzzling cars in ever greater numbers.

So, even as U.S. demand for most commodities is waning, total demand is rising.

"This is the China Syndrome," said Earl Sweet, senior economist at BMO Capital Markets in Toronto. "The U.S. economy is probably in a recession. And that normally would lead to weakening demand for all sorts of things."

"China accounts for 50% or more of the demand growth for copper, aluminum, zinc, lead and steel," said Mike Helmar, director of industry services at Moody's

Add to that India and smaller booming markets.
That's where the new demand is coming from.

Here's a chart of the CRB overall commodity price index:

No inflation there are all.....

Commercial Real Estate: The Next Shoe to Drop?

Calculated Risk has done an excellent job of keeping up with this story.

From the WSJ:

For the second month in a row, the Commerce Department reported a decline in spending on nonresidential construction -- which includes everything from hospitals to office parks to shopping malls. The report yesterday showed construction spending fell 1.7% in January from December, the steepest drop in 14 years. While residential construction accounted for a big part of the decline, spending on nonresidential construction slid 0.8%.

Meanwhile, there may be an oversupply of shopping malls and office buildings after a period of intensive construction. It adds up to bad news for employment, the economy and investors.

While the boom in commercial construction wasn't as dramatic as in home building, the impact of a slowdown on the economy could be significant. Nonresidential construction accounted for 3.6% of gross domestic product in the fourth quarter of 2007, up from 2.5% five years ago and the most since the second quarter of 1988, according to Moody's

As home construction got caught in a downward spiral last year, nonresidential construction continued to expand at a healthy clip. Spending on nonresidential structures rose 16% in 2007, the biggest four-quarter increase since 1984, according to Morgan Stanley.

Signs of trouble cropped up at the end of the year. As credit markets tightened, office space sold in the fourth quarter dropped 42% from a year earlier, and sales of large retail properties declined 31%, says Real Capital Analytics, a New York real-estate research group.

If spending continues to slow, construction workers, who are reeling from the housing slowdown, face more layoffs. Construction jobs made up 5.4% of nonfarm payrolls in January. While that's down from a peak of 5.7% in April 2006, it's still above the long-term average of 4.9%, say economists at Payden & Rygel in Los Angeles, leaving room for more job losses.

Let's flesh out this story with some graphs.

Above is a chart of real (inflation-adjusted) non-residential spending from the BEA.

Notice the steady increase over the last two years.

Above is the percentage change from the previous quarter in non-residential spending. Again, note the last two years have seen solid increases.

Let's look at the various REIT sectors that focus on commercial activities. These charts are from

Office REITS are in a clear correction. There are two support lines in this 5-year chart, and the index has broken both of them. Currently prices are in a clear downward channel and are trading near 2005 levels.

Like the office REIT sector, the industrial REIT sector has broken a clear uptrend and is moving lower in a channel pattern right now.

Hotels have also broken the uptrend they were in for 5 years. They are also clearly correcting right now.

Here is an overview of construction employment:

Notice that construction employment has clearly turned lower over the last half year or so.

Let's look at some graphs from the latest Quarterly Banking Profile.

Commercial and industrial loans comprise 19% of total charge-offs.

While the non-current commercial and industrial loan percentage as ticked up slightly at institutions with less than 1 billion assets -- the uptick is incredibly slight and could just as easily be called statistical noise.

However, non-current commercial and industrial loans have been increasing for the last 5 quarters.

And the quarterly net charge off rates at institutions larger than $1 billion are clearly increasing.

So -- what does all of this information tell us?

1.) The GDP numbers tell us there has been a huge commercial (non-residential) build-out in the last few years. Paces of this magnitude cannot be sustained.

2.) The REIT charts tell us that traders are already concerned about the profit potential of this sector. Traders have already taken some of their profits off the table and aren't looking to get back in anytime soon.

3.) The employment picture tells us that employment is clearly declining. This chart also indicates that commercial construction was probably responsible for absorbing some of residential real estates construction job losses over the last few years. However, with residential in the tank these absorbed workers have no where to go job-wise.

4.) The banking information tells us that that credit quality is starting to deteriorate and that total net charge-offs are starting to hit the big banks ($1 billion and up) at an increasing rate in 2007. In other words, there are cracks in the commercial real estate lending world.