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May 26, 2009

Are the Credit Markets Fixed?
by Mark McMillan

5/26/2009 11:28:44 AM

Introduction

This week we discuss the state of the credit markets and offer our take on where the market is headed. We are keeping this letter somewhat brief and hope you like the format.

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The Credit Markets

On a fundamental basis, the most important thing we have seen take place in the last year suggests that some credit markets are moving into a normal mode of operation. Specifically, interbank lending is now back in a "normal" range. On Friday, the TED Spread closed at 0.487. The "normal" range for the TED Spread is 0.10 to 0.50.

Recall that the TED Spread is the difference in interest rates between 3-month (T)reasuries and 3-month LIBOR rates. LIBOR is the London Inter Bank Offered Rate denominated in (E)uro (D)ollars.

We continue to believe that the worst is not yet over for the banks. In particular, the Mortgage Backed Securities (MBS) marketplace is still mostly frozen but the Treasury and FED have plans to offer more liquidity there. Since there hasn't yet been a bottom in home prices and inventory of existing and new homes are at or near historic highs, the MBS market isn't going to move into a normal mode any time soon.

We also believe that the other shoe to fall is for Commercial Mortgage Backed Securities (CMBS). This market is going to cause financial institutions a lot of pain on top of that already being caused by the residential MBS market. The "other" two major credit markets that will be adversely affected are the auto loan market and the credit card market.

Automobile loans are secured by the vehicle. A lack of payment on the auto loan results in a repossession of the vehicle. The borrower either pays up to bring the loan back into compliance or the vehicle is auctioned off. With new car sales being down so much, it is possible that used car prices may hold up better but we wouldn't want to be holding a lot of auto loans in during a recession.

Finally, with unemployment continuing to increase, lost jobs mean more missed credit card payments and escalating default rates. So, even though we have seen interbank lending move into a normal range, this is only one of the credit markets we monitor. Interbank lending is arguably the most important barometer we monitor in terms of credit markets, but these other markets will adversely affect bank earnings for the foreseeable future.

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Market Outlook and Conclusion

This week, we will still share some charts with you, but we are going to try to keep things "out of the weeds", as the expression goes. We will be focusing on some of the fundamentals and also share what traders are looking at for the major indexes. If you would like more details about charts, write to me and let me know.

At the risk of sounding like a broken record, we experienced another pull back last week and we heard more of the, "I told you the sell-off wasn't done!" refrains from pundits. Most continue to argue that the market is headed steeply downward.

One market prognosticator that I believe has a better handle on the markets than most is bearish but not yet ready to aggressively short the market. While he hasn't presented the 200-Day Moving Average (DMA) as the place where a turnaround will occur like we have, he is refining his short candidates list. We fall into the same camp, and we are waiting for our indicators to tell us when this opportunity is at hand.

We regularly cover three things in this section. We tend to lead with the TED Spread, but as you have already read in the credit markets section, the TED Spread has now moved into a "normal" range.

We also share the closing price of the closest month for futures trading of a barrel of crude oil. Last week, oil closed near its high this year at $61.67. This indicates a price rise of $5.33 or 9.5%. We also report on long term fixed income yields. Last week, the yield for the 10-year note rose ten basis points to close at 3.448% versus 3.12% the week earlier.

We will share one of the implied volatility charts with you as they are both somewhat similar. The VIX, which is the implied volatility of the S&P-500, continues to trend downward.

The only thing to note here is that the sharp rally in the VIX corresponded with weakness in the S&P-500, which is well-behaved as the two are supposed to have an inverse relationship. That rally didn't break the downtrend. Resistance has been met around the 20-Day Moving Average (DMA) and we would expect that to continue for another week or so.

We will now take a look at the Philadelphia Semiconductor index (SOX). As we have been discussing, the market seems to be following the SOX and last week the SOX was able to move up and over the 200-DMA and close the week above that support. The bounce up off of the 50-DMA that occurred two weeks ago suggests that when the 50-DMA shoots up through the 200-DMA, the SOX should continue to rally.

We can take a look at the NASDAQ Composite which illustrates the delicate balance the market is in right now.

The NASDAQ Composite is clearly struggling to break through the resistance of the 200-DMA. Each foray to this level has been met with the bears repelling the advance and sending the markets lower. They say the third time is the charm, and with two failed advances thus far, we would expect a foray above that level in the coming week will actually be successful, at least initially.

Finally, let's take a look at the Dow Jones Industrial Average (DJIA).

The battlefield for the broader market is clearly drawn (the S&P-500 looks quite similar to the DJIA). The 20-DMA is being used as support with the 50-DMA acting as a backstop not far below this level. With the 200-DMA looming not far overhead, the bull versus bear clash is set to be epic. As I suggested last week, the market reversal came a little early and we will see another move higher supported by the 20-DMA. Another reversal is likely as these indexes move up to challenge their 200-DMAs. Note the horizontal resistance won't meet the 200-DMA for another couple of weeks.

It is my guess that the bulls will force a challenge of horizontal resistance before the 200-DMA moves down to coincide with it. It is likely that they will be successful and the bears will them slam the indexes back down as they approach the 200-DMA.

Next week, we intend to use weekly charts of the indexes to illustrate how far the markets have moved since the end of 2007. It will illustrate to year the epic nature of the bull/bear clash we find ourselves witnessing in the near future.

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Mark McMillan
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