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August 15, 2007

Marking to Model...
by Mark McMillan

Fundamental Trader #115
8/15/2007 10:00:59 AM

Trade recommendations:

We are waiting until we see how the global credit crunch concerns work themselves through the market. At this time, we are negatively biased on all the major indexes.

This environment is one where the best strategy would be to short stocks within these major indexes that exhibit signs of weakness. However, the markets are quite oversold and we have been looking for reversal candidates for when the market signals a bottom.

We are "keeping our powder dry" as we wait for signs of such a bottom. We are likely to recommend a short trade on the next rise to the downtrend line to take advantage of continued weakness.

Discussion:

We could go on, at length, about the concerns over a global credit crunch. The European Central Bank has injected around $215B Euros into the banking system over the last two days. In addition, the Fed has also injected some $65B in the last week. Essentially, this is a balancing act to keep the funds trading at the rates the central banks have targeted.

For instance, the Fed has a target Fed Funds rate of 5.25%. When the market opened with Funds trading at 6.0%, the Fed stepped in to add supply to bring it into balance with demand such that funds actually traded at around 5.18%, a bit below the Fed Funds rate. Essentially, there weren't enough banks supplying funds to meet demand so the rate moved up. As the rate moved up, more banks were willing to supply funds until demand met supply at 6.0%. When the Fed added funds into the system, supply was greater than demand at 6.0% and the rate dropped back to 5.25%.

The problem for investors is no one knows how much the various derivatives are really worth. The large banks/brokers would buy up a bunch of mortgage loans, car loans, etc. Since there is something real behind them, they are collateralized. That collateral can revert to the lender in case of default. When a lot of these loans are packaged together, they are called Collateralized Debt Obligations, a.k.a. CDOs. These CDOs have been bought by investors around the world to generate income. The problem is that these CDOs aren't liquid and it is hard to determine what they are worth, as this would vary, based on defaults, changing interest rates, etc. In general, investments are marked to market, and when a fund lists its assets, the Net Asset Value (NAV) is determined by marking each security to market. With the lack of liquidity for CDOs, those assets have to be marked to a model, instead of the market. Of course, no one really knows what the model should be, so no one is sure what to use here. The underlying problem is that the collateral for mortgages are homes and with the housing market in a swoon, the investors could receive collateral worth less than they are owed, i.e. these assets could become worth substantially less than they were bought for.

Because CDOs are an unknown, hedge funds and other investors may receive margin calls as banks and other lenders want to reduce risks from the unknown. This creates selling pressure to sell liquid assets (even assets that look like they will continue to appreciate) in order to meet the margin calls. This can cause the entire market to sell-off until the margin calls are met. You can see, however, that one large hedge fund starting to sell assets causes downward price pressure on those assets, which then reduces the value of those assets held by other investors. Those other investors may then be forced to sell assets if they receive margin calls, etc. The cycle doesn't end until the selling is through, which occurs, in general, when the banks are satisfied that the funds/investors hold sufficient assets that the risk to the banks is tolerable.

The winners in this scenario are those investors who are able to buy CDOs and other assets on the cheap, which corresponds to near a market bottom. The problem, of course, is determining when that will occur.

With the uncertainty of how to value CDOs, this could go on weeks, months, and years. With defaults occurring when adjustable rate mortgages adjust upward, the default rate on various CDOs will take awhile to become apparent. Since these assets are held by investors globally, we will watch trends on a global basis to see how the reduction in liquidity and the value of these assets affects global markets.

We are going to continue to use Bank of America (NYSE:BAC) as a bellwether on the financial markets, and in particular, for large U.S. banks. As long as BAC continues to move in an upward path and doesn't break down below the $47.00 level, we will consider this as a sign of general health in U.S. financials. We will continue to review how BAC trades as an indicator of financial health.

Open Positions:

Long Positions:

We hit our first and second targets on FLIR before we had a chance to adjust them. Consequently, we missed potential upside, but we have close our entire position, half each at $47.50 and $51.00. This resulted in gains of $4.50 and $8.00 per share with an etnry price of $43.00 for gains of 10.4% and 18.6%.

INFY closed at $48.15 so we are negative in this trade $2.85 or 5.6% compared to our $51.00 entry price. We will exit this trade on a move below $47.30.

Short Positions:

None at this time.

Conclusion:

The biggest risk that we see is that consumer spending could slow to the point where it tips our economy into recession. If the U.S. economy enters recession, this will affect other economies, primarily those economies selling into the U.S. market, of which, China is the largest. However, our largest trade partner is Canada, and Mexico is also a large trade partner. Both of these economies would be adversely affected by a recession in the U.S.

Regards and Good Trading,

Mark McMillan
Fundamental Trader Alert

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