Act Two of the Credit Crisis is Coming

By: Michael Swanson | Mon, Sep 10, 2007
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Stocks got hit hard again Friday as the DOW fell over 249 points and the Nasdaq dropped 48 points following more bad economic news. The economy lost jobs in August and the real estate market is now as slow as it was in September, 2001 as the rate of mortgages going into foreclosure hit a record high in the second quarter. The Fed fund futures are now pricing in a 100% percent chance of a rate cut on September 18th and a 40% chance of a 50-basis point cut.

Friday's drop was troubling as it marked another day in which 90% of the volume on the NYSE was to the downside. We saw multiple days like this after the market peaked in July and it was unprecedented. 'Nine to one' down days usually come after weeks of a market falling and at the end of bear markets, not right after a market peak. It means that the selling pressure in the market has been unprecedented. When the market drops the sell orders are massive.

When I look at the basic price pattern of the market I don't like it. We had a big drop in July and August followed by a rebound on weak volume that took the market averages back up to their 200 and 50 day moving averages. In bear markets these areas act as resistance. Of course, the news is bad and the Fed is trying to intervene to bail out the credit markets as well as the stock market. On Friday, they injected over $30 billion more into the money supply.

The one big positive about this market though is that investor sentiment according to Investors Intelligence is very bearish and, from a contrarian standpoint, that is a good sign.

The market still runs a high risk of testing its August lows over the next 4-6 weeks. Whether it succeeds or not in holding them - if it does it will be lined up to rally into the end of the year - depends on whether or not the Fed can bail out the credit markets. And that really depends on how bad the credit problem is. We've seen scary gyrations in the short-term bond markets that suggest it is really serious. But, in reality, we have no way to know right now how bad the subprime mess is because we don't know how bad the losses are.

We will know that in October. The financial system is experiencing a crisis right now. In August and July the market dropped hard as hedge funds with subprime related losses got hit by margin calls and redemptions. They, in turn, sold more liquid stocks and pressured the stock market lower until the selling almost snowballed into a full blown crash on August the 16th. At that point the Fed stepped in and lowered the discount rate. The market has since bounced.

But the crisis isn't over. This crisis is a result of a bubble created by the previous cycle of lowering interest rates. When the Nasdaq bubble popped in 2000 the economy went into a recession and the Fed lowered rates to prop everything back up. However, they made rates artificially low and in effect put too much money into the money supply. Credit standards loosened and, at one point, it became easier to get a home mortgage than a credit card.

Real estate prices rose and became a bubble of their own, which topped out well over a year ago. Just as tech stock valuations became the bubble of 2000, now, subprime mortgage securities are the bubble of today that is in the process of imploding. Hedge funds and institutional investors made the mistake of buying mortgage debt securities just as individual investors made the mistake of buying overvalued tech stocks and tech mutual funds such as the Janus fund in 1999. As their positions dropped, they sold all of the way down.

To put it simply, the credit problems are the result of banks and mortgage institutions making loans to people not credit-worthy to purchase real estate that was overvalued. They then sold these loans as securities to hedge funds and other institutional investors. The drop in July and August was a result of the losses created by these securities and the redemptions and margin calls these big investors faced as a result.

The selling isn't over yet. Financial crises come in two waves. The first wave is when people realize there is a problem in the financial system and the second wave is when people find out how bad it is.

The market will know this as it receives quarterly reports from hedge funds over the next month. In the first few weeks of October, investors will receive quarterly reports from hedge funds for the July-September quarter, in which subprime securities collapsed. It is then that the markets will discover what the true size of the subprime crisis is and investors will hit those funds showing the biggest losses with redemption calls.

All financial crises end when the total size of the crisis becomes revealed. Think back to 1998 LTCM crisis, which a lot of people are comparing the current crisis as well. That crisis began in August when Russia defaulted on its debt obligations, causing a seizure in the international debt markets and unknown losses to hedge funds and institutional investors. It came to an end in October when the size of those losses became known, marked by the discovery of the collapse of the Long-Term Capital Management hedge fund.

When I deal with charts and scenarios of what the stock market may do I deal in probabilities. I have no way to know with certainty if the market is going to hold its August lows. If it doesn't, I don't know at what level it will stop dropping. Or, if in fact it doesn't retest and just builds a base instead of dropping back down. But what I do know is that we just went through the first half of a financial crisis in July and August. We are in a prelude to the second and final act, which will likely begin after the Fed lowers rates on September 18th and end once the depth of hedge fund losses becomes revealed by mid-October.

Knowing that is enough to be able to position myself accordingly and profit from these wild gyrations in the market. It is simple logic. What will gold stocks do? Is there a good time to take a position on the short side in this market? The background to what moves the market is what I discuss with you for free. What I actually do in my own accounts is something I reserve for my subscribers. Take a moment to sign up and get my personal battle plan to not only survive this current crisis, but come out on top.

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Michael Swanson

Author: Michael Swanson

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