The Ex Ante Factor: Another One Bites the Dust
From this weekends updates:
Financial institutional blow ups are getting larger and seem to be happening with more frequency. The latest debacle at Soc/Gen can be seen as a natural progression of the trend of larger and more leveraged trades which seem to inevitably find their way down the toilet. The common denominator behind all of these financial implosions is a tremendous amount of leverage and an increase in volatility. Orange County was interest rate derivatives, LTCM was about massively levering convergence trades, Amaranth was commodity derivatives, Bear Stearns was highly leveraged structured products and of course Soc/Gen's $7.2b loss in un-hedged equity index futures gave them the dubious honor of history's largest blow up. I don't mean to bemoan derivatives as they are a highly valuable tool. Like with these specific events, it's usually the speculator who gets taken out not the hedger. It is the capitulation of these leveraged speculative positions that can often mark turning points in markets.
On Jan 20, the day before all hell broke lose in the European futures markets as the US was closed for MLK day, we wrote in Jack Be Nimble:
We have also seen a credit market correction in the SPX from the October 2007 top that equals the LTCM correction in price at 1307. We aren't suggesting the declines are over or that we are in store for a 50% rally, but the inter-bank market is normalizing and the stock correction is near extreme levels and is starting to look cheap.
Of course we had no idea we would wake up Monday to witness the unwinding of a larger melt-down than LTCM. At extremes strong hands (real money) shake out the weak hands (leverage). We knew the market was at an extreme and were looking for some capitulation and volatility spike to put in a low. That is precisely what we got when Soc/Gen sold out of their position.
The previously mentioned financial debacles all marked turning points in the markets. It's important to realize that this is not a coincidence. What we have when a financial institution blows up is a cleansing of the market. The leverage is extreme, volatility picks up and the weak hands can't take the swings to their balance sheet so they puke leaving the market to the strongest of hands (like Berkshire Hathaway).
When Orange County went bankrupt in 1994 it was essentially a bad leveraged carry trade bet on inverse floaters that got blown out when the Fed raised interest rates from 3.25% in Feb to 5.50% by the end of the year. The 10YR yield went from 5.50% at the beginning of the year to almost 8.00% by the time they threw in the towel and declared bankruptcy in Dec. To this day the 10YR has not been as cheap as it was when they puked. Stocks had a rocky year in 1994 and basically bottomed in a higher low around 450 on the S&P 500. The following advance would take stocks on a 150% rally into the next debacle when LTCM blew up in 1998.
Ironically LTCM was founded in 1994 and was also employing a highly leveraged carry trade. The trade got too big and when volatility spiked surrounding the Asian and Russian problems (and Monica Lewinsky), the convergence diverged and their positions were too illiquid to unwind. They were trapped. When they finally were able to unload their positions, to the Wall Street banks who were their counterparties, there was a $4b loss to the fund. The S&P bottomed in Oct around 925 and with the system shaken out, embarked on an unprecedented rally of 60% into the Mar 2000 top.
In 2006 the market experienced a substantial correction and saw a similar spike in volatility as the S&P came off a May high and declined 8% into a June/July double bottom. Over the same time natural gas prices were coming off a parabolic high from the 2005 Katrina hurricane that saw prices spike over $14. By May of 2006, the price had fallen by 50% to the $7 area but this massive decline was not what took down Amaranth. It was the subsequent fall to just under $5 as they were increasing their leveraged long positions that became so large reportedly everyone in the pit knew about it. Chicago based Citadel and JP Morgan took down the positions on a "clean up" trade at a substantial discount and the stress was relieved. Volatility subsided and with the market cleansed it continued it's bull market rallying 25% into the 2007 highs where we found ourselves facing another historic debacle.
On Jul 1, two weeks prior to the Jul 17 top, we wrote in The more Wall St changes, the more Wall St stays the same:
As you can see the long term trend line of BSC has held during tumultuous events such as the bond bear market of 1994 (Orange Co blow up), the 1998 de-leveraging of LTCM and the 2000-2002 equity bear market. Bear Stearns has always been a top mortgage bond shop and they are arguably one of the more highly exposed investment banks, hedge fund blow up not withstanding, to the sub-prime and subsequent CDO implosions. Is this an isolated event or the tip of the iceberg? Judging by this chart showing some breaching of the trend line with a deteriorating RSI we would be on the lookout for further troubles in the mortgage/collateralized debt market and the subsequent losses in BSC's stock price. The XBD is viewed as a leading market index and a breakdown in BSC should be viewed as a warning for the overall market condition.
Obviously the BSC hedge fund blow up did not mark a low in stocks but it did mark a low in treasuries and no doubt was an omen of more pain to come in leveraged credit. In June we were waking up to massive selling in treasuries with the 10YR yield rising 75bps from the Feb lows and 50bps in Jun alone. The BSC highly leveraged structured finance mortgage portfolio was the poster child for the credit bubble and when they started seeing redemption requests and a liquidity squeeze, they presumably unloaded what they could to raise cash, which were their treasury hedges. The implosion of these funds was the first domino to fall and we are still feeling the repercussions. Since the blow up treasuries have been one of the best performing assets. Just months later the bond contract rallied 15 points (14%), 10YR yield is down to 3.50% with the 2YR down to 2.00% as the de-leveraging they ignited has driven a flight into risk-free assets.
Recognizing we are in a cycle of de-leveraging should in theory keep speculative leverage at a minimum. Being highly levered while others are de-levering can be a painful experience. That is the lesson of Soc/Gen's debacle. The details are still vague but we can be sure of one thing, this guy bit off more than he and the whole company could chew. The market was shaking out the weak hands and they couldn't handle the volatility. Since the apparent unwinding of their position and subsequent announcement of the trading loss coupled with the Fed's massive 125bps easing to cushion the selling, we have seen a nice 10% rally off the Jan 23 low.
Did Soc/Gen's puke put in a low or shall we be seeing further financial debacles that need to shake out the weak hands? We are fairly certain we will see further unwinding of overly leveraged positions in the future and the all pain is not behind us. The problems with the bond insurers and the potential ripple effect caused by their failure come to mind. However, the capitulation low put in as Soc/Gen was forced to sell that massive leveraged long position is similar to other historic disasters and thus potentially marking a turning point in the market. As of now we prefer to trade as if we are putting in some sort of bottom. The rally off the low has been impressive and brisk thus we are looking for a pullback next week. That said, we are buyers on an orderly corrective pullback and will look for higher prices in the weeks to come. We are not dropping a defensive posture but if this market has cleansed itself of the weak and leveraged positions we want to be exposed to higher prices.
Addendum: One of the biggest lows in recent memory was the 10/02-3/03 low in stock prices. This was not caused by a financial debacle but there was a very influential event that took place. The S&P 500 bottomed on 10/10/02 at 768.63. The next day the Senate approved the Iraq War resolution which gave permission for the President to disarm Saddam. The 3/03 low coincided with the actual invasion.
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Have a profitable and safe week trading, and remember:
"Unbiased Elliott Wave works!"