Stocks Back off the Ledge as the Fed Crosses the Rubicon

By: Michael Swanson | Sun, Mar 23, 2008
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Last weekend I wrote an article titled Stock Market on the Edge of Disaster. Well last week the market got right to the ledge and took a step back from it. On Monday the markets gapped down on the shocking $2 a share buyout of Bear Stearns by JP Morgan with the Fed's help. As part of the deal the Fed swapped $30 billion in Treasury bonds for $30 billion in worthless "Level 3" subprime securities that were on Bear's books. Talking heads are saying this isn't a bailout, but when the Fed does a transaction like this it can't be called anything else. It was these "Level 3" phantom assets that caused the run on Bear.

The Fed's actions may technically be illegal. Bear Stearns is a brokerage house investment bank and not a commercial bank. There is no basis in law for the Federal Reserve to step in and bail out a brokerage house, which isn't a bank and therefore isn't covered in the Fed's charter. The Emergency Banking Act, passed in the Depression to allow for government assistance to banks, is restricted to only commercial banks. Brokerages and investment banks aren't included.

Paul Volker on the Charlie Rose Show:

Former Fed Governor Paul Volker said on the Charlie Rose Show on Wednesday that "The Federal Reserve has not, in the past, been conceived as a place where you put in bad assets, possibly bad assets. Lending institutions take risks. I'm not suggesting the assets are terrible, but they have collateral. But that is a new departure. And at some point, the government ought to, in my view, the government ought to be taking responsibility for that kind of action, not the Federal Reserve, which is an independent agency designed to provide an ample supply of liquidity to the economy but not too much, protect against inflation, not to protect particular sectors of the economy from bad loans."

The London Telegraph claims that the Fed had to step in to prevent a derivatives implosion. "By taking this course, the Fed has crossed the Rubicon of central banking," write Ambrose Evans, "To understand why it has torn up the rule book, take a look at the latest Security and Exchange Commission filing by Bear Stearns. It contains a short table listing the broker's holding of derivatives contracts as of November 30 2007. Bear Stearns had total positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP - at least in "notional" terms. The contracts were described as "swaps", "swaptions", "caps", "collars" and "floors". This heady edifice of new-fangled instruments was built on an asset base of $80bn at best. On the other side of these contracts are banks, brokers, and hedge funds, linked in destiny by a nexus of interlocking claims. This is counterparty spaghetti. To make matters worse, Lehman Brothers, UBS, and Citigroup were all wobbling on the back foot as the hurricane hit."

As this credit crisis unfolds we will witness the Fed take even more extreme actions to try to bailout banks and stop the credit crunch. Interest rates are now 2 1/4 percent. What will the Fed do when they run out of rate cuts? Eventually people are going to wonder and flock into gold, but we aren't at that point yet. The Fed has crossed the Rubicon and gone beyond their charter to direct bailouts of individual banks.

Many are breathing a sigh of relief. We seem to be at a moment of calm. The market held its January lows. The S&P 500 went below the 1270 precipice and turned back up last week. I believe it will eventually fall below it at some point over the coming months, but we may see the S&P 500 stay above it for the next month or two and possibly launch one last rally before falling lower. But do not forget that this is a bear market and the risks are to the downside. We saw the market reach historic oversold levels back in January and fail to launch a meaningful rally. Caution is in order.

Another view of the Fed's actions from billionaire investor Jim Rogers from March 13:


Short-term the S&P 500 has resistance at the 1330 area. This is the closing high of last week. The DOW and Nasdaq are both in the same situation - if they can close above last week's high this week then they will be able to rally.

If the market does rally it will face stiff resistance in the 1375-1390 area for the S&P 500. This represents a 1/3 retracement of the October top and March low. After that resistance is in the 1411-1425 area. This marks the 50% retracement level and the downtrend line connecting the highs of October and December. If somehow the market got through this stiff resistance area it would face huge resistance at its 150 and 200 day moving averages in the 1440-1455 zone.

The market is still very dangerous. If it does rally I only see it being a temporary affair after which the market will fall apart again. I still expect to see a panic waterfall decline occur once the S&P 500 closes below the 1270 level. This could happen in two weeks or after a few months. From here a rally to 1425 for the S&P 500 would be a 7% gain. I really don't see the broad market worth playing for a long trade. The problem is if you buy a broad market ETF you'll need to put a stop on it near the March lows, which makes what you are risking for what you stand to gain too much. There are other opportunities elsewhere much better.

I also do not think the market has much upside to it, because the VIX has already dropped into the mid-20's. It has a support trendline going back to last February and it won't take much of a market rally or time to get it to that point again.

There has been a striking correlation between the action in the FXY Yen/dollar ETF and the S&P 500 for over a year. When the FXY has gotten oversold on a daily chart(it's daily stochastics crossing below 20 and then back above 20) the market has topped out and began a sharp drop within a week. At the same time every time the FXY has had a sharp rally and given an overbought sell signal(daily stochastics crossing above 80 and then back down) the broad market has put in a short-term bottom and then has tried to rally.

What is happening is that when the market has been dropping it has coincided with sharp rises in the yen against the US dollar. Foreign money has been apparently exiting the market during market corrections.

The FXY gave a sell signal on Thursday. This bodes well for the market for the short-term.

The TLT 20 year treasury bond has also gotten overbought on a daily chart. Over the past half a year it has risen when the market has dropped as money has gone out of stocks and into bonds as a safe haven. Short-term(4-6 week) bottoms in this ETF have been associated with tops in the S&P 500 and tops in the TLT have occurred at the same time that the S&P 500 has put in a short-term bottom. I believe TLT has topped out again and will likely fall down to the 89-91 area and possibly further over the next 4-6 weeks. This suggests that the stock market will hold up into the end of April above its January and March lows and will likely rally a bit above them.

As you can see this would be a triple top for the TLT ETF. I believe that treasury bonds are in the process of making a secular top that will take several months to complete. What the TLT will have to do to complete a secular top is fall down to its 200-day moving average, bounce to make a lower high, and then fall back down below its 200-day moving average again to make a new lower low.

If this happens it will be the most important event of the year for the financial markets, because it will end the safe haven status for bonds. It is odd that during recent corrections and bottoms money has flowed out of the US dollar and into other currencies, such as the Yen, while at the same time US bonds have rallied. However, if bonds go into a secular bear market they will lose their safe haven status. It is at that point that I believe gold and gold stocks will really take off. So far they are momentum plays. But once gold becomes a real safe haven play we should see gold stocks rally and junior mining stocks finally have their day.

For the rest of this article, with a discussion about gold stocks and a position I plan on taking today, click here.



Michael Swanson

Author: Michael Swanson

Michael Swanson,

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