Safehaven | Derivatives Risk Growing - Are You Listening?

September 17, 2005

Derivatives Risk Growing - Are You Listening?
by Greg Miller

Opening Whisper

The Wall Street Journal published an article on Thursday September 15 titled "Credit Derivatives And Their Risks Are On The Table" by Henny Sender. In the article Sender advised that the Fed was gathering the big Wall Street players to discuss the rising concerns about risk in what is known as the credit-derivatives markets. Sender goes on to make the case that the clearing structure of the dealers and hedge funds is not keeping pace with the exploding growth in these complex financial instruments. Confirmations of these trades are falling behind the growth of the trades and the paper is stacking up both at the dealers and the hedge funds. Quoting Sender, "The spotty record of confirmations can become a risk management issue in times of turbulence."

Bernie Schaeffer has another excellent article on his website www.schaeffersresearch.com entitled "The Aftermath of Katrina: What's Behind the Market's 'Resiliency'?" In that article Schaeffer points out what he believes to be the underlying support for the stock markets in the face of the July London bombings and hurricane Katrina. That "put support" involves the tenuous stability between naked put options sellers and stock-hedged put buyers. I recommend that you go to his site and read the details for yourself, but suffice it to say that there is a substantial and growing dynamic between the put sellers and buyers. This interaction can be mutually beneficial as long as the markets remain calm and oscillate only slightly above the major put support levels, those being 120 on the SPY (1200 on SPX) and 38 on the QQQQ. I believe that the "oscillation dampening effect" of that ever increasing put support volume can be seen in the chart below.

Mr. Schaeffer goes on to correctly advise that a market crash would be a low probability situation, but that low probability event is made more risky by the inevitable reactions by both the put sellers and put buyers which would result following a dramatic market break below put support. In effect, much follow-on selling of stocks would occur to attempt to stem the waterfall losses. The stability of the markets would be at risk once the selling starts. Mr. Schaeffer also points out that a lot of complacency has been built into the markets due to the limited market reactions to the London bombings and hurricane Katrina. Options trading, credit and other derivatives must grow in scope because of the decreasing market volatility as observed in the chart below. The derivative spring gets wound even tighter as the options participants seek more profit in a market whose trends get "flatter".

But what event would it take to shatter the fragile market support? It may not be any single event, but the sudden break in the levee resulting from the slow motion effect of rising energy prices and the coming recession. The forensic evidence for the Market Listener may be this week's dramatic plunges in the Philadelphia Fed and the Michigan Consumer Sentiment indexes.

The complacency will not last forever.

8 Year Weekly Chart of Nasdaq Composite

TECHNICALS: All major indices are sitting on top of their 50 day moving averages (DMA's). And these indices are also just above their rising 200 DMA's. The simple technical picture is that the indexes are holding just above these widely respected moving averages. The Dow Industrials is having the most difficulty in holding above both 50 and 200 DMA's. Volume has been above average for the last 2 weeks, but we must throw out Friday's peculiar upside volume which was the result of the S&P 500 re-weighting.

TREND FOLLOWING COMPLIANCE: The NDX was down a mere -0.52% on the week, but this downward momentum has strengthened the possibility that the next ZigZag leg will be a down leg.

The NDX continues in its relative underperformance as evidenced by the NDX/SPX ratio chart on the next page. The chart appears to be telling us that technology will lead the next trend leg lower.

A Cash signal was issued to subscribers on Wednesday and a Sell signal was confirmed on Thursday of this week. The following charts tend to support the fact that the next trend leg will be down. The Sell signal was weak on Thursday and was further weakened by the upside performance of the markets on Friday. The Sell signal remains in place until we get stopped out.

12 Month Chart, Daily Prices - NDX ZigZag

1 Year NDX/SPX Ratio

Our Fault Tolerant Cash Safety Stop is calculated to be 30 points above the NDX close at 1599 or 1629. However, since the week's highs were in the 1616 range, I would use that level as my exit since any close above that level would likely lead to higher highs and would negate the down trend channel. Our Early Exit line and stop loss level will be 1616. Limit your losses at all costs! And let your profits run.

Subscribers will receive an email with revised trailing stop levels if the market sells off next week. Subscriptions are free. Send an email to; subscribe@MarketListener.com with "subscribe" in the subject line.

30 Day Chart NDX - Trend Following Channel

RISK ASSESSMENT: The downside market risk (probability of a sell-off) is dominated by geo-politics, oil transport/refining and the very vulnerable consumer. The University of Michigan Consumer Sentiment index (Sept. Prelim) fell dramatically this week from August's 89.1 to 76.9. The upside/downside risk next week will be in how the markets interpret the FOMC announcement on Tuesday Sep. 20.

Our Trading System - What The Numbers Are Telling Us

On Wednesday, subscribers were notified to go to cash. On Thursday the Sell signal was put into effect before the close. We have had several signal changes in the last two weeks. This volatility in the markets is likely indicative of a market top. We will continue to use our faster chart model until the topping pattern resolves itself one way or another. Our optimized fast MACD parameters will lengthen if this rally extends into late September.

The daily stochastic has turned down from overbought territory flashing a sell sign. The Ultimate Oscillator never reached the overbought 70 level before turning down. The down trend has barely started and was somewhat corrected by the S&P re-weighting activity on Friday. All indices participated in the abnormal flurry of buying and selling of the S&P components in the last two hours of the day. The trend picture will be given more clarity next week after we get the FOMC announcement behind us.

NDX - Revised 6 Month Daily Chart Model - Friday Sep 16, 2005

What About Bonds? - The 30 Year T-Bond yield chart is shown below. If you look at the big 2-year picture, how could you infer that the ten-year yield is saying anything about "rising inflation worries"? It just doesn't show up in this chart yet.

2 Year Weekly - 30 Year T-Bond Yield

What About Gold? - The big inflation monger this week was gold. Newmont Mining and $HUI Gold Bugs index were up nearly 9% on the week. Where is it going and how far can this rally take us? The $HUI/GLD ratio chart suggests that we could get some more relative strength from the Gold Bugs before we get into uncharted territory.

3 Year Weekly $HUI / Gold Ratio

M3 Money - As expected the Fed was pumping a lot of money into the system post-Katrina. The numbers were huge and may have contributed to some market support this week. How long can the Fed pour gasoline on the smoldering inflation coals without causing a flame that gets out of control?

What Is The Current Market Sentiment?

The VIX continued its downward trend this week to 11.22. The CBOE Total P/C ratio was flat on the week. There seems to be a lot of negative sentiment on the street and in households, but the falling VIX indicates that put sellers are up to their old tricks again. They are likely selling the October puts with a vengeance. Complacency is reigning supreme even as the market is in a very vulnerable technical position.

Where Do We Go From Here and How To Listen For the Next Signal?

We have set our stop loss level at 1616. Our Sell signal is weak and vulnerable. With a bit of luck we might not get stopped out on Monday. On Tuesday afternoon we will get the FOMC announcement on the Fed Funds target rate. There is no use trying to surmise which way the markets would move either with a pause in the rate hikes or another 25 BP increase. Only time will tell us. By Tuesday at the close, the trend for the week, and possibly for several weeks, should be confirmed.

Market Listener Trend Timing Signal Summary

Current Signal: 100% SELL (Bought RYVNX Rydex Venture 100 Fund)
Subscribers were advised by email of the SELL signal before the close on Thursday Sep. 15.

Fault Tolerant Cash Safety Stop - For the Week of September 19, admit failure and exit to cash (RYMXX) on a daily close of NDX above 1616.

We will issue an email to subscribers next week if we get an exit signal or have a mid-week update necessary to adjust the FTCSS level.

The Market Listener Trend Indicators

Trends NDX 100	ZigZag Trend	ZigZag Pref %¹	Approx One-Way Snap-Shot Trends	ML Trend² Index
1 Month Aug 1	Down (weak 1.12%)	5%	1 Month	5
2 Month Jul 1	Up (8%)	5%	1 Month	5
3 Month Jun 1	Up (2%)	5%	1 Month	5
6 Month Mar 1	Up (5%)	5%	2 Months	10
12 Month Sep '04	Up (16%)	5%	4 Months	20

¹ The Preferred ZigZag % is that percentage that gives us up and down trends that are typically 2-3 months in length which work well in our system. Shorter trends are more difficult to identify. Longer trends require dynamic slowing of parameters. ² The ML Trend Index is a gross approximation of trend conditions which permit us to profit from trends. Our model profits best on index numbers above 10.

Signals & Results

(YTD Gain/Loss with RYVYX & RYVNX approx. + 24.1 % as of Sep. 16 Close)

Week Ending	Slo. Stoch. (fast)	StochRSI (fast)	ROC (fast)	MACD (Variable)	ML Signal ³
Sep 15, 2005	Sell	Sell	-	Buy	Sell
Sep 14, 2005	Sell	Sell	-	Buy	Cash
Sep 07, 2005	Buy	Buy	Sell	Buy (mod.)	Buy
Sep 06, 2005	Buy	Buy	Sell	Neutral	Cash
Aug 08, 2005	Buy-	Buy	Buy	Buy	Sell
Aug 04, 2005	Buy	Buy	Buy	Buy	Cash
July 08, 2005	Sell	Buy	Buy	Buy	Buy
June 24, 2005	Sell	Sell	Sell	Buy-	Cash
May 13, 2005	Buy	Buy	Buy	Sell++	Buy
May 06, 2005	Buy	Buy	Buy	Sell+	CASH
Feb 11, 2005	Sell	Sell	Sell	Sell	Sell
Feb 04, 2005	Sell	Cash	Sell	Sell	Cash
Jan 14, 2005	Sell	Sell	Sell	Buy	Sell

Dec 31, 2004	Buy	Buy	Buy	Sell	Cash
Aug 27, 2004	Buy	Buy	Sell	Sell	Buy
Aug 20, 2004	Sell	Buy	Sell+	Sell	Cash
Aug 06, 2004	Sell	Sell	Sell	Sell	Sell

³ This Market Listener signal is our base signal. The MACD is our primary weekly input, but can be "out-voted" by the other faster indicators on a daily basis when we need to go to cash to implement our Fault Tolerant Cash Safety Stop (FTCSS). You should not base your trading on this or any other single indicator. Our trend following system dynamically adjusts parameters based on current market conditions including volume and sentiment factors.
With Rydex Dynamic funds, we can trade in the morning and 5 minutes prior to the close during the trading day/week when we see that one or more of the fast signal indicators have changed signals. This is particularly important if we need to go to a CASH position in order to preserve capital. The above table shows the results of the Adaptive System Model Signals.

Listen To What He Says

NAB Mark 8:34-38 And He summoned the crowd with His disciples, and said to them, "If anyone wishes to come after Me, he must deny himself, and take up his cross and follow Me. "For whoever wishes to save his life will lose it, but whoever loses his life for My sake and the gospel's will save it. "For what does it profit a man to gain the whole world, and forfeit his soul? "For what will a man give in exchange for his soul?

"For whoever is ashamed of Me and My words in this adulterous and sinful generation, the Son of Man will also be ashamed of him when He comes in the glory of His Father with the holy angels."

I am working on the art of listening and hope that you are also.

Best Profits,

Gregory W. Miller, P.E.
The Market Listener
An Educational Newsletter for Stock Market Trend Timers

Paid Subscribers receive mid-week alerts to market changes that impact our system. The alerts advise of changes in stop level or signal changes prior to the Friday close of trading.

The Market Listener Trading System - My adaptive trend following trading system is the result of years of mistakes. I always seemed to be zigging when I should be zagging. My investing was based too much on emotion and inputs from so many varied newsletters and methods. After what has been literally years of personal research into cycles, Elliott Waves, artificial intelligence and many other systems, I have learned that my own trading style is best handled by avoiding the "art" of prediction at all costs!!! When I looked at moving averages for indication of trend direction, it seemed that they too were always 180 degrees out of phase with what I should have done. My conclusion, after many losses and much frustration, is that I needed to keep it very simple and let the market tell me what it wanted to do. In particular, I wanted to follow the trend, which is your friend, until the market whispered, or shouted to me that it wanted to change directions. And then, I found that Stochastics and Rate of Change indicators help me go to cash until the trend reverses or continues. Thats how my trend following system & its cash management component developed. I trade Rydex Venture and Velocity funds by which I can go short (x2) or long (x2) the NDX (NASDAQ 100 Index). I hope my newsletter and its insights can give you an education on alternative investment strategies. You might find your own technique or modify mine.

Links:
Rydex Funds: www.RydexFunds.com
Stock Charts: www.StockCharts.com

About the Author: Gregory Miller is a registered Professional Engineer (PE) in the State of Texas. He has been involved in electrical engineering and projects in the U.S. and some far-flung regions of the world. Greg has studied the markets for decades and enjoys applying his analytical abilities and computer number crunching to the science of investing.