Yuan Small Step

Heading into the weekend the big news  on trading desks was a blown call in Friday’s US soccer match against Slovenia.  Friday’s “Quadruple Witching” was about as uneventful as possible.  Over the weekend China decided to stir up the pot by announcing that it “has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.  To do so, China will place continued emphasis…[on] reflecting market supply and demand with reference to a basket of currencies.”  As is evident by the reaction of index futures over the weekend, this news was somewhat unexpected and a largely positive development.  In anticipation of the G-20 summit set to kick off in Toronto next week, China and US Treasury Secretary, Tim Geithner alike were both facing mounting pressure with regard to China’s exchange rate policy.  Both should now be breathing a sigh of relief.  The question begs whether the news is as significant as the market reaction to it.

It remains unclear as to how exactly China will pursue a more market-based exchange rate.  The statement itself is particularly vague as to this point and leaves a lot of room for speculation.  I agree with Barry Ritholtz’ statement that “the Chinese announcement is only that — an announcement which may or may not be followed through. As such, we should treat it as a precursor, and not the significant shift the market seems to be making of the announcement.”  Until there is clarity of action and an actual plan, these words are merely conjecture.  That being said, these words are significant conjecture and reflect a change in policy and posture from China on a significant issue of international significance.

In order to discuss the impact, we first have to understand the policy as to why China pegs the yuan to the dollar.  As a result of the Asian crisis in the late 1990s, countries learned that in order to whether an economic storm in which a currency crisis is but one component, countries need to stash a reserve of the dominant global currency (the dollar) in order to intervene and maintain an equilibrium for export prices.  These countries were very reliant on the international export market for domestic demand, and as such, exchange rate volatility led to export volatility.  Additionally, the IMF’s response to the crisis called for currency protection (i.e. the raising of interest rates) in a time when monetary policy should have been deployed to stimulate the domestic economy (i.e. the cutting of interest rates).  With a stash of US dollar reserves, countries learned that they could increase their level of control over their domestic economies, without having to rely on international decision-makers whose preference was to protect international players.

The stashing of reserve dollars overall results in the suppression of a large chunk of global aggregate demand and ultimately leads to large, pervasive imbalances in trade between nations.  This heightens global economic volatility (in a sense, these countries w/ dollar reserves gain stability by exporting volatility to the global market at large).  The impact of the change in policy from China (should it truly materialize) will be reflected in three key areas: 1) the price of exports from China to the US will increase; 2) the pricing of other countries’ exports to the US will be increasingly more competitive in international trade markets; and 3) China’s purchasing power on a global level will increase.  Each of these are significant in their own right.

In pegging the Yuan to the dollar, China has placed a significant burden on other global exporters and resource rich countries in order to compete internationally.  China’s policy directly led to Brazil placing capital controls on foreign purchases of assets and to New Zealand’s direct intervention in currency markets in order to make their dollar more competitive internationally.  Furthermore, the pegged Yuan has been one factor in the US undertaking an unprecedented trade deficit.  To many, this is the most significant component to watch as this news lays out.  While a freer floating yuan should have some impact, it remains to be seen whether this alone is enough of a step in order to really change the situation.  As Joseph Stiglitz said in March of this year, the rebalancing of the Yuan  “won’t do very much for the U.S. trade imbalances….the adjustment to the exchange rate will not be the full answer for global imbalances.”  We run a significant trade imbalance with the oil producing nations of the world, and until we figure out another way to harness energy, the bigger imbalance problem will persist.  All in all, I see this as one small step that deserves an optimistic, but tempered response.

Can the Market Rally Without the Financials?

Many analysts and pundits alike have proclaimed that this market cannot rally without the financial sector participating.  The story goes a bit like this: financial stocks led us down in 2007, they led us up in 2009 and their weakness of late will lead us lower for the duration of 2010.  The question has been asked during each move, both up and down, since the March ’09 bottom.  Many operate under the assumption that financial sector strength is not only necessary for the market to rally, but essential for the economy to continue.  Let’s take a look at the charts to test out this thesis.

The Financials vs. the S&P 500 and NASDAQ

In looking at a chart of the financials (as represented by XLF) against the S&P 500 and the NASDAQ (as represented by the QQQQs) since the October 2007 market highs, one can clearly see that the financials suffered the largest decline from peak to trough.  Since that time, the financials have recouped some of their losses, yet since July of 2009 they have remained stagnant while the broader markets continued higher.  Moreover, the NASDAQ in particular has exhibited significant strength and prices are now just 10% off of their 2007 highs.  While this is well below the all-time high set back in March of 2000, the index looks poised to regain a leadership roll.

This bodes particularly well for the longer term outlook of our economy and stock market.  Clearly the markets on the whole have been able to move higher without the help of the financial sector.  We are in a rolling credit crisis environment and pain in the financial sector does have implications for the broader economy, but from what we have seen since the 2009 bottom, there has been an impressive recovery, and even more impressive growth in some key sectors of our economy.  Pervasive weakness in the financials would not bode well for our economy, but stagnation (and under-performance) is a different story altogether.

The Financial Sector and its Roll in our Economy

Volatility tends to be cyclical by nature.  Slow and non-volatile moves tend to be followed by fast and dramatic volatility.  Just like anything else, volatility itself ebbs and flows over time.  From 2007 to July 2009, the financial sector went through a period of exceptional volatility and it would only be natural for the volatility to level off and the sector to stagnate.  As has often been the case, prices tend to overshoot to the upside, overshoot to the downside and level off at some sort of psychological equilibrium.

Following the popping of the Tech Bubble in the early 2000s, the financial sector went from being a relatively modest component of the S&P 500 to being a dominantly large sector.  Moreover, since 1960, the financial sector on the whole went from accounting for 4% of our GDP, to a high of 8% prior to the 2006 peak.  To an extent, this was the result of significant innovations in portfolio theory and money management; however, as we have subsequently learned, the explosion in financials from 2003 to 2007 was largely illusory in that it was built upon an explosion in leverage without the necessary economic growth to justify the rate of credit expansion.

In order for our economy to recover and reemerge on a growth trajectory, it is essential for new areas of innovation and growth to emerge.  That is certainly taking shape with the technology sector making an aggressive increase in its stature within the S&P 500 since 2008.  Whereas at the time, Tech accounted for 15.3% of the overall S&P, as of today it is now at 18.9% .  Technology remains well off its highs of 29.2% set back in 1999, but it is once again emerging as a leadership sector.

A Balanced Financial Sector Model of Growth

Not only is it possible for our economy to grow without the financial sector, many prominent economists think (or thought) it would be the preferable model.  Such thinkers include Hyman Minsky, Joseph Stiglitz and Paul Krugman, among others.  The line of thinking holds that in order to maximize investment and for the economy to grow, it is preferable to pursue policies of stabilization to constrain volatility in the financial sector.  A less volatile financial sector allows, and more importantly, encourages investment to flow into innovation and new technologies–the real sources of economic and job growth.

Many fear that the structural shift in debt from the private sector to the public and growing government debt as a percentage of GDP bode poorly for our growth prospects.  Jeff Miller at A Dash of Insight takes a pragmatic and optimistic view on our deficit “problem”:

If you want to understand how governments  (or large private organizations) deal with problems, you need to quit thinking in terms of your family, your small business, or a chess game.  This is not a situation where you see a problem, analyze alternative, identify a solution, and make a choice.  It is decision making under extreme uncertainty.  Most observers get this wrong.

Here are the paths that I see as plausible, and even likely:

1.  The economic rebound will increase tax revenues, reducing the non-structural part of the budget deficit.  (The structural deficit (simplified) is what we would still face if we were operating at full employment).

2.  The consideration of the Bush tax cuts will lead to a number of compromises.  Taxes will be increased, but some of the cuts will be preserved — at least in part.  Like all compromises, everyone will hate the result.  The final tax rates will be lower than we had in the Clinton era.

3.  Entitlement benefits will be cut.  This will require success from the Deficit Commission.  Once again, most will hate the result, but these commissions are the only way to achieve change.

With a patient and forward-looking approach, there will be exceptional investment opportunities as we continue to rebound from the 2009 lows.  With interest rates and Treasury yields historically low, there is little choice for investors to chase yield outside of equities.  This does not mean that every sector has to rally, and it places an increasing premium on stock selection and identifying the right themes and trends, but this can be done.  The more the growth areas of our economy continue to outperform the tradition, the more optimistic our future looks.  Not only CAN the market rally without the financials, should we do so, the better things look for our recovery chances.  All this is not to say that the financials will not go up if/when the market does, but it does mean that the financials can become a laggard sector rather than a leader.

Ass Kicking No More

President Obama just finished his latest in a series of ongoing speeches about British Petroleum and gave his best stock market value investor analysis.  The President proclaimed that he is “absolutely confident BP will meet its obligations.”  This is in contrast to the President’s recent remarks about looking for whose “ass to kick” with regard to the oil spill.  Listening to the speech, and watching the reaction in BP’s stock (an aggressive rally for those yet to see) I couldn’t help but think that President Obama had a long, difficult talk with his British counterpart, Prime Minster David Cameron, that went something like this (please take note, this is a FAKE conversation that I imagined in my head):

Barrack Obama: Hey David, how’s it going?  Things are a bit rough here and I just wanted to let you know that I am going to be kicking some British Petroleum ass pretty soon.  I figure since you’re new to the job you deserve a little heads up.

David Cameron: Cheers mate, in all honesty this is a serious call and I want to get right to the point.  While things are clearly not great in the Gulf, I would prefer if you would refrain from arse kicking for the time being.  This is ver…

BO: …What do you mean Dave…can I call you Dave? or is it David.  What you have to realize is that the pressure on me in this country from these Teabaggers is immense.  I mean one dayI talk about using alternative energies so that we don’t need to take oil from dangerous place and they call me Communist and Socialist and Hitler and Stalin all in one, and the next day they’re blaming me for the spill as if it’s MY fault.  What am I to do other than kick some ass?  I gotta tell you Dave, welcome to the top of world politics, but get out while you can.

DC: Well Barack, it turns out that a lot of our country’s pension plans and wealthy people are HEAVILY invested in BP stock.  Many people in my country LIVE off of this dividend.  I implore you to take that into consideration when proceeding with your arse kicking.  Our country is completely and utterly broke in both the public and private sectors.  I mean seriously Barack.  We are broke.  If your people think your deficit is a problem, I don’t even want to imagine what they would be saying over here.  We too bailed out our banks, but our recovery is far from robust like you Americans.  Besides, it’s our banks that own the most toxic of your assets over there.  Were it not for our power to print money, we too would go Greek.  There cannot be a second Tea Party in which you Americans kick our arses back across the pond.  Please throw me a bone here.

BO: Dave, you have some points there.  This is a complex situation and we need to find some sort of middle ground.  We need to find a way in which I appear to be kicking some what’s that British word you use for it?  Arse? without actually kicking that arse.  We need to find a way through which BP the company will take some pain, but its shareholders will take no more.  We just need to find some common ground in order to build a consensus.  Let’s work together and speak strongly while letting others take care of the actual planning and execution of our actual plan.  Does that sound like a viable approach?

DC: Brilliant!  That is an outstanding idea Barack.  Let’s not worry about the details about how exactly this will work, let’s just ensure that we are neither tough nor soft, neither loud nor quiet, neither right nor wrong.  I look forward to an outstanding piece of rhetoric from you yet again.

BO: Thanks Dave, much appreciated.  I work hard on these speeches of mine.  It’s pretty demanding with all these crises one after the other to come up with original ways to say pretty much the same thing.  Anyway, it’s time for me to get my speech writing on and to step up to the podium and delivery.  We’ll continue this conversation later in the day after your high tea.

DC: Pip pip cheerio Barack.

BO: Speak soon Dave.

What Next?

As uncertainty reigns supreme amidst these volatile/choppy markets of today, investors and traders alike are trying to assess whether we are on the brink of a “double-dip recession” or merely just a experiencing a blip–or correction–in the recovery from the throes of the 2008 deflationary spiral.  The answer to this question opens the door for vast opportunity; however, it’s increasingly difficult to deduce exactly where we stand on the road to recovery.  With the markets sitting just above their breakdown levels, the rhetoric and tone are increasingly bearish.  Each attempted rally gets sold with increasing force.  Yet still, the market remains above what many investors perceive to be a solid “value”/breakdown level for the market–S&P 1,040.   I want to “dumb it down” and focus on just a couple of metrics to watch for each side and simply offer some of the competing arguments as food for thought (but inevitably, I’ll give my brief personal conclusive thoughts in the end).

The Bear Case:

Without getting into too much detail about Europe, I want to focus on some key indicators at home in the US that do not bode well for the sustainability of the recovery (I am not altogether ignoring Europe, as the indicators I will discuss account for Eurozone risks).  First, let’s look at a weekly chart of the 20 year Treasury Note (as reflected by TLT) dating back to late 2006.  This has been my personal favorite risk-sentiment gauge during the course of the crisis and in its wake.

The Treasury market is a great risk sentiment indicator.  When the notes spike and the yields drop, we know that investors are more risk averse and looking for a liquid source of safety.  Over the course of the last month, Treasuries reached levels not seen since July 2009’s failed head and shoulders breakdown.  This is a significant sign, considering that thus far in 2010, Treasuries traded consistently in a tight range.  So long as the TLTs remain above the highs of their early 2010 range, the markets will be in “flight-to-safety” mode. Demand for US sovereign debt is to many “irrationally” high considering the increasing budget deficits the government continues to run; however, in the zer0-sum game of global finance, this is the most liquid market in the world and is the natural source of safety when things are hitting the proverbial fan.

Along with the rallying Long Bond came a stronger US dollar.  This both poses risks to the recovery in increasing the prices of US exports and is reflective of decreasing risk tolerance on the part of investors.  A strong dollar means that there is increasing demand for dollars in the global economy, and such a move is deflationary (I’ve written about this several times in the past).  Considering we are in the dawn of a recovery from a major credit crisis, such deflationary signs are scary in light of the troubles in Europe and the lack of monetary and fiscal policy ammunition as tools to place a bid under snowballing selling pressure in global asset prices.

Moreover, the Gulf disaster generates economic risk in its own right.  As the destruction of one of our nation’s important ecosystems and economies continues, the unquantifiable nature of the damage makes it difficult to gauge the overall impact.  There will be significant job losses from the seafood and travel industries which rely on the Gulf as their source of livelihood.  Additionally, companies who rely on offshore drilling will face increasing scrutiny, regulation and diminished earnings in the near-to mid-terms.

The Bull Case:

This arena holds what I believe to be one of the more surprising and optimistic indicators seen emerge over the past month: the recent rally in the Baltic Dry Index (BDI).  Click on this link to check out a Bloomberg chart of the index.  For those unfamiliar, the Baltic Dry Index is an index that tracks the prevailing rate on global shipping.  Strong up moves in the index are reflective of increasing demand for shipping, and vicariously, increasing global trade.  Surprisingly, this index marched steadily higher despite the deterioration in the Eurozone.  Now this uptick may be demonstrative of a desire on the part of resource owners to clear out inventory before wave 2 of the crisis widens, yet for some reason that seems unlikely.  Consumer confidence also checked in nicely higher in May despite the growing Eurozone crisis and this move seems more consistent with the positive developments in the BDI–consumption is making a strong recovery.

Furthermore, the Eurozone’s troubles can become the US’s strengths.  The crumbling Euro has come hand-in-hand with cheaper commodity prices, thus lowering the cost of important input goods such as oil and copper.  A stronger dollar helps boost America’s purchasing power on the global level, leaving consumers with excess wiggle room in their budgets with which to save.  Savings will go a long way towards strengthening the awful balance sheets of America’s households and businesses and this is THE critical step in moving from a stimulus induced recovery to self-sustaining private sector growth.  The rising Treasury rates that go hand-in-hand with Euro troubles  help keep the cost of financing US deficits much more manageable.   These are tangible long-run benefits.

In the words of Rahm Emanuel, “never waste a good crisis” and the Gulf situation should be no exception.  There are important lessons to learn out of this that can lead to long-term improvements and real economic gains.  Yes this comes with a hefty cost; however, rarely is there progress made without some sort of accrued cost.  This disaster clearly highlights the nature of negative externalities when dealing with resource expropriation and provides a much clearer picture of the true supply/demand equilibrium of oil in our economy.  We now know with a higher degree of certainty that alternative energies come with a fairer price-tag than original closed-ended calculations projected.  This is the catalyst that should help lead us to reconsider how we generate energy for consumption.

In Sum:

There you have it.  The key points at the moment for both sides of the coin.  Ultimately should the S&P break the 1,040 level, everything will change and technical selling pressure will highlight and lead to further fundamental weaknesses; however, should that level continue to hold this could be an actionable “long and strong” value level to use as a line in the sand for a portfolio.   Personally I am a believer in the longs, but will quickly change my stance should 1,040 break.  This is so because I give much weight to the improved consumer confidence and Baltic Dry Index numbers despite the multitude of negative sentiment and indicators swamping the headlines.  If today’s rally can hold, and the S&P can once again retake 1,100 this impressive rally off of the March 2009 lows will/should take another leg higher.

Zero Risk Trading

Brandon over at Trading Wall Street is out with a great post on Goldman Sachs spotless trading in 1Q 2010 and I think his conclusion deserves repeating:

I don’t want to make any outlandish conjectures but I cannot help but have a great deal of skepticism towards these results. In a world of ever-increasing efficiency, I don’t see how a firm can go full quarters without a single day of losses while clearing hundreds of millions of dollars. At the very least investors must know what they are buying when they purchase shares of GS. It is a proprietary trading firm that has done exceptionally well in recent years. Whether those returns can continue, I do not know but the sheer enormity of the returns makes me cautious. While this stance on my part may be foolish, I would rather stay away without a much clearer picture of how they are making so damn much money and never losing.

It is possible to run such a record in the short-run; however, in the long-run there are only three ways to trade each and every day without a loss:

1. There is a major market inefficiency to exploit
2. The trading strategy has an inherently large tail risk, with a very real chance of blowing up
3. Some form of either illegal fraud, (or the exploitation of a loophole in the letter of the law, which is incorporated into #1: a market inefficiency).

I believe some combination of #1 and #2 to be the most likely explanation for Goldman’s flawless quarter of trading.  Although it is unkosher, it seems unquestionable that Goldman as some combination of a market-maker and position-taker has access to more information as to the sentiment and directional bias in the trades of a large swath of the investment community.  Whether they explicitly make use of this information in their trading is irrelevant.  It is impossible for someone who knows a fact to ignore it when making consequential decisions.  It’s basically like asking a jury to disregard a defendant’s confession in a contested trial due to a procedural rule.  Sure they can “pretend” to not have heard that decision, but can one reasonably expect that fact to not weigh on the subconscious of the members of the jury in gauging the preponderance of the evidence?  Call me a cynic, but I surely don’t think so.

I think there has to be some sort of latent risk to Goldman’s trading strategy.  As Brandon pointed out, we don’t know what proportion of their trading profits resulted from their market-making as opposed to their proprietary trading; however, we do know that Goldman is substantially involved in the high frequency trading arena.  I am very interested to learn about the impact of May 6th on their trading performance.  Was that an immensely profitable day for the firm?  Or, did the computers shut off because something went incredibly wrong first?  Generally speaking, non-stop large profits come with some sort of tail risk.  At this time, we just might not know the full extent of Goldman’s risk.  Irregardless of May 6th, at some point, a competitive advantage of that sort is either minimized through improved competition or regulatory action.  For this very reason, trading profits are valued far lower than investment banking earnings in calculating a share price (i.e. the trading profits receive a lower p/e than do real earnings).

I think this to be the beginning, rather than the end of the story with regard to Goldman.  We are certainly dealing with a company that is as much a hedge fund as it is an investment bank and that has serious consequences for a variety of reasons.  To guess at the end-game right now is just impossible.  There are just far too many moving parts considering the state of markets and the proposed regulatory reforms.  Only time will tell…

The Morning After…

May 6, 2010.  Not gonna forget that one!  It was comforting to wake up this morning and see everything in its place.  Once again, nothing really changed.  The world is not fundamentally different than the day before, and sure enough, stock market prices are not all that far from where they were on May 5th (well far is a relative term here…the market still ended up going down a lot, but not all that much in the grand scheme of things).

Several thoughts are running through my head today:

• Get a solution to Greece.  The ECB has to do something and do it fast.  That does not mean they have to rush into making a rash decision.  There are several options that do not require a total dismantling of the Euro or an outright default by Greece.  The most attractive option I have read about recently was to have the ECB buy up some sovereign debt around Europe and print away part of the problem.  Sure it is inflationary, but so too is the collapse of the Euro.  Each day the price drops farther, the corresponding costs of goods in the Eurozone rise a corresponding amount.  Jean-Claude Trichet: GET IT DONE ALREADY!  This accomplishes several goals, and most importantly prolongs Greece’s ability to come up with real solutions and decisions not made in the midst of an emotional panic.  We all know how poor decisions can be amidst chaos and it takes hindsight to truly reflect and realize our mistakes.  Let’s not let that happen again (no need to rehash Lehman, AIG, TARP, etc.).

• Let’s get some humans in control of “plunge protection” in our stock markets.  Computers don’t know that Proctor and Gamble (PG) is worth far more than 30% below May 5ths closing price, but humans do.  A real specialist could comfortably step in and prop up those prices and prevent the plunge from happening.  My real frustration with all this is the fact that the “sophisticated investors” don’t get hurt nearly as bad as the retail investor in a frantic frenzy like yesterday.  Retail investors are told to “prudently” place stops below key levels and those stops did nothing but get blown out of the water yesterday.  Weak hands who weren’t all that weak potentially got flushed out of the market without even seeing or knowing about the crater on all equity charts.

• The selling should be flushed out.  Any weak hands, whether institutional or retail were taken out of the market yesterday and replaced with real buyers.  Yes that sucks for the weak hands, but it seems like when a vertical move happens, the trend reverses (vertical can be up or down, what I mean by that is when you see a big LINE amongst waves, then we’re talking vertical).  Sure the market can drift lower in a choppy way over the next day or weeks, but overall, this could help fuel the next leg of the rally off of our March 2008 lows.

• I keep wavering in my own opinion of the SLPs and my conclusion ultimately depends on what we learn to be the true catalyst for the selling.  If it was the fearful environment, then the SLPs did not do their job in preventing the bottom from collapsing.  On the other hand, if this were the result of a large erroneous order (I still don’t believe that), then the SLPs did a great job of reestablishing the bid and offer in the mid $112-114 range on the SPYs.  That snap back was vicious and fast, but my issue is that the damage was done.  Not only was it done, but I am 100% convinced that this move was fake.  It was fake.  It was not real, it was fake.

We have the job number coming out momentarily.  With the lingering fear from yesterday, who knows what to expect.  I’ll be back later today with some thoughts and observations.

Stock Market Crash not a Fat Finger

So there’s a report going around that a Citigroup trader hit the “b”illion button instead of the “m”illion and I just want to right off that bat make clear that not only do I not buy that story, but I am absolutely certain that it is not THE cause behind today’s collapse.  I believe today’s collapse is a confluence of factors that generated the perfect storm of volatility, chaos and panic.  Here are a few of those factors:

1. Global fear levels are elevated amidst talks of a Greece default and trouble in Spain.
2. Markets traded aggressively higher off of the February lows without a substantial pullback.  This led to large pent up selling demand.  People were waiting for the first downtick to sell, and when the selling begat selling.
3. With high frequency trading accounting for an ever-increasing percentage of total market volume, when the volatility storm, hit the computers shut off.  I was staring right at it in the Level IIs…the bids in just about every stock disappeared.  There was no liquidity.
4. Proctor and Gamble (PG) alone dropped almost $25 points from its intraday highs.  With the Dow being a price-weighted index–with each components $1 move correlating to 7.2 Dow points–PG alone accounted for 180 of the Dows nearly 1,000 point crash.  That’s insane for a stable company.   I’m not a huge Cramer fan, but I LOVE what he had to say live on TV: “if that stock is there just go buy it…that’s not real…just go buy it!”  Major props to Cramer for speaking some truth and bringing sanity to the panic.

Now just for some personal thoughts during all this and a rant: I got terribly scared today.  The speed with which the market dropped 700 Dow points, I could not help but think the worst.  My head was running wild.  Was there a terrorist attack?  A coup in Greece?  Hedge fund blowup?  Bank failure?  Sure enough there was not a single new story.  Nothing in the world changed!  Well not entirely true.  Trillions of dollars moved around, but absolutely NOTHING really changed.  The state of the economy and I’m sure investor and consumer confidence all took major hits today, but really, NOTHING CHANGED!  Sure it was perfectly explicable that there were sellers and the market went down today, but what happened?

I want to rant about #3 from my list of causes.  A considerable portion of high frequency trading is run by “supplemental liquidity providers.”  These SLP’s are supposed to be the good HFT programs which step in when bidders leave the market.  They are supposed to provide liquidity when there is none.  SLP programs run each and everyday and are incredibly profitable for their firms.  Sure enough, the largest such service provider and NYSE’s primary partner in the SLP initiate is none other than Goldman Sachs.  Where was the liquidity?  What happened!?!?  These SLPs run each and everyday, yet today when liquidity evaporates they’re not there?  I saw it.  There were NO BIDS!  Where were you Goldie when we need you?   Not necessarily saying it happened on purpose, but maybe just maybe we’d be better off bringing back a human specialist as opposed to a money-making machine.  HFT is not good liquidity and doesn’t seem to play itself out in a market-neutral manner.  It steamrolls on itself.

What an absolutely insane day.  I really cannot explain the emotions that run through while staring at capitalism spontaneously combust and rebound in a matter of minutes.  Yeah we had our 2008 when everything melted down, but that was a process.  There was news.  Things happened.  This was 2008 and 2009 combined into one 5 minutes bar on a candlestick chart.  What a joke.  If this was a computer glitch then bring back the specialists.  It makes everything seem so fake and unreal.  Since when was an economy measured by green and red digitized numbers flashing on a computer screen?  What ever happened to REAL things?  Innovation, production, etc.  Today was/is ridiculous and is a sign of the lack of progress we have made since this “financial crisis” began.

End Rant.

um yes that really did just happen…

Wow…you might not believe it, but yeah that did just happen.  Here’s the chart, below it are some thoughts/observations.

I mean seriously?  This is not real.  Stuff like that cannot/should not/does not happen in a real world.  In a world dominated by robots and inundated with fear, the story reality is a little different.  I am tempted to post the Proctor and Gamble (PG) chart but when a stock that is far from volatile plunged from $60 to $40 it’s hard to get a succinct visual depiction of what really transpired.  Pardon the rambling nature of this post, but my stomach is tumbling, my arm hairs are standing tall and my heart rate is through the roof.

There was no intraday/unique catalyst for this move.  We all know that Greece is in trouble, we all know that the Euro is particularly vulnerable at this time, but don’t we also know that the U.S. recovery is far more robust than anyone anticipated?  Well clearly fear is back in play in U.S. markets.  I said just the other day that a down move of that magnitude (Tuesday”s) generally gets follow-through.  Never in my wildest dreams did I expect this (and sure enough, I lost more money than I would’ve liked trying to buy this market too early…).

Tuesday was a rough day, today was a bloodbath.  Greece needs to leave the euro and get this over with now.  There is no other endgame that works.  Staying on the Euro and deflating is not an option.  It won’t work.  The euro may or may not survive this panic, but one thing is clear: the risks of monetary union in tough times are far greater than the rewards in good times.  After today, what people feared is now confirmed as the truth.

I will be back later on with some more thoughts, but I just wanted to put this out there for now.

More Dollar Strength on the Horizon

This post originally appeared on T3Live on January 12th, 2010.  This theme continues to play out and the trade continues to work.

In looking at a daily chart of the Euro (FXE), we can see the development of a bearish continuation pattern–the bear flag. The FXE index struggled mightily with the $150 level. After what appeared to be a breakout failed above that level, the currency quickly reversed course and traded lower.

Drawing in the Fibonacci levels shows that the recent rally stalled at exactly the 38.2% retracement level of the move from the November highs to the December lows. Aggressive traders looking to anticipate a breakdown can use yesterday’s high of $145.30 as a level to short against.

In taking a step back and looking at a monthly chart of the Euro, we see a bearish engulfing bar in December that wiped out nearly four months worth of gains for the currency. The next big level appears at around $140 on the FXE and will be a crucial tell as to whether lower prices are in store for the Euro and consequently higher prices for the dollar.

Several fundamental factors add up to add fuel to this potential move. Firstly, the Euro zone appears to face some significant troubles in the near future. Sovereign debt concerns in the PIIGS nations–Portugal, Ireland, Italy, Greece and Spain–has some talking about a move away from the Euro in the troubled countries. While such a move seems drastic, and is most certainly not imminent, the uncertainty that comes with growing public debt without localized monetary policy control will continue to weigh on some countries in the Eurozone, and vicariously weigh on the Euro.

Secondly, deflation in the private sector in the U.S. remains persistent. Demand for dollars and the need to capitalize outstanding debt are ultimately positive catalysts for the price of the dollar. While asset prices continue to appreciate in price, real demand in the economy remains sluggish. Case in point are the Alcoa (AA) earnings. The Market Guardian summed it up well in a post from yesterday evening:

The primary uses for refined aluminum are automobiles, aircraft, trucks, railway cars, marine vessels, bicycles, and other machines, as well as packaging such as cans and foil, along with construction with windows, doors, siding, building wire, studs, and framing, plus in a range of household items and consumer electronics.

Is manufacturing in any of these areas which extensively use aluminum improving? NO.

Will manufacturing using aluminum increase significantly in 2010. NOT LIKELY.

So, then, why exactly isn’t Alcoa’s stock price reflecting a dramatic drop in the use of aluminum and why isn’t the price of aluminum itself down substantially rather than up due to much lower demand?

The lack of end demand in the economy makes it increasingly likely that the Federal Reserve Bank will not raise interest rates as soon as some may think. The dollar rises when demand for dollars outpaces supply. Should the dollar breakout yet again here (and the Euro breakdown), we will have confirmation that private sector deflation is happening at a far greater rate than public sector inflation. Watch the FXE closely for the next tell.

Rough Day in the Markets

Just about everything got sold off today…you name a sector and it was red…that is, aside for two recent headline grabbers: Goldman Sachs and British Petroleum.  In some respects, it makes perfect sense that these two would hold up rather well today as they had an earlier start and suffered from particularly aggressive selling in recent days; however, there is something strange about seeing relative strength with these two while traders and investors alike are shifting to the risk aversion trade today.  These two stocks old off because their fundamental risk structure changed dramatically due to event-driven catalysts.  Whether the catalyst for the market’s drop was rumors of Spain requesting a bailout (rumors which Spain denies btw), continued fears about a Greece default, or maybe even the economic damage inflicted by the gulf oil spill, one thing was particularly clear–the flight to safety is on.

In the thirty minutes preceding today’s open, U.S. Treasuries rallied sharply, surpassing multi-month resistance levels.  This should help quiet some of those who claim that the U.S. is at risk of default.  Markets keep proving just how absurd some of the deficit rhetoric is.  Europe is a unique problem with its own complexities and at the end of the day this is all just a question of relativity anyway.  Earnings continue to recover at a faster rate than expected and this should help close the gap created by the rapid drop-off in U.S. tax receipts during the crisis.

In the near-term, I would expect to see some more broad-based selling.  A move like this is rather difficult to quickly shrug off; however, I will be looking for strategic levels to buy strong companies with solid balance sheets.  One of my themes is that we are in a rolling credit crisis.  As such, there will be times in which credit markets could become tumultuous in various subsets of the economy.   Companies with little short-term debt have a much better position to weather any short-term market turmoil (look no farther than Apple with its $20+billion of cash).  Commodities and commodity-based stocks become particularly volatile and weak amidst deflationary concerns.  Some commodities and derivative stocks which had been oversold of late, led the market lower in the early going (take a look at Cleveland Cliffs and U.S. Steel).  One would think that given the extent of the Gulf oil spill, and the potential short-term supply shock that would result from an offshore drilling moratorium, traders would use the news as a catalyst to further ramp up oil prices.

Turns out the global deflation story remains the key driving force these days.  In the U.S., we had our 2007-08 crisis and in 2010 it is now Europe’s turn.  I’ll be watching U.S. Treasuries (via the TLT) closely over the next few days to look for signs of a more serious move towards risk aversion.  Today’s move is of a large enough magnitude to warrant close attention and heightened concern in the short-term.

Just a little market rambling after one of those days in the markets…the signs were there…I saw them…I did not respond to them.  Sometimes days like today are just the cost of acquiring invaluable information about what’s really going on in the quest to generate alpha amidst the short-term fluctuations of asset prices.