Friday, July 11, 2008

Let the Bailouts Begin

From Bloomberg:

A government takeover of one or both companies is among several options that have been considered by White House officials, according to a person familiar with the discussions who spoke on condition of anonymity. Senior Bush administration officials are considering placing either or both firms in a conservatorship if their problems get worse, the person said.

The companies, which own or guarantee about half of the $12 trillion of U.S. mortgages, can count on a federal lifeline, said Republican Senator John McCain, and Democratic Senator Charles Schumer. Fannie Mae and Freddie Mac would have to post pretax losses and writedowns of about $77 billion before the U.S. would be compelled to start a rescue, according to estimates by Fox-Pitt Kelton and Friedman, Billings, Ramsey & Co.

``They must not fail,'' McCain, of Arizona, said yesterday during a campaign stop in Belleville, Michigan. Fannie Mae and Freddie Mac ``are vital to Americans' ability to own their own homes,'' he said at an earlier stop in the state, one of the worst affected by the surge in foreclosures.

From today's WSJ:

"They need a lot more capital," said John Paulson, who heads the hedge-fund manager Paulson & Co. that has made billions betting the housing market would decline. He pointed to "growing worries" about the deterioration of securities backed by mortgages as more homeowners default and home prices fall. Meanwhile, some high-profile bond investors snapped up Fannie and Freddie debt, believing the government would never allow them to default.


"Fannie Mae and Freddie Mac are too important to go under," said Democratic Sen. Charles Schumer of New York. "...If they need additional support, Congress will act quickly." But he added in an interview: "We're not at that stage. I hope and think it won't be needed."

A Treasury spokeswoman said: "As Secretary Paulson said today, we're not going to speculate about 'what ifs' on Fannie and Freddie. What we're focused on is legislative reform."

Marketwatch adds:

The Times said the administration also considered calling for legislation that provide an explicit government guarantee on the $5 trillion of debt owned or guaranteed by Fannie and Freddie. Such a move was seen as an unattractive option, however, because it would double the size of the public debt.

In addition, three options were suggested in the WSJ article:

In an email sent to clients Thursday morning, Beth Hammack, who heads trading in Fannie and Freddie debt at Goldman Sachs Group Inc., said she sees "many good options" falling short of the government taking over the companies. Among them, she said, would be a purchase by the Fed of some of their debt or mortgage-backed securities. A spokesman for Goldman, which is advising Freddie on possible ways to raise capital, said the views were Ms. Hammack's and not necessarily those of the firm.

If things get bad enough, said Bob Napoli, an analyst at the securities firm Piper Jaffray & Co., the Federal Reserve could make large, 10-year loans to the companies "to make it clear that they have enough capital."


Other possibilities might include the Treasury buying stock in the companies. In an extreme situation, the government might have to take over the companies in a transaction that might leave little or nothing for existing shareholders.

Option 1 (from the Marketwatch article) is a bail-out, but one that is a bit sly. The government is saying "we'll provide funding if X happens". However, my guess is the possibility of X happening is pretty high.

Option 2 (from the WSJ) is a bail-out of the direct kind, meaning one company takes on the distressed assets of another company.

Option 3 is an indirect bail-out with the Federal Reserve guaranteeing a steady supply of capital until the housing market recovered.

Option 4 is a corporate reorganization, plain and simple where company 1 buys a percentage of the stock of the second company.

Either option is a bail-out, make no mistake about it.

Now a bit of history.

First -- what exactly do these companies do? Basically, they provide liquidity to the mortgage market. The best way to explain this is to compare the mortgage market of 100 years ago and today. 100 years ago, you would go to your local banker and get a loan. If the banker thought you were credit worthy, you'd get a 30 year home mortgage. However, back then the bank would most likely own the mortgage for the entire life of the mortgage.

Fast forward to today. Banks don't keep loans on their books. Instead they sell them to investment banks, who then pool the mortgages into bonds -- either pass-through bonds or collateralized mortgage obligations (or CMOs). These in turn are sold to large, institutional investors like insurance companies, mutual funds etc...

Freddie and Fannie are quasi-public entities, meaning they have government charters but also raise capital from the private sector. In fact, many people who participate in the mortgage market have often felt that Freddie and Fannie have an unfair advantage because of their implied government backing. For years both institutions have said "no, we're not backed by the government." Now we know that's not true. Actually, we've always know that, it's just that now we really know.

Let's take a look at the charts.

Both charts say the same thing:

-- Prices are below all the SMAs

-- The shorter SMAs are below the longer SMAs

-- All the SMAs are heading lower

-- Prices are below the 200 day SMA

In addition, over the last few days both charts have fallen through major support on extremely heavy volume. Traders are dumping the stock as fast as they can. That should tell you something.

And this continues the downward saga of the financial sector in general:

Note the following:

-- Prices are below all the SMAs

-- The shorter SMAs are below the longer SMAs

-- All the SMAs are heading lower

-- Prices are below the 200 day SMA

Thursday, July 10, 2008

Today's Markets

I'm going to use three charts today. First, let's use a three months daily chart:

First, notice the following:

-- Prices are below the 200 day SMA

-- Prices are below all the SMAS

-- All the SMAs are moving lower

-- The shorter SMAs are below the longers SMAs

In other words, the price and SMA alignment is about as bearish as you can get.

Above is a 6 month chart. Notice that prices are right below the lows set earlier this year. These two lows were part of a double bottom formation from which the market rallied.

Above is this week's chart in 5 minute increments. Notice a few important points.

-- Prices are meandering between two points. That means prices are consolidating.

-- There is a double bottom formation, with the first bottom forming late Monday and the second bottom forming today.

-- There is a second double bottom formation, with both bottoms occurring during today's trading.

Earlier this week, Barry over at The Big Picture noted that after a bad month a rebound was possible. The 5-minute chart says a bottom is forming. The question now is where is the rebound.

A Look At the Federal Budget

I was emailing with some friends about what to do about the federal budget. Below are my thoughts and analysis, which should be classified as "back of the envelope" thinking.

Let's look at the problem.

First, according to the Bureau of Public Debt, the US has been increasing its total debt load by a minimum of $500 billion per year since 2003. This means the gap between spending and revenue is consistent and systemic.

According to the CBO the total US budget was 2.7 trillion in 2007. Of this 1.6 trillion was mandatory and 1 trillion was discretionary. The mandatory spending of 1.6 trillion is about 60% of the total US budget and includes SS, Medicare and Medicaid. A closer look reveals the following spending increases. Since 2000, SS spending has increased from $406 to $581 billion (a 43% increase), Medicare spending has increased from $216 to $487 (a 125% increase) and Medicaid spending has incresed from $117 to $190 billion (a 62% increase). In other words, the mandatory spending has spiked really hard.

At the same time, discretionary spending has spiked as well. The big increase here is from defense spending which increased from $295 to $549 billion (an 86% increase). Other domestic spending increased from $298 to $457 billion (a 52% increase)

And here's where the big screw-up comes in. Revenue from individual income taxes increased from $1 trillion in 2000 to $1.16 trillion in 2007 -- a 16% increase. This is the biggest source of funds for the federal government.

So, we have the following situation.

1.) A systemic problem of outlays outstripping revenues by at least $500 billion/year

2.) Nearly stagnant revenues

3.) Massive increases in spending.

Let's overlay the current economic environment on this situation. We're in a recession and we're not getting out of it anytime soon. That means that tactically, this is a terrible time to increase taxes. Clinton did raise the top rate, but only after the economy had been growing for a few quarters.

In addition, recessions usually mean increased government spending. The stimulus checks are a good example, as is the possibility of increased unemployment benefit spending. There is also talk at some level of a federal bail-out of the housing market, although the exact plan is still vague. But if it happens, it's going to be very expensive. Freddie and Fannie are going to need a ton of cash.

So, let's sum up everything so far just to make sure we're on the same page.

1.) The budget process is screwed and has been for the last 7 years.

2.) The budget is already a giant mess.

3.) Because the economy is in a recession, this is tactically the worst time to try and fix the budget.

All that being said, what do I advocate doing.

1.) Get us the hell out of Iraq. That's at least $150 billion a year and probably more.

2.) Let the Bush tax cuts expire. According to the Tax Policy Center, 57.6% of the 2001 - 2003 changes in tax law went to people with incomes over $100,000. At that level of the game, they can take care of themselves. The expiration will happen naturally because of the built-in sunset provisions. I have not seen an estimate of the amount of money this will bring into the Federal government. Let's be conservative and say an addition $150 billion year. That means between an expiration of the tax cuts and getting out of Iraq we've got $300 billion in savings.

That means we've got $200 billion more to go. I would advocate at least another $100 billion from the Pentagon. They've had a nice run of budget increases, but enough is enough. In addition, there have been several studies that say the Pentagon's accounting system is, well, fucked. That means all the increases we've seen in spending probably mean a ton of graft and corruption that needs to be investigated thoroughly.

So, now we've got an additional $100 billion. Frankly, if we get $400 billion in savings we'll be heroes. That would be enough from the markets perspective. If you want to get the extra $100 billion, I think there are plenty of places to get it from.

However -- and here's a big caution -- note the massive increases in mandatory spending over the last 7 years. Those increases are very real and will eventually eat our economic lunch if we don't deal with them now.

Thursday Oil Market Round-Up

For all the talk about the commodity sell-off this week, we're still in a bull market. Notice the following:

-- Prices are still above the upward sloping trend line that started in mid-March

-- All the SMAs are moving higher

-- The shorter SMAs are above the longer SMAs

-- Looking at the history of this chart, notice that during corrections prices have moved through the 10 and 20 day SMA to between the 20 and 50 day SMA and then corrected. While the past is not a guarantee of future performance, there is no reason to think this won't happen again.

Let's look at some other fundamentals in the market:

Crude oil stocks are still low

Gas stocks have been rising.

Gas prices are still inching higher, as are

Diesel prices, although it could also be argued that gas and diesel prices might be plateauing. However,

Once again, the U.S. average retail price for regular gasoline climbed higher into record territory, increasing 1.9 cents to 411.4 cents per gallon. Prices rose to record highs in each region with the exception of the West Coast where for the second week, the price dropped slightly. On the East Coast, the price increased 2.2 cents to 407.9 cents per gallon. In the Midwest, the price went up 2.8 cents to 405.9 cents per gallon. Despite an increase of 3 cents, the Gulf Coast price remained the lowest of any region and continued to be the only region where the price remained under $4 at 395.8 cents per gallon. The price rise of 3.1 cents to 406.5 cents per gallon in the Rocky Mountains was the largest gain of any region. The West Coast price fell slightly, dropping 1.6 cents to 444 cents per gallon. Nonetheless, the price remained more than 36 cents higher than any other region and 136.0 cents above a year ago. The average in California also declined somewhat, going down 2.3 cents to 455 cents per gallon.

Wednesday, July 9, 2008

Today's Markets

Not good. Not good at all. There are a few reasons for today's drop:

Fannie Mae (FNM.N: Quote, Profile, Research, Stock Buzz) and Freddie Mac (FRE.N: Quote, Profile, Research, Stock Buzz) dropped sharply as some investors worried that the two pillars of the U.S. housing market will need to raise billions of dollars in additional capital through stock sales, diluting the holdings of current investors.

Who are you going to believe -- the idiots who brought you this mess or the analyst who says things aren't that hot. In addition, every time we've heard "things are nowhere near that bad" from a company executive, things have fallen through the floor.

"There is also concern that as the earnings reports come out, that the projections for future performance for technology may not be as strong due to the weakness in economy."

Gee -- do you think that with the economy on the edge of a recession or in one earnings will drop? At least analysts have stopped their happy talk:

Analysts are now expecting a 13.5 percent drop in second-quarter earnings of S&P 500 companies, according to the average estimate of analysts polled by Thomson Reuters. That's compared to the 2 percent drop they were expecting in April.

And it's official --

U.S. stocks crumpled Wednesday, with the S&P 500 closing in bear market territory, as financial and technology stocks took it on the chin in the face of escalating fears about the impact of the slowing economy and credit crunch on coming earnings reports.


The Dow and Nasdaq are off more than 21% from October peaks, with banks crumbling, crude back on the rise and a warning about Cisco.

Let's go to the charts:

The markets moved sideways with a slightly upward bias at the beginning of the day. Then the market moved through all the SMAs and had small drop right around noon CST. Then after 1 all hell broke lose, with the average gapping down, consolidating and then gapping down again at the end of the trading day.

Above is the yearly chart. Notice the following:

-- We're at the yearly lows right now.

-- Prices have moved below crucial support established on two different trading days earlier this year.

-- All the SMAs are moving lower

-- The shorter SMAs are below the longer SMAs

-- Prices are below all the SMAs

Short version: this is a bearish chart, plain and simple.

My Kind of Central Banker

From Reuters:

Central banks must act firmly to avoid risks to price stability from rising inflation, European Central Bank Governing Council member Miguel Angel Fernandez Ordonez said on Wednesday.

Ordonez saw risks soaring raw material costs would lead to a spiral in consumer prices and wage demands that would further feed inflation. "Economic authorities, in particular monetary ones, have the duty to avoid these risks, to prevent these threats to price stability materializing, and as a result they must - we must - act with firmness," Ordonez, also governor of the Bank of Spain, said during an economic seminar in Madrid.

Let's compare this idea with the US method for dealing with inflation.

First, the US changes the way it computes CPI in order to make it look lower:

See -- inflation is lower! We can now lower interest rates.

Then instead of looking at all prices, we only look at those prices that are low, thereby making it easier to lower rates. This is the "core inflation canard" that was instigated by Greenspan. It's a wonderful way to deal with inflation -- if you don't consume food or energy. For those of us who like to eat three squares a day and leave the house occasionally, it is a terrible way to measure inflation.

Here's what's great about the "core canard". This chart doesn't matter:

And neither does this one:

Thanks to the magic of ignoring important facts we can set interest policy where we want! YEAH!

Until the US realizes that its fundamental central bank methodology is fundamentally flawed we'll continue to experience the problems we currently have -- asset inflation caused by recklessly low interest rates.

What's Good for GM.....

A few weeks back a research report came out that said GM was burning cash faster than the street thought and bankruptcy was not out of the question. This shouldn't be surprising to anybody, but for some reason using the words "bankruptcy" and "GM" in the same sentence is forbidden. Well -- it shouldn't be because both Ford and GM have major problems. They tied themselves into the gas guzzlers which aren't popular in a high gas environment. As a result, both companies sales are down as are their respective stock prices. Today we learned this about GM:

General Motors Corp., the world's biggest carmaker, sold 5.5 percent fewer vehicles in Europe last month, led by a decline at the Opel and Vauxhall brands.

European deliveries fell to 202,869 cars and sport-utility vehicles in June from 214,574 a year earlier, the company's Glattbrugg, Switzerland-based GM Europe division said today in a statement. Sales by Opel, which is uses the Vauxhall name in the U.K., fell 10 percent to 149,497 vehicles.

Six-month sales rose 2.8 percent to a record 1.16 million cars and SUVs, as demand for the Aveo compact and Captiva SUV helped the Chevrolet brand boost deliveries by 24 percent.

The GM death march continues.....

Wednesday Commodities Round-Up

There have been some really strong price moves in the commodity markets over the last few days.

Commodity markets slumped for a third straight session Tuesday, as a surging dollar and fewer worries over supplies hammered energy, metals and agricultural prices.

U.S. crude closed down nearly $6, bringing it almost $10 off Friday's record high near $146 a barrel.

Among industrial metals, aluminum lost 6% in London and copper fell nearly 4% in New York. Gold, which moves in step with oil but opposite to the dollar, also closed down.

Corn futures finished 3% lower and soybeans fell almost 2% in Chicago, retreating further from record highs last month.


"Overall, a stronger U.S. dollar, weaker oil and concerns about the global economic outlook have hurt the complex," said David Thurtell, an analyst at BNP Paribas in London.

But before we start to celebrate, let's take a look at the charts.

On the overall CRB index, note the following:

-- The uptrend is still in place.

-- Although prices have moved through the 10 and 20 day SMA, prices have actually used the 50 day SMA for technical support in the current rally.

-- All the SMAs are still moving higher

-- There is a great deal of technical support around 440.

Short version: we've seen two days of profit taking. But we haven't seen the kind of technical damage to the chart that will get traders to dump long positions yet.

Agricultural prices are interesting. I have been writing for several weeks that the chart looked like it might be forming a double top. That seems to be more and more likely. Remember the latest rally was caused by a natural disaster which by definition has a time limit. As a result, when the disaster retreats so does the reason for price increases. Also remember an old adage that one of the cures for high prices is high prices. This simply means that when prices get high enough they lead producers to find more product to sell or decrease demand in some way. Either way, it adds downward pressure to prices.

Gold is a proxy for inflation expectations in the markets, which also means gold can give us an idea for what traders are thinking about the future prices of commodities. Golds chart is sending a bunch of very mixed signals.

On the bearish side:

-- Prices are still in the price valley that formed after their peak in early March.

-- Although the SMAs are technically in a bullish alignment, they are still bunched up in a narrow range.

-- Prices are still meandering in a fairly tight range.

On the bullish side:

-- Prices are above all the SMAs

-- The shorter SMAs are above the longer SMAs

-- Prices have spent a few months consolidating from the highs in late March, but haven't crashed.

Tuesday, July 8, 2008

Today's Markets

Another crazy day in the markets. Basically today there were a few important events that helped to calm down fears in the market's most vulnerable places.

Financial shares climbed after Federal Reserve Chairman Ben Bernanke said in a speech that the U.S. central bank may extend emergency lending facilities for big Wall Street banks past year-end, showing the Fed is determined to stop the housing-inspired credit crisis from wreaking further havoc in the economy.

The financial sector was up 6.07%.

There was also a big drop in oil:

Crude oil fell more than $5 a barrel, the biggest decline in three months, as signs that the global economy may slow prompted investors to sell commodities.

Oil in New York has dropped more than $9 since reaching a record $145.85 a barrel on July 3. Gold, silver, copper and corn also declined. The U.S. economy has sagged amid credit-market and housing slides. Contracts to buy previously owned homes fell more than forecast in May, signaling prices have yet to bottom.

``All the bad economic news is making people take a second look at commodities,'' said Michael Lynch, president of Strategic Energy & Economic Research in Winchester, Massachusetts. ``Commodities were purchased as a hedge against inflation. A global recession is looking more likely, and it's the greatest weapon in the fight against inflation.''

As to whether or not this is the beginning of a trend has yet to be seen. Remember that oil has been rallying for the better part of a year; two days of strong profit taking don't change that. However, this is a good start. Let's go to the charts:

Let's pull back a touch and look at two days worth of price action. First, remember that yesterday he had a really big sell-off. Today that sell-off consolidated in a triangle pattern that lasted for most of the day. What's important here is the market didn't do much of anything until it broke through upside resistance about 1:30 PM CST. Then it was Katy bar the door. Prices advanced smartly on strong volume. Also note that prices are about where they were at the start of trading yesterday. That means we're about even for the week.

There is still a very bearish orientation to the daily chart. However, also notice that over the last few days we've had very strong volume and today we printed a really strong bullish bar. In other words, the last 4-6 days are looking like a reversal. But, nothing is set in stone.

Ben Bernanke -- Socialist

Today, Ben Bernanke gave a speech about financial regulation. In the speech he discussed what happened with Bear Stearns. It is an interesting explanation.

As you are aware, one of the key events in financial markets in recent months was the near-bankruptcy in March of the investment bank Bear Stearns. The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns's borrowings were largely secured--that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Hence, they refused to renew their loans and demanded repayment.

This is a really interesting situation and it explains a great deal about the problems in the credit markets. Even though the lenders had collateral in their hands they were unsure they could actually sell the collateral. Bernanke makes no mention of what type of collateral the lenders had. However, I seriously doubt lenders took highly exotic paper to secure a loan. Assuming that to be a fair reading of the situation, we know the credit markets were literally frozen solid.

Bear Stearns's contingency planning had not envisioned a sudden loss of access to secured funding, so it did not have adequate liquidity to meet those demands for repayment. If a sale of the firm could not have been arranged, it would have filed for bankruptcy. Our analyses persuaded us and our colleagues at the Securities and Exchange Commission (SEC) and the Treasury that allowing Bear Stearns to fail so abruptly at a time when the financial markets were already under considerable stress would likely have had extremely adverse implications for the financial system and for the broader economy. In particular, Bear Stearns' failure under those circumstances would have seriously disrupted certain key secured funding markets and derivatives markets and possibly would have led to runs on other financial firms. To protect the financial system and the economy, the Federal Reserve facilitated the acquisition of Bear Stearns by the commercial bank JPMorgan Chase.

Short version: If Bear Stearns went under we were in deep shit. Fair enough -- and I think a fairly accurate statement about what would have happened if they had gone under. HOWEVER, we now get into a really interesting policy debate. Earlier in the speech, Bernanke made the following observation:

As you know, those poor lending practices have contributed to a sharp increase in mortgage delinquencies and foreclosures. The resulting costs have been felt not only by borrowers but also by entire communities, as foreclosure clusters have caused neighborhoods to deteriorate and reduced municipal tax bases. The decline in the national housing market, which has been a major cause of the broader slowdown in economic activity, was in turn greatly exacerbated by the collapse of subprime lending.

So -- poor lending standards have led to the collapse of communities and harder times for cities. Shouldn't they be getting some help too? Aren't they too big to fail as well? This is the problem with bailing out Bear Stearns and the accompanying moral hazard. You get into these kinds of debates about who is too important or too big to fail and there is never a clear answer. However, I can tell you what this situation looks like: Wall Street firm makes many bad loans and gets bailed out despite their stupidity.

The PDCF and the TSLF were created under the Federal Reserve's emergency lending powers, with the term of the PDCF set for a period of at least six months, through mid-September. The Federal Reserve is strongly committed to supporting the stability and improved functioning of the financial system. We are currently monitoring developments in financial markets closely and considering several options, including extending the duration of our facilities for primary dealers beyond year-end, should the current unusual and exigent circumstances continue to prevail in dealer funding markets. At the same time, we are taking measures that will serve over time to strengthen the primary dealers, other financial institutions, and the overall financial system. As I will discuss, these measures include working with the SEC and the primary dealers to increase the firms' capital and liquidity buffers and cooperating with other regulators and the private sector to help make the financial infrastructure more resilient.

So, Ben, what is the exact definition of "unusual and exigent circumstances"? When exactly are these over and who decides? Again -- we are now getting into a really gray area for which there is no answer. But, again, I can tell you what this looks like: Privatize the profits and socialize the losses.

The Credit Crisis is Nowhere Near Over

From IBD:

A research report from Lehman Bros. saying that a new accounting rule might require companies to account for securitized assets on their balance sheets sent shares of Fannie Mae and Freddie Mac, the largest providers of funding for U.S. home mortgages, to their lowest levels since 1992 on concern that they would need to raise more capital amid larger-than-expected losses.

Remember about a year ago when a research analyst wrote a report about Citigroup that said the company would cut its dividend and take massive writedowns? That analyst was pilloried for that report. Since that report Citigroup has dropped about 60% because they have written down a ton of debt and had to raise additional capital. Here's the chart:

I raise the Citigroup comparison because they are hardly alone. In fact the entire financial industry is under tremendous selling pressure. Take a look at the Financial ETF:

Prices have been in a confirmed downtrend since mid-2007. They have continually made lower lows and lower highs. All the SMAs are moving lower, prices are below all the SMAs and the shorter SMAs are below the longer SMAs. This is a bearish chart if ever there was one.

The regional banks are no different:

Prices have been in a confirmed downtrend since mid-2007. They have continually made lower lows and lower highs. All the SMAs are moving lower, prices are below all the SMAs and the shorter SMAs are below the longer SMAs. This is a bearish chart if ever there was one.

And now we have two of the most important financial companies in the market with big problems on their hands.

Fannie Mae and Freddie Mac triggered a surge in the cost of protecting company debt from default to the highest in 14 weeks on concern the two largest U.S. mortgage finance companies may need to raise $75 billion.

How important are Freddie and Fannie?

Fannie and Freddie are government-chartered companies that provide the bulk of funding for U.S. home mortgages. They own or guarantee about $5.2 trillion of home mortgages, or roughly half of all home loans outstanding.

That's how important. Half of the mortgage market depends on these two companies being healthy. And their stock price indicates they are not:

Freddie stock has fallen off a cliff, moving from the mid-50s to $11.91. That's a huge drop. And Fannie isn't doing much better:

Fannie has also moved from the mid-50s to 15.75 or so.

And yet -- despite all of these obvious problems -- talking heads on TV are still saying the financial sector is cheap! It's time to buy! Anyone who is taking this advice deserves to lose every single dollar they invest. These guys are idiots of the highest order.

The bottom line is we are nowhere near an end to the problems in the financial sector.

Treasury Tuesdays

Some interesting trends developing in the Treasury market right now. Let's review what should move the markets and why:

1.) Inflation expectations are perhaps the biggest determinant of direction. Because bonds have a fixed rate of return, anything that lowers that rate lowers demand. Rising inflation takes away more of the money investors get from fixed income payments, so a period of rising inflation should lower the bid for bonds.

2.) Flight to safety: whenever things get really crazy, investors flock to bonds as a safe haven bid. This simply means that bonds have a specific payment investors can continually expect to receive from their interest rates. This is attractive when the overall environment is a bit nuts.

On the 7-10 year chart, notice the following:

-- Prices rose through mid-April. That was the result of the rally that started at the end of last summer. This rally was the classic "flight to safety" bid. As the financial markets dropped, investors flocked to the safety of the Treasury market.

-- Prices fell starting in mid-March. This was a reaction to the Fed's move to back-up the JP Morgan/Bear Stearns deal. This move sparked a rally in the stock market which means bonds would probably sell-off (which they did).

-- However bonds have risen since mid-June. The question is why? There are several reasons. First, it's become more and more obvious the Federal Reserve won't be raising interest rates anytime soon. This makes the current run of Treasuries more attractive because investors know that bonds with a higher coupon won't be coming down the pike. There is also the increase in overall volatility which makes the safe haven of bonds more attractive. However, what I find interesting is this is happening in a period of higher inflationary pressures. Theoretically, higher inflation should take the bid away from Treasuries. Instead we are seeing an increase in Treasury prices. I'm guessing there are two inter-related reasons for this. First, traders are expecting inflation to come down. The Fed has continually stated they see lower inflation ahead. In addition, yesterday we saw big drops in commodity prices adding fuel to the lower inflation fire. Secondly, the stock markets have been extremely volatile. This makes the fixed return of the bond markets very attractive.

Monday, July 7, 2008

Today's Markets

Wow -- can you say roller coaster? Today was one hell of a ride. The main news that got the market dropping was from Freddie and Fannie.

Freddie Mac and Fannie Mae fell to the lowest in 13 years in New York Stock Exchange composite trading as concerns grew the two largest U.S. mortgage-finance companies may need to raise more capital to overcome writedowns and satisfy new accounting rules.

Freddie Mac fell 18 percent and Fannie Mae dropped 16 percent after Lehman Brothers Holdings Inc. analysts said in a report today that an accounting change may force them to raise a combined $75 billion. Speculation that the companies may take further writedowns also weighed on the stock, said John Tierney, a credit strategist at Deutsche Bank AG in New York.

``There's a lot of apprehension about writedowns,'' Tierney said. ``If they have writedowns, they have to raise capital. How much do they raise and how easily can they do that? Those are the questions that everybody is asking.''

The size of those requirements indicates the analysts are deeply concerned about the companies' equity going forward. In addition, capital requirements that large imply a taxpayer bailout may not be that far behind.

Let's go to the charts.

The SPYs gapped higher at the open. Gaps up are considered strong moves because they indicate there is a fundamental mismatch between supply and demand in the market. However, note the index couldn't maintain the upward momentum. Instead, the index rallied to just below the 200 minute SMA and then slowly headed lower. The index continued to move lower, moving through the 10, 20 and 50 day SMAs until prices were just below all three. Then right after 11 CST the index dropped hard, with a downward move of nearly 1%. Then the index consolidated before moving lower. Then then market consolidated for the better part of two hours. Right around 2 PM CST the market rallied hard. My guess is this was the result of program trading. The market moved sharply higher rapidly covering 1.61%. Finally, the market fell hard, eventually ending down 1% on the day.

On the IWMs, notice the index moved lower a bit faster. From an inter-market analysis perspective this would have given some serious clues as to the SPYs possible direction.

Market Monday's -- the IWMs

Let's finish up with a look at the Russell 2000 tracking stock, the IWMs:

On the weekly chart, notice the index was in a rally from the end of 2005 to end of 2007, when the index fell from a double top formation. The index then dropped and formed a double bottom in early 2008. The index rallied -- like all other rallies -- when the Fed backstopped the Bear Stearns deal. But now the momentum has run out and the index is falling.

On the daily chart, notice the following:

-- Prices have been dropping for the last few weeks

-- Prices are below all the SMAs

-- All the SMAs are moving lower

-- The shorter SMAs are below the longer SMAs

This is a very bearish chart

On the P&F chart, notice prices are at a crucial support level.

Market Monday's --- The QQQQs

Let's continue looking at the broader market by examining the QQQQ charts

The QQQQs were in a rally from the middle of 2006 to the end of 2007. However, the index formed a double top in 2007 and then went through the trend line at the beginning of 2008. Since then the index has until mid-March when it rose with the broader market. The March 2008 rally was in reaction to the Federal Reserve's involvement with the JP Morgan/Bear Stearns deal. After rallying for a few months, the index is dropping again.

On the daily chart, notice the following:

-- Prices have fallen through the trend line started after the Fed/Bear Stearns deal

-- Prices are currently below all the SMAs

-- The shorter SMAs are below the longer SMAs

-- All the SMAs are headed lower

This chart is turning bearish.

The P&F chart is showing a picture of a chart turning more and more bearish with a set of lower highs. However, prices are still above the important technical level of 42. A move below that level will indicate some serious problems are ahead.

Finding Their Inner Volcker

From Bloomberg:

Policy makers in emerging economies from Russia to Vietnam may have to start acting less like Ben S. Bernanke and more like Paul Volcker if they want to bring inflation under control.

With currencies tied to the U.S. dollar, officials in many developing countries have had to keep their monetary policies linked to the Federal Reserve's. Now, after chairman Bernanke led the Fed's most aggressive easing in two decades, their central banks find themselves with interest rates too low for their economies and the worst bout of inflation in a generation.

``There's a lack of independent monetary policy; it's been inappropriately stimulative,'' says Nariman Behravesh, chief economist with Global Insight in Lexington, Massachusetts. The answer, he says, may be to ``tighten credit more aggressively,'' the way then-chairman Volcker did in the early 1980s.

Such a policy shift would mean pushing borrowing costs above the level of inflation and keeping them there even at the cost of a steep slowdown that might send commodity prices into a tailspin. Faced with inflation that approached 15 percent in 1980, Volcker pushed interest rates as high as 20 percent and drove the U.S. into its deepest recession since the 1930s.

Prices are now surging across the developing world. China's inflation rate stayed near a 12-year high of 8.7 percent in May; prices in Vietnam jumped 27 percent in June and Indian wholesale prices increased 11.6 percent last month, the fastest in 13 years. Inflation exceeds benchmark lending rates in China, Russia, India and at least a dozen other emerging economies

Paul Volcker is my favorite Federal Reserve Chairman. He was faced with the most difficult policy decision a central banker can face -- high inflation and a slowing economy. Volcker chose to raise interest rates to kill inflation. He was directly responsible for the double dip recession of the early 1980s which really hurt. But on the other side of that policy decision was low inflation which makes life a great deal easier.

Volcker realized a very important point: as a central banker sometimes you have to sacrifice popularity in order to do the right thing. By the time Volcker took office the inflation genie was already out of the bottle and the only way to contain it was to spike interest rates hard.

Right now all central banks are facing a similar situation -- declining growth and spiking commodity prices. The US attempted to dodge this bullet by arguing only core CPI mattered in their interest rate decisions. Other central banks weren't so brazen in their attempts to dodge the problem. However they are still facing similar problems.

In addition, the US is dealing with a problem of self-deception. Here is a chart from the website Shadow Stats that shows how the US has changed the way it computes CPI.

If we justs change the way we compute CPI all will be well. Unfortunately, the market is not buying it.

Notice that gold has nearly doubled in the last 3 years. Assuming that gold is a proxy for inflation expectations (which it is) this chart indicates traders are really worried about inflation.

Also note the massive drop in the dollar's value since 2006:

This didn't happen by accident. Traders are looking at the US economy and it's underlying fundamentals and voting with their trades to get the hell out.

There are no easy ways to deal with the current situation. Commodity prices are spiking because of increased demand. These spiking prices are doing two things -- they are creating a wave of supply push inflation which in turn is raising prices. This is leading to a slowing economy as manufacturers pass these cost increases onto consumers in various forms. For example, DuPont just announced a 25% increase in prices because rising manufacturing costs. FedEx and UPS have also announced several price increases as have all the airlines. And don't get me started about gas prices.

Whoever wins the election and whoever assumes Fed leadership after Bernanke will have to find their inner Volcker. And fast.

Market Monday's

I hope that everybody had a good and safe Fourth of July. We now return with a full week a trading and a market that isn't looking that hot.

On the weekly view, notice the following:

-- The SPYs formed a double top in mid-2007. Since then they have dropped

-- Prices are below the 200 week SMA

-- Prices are below all the SMAs

-- All the SMAs are heading lower

-- If price move through 124 in a convincing way, the next support level is at 117

On the daily chart, notice the following:

-- Prices are below all the SMAs

-- All the SMAs are headed lower

-- The shorter SMAs are below the longer SMAs

The P and F chart shows the precariousness of the current price situation. Notice the importance of 124 as a support level.