Trader’s Narrative

For economic and market news and to see what you may have missed last week, check out the list below. It is just a few choice examples from news.tradersnarrative.com:

• What Does Climate Change Have to do with Goldman Sachs?
• Barry Ritholtz Podcast Interview
• Five Pitfalls of Developing Traders
• KKR Goes Public Through IPO Backdoor
• Get a FREE Subscription to Financial Magazines
• Spotting Trend Reversals With MACD
• Obama’s Financial Reform
• End of Nortel - Sale to Nokia & Delisting
• Buffett: US Economy In “Shambles” .. No Signs of Recovery Yet
• What is the difference between a triangle and a pennant?
• Free trading videos
• Volcker Not Calling Shots in Financial Reform
• Central Banks Can’t Control the Market

For the complete list, follow the graphic below:

And remember to check back regularly since there are interesting links added throughout the week.

Week Ahead

Not a moment too soon, the financial markets reacted to leadership from European governments and central banks over the weekend. Sadly, the US team of Bush (excuse me while I roll on the floor convulsing with laughter) Paulson and Bernanke didn’t exhibit one iota of leadership or common sense. Did anyone expect the same team that continuously reassured the world that everything was fine over the past 2 years to be the ones to actually solve this?

The consensus among smart economists (Roubini), investors and traders (Soros) has been the need for “capital injection” - a euphemism for “buy a truckload of financial common stocks”.

The Old World Shows The Way
The US’s muddled TARP proposal instead was aimed at buying into the nebulous and toxic derivatives at the heart of this crisis. Shares are easily priced each second on the open market so it can’t be easier to value a bank’s “worth”. Whereas the derivatives are next to impossible to untangle and value. Also, a share, because of its perpetual existence, has a multiplier effect. So by injecting $100 billion of capital, you in turn leverage the effect by the P/E ratio which even now is around 10 for the average financial institution.

Of course, by now TARP has morphed into the European model. Which can arguably be also called the Swedish model, since this very solution was used by them in the early 1990’s to get a banking crisis under control. And unless I’m mistaken, the Swedish taxpayer actually got significant capital gains out of the whole thing. Seriously, how ridiculous does Paulson sound when he proposes with a straight face to simply use government money to buy assets of dubious quality and worth… without receiving absolutely anything in return?

You don’t need a PhD in finance to know that way lies madness.

Then again, the news of a concerted European effort may simply have coincided with a snap back rally. If you recall, many had high hopes for the TARP announcement to reverse the market’s decline. It did no such thing. So in effect, while the news seems to have caused the market to rally, we can’t truly prove that it was the force behind it. There are strong reasons to believe that the market was simply exhausted from relentless forced liquidation and just hit the wall.

Timing
Last week I facetiously suggested that if this wasn’t the stock market bottom, we should flee to the hills and buy guns. The future was starting to look like some kind of Mad Max distopia, at least if you believed the breathless analysts on TV and the headlines across newspapers. Then just hours later I learned that Tony Oz had taken a large long position, based on similar conclusions.

Of course, no one knows what will happen in the market. The best one can do is to put aside emotion and to look at the facts. Or one better, and use emotion to your advantage by looking at sentiment, rather than having it control you. Last week’s sentiment overview was clearly the most pessimistic in a very very long time.

90-90 Day? - You Betcha! (wink)
As much as last week’s market’s were smashing all records on the way down, Monday’s rally smashed them on the way up. This was as broad based and furious a come back as the bulls could have mounted.

In terms of volume, 95% was accounted by advancing stocks on the NYSE. We went from seeing more than 2,500 stocks on the Big Board hitting new 52 week lows on Friday… to seeing less than 60 today doing the same today. So yes, today definitely met the requirements for a Lowry’s 90-90 up day - and more!. This is something that we had been waiting for because according to the research, a significant floor is created when the market has fallen significantly (90-90 down days) and then reverses with the same ferocity.

Here is a short excerpt from the research done by Paul Desmond of Lowry’s Research:

The historical record shows that 90% Downside Days do not usually occur as a single incident on the bottom day of an important market decline, but typically occur on a number of occasions throughout a major decline, often spread apart by as much as thirty trading days. For example, there were seven such days during the 1962 decline, six during 1970, fourteen during the 1973-74 bear market, two before the bottom in 1987, seven throughout the 1990 decline, and three before the lows of 1998. These 90% Downside Days are a key part of an eventual market bottom, since they show that prices are being deeply discounted, perhaps far beyond rational valuations, and that the desire to sell is being exhausted.

But, there is a second key ingredient to every major market bottom. It is essential to recognize that days of panic selling cannot, by themselves, produce a market reversal, any more than simply lowering the sale price on a house will suddenly produce an enthusiastic buyer. As the Law of Supply and Demand would emphasize, it takes strong Demand, not just a reduction in Supply, to cause prices to rise substantially. It does not matter how much prices are discounted; if investors are not attracted to buy, even at deeply depressed levels, sellers will eventually be forced to discount prices further still, until Demand is eventually rejuvenated. Thus, our 69-year record shows that declines containing two or more 90% Downside Days usually persist, on a trend basis, until investors eventually come rushing back in to snap up what they perceive to be the bargains of the decade and, in the process, produce a 90% Upside Day (in which Points Gained equal 90.0% or more of the sum of Points Gained plus Points Lost, and on which Upside Volume equals 90.0% or more of the sum of Upside plus Downside Volume). These two events – panic selling (one or more 90% Downside Days) and panic buying (a 90% Upside Day, or on rare occasions, two back-to-back 80% Upside Days) – produce very powerful probabilities that a major trend reversal has begun, and that the market’s Sweet Spot is ready to be savored.

Source: Identifying Bear Market Bottoms and New Bull Markets (Dow Awards folder)

Believe it or not, this is the second Lowry’s 90-90 up day we’ve had within 9 trading days. According to Lowry’s 90-90 up days can be spaced out as far as 30 days from each other and still be effective. And although most people keep strictly to the 90-90 definition, Lowry’s actually mentions above that 80-80 up days also qualify. So if you want to be more flexible like them, on September 18th 2008 we had a 89.5% up day which would make it three strong up days.

LIBOR & TED Spread
As I mentioned a few days back, LIBOR and the TED spread stopped going up and today they actually fell hinting that we may have seen the worst of the credit crisis. As banks start to trust one another and lend again, liquidity will flow back into the financial markets and the forced liquidation will cease. It is still too early to be complacent about this but the first signs of a return to normalcy are there.

So after the Fed cut rates as expected, and the market was miffed that it wouldn’t be enough to remedy the credit crisis wreaking havoc in the financial sector.

And then a day later the Fed came out with all guns blazing, with their international “friends” in Switzerland, Canada, Europe and England by their side.

But, to paraphrase Austin Powers, “Whoop Dee Doo, But what does Global Coordinated Liquidity Injection really mean, Bernanke?”

Since I’ve already explained the sub-prime market in simple terms, lets see if we can also explain this new Fed maneuver.

Federal Reserve Discount Window
Before we get to the explanation of what the global central banks will be implementing, we need to understand what the discount window is. Normally banks borrow from each other, or the fixed income market when they need capital. The discount window at the Fed is an option of last resort for banks what can not find financing using normal channels or anywhere else for that matter.

Although the discount window has been open, the rate reasonable and the need beyond extreme, no significant amount has been drawn through it by any major bank.

Global Coordinated Liquidity Injection
So why would banks act so stubbornly? Why sit there and bleed slowly? Or seek capital elsewhere at much higher rates than the Fed’s discount window?

It turns out that banks, unlike the current batch of Hollywood starlets, are prone to public embarrassment. The stigma of having to rely on the generosity of the Federal Reserve is too much They fear that were they to seek out this available solution, they would expose themselves to evaporating public confidence.

Shhhh, It’s A Secret
The coordinated liquidity injection allows banks to access the discount window with anonymity. So they can borrow at below interbank rates, using the same collateral that they would put up in a discount window transaction, but the transaction is secret. No one will find out who and how much… and so, no stigma.

There will be four auctions of $20 each. The first will be next Monday, the second December 20th for $20 Billion each. The third and fourth will be contingent on the evolving international credit situation.

Private Banking
Reminds me of the time I had to withdraw a rather large sum from a European bank a few years ago. Since this was the first time for me, I was a bit nervous. I didn’t want to stand at the counter while the money was given to me in open view of everyone. I didn’t know they have special rooms in the back for these sort of transactions.

Walking to the back was an interesting experience. No music sounds sweeter than the whirring of counting machines. Walk in with a briefcase, walk out with a briefcase. No public scrutiny. No one the wiser that the briefcase was a little bit heavier than before.

I have a feeling that many US banks are now running towards their favourite central bank with very very large briefcases.

As I mentioned a few days ago, my gut instinct tells me that the major central banks are about to turn and enter into an easing cycle. The Australian monetary authority and their European counterparts stayed pat but the British had a surprise in store for the markets today.

Bank of England’s “Surprise” Cut
Today, the BoE reduced the bank rate by 25 basis points to 5.5% - at which, it is still the highest rate in Europe. According to Bloomberg, the vast majority of economists were not predicting the reduction.

This is the Bank’s first cut in more than 2 years and brings the rate down from a 6 year high. Most are now expecting that this will be accompanied by further cuts in the near future.

Similar to the Bank of Canada, the decision was spurred on by concern of an expanding credit crisis brought about by the sub-prime mortgage crisis in the US. An excerpt from their statement:

Although output in the United Kingdom has expanded at a brisk pace for the past two years, there are now signs that growth has begun to slow… conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead.

According to HBOS plc, the UK’s largest mortgage and savings provider, house prices fell for a 3rd month in November by 1.1%. That’s the worst streak for property values since 1995.

European Central Bank Stands Aside
Citing an unexpected rise in inflation, the ECB decided to hold rates steady at 4%. If inflation hadn’t come in at 3% - a full percentage point above their target - I’m think they would also have reduced rates.

Unlike the Bank of England’s decision most economists and analysts expected the rate decision, so no surprise.

More or less, the world’s central banks operate in concert with one another, often even cooperating hand in hand to help each other (whether it is in setting interest rates or foreign currency interventions).

Today the Bank of Canada surprised everyone with a 25 point basis cut. Although the higher Canadian dollar had created concern about Canadian exports, most thought that the Canadian central bank would opt to leave rates unchanged due to a buoyant economy thanks to high commodity prices.

But the sub-prime mess has once again reared its head (excerpt from their press release):

Global financial market difficulties related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist for a longer period of time. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further.

The Bank of Canada is also worried that the effects of the sub-prime mortgage crisis will dampen the US (and global) economies enough to diminish demand for Canadian exports.

If the commodity markets are topping, then this would be a double whammy to the Canadian economy, so the Bank of Canada is smart to judge a “shift to the downside in the balance of risks”.

Since central banks don’t just lower or raise rates in a random fashion, this change in stance is probably the beginning of a series of rate cuts. Following the built in assumption of another rate cut from the Federal Reserve’s meeting next Tuesday, the Canadian central bank is now set upon an easing campaign.

The European, Australian and English central banks (or counterparts) will be meeting this week and my bet is that similar decisions will be coming out of those hallowed halls.

Which would spell some relief for the poor old US dollar (and a cautious note for precious metal bulls).