Trader’s Narrative

Hoo-Kay… let’s see. Why is this a buying opportunity for someone with a medium to long term time horizon?

Glad you asked.

Fund Flows
We already know that the vast majority of investor’s money is flowing oversears, eschewing the US equity market. But with the recent market decline, investors are now pulling money out in a panic. According to TrimTabs, they withdrew $7.6 Billion last week. That sort of panic is similar to what we saw in late February 2007 when investors pulled $6.5 Billion.

Insiders Are Buying
Meanwhile, insiders have been scooping up unloved shares at a pace not seen in 3 years. That was in August 2004 as stocks hit an intermediate bottom. Ask yourself, is there anything insiders know that we don’t? Who would I rather side with? insiders or Mom’n'Pop investors who are ruled by emotion?

Sentiment
Speaking of emotion, while sentiment surveys are not yet in, I suspect that we’ll see a marked decline in bullishness and a rise in bearishness. Only one is in so far and it shows a tilt towards bearishness as fear grips investors. But looking at unorthodox places like newspaper headlines and media stories we can find a lot of negative chatter.

“Usual Suspects” Show Fear
The usual indicators that most people turn to are showing fear: volatility indices and the put/call ratios. And the increasingly popular % of stocks above a moving average.

Scapegoat: Sub-Prime Mortgates
Everytime the market falls, a convenient reason is trotted out to explain it in a sound bite. Today’s is the subprime mortgage market. In the spring it was China’s fault. They sneezed. We caught a cold. While it is ugly out there in the subprime market, risk profiles are returning to more normal levels.

It is not the end of the world as we know it. According to the credit default swap market, we are in full blown panic right now. As a result the financial sector has gotten crushed to absurd valuation levels. Over the long term, this is one heck of a great buying opportunity as people panic and throw out the baby with the bathwater.

Market Internals
Popping the hood on the market and taking a peek inside we see that the internals are also showing panic and fear. At levels which historically have installed important market bottoms. Take a look at the new highs, versus new lows. The advance decline line, likewise has found a high probability buy zone here.

The Commercials
Like the insiders, they know something. They aren’t telling exactly what, but who cares? All we need to do is follow what they do. That’s the most convincing argument they can put forth: money where their mouth is. The commercials have steadfastly and consistently increased a ginormous net long position. Who do you want to side with? them or the little guy who was buying calls like crazy just before the market dove off?

Fundymentals
Let’s not give the technical tools all the fun. How abou the IBES model? It is showing that equity markets are very cheap here. Yes, very. And cheap. Don’t like the IBES? Fine. How about that the market’s forward multiple is 14.7, which is a little below its 20 year average? Still think the market is inordinantly expensive and in need of a fall?

Bond Market
A lot was made of the bond market’s fall in June 2007. But guess what, the yields spiked on the 10 year and 30 year Notes have fallen dramatically. Don’t believe me? Pull up a quote. If you’re a chart and system junkie, take a look at the 30 day rate of change for the bond market.

Traditional Technical Analyisis
Price, moving averages, trendlines and good ol’ support and resistance. The market has fallen to its 200 day moving average, where it has found footing before several times. The uptrend is still intact. And the S&P 500 is right at the support (previous resistance) line at 1460(ish) - check out the graph.

Bad News Trio
Bad news is everywhere: American Home Mortgage is in bankruptcy, Sowood Capital, imploded taking with it hundreds of millions of investor’s money. And just today rumours were swirling of Beazer Homes’ (BZH) bankruptcy. As far as I know they were unsubstantiated. But the important thing is that the negative headlines and fear is palpable. Just this week there was an article on the Wall Street Journal asking if the bull market was over? This cluster of negative articles and media attention accompanies market bottoms, not tops.

The IPO Market Speaks
When things get frothy, the IPO market goes insane. Crazy ideas are funded and taken public. Remember the turds from the bubble years? e-Stamps anyone? Right now though we have a healthy IPO market. One that is open and functioning without being irrationally exuberant. That bodes well for the market in general as this study from Thomson Financial shows.

The subprime crisis which came to a head when Bear Stearns’ (BSC) funds imploded has now officially spilled over into the rest of the bond market. Take a look at the BBB rated bonds in the mortgage markets:

What looked benign just less than a month ago, has now filtered through the market such that the BBB paper is priced at less than 40 cents on the dollar. As I noted back then the chart for Bear Stearns (BSC) looked ominous but the credit default swaps were showing no real panic in the market.

How much difference a few weeks makes. The credit default swap rate spread has spiked higher than May 2006, when the market last found its most significant bottom.

The poster child for this mess is American Home Mortgage Investment Corp. (AHM) which dropped 90% today to close at penny stock prices.

Here’s another chart (from Jim Stack’s InvesTech) which shows the devastation being wrought in this sector:

Notice how the critical support line (dotted) coincides with the consolidation in the BBB market around 65-70. That is one brutal chart. The only positive thought I can muster is that it looks like most of the damage is over.

What are CDS’ and why should you care what their rate is doing?

Credit default swaps are financial instruments which transfer the risk of a bond issuer defaulting from the seller of the instrument to the buyer. Although they are infinitely more complex, think of them as put options. Just as being long a stock and a put protects you from the downside, so does a credit default swap protect the bond holder from catastrophic loss due to default.

This is a relatively new financial instrument but it’s market is growing like crazy. Of course, it is off limits to regular traders and investors due to its complexity and size. Yet just by watching this interesting market we can get an inkling into the animal spirits driving a market.

By comparing the credit default swap rates to a theoretically risk free security like a Treasury bill, we can track how much risk is being tolerated out there.

The more market participants perceive risk, the more premium they will demand for taking it on. And so the spread between the two rates will widen. And the less risk perceived, the less premium and the spread will collapse.

Although this is a young indicator, it has shown promise. Check out this chart of the S&P 500 index. The green arrows point to when the spread between credit default swap rates and risk free rates widened both significantly and within a short time. That is, a quick and large move.

As I briefly mentioned last week when commenting on the Bear Stearns (BSC) sub-prime debacle, credit default swaps were taking it all in stride. But from then to now, they have indeed moved sharply.

Why now? and why not last week? I have no idea. All I know is the bond market is now more frightened of defaults than it was then. And that is actually quite bullish for equities going forward.

Data and indicator courtesy of SentimenTrader.com