Trader’s Narrative

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

By now you’re probably well familiar with the drama playing out over at Bear Stearns (BSC) as they try to come to grips with their exposure to the subprime meltdown. Their massive CDO portfolio is melting faster than a snowman in the Gobi desert. And all the rest of Wall Street wants to do is sit back and watch. And maybe pull a Nelson Muntz.

Bad Karma
Bear Stearns earned some really nasty karma by not helping during the LTCM debacle and now they are reaping what they sowed. Payback’s a bitch.

I’ve been making some bearish noises for a while now. And I think we’re still not in the clear.

Today’s market action was ugly. It gave a slight hint of hope in the morning and then dashed them during the afternoon. Since market lore tells us that the morning belongs to amateurs and the close to the pros, this is a weak market.

The financials, banks and brokers have been a very weak spot in the market and this isn’t going to help at all. If we were already in a protracted decline, and we had a meltdown of a fund or a crisis like Bear Stearns’ then I might have interpreted it as a bullish sign. But right now, this looks pretty ominous. We’re just teetering and it may be an edge.

200 Day Moving Average
I took a look at Bear Stearns’ long term chart and for the duration of this bull market, it has acted very faithfully with respect to its long term moving average. From 2003 till now, it has spent very little time below its moving average. In fact, it has usually just kissed it and zoomed back up.

It did so during:

July 2003
November 2003
May 2004
May 2005
August 2005
October 2005
June 2006
September 2006

But the recent price action is uncharacteristic since it doesn’t follow this pattern (see graph below). In late February and early March 2007, Bear Stearns (BSC) fell to its 200 day moving average. This was the time of the market wide correction so no biggie. But then it spent the next months trying to liftoff without success.

Click to Enlarge Graph

And right now it is beneath its 200 day moving average like never before. Well, atleast not in the past 3 years. We may actually get a quick snap back rally but there’s no question that technical damage has been done.

Credit Default Swaps
Now, here’s the really curious part of this whole mess. With BSC trying desperately to offload their ginormous CDO portfolio and save their funds, you’d think that the bond market would be spooked, right?

But according to credit default swap market is taking all of this in stride. CDS’ allow you to offload the risk of high yield bonds by selling the exposure of default to someone else.

By comparing the CDS rates to ‘risk free’ Treasury bonds we can measure how scared the bond market is to default risk. Right now, they simply aren’t. Which, from a contrarian sentiment point of view, paints a negative picture.

Interestingly enough, although this indicator doesn’t have that much history, it has done a good job of also flagging inflection points in equities after a decline. It isn’t finding one here.