Trader’s Narrative

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.

Unless you’ve been living in a cave, you know that there is total carnage in the stock market, especially within the financial sector. By the way, if you have been living in a cave, congratulations on a very astute real estate investment.

Anyway, bank and investment bank stocks are trading at empty shadows of their glorious past. It almost makes you pine for the dot com bust. Almost. But even amid all this mayhem, are there financial stocks which are left standing, more or less unhurt? or dare I say it, strong?

It turns out, yes, although you have to sift through a lot of muck. And what you do find are small to medium capitalization stocks. The fact that these stocks have held up and are actually going up in some instances while the market as a whole craters is a huge sign.
Continue reading ‘Are There Any Strong Financial Stocks Left Standing?’

The financial sector, as measured by its proxy, the Philadelphia Banking Index (BKX) has definitely broken down. I said as much before the end of last month. While it seemed that the line everyone was watching (level 75 on the chart) might act as support, it didn’t convince me.

While it put up a bit of a struggle dancing around the line for 3 more trading days, it has now decidedly broken down:

The red line marks when I suggested that the sector would break down. The next support, as you can see, is still some way down. So I would stay away from the long side until it reaches that level.

But the good news is that if or when it does plumb those depths, there is a good chance that it will find significant support. It will be fourth time, after the 1998 LTCM bottom, early 2000 and the late 2002 bear market floor.

There is some technical support level at 70 but before a definitive bottom can be in place this sector may need to get to real support and wash out all the weak hands.

And I suspect that by the time the Bank Index finds its way down to 65 or thereabouts, the bullish percent index will have commensurately fallen to significant buy areas:

That would be, at least, a 20% points drop. Until then, while rumors like those swirling around Lehman Bros. (LEH) may fly and the negative sentiment may get even thicker than it is right now, I doubt that this sector will find its footing.

But while this may be bad news to those long banks, or other financial stocks, I don’t think that it necessarily means the market itself is somehow doomed. A bull market doesn’t need financial stocks.

The financial stocks are not doing too well right now. I’m just telling you in case you’ve been hiding under a rock or have been floating in sensory deprivation tank for the last whee bit.

It seems everyone is looking at the poor financials and noting how weak they are relative to the market. The shibboleth is then trotted out that we need the financial stocks for a healthy bull market. I’m sure you’ve heard or read this multiple times.

I caught myself repeating it in my previous post (see above link). But rather than accept it at face value, lets put it to the test.

Does a bull market truly need the leadership or participation of the financial sector?

To begin, here is the chart of the Philadelphia Banking Index (BKX) compared to the S&P 500 Index (SPX):

Remember, this is a relative chart. When the financial sector is doing better than the general stock market, the line trends up, and when they are weaker than the general market, the line goes down. And while the ratio showed incredible volatility between 1998 - 2003, the BKX was relatively unchanged, simply treading water the whole time.

Now lets see how the market actually behaved during the times that the financial stocks were leading and during the times that they were weak:

The bull market didn’t start in 1995 but it certainly did intensify with a sharp upturn in its slope. While the S&P 500 continued to rally - with intermittent corrections - until 2000, the Philadelphia Banking Index (BKX) only kept up its leadership till early 1998.

From then to the S&P 500 market top (otherwise referred to as the “bubble top”) financial stocks actually performed weaker than the general market. It certainly didn’t faze the bull market though.

Bull or Bear, Banks Don’t Care
As the tone changed and a bear market took hold, the financial stocks re-awakened and took leadership once again. They actually performed better than the S&P 500 as the bear market raged on. In retrospect, they were a decent hiding place. You didn’t make much money on an absolute level but you didn’t lose money either. If you had borrowed a tactic from a hedge fund playbook, I suppose you could have made money going long financial and short the S&P 500.

Finally, as the bear market subsided and a new bull market was born, the financial sector lost its luster and started to underperform again. Little at first but more recently, at a torrid pace.

I know this is a short slice of market history but even from such cursory analysis it seems that there isn’t much stock in the common belief that financial stocks need to lead a rally. Nor that they need to perform better than the general market for us to enjoy a bull market. In fact, there is no real relationship that I can discern. If you see one, please edumacate me.

I believe there are conditions that precede bull markets - this just isn’t one of them.

Sacred cows make the best burgers and this one is of kobe proportions. If your blood-lust is not satiated, let the intellectual slaughter continue by checking out how cumulative breadth can be misleading.

Want to see something that will knock your socks off?

US Financial Stress Index
The BCA US Financial Stress Index (left) is a proprietary and nutritious blend of these econometric and statistical ingredients:

• performance of bank stocks relative to the general stock market
• the yield curve
• credit spreads
• real stock prices
• consumer confidence
• market leverage
• private debt
• new bond issuance
• new equity issuance

BCA Research is the world re-known financial markets analysis firm out of Montreal. According to this indicator, the only previous crisis in recent history to outdo our present subprime debacle is the Savings and Loan boondoggle that was the epitome of the 80’s excess.

Which would explain why BCA Research is not giving up on their bullish bias:

The long running bull market in equities is not dead yet. The Fed is not the only game in town. The U.S.economy is not falling apart, the dollar has cheapened substantially and bond yields have melted. Most important, equities offer good value and the areas most exposed to the subprime crisis are already attractively priced.

If you’re still wondering how the Sub-Prime mess came about, there is no simpler explanation than this.

Here’s a more serious one (don’t forget to check the “How it went wrong” checkmark).