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.

In June when crude oil closed above $138, I featured the chart below, showing that adjusted for inflation crude oil was not only exhibiting classic bubble behavior, but that it dwarfed previous oil spikes:

The next day as Texas tea ramped up the most dollars in its trading history, I mentioned that even if we looked at crude oil priced in gold, it was expensive:

…which would imply that if this ratio has any significance, a top in oil is close at hand.

It took a few weeks until the top was put in oil at ~$148 in mid July. But as of now it is down approximately 27%

A quick glance at the chart shows previous resistance, now support, at the round number $100. When or if, oil continues to fall, it will provide relief for the economy. As for whether the spike up was manipulation, normal market dynamics, a bubble, etc. I’ll leave you to explore that for yourself.

You can find a lot of links about oil and the price of oil here.

What can possibly explain the behavior of the price of oil? The Senate committee has heard testimony from a variety of sources and a variety of viewpoints ranging from accusing the regulators to be tacit participants in market manipulation to “Peak Oil”.

This same sort of back and forth happens whenever we have bubbles forming. There are always those who argue that it is simply a speculative mania, and then there are the true “believers” who bring arguments and evidence why things have changed.

To show you how difficult it is to make any sense of this, consider that two very smart and very wealthy investors find themselves on opposite sides of the argument: George Soros believes there is a bubble, while his ex-partner, Jim Rogers, feels the opposite is true.

But it isn’t difficult to see why many believe that the price of oil no longer represents a true picture of the value of this commodity; after all, it has more than doubled within the span of less than two years:

Note that the chart above is using a logarithmic axis for price and even then you can see that the slope of the rise from 2007 to present is much steeper than that between 2002 - 2006. Here’s an even more long term chart of crude, this time adjusted for inflation:

Source: St. Louis Fed (FRED database)

Oil Shock
This chart clearly shows that the world economy is undergoing a severe “oil shock”. One that pales in comparison to ones which we’ve seen so far in either the Gulf War or the 1979 Iranian Revolution (or the 1973-4 oil embargo - not shown on chart). Which goes a long way in explaining why consumer sentiment is at multi-decade lows.

One of the defining characteristics of a mania is a parabolic chart: increasingly steep price curve within a shorter and shorter time frame. And clearly, that is what we are seeing. While there may be disagreements whether this is really a bubble, what most can not deny is that the rise we have seen so far is just unsustainable if projected into the future.

Perfect Storm
My gut feeling is that we are seeing a confluence of forces, among them, long only commodity funds, a weak dollar, negative real interest rates (which always increase commodity prices) and demand from an increasingly voracious industrial complex in China and India.

But the fact that the increase in price has come in such a short time and it has been so incredibly sharp tells me that it can not be simply explained by the usual market forces of demand and supply. Something else must be at work to drive the price of crude as high as it has done within such a short time span. But only time will reveal what exactly what that “something else” is.

If you doubt that bubbles can not form in “real assets” then you’ve probably overlooked a lot of examples from history: the Japanese real estate bubble, gold, silver, etc. And if you believe that market manipulation is impossible or the overworked imagination of conspiracy theorists, then I would remind you of the California electricity crisis in 2000.

Silver Lining
If the price of oil here truly represents real demand and supply the potential silver lining on such a cloud is that it will not only change people’s consumption habits, it will spur on the development of better alternative energy sources. This is what I don’t understand, if you are a dyed in the wool “peak oil” believer, why invest in a dying industry? why not invest in those companies which will rise up out of the ashes and propel us forward? or do the “peak oilers” believe we are going to regress technologically?

Or consider it another way, if you were to go back in time, would you try to corner the whale oil market? or invest in Texas oil fields?