Trader’s Narrative

Since I got my hands on my copy of Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, I’ve been devouring it almost non-stop.

Written by Barry Ritholtz, Director of Equity Research at Fusion IQ, and blogger at The Big Picture, it promised to be a definitive guide to the financial mess - and it didn’t disappoint.

In his inimitable colloquial tone Ritholtz sets out to meticulously explain how the stage was set for the historic unraveling of the global economy in 2008. Although we will no doubt have a plethora of similar books, Ritholtz’s book, for its detailed historical approach and its comprehensiveness will probably end up being the encyclopaedia that future historians and traders come back to.

Filled with charts, diagrams, cartoons and highlighted sections, Bailout Nation grabs hold of your attention and never lets you come up for air until the very end. I found very few errors or bumps along the way. Some sections were a bit repetitive. For example, referring to the case of LTCM, he says:

The collapse of that hedge fund in 1998 and its subsequent Fed-orchestrated rescue plan provided one of the greatest — and most terrible — examples of moral hazard ever known.

Then a few paragraphs later:

Contrary to what Greenspan claimed, the Federal Reserve’s involvement did not create “slight” moral hazard. Rather, the 1998 Fed-orchestrated rescue was moral hazard writ humongous.

Yes, we get it Barry! But because the book is so well written and researched, I’m nitpicking here really.

I truly appreciate that Ritholtz comes across as politically agnostic. He excoriates both the Democrats and the Republicans for reckless policies and decisions that have no logic but foster a culture of entitlement, reduce or entirely eliminate regulation and get private enterprises addicted to public funds.

Most Americans are labouring under the patriotic delusion that they live in a free market society. But for all their pro-capitalistic bravado, America’s history is replete with corporate welfare. Both Democratic and Republican governments have lavished public funds on businesses that would have gone extinct in a real free market. To start at the beginning, Ritholtz highlights the precedent setting bailout of Lockheed Martin in 1971. This was the first time the US government had acted to help out a single corporation. He then proceeds to describe the other bailouts, which by now had become the norm.

Ritholtz spies a 10 step pattern of bailouts:

1. Risk Event
2. Pre-awareness
3. First Reactions
4. Bigger Reactions
5. “Interested Party” Agitation
6. Official Concern
7. Broader Worry, Deepening Panic
8. Major Intervention/Bailout
9. Rationalization & Apologies
10. Expected Results and Unintended Consequences

It isn’t too hard to spot us at stage 9 - with Greenspan’s sheepish “flaw” apology and Geithner’s haphazard attempts to sell everyone on his ill thought out PPIP proposal.

When it comes to casting blame, Ritholtz doesn’t pull any punches. As you can imagine, with a foreword written by Bill Fleckenstein (author of Greenspan’s Bubbles), Ritholtz doesn’t shy away from criticizing the Maestro. In fact, he puts him front and center, as the primary enabler of this convoluted tragedy. But he also defends what he considers to be “misplaced fault” such as naked shorting, mortgage interest deduction, etc. I don’t totally agree with him on naked short selling. The deregulation that he cites elsewhere was also why naked shorting was allowed to take place - at times on a massive scale, with devastating consequences.

Ritholtz also cites a very clever reason for why Wall St. got greedy in the first place and went into overdrive, taking on fatal amounts of risk. I won’t ruin the aha! moment for you but it is signature Ritholtz to be able to pull together very disparate variables and see a pattern emerge.

I’m often asked by friends and family members to explain why Wall Street just imploded. Bailout Nation is an accessible and fun to read book that explains every question they have - and a few they never even thought of asking.

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.

Here’s a chart of +50 years of the intended Federal Funds rate:

Now is an appropriate time to take a step back and look at the bigger picture because what the Fed has just done is extremely rare.

It has reduced the interest rate by more than 43% in less than 6 months. To find such a frantic slashing of rates we’d have to go back to the Volcker years in the early 1980’s.

The only other time in recent history that is remotely similar is the aftermath of the 9/11 tragedy in late 2001.

What makes it intriguing is that unlike the 1980’s and 2001 when everyone knew something horrible had gone wrong, we don’t really have that now. I think it will take some time for us to understand just what happened.

It seems surreal now as we are going through it. Perhaps the only way to understand it is through the perspective of time. Who would have believed that the current credit crunch makes the 1998 crisis pale in comparison?

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.