Trader’s Narrative

As I mentioned a few days ago, my gut instinct tells me that the major central banks are about to turn and enter into an easing cycle. The Australian monetary authority and their European counterparts stayed pat but the British had a surprise in store for the markets today.

Bank of England’s “Surprise” Cut
Today, the BoE reduced the bank rate by 25 basis points to 5.5% - at which, it is still the highest rate in Europe. According to Bloomberg, the vast majority of economists were not predicting the reduction.

This is the Bank’s first cut in more than 2 years and brings the rate down from a 6 year high. Most are now expecting that this will be accompanied by further cuts in the near future.

Similar to the Bank of Canada, the decision was spurred on by concern of an expanding credit crisis brought about by the sub-prime mortgage crisis in the US. An excerpt from their statement:

Although output in the United Kingdom has expanded at a brisk pace for the past two years, there are now signs that growth has begun to slow… conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead.

According to HBOS plc, the UK’s largest mortgage and savings provider, house prices fell for a 3rd month in November by 1.1%. That’s the worst streak for property values since 1995.

European Central Bank Stands Aside
Citing an unexpected rise in inflation, the ECB decided to hold rates steady at 4%. If inflation hadn’t come in at 3% - a full percentage point above their target - I’m think they would also have reduced rates.

Unlike the Bank of England’s decision most economists and analysts expected the rate decision, so no surprise.

More or less, the world’s central banks operate in concert with one another, often even cooperating hand in hand to help each other (whether it is in setting interest rates or foreign currency interventions).

Today the Bank of Canada surprised everyone with a 25 point basis cut. Although the higher Canadian dollar had created concern about Canadian exports, most thought that the Canadian central bank would opt to leave rates unchanged due to a buoyant economy thanks to high commodity prices.

But the sub-prime mess has once again reared its head (excerpt from their press release):

Global financial market difficulties related to the valuation of structured products and anticipated losses on U.S. sub-prime mortgages have worsened since mid-October, and are expected to persist for a longer period of time. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further.

The Bank of Canada is also worried that the effects of the sub-prime mortgage crisis will dampen the US (and global) economies enough to diminish demand for Canadian exports.

If the commodity markets are topping, then this would be a double whammy to the Canadian economy, so the Bank of Canada is smart to judge a “shift to the downside in the balance of risks”.

Since central banks don’t just lower or raise rates in a random fashion, this change in stance is probably the beginning of a series of rate cuts. Following the built in assumption of another rate cut from the Federal Reserve’s meeting next Tuesday, the Canadian central bank is now set upon an easing campaign.

The European, Australian and English central banks (or counterparts) will be meeting this week and my bet is that similar decisions will be coming out of those hallowed halls.

Which would spell some relief for the poor old US dollar (and a cautious note for precious metal bulls).

I know this is a bit late but lets cover last week’s sentiment landscape:

Hulbert Stock Newsletter Sentiment
According to Mark Hulbert, there is a stark contrast in the land of newsletters. The newsletters with the best track record in timing the stock market are bullish with an average 83% equity exposure. Contrast that with newsletters with the worst track record which are bearish with an average of only 9% exposure.

LowRisk 30-Day Outlook
Last week this survey had 64% bearish and only 18% bullish. That was a head spinning change of mind from the week previous to that when there were 34% bears and 50% bulls. As I’ve said before, LowRisk is a very volatile sentiment survey but nevertheless, this level of bearishness should be noted. The last time we saw something similar was back in August 2007.

Investor’s Intelligence
In contrast, newsletter sentiment as judged by II shows 51.1% bulls and 26.7% bears. Although that is down a bit from the 60+% of bulls the survey was showing just a while ago, it is still quite bearish from a contrarian point of view.

AAII
And to thoroughly confuse you, the retail investors are actually rather fearful: 50% bearish and only 33% bullish. This level of sentiment has corresponded historically with important intermediate stock market bottoms.

ISE Sentiment Index
Last week (November 16th) the ISEE sentiment index fell to 68 - that is, 68 long call options were initiated for every 100 put options. This is not the extreme historical lows but it is low enough to be a strong signal. Perhaps of an upcoming intermediate bottom being carved out from abundant fear and loathing.

Magazine Cover
According to the Economist, the US economy is about to be gobbled up by a recession? sub-prime mortgage and/or credit crisis? the disappearing dollar? I have no idea what the shark is supposed to represent exactly.

But it doesn’t matter since the Fed seems to agree. At least thats what it seems from the newly released minutes of the Oct. 30-31 Fed meeting. The Fed Funds futures market has now built in another 25 basis point cut when the Fed meets next in December.

Hmmm… that sounds remarkably familiar. Where did I read about the Fed cutting rates in the summer before they started slashing? And then again about one last rate cut before the year’s end?

It just rings a bell

Interesting article on Goldman Sachs’ “luck” in escaping unscathed from the sub-prime mortgage mess:

Goldman’s good fortune cannot be explained by luck alone. Late last year, as the markets roared along, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting in his meticulous 30th-floor office in Lower Manhattan.

At that point, the holdings of Goldman’s mortgage desk were down somewhat, but the notoriously nervous Mr. Viniar was worried about bigger problems. After reviewing the full portfolio with other executives, his message was clear: the bank should reduce its stockpile of mortgages and mortgage-related securities and buy expensive insurance as protection against further losses, a person briefed on the meeting said.

The article fails to mention that Goldman Sachs (GS) is Wall Street. They might as well own it outright. And now they’re making inroads into government where policy and oversight reside. They don’t play the game, they are the game.

But in the end, even if you practically own the place, risk and its management is the real game:

At Goldman, the controller’s office — the group responsible for valuing the firm’s huge positions — has 1,100 people, including 20 Ph.D.’s. If there is a dispute, the controller is always deemed right unless the trading desk can make a convincing case for an alternate valuation. The bank says risk managers swap jobs with traders and bankers over a career and can be paid the same multimillion-dollar salaries as investment bankers.

One of my favourite market axioms is “Discipline over conviction.” There is no point in risking ruin when you don’t have to. Coming back to play another day is a prime victory. Had Niederhoffer hired one or two risk controllers, he wouldn’t have blown up (again).

This graph tells the whole story:

By the grace of hindsight, the riddle of their weak relative strength is crystal clear. The market was telegraphing the coming correction and the crisis in the sub-prime mortgage sector.

But just as this sector signalled weakness in early summer, yesterday and today I noticed the opposite. While the general market broke down below its previous lows, the financial sector didn’t. It grudgingly inched lower but held its ground for the most part. And today, it rallied to close up almost 5%.

This is after all, the sector that wears an albatross around its neck. The guilty party that caused us all this grief. Why would it be showing strength? especially as all around it shares were being getting pummeled?

I suspect the message of the market this time is that the worst is over. Giant, well diversified financial institutions like Goldman Sachs (GS) and Citigroup (C) are not going to fold over this. They’ve weathered storms before and they will weather this one.

Take a look at the Phili Banking Index (BKX). Hmmm… is that a double bottom?