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Moral Hazard and the Topsy -Turvy Market
The last few days have been quite a rollercoaster ride for the market. Every trading session (even the one on the holiday-shortened Friday) has seen intraday ranges of more than 200 points for the Dow. These types of violent swings are indicative of a market in a state of total uncertainty and until this malaise passes, we should expect more of the same.
Monday morning, the major averages got off to a good start on the heels of a good retail report coming from Black Friday (the best shopping day of the year). The mood quickly soured though, when it was revealed that a certain Senator had sent a letter to the Chairman of the Federal Home Loan Bank, urging him to cut off funding to Countrywide Financial (one of the top mortgage providers in the country). This sent stocks into a tailspin, which was enough to erase all the gains from the prior week, and more importantly, for the entire year.
The same old problems continue to plague the market and one wonders when this is going to end. I believe the market wants all financial institutions to disclose the extent of their exposure to these bad loans - a sort of catharsis, if you will. Once this happens, the markets can more accurately start the discounting process. The valuations of some of these stocks are dependent upon full transparency and until this is attained, selling them will be the preferred way.
Some people believe that a bail out of these financial institutions is needed to stave off further deterioration of the markets. I don't believe this to be necessary, as it encourages "moral hazard" and furthermore, should be discouraged. In the future perhaps lenders will be more prudent in their standards, knowing there will be no backstop if things go wrong. For those of you who might not be familiar with the term "moral hazard", essentially it means that a company or individual will engage in riskier behavior, if they have assurances that they will not bear the full liability of those actions.
It's not often I comment on interest rates, but the dramatic moves we've seen in this market of late, compel me to do so. First, we need to have a basic understanding of the relationship between stocks and bonds (yield instruments). For one, they are two distinct asset classes that compete for investor dollars. Yield instruments are perceived to be safer than stocks (especially those issued by the US treasury). For this reason, when investors start selling stocks, they usually buy safer investments, i.e. (T-bills, notes, and bonds). As the demand for these instruments increases, so does their price. This in turn drive yields lower. The chart of the ten-year note yields (below) illustrates the dramatic move rates have taken since the summer.
The precipitous decline in rates can be perceived in several ways. One view may be that the appetite for risk is very subdued, and thus, large sums of money are being placed in the "safe harbor" of the bond market. With all the money being lost in subprime, this makes sense. The other and more ominous viewpoint is that the bond market is sniffing out a recession. Generally, a robust economy and lower yields are inconsistent with one another. Readers know I thought a recession was in the cards for next year and these lower yields may be telegraphing that.
Since only a few trading days have transpired since my last newsletter, not a lot has changed. The daily chart of the ER2 below is still reflecting a textbook downtrend (a series of lower highs and lower lows).
The 10 min chart of the ER2 is indicating a basing process has begun. Note the trading range formed in Tuesday's trading session. It's clear that the 747 (Tuesday's intraday high) will be first resistance, followed by 760, which if breached, will be the first sign of a change in trend.
In summary: The market was finally able to put a rally together on Friday and Tuesday. The key for the bulls will be in their ability to string together more than a one-day wonder. Housing data is coming out Wednesday and Thursday of this week. Everyone anticipates this information will be weak, and I feel the market has already discounted it. In addition, the Durable goods number will be released this week. This data will gauge the health of the consumer and spark further debate of a recession. The market seems to be playing a game my two little boys love to play, called whack-a-mole. Just when it seems the bulls are going to regain control, the bears come in to knock them down again. I suspect at some point – just as with my children - that game will get old soon.
So until next time, I hope everyone has a profitable week.
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Gabe Velazquez is a professional
trader with 14 years of experience. His focus is intra-day and swing trading the
ER2 (Russell 2000 e-mini) using technical analysis as his primary tool. Gabe has
managed both stocks and futures accounts as well as conducted educational seminars
on technical analysis for the past ten years. He is a frequent guest on Biz radio,
where he shares his market knowledge and utilization of technical indicators.
Gabe also teaches the