Hanging Out On The Fence Until The Fireworks Are Over

Hanging Out on the Fence Until the Fireworks are Over

We've been emphasizing being fully on the sidelines in T-bills in recent columns and this market environment is a good illustration of why.  Shorts get decimated when short-sale rules are adjusted or bailout package rallies unfold.  Longs are killed every other day.  The volatility is unbelievable.  There are growing short signals but the reward/risk of any of these trades is not very favorable because the risk is so high.  Nearly any trade you take here is really one trade - either betting on more downside or on and end to the carnage and enough of a bailout to stop the panic.  Long gold will get killed if the panic calms down as will any short.  It is too early to buy and too late to short.  T-bill cash continues to look good and we suggest you patiently hang out on this fence of the sidelines and wait till the fireworks are over - something we've suggested for a while. 

We want to reiterate how important it is for investors to understand as fully as possible what is happening, why, and what is necessary to fix it.  Readers of this column can email us at staff@investmentresearchassociates.com to request a free copy of last weekend's PSL which discusses this in detail.   This is the most critical market crisis since the 1930's and understanding it fully is absolutely critical to investing in the period ahead for many years.  We cannot cover this vast subject in this small column, but suggest that those reading this get a free copy of our PSL newsletter to get a clear understanding of what's happening and what it is likely to mean and what to watch to determine how to invest ahead in this massive global crisis.

Markets continue to riot because authorities are not yet attacking the heart of the problem.  Interbank lending remains totally frozen and is critical to end or the crisis will continue to spread.  Banks have no transparency into each other's problems and so have no confidence to loan to anyone.  Until the Fed guarantees the entire banking system (especially interbank rates) the credit crisis will continue to do damage.  There is also a run on financial entities who employ leverage and on banks and investment banks for amounts over $250,000 - the limit of FDIC insurance.  Either all deposits need to be guaranteed fast or this run will accelerate. 

A guarantee of the entire banking system may now be required, along with coordinated global stimulus plans.  WAKE UP central banks!!  Until we get some letup in the credit crunch (watch LiborOIS spread, Ted spread, Euribor rates, Commercial paper rates, and T-bill rates), the markets are likely to have to continue to riot (violently decline).  There are talks now of taking some of these actions, but the Fed and other central bankers need to act this weekend or sooner in some way to stop markets from falling as the S&P approaches the 2002 lows.  A weak close on the lows on Friday would be ominous and would likely require massive action over the weekend to prevent an even more accelerated crash on Monday.  Government action could become more Draconian and trample innocent players, so stay cautious.

It is not stocks but the credit system that is now the epicenter of this crisis.  Interbank lending is totally frozen.  Commercial paper is not being rolled over or rates are exorbitant, meaning corporations can't get the funding they need for short-term normal activities.  The fractional reserve fiat currency central bank system will delever and implode in a vicious downward spiral if lending cannot quickly be restored.  Watch credit market internal indicators like Libor, Euribor, TED spread, and commercial paper rates and spreads to see when relief is even starting.
 
Chart 1:  Credit crisis not being addressed as long as interbank lending rates and spreads still soaring!  Crtsy Bloomberg

 
Chart 2:  Commercial paper rates and spreads need to drop if Fed's new plan is to calm markets.  Courtesy Bloomberg

Remember too that  Lehman's CDS settlement is Friday October 10 and its defaulted bonds are trading at 10 cents on the dollar, meaning that the gross amount insured could cost $360 billion that could have a very negative impact on markets if it does not go well.  Then WaMu bondholders auction on October 23 will determine how bad a hit that CDS recovery event will cost.  There are some big potential landmines out there still.  Global recession is nearly assured from market action, and manufacturing is in decline, while the European banking system is falling into an abyss.  Whether an eventual policy induced rally develops from here will depend on the breadth and volume of activity AFTER the market makes a climax low and rallies sharply and broadly on huge volume, and on how fast and broadly authorities move to end the credit market crisis more completely.  Until then it's a wild market that is more volatile and rumor prone than any we can remember. 

Gold has rallied off its lows and consolidated, and some see it as a potential island of safety.  Yet gold stocks and other precious metals are underperforming gold badly.  Therefore gold needs to break over 92 to get us to consider positions, and over 95.5 to force us to look at small nibbles.  A real breakout by gold ALONG with a strong dollar, argues for a Depression scenario developing.  Unfortunately the odds of this scenario are increasing, especially if authorities continue to lag behind markets and don't solve credit crisis problems fast.  The vulnerability of the fractional reserve banking system is that it builds prolonged and growing debt until it either implodes via a debt-unwinding deleveraging depression (which we are facing increasingly here) or hyper-inflation.  We are getting close to the edge of the cliff of deflation if authorities do not act decisively, in a globally coordinated fashion, and quickly.  A 20% type of daily decline in stocks may develop if things are not addressed better fast.  At some point either policy actions will be substantial enough to stop the markets from crashing, or the financial system will become systematically unglued in a way that will mark a generational turning point economically and take a decade or more to iron out.  A self-perpetuating cycle of deleveraging (hedge funds try to hedge all day and then have to dump what they cannot because of margin calls in the last hour), margin calls, asset price declines, and panic is underway - and if it is not quickly halted it may get worse before it gets better - as forced liquidation has no concern for fundamental value.   S&P holding its 2002 lows is critical technically, as these are at the 50% support from the entire secular bull market since July 1982.

Our long/short strategy remains happily 100% in T-bills awaiting new trades.  Since our last update we got close calls on the buy side from nothing, with close calls on the short-side from a dozen stocks but all with risk to stops that are too high to take.  Check out www.midasresourcegroup.com for daily listings of Top EPS/RS New Highs and Bottom EPS/RS New Lows to make sure you catch all potential breakouts meeting our criteria.  As the chart at the bottom of the page illustrates, we do now have bottom RS/EPS new lows in a clearly dominant position (40 over the other for 5 or more days in a row) that would normally signal a potentially good environment for short-side dominated activity, but the market is way too oversold and too volatile and risk too high to short here now.  As we've been saying for months and recent action is clearly proving out, this is often the most dangerous, volatile, and tricky phase of a bear market and we suggest the sidelines heavily.

For those not familiar with our long/short strategies, we suggest you
review my book "The Hedge Fund Edge," my course "The Science of Trading," my video seminar, where I discuss many new techniques, and my latest educational product, the interactive training module. Basically, we have rigorous criteria for potential long stocks that we call "upfuel," as well as rigorous criteria for potential short
 stocks that we call "down-fuel." Each day we review the list of new highs on our "Top RS and EPS New High List" published
on www.midasresourcegroup.com for breakouts of four-week or longer flags, or of valid cup-and handles of more than four weeks. Buy trades are taken only on valid breakouts of stocks that also meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags
 or cup and handles on the downside. We then continue to buy new long signals and sell short new short signals until our portfolio is
100% long and 100% short (less aggressive investors stop at 50% long
 and 50% short).   We keep capital in T-bill cash while waiting for more trades.  We have been 100% cash for some time now, and very glad of it in this incredibly dangerous and volatile market period.

The chart below shows that Bottom EPS/RS New Lows are more than 40 over Top RS new highs (available on www.midasresourcegroup.com< /a>), and have been so for a period of over 5 days in a row which would signal a good short-sale environment.  However, short-sales have been prohibited on many stocks, others are increasingly difficult to borrow, and since we are not getting blatantly clear valid short sales or else only signals with excessively high percentage risk to open protective stop levels, we'll stand on the sidelines until the market stabilizes some.  Remember not even surfers try to ride hurricane waves!  Heavy cash T-bill defense remains warranted as opportunities build.  These are historic markets and your goal should be to survive them until the panic subsides.  Government action can blindside even the best trader in these environments, which is why so many top hedge funds are getting killed here.