Snapshot Notes - June 30, 2008


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MONDAY, JUNE 30, 2008

The "Panic Button" Has Not Been Pressed

06/30/08 9:05 AM EST

As of:

SPX 1386

HELP ARCHIVE

Good Monday morning...We begin the last day of the (possibly) worst June in the history of the S&P 500 with a modest, mixed move in the pre-market futures. Oil is once again causing some trouble for traders, and foreign markets were mixed. Economic reports are relatively light this week, though there are a couple that will garner at least some attention, including vehicle sales tonight and tomorrow morning, the ISM Prices Paid report tomorrow morning, and the jobs report on Thursday.

I normally wouldn't include vehicle sales as a report to watch, but I've been keeping an eye on the credit default swaps for Ford Credit and GMAC, the financing arms of Ford and General Motors. Credit default swaps show us how expensive it is to buy protection against the possibility of those firms defaulting on their bonds. The more expensive the insurance, the higher the probability investors are assigning to a default.

As you can see from the chart below, the cost of insuring against default in these two auto-financing arms has been skyrocketing, and is now higher than what it was at the March highs:

Needless to say, a fear of bankruptcy for two of the most iconic companies in America (and among the largest employers, with 500,000 between them) could send shivers of panic along the spines of investors.

Last week, in both a longer-term note and again several times in the daily updates, I mentioned that we weren't seeing some signs that we normally see at a typical bear-market low.

"Typical" is of course a generality, and we don't always see the same thing every time the market bottoms - March 2003 is a prime example. But during a bear market - within which there is little doubt we remain mired - the market doesn't often form a multi-week or multi-month bottom unless certain levels of panic are reached.

There are a number of ways to determine those panic levels, but several of them have historically been excellent signs. So I created one indicator that meshes a few of them together, and that gives us one simple way to measure the level of panic in the air.

This indicator incorporates the TED Spread, Junk Bond Yield Spreads, a ratio of Volatility to 3-Month Treasury Bill Yields and High-Yield CDS Spreads. All of these spike higher when uncertainty about the economy and stock prices are high, and reach extreme high levels only during times of outright panic.

Let's call it the Panic Button Indicator, just for fun. A 10-year chart is shown below.

Historically, a Panic Button level of 3 (essentially equating to panic exceeding 3 standard deviations above the norm) has coincided with a time of great distress in the market, when headlines were the worst and the end of the world seemed imminent. Levels higher than that were true all-out panics.

For example, the Panic Button has reached a level of 5 only six times since 1954. Those were May 1962, May 1970, August 1982, October 1987, August 2007 and March 2008. All except the last two (?) were at or very near the bottoms of drastic market declines and ended up being bear-market bottoms. That shows us just how unusual true panic is, and also how unbelievably unusual the last six months have been.

Because of the recent spikes, it's going to be just a little bit more difficult to see panic readings again, because the bar for what we can consider true panic has now been raised. But even so, the Panic Button level as of Friday registered a tame 0.7. That isn't much higher than average, and is nowhere near concern, much less panic.

Historically, the indicator has been a good sign of long-term returns. When Panic has reached a level of 3 or higher and started to recede, the six-month return in the S&P 500 averaged +12.2% with 86% of days showing a positive return. While this is not meant to also be a "complacency" indicator, when everything was right with the world and Panic fell to -2 or below, then the six-month return in the S&P averaged a meager +0.5% and only 40% of days were positive, so it can work in reverse too.

As for the short-term, on Friday I mentioned that given a few of the intermediate-term sentiment extremes we were seeing, a new batch of oversold short-term readings, some positive seasonality that was imminent, and the proximity to probable technical support for the S&P 500, I had a tepid preference for the long side, especially as the S&P approached that 1275 level for the first time.

The market does have a tendency to bounce back when it has dropped heading into the end of a month. Since 1950, when the S&P has dropped 3% or more in the week leading up to the last day of the month, buying the day before the last day and holding through the first two days of the new month resulted in 73% winning trades (32 out of 44) and an average return of +0.8%. It has happened five times heading into July, and resulted in four winning trades.

Those times it didn't work, and led to some additional selling on either the last day of the month or first day of the new month, typically resulted in severe rallies soon thereafter. With the additional positively-influenced 4th of July holiday just ahead, I suspect that would be the case this time around as well. The one time we saw selling in the first couple days of July (2002), it resulted in a wicked two-day rally surrounding the holiday.

I'm not sure if the almost picture-perfect bounce off 1275ish on the S&P will stand, as it's almost too scripted. But I do continue to have a general (though still tepid) preference for long-side trades as we head into and just past Independence Day. My long-side bias would almost certainly bump up a couple of notches if we continue to see some selling pressure today and/or tomorrow and we get closer to the holiday trading period.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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