Still Focusing On Credit Turmoil

09/17/08 3:15 PM EST

As of: SPX 1187 HELP  ARCHIVE

Because our current issues are more credit-related than anything, my focus has been on monitoring that market more than equities.  Frankly, I don't really care where the VIX or most any other equity-related indicator is at today - it's not the driving force.

The perception of trouble can be most clearly seen via the price of Credit Default Swaps.  The chart below shows the past nine months' pricing for Lehman, Morgan and Goldman.  The latter two are getting slammed again today, and the price of insuring the two remaining firms' debt has skyrocketed, with Morgan surpassing Lehman.  We need to see improvement in the credit market - about the only good thing to say about it at the moment is that it's so bad, it's (almost) inconceivable to see it get much worse.

This is the type of issue that seeps into the Panic Button indicator that we've touched on in almost every note this week.  With the incredible rush into short-term Tbills today, that measure has shot up to 9.8, by far a new record (the previous highs were 7.9 in August 1982 and 7.6 in October 1987 as we went over this morning).

Earlier, we discussed volume and the number of new lows on the NYSE, which both nearly set records yesterday (volume did, new lows not quite).  We're seeing more than 1,000 new 52-week lows yet again today, marking the first time since the crash of '87 that we saw back-to-back days with more than 30% of securities on that exchange hitting a new low.

Over the past 45 years, there have been 10 other such instances, and the S&P was up the next day all 10 times by an average of +2.3% (without '87, the average was +1.5%).  Three days later, it was up 9 of 10 by an average of +2.7%, then we get into the issue of short-term violent whipsaws before forming longer-term lows.  The same kind of thing we've been discussing since last week.

The readings we've seen over the past couple of days are what we've seen at or after major crashes during the past 60 years - not the kind that precedes them.  Today has been "iffy" in terms of stocks holding up, which doesn't seem an especially good sign.  Historically, stocks have rocketed higher in the short-term after readings like these, and we do not want to see anything different now, or we'll have to pretty much throw out any historical comparisons.

Obviously, every moment in the market is unique.  We've rarely had so many momentous issues thrown at the market at one time, so perhaps this time really is different.  I'm not ready to make assumption yet, however, and am sticking with the thought that we're headed generally higher over the next week or so.  From an intermediate-term basis, I continue to believe the best risk/reward scenario will occur during the next one to three weeks, not necessarily here - a better bet would be to see a buying thrust, followed by a pullback.  I suspect that's what we're going to get.

A Brief Update

09/17/08 11:10 AM EST

As of: SPX 1187 HELP  ARCHIVE

One of my main areas of focus over the past several days has been the credit market, specifically the amount of uncertainty being priced into it.

As a reflection of the turmoil, I've been writing quite a bit about the Panic Button, an indicator which combines several different measures of concern in credit.  Yesterday afternoon it reached the 5.0 level, historically important, before settling back into the close (see yesterday's note for a chart).

This morning, we're seeing a tremendous flight into short-term Treasuries, the same thing that happened the last time (in September 1994) that a money market fund "broke the buck".  In addition, Libor rates remain elevated.

That combination has been enough to push the Panic Button to a reading of 8.1 this morning.  I don't have intraday data for historical readings, so we can only compare today with prior closing readings.  If we recover again into the close, then we probably won't see an extreme like we are currently.

But it's notable that this is a new all-time record high in Panic, dating back to 1953.  The only other instances which came close were a reading of 7.9 on August 20th, 1982 and a reading of 7.6 on Black Monday, October 19th, 1987.  Both were important historical dates (and very bullish).

So what we must ask ourselves is this:  "Is this time different?".  Are we seeing something so totally unique, so many crises coming together at the same time, that we simply have no historical comparison?  It's possible, and if so then we could crash.  A 10% or larger down day, to finally wash it out.

The kinds of readings we're seeing now, and over the past few days, are only comparable to what we've seen AFTER past crashes and crises, not immediately before, so we really have no comparison if we see continued weakness.  We should be rallying...right now...and not drifting along to the downside.  This is not typical, and not healthy.

I'm continuing to bank on the idea that we will mostly conform to historical precedent and see generally rising prices over the next week or so, before a probable re-test of any potential low formed around here.  I'm concerned, though, that we are not getting a better reaction.

Panic Recedes, But Still Evident

09/17/08 9:15 AM EST

Good Wednesday morning...We begin the day with another large gap down in the major indices, something that has proven to be a short-term buy signal almost without fail lately.  I will be keying once again off the low that's formed during the first half-hour of trading - if the low holds, then we should continue higher throughout the day; if we go on to make lower intraday lows, then the probability of a reversal later in the day decreases dramatically.

There are a few reasons to expect the early low to hold, or at least not see much selling pressure beyond yesterday's lows.  Let's go over a couple of basic indicators that are probably old-hat by now, but no less important:  volume and new lows.

One of the clues we should be watching for if looking for another intermediate-term climactic low is a surge in volume.  Each of the other periods of recovery since last year has been preceded by a spike in volume to a new all-time record, or close to it.

We accomplished that yesterday, and how.  Turnover on the NYSE reached over 10 billion shares (figures vary from quote source to quote source).  That is a tremendous surge, well above any previous day.

Before I get a deluge of "yes, but..." emails explaining that it was due to AIG, the chart below shows the same composite volume figure for the NYSE, but the volume for AIG and Lehman has been removed.  Still a record.  By a bunch.

Part of the reason for the volume explosion was a jump in the number of stocks hitting new 52-week lows.  When a stock hits a new yearly low, volume tends to increase, so when we see a large number of them hitting lows at the same time, volume usually jumps too.

On the NYSE yesterday, more than 1,200 securities fell to a fresh 52-week low, the third-highest figure we've seen since the trouble began.  That number amounts to just over 34% of the issues traded on the exchange.  On July 15th, we showed a table that showed the edge going forward after previous instances.

Over the past couple of days, we've discussed the Panic Button indicator, a measure of stress and uncertainty in the credit markets that has taken on increased importance over the past year.  Personally, I place more weight on that measure now than I do any other indicator I follow, due to the fact that our troubles now are primarily credit-related.

Yesterday morning, the Panic Button was indicated at 4.0, an elevated level but not quite to the red-lining reading of 5.0 that we've seen only a handful of times in the past 58 years.  In an afternoon note, I mentioned that due to a continued deterioration in sentiment, the Button actually did reach 5.0, which it did shortly before I sent out the note.  With the recovery we saw into the close, we did not get a closing reading above 5.0 (it closed at 4.6).

Looking at dates it first closed above that level, we get a few more instances, shown in the table below.  Once again, very bullish across all time frames up to three months later.

We also had a nice upside reversal from a low yesterday.  Checking the S&P 500 from 1950, we can look for any other time the index dropped at least 1% to a new 52-week low, then reversed to close at least 1% higher on the day.  Out of 11 occurrences, the index was up a week later 9 times by an average of +2.7%.  We saw some mixed, volatile trading after that, but still by three months later 10 of the 11 were positive, averaging +4.5%.  April of 1970 was really the only time this pattern faked out buyers.

Since late last week, we've been going over several scenarios, the most likely of which appeared to be one to three weeks of extreme short-term volatility with a downward bias, that leads to a tradeable rally into the fourth quarter.

The trouble with that is that we hadn't seen much in terms of panic or even a heightened sense of concern heading into this week, which changed in a hurry on Monday.  Now the question is "was that it?".

Hard to say of course, but given the Panic Button reading from yesterday, the explosion in volume, the surge in new lows, the increasing number of sentiment guides sitting in excessive pessimism territory (still not as high as I would like, but...), and the reversal from yesterday, it looks pretty close.

The financial headlines are scary, with Russian collapsing yet again, a large money market fund breaking the buck (truly a chilling development), and a wave of international financial firms scrambling to chase a limited amount of capital, we're still subject to overnight and intraday shocks that will move the markets several percentage points within minutes, both ways.

We're moving rapidly towards resolution of some of the major issues, at least the ones that are known.  What typically happens is that we get a relief rally based off the major resolutions, then another downside wave as the secondary and tertiary concerns hit the tape (hedge fund failures, etc.).  That's why we almost always get a short-term bounce of several percent, a test of the low as the second wave hits, then a more lasting bottom.  That's usually the best time to establish longer-term positions, not rushing in whole-hog on the first signs of what looks like a bottom.

Based on what we've gone over, it appears as though the best bet from here is concentrating on long-side trades, but they are just that - trades.  We should be morphing into an intermediate-term low here, but the risk/reward still looks high, and waiting for an upside surge followed by a test of the low would be a better bet.  We'd be counting on several "ifs" for that to occur, but it's a consistent pattern and I expect the same this time around.

I'm moving our little signal strength icon to a slightly bullish position based on the futures being down about 26 points on the S&P, but please don't take that as a trade indication - it's only a quick reflection of the tone of these comments, and the expectation that we'll see generally higher prices over the next week or so - just be prepared for extreme volatility.