Snapshot Notes - September 25, 2008

Good Thursday morning...We begin the day with slight gains in the pre-market futures, and most foreign equity markets. There are continued signs of stress in the credit market, and that probably won't change until we hear something concrete from Congress.

Apropos of some of the recent discussions we've had regarding high cash levels (see here and here), the Financial Times noted in an article this morning that hedge funds have stuffed $100 billion into money market funds, part of their $600 billion cash hoard, despite the recent trouble with some funds breaking the buck, or trading below $1 per share.

From the Hedge Fund Equity Exposure chart on the site, it's clear that hedge funds are not currently positioned for a rally. When we combine that with their stash of cash, it leads one to believe that there is some substantial buying power waiting for a bit of clarity. Some funds will only be able to save themselves with a good fourth quarter, and should be aggressive buyers if they do not receive a flood of redemption orders when lockup periods expire.

Last week, we spent much of the space in these comments discussing the Panic Button indicator of credit market stress. Last Wednesday, it spiked to an all-time record high as the wheels were falling off the credit market wagon.

By the next day, it had begun to recover, and has been sitting at 1.0 for the past few days. On the surface, that suggests that we're seeing relative calm, but in actuality it's a little more complicated. Basically, because of the unbelievable extremes we saw last week, it's going to take an all-out crash for us to see any kind of extreme in the Panic Button any time soon.

The indicator is constructed a little bit like several of our models on the site. When an extreme is reached, it takes an even bigger event to trigger yet another extreme.

The purpose of constructing them in such a manner is that these moments in the market are usually do-or-die situations - either we rally, or something seriously wrong is happening. We don't want a model to keep giving us oversold reading after oversold reading when the market is not responding.

One of the main triggers for last week's extremes was the rush into very short-term Treasury Bills, pushing the yields there to multi-decade lows. That fed into the Panic Button and helped to create such unprecedented readings.

There was a big rush into TBills yesterday, too, but not quite to the same degree. Just playing "what if" for a second, if the yield on 3-month TBills dropped to the same level it did last week, then today's Panic Button would be 5.8 instead of 1.0. So that record rush into the safety of short-term government debt last week is having an outsized impact on the Panic Button, and the main reason we're not seeing it spike higher now.

Also in the Financial Times, they mentioned that the UK's version of the SEC has denied pleas by more than a dozen firms to have their shares placed on the no-short list. In a Data Brief yesterday, we looked at sector allocations among the countries that have instituted such a ban, with the UK currently pure with 100% financials.

The U.S. has been more relaxed, with 89% financials and a hodgepodge of others. Look for the list to grow - quite possibly covering all stocks - should we continue to challenge last weeks equity-market lows.

I've been pretty clear that while I don't want to bore you with soapbox arguments about what the government is doing, I generally agree with their proposals to buy up some mortgage assets, and pretty much anything they do to shore up confidence in money market funds. I am adamantly against the short sale ban, due to the law of unintended consequences.

The SEC may want to take a peak at a 2005 paper by Charoenrook and Daouk, the conclusion of which is below (highlights are mine):

Our study provides a number of implications.

First, we examine how well current theories work for market-wide short-selling restrictions and market returns. We confirm theoretical predictions on liquidity; we find reduced market liquidity when short-selling is not possible. However, we find short-selling restrictions have no effect on skewness of market returns or market crashes as some theories predict.

There is strong empirical evidence that volatility is lower when short-selling is possible although the theoretical predictions are ambiguous. Our finding on volatility is similar to some findings reported in empirical studies at the firm level that volatility declines when short-selling constraints decline.

Second, the effect of short-selling restrictions on aggregate market returns differs from that on individual firm returns reported in existing literatures. Short-selling prohibition can increase expected returns due to higher market volatility and lower market liquidity. It can also cause the aggregate market to be over priced because information of pessimistic investors who cannot short sale is not incorporated in the market price, which implies that when short-selling restrictions are lifted stock prices decline.

Our empirical evidence shows that expected returns are lower when short-selling is possible, and the market price increases when short-selling restrictions are lifted. Firm level short-selling restrictions can also affect individual stock return distributions. But if these effects differ among firms, they are diversified away and do not affect the expected return required by investors.

Short-selling restrictions can also cause overpricing of individual stocks. Our finding on expected return at the market level appears contrary to many other empirical studies of short-sale constraints and expected return at the individual stock level which find stock price decline when short- selling restrictions are lowered.

We conclude that while in many cases the overpricing effect may dominate at the individual stock level, the lower required expected return dominates at the market level. This distinction has not been made explicit in the literature so far.

Finally, we find no evidence that short-selling disrupts orderly markets by causing panic selling, high volatility, or market crashes. Our empirical evidence shows overall that allowing short sales enhances market quality.

Basically, allowing short sales increases liquidity (which lowers transaction costs for investors) and dampens volatility, with no evidence that it causes market crashes. That's why I stick with my assertion that the no-short rule is a misguided, knee-jerk move to shore up confidence.

In the past, we've looked at situations where stocks dropped sharply, then went through a range contraction - a drying up of the selling pressure. Typically, it has resulted in prices rising in the short-term.

For example, there were 24 times since 1982 (when intraday prices for the S&P 500 became more reliable) that the index dropped 1% or more, then fell again the next day but with the smallest intraday range of any other day of the past seven trading sessions like it did yesterday.

Over the course of the next two sessions, the S&P rose 20 times (an 83% win rate), with an average return of +1.1%. Three of the four losers were smaller than -0.65%, and the average winner was +1.5%. It has happened once this year, on April 14th, which followed through with the usual short-term pop higher.

3. One to three days of selling pressure as realization of what just happened sets in

4. Another buying binge as those who missed the initial low spot their opportunity

5. The back-and-forth frustration that hammers out a longer-term low and better intermediate-term risk/reward investment opportunity.

I've been looking for this general series of events to play out for a couple of weeks, and the market has held pretty true to it so far. If that continues, then we should be entering the phase where we get the second short-term upside boost (number 4 above), before we enter more of a trading range that presents a better intermediate-term opportunity. Given the price pattern mentioned above, and probable optimism that Congress will move to get a bill in place before the weekend, it makes sense to expect another rally attempt here.

While I'm never a fan of gap up openings unless I'm looking for a spot to sell short, I'm impressed that the futures have held up in spite of the warning from GE and what looks like pretty terrible headline economic numbers. We still have the GDP report tomorrow, but all eyes remain on announcements out of Washington, and the market's reception of their impending proposal is what is going to send us moving several percent over the next few sessions. Trading either direction here seems to be a pretty pure bet on whether Congress is going to pass a market-friendly bill, and that's a bet that's difficult to make.