The Difficulty In Trusting Market Prices

09/26/08 2:35 PM EST

As of: SPX 1270 HELP  ARCHIVE

Like yesterday, we're seeing mixed trading in the credit market, with some signs of improvement and other signs of increased stress.  Also like yesterday, stocks seem to be trading more off the prospects of a Congressional agreement by early next week than anything else.

One of the problems with the bailout bill is how to price the securities the government may purchase.  With banks hesitant to price them too high - or too low - traders are worried that the government's pricing mechanism will cause market prices to swing wildly in a very short period of time.

This doesn't just impact fancy Wall Street quant jocks.  Many exchange-traded funds marketed to the individual investor have been introduced over the past several years that are running into trouble getting accurate pricing.  And lately, the price of the funds can be markedly different than the underlying value according to the fund company (there was an article in the Wall Street Journal today that overviewed why some of these funds are hard to price).

That's been true with leveraged and inverse index ETFs, along with several bond funds.  As I mentioned this morning, I watch the HYG fund that tracks a high-yield bond index (i.e. junk bonds) as one sign of credit stress.  Another popular fund is HYG's brother, LQD, which tracks the investment-grade market.

Anyone watching LQD over the past week has got to be scratching their heads...today included, with it tanking another 3.5% and threatening last week's lows.  Taking a look at that, one would conclude that the credit markets remain in dire straights.

But it may not be an accurate reflection of what the fund is actually worth.  As you can see from the chart at the right, the trading price of the fund has deviated wildly from the underlying fund's value.

Last week, LQD traded at a 5% discount to its underlying value, an unheard-of deviation that was twice as large as any other (up or down) since the fund's inception in 2002.  The discount has tightened over the past few days, but today's big move in the fund's price may trigger another big discount, depending on where the fund company prices the NAV.

These extreme deviations are a sign of just how chaotic the market is, and it's not just on Wall Street - it's impacting everyone.  Almost always, dislocations this large are tremendous opportunities to go the other way.

Not many traders are willing to do that just yet, not in size anyway, and I can't blame them as I'm doing the same thing.  Stocks have been trading pretty well in line with the latest rumor or press conference coming out of Washington, and that's probably not going to change until we get explicit agreement on a bill from Congress, assuming they sign something at all.

After that, we'll be able to rely more comfortably on our guides, but until then I can't see the sense in trying to trade ahead of an unknown that is likely to move us several percent either way in a very short period of time.  I'm treating this like I usually do highly anticipated FOMC meetings - doing pretty much nothing ahead of the news which we know is coming, then probably fading (i.e. trading against) an extreme move after the news is released.  I continue to like our intermediate-term prospects for the fourth quarter based on what we discussed last week, though the short-term volatility makes the risk/reward of taking a stance now very difficult to judge.

Credit, Congress, and Confusion

09/26/08 9:15 AM EST

Good Friday morning...We begin the day with a large gap down open in the pre-market futures as traders weigh the importance of the largest financial failure in history, and the feet-dragging in Washington.  Commodities are getting hit this morning, and foreign stocks are getting hit even harder.

Like March and July, we're currently hamstrung by headline risk.  As we saw yesterday and again this morning, the markets will swing several percent either way depending on the latest developments coming out of Congress.

While there is certainly some added pressure due to stock-specific situations (such as Wamu) and economic releases (the latest data has been horrible), the short-term is being driven by the probability that 1) Congress will come up with something and 2) the final bill will be market-friendly.

Unless you've got some contacts in Washington, it's tough to place any bets on how this will swing in equities or credit.  Over the past week, we've been focused more on credit-market indicators than equity ones, and I think that's still the proper course.

Last Wednesday, the Panic Button indicator spiked to a nearly 60-year high based on the stress evident in the credit markets.  The past few days, it has been hovering near 1.0, a neutral reading, and we discussed yesterday why that is.

Below, I've attached a thumbnail chart of the components of the Panic Button, and where they are now.  The big driver currently is 3-month Treasury Bill yields, which is still one of the most important measures - if not THE most - right now.

Those wanting to watch it during the day can usually use the ticker IRX as a good proxy.  If you're looking for stocks to rally, then we should see yields rise as traders become more risk-seeking in their behavior and shy away from TBills in favor of vehicles with a little more exposure to corporate health.

These measures are what I'll be watching today, of course along with the latest developments from Washington.  Frankly, I don't think anything else much matters when gauging the risk/reward in stocks over the next several sessions.  This morning's gap open should take us near yesterday's low - something I would normally look to buy given what we went over yesterday - but again in this environment it's really difficult to have any conviction with trades when we're subject to the whims of politicians.