A Weekend That Couldn't Come Soon Enough

10/03/08 4:15 PM EST

As of: SPX 1270 HELP  ARCHIVE

This is a week that many folks are very, very happy to see come to an end.

Monday's crash, the nearly complete seizing up of the credit markets, the constant fear of headlines swinging the market several percent in the blink of an eye...in short, the end of one of the worst months on record for individual and professional investors alike.  You know it's gotta be bad when the well-groomed gentlemen with gray hair all say they've never seen anything like this before.

The question we have to struggle with is if it's bad enough.  If we've seen extremes so, well - extreme - that markets will respond how they typically do and enjoy a relief rally of one to three months.

After Monday's drubbing, we looked at several different facets of that day's trading, such as the magnitude of the price losses and the unbelievably skewed breadth, and concluded that the only comparable periods in the past 100 years were other crashes.  Based on a look at those other periods, it was fairly clear what we should expect going forward - one to three days of a wicked upside rally, which quickly failed and led to a testing of the panic low within one to two weeks.

The market played out that scenario quite closely this week, though the time frame was compressed.  We really only saw one day of rallying, and within a few days we're already below Monday's low.  It usually takes longer than this.

Yesterday we looked at some other extremes, in terms of the allocation to stocks recommended by Main Street and Wall Street.  Both are at multi-year lows.  We also looked at how the S&P 500 has done in the past when it drops to a new low in September, and it rallied every time during the fourth quarter.  Earlier today, we discussed delivery failures in Treasury Bonds, and public's all-time high focus on measures like the TED Spread, something that has effectively predicted at least a temporary peak in the credit panic over the past year.  Even the old "magazine cover indicator" is flashing contrary signals.

It's not unheard of - in fact, it's quite common - to see the market violate an initial panic low, before forming a more lasting intermediate-term bottom.  Even during prior bear markets, this was a common pattern.  The problem will come in if we don't recover back over Monday's lows within the next week or so, and preferably within the next couple of days.  Then we'll be witnessing a level of price rejection from a crash that we have really never seen before.  The only other times in its history that the S&P 500 lost more than it did this week were the weeks of 10/19/87, 04/10/00 and 09/17/01 - all three times it bounced back the following week (by an average of +5%) and following quarter (by an average of +8.9%).

A lot of folks I interact with have been looking for a move to 1050 to 1075 on the S&P as a good spot to start to leg into long positions.  I've already started building some longs in small sizes, but if we would happen to see a move to that area early next week, particularly Monday, then I will be adding more aggressively.  There are simply too many signs that have come together to suggest we've already seen the bulk of the selling pressure, that I can't buy into the argument that "this time is different" just yet.

The Public's Mood...So Bad It's Finally Good?

10/03/08 9:05 AM EST

Good Friday morning...We begin the day with modest gains in the pre-market futures, though they have been very volatile and things could change dramatically before the open.  Trading in commodities is mixed, and foreign markets are showing a rare day of tame moves, with most markets little changed on the day.

Stories of stress and crises abound in the media, and it's hard to separate out just one that seems more meaningful than the others.  Virtually all aspects of the credit markets are in turmoil, from money markets to commercial paper to muni bonds to corporate bonds (both high-yield and investment grade), and even the Treasury market.

The government releases weekly data on the failure of dealers to deliver Treasury bonds to make good on trades they agreed to with counterparties.  For the latest week, failures to receive and deliver Treasuries spiked to an all-time record high.

This failure can occur for any number of reasons, including just technicalities, but it's clear that the current spike was due to the tremendous surge in demand for Treasuries.  That makes it very expensive, if not impossible, for some dealers to obtain them in order to complete the trades.

Whatever the reason, the historical precedents are pretty clear that we usually see major spikes in failures to deliver during times of great duress in the credit markets.

We saw it after 9/11, we saw it this past spring (we actually discussed it then, too...click here to read that comment from March 20th), and we're seeing it to a record degree now.

Over the past few weeks, we've gone over quite a few measures that we don't normally discuss.  Most of them feed into the Panic Button indicator of credit stress, and that measure's all-time record high two weeks ago was a clear sign that our current mess in equities is just a reflection of the chaos in the credit markets.

One of the components to the Panic Button is the TED Spread, the difference between Libor and short-term Treasury Bills.  That has been as accurate a gauge as any at pointing to the continued stress in credit.

But now that CNBC has started running a "bug" on their screens showing Libor, and it has been mentioned in story after story in the mainstream press, one has to wonder if we're either at the end of the TED Spread's rise, or the indicator is about to stumble as an accurate measure of credit market stress.

Bloomberg ran an amusing / scary story this morning on just how illiterate the public, and our elected officials, are when it comes to the rates that determine so many of our outstanding loans.  But at least the public is becoming more interested in finding out more about it.

The chart to the left shows Google Trends data for searches on "Libor".  Sure enough, spikes in public interest have coincided - every time - with a peak in the TED Spread.

The whole mess has certainly seeped into the public's mood.

The financial morass is usually the lead story on the national news, and even Comedy Central's The Daily Show has made it a regular part of their broadcasts.  The last time I remember them doing that was in July 2002.

A quick look at some of the major magazine covers clearly shows the attitude out there.  Time writes about "The New Hard Times", Business Week "The New Financial Ice Age", The Economist covers a "World On Edge" and Forbes depicts investors hanging by their fingers to a sagging stock market.

I'm not a big fan of things like the magazine cover indicator, unless we see issue after issue cover the same topic, and in an overly dramatic fashion.  But I think it says something when you look at the newsstands, and you see pictures of the Great Depression, and a Wooly Mammoth, and a guy about to leap off a cliff.

Starting about a month ago, we looked at several studies that suggested we should see one to three weeks of extreme short-term volatility, with a downside bias, that ultimately leads to another intermediate-term market low and what should be decent gains during the fourth quarter.

It's safe to say that the past couple of weeks have been extremely volatile, and with a downside bias.  It's been so volatile, in fact, that the only comparison in nearly six decades is the aftermath of the 1987 crash.  And the downside, particularly Monday of course, has been so severe that the only comparisons in the past 100 years have been 9 other market crashes.

Those precedents were consistent in that we should look for a wicked short-term bounce from the day of the crash that lasts one to three days, then several days to two weeks of generally declining prices that challenge the panic low.  It's played out that way this time around fairly well, although the downside yesterday has us challenging Monday's low sooner than we've typically seen.

Still, I don't see much reason to change the outlook that we've already likely seen the vast bulk of the selling pressure, and if we do eclipse Monday's low in the S&P, it should only be temporary, with us regaining those lows within a few sessions at most.  Unfortunately, if I'm wrong about that, it's going to hurt as the only way to know will be what would likely be an even more severe and prolonged drop.  Because of the penalty for being wrong, I'm continuing to use small position sizes...but I still believe we will be heading for good gains during the fourth quarter this year.

Yesterday morning I wrote that the Fed Funds futures market was pricing in a 72% probability of the FOMC lowering their target interest rate by 50bps by the end of the month.  That climbed throughout the day, hitting 90%+ by the end of the day.  This morning, it's pricing in a 100% probability.  The jobs report wasn't as bad as many feared, and equity futures are holding in positive territory.  Another bad day today, though, and we will almost certainly see dramatic moves by the FOMC over the weekend to try to avoid another repeat of last Monday.  There remains tremendous risk on both sides of the coin in the short-term here.