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FRIDAY, OCTOBER 10, 2008

 

That Should Be "It".  If Not...

10/10/08 4:20 PM EST

 

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Well, the longest...week...in...history finally comes to a close.  Like many others, I'm scratching my head, rubbing my chin and wondering what the hell just happened.

 

Over the past few weeks, we've discussed at length a scenario that seemed the most plausible given a series of studies that looked at the price structure during mid-September.  At the time, it looked like we should see a highly volatile, downward-skewed move into the end of the month that led to a vicious short-term bounce then a re-test of the momentum low before a rally during the fourth quarter.

 

I tend to run screaming from crystal-ball forecasts like that, but the studies were pretty compelling and the market followed the script very closely as the days passed.  On September 29th, we got what could only be considered a crash, and that seemed like it should have been the culmination of the worst of the selling pressure.

 

Based on a look at previous crashes over the past 100 years, we should have been looking for a one- to three-day rally that then petered out and gave us a re-test of the panic low somewhere within the next 5 to 10 days.  That didn't take long, as within a couple of days we were already violating those lows.

 

Still, that wasn't too much out of the ordinary, and some further selling pressure below the lows of the 29th could actually be a good thing, as it would finally give us a sentiment extreme that was missing.  We were seeing all-out panic in the credit market (the Panic Button indicator had spiked to a 50-year high), but no outsized concern in equities despite the price losses.

 

Coming into this week, I was looking to make a more aggressive long-side stand if the S&P 500 would happen to drop towards 1050-1075.  It did so...and then just kept right on going.  We went much, much further to the downside than I thought was probable in even the worst-case scenario.

 

During the week, we discussed the idea that if we are going to form a bottom, then it was going to be this week - and probably Friday (today).  There were a number of different seasonal factors coming into play, but most importantly the auction of Lehman derivatives.  While the morning didn't pan out as I'd hoped due to the large gap down opening, we did bottom just after 2:45pm like we did on Monday when the final results of the auction for Fannie Mae and Freddie Mac percolated through the market.

 

During the week, we carved out more extremes, and more multi-decade or all-time records, than I can count (see Thursday's note for a recap of some of them).  That continued today, with an absolutely shocking 75% of all issues on the NYSE hitting a fresh 52-week low.  Even during the most foul depths of what has been thrown at this market over the past 40+ years, the previous worst before this week was 58%.  I think that sums up the week better than any other stat I could muster.

 

With the late-day rally, of course, the big question is whether this is "it" or not.  Heading into today, we were approaching it was though it would be, and the reversal into the close gives a bit of hope that's the case.

 

"Hope" is a dirty word in this business - it's supposed to be all about objective analysis and cool conjectures, but at this point hope is about all we have.  Hope that the financial system isn't about to crumble, hope that we don't cascade into some kind of every-man-for-himself world, hope that the government can help us find a way out.  That last one is probably the biggest stretch of them all, but hey we can hope.

 

There's really no sense in going over all the extremes we've witnessed this week.  Feel free to browse through the archives, many of them are in there.  By all rights, today should have been the final selling exhaustion we were looking for, and we should be on our way to greener pastures.  If so, then we should not see lower lows next week, especially past Monday or Tuesday.  If we do, then quite frankly I just won't know what to think, as we'd be witnessing a level of financial asset destruction that would have no precedent.

 

Have a safe and peaceful weekend, and we'll try to sort through all of this again next week.

 

 

A Week Of Firsts

10/10/08 12:15 PM EST

 

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We remain in the discovery phase of the post-Lehman auction, and I'm not hearing anything solid about the total size of losses from insurers.  That may be the case until final bids are received later this afternoon.

 

This week we've had ample opportunity to go over extremes, a recap of which we did on Thursday morning.  There are so many things we could point to that are either once-in-a-generation events or worse.

 

As noted yesterday, the Dow has never had six straight losses of 1% or more, something it managed to accomplish this time.  It's now on track to close the week down more than 20%, something else it has never done before (at least going back to 1897).  Even after the '87 crash, it recovered to close the week "only" down 13% or so.  It did close down 23% in December 1914, but that was after the market had been closed for several months due to WWI.

 

Our Smart Money / Dumb Money Confidence moved to a new extreme at yesterday's close as the panic has rolled from credit to equities.  The spread between the two has moved to +63% for one of the few times in its history (11/5/90, 4/12/94, 8/28/98, 7/23/02 and 3/17/08 were the others).  It probably will not get any more extreme than this based on where the component indicators are in relation to their respective levels.

 

Adding to the records, an unheard-of 72% of all stocks on the NYSE dipped to a fresh 52-week low today.  That is far beyond anything we've witnessed in at least 40 years, topping the old record of 58% (set this week).

 

There is some disagreement as to whether or not the market can bottom on a Friday.  If we take a look at all of the 68 intermediate-term (three-month) lows in the S&P 500 since 1950, here's the distribution by day of the week:

 

Day of Week # %
Monday 16 24%
Tuesday 20 29%
Wednesday 11 16%
Thursday 8 12%
Friday 13 19%

 

Monday and Tuesday combined accounted for nearly 53% of all the lows, not especially surprising given what we've discussed in the past with regard to "Turnaround Tuesday".  Wednesday and Thursday were the least likely to lead to a low, with Friday in third place.  Other than the Monday/Tuesday phenomenon, I wouldn't say the data is especially convincing.

 

As should be expected with such an uncertain time, there are so many conflicting pieces of advice it makes one's head spin.  Most everyone believes the open today was classic capitulation (of course, it looked like that yesterday, too...and Wednesday...and the day before that), but others are still holding out that we haven't seen a total give-up yet based on their favorite pet indicator or technical level (the previous bear-market low is a popular one).

 

My take has been that based on everything we've discussed over the past several weeks, this week should mark the exhaustion point, particularly today with the Lehman auction finally out in the open.  The week's losses have gone far (far...) beyond what I thought was probable in even the worst-case scenario, and I'm not especially happy with how today is unfolding either - I would have preferred to see stiff selling pressure into the Lehman auction, not a rally immediately from the opening prices.

 

My thought heading into today was either that we'd see a massive rally if the Lehman results came in better than expected, or we'd get a ~10% drop that should be buyable.  We haven't quite seen either, and this limbo is more frustrating than anything.  Frankly I have no idea how the rest of the day will unfold at this point as we head into a weekend where parts of the credit market will be closed for a holiday weekend, and final results from the Lehman auction are made public.  I do plan on adding more long exposure into the weekend. 

 

 

Sorting Through The Mess

10/10/08 10:55 AM EST

 

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The big unknown, Lehman's CDS auction, has passed the first hurdle and we're now in the sorting-out phase.

 

According to Markit group, the pricing came about in line with the expectations that I mentioned this morning, right around 10 cents on the dollar.  That's not final yet, and can change a bit as the day wears on.  Pricing is only one piece - the amount outstanding is the other - and I still don't have a good handle on that.  Those two data points are required to understand just how massive the overall losses will be.

 

We haven't seen too much of a market reaction yet as stocks as a whole have simply settled back a bit from the early spike higher.  Most of the firms thought to have the highest exposure are pretty much acting the same way.

 

I'm just sitting back and watching at this point, it's going to take some time to find out whether the total losses from this Lehman deal are significantly better or worse than expected.  The initial selling pressure didn't quite make the threshold for buying I noted earlier, so I have made no changes yet today.

 

 

The Day Of Reckoning

10/10/08 7:45 AM EST

 

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Good Friday morning...We begin the day with selling pressure in the pre-market futures.  Our domestic futures dropped heavily yesterday evening at the opening of Asian markets, which suffered massive losses.  That has carried into Europe, but we've stayed relatively steady since last night.

 

Yesterday morning, the title of my opening note was "Could Tomorrow...Finally...Be "It"?".  The reasoning for that was several-fold, centering on the historic extremes we've witnessed and the coming-together of seasonal factors, but most importantly it was the due-date for the auction of Lehman's CDS derivatives.

 

I'm not going to blow smoke up your arse pretending to be an expert on the inner workings of the auction mechanism or all of its possible repercussions, but I am convinced that the major reason we've seen such massive forced liquidations has been the uncertainty regarding "who" owes "what" in regards to the writing of protection against a Lehman bankruptcy, and the unknowables from a chain reaction.

 

Lehman is a big deal because it's the second-largest auction for these things that we're going to see, behind the auction on Fannie Mae and Freddie Mac derivatives that occurred on Monday.  But unlike those firms, Lehman wasn't backed by the government, so this is the first (and largest) auction for those who bet against a default on corporate bonds.  There is another one for Washington Mutual derivatives on October 23rd, but that firm had a buyer, and we will also have a much better idea of the pricing to expect because of today's auction on Lehman.

 

Broad estimates are that the firms who sold insurance contracts betting against a collapse of Lehman will have to pay out somewhere between $200 billion to $1 trillion.  A big reason we've seen such uncertainty in the equity and credit markets is that nobody really knows how much in those contracts is outstanding, and what the actual payout price will be.

 

Fannie and Freddie settlements went for a rough average of about 95 cents on the dollar (which was higher than earlier estimates of about 85 cents); estimates for Lehman seem to be centered around 10 cents.  If it turns out that less protection than expected was written, or the recovery rate somehow comes in higher than expected, then I fully expect to see a massive and sustained rally in both the equity and credit markets.

 

If it's significantly worse than expected, then I am bracing for another potentially large decline, though I also believe that it would mark the low, with an upside reversal either later in the afternoon like we saw on Monday after the FNM/FRE auction or on Monday after a massive, coordinated government response over the weekend (your guess is as good as mine as to what that might entail).  As far as how much selling to expect, that's absolutely just a guess, but if we saw anything near a 10% drop in the major averages, I would be a buyer.

 

As far as what magnitude of a rally to expect (if and when it comes), my expectations have shifted as the crash has unfolded.  As we've had an opportunity to discuss several times this year, my usual expectation for bear-market rallies is for a one- to three-month rally of between 5% - 10% in broad averages like the S&P 500, with some back-and-forth testing of the initial panic low.  That has been a pretty good rule of thumb this year.

 

Due to the severity of this latest episode, and historical precedent, my best guess at this point is that we will see a short-term rally of 10%-15% in the S&P, and an intermediate-term one of 20%-30% that perhaps lasts into the early spring.  I do not expect further testing of whatever panic low we may put in here - I will expect something more akin to a V-shaped bottom.

 

The initial auction results are due to be revealed at 10:30am EST.  There will be a sorting-out period afterward as traders try to figure out the losses and determine the biggest winners and losers, so I don't expect that exact time to be the end-all, be-all.  On Monday, we formed an initial low at 10:30, then another around 2:45.

 

All the best,

 

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

 

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