December 1st, 2008

Bouncing bulls, but bears reign.

Equities traded considerably higher following yesterday's mass carnage, but the market tone remains questionable. The day-to-day direction of the market is highly uncertain, but I do believe that we are in the process of finding a bottom. The highly volatile and essentially directionless trade witnessed in the most recent two months of trading supports this premise as markets have a tendency to behave erratically before a large trend change. However, the process can be long and painful and may even include another new low before all is said and done.

The early morning technical rally was thwarted by news of weak auto sales. U.S. sales are on pace for another record low in November. Do not forget that October's seasonally adjusted sales rate of 10.6 million was the weakest reading in over 25 years. Analysts were calling for the November sales to come in slightly better due to aggressive incentive programs. However, domestic auto sales are on pace to see another record low as Toyota, Honda and Ford all report a decrease in sales of over 30%. Ironically (or maybe not so ironically), the sales reports were announced on the same day the U.S. automakers were scheduled to testify in front of Congress. The "big 3" will once again be asking for a $25 billion federal loan in an attempt to avoid filing for bankruptcy.

Meanwhile, crude oil looks to be comfortably trading below $50 per barrel. The price of crude oil has been relatively positively correlated to the stock market as energy traders are equating sluggish equity markets with a weak economy and thus weak demand.

The relationship between equities and interest rates has also been skewed in light of economic struggles. History suggests that stocks and bonds are negatively correlated and accordingly should move in the opposite directions. However, in recent months there has been a disconnect. We are now finding equities reacting negatively to higher bond prices. While logic tells us that lower yields should be prosperous for corporate growth, traders are seeing it as a sign of a lack of confidence in the system. Accordingly, stocks seem to be holding back as yields decline.

In yesterday's newsletter I made the following statement and it still applies:

At this point, I guess you could say that I am "on the fence" but maintaining a slightly higher bias. Assuming that the 50% retracement of the move higher holds, we should see another run at intermediate term resistance at 8,590 in the Dow, 880 in the S&P and 1196 in the NASDAQ. Failure at current levels could translate into another retest of the lows.

The Bond Bulletin

The Treasury freight train chugs on.

"There is nothing so disastrous than a rational investment policy in an irrational world" - John Maynard Keynes

U.S. backed fixed income securities have enjoyed one of the largest bull runs in history, yet looking at the COT data it seems that many futures traders were less than thrilled. In fact, most speculators (small and large) have been decisively short the market while commercials are heavily long.

This doesn't mean that commercial traders are "smarter" than the rest, they are simply hedging their risk and happen to be on the right side this time around. Remember, COT data suggests that commercial traders were also heavily long during the October bond plunge. What we can get out of the COT data is the fact that if there are too many speculative shorts, the market is susceptible to buy stop running and short traders buying positions back on dips, which was evident in today's early morning comeback from negative territory. In my opinion, short covering is in large part the driving force behind the current rally. If commercials aren't budging and speculators are already short the market is left with few sellers. At a time that people were looking to the stock market for what was supposed to have been the "mother" of short squeezes, bond shorts didn't see it coming.

Insiders say that today's trade was dominated by spread trading and it was noted that call option sellers were active. Volume was incredibly light and this leaves the market vulnerable to large price moves with little warning.

The March bond is due for a ten handle correction to 121 (if you think that it sounds crazy, try typing it). However, if you are "caught" in this move, don't get greedy. I would look to downsize on dips, it is better to lose some than lose it all. Likewise, the 10-year note should see a move much lower. My first target is 116'16, but don't jump in front of the freight train. I like buying out of the money puts, or lottery tickets a I often call them. You should be able to get the 119 puts for about 20 ticks.