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June 2, 2008

Something is Very, Very Wrong

Remember the sub-prime crisis? Banks of all sizes were hit with write-downs of epic proportions. Financial stocks cratered. Bear Stearns was milliseconds away from bankruptcy until Señor Bernanke played the banana republic card and printed money for J.P. Morgan to bail them out. And so the banking system was saved. All is well, right? Well, let's have a look, shall we?

stock chart

Oops! The banks are still hurting, and this break down is quite ominous. I suspect some nasty news is going to emerge from the banking complex within days. In a related event, two-year Treasuries saw 15 bp lopped off their yields today... the largest one-day drop since January. This move could represent a new flight to safety, thereby indicating somebody knows something the rest of us would like to know. Keep an eye on this yield.

Longer-dated yields also fell. Why anyone would want to own 10-year, dollar-denominated paper at 2.2% with inflation running in the 7-10% range is beyond me. There will be quite a tug-of-war going on at the long end of the spectrum. If holders of U.S. paper ever start bailing out en masse, it will be very bad for our currency.

Also of great concern is the refusal of oil to break down after a monster run. Usually oil price will soar, a recession will ensue, and then oil will settle back down as demand is mitigated by the recession. Well, two out of three is not good. We have a recession... one that is not feeling too tame... and oil keeps going up. You can thank the spendthrifts in Congress for that. If we see oilbreak higher again, stocks are going to get slammed.

Let's take a look at the indexes.

stock chart

Even if one does not believe the market is about to cave in, you have to be quite skeptical about the possibility of any significant rally here. One way to play such an outlook would be to sell OTM calls near the rally high (2050)

stock chart

As you can see, the S&P 500 made a much feebler attempt at recovery last week than did the NDX. If the banks slip into melt-down mode here, the SPX will be toast.


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