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September 21, 2008

The Dukes of Moral Hazard

A week ago I concluded a post with a suggestion that the coming week would be thrilling. The markets did not disappoint. The events of September 15-19 will be studied in economics and history classes for at least a generation. Three major financial institutions disappeared. Four out of the five sessions saw 4% moves on the S&P 500, and we witnessed a two-day low to high swing of over 10%! Furthermore, Ben Bernanke and Hank Paulson, the Dukes, tinkered with markets in ways that can be described, at best, as reckless and desperate.

For one, their overnight ban on short sales for 799 financial companies wreaked havoc. Dozens of hedge funds... prudent organizations with no culpability in the financial crisis... saw their yearly performance ruined in an instant, and I'm sure we will hear of a handful of them folding in coming days. It is a testament to the Dukes' ignorance of how markets function that their policy of targeting short sellers will only force more disorganized liquidation, reduce liquidity in the market, and perhaps even lock up the options market as market makers refuse to write options against securities they cannot hedge with short positions!

Somehow I don't think Ben and Hank are going to be quite as proficient at getting out of a tight spot as Bo and Luke. Their malfeasances have not changed the fact that we are in a secular bear market. The banks are not going to suddenly start expanding credit. Housing prices are not going to move higher... or even stabilize... while so much oversupply remains on the market. National production is not going to suddenly rise. No new jobs are being created. Household and national debt remain at records and thanks to the Dukes, are now gapping higher. Wealth simply cannot be created by printing money, and I shudder to think what kind of black magic they will try to summon if the banking system comes under heavier threat before the election.

So now that the largest short squeeze in the history of the world is behind us, where do we go? I'm going to venture that the aftermath of all these criminal interventions sees the market drift back down to at least a test of the low. Part of the reason for this suspicion is that a couple of the sentiment indicators I follow never reached the extremes normally seen at significant bottoms.

indicator chart

indicator chart

From a plainly contrarian point-of-view, a drift back to the lows is probably the least expected outcome among the public right now.

And now I will make a sloppy attempt at converting a noun into an adjective. As evidence to the "short-squeezedness" of this week's late rally, note how MACD on the 60-min SPX chart went from extremely oversold to buy signal to extremely overbought in just a few hours!

index chart

One would have to believe that this rally has exhausted itself in a heartbeat. Even if higher prices are to be seen, a labored consolidation period needs to unfold.

Speaking of wild swings, the banking index swung from piercing support to shattering major resistance:

index chart

Again, if higher prices are in order, a back test of broken resistance will almost certainly have to take place.

Precious metals also blasted higher as it became apparent the goverment is going to try to print its way out of our economic woes. Why this outcome was ever in any doubt is beyond me. After all, Ben Bernanke was trained to print money. The only startling part is that no one questions his training. In any case, I don't buy into the massive rally in precious metals. The government announces it's printing $700B in new money and every thing goes straight up? It's too easy. I'm guessing the lows get tested or broken before metals rally in earnest.

In the meantime, commodities do look like they will extend this countertrend rally, and if so, we should see the CRB break the trendline formed by the first down leg:

CRB chart

How to play this bounce becomes a pressing question. I do not want to chase precious metals. Scanning through the charts of various commodities, I found a compelling setup in copper:

copper chart

In his weekend report to subscribers, Gary Savage noted that the Blees rating on copper hit 100 this week, so I feel even better about the trade.

Here are a few other trade ideas under consideration by the author:

Write Calls on the SPX
Even if one does not believe stocks will turn tail and head straight back to lows, there is very little reason to expect a sharp continuation of the rally. Writing OTM calls at this juncture would capture the deceleration of the rally as well as the abnormally high volatility premiums being sported at the moment.

Gold Straddle
I may have no strong feel for the near-term direction of precious metals, but I'm sure they will remain quite volatile. Big moves in one direction or another are almost a given. Buying an at-the-money straddle on December gold would be a way to bank this volatility. Such a straddle is priced at about $115 right now which, as can be expected, is a bit pricier than normal. I would wait a few days for gold to put in a few sessions with sub-$50 ranges in hopes of seeing a better deal on the ATM straddle.

Short Oil
Whether oil will continue its downtrend or commence a larger rally here, it is likely to test the recent low at $90. I'd wait for oil to hit a resistance zone... the most obvious being the $112-120 consolidation zone... and then by puts. Outright shorting is too dangerous given the daily threats by Israel and the U.S. to attack Iran.

Short Home Builders
The recent maneuvers by the Dukes will in no way stimulate the housing market. Quite the opposite since the regular market-clearing mechanisms of capitalism are being impeded. Despite the fact that home builder shares rallied with the general market this week, their economic outlook has just been made worse. Fading this rally with a short on XHB or perhaps writing OTM calls seems promising.

Fade the Banks
Now that the Dukes have emptied their arsenal trying to save the banks, fading the short squeeze seems potentially profitable. What else are they going to throw at them? Buying puts or writing calls (because you can't short them!) as the BKX approaches resistance at 88 would provide for a close stop loss.

Buy Agriculture
Agricultural commodities have been demolished during this cycle down in the commodity bull market. As a longer-term play, I am considering adding shares of RJA to my core positions. I'll probably wait for some sort of base to form before pulling the trigger.

I hope none of you were hurt by this week's gyrations. Things should remain quite interesting between now and the election, so keep a cool head.


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