Thursday, September 25, 2008

Buy the Rumor, Sell the News


And back in the real economy, the news coming out of the United States keeps getting worse:
Weekly jobless claims surged to the highest level in seven years, durable goods orders took a bigger-than-expected tumble and new home sales plunged to the slowest pace in 17 years, according to government data released Thursday.

The latest trifecta of bad news about the economy raised new worries about a possible recession and underscored the concerns that are driving Congress and the White House to reach agreement on an historic bailout of the financial system.
Meanwhile, Standard & Poor's reported that the default rate among high-yield, high-risk, non-financial borrowers may rise to 23.2 percent by 2010, the highest level since 1981:

The "worst-case scenario'' estimate suggests that 353 junk- rated borrowers outside the financial sector may default in the next two years, with more than 200 defaults occurring in the second half of 2009 and in 2010, analysts led by Diane Vazza in New York wrote in a report today.

"As the financial landscape adapts to changes unseen since the Great Depression of the 1930's, the heat will eventually spread among non-financials,'' the analysts wrote, adding to default pressure "on a much bigger scale than has materialized to date.''

Defaults in the housing and financial sectors mark the first two phases of the default cycle, according to the report. A third cycle, which will see tightened lending conditions spread to non- financials, particularly consumer products, media and entertainment companies, and retail and restaurant borrowers, has yet to come, the report said.

So what did the stock market decide to do? It rallied as investors became optimistic that an agreement on the bailout was near:

"Optimism lies in the hope that we're nearing the end of the credit crisis and that Paulson's plan will help settle things down and businesses can get back to functioning as normal,'' said James Gaul, a Boston-based money manager at Boston Advisors LLC, which oversees $1.8 billion.

The market extended its rally after Dodd, speaking to reporters on Capitol Hill, said the principles will allow Congress to "act expeditiously'' and "send a message to the markets.'' President George W. Bush said last night that a rescue plan for financial firms is needed to avert a "long and painful'' recession.

I wonder if they will announce something before the bell tomorrow morning to get the bulls going right before the weekend and hopefully continue the momentum next week.

But before you get too excited, I suggest you listen to Tim Knight's short video in his latest comment, Two Things To Remember (click on the link to watch).

Tim is short and buying puts on individual companies. His two main messages are the following:
  1. The bailout is not good for stocks; and
  2. Do not underestimate how far stocks can fall.
I strongly urge you to listen to his comments and watch how things unfold as this bailout is announced. Today's buying frenzy can quickly turn into a selling frenzy as traders always tend to buy the rumor and sell the news.

I would be very careful about getting overly excited on any bailout announcement and pulling the trigger too quickly to buy stocks. I am reading a slew of positive articles, including one that quotes a "top-rated analyst" who says that President George W. Bush, billionaire Warren Buffett and Black Rock Inc.'s Laurence Fink are "absolutely'' right to say a $700 billion U.S. plan to buy assets from financial firms may cost taxpayers nothing even with purchases at above-market prices.

So this is it? Congress agrees to a deal on bailout and we have finally fixed the problems in the financial system and stocks will rush back up to make new highs?

If only it were that easy. This much touted bailout might just be the catalyst for more selling, not buying of stocks.

Look at some of the news stories currently impacting markets:

Fortis Drops to 13-Year Low on Funding Concern

Fortis, the financial-services company that set out in June to raise 8.3 billion euros ($12.2 billion) to bolster capital, fell in Brussels trading to a 13-year low on concern it needs help with funding.

Libor Rises Most Since 1999 as Banks Shun Money-Market Lending

Money-market rates around the world soared on concern the U.S. Treasury's $700 billion bailout plan will be diluted as it makes its way through Congress, causing banks to hoard cash to meet their future funding needs.

Bernanke Moves Closer to Rate Cut as Risks Intensify

Federal Reserve Chairman Ben S. Bernanke moved closer to cutting interest rates, signaling that risks to U.S. growth are greater than policy makers saw them just last week.

Moreover, I would heed the warnings of the head of France's AXA, who said it was too early to say the worst of the U.S. financial crisis was over:

"It would be totally premature to say that the worst is behind us," AXA Chief Executive Henri de Castries told Europe 1 radio. "We are at the heart of something that is in the process of redefining the U.S. financial system and the financial system of the whole world."

In fact, housing is nowhere near a bottom in the United States.

So if you think this is the bottom, I got news for you. It may just be the beginning of another selloff, one that will be considerably more vicious than previous selloffs.

Finally, it seems that the credit crisis is dampening the use of derivatives by U.S. pension funds:

"At a time when pension funds would have benefited most from having well-considered hedges in place, market conditions have been against them," said Chris DeMeo, senior investment consultant at Watson Wyatt. "Since the start of the credit crisis last year, there have been significant delays in the execution of derivatives-based liability hedging strategies for pension funds. This has been due to documentation taking substantially longer to process because of more onerous legal conditions, as well as there being a general mood of risk aversion among banks.

At points during the year, the yields available were also not considered attractive, DeMeo said. "We have also noted very large increases in transaction costs for shorter-dated contracts. In light of more recent market events, it is unsurprising that some banks are now either less willing or less able to retain unhedged risks on their balance sheets, but the net result is that pension funds now have to delay the execution of these risk-reducing strategies, which we expect will also hinder their wider adoption."

For those funds that have these strategies in place, Watson Wyatt advises that they should ensure that both their documentation and collateral are robust, as primary security comes from these. In addition, funds should have diverse counterparties in place in order to manage the default-to-replacement risk. The firm also advises that, in the event of default, it is important for funds to replace positions quickly to minimize possible market loss.

"While Lehman Brothers' bankruptcy and ongoing volatile markets have perpetuated the very challenging investment environment, those high governance funds that use interest rate swaps will have found that they have proved their worth in managing deficit risk," said DeMeo.

"As such, we expect pension funds and their sponsors to continue to use various derivative instruments, albeit at a slower rate, because of a broad realization that they can provide protection, enhanced performance and a better match for liabilities."

One market that is already in decline is the credit derivatives market, which shrank by 12%, its first decline in years as credit-default swap dealers reduced outstanding contracts for the first time amid efforts to cut risk by cleaning up the derivatives market:

"I would expect that if they were to re-poll next week, you would see an even smaller number from netting activities and trade cancellations surrounding the Lehman Brothers default,'' said Brian Yelvington, a strategist at CreditSights Inc. in New York.

But the damage is already done and investors better be cautious in the next few days as optimism will dissipate quickly once traders sell the news.

***Update:

JPMorgan Chase & Co. Inc. came to the rescue of Washington Mutual Inc. Thursday, buying the thrift's banking assets after WaMu was seized by the Federal Deposit Insurance Corp. in the largest failure ever of a U.S. bank:

This is the second time in six months that JPMorgan Chase has taken over a major financial institution crippled by bad bets in the mortgage market.

The deal will cost JPMorgan Chase $1.9 billion, and the bank said in a statement it planned to write down WaMu's loan portfolio by approximately $31 billion. JPMorgan Chase, which acquired Bear Stearns Cos. last March, also said it would sell $8 billion in common stock to raise its capital position.

The FDIC, which insures bank deposits, said it would not have to dip into the insurance fund as a result of the seizure. There had been concerns that the fund, which took a big hit after the seizure of IndyMac Bank, could be depleted by a WaMu seizure.

WaMu "was under severe liquidity pressure," FDIC Chairman Sheila Bair told reporters in a conference call.

"For all depositors and other customers of Washington Mutual Bank, this is simply a combination of two banks," Bair said in a statement. "For bank customers, it will be a seamless transition. There will be no interruption in services and bank customers should expect business as usual come Friday morning."


***Uh Oh! Bailout deal stalls:

A Republican revolt stalled urgent efforts to lash together a national economic rescue plan Thursday, a chaotic turnaround on a day that had seemed headed for a success that President Bush, both political parties and their presidential candidates could celebrate at an extraordinary White House meeting.

Also, see what taxpayers in Palo Alto think of this bailout. The message from Main Street is "No Blank Check for Wall Street."

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