8/19/08 (Muddy Water? Home Depot, PPI JUMPS!)

Traders,


Volatility continues to rule the day as the market gives up steam heading to the upside. These are not the times to be stubbornly bullish or bearish, but rather accept that fact that at any time and any moment the market can make surprisingly huge moves. As the economic landscape remains unclear, investors chase yields, and analyst continue to make rudimentary observations with only a few pieces of the puzzle – we will continue to ride the wave of uncertainty.

The problem with the market is transparency, as we accept the fact that massive deleveraging is happening from the consumer to the corporation, the government and regulatory organizations preventing failure at any and all costs has clouded the ability for investors and traders to ascertain value. Is Lehman OK? Do they have enough capital to manage their balance sheets? We do NOT know because between the SEC short prevention, ability to borrow from the Discount Window, and a plethora of other incestuous relationships between government and regulatory bodies – creates a fog of uncertainty. Buffet last year already correctly called the write downs based on mark-to-market accounting, Mark-to-MYTH.

Freddie and Fannie too are also deep in mud and government regulation and oversight. The slug on the books of no performing paper is beyond $1 trillion (20% of their paper) and it could be worse. It is very possible that the GSEs are quickly to become government owned.

However, the question no one is asking – the Discount Window has been the KEY to keeping the GSEs and financial institutions afloat. The loan traditionally a 30 day short-term loan was only available to members of the FED, has now been made available to NON-members (investment banks and the GSEs). In the history of the FED the money being borrowed is unfathomable, even dunning the S&L crisis we never saw this kind of money being lent, 100s of billions. The Discount Window being open to NON-members was enacted by the FED as an emergency temporary measure – but the amount of money being lent and the temporary limited time (until Sept.) has obviously been extended to January 09 and the loans are now extended from 30 days to 84 days. The question, what happens in January? What happens when the loans are due? Do we really think the Lehman’s and others can pay back (even in 84 days) the 100s of billions being lent? Of course not, my guess is the window will be extended again in January. We may even see Congress change the mandate and powers of the Fed and permanently allow these non-members to borrow money, or even make them defacto members. Talking to a colleague he made an interesting observation, if there is not enough money in the reserve pools and the borrowing of money at the Discount Window becomes the standard of the industry, doesn’t that mean the banks technically have become nationalized? Interesting observation and something to think about. True, as Bernanke has pointed out, that not a single loan at the Discount Window has failed. However, it is also true if you continue to extend the length of time to pay back that loan – you could honestly say that they would never fail. Extending the date may fool some of the people some of the time, eventually someone has to pay, could that be tax payers?

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Producer Price Index (PPI) jumps 1.2%

As the Fed has continued to say that inflation (based on the “Core”) is moderate, the reality is that we (both the consumers and corporations) are feeling it. The PPI, the measurement of inflation affecting companies, jumped 1.2% in July (the Core increased .7%). The forecast by economist had been considerably lower based on the falling prices in oil (.6%) - but the PPI doubled forecasts.

Some economist believe that July will be the peak of inflation measured by the PPI as oil prices continue to come off, however I suspect that while this might be a peak – it may only be a peak in the short-term. Smart commodities people are predicting a rise or continual high prices in oil in the 4th quarter and 1st quarter (09). The peak predictions don’t explain the Core rising by .7%, (their expectations were for .2%) – that is showing that other commodity and raw material prices are also on the rise. While true the dollar has seen a rebound of late, which should curtail CORE rates from further increasing – that assumes the dollar remains strong.

The big questions are two-fold, Has oil prices peaked, not to return? Did the dollar bottom and is now going to continue to rise? If you answer yes to both of those questions, then it is quite possible the PPI (and possibly the CPI) have peaked. If you answer NO to just one of those two questions – inflation may continue to increase.
The futures sure didn’t like the news – and have dropped sharply.

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Home Depot Profits Fall

As expected, after Lowe’s news, Home Depot follows suit with lower profits. The good news, they fell less than analyst expectations – and the stock seems to be holding ground in the pre-market. The bad news – they are predicting a further drop in profits over the next year and no rebound foreseeable until 2009. However, predictions that far out (IMHO) are pretty much worthless. For Home Depot to predict that next year they will be seeing an increase in profits is a pretty big assumption based on many economic forces that so far even the brightest economist have failed at. Give there short-term forecasts (next quarter) some weight – telling investors that they are going to see profits rise in the 2nd quarter of 09 is “feel good” talk by the CEO – nothing more and nothing less.

They did sell lots of plywood, batteries, and other hurricane related items this last week in Florida as FAY was expected to be more than a tropical storm. Additionally hurricane season is getting in full force now – so we could see some sales increase in the South East – but that may not make up for broader profit short-falls.

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Futures Pre-Market

The futures were down, but the knock down came when the PPI reported a double jump over expectations. The drop in futures also created a decent spread going into the opening. Expect Arb traders to buy the futures and short the cash going into the opening – to drive that spread to parity. If the spread remains this wide going into the opening – expect ARB traders to put pressure on the cash at the opening = meaning a gap down!

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Support / Resistance

Again – volatility plays a roll and the market shrinks back to supports. Just as we were ratcheting higher, and rolling up your hedges was prudent, we see a mass pull back testing and breaking some of those supports.

INDU 11300 (11450) / 11800 (The 11,450 area is NOT support but a key place we need to close above if we are to hold this area and maintain the ratcheting upward move. If 11450 fails at the close – then the short-term ratchet trend has failed. Don’t get stubborn at 11,450 – that is a place for LONG deltas to have enough Gamma to get them flat to short in a drop by 11,400.)

NDX 1925 / 1975 (We have been consolidating in a wide band in the 1950 area – a solid close above 1950 would be a sign of supporting the consolidation area – otherwise testing 1925 is in the cards. I wouldn’t get long 1925 if we break – but flat with gamma. If you get long at 1925, make sure you have enough gamma to get flat in case we break that line. A close below 1925 means 1900 is in the cards and a visit to 1850 again is possible.)

SPX 1275 / 1300 (Do NOT get long or short hard deltas at 1275 unless you are 2:1 MAX Delta to Gamma – we could and we will rip from that 1275 line either up or down. Calling direction at 1275 is risky unless you can back up your deltas with some solid gamma – and I am not talking about little OTM options, which may not help against hard deltas.)

RUT 720-740 / 760 (Yuck, I would not be buying at 740 as picking a bottom unless I was fully sacked up with Gamma. I don’t think 740 will hold and that means we could have a vacuum suck out down to 720 – as the volume between 720-740 is close to nothing. That means BIG volatility action between the 720-740 area but that range also means don’t go home long or short hard deltas in that range.)

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Conclusion

The fog that clouds transparency as to the solvency of many financial institutions and GSEs is every more cloudy as the government intervention continues. I heard Mr. Frank already make the suggestion of nationalizing the GSEs (another suggestion to save them) – thanks Barney, who championed this mess to begin with. Was he and Ms. Pelosi not already warned about extending the credit lines and ability of the GSEs would be their doom back in February? It was predicted that if they pushed through their bailout of the sub-prime by letting the GSEs absorb that crud paper – it would mean we would have to bailout the bailout. As much as we point fingers at China and Venezuela (Hugo Chavez) for nationalization of some of their industries – we are lock-step marching in the same direction.

I can’t imagine the U.S. nationalizing the mortgage industry (GSE) or the financial institutions and banks (via the never-ending borrowing from the Discount Window). Not letting anyone fail (citizens or corporations) means we as a government fails – because a loss is a loss – shifting it to the government doesn’t mean it is gone. It means we print more (FIAT) money and tax people more to bailout these losses. I don’t know how much more treasuries we can sell – since foreign nations are sideline on big purchases – as seen in the current auctions as it is.
One of the big questions this election you should be asking yourself is:

1. Do you believe it IS the government’s roll to bailout the banks and consumers?
2. If so, the only way to pay for that is MORE taxes with the very high possibility for more inflation – as the short-term will require printing of more money (via more loans).
That is one of the biggest differences between McCain and Obama.

However, even though McCain may not be for more taxes and bailout – at some levels is really out of Obama’s and McCain’s hands – as Congress, the Fed, and Treasury have already been leading the charge as to bailing everything and everyone out.

I now wonder what could McCain or Obama (not that he would stop it) – be able to do?

Is the problem so big that we have moved past the point of no return – the Tipping Point? Enough so that even a president opposed to such an endeavor is powerless to stop it?

The shift of power is taking place.