8/27/08 (Hillary Done, GSE Rally?, Durable Goods.)

Traders,

We saw Hillary pass the torch and urge her supporters to vote of Obama, I guess 2012 is not in her plans. Yet – she still demanded a roll call and is meeting with her delegates today – confusing I know. Her prepared remarks were fairly well delivered, but not nearly the kind of “pick yourself up” inspirational as Michelle Obama. Tonight it is President Clinton’s turn. So far no surprises.

The market saw little volatility and hovering at the interim support area. The close in the INDU above 11400 and RUT above the 720 has given short-term confirmation, but nothing to give us any confidence at this point. Volatility (premiums) came in yesterday and the VIX around the 20 level is still too low vs. statistical volatility that we are actually seeing. Hidden Volatility is ramping and that is something to be concerned about. Keep an eye on the Skew – that will give you a better indication of actual volatility expectation.

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Freddie and Fannie mortgage profits

The irony should not escape you – these GSEs have all but failed, going to the Discount Window to borrow money, getting extended leverage by Congress, and over 1.5 trillion in no performing paper. However, let’s ignore that and just look at the current paper that has been issued yielding 40bps, almost twice as high as traditional 20bps rate against bonds.

While this is good news for sure, is it enough to cover the losses? Not even close, it will off-set losses. Barney Frank has been calling this a success. Is it really – are they not still borrowing at the Discount Window and still have over a trillion in none performing?
And what does these mean to borrowers? It means money is getting very tight – the GSEs don’t collect MORE money unless they are charging HIGHER rates. Someone is paying the extra 20 bps.

Again – this IS good news and a step in the right direction, but we can’t ignore the big picture. Do we really expect MORE mortgages to be issued that are more secure (better credit rating) then sub-prime issued at higher rates? Probably not any time soon.

Remember – it’s a profit based on a spread – they BORROW money at a certain rate and LEND money at another. For those of you that are in the know – this is NOT arbitrage, but rather two different bets with two different risk profiles. The spread right now is favorable, but the fact remains their leverage is EXPANDING – it only takes one side of that spread to fail or falter to see them take several steps back, AGAIN.

The stocks are getting a great pop in the premarket, following yesterday’s rally. This is NOT a place for long-term investors – regardless of the gains – because nationalization, the Discount Window, and increasing debt (liabilities) has not changed.

Expect some high volatility in these issues. Expect many to dump shares and the short-interest (even though they are on the SEC protection list) is still rather large – which could also fuel some short-covering. Stocks are rallying with more optimism then fundamental reality – go figure. Didn’t anyone read the Case-Shiller report yesterday – I guess not.

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Durable Goods gain!

As we are seeing an economic slowdown, we also saw orders for Durable Goods unexpectedly rise – this has been the story of the multinationals, like CAT – that continue to expand overseas that make up for domestic short falls. Clearly the weaker dollar over the last year has given the trade window for the multinationals a bigger pipeline. But the news yesterday in German’s business confidence falling, which also sent the dollar up against the Euro, combined with China’s increasing inflation and growth slowdown – may see the orders for durable goods over the next quarter slowdown.

Economist had expected the orders to be unchanged, expecting the global slowdown to even squeeze the multinationals – but that has not happened yet. The question is not IF we will see a contraction it is WHEN. The dollar is also going to play a key role - strong dollar will help inflation and domestically but will hurt the trade balance. You can’t have your cake and eat it too.

The futures got a good jolt to the upside from the news – moving from the negative to positive.

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Futures Pre-market

We saw the futures down prior to the durable good numbers, then a pop from negative to positive. The futures are front running the cash and the spreads did widen a little, however the volatility of the futures to fair value in the premarket may keep some of the Arb traders sideline until the market opens, not willing to take leg risk. If the spread remains, expect a pop in the cash at the opening – but not too big.

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Support / Resistance

We saw some support in the INDU, RUT, and a little in the SPX. The area has been gaining momentum and volatility is coming off. The means the longer we stay here the more violent the move away from here when it does happen. These are fairly weak support areas – so hard delta is a bigger than normal long risk factor.

INDU 11275-11400 / 11500 (This is a tricky area, with many variables. It could either not hold 11,400 and fall to 11275 or we could RAMP – violently to the upside break through 11500 and even touch the 11600 level again. The semi-good news in the GSEs might create enough euphoria to do it – but fundamentally there is a drag. I am expecting the 11400 to be a straddle strike and a possible violent move away (up or down) from here. Double bottom or weak support – it’s 50/50 at this point.)

NDX 1850 / 1900 (We are hovering close to the previous 1900 support, but closed below it. 1850 is in the cards and there is really nothing in the 3rd quarter to fundamentally ramp the market higher at this point.)

SPX 1260-1275 / 1290-1300 (We are in a very similar situation as the INDU – breakdown or rip higher very fast and hard, again on euphoric optimism. At this point it’s clearly a crap shoot. Treat this area as a straddle strike and expect violent volatile move away.)

RUT 720 / 740 (The broadest market, which recently saw hyper volatility, is back down in the support area – we are above the 720 line – but it is all about the close. Watch 720 – that is key as to flow in or out of the market vs. treasuries.)

This is NOT a market about bulls or bears – but rather knee jerk reaction and volatility. I will continue to repeat don’t expect the VIX to have a clue as to actual statistical volatility – so far the VIX vs. actual has been very wrong. Gamma traders that have hedged hard deltas have either been making huge money or not losing very much. Those top and bottom pickers are seeing P&L swings that make the VIX blush.

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Conclusion

I am not biting on the Freddie and Fannie news as if it’s all ok and the problem is resolved. The stocks are acting like it – but I think, just like the short covering and 30-40% rally in the financials after the SEC rule change – will be short lived. We will not find a bottom until we shake out the debt, close the Discount Window, and see lending get very lean. Defaults are still up – so I don’t know what Freddie and Fannie are thinking – increasing their debt on a bond vs. lending spread – yeah – that is a brilliant plan! For now Frank, Pelosi, and Dodd are saying “See it’s working!” – but I think they are in for second round of bigger surprises.

We are also seeing the VIX pull off too much and are in a precarious range in the indices between a traditional support with euphoric optimism and short covering fueling another hyper 2-3% rally or a break-down and loss of confidence as we drift lower. I don’t think any wise people should be betting any serious hard deltas on direction up or down. This is investor sideline area and trader gamma time – nothing more or less. For those that don’t have your hedge on – premiums are VERY CHEAP compared to statistical volatility – if you don’t have your long or short hedges on, well you have no one to blame but yourselves.

The longer we don’t move the bigger the move tomorrow. Hidden volatility is ramping.