10/29/08 (The Bear Stands Up! 100 bps cut in the cards?)

Traders,

Well we tested the supports again – but in the closing session we had a massive rally. We had seen rallies going into the close before – but nothing like this. It was a hyper rally – but really on little to no news. The LIBOR rate is still in the 3.40-3.50 range, credit is still moving very slowly, and more layoffs expected. Other than the expect 50bps rate cut this week (which we were all expecting) there was really no news to drive the market into a hyper rally.
The word “Bear Market” derived from the method of how a Bear attacks. The Bear stands up on its hind legs and swipes downward, while a Bull on the other hand points his head down and lifts his horns up. In a Bull market you have a steady climb, with big moves down as the Bull lowers his head and attacks again. In a Bear market you have a steady downward move, with big moves up as the Bear stands up to swipe back down.
I would warn you – just because we had a 10% rally in a day – it doesn’t mean the “worst is behind us” and some traders are even looking at this as an opportunity to re-short into the market. We could climb higher into resistance levels – I would suggest if you are long this morning – get flat at the very least. For those gamma traders, taking a short position against gamma after the opening may be an opportunity. At the very least flatten those deltas.

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P&G another recession stock?

Certainly Wal-mart is proving to be a recession stock – while the stock price may get hit a little – it is certainly a survivor and will maintain revenue in a slow-down. So think about this – what does Wal-mart stock it’s shelves with? Lots of P&G products that’s for sure. Whether its diapers, dish soap, razors, shampoo, etc…you can bet that every American has at least one Procter and Gamble product in their home. In fact it is pretty hard not to buy a P&G product, not only do they provide many home “need” products – but they have many price points in several of those product groups (LUVS vs. Pampers is an example). Consumers may slow down their purchases of DVDs, video games, and other fun “want” products – but you still need to shower, shave, and change those diapers.
P&G’s earnings reported a profit that rose more than analyst estimates and net income climbed 8%. P&G had raised the prices on their good slightly to buffet against increase costs of raw materials – but those price increases we slight as to not affect consumer purchasing decisions. The decision to stay ahead of material costs helped increase margins that many analyst expected would cause pressure to returns. P&G CFO mentioned this morning on CNBC – they had planned over the last 18 months increase in oil and raw material prices that would affect both shipping and build costs and looked to cut expenses and/or increase costs or reduce package sizes as to not burden the consumers purchasing while also taking margins into consideration. Just a slight decrease in product size (say a .10 of a oz in a soap container) will decrease costs to build – while not having to increase prices to consumers to make up for the increase cost. Those little decisions on a large scale can make huge impacts to the bottom line at the end of the quarter. That foresight going into the ramping energy and material costs in the last 18 months – has now put them ahead of the game for the next several quarters as prices have come down. They can now even compete on price – if consumers become more pinched.
Squarely P&G is another recession stock - they are currently seeing a slight boost in the pre-market.

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FED CUT

The FED is expected to cut again, most are expecting a 50bps cut – but now there is talk about even a 100 bps cut. That would be rather shocking and good give the market a surprised follow-through boost from yesterday’s rally. The big problem is that while a cut is a clearly a move towards freeing up capital – if the banks will not lend to each other – it doesn’t matter if interest rates are set to 0. What will make a difference is the lending rate at the Discount Window – which will most likely come down in tandem with the Target rate. Since everyone is going to the Discount Window – any cut in rates is very welcomed.
Remember, Bernanke not only extended the loan to 3 months (matching 3-month LIBOR) – but he also significantly lowered the standard of collateral to borrow from the FED to include TOXIC paper (regardless of rating). Here is a fundamental problem that we can escape – the Discount Window usually charges a significantly higher rate than the target rate – to discourage borrowing from the Fed. However, that spread (which has been has high as 75-150bps over target) is narrowed to 25 bps – there is almost no incentive to lend to each other. Just go to the FED and borrow for 3-months and post all your toxic paper.
This cut may spawn a euphoric rally in the market – but it will not solve any problems. LIBOR has to come down (which it is – but still very high) and now LIBOR will have to play another 50-100bps catch up if the Discount Window is front running LIBOR on a race to ZERO. Who would ever go to LIBOR if you can borrow from the FED at 1% or .5%.
We are quickly turning into JAPAN – maybe soon every country will come to the US to borrow cheap money and we will be the CARRY TRADE? If that is the case expect long stagflation.

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Futures Premarket

They were down after the hyper rally yesterday, then popped on P&G news coupled with rumors of a 100 bps cut, then headed back down after that wave of euphoria subsided. I think ARB traders may want to stay slide lined this morning as the futures have moved up and down through fair value.

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Support / Resistance

Well we made a good haul to resistance levels yesterday – we could touch them this morning – but futures are starting to look rather mixed.

INDU 8500 / 9500 (We made a good run and could see a move a little higher from here. I would flatten ANY long hard deltas at this point and roll up hedges. Traders with gamma – a short play is in here and gamma will protect you against any upside move.)

NDX 1200 (1300) 1400 (We are at a good resistance point of 1300 – but has some pivotal action as well. Good place to get flat, and traders with gamma to get short – I would be careful getting short greater than 1:1 against gamma as the NDX is a hyper volatile index and a higher move could play out.)

SPX 900 (950) 1000 (900 is not really support because it was broken, but to the downside it is a place to start flattening out short-deltas. We could see a jerk move to the upper 900 band – a good place to get short against gamma. I would flatten deltas in this range and let my gamma work FOR me.)

RUT 450 / 500 (Unlike the other indices the broadest index has gone lower and also didn’t get the rebound we saw in the narrower based indices. That is not a good sign as to a continue rally – in fact it is a rather weak sign.)

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Conclusion

A 10% move to the upside is VERY big volatility – regardless of what the VIX says. Remember the VIX ONLY measures premium of options – it is not a very good indicator of actual volatility of the underlying. Think about it like this – it is the ASSUMED volatility of the market, rather than the actual market volatility. As the market goes down people panic and over pay for options as the market rallies they sell options. Some talking heads refer to it as a measure of FEAR, I guess in some respects you could infer that. What they don’t talk about – which is even a more important guide as to premiums – is the SKEW (which measures the premium / performance of the OTM (out-of-the-money) options are compared to the ATM (at-the-money) options. While the VIX does incorporate the skew (to some extent with its weighting system) – you can NEVER tell if the VIX is going up because the SKEW has increased or because the SKEW has remained the same and the ATM options are increasing. I have been working on my own model (HIDDEN VOLATILITY ) to get a better gauge of the action.
Yesterday was a gift from the BEAR – he took a break – it was/is the time to hedge long delta risk, get out of bad positions, roll up hedges, and ease some concerns. It wasn’t a time to jump into the water with both feet and “hope” the worst is behind us.