Tuesday, July 29, 2008

The Debts of the Spenders: Explaining Bear Rallies

The equities market has gone through several "bear rallies" since the sub-prime news first hit the mainstream. First, was last August/early September when quant models failed and Bank CEOs rushed to assuage investors with soothing words. Second, was the Fed engineered bailout of Bear Sterns in Mid-March that petered out by May. Third, and current, is the SEC anti-short selling rule.

What does it mean? How can companies and government agencies release bad news and have the indices rally?

Simple. We look to Pakistan and the futures markets for the answer.

First, - In May, Pakistani regulators banned short selling and set price floors on stocks on the Karachi Stock Exchange. This had the short term effect of bolstering stocks but the longer term effect of causing foreign money to leave the country. The result? Nearly consecutive months of losses. The regulators finally wised up and abolished the rule - only to see the pent up market forces wreak further havoc on share prices.

Second, - Futures markets are heavily leveraged. Traditionally, the smart (aka institutional) money has been the dominant player. Many of these institutions are banks, have some sort of lending arm, or are otherwise exposed to CDOs, sub-prime, Alt-As, and other toxic crap. Fund managers are being forced under the SEC and Treasury's new capital adequacy requirements to further increase their free cash flow. Translation? Liquidate assets and reduce leveraged activities. This has resulted in lower liquidity and higher volatility in the futures markets.

But, what do these two things have in common? Simple, volatility. When regulators attempt to manipulate share prices, they are also manipulating 1) the bid and ask spreads which in turns leads to 2) lower liquidity. Since the US markets are deeper and more liquid than Pakistan's, we are unlikely to see index wide monthly consecutive losses. Instead, since the US markets are well capitalized and run by a network of casino bosses - I mean exchange officials and market makers - reactions are going to be a lot different. When I say well capitalized I mean there are more suck-...err ...retail investors and foreign funds involved.

Wider spreads lead to sharper market swings. The slightest bit of news - good or bad - can be enough to send markets into a 200+/- vector. While analyst expectations are already massively lowered in financials, they are being raised higher elsewhere in other sectors. Seemingly unrelated companies can be caught in a sector wide punishment - or benificence.

Don't believe me? Look at the market's reaction to Ford (-250 Dow) and US Steel (+260 Dow) in the past two weeks alone. When Ford plunged it took the steelmakers down with it. Now on the other hand, when US Steel rose, it carried financials up with it.

The element of human emotion is more present than ever before in this market environment. Fear - and greed - are apparent as never before.

My advice to predict a bull or bear market on a daily basis? (It is impossible to predict a weekly basis in this new environment)

1) Look at what macro-numbers are out 2) Listen to Gov official announcements and 3) Examine the Earnings Calendar for companies. This is old advice for veteran traders but take on increasing importance in today's market. Number one seems to have been largely discounted as manufactured numbers released to contain political damage. Number two is important with regards to certain trading behaviors.

Three is the most critical. A single company's performance ability to meet, miss, or beat analyst expectations can be enough to send the entire index up or down. There is increasingly no sideways action (thanks to the SEC, Fed, and Treasury).