Tempting Tuesday Morning

We've had improvements in the pre-market but do not be easily led into temptation.

It is very normal to get a 20% bounce off a harsh drop, while that would give us 150 Dow points and 40 Nasdaq points and 20 on the S&P, that is nothing to get excited about.  Anything less than a 40% recovery is pretty much a continuing downtrend.  The last play we looked at yesterday, at 3:43 was a speculative bounce play on the QQQQ $38s at $1.69 but, as I said to members at 11:20 yesterday (with the Dow was still up over 10,800) when we were still looking for bearish plays: "Technicals on all the indexes say we are doomed and TA has been very good at predicting lately.  If this bailout doesn’t give us traction soon, we probably are doomed so don’t go too crazy on the long side, I’d have to say that calls are still the speculative plays as the preponderance of evidence is against them."

We had our clue to worry from watching the VIX early in the morning and at 10:48 I had noted: "Looks like the market is not done going down and the VIX is up high enough for us to get back to 10,600 or it may mean we are 200 points too far down already – tough call with all this negativity!"  The VIX is an excellent indicator of trouble brewing in the markets.  At the time I made that comment to members it was just touching 40, by the end of the day the VIX spiked all the way to 48, possibly an all-time high, which we then noted would make for some good puts on the index of course.

Our worry was that Congress would pass the bailout package but it would be perceived as not enough (the morning post was titled "Too Little, Too Late?" but it did not occur to us until the voting started that they would actually vote it down and, rather than "too little, too late" we got NOTHING AT ALL.  What did doing nothing cost us yesterday?  Well the markets lost $1.2Tn in market cap, something that has a pretty broad-reaching effect on America but nowhere near what it would be if we had gambled our Social Security Trust Fund on the markets.  Of course, now may be a good time to bottom fish with our $2.5Tn of inadequate coverage as things have not been cheaper since 2005 and if Congress does finally get it together and come up with a good plan, we may be able to roll a double with some savvy investments so let's bust open that lock box and do a little speculating!

Pre-markets are holding up very well as hope does spring eternal that both the bailout will pass AND it will work if we miss either one of those two points, those SKF calls continue to be your best friend.  There are a lot of tempting values out there but it will be a while before we can claim to be out of the recessionary woods, even if the plan does pass AND it works so we need to look at very long-term positions, like the ones in our Trade Ideas section. 

My favorite at the moment is MSFT 2011 $22.50s, which closed at $7.38 yesterday and we are back about the price the stock was at before they announced a $40bn (about 20%) buyback last week.  MSFT may not be recession proof but, like oil, it's a necessity that people consume every time they buy a computer (most anyway).  Earnings are on October 23rd and expectations are for a modest 5% increase over last year, far lower than prior trends.  With 27 months to sell calls against them, you only have to collect .20 per month in premiums to pay for the calls but back at $25, it pays to wait to sell the Nov $27s for $1 or better, now .40. 

These are the kinds of plays you can construct on any stock you feel is at a good bottom.  Of course, as I said, calls are the speculative plays in this market and need to be treated as such.  We are assuming a plan that works coming from our government to "fix" the markets – not exactly something you want to bet the farm on.  USUALLY, when the VIX is this high, it precedes a short-term market rally but it is no indication of a long-term turn.  The VIX tracks the implied volatilities of S&P index options and a high VIX means it's a terrible time to buy options and a good time to sell them in general.  30 or more is generally considered high on the VIX, over 40 and we get what happened yesterday…

What's happening today is Bush is speaking at 8:45 and the international markets are expecting good news as Asia was down far less than expected (from the FXI  action yesterday) with the Nikkei falling "just" 4.12% and the Hang Seng actually closing UP 135 points (0.76%) and the mainland markets were closed, possibly for the Jewish New Year…  The Hang Seng notably recovered from a 1,000-point gap down and went straight up all day ONLY on the hopes that Congress WILL pass a bailout package on Thursday. 

"Just as the casket began its descent, signs of life emerged in the Aussie market to claw its way back from 340 points down. Investors showed glimpses of optimism as sentiment was mirrored throughout Asia," said Martin Batur, deputy head of dealing at IG Markets in Australia. However, analysts weren't willing to call a near-term bottom, and volume in many markets was low.  Government and central bank officials around Asia rushed to reassure investors they had measures in place to cope with the large market volatility. Overnight, several Central Banks stepped up their coordinated liquidity provisions to try and keep credit markets pumped with cash and borrowing costs down.  Bear in mind this is how our global markets are performing with unprecedented amounts of Central Banks support – if we have a good couple of days, we should consider it an opportunity to take on some more put plays and gold is still a great hedge as the world is awash in new capital being created by CBs at a record pace.

Europe is also staging an afternoon comeback (8:30), also on rumors that yesterday's disaster in Congress was only a bump in the road that will be fixed on Thursday.  The EU is overhauling banking regulations in actions that will affect our own international banks including "changes that include creating groups of national regulators to supervise banks doing business across national borders."  Europe's 15 biggest listed banks by market value held 24% of their assets in European countries outside their own, up from 11% in 1997.

Bankers have decried the new proposals, saying they will increase the price of raising debt and kill off a market already hit by the credit crunch.  But critics of the current system say the weekend's rescues offer little comfort. "Nobody should draw too many reassurances for other cases," says Wim Fonteyne, a senior euro-zone economist at the International Monetary Fund.

Another factor driving the European markets this morning is huge speculation that the Fed will make an emergency rate cut.  Our Fed already dumped another $600Bn into the markets yesterday morning and the ECB has a rate decision coming on Thursday and is also expected to capitulate and cut rates.  Ireland stepped in and announced they would, for the next two years: "guarantee all deposits, covered bonds, senior debt and dated subordinated debt of the four main banks."   This, of course, was a huge relief to that sector and sent their market flying – something the US could have done at any time.  The finance minister said the market has been making "severe judgments" about Irish banks. "We are in the eye of the storm … It's time for swift and decisive action," he said, adding that Irish banks will be subject to tighter regulation.  The guarantee will be financed through a commercial charge for Irish Banks.

Bush at 8:45:  "I assure our citizens and citizens around the world that this is not the end of our legislative process…  It does not matter how we get a law, what matters is that we get a law… that allows our country to get moving again…  The reality is that we are in an urgent situation and the consequences will get worse each day that we do not act…  If our nation continues on this course, the economic damage will be painful and lasting.   The drop in the stock market yesterday represented more than $1Tn in losses and (the bailout) would ultimately cost far less than $700Bn…  Congress must act!"

So, keep in mind that governments are doing everything they possibly can to prop up the markets.  As I said a couple of weeks ago, this is very much like the government throwing sandbags behind the totally inadequate levees in New Orleans ahead of hurricane Katrina – it may look like they are doing something but if the storm hits us, all these efforts will quickly wash away like sandcastles in the tide.  Paulson and Bernanke are right, the time to act is well before you are engulfed by the crisis but that time may have passed a long time ago as those same men were assuring us as recently as July that the markets were sound and the economy was strong.  Is this the right plan?  Probably not but, like throwing sandbags at the levee and hoping it will hold, it's the only plan we have with the waves coming straight for us.

TBoone's BP Capital fund got caught in the wave that washed out the energy market and he sounded downright depressed this morning on his CNBC interview and, like everyone else, he is pinning his hopes on the bailout package, mentioning Buffett said to him if Congress doesn't act, we may be looking at a 2,000-point drop in the Dow (presumably from 11,000). 

Meanwhile, home prices continue to head lower – dropping at a record pace in July and, now that Congress has failed to act, the threat of massive layoffs loom for corporate America.  Without Congressional approval on the bailout, the Fed will be forced to cut rates and oil is already moving up on that premise and rates are already down from 5.25% to 2% yet mortgages have only gone down from 7% to 6% so all this has been doing is saving the banks from collapse, it has done nothing for the taxpayers who subsidize these low rates through deficits and inflation, no wonder Ron Paul is so pissed…

The FDIC can bail out banks without Congressional approval but it would be seen as circumventing Congress.  "There's really expansive authority for the FDIC to prevent systemic risk," said Michael Bradfield, a partner at Jones Day and former Fed general counsel. Waiving the usual FDIC procedures could "make banks willing to lend to one another, if they knew that regardless of who they lent to they were going to get bailed out if that bank failed."  The Fed could broker more deal like they did with BSC, where they tossed in $30Bn to make the deal palatable for JPM and they can also undertake "emergency asset purchases," also side-stepping Congress.

The Treasury could take other incremental steps to help mitigate the crisis, including further expanding its program to buy mortgage-backed securities issued by Fannie Mae and Freddie Mac. The new program, created during the government's recent takeover of the companies, has already doubled to buy $10 billion of MBS backed by Fannie and Freddie.  The Treasury could also turn to a Depression-era fund to find money for loans or loan guarantees to financial institutions. The Exchange Stabilization Fund has about $50 billion in it, and the Treasury could use that money to backstop financial firms. However, it's a small amount, compared with the $700 billion the Treasury said it needs to stem the problem.

So we will see what happens but, although it is tempted to call a bottom, just remember we are almost 1,000 points below the 50 dma at 11,352, so it's not likely we'll miss too much be being a little cautious at this stage.