Correlation or Contagion?

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Sally Limantour

The selling continues this morning as the Chinese government this morning has rekindled global slowing concerns. We have taken out last weeks lows and now are focused on China’s promise of increased regulation of banking and real estate as well as the possibility of additional interest rate hikes. We still have our usual suspects lurking in the background – carry trade unwinds, sub-prime home blues, and recession fears. With stocks, commodities and currencies falling across the board a question is circulating across the globe – is this a typical “healthy correction” where contagion kicks in as investors/traders liquidate positions across the board in all asset classes? Or does this have a different premise where the global macro backdrop of different asset classes is so highly correlated that a new paradigm is evolving which will threaten our beloved Goldilocks scenario?

“US demand has come in weaker than expected. Maybe the China story and the sub prime story are linked. The weakness in housing is going to cause real problems in the supply chain to the US consumer and that could be US small caps, or it could be in Asia. The saying these days is that the only thing that goes up when the market goes down is correlation.” --from FT.com article, Feb 28, titled: ‘Correlation rather than contagion’

People are now focused on concerns and until that changes, markets will stay under pressure. Now the hard questions are being asked concerning China and their murky accounting practices, their still stringent capital controls which defacto prevent an exit and the true rights and claims of so called Chinese shareholders (350 out of 500 of the largest listed Chinese stocks are still government owned). In addition questions regarding the private equity market (which is for the most part unregulated and unreported) and its size and risk to the overall banking and financial system are being asked. Not to mention the size of the carry trade unwind and derivative positions. I am not one to get to negative, but as I said last Wednesday we are trying to assess where real liquidity begins and leverage ends. It is a tangled web.

In the short term I expect a short covering rally perhaps early in the week and then further weakness in the equity markets. My shortest term model is getting close to a buy signal and we have the put to call ratio now at a high level. Intraday ranges should continue to be wider than what we became accustomed to and volatility will continue to move higher.

I watched Master and Commander (for the 3rd time) over the weekend and there is a classic scene when the ship is under attack and a small boy is crouching with fear. The Captain pulls him up and says, “stand tall in the quarterdeck,” meaning, be present and responsible. Heading into the week listen carefully to what the market has to say, respect the charts, preserve your capital and trade only with good risk/reward scenarios.

Market Timing

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Fari Hamzei

Given the high readings we have empirically observed in our Volatility Indices during the last week, for market timing purposes, go to CASH for a minimum of two weeks -- past the March Quad-Witching Options Expiration (Friday, March 16th) and the Vernal Equinox (March 21st, 00:07 GMT).

Market participants should expect massive vol expansion at or near the March Expiry, while historically speaking, both Vernal & Autumnal Equinoxes, plus or minus 1 to 2 days, have often been a time for key reversal days in the equity markets.

First, let's review our 'new & improved' Timer Chart.

While a -222 reading on McClellan Oscillator for NYSE and a -196 reading for NASDAQ's sounds like a good buying opportunity, we are mindful of recent outlier events for VIX (see my Feb 28 post titled, "Volatility -- My Two Cents").


Part of the reasoning here is for us to wait and observe the strong vol retest we expect both in magnitude and Sigma Channel position. That event should complete before the month end. This is also in line with the talk Sherman McClellan gave at our last meeting of LA Chapter of MTA, which met on January 30th in Seal Beach, CA.

Here is VIX sigma chart as of Friday Close. Notice on Friday, VIX fell below +3 Sigma. Ideally, VIX, as part of our anticipated vol retest, should visit +4 to +5 sigma levels before the dust settles.

HOTS Weekly Options Commentary

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Peter Stoclers

Earnings are good, the economy is strong, employment is full, the P/E ratios are in-line… The stocks that looked good a week ago still look good and they are cheaper. What could possibly cause the market to go down? In a word – fear.

When traders are over-extended, they can’t take the heat when the market starts to fall. That is a classic shakeout. Most people think… well I’m in it for the long haul and I’ll just ride it out. That mentality works for the first 10% move. By the next 10%, they are nervous and they are out. A big decline with a “V” bottom becomes a mere blip on the radar screen of a 10-year chart. However, seasoned traders look at those blips and remember the blood that was spilled.

Such was the case in 1998. I had grown one of the largest option order desks in the country and I had thousands of option traders using our services. The economy was strong, the earnings were good, interest rates were in line and the internet was creating a buzz. Out of nowhere, we had a big rally to new highs and a sharp reversal. Sound familiar? Everyone looked at the fundamentals and took comfort knowing that everything was still intact. It seemed that a hedge fund had lost some money. Initially, everyone thought… so what, it’s one hedge fund. The stock I liked yesterday is the same today, except it is 5% cheaper. Two brilliant men created the hedge fund in question and it was called Long-Term Capital Management. They were both founders of the modern day Black-Scholes option-pricing model (Robert Merton and Myron Scholes). They had a very “conservative” arbitrage model and brokerage firms felt very comfortable letting them leverage the positions. In 1998 one of the wheels came off when Russia defaulted on their debt and the whole house of cards came crashing down. The ensuing sell off in 1998 was huge and the SPY fell 25% in two months.

Prior to the hedge fund collapse the market had been on a steady four-year climb. You could throw anything at it and it wouldn’t go down. Mind you, the SPY was still 25% below the 2000 high and it had a long way to go.

Fast forward to 2007.

The Yen-Carry trade borrows cheap money by selling low yield Japanese debt. It then uses the proceeds to buy other assets with higher yields. Last month, Japan raised interest rates. Consequently, the loan is still cheap, but getting more expensive. On the other side of the trade, the higher yielding assets that are denominated in other currencies started to take heat. As the trade unwinds, the first traders to hit the exit sell their higher yielding assets. With every trader that unwinds the trade, those assets get cheaper and the squeeze is on. This trade has been leveraged at a ratio of 15:1 and as the asset prices drop, liquidation is force to cover margins. Currently, there are more hedge funds than ever.

Did you realize that retail margin debits as a percentage of the account balances are at the levels seen in the year 2000? Your fellow trader is leveraged up to his eyeballs and I sense a shakeout. This is a time to be balanced and to keep a portfolio of longs and shorts. If you are over-exposed on the long side, reduce your risk exposure.

After the dust settled in 1998, there was a great buying opportunity and the SPY went from 95 to 140 in less than a year. The take away is that the market was a good buy in 1998 at 125. However, if you were an option trader, you blew through your capital and you never got a chance to participate.

Now let’s talk about us. This was a brutal week. We got into our new options trades on Tuesday and we were stopped out within a day or two. Our existing longs that were making progress also stopped out for losses. In the spirit of the report, this is not supposed to be an in and out service with continual adjustments. I felt that I needed to let the stops and targets work as they were designed to. My biggest error was not being persistent in having a hedged position on at all times. In the four months since inception I have always had at least 2 or 3 short positions on. During the rallies, one by one we were getting picked off and the hedges were costing us money. Even worse, once we were stopped out, we no longer had protection.

This was the largest drop since 9/11 and the Weekly Report did not suffer a big draw down. I hate giving back profits, but these events happen and they can’t be predicted. In the long run, it will set us up with some great trading opportunities on both sides of the market and the profits can come quickly. We are very liquid and we will be trading form a position of strength. Before the market gets better, it will get worse.

In the next week or two, we are going to be looking for longer-term entry points. We are going to distance ourselves from the market and we will keep our powder relatively dry. As the market compresses and the lows are established and tested, I will start layering buy stop orders so that when the market rebounds, our orders will be executed on the way up. I still feel that the earnings are good, interest rates are relatively low, employment is robust and inflation is in check. This is also the third year of a Presidential term and that has historically been very bullish. If I had to pick support levels, I would say SPY 132.50 and then SPY 125. The missing piece of the puzzle is the leverage used by the hedge funds. We don’t know that answer, but the brokerage firms that clear their business do. Come to think of it, those same firms have proprietary trading operations. I’m sure there is a “China Wall” between those divisions and that information is never shared – not. They know the “panic levels” and someone will get hurt. We’ll let the charts be out guide.

Flash Update on SPX & Gold

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Frank Barbera

We are issuing this brief flash update, as we see a great of evidence continuing to mount that both the S&P and the Gold market are near an important short term low. In the case of the S&P 500, prices spiked down violently yesterday morning marginally taking out the prior panic low. Importantly, prices then recovered off the token new low leaving a distinct positive divergence on the 5 minute chart. The subsequent recovery was strong enough to lift prices back up across the range testing some important price resistance at 1410.00. At this point in time, we still cannot altogether rule out a final retest of the 1390 level, however, the prospect of such a retest appears to be fading fast with the market trying to engineer a rally back into positive territory. Even if, on the long shot chance, that prices did retest 1390 again, the odds at this point favor a bottoming sequence and a lead into a powerful recovery rally. In our view, any move above yesterday’s highs by the S&P 500 at 1409.50 should trigger a very large stock market rally, which would complete this corrective bottom. Bottom Line for the stock market: prices have been basing, this is most likely positive action, and a break above 1410 should unleash the bull once again.

Turning to Gold prices, we just witness a similar style waterfall panic in gold this morning, very much along the lines of the sharp stabbing move down that was seen in the S&P yesterday AM. April Gold is presently fully oversold on both the Short Hourly RSI – 9 Hours – at +18.78, and the Long Hourly – 20 Hours, at +30.72 (where +32 is the oversold benchmark. In hour view, while Gold is not yet fully stable, the odds are very high that prices bottom in this $645 to $650 range and begin a rally back up toward $670.

Market Gyrations

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Sally Limantour

An unexpected rebound in the Feb. manufacturing survey helped support the market after a swift move down. Personal income was also up 1% which was better than expected, but the embedded core PCE was up 0.3% in Jan. after a 0.1% in Dec., or 2.3% y/y. Remember, a reading over the Fed’s 2% is taken to mean no rate cut anytime soon. Construction activity was down as was single and multi-family building. No surprise there.

In Japan, the Nikkei lost 1.35% on its 4th day of a losing streak. It has now given back all of this year’s gains. The Yen continues to rally and is fast approaching my 1st target of 86.00.The strong yen, of course, plays into the fears of “the great unwind” but the question is whether this is actual unwinding of the buildup of carry trades or… a feeding frenzy of speculators trying to jump in ahead of a potential unwinding. If anyone has a good understanding or a way of measuring this to get a handle on it I am all ears. The important thing to realize is the dollar is rising against the Euro but crashing against the yen. I think it is challenging to fully comprehend the correlation of stock markets with currencies and perhaps this uncertainty alone is enough to keep the market jittery for a while.

Bloomberg reports that it is real unwinding (versus unreal?) and will continue as “carry-trades are inherently risky and everyone wants to dump risk these days.” Meanwhile EconMin Ota is saying the Yen’s rise will not effect the economy. This makes no sense to me as the weak yen is a boon to exporters and they are the key strength for the Nikkei. The yen is making its biggest weekly gains in over a year against many currencies – Australian $, New Zealand $ and the South African rand which are all high yielders and favored carry-trade plays.

Note too, these are the commodity related currencies which is important and something to pay attention to as we have witnessed a stampede into the commodity arena both for diversification purposes and to chase returns.

In my virtual training class last night we were looking at a chart of the continuous commodity index (CCI) which is a basket of 17 commodities. Open interest recently set a record and we have seen outsized gains in different commodities over the last few years. My biggest question and fear (and we always have to carry a worse case scenario to be prepared) is what are the chances of these supposed non correlated asset classes declining in unison coupled with an unwinding of the carry trade? This is something on my radar as I hunker down the way I do on a sailboat right before a storm. Batten down the hatches! As mentioned yesterday I tightened stops in commodity position to lock in gains and they did take me out yesterday. I will observe and monitor metals, grains, etc and will write more on this sector over the weekend. Stops are your friend.

Coming in this morning, we have a pivot of 1399.00 in ESH with 1st resistance at 1410, then 1417. Support comes in at 1386.50, then 1368.25. We need to get above 1404 early to get things moving up, otherwise I suspect, given its Friday with rattled nerves we could have a fast move lower. Stay nimble and disciplined.

Rest up and enjoy the weekend.

Equity Index Update

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Brad Sullivan

THE UNWINDING CONTINUES…yes the infamous carry trade continues to dominate the trading headlines and collective minds of participants. Just how far and how fast the Yen travels vs. the Dollar, Euro, Kiwi, Rand and Aussie remains to be seen…but the velocity with which it has come so far this week shows that liquidation remains the name of the game. This morning, things were relatively docile in Europe…then the YEN started to pick up strength and before one could blink an eye, the SPH7 dropped from 1405 to 1396. Given the dramatic increase in volatility it should be expected that these moves will continue over the next several weeks.

Yesterday’s action was dramatic and quick. Indeed if one were fortunate enough to buy the dip off the initial opening bell sale, it proved to be a tremendous month of profits by the end of the first hour of trading. The remainder of the session consisted of strong bids lying in wait underneath the higher pricing zones. However, each index failed to hold their unchanged levels – and more importantly were sold lower rather easily in the final hour trading. The impact of today’s carry lower overnight should provide ample opportunity in today’s session.

One of the keys today will be the response to the Yen/Dollar trade…earlier this morning, the YEN traded to a new high for the move, up about +3% on the week vs. the dollar. Since that high print, the YEN has come off a bit and that has corresponded with a bounce in the SPH7 from 1393.50 to 1399.50. Obviously…we can see the trend in the overnight markets in terms of taking their direction from this trade. However, it is not as clear that this indicator will work as well during our day session. In other words…utilize the YEN/Dollar as a trading input, but not as sole discretion for a trade.

Sullivan talked .....the Market listened !

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From our Virtual Trading Room Transcript

11:57:14 PST> Fari_Hamzei : 2 min before last hour begins
12:00:15 PST> Fari_Hamzei : what happened with SLV ?
12:00:54 PST> Fari_Hamzei : weekly outside bar reversal completed today !!
12:04:28 PST> Thomas_Bohn : we turned when treasuries sold off
12:05:09 PST> Thomas_Bohn : if that was the source of funds
12:05:19 PST> Thomas_Bohn : to buy equities
12:05:36 PST> Thomas_Bohn : the buying may be done
12:07:09 PST> Fari_Hamzei : Ken, are you happy now ?
12:10:41 PST> Ken_McCue : I am always happy!
12:13:34 PST> Ken_McCue : Interesting divergence between the BCs and the ES / SPX
12:14:10 PST> Fari_Hamzei : yes but not between HBs and NQ
12:14:17 PST> Fari_Hamzei : BUY pgms
12:14:25 PST> Fari_Hamzei : high TICK again
12:16:10 PST> Thomas_Hall : yen not really losing its bid though
12:20:03 PST> Brad_Sullivan : I think
12:20:09 PST> Brad_Sullivan : the key of bottoming
12:20:15 PST> Brad_Sullivan : is how we finish this hour
12:20:27 PST> Brad_Sullivan : sellers came in right at the stroke of 2:00 pm CST
12:20:50 PST> Brad_Sullivan : the final 30 minutes
12:20:53 PST> Brad_Sullivan : should be eventful
12:20:57 PST> Brad_Sullivan : any push
12:21:00 PST> Brad_Sullivan : below
12:21:05 PST> Brad_Sullivan : 1404 in SP H7
12:21:16 PST> Brad_Sullivan : on a settlement basis
12:21:29 PST> Brad_Sullivan : would leave me wondering
12:21:34 PST> Brad_Sullivan : if this was not a setup
12:21:38 PST> Brad_Sullivan : for more downside
12:21:40 PST> Brad_Sullivan : next week
12:22:03 PST> Fari_Hamzei : we will see a vol retest
12:22:12 PST> Fari_Hamzei : maybe sooner that later
12:22:15 PST> Fari_Hamzei : i favor later
12:22:27 PST> Fari_Hamzei : when everyone is very comfy
12:22:49 PST> Thomas_Bohn : very good points
12:23:02 PST> Thomas_Bohn : if they can't finish the job
12:23:12 PST> Thomas_Bohn : it won't look good
12:23:16 PST> Brad_Sullivan : right
12:23:18 PST> Brad_Sullivan : in addition
12:23:23 PST> Brad_Sullivan : the move up
12:23:30 PST> Brad_Sullivan : was on very light volume
12:23:41 PST> Brad_Sullivan : NOT THE EARLY REVERSAL UPDRAFT
12:23:45 PST> Brad_Sullivan : but the move
12:23:52 PST> Brad_Sullivan : from 11:30 to 2:00
12:26:45 PST> Thomas_Bohn : Sullivan talked .....the market listened !
12:29:24 PST> Ken_McCue : Yep good call - pyshic?
12:29:41 PST> Thomas_Bohn : very nice Brad
12:30:02 PST> Brad_Sullivan : every now and then
12:30:10 PST> Fari_Hamzei : LOL

Volatility Squared

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Sally Limantour

Carry traders are in an option buying frenzy with implied volatility on a 1-month dollar-yen option moving to its highest level since Aug. Some are predicting a 10% move by month end. As mentioned here these last two weeks, volatility was a screaming buy in many asset classes – not just stocks and the VIX. Meanwhile, the 30-day statistical volatility of the volatility indices more than doubled overnight!

Yesterday’s Chicago purchasing manager’s Index for Feb. came in at 48.7 and anything under 50 is not particularly healthy. In addition inventories rose sharply to 54.5 from 41.9 which is bothersome as is the new home sales number in January, which fell 16.6%. With the medium/long term models still on a sell signal from last week and the short term model on a sell from Tuesday morning, my view remains the same as Monday – continued weakness with increased intraday volatility that will make day trading a fun job again. Witness this morning’s sharp break and rally, something nimble traders welcome. Until we get solid closes over 1429.00 in ESH7 and models turn at least neutral, I will stay defensive while taking advantage of intraday extremes.

Bernanke said he did not see a “real trigger” for the sell off on Tuesday. I wholeheartedly disagree as mentioned in, “the great unwind.” He also said he doesn’t see any real issue with liquidity. This statement is causing mixed interpretations. Some think he is communicating an ongoing “Greenspan put” (which refers to investor faith that the Fed will always combat market declines) while others think he means this is not the Greenspan Fed and we should not expect rate cuts if financial markets get wobbly. You choose, but remember it was Bernanke who in 2004 during a Q&A said, “I think it’s extraordinarily difficult for central bank to know in advance or even after the fact whether or not there’s been a bubble in an asset price.” (Note to self - watch the charts. They speak volumes without the ambiguity).

On dips, I continue to add to volatility positions in currencies and stocks and added to long positions in yen, gold and silver while moving up stops in the agricultural sector to protect profits. The metals and agricultural sectors have been outperforming and corn is up 90% since first writing about the bullish outlook.

Volatility -- My Two Cents

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Fari Hamzei

We have enjoyed a Low Vol environment fueled by tremendous global liquidity that began approximately about a week before Gen. Tommy Franks commenced his precision air campaign to get rid of Saddam Hussein's atrocious regime. This coiled-up Un-Vol got adjusted yesterday. It always does. In all cases, we revert back to the mean, after a strong retest. To put it all in proper perspective here are some sigma channel charts:

On October 27, 1997, the DOW dropped 554 pts, SPX dropped 65 handles (-6.9%) while VIX went from 23.17 to 31.12 (up 34%) which made VIX hit its +4 sigma channel (63.34 per million probability of occurrence) if one assumes options prices are normally distributed – after all VIX is a multi-way MIV calculation of SPX options. The following day, one of the greatest speculators of all times, the legendary statistical anomaly trader Victor Niederhoffer, closed all of his funds.

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In August thru Oct 98, leading to the LTCM debacle, when some of Wall Street’s best and brightest went bankrupt, the big VIX day was on Monday Aug 31st. Dow was halted after 550 pts drop, SPX dropped -6.8% for the day and yet VIX only went from 39.6 to 44 (11%) and sigma channels chart shows it hit its +2 sigma and change area (1.24% probability of occurrence)

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During a more recent market sell-off, on April 15, 2005, VIX went above its +3 sigma channel, as the SPX sold off -1.64%;

and on May 15, 2006, after a two-day SPX rapid sell off of 31 pts, VIX only hit +4 sigma.

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Yesterday, we saw a 6 sigma channel move in VIX. This was truly an extraordinary event. DOW dropped 416 pts, or 3.3% (max drawdown was -546 pts) -- SPX dropped 50 handles or -3.47% and VIX shot up 64% and hit its 6 sigma (1.973 per billion probability of occurrence).

And for comparison only, here is yesterday's VXN chart (NDX Vol Index) -- notice it only hit +4 Sigma yesterday!!

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Bottom line – the big question is what are we in for in the near future ??

The Vol will come back to the norm very rapidly. It always does. In my book, this was a China event. In the long run, it is good for all of us, as painful as the next few days may be, as Chinese financial systems enter 20th Century by western standards.

US Economy is strong, liquidity is ample, and thanks to Secretary of Treasury and former Chairman/CEO of Goldman Sachs Group, Hank Paulson, we have a rejuvenated PPT and as Uncle Ben testified this am, “the Working Group is monitoring the markets very closely.” Once we go thru the vol retest and the forgetting rate kicks in our collective brains, we will resume the “normal course” again. A Six-Sigma Event is never normal.

In the near future, the Inflation, Gold and Crude Oil will come back. So would be the Stocks and the ETFs. We just have to work this hemorrhage out of our system.

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One of our professional traders was quoted today in Wall Street Journal's Market Beat Blog on using our Dollar-Weighted Put/Call Ratios to get short last Thursday. Click here for more details:

http://blogs.wsj.com/marketbeat/2007/02/28/better-lucky-than-long/

Equity Index Update

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Brad Sullivan

Driving into work this morning I was listening to a local Chicago radio station when the news report came on and the pre – news conversation turned to yesterday’s decline in the equity markets. This show is anything but serious and I was struck when the star of the show said his brother was a stockbroker and how he wanted him to buy during yesterday’s decline. This prompted the news reporter to talk about how traders woke up to the Asian bloodletting yesterday and just kept on selling…but it will come back, like it always does.

Normally, on the heels of such a whipping, I reverse course and become a buyer…and I was up much of the night trading on that very theme. However, those were trades to take specific advantage of the enormous discount we settled at to fair value yesterday across the index board. That trade has played out as the indices are called to open sharply higher from settlement, but around their respective fair values. Now…things become a bit more difficult. Certainly, I was a bit surprised to hear such complacent talk after a -4% decline on the morning radio. Could this be a sign that there is more to come on the downside?

It is worth noting that the SP minis traded a whopping 3.5 million contracts in yesterday’s action…that equates to the single largest volume session in this contract's history by nearly 50%. In addition the volatility that captured the market after the much discussed computer glitch in the DJIA calculations seemed to catch everybody searching for answers. There is no question that the move was heart wrenching to the downside, but after watching Cramerica last night, I have to wonder if there is not just a little too much cheerleading and explanation of the decline for there to not be more – and potentially much more behind this downdraft. I remain steadfast that this move picked up acceleration with the strong drop in Yen/Dollar and the unwinding of the infamous Carry Trade. As I write this…the Yen is rallying to highs for the session vs. the Dollar and the index market is buckling. It is and will continue to be the number one indicator in my book moving forward.

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As for the session today…expect HEAVY doses of volatility and whatever you do…don’t get caught selling bottoms and buying tops because the reversals are lurking behind every tick. I suspect we will have an inside session…most likely inside the final two hours of trading from yesterday. Keep in mind that there will be lots of gunslingers hitting the trade today…utilize a strong plan to stay out of trouble.