Dallas, TX
May 12, 2010, 08:00 EST		 Dr. Joe Duarte's Market I.Q.


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Intelligence, Market Timing, And Trading Strategy For Traders and Investors

Day 3: It's A Shadow Market
What's Hot Today:

U.S. stock index futures were predicting a slightly higher open on Wednesday. The Euro remained below 1.27 but was not falling precipitously. Asian and European markets were stable. Gold added another $22 to its Tuesday tally.

News For Thought

Casino walks away from loan, with court approval to do so. According to The Wall Street Journal: "A federal court has allowed an American Indian tribe to get out of a $50 million bond it owed to a private investor, raising concerns among others financing tribal casinos. The 3,500-member Lac du Flambeau Band of Lake Superior Chippewa Indians, in northern Wisconsin, said $782,000 in monthly bond payments were bleeding it dry. Last fall, it stopped making them, arguing that the deal was invalid. A U.S. District Court in Wisconsin last month upheld an earlier ruling that the bond deal, cut in 2008, violated federal Indian casino law." The Journal added: "The decision marked the first time a federal court has invalidated a bond because of a violation of Indian casino law, experts say. If the decision stands on appeal, it is unclear how the lender, Saybrook Capital LLC, will be able to recoup its $50 million. The ruling sent lenders and tribes, a few of which are struggling to make payments, rushing to determine whether it could set a precedent that could impact other deals as well."

Secret Report: Russia turns to West. According to The Wall Street Journal: "In a confidential report, Russia outlined a shift toward a more pragmatic foreign policy aimed at building closer ties with the U.S. and Europe to help modernize its outdated industries. The program detailed a shift away from the more confrontational line the Kremlin had taken in past years. It singled out the Obama administration for praise for its more cooperative approach to Moscow." According to the Journal: "A Russian official confirmed the authenticity of the document, which was addressed to President Dmitry Medvedev by Foreign Minister Sergei Lavrov. It was first reported Monday by Russian Newsweek, which ran the document's full text on its website. A Kremlin spokesman said the program, dated February, hasn't been officially approved. But some elements, such as a deal with the U.S. to reduce nuclear weapons, have already been implemented. Its spirit was reflected Sunday, when U.S. and European troops for the first time marched alongside Russian forces during Moscow's annual military parade marking the end of World War II." They must be planning to make their move right after they help Iran fire its first nuclear missile at New York.

Think we're being cheeky? Try this item on for size and as a contradiction/slash validation of the Kremlin's Helter Skelter policy world. According to Reuters: "Russia may help build a nuclear power plant in Syria, Russia's energy minister said on Tuesday, a step that could upset the West due to unresolved allegations Damascus tried to construct a potential nuclear weapons facility in secret."

Day 3: It's A Shadow Market
The Day That Computers And Derivatives Took The Market For A wild Ride
It's day 3 in the Post 1000 Point Dow Jones debacle from May 6th. And the details, or lack of details emerging are plenty impressive, as much for what they are saying as for what is not being said. And the implications are pretty important, to the markets and to individual investors whose life savings hang on the whims and the impressions of people with lots of money and the ability to impose their point of view on the world.

It’s amazing to think that anyone would believe that a “trading error” led to the 1000 point decline in the Dow Jones Industrial average on Thursday, when it is now known that there is the potential for billions of dollars of “off the books” bets on Wall Street at anyone time. Yet, the media and the rumor mill took its chances on Thursday, trying to deliver an instant sound byte answer to something that was clearly extraordinary.

Thus, the flat market on Day 2 after what The Wall Street Journal reports may have been triggered by a hedge fund betting that the S & P 500 was going to fall to 800 by June. What we don’t know, and may never know, is how a public bet led to such a precipitous decline. Sure, we’ve heard that high frequency trades pulled away from the markets, and that the exchanges didn’t have adequate defenses in place, and that the market was vulnerable. O.K. all that’s plausible. But in the days after CDOs, CDSs and Enron, who’s to know what really happened, until somebody really digs in and writes a book, similar to what was exposed in “The Big Short” by Michael Lewis.

According to SEC Chairman Mary Schapiro "several widely discussed causes of the violent swings in the market were unlikely to have played an important role. These include a "fat-finger" erroneous trade that started it all; hacking or terrorist activity; unusual trading in shares of Proctor & Gamble, a component of the Dow Jones industrial average; and futures trades linked to the Standard & Poor's 500-stock index," according to The Washington Post.

In fact, Schapiro told Congress that at least part of the problem was caused by the fact that 'that firms known as "liquidity providers" stopped buying many of the stocks that were suffering the largest declines last Thursday.' Now it gets tricky. Some of these firms "which are part of major banks -- have an obligation under securities rules to act only in ways that stabilize the market. But other firms, which focus on make lightning-fast trades based on computer algorithms, do not have such obligations." In other words, the high frequency traders pulled back their trades leaving the market makers to hang, which prompted the market makers to pull back, and then the market plunged bigger and faster.

According to The Wall Street Journal, at least some of what happenned was caused by a hedge fund which looks for "Black Swan" moments, or unlikely events that actually do happen and cause situations, such as the one we saw on 5-6. The Journal reported: "Shortly after 2:15 p.m. Eastern time on Thursday, hedge fund Universa Investments LP placed a big bet in the Chicago options trading pits that stocks would continue their sharp declines. On any other day, this $7.5 million trade for 50,000 options contracts might have briefly hurt stock prices, though not caused much of a ripple. But coming on a day when all varieties of financial markets were deeply unsettled, the trade may have played a key role in the stock-market collapse just 20 minutes later."

So a well timed options trade by an opportunistic hedge fund actually hit a home run, and here we are. According to the Journal: "The trade by Universa, a hedge fund advised by Nassim Taleb, author of "Black Swan: The Impact of the Highly Improbable," led traders on the other side of the transaction—including Barclays Capital, the brokerage arm of British bank Barclays PLC—to do their own selling to offset some of the risk, according to traders in Chicago. Then, as the market fell, those declines are likely to have forced even more "hedging" sales, creating a tsunami of pressure that spread to nearly all parts of the market."

What happened next was that "The tidal wave of selling fed into a market already on edge about the economy in Europe. As the selling spread, a blast of orders appears to have jarred the flow of data going into brokerage firms, such as Barclays Capital, according to people familiar with the matter. Exchanges, in turn, were clogged by huge volumes of offers to buy and sell stocks, say traders and exchange executives. Even before some individual stocks collapsed to just a penny a share, data from the NYSE Euronext's electronic Arca exchange started to appear questionable, say traders." As a result, people that would normally participate in the market started pulling away, and the downward spiral continued.

O.K. so the rant is over and the analysis begins. Where this leaves the market is nowhere, which is why on Tuesday, after the inevitable Monday bounce which shook out the shorts, stocks were flat in the U.S.

But beyond U.S. stocks, look at the Euro, which continues to slip further. Look at what’s happening to emerging markets, whose trends are now very rocky looking. And look at China, which is also struggling.

These are signs that despite Monday’s huge bounce, something may be “structural(ly)”different from here, to borrow the latest buzzword coming out of Pimco, the guys who gave us “the new normal.”

What we mean is that despite the market’s brave face, there is suddenly a whole lot of uncertainty. The European Union has just agreed to print, borrow, or invent $750 billion Euros in order to not just bail out Greece, but to keep itself from imploding. What no one is saying is that the EU is doing this from a weakened position, as it has yet to recover from the 2007, subprime mortgage led global economy meltdown, unlike the U.S. and China, which although wounded, are in a better position.

That’s why the Euro has been falling. That’s why European markets have been wobbly. And that’s why emerging markets, which became more Eurocentric and China-centric over the Bush years are starting to show signs of wear and tear.

Conclusion

This is a fragile market, in which any little thing could shave 20 points off of the Dow Jones Industrial average in the blink of an eye, much less a hundred points in a minute or less. The fundamentals don't really matter as much as they did just a few days ago, either on the good or the bad side.

Think about it. If there is an economic recovery underway, nothing has happened to stop it, as far as we can tell. And aside from Europe's problems, and China's potential problems, people are still getting up every morning and trying to make a go of things, no matter how bad they may or may not be.

But this isn't about that. This is about weird rumors, and even weirder derivative trades, both in the open, and likely in the deep bowels of obscure trading desks in the bond market and in hedge fund land.

This is one of those markets where only The Shadow knows what evil lies in the hearts of man.

Know when to sell and how to make money when the market falls. Get a detailed trading plan in your pocket. Read Dr. Duarte's All NEW Books "Market Timing For Dummies." and "Trading Futures For Dummies." The Trading Manuals for All Seasons. Also Available As Kindle Books.

 

Market Moves - Stock Of The Day
Shares of Capstead Mortgage (NYSE: CMO) May Be Telling An Important Story
Capstead Mortgage (NYSE: CMO) has been falling lately, despite making money in its last quarter.



Chart Courtesy of StockCharts.com


If the stock market truly deals in reality, then the action in Capstead Mortgage is a cautionary tale. On April 28th, the company reported net income of "$40,437,000 or $0.51 per diluted common share for the quarter ended March 31, 2010. This compares to net income of $42,076,000, or $0.57 per diluted common share for the quarter ended March 31, 2009," according to their press release.

O.K. they made less money than last year, but this is a mortgage company that number one, is still in business, and number two reported earnings, not losses. So why did the stock roll over and go lower?

So, if you dig a little deeper, you find the answer. Capstead invests in mortgages "issued and guaranteed" by Fannie Mae, Freddie Mac, and Ginnie Mae. And lately, a significant amount of the money made by Capstead came from Fannie and Freddie buying back toxic loans from Capstead. That means that Capstead is now depending, for at least part of its income, on Freddie and Fannie, two irreparably bankrupt, by their own admission, government owned agencies.

As recent reports have made clear, Fannie and Freddie will never make any money, and are asking the government to give them more money so that they can continue to take the bad loans from Capstead and companies like Capstead.

In fact, Capstead thinks that things are not just bad right now, but that they're going to get worse. In its press release it noted the following: "Yields on the Company's interest-earning assets averaged 2.99% during the first quarter of 2010, a decline of 51 basis points from an average of 3.50% achieved during the fourth quarter of 2009. The decline primarily reflects higher investment premium amortization resulting from higher portfolio runoff, as well as lower coupon interest rates on ARM loans underlying the portfolio that reset to more current interest rates and lower yielding portfolio acquisitions. Portfolio runoff averaged 31.8% on an annualized basis during the first quarter (a 30.0% constant prepayment rate) compared to 20.9% (a 19.1% constant prepayment rate) during the fourth quarter of 2009."

Portfolio runoff is defined as lost interest income from mortgages that are prepaid. So, why is Capstead forecasting more portfolio runoff? Because it expects Freddie and Fannie to buy more bad loans in the coming quarters. Here's the way Capstead put it: "Elevated levels of mortgage prepayments are expected during the second quarter, and potentially early in the third quarter, as a result of Fannie Mae's buyout program of seriously delinquent loans from its mortgage guarantee portfolio."

To make matters worse, Capstead is worried about continued low interest rates from the Federal Reserve and the bond market, eating into its income yield in the future. This is especially troublesome because, as they point out in their earnings report: "This decline reflects the current low short-term interest rate environment and the expiration of $1.70 billion in relatively high-rate interest rate swap positions since November 2009."

Why should this be of any concern to investors? For one thing, the real estate market is now hanging on a thread, being held together only by U.S. Treasury handouts to Fannie and Freddie, who have clearly stated that they will never make money. Still, they are buying bad loans from mortgage companies so that the mortgage companies will have a chance to stay in business.

But as everyone knows, there are several hundred thousands of Option-ARM mortgages that are due to reset in the next few months. And at some point, many of them are likely to default. That will put more bad loans onto Capstead's balance sheet, that it will ask Fannie and Freddie to buy. Fannie and Freddie will likely buy them and hold them, forever on the U.S. government's balance sheet, but not quite because it's uncertain how the government is accounting for the junk on Fannie and Freddies books, which is somewhere in the $50 billion range according to Freddie's most recent earnings report.

We think this is a story that no one has put together yet, because they've been worried about Greece. But, it also tells us that somebody, somewhere, may be looking to buy credit default swaps on this becoming the next down leg in the financial markets.

The stock market looks as if it's trying to bounce now. We're not so sure, that any significant rally will develop from this point. Still, we are trend followers and we are watching the action carefully.

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