What Happens After This Rally

I put on my thinking cap and did some data diving. I looked at 3 periods

1. The 1990 Recession - Began July 1990 and ran into 1991

2. The 2001 Recession - Began February 2001 and lasted until late 2001

3. Recent Downturn - Began October 2007 when the Q4 '07 GDP slipped to 0.6%

Downturns are not created equal: they all have different causes. But the symptoms are always the same: low consumer spending, higher unemployment, low business investment, and a low stockmarket.

It's the latter part I want to explore. How will this downturn play out in the stockmarket. Because I want to be short when the big bear bites.

I looked but couldn't find anything, so I did my own research. I took the DOW weekly closing prices and I charted them against a starting point. I chose the day 1 year before the recessions officially started. Next, I set that DOW closing price as the starting point and compared each subsequent week's price against that price. There's no exact science so I chose a starting date equal for all periods. So I may be off somewhat in terms of measuring the high or lows, but the overall shape will be clear and that's what I'm after.

Next I looked for the rallies and crashes that accompany a recession. I defined a rally or crash as a trendline ~10%.

Comparing the last 2 recessions, we see at least one major difference: the DOW rose at the end of the 1990 recession wheras the Dow rallied and then crashed even harder. I leave it to economists to puzzle that one out, but I think the cause was false hope that the end of the recession signalled economic growth. When it didn't, the market crashed again and harder. I suspect that this time will be similar to the 2001 reaction - a prolonged drop.

There are, however, many more points of commonality.
1. In terms of depth, crashes are deep and fast, whereas rallies are shallower and slow

2. The Dow was rising as the recession starts.

3. A major rally immediately precedes the recession, like a last gasp. Prior to that point, the economic data is mixed although the downturn is in the air. During that period, the market swings in 10% cycles. Then a bigger swing up and a bigger crash down. In 1990, an 8 month run of 15% was followed by a 3 month 25% drop. In 2001, a 3 month 15% run preceded the 4 month 30% crash.
4. In terms of timing, the big Dow crash occurs within 45 days of the recession.

Why does the market swing up and down even as the GDP figures indicate a slowdown? Human behavior. Investors are driven by official reports and, prior to the recession, slowdowns are very sector specific. They are, by definition, at least 90 days late to the party - earnings releases and GDP data is 90 days after the fact. Then they panic - hence the deeper moves down.

Also, contractions are delayed across sectors. Investors tend to think of them as isolated events and respond by dumping a sector. That pushes the market down, but it rallies on strength elsewhere. Housing slow? No problem, banking is still strong.

Point #4 bears repeating: the big Dow crash occurs within 45 days of the recession.

I misread the last few months of data. I thought we entered recession and the February crash was the big crash. The one that would be 20%+.

Instead, I think we just entered the last big rally before the big collapse

If I am reading the data correctly, we could see a 15 point rally from the recent bottom. Possibly as high as 14,000. But then it will collapse to 11,200 really fast.

When? I think very soon. We get Q1 GDP and earnings releases in the next few weeks. A tthat point, investors will be forced to acknowledge:

1. It isn't a liquidity issue anymore but a true cyclical slowdown

2. It is broad based

3. It will be deeper an dmore prolonged than expected

If that 45 day rule holds, then we are almost there. We wil lhave a bit more of a rally and then a fast drop.

That is why I am sticking to my guns and staying with the short positions.

Selling CF $110s

Bid price is $28.10.

CF update

Wow - The stock is trading at $124+, up $10 for the day.

The stock price puts our Aug $110 calls $13 in the money with 4+ months to go.
The calls are trading for $27. I'm very glad that we didn't sell yesterday AND that I decided to hold off until the MOS earnings.

Today's objective: close out our position.
I'm sensing mad money, so we are going to watch and see it it hits closer to $29. I'm thinking a stock price of $126 will do it.

Stay tuned

Unemployment Surges

http://biz.yahoo.com/ap/080404/economy.html

Another 80,000 people were laid off in March, significantly more than the 50,000 economists expected.
Unemployment is now at 5.1%. A 0.3% jump in 1 month. We haven't seen a reduction like this since 2003, when the last recession was ending.

(If you recall, yesterday I reported that the experts think we'll hit 5.5% by December. I predicted 6.3% by December.)

The sad part is that the only places hiring are the government and the leisure industry. And I expect the leisure industry to soften by the Summer time.

For a while I've been saying that things are worse than what is being reported and worse than what is expected. In response, I have been told that I have a doom-and-gloom outlook. Actually, it would appear that I have a realistic outlook and others are Polyannas.

Understanding reality enables better investing. Period.

CF Poised to rise

MOS, a major CF competitor, released phenomenal earnings and predicted prices would rise 48% in the next 3 months.
Shares have surged 8% in pre-opening.

* Earnings rose 11X from $0.10 to $1.17. And they beat expectations of $0.95
* Revenue rose 100%

The cost of inputs have also grown (ammonia and sulfur) but they have been easily absorbed and look poised to continue.

Like CF, MOS trades at ~10 P/E.

Rolling the dice on CF

I'm torn between selling ASAP and trying to get that $22 per call.

CF had a major run-up today in advance of the MOS earnings. That means a strong chance of a pullback unless MOS completely blows out the numbers.

On the other hand, another $2 or $3 ($117 in stock, for example) and we are doing even better.

I am going to gamble and take off the sell order. I will be watching and moving very, very quickly. I do not want to wait a long time because of the market volatility. We haven't seen a market pullback yet, and we will.

Sell CF Calls for $22

Well, I hoped for a bit more earlier today, once it cruised above $21. And it briefly moved above $22 before pulling back.

I think MOS may goose it up a bit tomorrow but then profit taking.
Set the sell at $22 and let's move on.

Cancelling the CF $22

It may go higher today

CF Watch

We own the Aug $110 Calls @ $14.60
It is trading up today: Bid price is now $19.60

That's a 34% return.
I am putting an order to sell for $22 (a 51% return). That is effectively a CF stock price of ~$116.

I am watching this closely - my strategy is to not hold the long calls beyond the week. If we don't come close to $22, I may sell as high as possible to lock in gains.

MEMC Guides down

First of all, this is not a sign of worse to come.
MEMC had manufacturing issues that reduced factory utilization by 20%. As a result:

Q1 Guidance lowered by ~10%
* Sales closer to $500M, instead of $560M
* Margins slipping to 52% from 54%

Jobless Claims Up - Break 400,000

The US is a consumer driven economy. Anything disrupting spending will reduce GDP and corporate earnings.

http://biz.yahoo.com/ap/080403/economy.html
The Labor Department reported that jobless claims rose 38,000 to hit 407,000. That's a powerful indicator, or, as one analyst put it: "This report supports the view that the jobs market is deteriorating toward recessionary conditions." Also significant is that the 400,000 mark is a psychological figure that traditionally means recession is going to happen. It is a 30% increase year-over-year in unemployment.

Economists are 'shocked': they expected a drop to 365,000. In fact, yesterday ADP (a US accounting company responsible for processing 1 out of 6 non-farm paychecks) reported an uptick in employment of 8,000.

This just shows that the experts don't grasp the extent to which the economy is heading to hell in a hand basket. And that means investment opportunities for us.
After all, if the experts are predicting unemployment rates of 5.5 by year end, we can pretty much assume that it will be much higher: 6.3%.

We are short consumer goods and consumer services, among other things.

If you followed me and bought ETFC

ETFC has had a major run-up (up ~30% in <10 days). Lock in some gains.
Good chance they can run to $6 by earnings in 2 weeks, but start thinking about cashing out.

For example, set a stop on 25% of your shares at $4.50 and another 25% at $5.
If you bought 1000 shares at $3.50 (when I pointed them out), that's a $3.5K cost basis.
* Sell 25% at $4.50 and get $1125.
* Profit on 250 shares is $250 or 29%
* For remaining shares, cost basis is $2,375 for 750 shares or $3.17 per share
* Sell 25% at $5 and get $1250
* Profit on 250 shares is $375 or 43%. Total profit is $525
* For remaining shares, cost basis is $1,125 for 500 shares or $2.25 per share

At this point, you will have huge flexibility. Investment exposure has been reduced 2/3s. But you retain ~50% of your initial shares.

Or you can get greedy and see how high it will run.

Nothing can stop the foreclosure train

The question wsa asked: how will the Dodd/Frank Bill affect foreclosures?

The Dodd/Frank Bill first has to get through Congress. Both are Democrats, and Republicans have to be convinced to participate. John McCain recently came down on bailouts, and he didn't do it because he is for responsible borrowing/lending. Well, maybe that too. But he did it largely because polls show the majority of Americans are against this bailout.

Politics will slow this down, as will realities of time. If/when such a bill ever makes it live, it is at least a year before folks are affected. 43% of California ARMs re-set by December.

And the bill is really just political grandstanding. The thrust of the bill is for lenders to take a loss and to re-finance at lower rates. The government (aka the taxpayer) would guarantee the loan. They will guarantee $30B.
Now, with $1T in loans re-setting, and Goldman Sachs estimating ~$500B in losses, that $30B doesn't go very far.

At heart, this is a government buyout of distressed properties. And a buyout at premium prices.

This plan is DOA because it won't stop foreclosures.

And, in fact, no plan will stop foreclosures or a collapse in home prices. To understand this you must understand how lending works. Banks are middlemen - they package the loans and sell them on. It's called ABS or Asset backed securities. You've heard versions of them called CDOs. They are bought by pension funds, insurance companies, other banks and investors - groups that need a guaranteed payment stream to offset their own payouts. Mortgages are great for this because they lock in rates for 30 years.

Banks can originate their own loans, called Agency loans, but these days, most lack enough funds. The entire US housing mortgage market depends on re-selling loans (the ABS). SO here are the problems:
* Why buy new ABS when the old ones are plentiful and selling at a deep discount. Centex homes just sold multiple properties for $162M when they were originally valued at $1B+. That's how cheap housing is becoming - literally pennies on the dollar.
* Why buy US mortgages when the default rates are moving up and expected to go up even higher?
* Why buy US mortgages when the dollar is eroding?
In February 2007, $323B of ABS were sold. Fast forward 1 year. In February 2008, barely $83B were sold. There gush of Other People's Money has slowed to a trickle.

Having to use their own money, banks are suddenly more cautious and demanding. Downpayments are back. Risk premiums are being charged. That's why mortgage rates have moved up while interest rates have moved down.

But lenders have to lend, so why wouldn't they work out some solution? Many are, in fact, tryingto do so. The realities are that banks are swamped and lack the manpower to deal with the massive volumes of foreclosures. Many are proposing solutions that basically delay the day of reckoning, following a strategy that the borrower's finances will improve (not likely) or that prices will stabilize (not likely).

And there is a ticking time-bomb called regulations. Laws force the hand of the banks. At some point the accountants force banks to take action with a loan default. Banks have a fiduciary responsibility to shareholders as well. Marking the asset to market would hurt the banks because they would be forced to recognize the loss in value and build up cash reserves - something that leads to credit tightening.

Banks need cash at the moment. Their borrowers are paying $0 (hence the notices of default leading up to foreclosure and these discussions between lenders and borrowers). And the reality is that banks that do the due diligence can determine ability to pay. That strawberry picker in Gilroy earning $30K and buying a $700K house, for example, is more likely than not to default anyway. Foreclose, take the home and get cash by selling. Banks are helped out in this situation by already writing off the loan and taking the loss.

Banks will harden their stance as folks begin defaulting in earnest (you can start to see the wave building now - even Kudlow has mentioned it).

Bottom line: throughout the housing bubble, banks found a way to avoid holding the bag. With no consequences, they were more than happy to give away money on easy terms. Now that they are no longer able to avoid the risk, they are back to being banks and not loan processing machines.

California Housing revisited: And now for the Alt-A Loans

The above is a very familiar chart showing ARM re-sets. ARMs are problematic for several reasons:

For Lenders: these represent the bulk of outstanding loans.

For Borrowers: Many are finding themselves in a hole due to stricter lending and higher mortgage rates. Gone are the 4% teaser rates - ARMs are at least 100 basis points higher than they were a few years ago. And even if they could jump the hurdles of tighter credit standards, many would not get the full loan re-financed. Unfortunately, property losses are severe and many lenders demand downpayments

Let's ignore the lenders: we're more concerned about the consumer side of the equation.

How thin is the ice?

http://www.newyorkfed.org/regional/States_ABS_2007_12.xls

According to the Federal reserve, California owner occupied homes:

72% of all loans are variable

Mortgage rates and home prices are central to the California housing market. With home prices now at 2003/2004 levels, that means that the homes re-setting are also under water: the value of the home is less than the loan.

So how are folks doing?

% of loans not current: 42%

% 2 months delinquent: 9.3%

% 3 months delinquent: 5.6%

% >3 months delinquent: 8.2%

The rest are REO or in foreclosure

And a whopping 25% loans have no documentation - aka liar loans.

Not only are folks facing problems re-financing their homes. California is leading the nation for withdrawing 'equity' from the home: only 38% of all loans went to home purchases. Fully 45% of all loans were for cashing out.

A lot of belt tightening is about to hit California. Some 43% of all California ARMs are due to re-set in the next 12 months.

It's a death spiral in action as the entire housing boom unwinds.

Look at the Bay Area. The Median home price requires a Jumbo loan. The rates for Jumbo ARMs are almost 6%. In addition, to qualify, most have to now have downpayments.

By the end of this Summer, the Subprime ARM wave wil have subsided. But the next wave will be just starting: Prime and Alt-A. In theory, these folks can re-finance easier (they have better credit histories). But in reality, they will face the same big hurdle: lenders will not loan more than the house is worth. And the house in late 2008 will be worth a lot less than the original loan amount.

And many of these supposedly solid credit borrowers used 2 mortgages to afford the home.

It's possible that mortgage rates will fall by then, but not enough to offset the drop in property values. This will be the reality throughout 2009 and 2010.

You can expect a lot more inventory this time next year. By 2010, nobody will be looking to buy a home, which is exactly when one should buy a home.

Late 2008 is when things will pick up steam:

* Mainstream media will be reporting that housing is in a long term bust and prices will drop - this will reduce demand and, at the same time, motivate sellers to price competitively

* Recession will be biting hard, further reducing demand

* Banks will have surging inventory of repossessed homes

* Weak 2008 summer sales will push banks to unload their inventory at fire-sale prices

By 2009, inventories of distressed housing will surge again. This will scare both buyers, sellers, and lenders. By late 2009, housing will be like a ghost town. Then another surge in 2010 will seal the deal: housing will be the last place folks will buy.

Further affecting things will be the drop in municpal and state taxes. Homeowners will force tax re-assessments. The consequent plunge in services will drive an outflow of residents. Folks will simply move to other, cheaper states.

Then add corporate pressure. Many companies will be tempted to move out of state to preserve margins. To be honest, a great way to cut the payroll is to simply move the team to Colorado or Arizona. This is more insidious because it is the long-term lifeline of the State's income.

California property is about to be as famous as Florida swampland. It will take years to recover.

Shift gears away from housing and focus on consumer spending. If Californians are struggling to pay off loans, they won't be partying in Vegas or dancing all night in LA clubs. The Californian economy is going to sag. Which may be a good thing for the infrastructure: fewer kids in school, fewer cars on the road, etc. But local economies are going to get desperate.

And California is a major driver of the US economy.

This is why I am short the consumer spending stocks, among others.

My Trading Strategy

I am short-term long and long-term short

Our Puts and Ultrashort ETFs are getting hammered. But I am sticking to my guns that this is merely a rally on the way down.

Buying another 1000 ETFC's and writing covered calls

Buying 1000 ETFC @ $4.07
Selling April $4 Covered call for $0.35

Market should do well today

Mixed news about banks
* UBS writes off $19B
* Deutsche Bank writes off $4B
* Lehman (LEH) obtained $3B in private financing last night.

I think the UBS write-down is shocking but also a relief - it's a touch of reality and a possible sign that they are finally recognizing the extent of the problem.

The LEH move is a positive because many expected it to go belly-up

Removing the uncertainty will boost markets.

I think Financials are bottoming (ETFC looks good for a 2nd bite). But the rest of the market is just not ready. If CF surges, we'll sell the calls that we bought yesterday.

US and Japan are definitely recession bound. I think the EU is 6 months behind. I also think that Chindia are not decoupled from these markets and will turn down as well. My concerns about a global recession are making me feel like adeeper recession will happen.

Buying CF calls

Buying 10 contracts CF Aug $110 @ $14.60

What to expect the next 2 weeks

It is highly likely that last week was about locking in profits.

Hedge Funds had to show that they can make money, so they enjoyed a fast run up in the market and cashed out.

I see competing trends - recessionary signs versus loose lending. Throw in April 15th tax time and this is very confusing.

Lots of competing forces here. People need cash to pay the tax bills, so stock is getting sold. At the same time, the funds have new money to invest thanks to the Fed.

This makes for a very skittish market ready to collapse if there are signs of weakness. And there will be plenty of those as corporate guidance indicates recession in the US and possibly creeping into the EU.

Upside surprises will likely be the agriculture (soybean, potash, etc) and commodity stocks (oil, coal, chemicals, etc). And global consumer companies that enjoy exchange rate advantages.

But overall, we are highly positioned for a steep drop an dlong term bearish market. I believe there wil lbe a lot of volatility as the market seeks direction and hopes beyond hope that things will improve. That means to me that I will be buying and selling calls/puts sometimes within a day. I will be selling into strength (writing covered calls or buying puts) and buying into weakness. But not to hold for long.