Murphy’s Law struck and of all the days – seriously – it was yesterday in which our open position files from the clearing firm were not updated in the morning (the clearing firm was having problems). I was excited to get into work with the market down significantly, as we were over-hedged in all positions and it was a phenomenal opportunity to buy in stock at significantly lower prices. It was a profitable day, but we left opportunity on the table because we spent 2 hours updating our positions. The lesson learned today, just because YOU are prepared for a day like yesterday – doesn’t mean everyone you are doing business with is (example – our clearing firm). Always plan contingencies; for instance we have multiple execution gateways, floor brokers, and back-up systems. Just expect Murphy’s Law to happen when you least expect it and you will be prepared. Needless to say, I didn’t have time to write a market preview as I was dealing with a position file (of all the days).
Everyone was trying to look for answers as to why the market was selling off and no one could find satisfactory answers. They want a reason, an explanation, something that makes sense, a headline that could be blamed for the catalyst, but there was nothing. Many pointed to China, but the China slow down story, currency peg-moves, and interest rate cuts have been happening for months.
I have been frequently asked; “why did the market go up?” or “why did the market go down?” It’s a question with a simple answer; there were more buyers than sellers or more sellers than buyers. The momentum of the move is driven in many cases from margin calls (short covering on the way up, and margin calls on the way down).
In some ways you can think of the global market as a herd of Lemmings. Lemmings are an interesting lot – they do the darndest things with no reason or logic, because they just follow the herd. Frequently cartoons will show one lemming jumping off the cliff and then a herd of lemmings will follow – for no other reason than one jumped off first. I like to use the word “lemmings” to describe various herd mentality watershed moments in which the justification is that someone else did it. Just like when the herd rushes into buying the markets, the same mentality starts selling. Frequently the joke is the public investor buys the top and sells the bottom; because they follow the lemmings. The global lemmings’ trade is as follows; China sells off, then Europe sells off because China did, and as the world turns it comes to our shores as we sell off. In some respects we are just a herd of investors that follow the leader.
Courtesy of hedgeye
The unsatisfying truth is that it was just a Supply & Demand issue, related to Margin (I wrote about it last week). Once the catalyst of margin calls kick in, there is no stopping. Clearing firms (brokerages) just start liquidating investor positions so the firm can avoid a loss. That selling pressure can be enormous and was at the opening. There were massive market sell orders on the open of which $100s of millions were margin calls. I explained Margin Calls and this possible watershed moment in the last Market Preview: Margin Calls. Today was an example of it and unfortunately there doesn’t need to be any single “headline” to give us justification as to why it happened.
The “Dot.com” and “Housing” bubble sells offs were due to margin, nothing more or less. There was simply no more money to lend and those that borrowed were unable to finance the debt. So the debt is called in and if too much debt is called in, you see mass liquidation that turns into a panic and soon the proverbial “baby is tossed out with the bathwater”. In both the “dot.com” and “housing” bubbles, we saw stocks with huge cash, profits, growing top-line revenue, and no debt sell off to ridiculous levels. They sold off, not because they were over-valued or bad investments, they sold off because the investors were FORCED to liquidate because they had borrowed too much and the lender (bank/brokerage) wanted their money back.
Will the selling continue, perhaps? The “ace in the hole” is the FOMC meeting that is upon us and I have been preaching for the entire year – there will be NO RATE HIKE. I have made my position as to why very clear, backing it with reason and logic – rather than ideological rhetoric. I have previously explained why the debate as to whether they hike or not is a silly one, when the real debate should be are we in a “new normal” – which sounds cliché – but are we? Market Preview: Normalization
I would argue that since the “Dot.com” bubble burst (15 years ago) – NORMAL Interest Rates are 1.07% (Normal as defined as “conforming to a standard” or “of a nature of/or pertaining to a mathematical normal”). 1.07% has been the median interest rate since January 2000 to the present. In fact one could argue that 5%, 4%, or even 3% is far above “normal”. We hear so much talk about “normalization”; I don’t even know what that is. Because if they think 4% is normal, we have spent less than 22% at or above that level.
The Fed is not raising rates and with China, Greece, and now the U.S. equity markets heading into the tail-spin, they are going to be cautious as not to put the death knell on this market by raising rates. In fact there is a probability that we may hear of additional easing or some other mechanisms to keep the easy times flowing.
Don’t Should on Me
I can spend endless hours telling you what they “should” do and why what they are doing can have disastrous long-term effects and that it will certainly not end well. The when and how bad is unknown, yet the math is certain. However, I am not going to bother with what they “should” do, because you can’t take “should” to the bank.
What they WILL do is another story, right or wrong, save the righteousness for a friendly debate over a beer with a friend. They will remain accommodative and they will begin to quash any short-term concerns of rate hikes, and that will, most likely, rally the equity and bond markets higher (yields lower).
While certainly unsustainable for the long-term, no one knows what the long-term is. You and I both know people that lived in a “million dollar McMansion” with interest only payments that barely kept up for years and when foreclosure came it took even more years for everything to unwind. We also know that Japan has been on the ZIRP train to nowhere going on two decades. The Fed has a bigger and better printing press, so who knows how long “sustainability” is. What the math says is clear, it is NOT indefinite, it is finite.
However, I believe they still have paper and ink, so they perhaps can buy some more time. If they are able to convince the market there is no rate hikes and they remain dovish, we could be setting up for a strong rally.
Let’s stop looking for headlines. Yesterday the opening was driven by huge margin calls based on a massive pre-market futures sell off. The bounce came when the margin calls finished and the panic selling abated.
The futures over-night were down as Japan and China sold off, what sparked the rally in the pre-markets this morning? It was China’s late announcement of setting interest rates – it was the catalyst to give justification to buy. However, is this just a dead cat bounce? China cutting interest rates means that China is dealing with a slow-down and that is not a good thing for the global economy.
What the media is missing is that it is NOT China’s rate cut driving up the pre-market futures, but rather what it implies. When one of the biggest economies cuts rates to boost competition, it confirms that it will be very hard for the FED to raise rates. The Chinese yuan is still pegged to the dollar (even though China moved the pegged a few times). A lower rate, with more rates cuts, will certainly put pressure on U.S. exports.
Add the confidence that the Fed won’t raise rates and that we just washed out some margin yesterday, we should get a good bounce. I doubt we will have large scale margin selling today.
While I think China’s monetary policy and interest rate changes are more confirmation of the Fed not hiking rates, I think we are in for a volatility ride until the Fed FOMC meeting comes to a close. This knee jerking up and down, fueling margin calls and exorbitant selling is not going away until the market gets some certainty.
Trading / Investing
Don’t expect the futures rally in the pre-market convince you this is the bottom yet. Again, the Fed needs to bring certainty and no matter what the market expects or believes will happen, we still have to wait for the “fat lady to sing”.
In the interim, this is a traders market. If you don’t know the difference between trader and investor, than you are most likely an investor.
For investors, keep it simple. Use options to hedge long equity positions, keep margin powder dry (give your-self room), and look for buying opportunities. You never want to receive a margin call – EVER! Yesterday should have been a day of opportunity – NOT panic. If you have been hedging your long positions, you would have had a lot of room to pick up stock yesterday.
If you are unfamiliar with options and how to use them as a hedging tool, I suggest you talk with your financial advisor / broker. If they can’t help you – find one that is well informed.
For traders – this is an excellent market to take advantage of. Traders love volatility. I had been mentioning prior to the sell-off that the VIX was too low and prior to the sell-off should have been priced in the high-teens. That was a time to buy some “cheap” Gamma (curvature) to play the market moves. Be it buying strangles, straddles, synthetic long curvature, it didn’t matter – it was cheap to buy and with huge swings it was easy to buy and sell huge Deltas. Not only was buying the “cheap” Gamma great for getting Delta action, the volatility exploded and you could have just traded options against the “curvature” converting positions into credit flies.
Strangle Example – courtesy of Silexx
I believe the trading opportunities will continue to exist heading into the FOMC meeting, so hang on. Don’t be surprised if the market rallies on the open and then sells back off. I have a feeling this is not over and this could easily be a selling opportunity at the open on a “Dead Cat” bounce as it is the start of a rally out of the hole. Having “Gamma” means it doesn’t matter which way it moves, as long as the market moves!
Support & Resistance
INDU 15,000 – 17,000
Sure it’s a wide range, but with all the buyers knocked out and margin calls – we could easily head to 15,000 or 17,000. I would look at selling pressure starting at 16,400 range. Looking at market depth and liquidity – no one wants to post any huge buy or sell positions. The means until we see some volume or accumulation at some level, we can’t really know where buyers or sellers will begin stepping in. Expect volatility.
NDX 3800 – 4200
This too is a wide range. Tim Cook (Apple CEO) brought some confidence back to the market after he squashed concerns about a slow-down in China. He stated that Apple iPhone activations were actually up in China. That buoyed Apple after the openings and help bring confidence to the tech sector. We could still visit 3,800 and even go lower. For now we look like we are going to have a strong opening. I would expect some selling pressure to come in at 4200.
SPX 1850 – 2000
We could start seeing selling pressure around the 1950 range. Again, this market has to equalize somewhere and that leaves open a wide range. We won’t fully find that range until the FOMC meeting brings certainty to the market.
RUT 1040 – 1200
I have been voicing concern lately that the Russell has been fairly weak and on Friday it closed on the low followed by huge selling yesterday. Unlike the other indices it did NOT get the strong bounce and closed near the low. I would continue to watch the Russell to give any real indication of order flow. I think we do have room to visit 1060 or 1040 before finding strong buying. It will bounce in the morning, but watch it to determine if this is a “dead cat” bounce or has any real legs.
I was concerned that the VIX was significantly underpriced relative to the potential volatility, I thought a proper price based on the probability, should have been in the high-teens. We are now up and far over-extended in the 40 range. Expect the VIX to pull back hard this morning at the opening and could even get down to the 25 range. However, this all depends on today’s market action. If we can hold the opening levels throughout the day and if intraday stock volatility calms, the VIX will come tumbling down. In this market heading into the Fed meeting, I think 25 is a more proper median for the VIX. Post Fed meeting and no rate hike, we should get back to the mid-to-high teens. That leaves still a lot of unknowns out there that could drive spikes of volatility into the market. At 40+ we are certainly running high premiums, which is only warranted if we have back-to-back 50+ point moves in the S&P 500.