Shadow Capitalism

Something like 17 of the last 19 Mondays have been up days in the market, with 80% of the market’s rally from March 2009 lows being accounted for by Monday moves. Though the rally’s reversal may unwind some correlations, including the “Monday effect”, Friday’s market action near close combined with this Monday correlation is making me hedge my short position by selling puts in SPY, XLF, and X.

The Financials SPDR (XLF) is at support around $13.50, so it may have a technical bounce here. SPY isn’t at any significant support level, but it is oversold after the sell-off in the last two weeks, so it could find some buyers here, too.

This week could still offer more downside, especially if correlations are unwinding with this reversal. But the probability of a bounce here is more likely than in the last two weeks and taking some gains/hedging positions is prudent. Because of a lot of upside resistance from broken support levels in the last two weeks, the market could be headed for some choppy action this week if it doesn’t continue its selloff.

As I stated in an earlier post:

A note to readers: I was deciding between this and Freemont-Mcmoran Copper & Gold (FCX) as my third posted trade. FCX is also a high beta commodity name with big gains since March. With China’s bubbly copper purchases running out of fuel (and the beginning of the liquidity extraction process there), FCX is a great fundamental and technical play, especially if the USD continues climbing. It also had a huge down day today.

And according to Nomura, FCX is 17th on the list of highest trading value equities, with a monthly turnover of over 67%, underscoring how much of a high beta, hot potato stock this really is.

If the market continues its sell-off, FCX should me among the hardest sold names. It remains perched on its 200DMA right now but I am selling/shorting strength at this point and the bounce to $72 and subsequent correction triggered my short at the $71 level. Markets are choppy right now, so this could be a stock we have to try a few times on the short side before we get a sustainable position that isn’t stopped out.

The QE sugar daddy is gone and with it seems to be departing the never-ending barrage of USD-carried yield chasing that characterized post-March 2009.

The Dollar Index traded up 0.75% to 80.15 today, breaking the 79.70 resistance level. We expect the USD to continue marching higher as demand from real economy deleveraging outstrips excess USD supply (both QE liquidity and the Fed’s dollar liquidity swaps are all but gone). The pervasiveness of the dollar carry trade will amplify the USD spike, as shorts get squeezed, forcing a positive-feedback demand loop. Dollar-funded carry trades across various forex pairs were sharply unwound today.

Meanwhile, sovereign debt fears continue to heighten. Greece and Portugal CDS spreads are not the only ones widening, either, as contagion risk spreads across the eurozone, tanking the euro. German 5yr CDS traded up to 55/60 today, as Greek and Portuguese default risk becomes increasingly priced into bailout-gifting bunds. United States 5yr CDS shot up to 55/60, as well today. From an earlier post:

The long bond has seen dramatically rising yields since January as the yield curve steepens due to rising inflationary concerns and deteriorating sovereign credit risk (USA CDS was one of the worst-performing sovereign names in Q4 2009, widening 13.5bps or about 66%). However, the 30yr yield seems to hit an important long-term resistance level at 475bps and appears ready to go back down. Since September, the 30yr has been defined by a rising channel; once that breaks, long bond yields could sell back off, with the 30yr targeting the 420bps support level, and if that breaks the 390bps support level, both of which are significant S/R zones. With risk aversion creeping back into the market (and the Treasury’s desperate funding crisis it may try to resolve by the Fed draining liquidity and/or engineering a risk asset selloff), US sovereign fixed-income should find some inflows from risk assets. Though we suspect the back-end of the curve to not see a lot of inflows on a relative basis, hedging that steepener trade on the short/intermediate term may be prudent.

Credit markets showed risk aversion en masse today, as IG witnessed a 61:1 widener-tightener ratio today, en route to its close at 99.75bps (though it touched triple digits earlier today). We expect continued deterioration in credit (as well as equity) and are watching for non-sovereign spread widening to complement the sovereign widening that’s been occurring for about 3-4 months now.

We aren’t the only ones bearish on credit going forward, either, as BlueMountain Capital announced a liquidation of their debt fund incepted at the depths of the credit crisis last March:

“We’ve captured most of the big opportunity,” BlueMountain co-founder Stephen Siderow, 42, said. “It isn’t going to happen again anytime soon and that’s why we urged our clients to move on.” They’re reinvesting in other credit funds of the $4 billion money manager that aren’t dependent on markets rising, he said.

BlueMountain last month returned money to investors from a $100 million two-year loan fund that gained 34 percent since its inception in March. Silverback Asset Management LLC is giving money back from its $210 million two-year convertible-bond fund, the firm said. Highland Capital Management LP said it liquidated a November 2008 fund that gained 138 percent before fees by investing in collateralized loan obligations.

Hedge funds and money managers are cashing out after assets from junk bonds to convertible debt had record gains last year, following unprecedented losses in the wake of bankruptcy of Lehman Brothers Holdings Inc. in September 2008. Debt markets soared in 2009 as central banks lowered interest rates to near zero and governments globally sought to avert the failure of the world’s largest financial institutions with capital injections and lending guarantees.

To put it simply:

“The easy money is over,” said Nexar Capital’s Attias.

Indeed it is, and Moody’s issued concern over the sustainability of America’s AAA rating today.

Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the Aaa government bond rating.

But the USA isn’t the only AAA-rated borrower facing deterioration in perceived credit risk. Berkshire Hathaway (BRK.A/BRK.B) was downgraded by Fitch to AA+ on potential derivatives losses.

Crude was down $3.84/bbl (5%) today, as the contango trade unwinds. From an earlier post:

Crude is still in its rising wedge and may break down soon. This would be very bullish for USD and bearish for other risk assets. The 200DMA is approaching and crude’s behavior around there should dictate its future direction. Also, the contango trade from early 2009 is now unwinding, as the promises for delivery from traders who picked up crude during early 2009 contango for Jan-Mar 2009 physical delivery come due. A recent WSJ article delved into this concern:

Contango has narrowed to around 40 cents a barrel, and “to cover your freight and other costs you need at least 90 cents,” said Torbjorn Kjus, an oil analyst at DnB NOR Markets.

The contango trade is 50c/bbl out of the money at current levels and consequently no demand from that thesis is existent right now. This has big implications for crude prices, as the contango trade isn’t rolled over. Much of the crude due for physical delivery from the contango trade’s origination is due in February and March, and experts are voicing concerns over a lack of demand for tankers as storage demand declines:

ICAP said there were currently 21 trading VLCCs offshore with some 43 million barrels of crude. Seven of these are expected to discharge in February and one more in March. So far, it appeared those discharged cargoes wouldn’t be replaced by new ones.

“I haven’t seen any fixtures for VLCC storage in the last two weeks,” said Simon Newman, ICAP’s senior tanker analyst. “That would imply that storage looks set to fall in the short term.”

Assuming there are no new fixtures, the amount of crude in storage could sink to 27 million barrels by March, the lowest level since the current contango play began in late 2008.

More than 70% of oil’s rally from January 2009 came from January to July 2009, while it was in contango. The spread shifted to backwardation in July but soon reverted back into contango, though not nearly as steep as in the days of January 2009. The contango trade represents the demand behind oil’s rally from January to July 2009 and as that ended, the oil market flattened out (crude is back to July 2009 prices after its recent selloff). However, the big issue going forward is the imminent supply influx coming as the contango trade unwinds and key players are forced to provide their stored crude for physical delivery, rushing supply back into the market. And with such a tight contango and a net-negative profit from origination for the contango trade at current levels, the contango trade won’t be rolled over and what was previously demand will come due as supply.

The rising wedge mentioned above is now breaking down, signaling the unwind is at hand. Expect falling oil prices.

Meanwhile, even gold found selling today, exemplifying just how pervasive the dollar carry trade really is, as it broke below its descending triangle support line that we’ve been highlighting. Additionally, silver broke down below an important technical level, as well. We expect the gold:silver ratio to start rising once again on liquidity risks.

In a recent post about Amazon (AMZN), we noted:

Amazon’s stock has more than tripled from its lows, its EV/EBITDA is currently at 43.6x, and its P/E at 68.79. What drove this (and every other) stock up in 2009 was a combination of onetime bank injections (via AIG CDS unwinds) catalyzing a negative convexity dynamic hedging-driven short covering rally and the combined effects of QE liquidity and the USD-funded carry trade.

Now, with QE liquidity dried and credit events flaring up left and right (Greece in crisis, sovereign CDS breaking out, CRE defaults all over the news, and the housing double-dip manifesting), it’s time to look toward the exits.

We continue trading this thesis, as the positive-feedback demand becomes supply. And in regards to Amazon, it appears ready to break down below its 116 support level. We expect the October 2009 earnings gap to be filled and for this stock to trade back in double digits.

This seems to be the beginning of the reversal, and our portfolios are positioned for it. We expect vol expansion from here, as well as for high beta names to underperform. We also expect reactionary policy from the FRB, and a second iteration of QE and another round of liquidity swap extensions will bring back the short-USD (re/in)flation trade. Until then, we will stay long USD and short risk assets.

Some equity index charting:

Written by Naufal Sanaullah (University of Michigan) & Mohammad Ali “Qasim” Khan (Duke University)

There is a certain increase in comfort in defending one’s more controversial beliefs after events transpire that vindicate one of these non-mainstream opinions. Contrarians and conspiracy theorists have used the financial crisis as “proof” of every theory, belief, and emotion under the sun, and as a testament to derailing the entire notion of conventional wisdom.

Surely, asset bubble unwinds expose the pervasive misconceptions and twisted principles that bled through the masses during bubbles’ inflations. And the sense of vindication that John Paulson, Nouriel Roubini, Peter Schiff, Robert Schiller, Marc Faber, and the like must have felt is undoubtedly tantalizing. But anyone and everyone wants a share of that “I-predicted-it pie”.

Including the blamegamers, the scapegoaters, and other various groups of people shamelessly engrossed in one straw man fallacy after another.

This of course includes the critics of the too-big-to-fail institutions, blaming them for everything from the credit crisis to civil wars abroad. The fact is, at worst, these financial institutions were merely agents of demise, not originators of them.

I am personally of the opinion that the entire United States needs sharp deleveraging on all levels and a return to sound economic and financial principles to lead to efficiently-allocated capital and organic growth. Surely, many banks (especially those who were benficiaries of TARP, TLGP, etc) characterize the reckless, overleveraged, risk-ignorant principles that pervade the current flawed financial system. But is it the moral and legal obligation of banks to ensure the soundness of the financial structure of the United States and the world?

The answer is a pure and simple no.

Banks have intrinsic obligations not the US taxpayer, but to their shareholders. Their decree is to maximize profits for their investors, for the owners of the firms. When circumstances arise in which in order to merely compete with rival firms in your industry, important principles of risk aversion and financial soundness must be abandoned, the firm’s obligations becomes an incentive crisis, which is the harbinger of moral hazard.

Anyone who follows markets knows the story of famed investor Julian Robertson. From 1980, his hedge fund Tiger Management Corp turned $5 million of seed capital into $22 billion in 1998. But his reluctance to buy into the tech bubble led to investment losses and, more significantly, investor redemptions. He correctly predicted the current financial crisis and has made over $1 billion on trading gains based on it. But the point to take home from his story is the problem of opportunity cost in competition when the underlying drivers of growth are unsustainable.

Goldman Sachs, JP Morgan Chase, Morgan Stanley, Wells Fargo, Citigroup, and the like did not sit out the housing bubble. Had they, they may not exist today, irrespective of taxpayer bailouts, purely because of loss in competition against rival firms. Citicorp’s 1998 merger with Travelers Group, for example, was not met with prescient criticism targeted at the forming moral hazard and systemic risk. Rather, it was largely lauded with acclaim at the time.

Capitalism works because instead of fighting human nature, it embraces it, and funnels it into sustainable and organic growth, by checking it with natural negative-feedback mechanisms. The fundamental basis of this principle is found in the law of supply and demand. As demand rises, price does as well. And as prices rise, demand marginally falls.

But when these situations don’t exist, when the circumstances don’t allow for self-checking processes, the result is an assortment of myriad positive-feedback, unsustainable, inherently implosive and entropy-generating loops.

The fundamental blame for this financial crisis and the moral hazard accompanying it should be directed toward the purveyors of the artificial situations in financial markets that eliminated the natural self-checks of capitalism. This of course is found with the Federal Reserve and Congress.

Everyone knows about the Fed’s lax monetary policy that injected the financial system with free money at low borrowing costs. Everyone knows about the ramifications of Gramm-Leach-Bliley. And there is a lot of justified blame directed at these causes of crisis, as well. But much of it is misdirected toward banks.

The fact is, if any one of us were in the positions of the banks’ management, we would operate the same way. The idea of self-interest is intrinsic to human nature. That is the point of capitalism: to funnel that biological imperative into sustainable growth for the individual and the collective, and have natural checks and balances to prevent it from exploitative and unsustainable excesses.

Banks that engaged in illegal forms of predatory lending clearly broke the law and were unethical. But corruption and fraud exists in every industry, not just financial services. I’ve heard upwards of 90% of alt-A paper was originated on the premise of falsified borrower stated income. Surely these lax lending standards (through probably exaggerated by that statistic) led to the excesses behind the bubble and subsequent crash. But what about the borrowers themselves? “Everyone was doing it” and they would be at a competitive disadvantage by not engaging in such fundamentally unsound acts. This analogy is clear and direct, but absolutely lost to the conspiracy theorists, especially pervasive in financial blogophere.

It is no secret that Washington is a ticking pendulum of hypocrisy. Go back two years and see the Republican treatment of anti-government protestors; now the tea-bagging brigade has become the impetus for their dramatic revival. So it is no surprise to see the government so vehemently persecute banks that, although very clearly benefited from government support, have repaid their TARP debts, yet continue to support a dying American auto industry.

The new Obama tax to recover the TARP fund deficit is very problematic because while the banks did indeed require significant assistance, they were not responsible for the failure of the American auto industry; yet, the banks, which have already repaid their TARP debts are being forced to compensate for the lack of success of a completely unrelated industry, ironically making the auto bailout a Wall Street bailout for Main Street.

Let us ask ourselves who is the true culprit of the Too Big To Fail hostage dilemma. When viewing history objectively, the answer is immediately apparent. The fact of the matter is we have been here before with the American auto industry and left with the exact same results. A mere Google search of the ’79 Chrysler bailout forces one to double take and check the dates on the printed articles because they describe the very situation we see today.

The fact is that frequently neither Congress nor the Fed uphold their respective oaths. And in the cases where the government is not lacking in genuine intention, they often lack the understanding necessary for pragmatic implementation.

As Milton Friedman once said, “We all know a famous road that is paved with good intentions. The people who go around talking about their soft heart — I share their — I admire them for the softness of their heart, but unfortunately, it very often extends to their head as well.”

Take the idea that reducing the size of banks will reduce the systemic risk they present. Proponents of this idea somehow fool themselves into believing that one and two halves are not the same; in an industry that is fundamentally predicated upon mimicry, the likelihood of ten smaller firms engaging in risky behavior or one large firm engaging in such behavior is at best the same and at worst greater due to heightened competition.

Illegal acts during the bubble and in response to the crash are clearly not the subject of my attempted exoneration of the TBTFs. Many modern controversies, including the AIG CDS counterparty par-value payments and the accounting standards employed on marking asset books, are issues I follow closely and am very opinionated on. But these banks were employing the principle of self-interest and without logical, natural checks to it, the self-interest ends up damaging others.

The true blameworthy entities of the genesis of the financial crisis as well as the political and moral hazards associated with it are the Fed and Congress. By allowing excess money to float around at little to no cost of borrowing, the Fed allowed banks access to excessive money, all of which chased yield and all of which chased incrementally worse assets. This causes unsustainable valuations and also leads to paradigm shifts because of confirmation bias, which further feeds the inflating flame. Meanwhile, by allowing commercial and investment banking units to operate under the same corporate flag, Congress opened up depositor capital, which is inherently supposed to be liquid and accessible and only used to collect a spread by investing it into low-risk securities, to chase these illiquid, risky, overvalued assets that were bubbling up.

The basis of my argument is that, had it not been for the Fed’s and Congress’s lax monetary and regulatory policies in the late 1990s and early 2000s, the banks could have never engaged in forming a housing bubble and subsequently receiving taxpayer bailouts because of moral hazard and systemic risk. But had Goldman Sachs not joined the bubble bandwagon, the bubble wouldn’t go away: another bank would just take Goldman’s reins.

I have criticized bank actions in various articles, and I stick to them. Employing unsustainable leverage, having a toxic asset book, etc etc are all subjects of my critique. But the true blame falls on the supervisors allowing the artificial circumstances that permit these bank actions from being profitable in the first place.

Yes, I acknowledge the Wall Street lobby is one of the strongest and most influential on Wall Street. But all that means is the banks do the best job at getting their self-interests employed by regulators.

Blame the actual pervertors of American capitalism, the Federal Reserve and the Congress, for creating a situation in which the profitable way is an inherently destructive way in the long-run. Don’t fault the banks for simply going along for the ride.

Still don’t agree? Consider the following argument:

If A and B, then C.
If C and D, then E.

Then consider:

If A and F, then G.
If G and D, then H.

Now substitute:

A = Federal Reserve & Congress determine overreaching monetary and financial conditions
B = Federal Reserve & Congress allow free-market supply/demand valuations and self-checks to excessive risk
C = no asset bubbles exist and fundamentally sound risk assessment and valuations pervade
D = banks attempt maximizing profits and appeasing self-interest as much as possible, given monetary policy and regulatory laws
E = banks don’t engage in intrinsically destructive actions and no moral hazard or systemic risk exists
F = Federal Reserve & Congress allow free and cheap money and leveraging of depositor and other low-risk capital into high-risk and illiquid securities
G = asset bubbles exist and valuations and risk assessment are negatively skewed
H = banks become too-big-to-fail and the subject of populist rage.

There’s tons of wrongdoing by banks to be addressed and criminality to be punished. But the myopia in excessively blaming banks for everything under the sun is unwarranted and a by-product of the crash’s vindication of a select few, with the entire conspiracy theorist and contrarian bloc seeking a piece of that pie for their own agendas’ propagation.

In October 2004, the FBI’s assistant director of its Criminal Investigations Division made this statement before the Chairman of the Federal Reserve House Financial Services Committee on Housing and Community Opportunity:

“Based upon existing investigations and mortgage fraud reporting, 80% of all reported fraud losses involve collaboration or collusion by industry insiders. These schemes involve industry insiders to override lender controls.”

And what did the FOMC do from 2004 to 2007? Lower interest rates 17 times.

Blame Paulson the Secretary Treasury (hell, blame Bush for appointing Paulson). But don’t blame Paulson the CEO of GS.

But that’s just our view.

The Federal Reserve’s dollar liquidity swap extensions saved foreign banks in H2 2008, particularly in Europe, as foreign bank balance sheets faced big losses in USD-denominated securities, with no recourse of injecting new dollar liquidity to stem the tide of collateral demand, as well as rush to liquidity/safety.

This had clear implications on the global supply/demand dynamics of the US Dollar (as is evident in the chart above [source: Federal Reserve H.4.1). But now the swaps are back to about zero and global deleveraging has not yet wiped out all malinvestment, especially considering the inflated marks on financial balance sheets globally.

The ramification of zero liquidity swaps to draw upon is that foreign banks now have no excess supply of USD (indirectly, through their respective central banks) to use for filling funding mismatches if another round of deleveraging, counterparty risk heightening, and liquidity chasing returns.

As the chart below (source: Bank of International Settlements– Detailed tables on provisional locational and consolidated banking statistics at end-September 2009– Table 5A) shows, global bank balance sheet deleveraging, adjusted for the currency’s proportion of total denominations, has been very muted in the dollar relative to other currencies.

Given the crisis risks going forward in commercial real estate, sovereign debt (particularly eastern Europe, PIIGS, Dubai/UAE, UK, etc), and alt-A/option ARM, we find it hard to believe that foreign banks will not need a second round of liquidity swap line extensions by the Federal Reserve.

Of course, such a move would be reactionary in nature, meaning a sharp unwind in the form of a eurodollar squeeze sending the USD surging (in the short term, before the Fed’s swap lines are re-instituted) would materialize.

The big variable going forward, however, is the emergence of the dollar-funded carry trade. Now, instead of just two demand-oriented variables driving the dollar funding mismatch (deleveraging and flight to safety), a third unwind exists in the form of the ultra-crowded USD carry trade. The emergence of non-USD reserves in central bank balance sheets confirms the uber-short position the world effectively has on USD. Once deleveraging round two commences, this carry trade is an enormous position that will face a sharp unwind, further amplifying the effect on USD exchange rates, like in July 2008 to January 2009.

The liquidity swaps are evaporating just as QE liquidity dries up here in the United States. The excess globally (and domestically) injected supply of dollars that drove assets up in 2009 and the USD down are all but gone. But the debt has a long way to go before being completely purged. The implication here is that an exogenous event (several of which are popping up every day again) driving a rush to USD will face unprecedented amplification and unwind severity because of the added variables in the USD supply/demand (im)balance.

And as we discussed before, foreign banks have no short-term credit access when the USD rallies:

If the current rally in the USD persists, the TED spread may once again widen (though the global central bank subsidization of private entity risk has effected LIBOR’s utility as a relevant metric) and the dollar carry trade unwind will experience a harsh negative convexity, which will be met with yet further unprecedented reactionary policy from the Fed.

Suggested reading:

The Global Financial Crisis and Offshore Dollar Markets: Niall Coffey, Warren B. Hrung, Hoai-Luu Nguyen, Asani Sarkar: Federal Reserve Bank of New York

The US dollar shortage in global banking and the international policy response: Patrick McGuire and Goetz von Peter: Bank of International Settlements

Detailed tables on provisional locational and consolidated banking statistics at end-September 2009: Bank of International Settlements

Though millions of people are buying Kindles, the Charles Mackay classic is still unavailable in Kindle edition. (Click here to request the publisher to do so). Evidently Kindle buyers are busy reading Jim Cramer’s books, which are ever-so-conveniently already available in Kindle editions.

Amazon (AMZN) released earnings after the bell on Friday, with 85 cents EPS vs 72 cents consensus. The $9.5 billion in revs beat both the consensus top-line estimates from analysts ($9.04B) and management guidance from Q3 ($8.13-9.13B).

But the earnings beat came with its dose of bad news, too. Gross margins were down 260bps sequentially and 65bps year-over-year (on a pro forma basis) and international operating margins were down 45bps sequentially and 43bps YoY.

In addition, Amazon was forced to cave to publisher MacMillan’s eBook pricing demands, and will be repricing certain books from $9.99 to $14.99 contingent on consumer response.

Meanwhile, Apple announced the iPad, which will be a direct competitor to Amazon’s eBook business.

What’s all of this mean? About nothing, really. Amazon’s stock has more than tripled from its lows, its EV/EBITDA is currently at 43.6x, and its P/E at 68.79. What drove this (and every other) stock up in 2009 was a combination of onetime bank injections (via AIG CDS unwinds) catalyzing a negative convexity dynamic hedging-driven short covering rally and the combined effects of QE liquidity and the USD-funded carry trade.

Now, with QE liquidity dried and credit events flaring up left and right (Greece in crisis, sovereign CDS breaking out, CRE defaults all over the news, and the housing double-dip manifesting), it’s time to look toward the exits.

And boy are the people in AMZN exiting.

The stock is down close to 7% on 13.6M shares traded just two hours into today’s session. The margin decline and eBook repricing are the primary culprits, but beware of upcoming analyst downgrades to push more selling.

The important $116 support level is close to being taken out. If it does, the break could trigger some big selling that could eventually send this stock back to pre-Q3 2009 earnings levels back in the double digits.

But the real problem is not in what the fundamental news events cause (selling in the short term). It’s what their effects catalyze, which is a shift in momentum that will drive momo chasers (the thesis behind the entire demand in the equity market) to selling rather than buying. And this into a very illiquid market environment.

Still deciding whether or not I will be shorting in size on the breakdown, but shorting AMZN today could end up being one of the bigger trades of 2010.

Either that or the Dow 30,000 trade.

SPY continues its decline off of its January highs. The 107 level could act as important support, and marked September 2009 highs and November-December lows. Volume is picking up and the 50DMA remains broken, so keep watching for further decline. On short-term timeframes, the probability for a bounce off of the 107 level is high.

The VIX is coiling for a big move to the upside, in my opinion. It spent the entire year of 2009 in a linear downtrend that seems to be breaking out or ready to break out soon. The 200DMA is going to be an important zone going forward and a sustainable push above that level should send the VIX to the 30s, 40s, and beyond. In addition, as the Tsy yield curve begins flattening (front end of the curve is at a nominal floor that has nowhere to go but up while back end should tighten short term due to risk aversion), this will start decreasing MBS duration (the correlation between FNCL-LIBOR effective duration and 2s10s Tsy spread is very high), which could cause a large spike in vol as the “pure market” negative OAS manifests in surging rate vol. I will be going long OTM VIX calls in size for 1-3+ month maturities soon, if the charts confirm my theses.

Apple (AAPL) broke two significant uptrend support lines in its high-volume selloff January. Additionally, AAPL’s 50DMA has been taken out. I’m looking to see this drop to its 200DMA after a possible short-term bounce, and a break below its 200DMA should send it selling off further.

First Solar (FSLR) sticks out to me because it is in a huge 20-month symmetrical triangle pattern that has been consolidating its huge 2006-2007 run-up from its IPO. The triangle has been broken and FSLR now sits at support around 111 and seems to be bear flagging. With continued weakness in the overall market, especially in Chinese equities, FSLR could suffer a huge sell-off, if its chart pattern’s size and duration mean anything, sending it back to double digits.

The Pound/US Dollar (GBP/USD) pair is showing continued weakness, which is helping ShadowCap’s short trade idea. The 1.57 level is an important S/R zone, and if the GBP breaks it to the downside, it could revisit January 2009 lows quickly.

We mentioned the possibility of a reversal in the Euro/Australian Dollar (EUR/AUD)’s decline a few weeks ago. Now the pair has bounced off of the long-term support we had mentioned and appears ready to battle resistance at 1.59-1.60. This pair rallying is going to be a huge risk aversion event going forward.

Gold remains in its descending triangle at its support level around 105 in the GLD ETF. Continued dollar strength will send gold breaking down with other risk assets. I expect a short-term bounce early this week in gold and other risk assets and will most likely be shorting gold, silver, and precious metals-related equities (though I am long PMs since November 2008 for the long term and will be buying on weakness to add to my longer term positions, most likely this spring or summer; these shorts are more hedges than anything else).

Copper has been one of the biggest rallies in commoditysphere since the risk asset rally began. However, it has broken down from its rising wedge pattern that defined its ascent since late March 2009, as well as broken its 50DMA. January featured copper’s biggest monthly drop since 2008 and concerns about diminishing demand from China (especially as it begins tightening) and a rallying USD should send this bubbly commodity selling off much further. Again, be wary of a short-term bounce, however.

Crude is still in its rising wedge and may break down soon. This would be very bullish for USD and bearish for other risk assets. The 200DMA is approaching and crude’s behavior around there should dictate its future direction. Also, the contango trade from early 2009 is now unwinding, as the promises for delivery from traders who picked up crude during early 2009 contango for Jan-Mar 2009 physical delivery come due. A recent WSJ article delved into this concern:

Contango has narrowed to around 40 cents a barrel, and “to cover your freight and other costs you need at least 90 cents,” said Torbjorn Kjus, an oil analyst at DnB NOR Markets.

The contango trade is 50c/bbl out of the money at current levels and consequently no demand from that thesis is existent right now. This has big implications for crude prices, as the contango trade isn’t rolled over. Much of the crude due for physical delivery from the contango trade’s origination is due in February and March, and experts are voicing concerns over a lack of demand for tankers as storage demand declines:

ICAP said there were currently 21 trading VLCCs offshore with some 43 million barrels of crude. Seven of these are expected to discharge in February and one more in March. So far, it appeared those discharged cargoes wouldn’t be replaced by new ones.

“I haven’t seen any fixtures for VLCC storage in the last two weeks,” said Simon Newman, ICAP’s senior tanker analyst. “That would imply that storage looks set to fall in the short term.”

Assuming there are no new fixtures, the amount of crude in storage could sink to 27 million barrels by March, the lowest level since the current contango play began in late 2008.

More than 70% of oil’s rally from January 2009 came from January to July 2009, while it was in contango. The spread shifted to backwardation in July but soon reverted back into contango, though not nearly as steep as in the days of January 2009. The contango trade represents the demand behind oil’s rally from January to July 2009 and as that ended, the oil market flattened out (crude is back to July 2009 prices after its recent selloff). However, the big issue going forward is the imminent supply influx coming as the contango trade unwinds and key players are forced to provide their stored crude for physical delivery, rushing supply back into the market. And with such a tight contango and a net-negative profit from origination for the contango trade at current levels, the contango trade won’t be rolled over and what was previously demand will come due as supply.

The US Dollar Index broke its 200DMA last week. The last time it had a 200DMA breakout was August 2008, which preceded the commodity crash and the equity crash a month later. It sits at an important resistance level around 80 and I expect a short-term correction in the DX and maybe a retest of the 200DMA. If it holds, however, a breakout through the 80 level could trigger further decline in basically all assets besides USD and Tsys.

Another important 200DMA breach last week was in the Shanghai Index, this time to the downside. Its ascending triangle that it broke down from appears to be a repeat of January 2008, which was the top and preceded a crash of epic proportions. The last time the Shanghai broke its 200DMA to the downside was back in the spring of 2008, right before all hell broke loose. China announcing tightening surely affected Chinese equities this past month. I’m keeping my eyes peeled for excellent China shorts. I expect this decline to be susbstantial, as well.

Regular readers are aware of ShadowCap’s currently bearish slant toward risk assets and bullish outlook on the US Dollar (at least for the short- to intermediate-term). Volatility is a great way to play these outlooks, as prices decline into illiquid market environments. But even besides asset declines, going long vol has other attractive variables that have finally started to come out of the woodwork.

The decline in marginal liquidity provisioning from quant funds has been well-documented by blogs like Zero Hedge since last year, and is obvious when market-neutral index performances are considered. This has led to an illiquid market landscape that is increasingly dominated by other liquidity provisioners, such as Goldman Sachs principal program trading.

Additionally, as the market continued the fall-winter 2008 decline into February and March 2009, many dealers’ equity derivatives portfolios were net-short bullish gamma as a consequence of delta hedging in a market declining at a rapid pace. As the market reversed in early March and began rallying, these derivative books were forced to delta hedge by going long the underlying. With delevaging quants, the negative convexity of delta hedging equity derivatives books led to a highly momentum-based market environment. This eventually led to dynamic prop strategies to essentially chase momentum, furthering the positive-feedback loop.

Like the portfolio insurance ubiquitously pervasive back in 1987, delta hedging is a form of dynamic portfolio hedging that inherently chases momentum. The risk of dynamic hedgers is statistical: fat tails lead to massive positive-feedback unwinds; and with increasing reflexivity, especially in equity cash markets relative to the listed and OTC derivatives markets they hedge, a sharp move up in a market environment like early March 2009′s leads to delta hedgers simultaneously causing and chasing rising markets in of the ultimate negative convexity phenomena.

Market-neutrals, as measured by the Highbridge Statistical Market Neutral Class A (HSKAX), have risen substantially in January, marking a possible end to the massive quant prop delta hedging that drove equity cash demand in 2009. If that is the case, and 1987 is an appropriate analogue, volatility is set to surge as assets decline in tandem with each other. Given the Treasury’s desperate funding mismatches, and the rush into USD and Tsys that occurs with asset declines (particularly after USD-funded carry trades across all risk asset classes driving demand), one could argue that the US government and Federal Reserve are incentivized for such an occurrence. Not to say they will cause or catalyze it, but “don’t fight the Fed” is a mantra I take quite seriously.

The VIX spent the majority of the second half of 2009 trading under 25. With such low volatility, demand for equity indices and single names from delta hedging clearly diminished into year-end, though many of the momo strategies essentially chasing market chasers (dynamic hedging dealers) probably continued buying.

We are now at a turning point where the USD is rallying, risk assets (including equities) are selling off, and vol is increasing. The potential for volatility expansion is quite large, given today’s liquidity landscape and the imminent unwind of the positive-feedback loop from delta-hedging short-bullish gamma books into a statistically significant rallying market.

Indeed, vanilla money has chased the delta hedging (out of necessity), as signified in the below graphs from Sentiment Trader. Crowded trades of this nature lead to explosive positive-feedback unwinds. Essentially the entire equity universe is caught in a momo trade chasing a demand driver that is now reversing. This should increase vol.

In addition, as Richard Whalen of Institutional Risk Analytics suggests in a recent article, the Fed’s acquisition of duration risk with its MBS purchases has suppressed market volatility by masking the negativity of OAS spreads net of Fed asset purchases. When the shoe drops, a rush to hedge may prove the VIX at current levels to be under-representative of current prevailing risk as well as undervalued.

The VXX ETF isn’t the best proxy for the VIX, but it is a nice trading vehicle, especially from a chartists point of view. Still in its declining channel, but a possible bull flag is developing. Most likely will be going long around $32.

Leveraged ETFs, particularly inverse ones, are highly risky and potentially dangerous trading vehicles not only because of the leverage employed, but because of the dynamics of the funds themselves. For example, the hedging flows of short ETFs are at times 2-3x greater than long ETFs because of differing incremental NAV changes between bull and bear ETFs (the same reason why shorting allows for a maximum return of 100%, whereas a long position’s maximum return is theoretically infinity). Timing is a necessary key for levered ETFs, particularly inverse ETFs, as time decay is increasingly prevalent and convexity issues, particularly from near-market close hedging demand, cause massive divergences between the ETFs and the underlying.

Nonetheless, our fourth trade idea is a long play on the epitome of leveraged trading vehicles– the 3x inverse financials ETF (ticker FAZ) from Direxion. It has experienced a massive 99.2% move from January 2008 highs to its recent low two years later in an unprecedented decline and imbalance from the underlying. However, we see a developing rally in the ETF that could offer some large profits to the upside.

American banks led global equity markets out of their troughs back in spring last year, as news of record earnings fueled a rally in valuations. The AIG CDS unwind counterparty payments at par value injected banks with billions of dollars that boosted their capital bases and earnings power with onetime gains, while the ultra-steep yield curve offered an easy carry trade for banks. Additionally, from the prop trading side, the USD carry trade provided huge revenues and the historically wide spreads in fixed-income issues offered unprecedented scalping potential. The Fed’s March 2009 announcement of the continuation of the MBS purchase program and issuance of the Treasury purchase program greatly helped banks, as well as markets, too.

However, spreads have tightened, QE liquidity has been deployed, and there are no more zero-haircut counterparty bailout payments to be funneled into bank balance sheets. Meanwhile, bank balance sheets have not delevered significantly, asset marks have continued to be significantly inflated relative to market values, and the double-dip catalysts on the asset book side (option-ARM/Alt-A, commercial real estate, eastern Europe) have began manifesting.

Banks have utilized the risk asset rally to issue massive amounts of debt and equity in attempts to recapitalize balance sheets, as well as pay back TARP funds in the case of the bailout beneficiaries. However, loan loss provisioning hasn’t substantively increased and capital buffers for future losses on asset books are weak at best. Charge-offs in commercial real estate and credit cards and nonperforming loans and loan-backed securitized assets continue to increase, but loss provisioning has not moved in lockstep. For example, Wells Fargo’s annual charge-off rate for its commercial real estate book increased over 5x YoY from Q4 2008, while its residential real estate book’s annual charge-off rate rose over 1.5x in the same period. Meanwhile, its loss buffers have gone nowhere fast, and Wells’ ratio of nonperforming assets + 90 days’ past due to loss provisions increased almost 140%, suffering an almost doubled Texas ratio.

Commercial real estate portfolios are going to witness large writedowns in the near future, as the crisis everyone had been warning about finally materializes. In December, Morgan Stanley relinquished five SanFran office buildings to lenders, while days ago Tishman Speyer and Blackrock Realty defaulted on a $4.4B loan that financed their $5.4B purchase of Stuyvesant Town/Peter Cooper Village in 2006, leading to imminent foreclosure.

Though subprime losses have been mostly written down, a new wave of defaults from Alt-A paper and hybrid- and option-ARM resets are quickly coming and not marked down. This spells trouble for bank balance sheets. Meanwhile, the Fed’s MBS purchase programs that drove down mortgage rates is ending and the Obama administration’s various mortgage modification programs have already run their course. Additionally, the ratio of 120+ past due mortgages that haven’t been foreclosed on has more than doubled YoY.

Already the writedowns are coming. Just days ago, Spanish bank BBVA announced a 94% decline in quarterly earnings YoY on writedowns. Contagion risk is particularly high in the financial sector and the resurgence of asset book writedowns depleting capital reserves should manifest in 2010.

Technically, FAZ broke out of its long falling wedge back on the 22nd and is currently bull flagging that move. A correction to about 18.75, near the support level of this bull flag, is our first target point of entry, with very tight stops. A breakout through $20.25 is the other buy trigger. The high convexity of this issue, combined with reversing markets and a rallying USD, should make this a potentially large trade, as well as more risky.