September 18, 2008
Author: Peter Stolcers, Founder of OneOption

On the trading floor, your word is your bond. Once your integrity is questioned, you’re finished. This week, financial institutions that have been trading with each other for decades have stopped - the trust is gone. Financial behemoths like Bear Stearns, Lehman and AIG have been carried off in body bags. Merrill Lynch wisely struck a deal with Bank of America as the noose was tightening. After posting decent numbers, Goldman Sachs and Morgan Stanley have been pounded. How can you trust the other side when you can't even reconcile your own books? The issue at hand is transparency. Financial institutions are laden with complex derivative products that can't be priced. Credit spreads in the inter-bank market have widened dramatically as firms stop trading with each other and they could freeze up. Central banks around the world are flooding the market with money in hopes of avoiding that. The smart money is sitting this out and capital is very tough to attract. Rumor has it that China is looking to take a 50% stake in Morgan Stanley. That might help to temporarily restore confidence. Mergers like the Bank of America/Merrill Lynch deal are also a possibility. Large deposits held by banks could ease leverage concerns and stop the massacre in the investment banking group. This is not a long-term solution. Banks themselves are in a tough spot. Unemployment is on the rise and so are mortgage defaults. One out of every ten homeowners has no equity in their property and many are "underwater". Two weak companies rarely evolve into a strong one. The economic data today was positive, but it has been ignored. Durable goods and GDP will be released next week, but in the grand scheme of things they are insignificant. Confidence in our financial system is of paramount importance. Emerging markets have not been spared. Hyper-growth spawns loose lending practices and those investments could also be in danger. One thing is certain, new capital will be hard to come by and growth in developing countries will slow dramatically. Russia was considered to have tremendous potential and this week it closed its market after an 11% plunge. That does little to instill confidence. Stocks represent a great value at this level, but value doesn't mean anything during a liquidity squeeze. Those who need to generate cash sell everything. In an unprecedented move, the Fed decided to accept equities as a form of collateral. Conceptually, it will keep financial institutions from dumping stocks. Unfortunately, it's not working. Financial institutions are selling stocks with the notion that they can buy them cheaper in the future. They also don’t want any “favors” from a Fed that has wiped out shareholder equity. Individuals are pulling money out of the market as well. The nightly news has focused on bank failures and dramatic declines in the market. As I search for sector rotation, I don't see any. All of the money that has come out of commodity/tech stocks has not rotated into other sectors. The VIX has spiked to 36 and many analysts are calling for a capitulation low. We have convincingly taken out the SPY 120 level and I believe we are beginning the next down leg. I have seen the VIX stay elevated for months while issues like this are resolved. There will be snap back rallies, but clearly the trend is down. The kitchen sink has been thrown at the financial crisis and I can't imagine a quick solution to a problem that has accumulated over decades. I am hearing analysts talk about Japan and how they solved their problem. When I started working on the trading floor in 1989, the Nikkei was at 40,000. Look at where it is 20 years later. Option expiration favors the bears. Sell programs and a reluctance to go home long over the weekend will push the market lower. We are also heading into the weakest seasonal pattern of the year. I have not been this bearish in 20 years. image

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