Thursday, June 21, 2007

US Equity Indices & Bonds

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Jason Roney

Yesterday was a very dynamic day in markets of course. Let’s first note where we are in the cycle for equities. It’s the week after expiration. SP does not trade with same underlying bid it had the week before because of the expiration. At same time, stocks are increasingly sensitive to interest rates (just look at BKX index versus fixed income).

Now we throw in the Bear Stearns fund fallout. The fund held more than 20bill of derivative investments mostly backed by subprime mortgages. as redemptions came in, the fund was forced to auction off assets from in an already illiquid market (sub-prime stuff). actually, the subprime index began to melt down very late Friday afternoon.

due to conflicts of interest between fund / house, Bear Stearns had to allow other firms to handle the liquidation. this produced the "bid wanted" lists from MER, DB, etc. buyers of these had to of course sell treasuries against.

Early part of week, stocks held in relatively well as the bear fund assets had not yet been auctioned off, treasuries were still near their pullback highs, and Asian equities remained well bid. Yesterday morning we opened above prior day high with potential for breakout. But once the other firms sent out the bid wanted list and began auctioning off the bear assets, two things happened: (1) treasuries sold off as a result of the necessary hedge and (2) market began to realize there was very little liquidity for the bear assets. Those two combined to create selling pressure in SP. Given the expiry up bias was removed stocks were highly vulnerable to a meaningful pullback. Once the outside day was in (yesterday’s move below Tuesday’s low), the hook was in. classic trend day from gap reversal.

To revisit things I mentioned in the chat a few weeks ago. There were several “tells”: (1) SP pit session had 4 consecutive days range less than prior day range (as of Monday close) – implying larger than expected move was imminent. (2) SP had shown clear relationship with fixed income over the prior week(s) and fixed was clearly the lead. (3) Because it was the week after expiration, any surprise move should have been to the downside.

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