Earnings are good, the economy is strong, employment is full, the P/E ratios are in-line… The stocks that looked good a week ago still look good and they are cheaper. What could possibly cause the market to go down? In a word – fear.
When traders are over-extended, they can’t take the heat when the market starts to fall. That is a classic shakeout. Most people think… well I’m in it for the long haul and I’ll just ride it out. That mentality works for the first 10% move. By the next 10%, they are nervous and they are out. A big decline with a “V” bottom becomes a mere blip on the radar screen of a 10-year chart. However, seasoned traders look at those blips and remember the blood that was spilled.
Such was the case in 1998. I had grown one of the largest option order desks in the country and I had thousands of option traders using our services. The economy was strong, the earnings were good, interest rates were in line and the internet was creating a buzz. Out of nowhere, we had a big rally to new highs and a sharp reversal. Sound familiar? Everyone looked at the fundamentals and took comfort knowing that everything was still intact. It seemed that a hedge fund had lost some money. Initially, everyone thought… so what, it’s one hedge fund. The stock I liked yesterday is the same today, except it is 5% cheaper. Two brilliant men created the hedge fund in question and it was called Long-Term Capital Management. They were both founders of the modern day Black-Scholes option-pricing model (Robert Merton and Myron Scholes). They had a very “conservative” arbitrage model and brokerage firms felt very comfortable letting them leverage the positions. In 1998 one of the wheels came off when Russia defaulted on their debt and the whole house of cards came crashing down. The ensuing sell off in 1998 was huge and the SPY fell 25% in two months.
Prior to the hedge fund collapse the market had been on a steady four-year climb. You could throw anything at it and it wouldn’t go down. Mind you, the SPY was still 25% below the 2000 high and it had a long way to go.
Fast forward to 2007.
The Yen-Carry trade borrows cheap money by selling low yield Japanese debt. It then uses the proceeds to buy other assets with higher yields. Last month, Japan raised interest rates. Consequently, the loan is still cheap, but getting more expensive. On the other side of the trade, the higher yielding assets that are denominated in other currencies started to take heat. As the trade unwinds, the first traders to hit the exit sell their higher yielding assets. With every trader that unwinds the trade, those assets get cheaper and the squeeze is on. This trade has been leveraged at a ratio of 15:1 and as the asset prices drop, liquidation is force to cover margins. Currently, there are more hedge funds than ever.
Did you realize that retail margin debits as a percentage of the account balances are at the levels seen in the year 2000? Your fellow trader is leveraged up to his eyeballs and I sense a shakeout. This is a time to be balanced and to keep a portfolio of longs and shorts. If you are over-exposed on the long side, reduce your risk exposure.
After the dust settled in 1998, there was a great buying opportunity and the SPY went from 95 to 140 in less than a year. The take away is that the market was a good buy in 1998 at 125. However, if you were an option trader, you blew through your capital and you never got a chance to participate.
Now let’s talk about us. This was a brutal week. We got into our new options trades on Tuesday and we were stopped out within a day or two. Our existing longs that were making progress also stopped out for losses. In the spirit of the report, this is not supposed to be an in and out service with continual adjustments. I felt that I needed to let the stops and targets work as they were designed to. My biggest error was not being persistent in having a hedged position on at all times. In the four months since inception I have always had at least 2 or 3 short positions on. During the rallies, one by one we were getting picked off and the hedges were costing us money. Even worse, once we were stopped out, we no longer had protection.
This was the largest drop since 9/11 and the Weekly Report did not suffer a big draw down. I hate giving back profits, but these events happen and they can’t be predicted. In the long run, it will set us up with some great trading opportunities on both sides of the market and the profits can come quickly. We are very liquid and we will be trading form a position of strength. Before the market gets better, it will get worse.In the next week or two, we are going to be looking for longer-term entry points. We are going to distance ourselves from the market and we will keep our powder relatively dry. As the market compresses and the lows are established and tested, I will start layering buy stop orders so that when the market rebounds, our orders will be executed on the way up. I still feel that the earnings are good, interest rates are relatively low, employment is robust and inflation is in check. This is also the third year of a Presidential term and that has historically been very bullish. If I had to pick support levels, I would say SPY 132.50 and then SPY 125. The missing piece of the puzzle is the leverage used by the hedge funds. We don’t know that answer, but the brokerage firms that clear their business do. Come to think of it, those same firms have proprietary trading operations. I’m sure there is a “China Wall” between those divisions and that information is never shared – not. They know the “panic levels” and someone will get hurt. We’ll let the charts be out guide.