Inflation Update

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Sally Limantour

The Chinese rate hike over the weekend initially scared traders as last night the market opened lower. Initially, the dollar fell and the metals came in unchanged to a bit higher.

The Shanghai index proceeded to gain 3% which defied the typical stock market reaction to a rate hike. Are we out of the woods? Are the sub prime woes behind us? Two things that disturb me are that unlike the sell off in May/June ‘06 the break from the recent highs has been lead by the financials. One has only to look at the chart of the bank index to see the weakness.

The other issue is inflation. With US core CPI now at 2.7% y/y (well over the Fed’s 2% cap) it is hard to imagine the Fed cutting rates. I think this is what is meant when people say the Fed is between a rock and a hard place. There still seems to be a predominant belief that the Greenspan put will be adopted by Bernanke and the Fed will, once again, save the day. I think we have to look at the reality of inflation and realize the importance of food prices in particular.

Food prices are reaching high levels, particularly the category of ‘food away from home’, such as restaurants, take away food and so on. This component alone has reached its highest annual rate since April 1991. In addition food at home prices are also picking up. After reaching a low of 0.8% in May 2006 prices have now accelerated to almost 3% annual inflation. Corn prices alone have doubled and this has caused problems ranging from run away tortilla prices in Mexico to beer producers raising their prices. No longer are producers able to contain prices and have to now pass it onto the consumer.

Another aspect of the inflation picture is that whereas last years sub component prices were dominated by oil prices we now see a broader participation by other areas. Shelter remains at elevated levels, medical care inflation is back at its higher levels and apparel inflation is unusually inflationary at the current time.

In addition money supply growth is accelerating and the high level of asset prices around the world is now a problem for central bankers. Going forward
it appears we will be finding out where liquidity begins and leverage ends.

Tomorrow the FOMC begins a two day meeting and housing starts will be reported. Last January’s housing starts fell more than 14% due to the bad weather, so all eyes will be on February’s number. For today, next resistance is 1415 with strong R at 1418.75. Breaking the 1399-1401 level will clearly put the market on the defensive while rallies that hold above 1415 area should attract buying.

Equity Index Update

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Brad Sullivan

The index market continues to mirror its recent behavior of Yen/Dollar watching and is called to open higher by nearly 0.5% this morning in the SPM contract at 1406.50. The Yen/Dollar has fallen by about -0.7% relieving fears of the carry trade unwind – at least for the time being. This week is highlighted by the FOMC 2-day meeting that begins tomorrow and concludes with Wednesday afternoon’s statement. Typically, the indices have rallied into and through these meetings over the past several instances…however, with a peculiar batch of economic data it appears difficult for the market to get a clean gauge on Dr. Bernanke’s next play.

On the Monday merger mania front…Barclays Bank and ABN Amro are in discussions to merge and become a $160 billion behemoth. Even the once “given up for dead” Service Master was able to find a buyer in Private Equity Land for nearly $5 billion. If one adds the Blackstone IPO to this picture, it is hard to be overtly bearish looking down the road. I certainly do not want that statement to be misconstrued as the Sub-Prime blowout may have ramifications that we do not see on the horizon…however, I always try and construct my ideas around the money…Follow the money, is a message I try and repeat to myself when I think the markets are at a crossroads. Simply put, the liquidity driven marketplace remains intact and that is being seen in the appetite for deals. Let’s not forget that somehow LEND was able to find a buyer for some of its debt leading to rally in the entire Sub-prime sector. In my opinion, the short term picture remains shaky, but, it is worth reminding ourselves how resilient this equity market has been during this bull move. The fact remains that this is a liquidity driven bull market. Fears are rampant about the Carry trade being unwound and if something triggers a mass covering it would be awfully ugly for the indices. However, if the unwinding is gentle one has to wonder if the worst of this move is behind us.

As for short term trading, the best indicators for market direction remain GS, GOOG and the YEN/Dollar. Odds appear to favor a short term bracketing in the trade as we move from one end to the other in a range around 1.5% in the SPX.

HOTS Weekly Options Commentary

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Peter Stolcers

Last week I did not see the activity on Tuesday's sell off or on Wednesday's rally back to tell me that the lows are in. A "V" bottom will be formed when there is fear and volume on the way down and confidence and volume on the way up. The bears want each market rally to find resistance a little sooner than the time before. Eventually, the market will drift lower and test support. When it fails to bounce after a decline and we get 2-3 consecutive days of selling, fear will set in. We have not seen that yet and bullish speculators have not been scared out - yet. The bid to the market continues to surprise me. Thursday we saw the market rally after a "hot" PPI number. Friday morning we woke up to global market weakness and it looked like we might open lower. The CPI came in "hot" and it exceeded estimates by .1%. Then, consumer confidence fell to its lowest level in 2 years. The market dismissed both economic indicators and staged an early quad-witch rally.

During the week, Norway and Switzerland were added to the list of countries that have recently raised interest rates. If our interest rates remain unchanged (as opposed to going higher), this puts downward pressure on the dollar. Recently, the market has been declining when the dollar falls.

Single digit earnings growth is expected this quarter and the market lacks a catalyst to drive stock prices higher. I feel that the price action is getting heavy and that the market has shouldered all of the bad news it can take. If you look at the chart you can see the SPY 141 resistance level. The longer the market stays below that level, the more significant that resistance becomes. Also note the blue dotted lines in the chart. You can see that the market made a lower low on the second wave of selling and the bounce was weaker. Sellers were more aggressive this time around and they started hitting bids before the market could make another assault on SPY 141. The message is pretty clear to me.

The housing market is weak and with inflation on the rise, the Fed will not be in a position to help out by lowering rates. The slump will have to cycle through the economy on its own. If you're wondering how important housing is to the economy, here is an interesting statistic. From 2001 - 2006, 50% of US job growth came from this industry. That includes lending, sales and construction. Sub-prime may be a small part of the total picture, but there is a ripple affect. There are many more marginal homeowners with adjustable rate mortgages that will convert from a low 3-year fixed rate to an ARM in the next year. This is certain to affect consumption. The economic releases are very light next week and they are highlighted by more housing data.

Equity Index Update

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Brad Sullivan

BEWARE THE IDES OF MARCH…so warned Mr. Shakespeare long, long ago. Maybe he should have written beware selling new lows for the move in the index markets the day before the ides of March. The tide turned awfully fast across the board for those trading indices yesterday in the late morning. After undercutting the previous lows made from our downdraft in the last two weeks buyers came rushing in and fresh shorts were forced to pay up in order to cover. When the dust settled it was a fabulous show of strength from the Hedgies ahead of this critical expiration…and to that end I say touché.

This morning the index markets, which had been trading higher earlier, are called to open lower on the heels of our PPI reading this morning. The reading came in at +1.3 on the headline and +0.4 on the core…well above expectations on both counts. However, this reading is notoriously volatile and fickle – my assumption is that the markets will wait until we get tomorrow’s CPI before making any rush to judgment about inflation. Accordingly, I would take this open with a grain of salt and assume that the path of least resistance will be towards the upside.

March Madness begins today, I would anticipate a lightening of the volume by mid-morning ahead of this annual gambling extravaganza. Beware…

Wednesday of Options X -- The Low we put in Today, was that the Bottom you were looking for?

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Fari Hamzei

Not exactly !!

I was asked that question a number of times earlier today, both by professional and institutional traders.

IMHO, the market is following the Script we put out two Sundays ago on this blog (see http://hamzeianalytics.blogspot.com/2007/03/market-timing.html).

Our Script calls for a volalitity retest in the +4 to +5 sigma region. That should translate to a test of our last May 2006 high (~1326 on SPX), now acting as a critical Support. If that support level does not hold, the next logical stop is 1280 on SPX (July 2006 highs).

Here are two Volatility Indices that we follow very closely. (I am in the Prof. Robert Whaely's camp (the orginal VIX inventor), now called VXO -- and yes, I don't like the new VIX, as it has to do with its construct).


During this vol retest, we should see the VXO between the high 20s to low 30s, and

We should see VXN in the mid 30s before the dust settles. As far as its timing, with this week's quad-witching March Expiry as a backdrop, market should sell thru Friday and Monday ahead of Tuesday which happens to be Vernal Equinox (First Day of the Spring or "Norouz" in Persian).

Equity Index Update

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Brad Sullivan

Was it the other shoe…or did we just untie it? That is the question, and the only question that really matters facing the domestic and global index markets over the next several weeks. Yesterday’s severe decline was the 2nd such implosion over the last 11 sessions and laid to rest the silly notion that the massive selling from two weeks ago was due to a computer glitch revolving around the DJIA pricing. Given the complete lack of volume on any of the higher sessions during this bounce phase, yesterday’s action does not come as a total surprise. Sooner or later something would trigger another round of selling and the fact that it happened during expiration only exaggerates the move. More importantly, this downdraft may continue to spiral lower due to the expiration of options and futures this week. I have continued to point out that the favorite fund game on the board over the last 3 trading years has been to sell naked puts…when the jig is up on expiration week the moves, potentially speaking, can become quite severe. Yesterday morning I commented that this market had about 5% of downside risk by Friday. After yesterday, we are only 3% away. While I felt the odds of such a trade were remote, they have increased dramatically after yesterday’s action and those that are speculatively short --- particularly those that have watched out of the money puts become in the money --- are faced with the decision as to take in some of the position, all of the position or none of the position. Personally I took in enough yesterday to give me a free roll + profits no matter what plays out from here.

Subprime...I am wondering if it will become a verb in the next few years, like “Homer” in the classic Simpson’s episode where Homer’s constant idiocy becomes a cult classic of “ oop’s I did a Homer” when making a mistake. Only time will tell. But, there is no question that this fiasco lit the fuse yesterday. Accredited Home Lenders (LEND) got the ball rolling saying it was in financial trouble and in need of waivers on outstanding debt. New Century (NEW) was delisted from the NYSE and closed at .85 on the pink sheets. Bear Stearns is the supposed target of subpoena’s on bullish research in this zone. Essentially, we are watching a implosion of a financial product that created affordable homes and thousands of jobs – Savings and Loan scandal anyone? This will end when there is no longer a purely subprime lender left in the building, and at the rate of descent, that may happen sooner than one can imagine. The only question that matters within this arena is will this meltdown trickle through the broader economy? If it does, as many of the bears are forecasting, the result will be recessionary in nature. After a choppy overnight session, the indices have caught a bid from their respective lows and are called to open around UNCH. The Yen/Dollar is trading around UNCH as well after having been well bid earlier in the evening session. Keep a close eye on all product classes today as yesterday’s equity market action drove prices lower in grains, gold, crude and higher in treasuries. Funds are forced to push out positions in one market as their other positions lose value…sell beans, sell SPM7 for example. I don’t expect that to change anytime soon.

Equity Index Update

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Brad Sullivan

The index markets are called to open at or near their respective low trading zones over the past 3 trading sessions. A combination of the sub-prime lending blowup, a weak retail sales report and – most importantly – whispers of INFLATION out of the BOJ last night has produced another big leg of unwinding in the YEN carry trade. On the flip side, GS produced blow out numbers on its quarterly earnings report released this morning…keep a close eye on this stock as it has been our proxy over the last several months.

One of the concerns behind yesterday’s small move higher was the complete lack of volume. It seemed as though it was a holiday trade yesterday as players were on the sidelines…this morning it appears players have awoken from their collective slumber and appear ready to monitor their collective portfolio risk. One key aspect of the trade that few have discussed is the expiration week that we are currently 1/5th of the way through.

Since our massive selling 2 weeks ago today, the indices have been able to hold at higher, but rather uninspired levels. There is little question that this move has been propped by large demand amongst the funds as they try and protect their favorite trade of selling options. If there were to be an unwinding this week of the YEN/DOLLAR it would have dramatic ramifications on the index market. Players are holding their breadth that this does not turn out to be the case, but, if they must let their positioning go due to the risk department LOOK OUT. Certainly the odds of such an event are outlier by definition. However, when looking at such events in a historical context there is always a trigger. The index markets are faced with a POTENTIAL trigger of a YEN carry unwinding that forces index positions out of portfolios creating a vacuum of selling. If this scenario plays out – I would suspect the SPX would fall roughly -4% by Friday’s close from current levels. Keep in mind that the probability of such a happening is small – perhaps as little as 5% to 10% so any plays on this theory should be done with ample speculative cash.

Finally, keep a close eye on GS…a reversal below 200 would put the overall market in jeopardy.

HOTS Weekly Options Commentary

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Peter Stolcers

The character of the market has changed in the last two weeks. From September through most of February, we experienced a nice, tight upward trending channel. Option premiums dropped to historically low levels and the public borrowed on margin to buy into the global growth story. Along the way, we heard the words “soft landing” over and over again.

Out of nowhere, we hit an “air pocket” and the bid to the market was gone. After establishing a low Monday, the market rallied the rest of the week and formed a “V” bottom. The initial drop tells me that there was a legitimate concern with the Yen-Carry trade. Most of the large brokerage firms that clear hedge fund trades also engage in proprietary trading and they know the risk exposure. On the retail side of the equation, the public was reassured to stay the course. Paper losses were mitigated last week and now retail traders are hoping for another rally to make them whole. I believe a warning shot has been fired and the market will retest the lows from Monday.

The “air pocket” I spoke of is caused by fear and it suggests that liquidity is drying up. A few weeks ago, China raised its reserve requirements. Two weeks ago, Japan raised interest rates and last week the ECB raised interest rates. Domestically, lenders are tightening credit policies after seeing the defaults in the sub-prime sector.

I see two problems. First, traders are over-leveraged. The run-up in emerging markets, the Yen-Carry trade, the premiums being paid in private equity deals and the debit margin carried by retail traders are examples of excess speculation. Secondly, the market lacks a catalyst. Earnings guidance indicates a single-digit growth rate for next quarter and the Fed is not going to ease. A few weeks ago, the path of least resistance was up and that was all the market needed to move higher.

There are three events that will drive the market this week: quadruple witching, earnings from Goldman Sachs, and the CPI/PPI. SPY 141 is a critical level because a number of technical indicators are converging on that point. Some traders will view it as a pivot point to switch from short to long. Last week’s bounce represented a Fibonacci retracement. The rally brought the SPY right to its 100-day moving average and to a horizontal support/resistance level. A close above SPY 141will put me into the “neutral camp” and a pullback will confirm my short-term bearish bias. At this juncture, we have to take our lead from the price action. In very short order, the market will tell us how to position ourselves.

Equity Index Update

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Brad Sullivan

The index markets gapped open strongly for the second session this week on the heels of a large scale reversal in the Yen vs. all its major counterparts. The reason behind the latest Yen move seems to be the rate hike in New Zealand to 7.25% will allow some of the favored carry countries to continue participating in the infamous lever trade. In response to this move in the Yen, the index markets rallied sharply overnight and continued their gains throughout much of a rather quiet session ahead of today’s February Employment Report released by BLS.

The report this morning came in right around consensus expectations on all levels…and that produced a sharp pre-opening bid in the marketplace. Currently the SPM7 contract is trading at 1424.50, which would equate to roughly 1410 in SP500 Cash index. Using the cash market, 1410 to 1415 should provide significant resistance in today’s session.


The real key behind today’s action will be whether or not the indices can hold their opening rounds of buying. Typically on Employment sessions, the move is fast and violent in the first hour, followed by a counter chop oriented trade. I suspect that will play out today, with one exception and that will be the final hour of trading. I expect to see selling across the index complex during that time frame…remember – since last Tuesday’s debacle, the final hour produced only 1 higher close. And that was a total of 0.30 points in the SPX market.

However we settle out today’s session, next week should provide fireworks as we enter the week of “witching.” There are lots of nervous positions on the books of hedge funds right now…and the fact that these bounces have occurred during overnight hours shows how much “supporting of positions” there continues to be in the marketplace. Next week should provide all the answers needed…if there is a forced liquidation trade during expiration week it will be very ugly. Keep in mind that last year we witnessed consecutive massive legs lower in May and June during their expiration weeks.

The Mysteries of Up & Down Volume

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Jason Goepfert

Over the past week, we’ve seen a laundry list of extremes across a variety of shorter-term sentiment- and breadth-related indicators.

One of the more remarkable is that of the relationship between “up” volume and “down” volume on the NYSE. Up volume is simply the number of shares traded in stocks that closed higher than the previous close, and vice-versa for down volume.

Last Tuesday, that ratio was skewed 100-to-1 in favor of the downside, the worst since the crash of 1987. A week later, however, buyers returned in force and the skew was 15-to-1 in favor of upside volume. Historically, it’s rare to see two such opposite extremes within a week of each other, and it might be instructive to take a look at them.

Each of the four instances in the past 50 years was consistent in their pattern:

1. At least a 15-to-1 skew of down volume to up volume.
2. At least a 15-to-1 skew of up volume to down volume less than one week later.
3. A retest of the recent low within 30 days.
4. A rally off a successful test of that low.

The four charts below highlight each of the occurrences, and it provides a general outline of what we may see this time around if the pattern holds somewhat true. This time we’re seeing the volume reversal soon after a market high, whereas the others occurred after a major downtrend, so that’s one caveat here. And if the recent low breaks, it will invalidate this pattern and I would not be looking for higher prices based on this extreme volume reversal any longer.


October 23, 1957:

June 30, 1965:

May 27, 1970:

October 21, 1987: