Risk Aversion Behavior

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Sally Limantour

The biggest news today is the 9% collapse in China’s share prices. The People’s Bank of China’s decision to raise the discount rate one more time in the day prior to the Lunar New Year is piercing the bubble in what is the largest sell off in more than a decade.
We are coming into the market with this spreading globally and the S&P down .93% and the NQ down 1.66%. The mini S&P just went through the support level I mentioned on my 12/23/07 update of 1440.00. We also had a very weak durable goods number this morning coupled with the Greenspan “R” word in our collective psyche’s, the sub prime worries and geopolitical concerns.

Earlier this month Mr. Cheng Siwei, the Vice Chairman of the National People’s Congress, said the speculative rise in share prices was a “bubble” and that investors need to be concerned about the risks in the stock market.

In the FT he said, “In a bull market people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing.That is their risk and their choice.” The question on everyone’s mind this morning is whether the liquidity spigot will turn to a slow drip as huge capital inflows from China has allowed excess capital to move globally propping up stock markets everywhere. Or… to we do what has been working for so long which is to buy the breaks.

This morning has the taste of fear and liquidation. My first good support in ESH7 comes in at 1229.50. As mentioned yesterday, after having my shortest term model on a sell for a week, it went back to long and many people emailed asking how to I use this model. I use it for day trading only- no overnight positions in this timeframe. If it is flashing a sell, I tend to be more aggressive on selling during the day. If it is in a buy mode, I will more actively pursue the long side on breaks which is what I did yesterday. All last week, starting on Friday Feb 16th, the sell signal was predominant so my strategy was to sell rallies until yesterday. Coming in today on this short term model I am flat and it has turned back to the sell mode.
This does not mean to come in and sell the ESH7 at the open, but to watch and see if there will be any good intraday opportunities to go short. Obviously as a day trader I may pursue the long side on a sharp spike down to that 1429.00 area, but will see how the day unfolds.

Given the current risk aversion playing out across global equity markets coupled with my medium term indicators warning of a high probability of risk aversion behavior this is not a time to be buying dips aggressively and holding in my opinion. We have had a one way market for most global equities since June/July 2006 and the cracks are starting to appear.
Long volatility positions in the stock indices mentioned weeks ago were established as a way to capture a potential wave of risk aversion for the next few months.

Going forward should this turn into a more meaningful sell off we have to assess how this will carry into other asset classes that have benefited from
this global infusion of capital, such as the commodity sector. The metals are taking a hit from this as is the dollar. Bonds, however are benefiting from this and exhibiting the flight to quality behavior as we approach key resistance levels in the June bonds of 112.20-113.00. Currently, I am holding off on short positions in bonds and tightening stops on most commodity long positions.

S&P and Commodity Prices

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Sally Limantour

The S&P had a small loss last week falling 0.25% with concerns over the sub prime lenders, rising inflation and geopolitical issues in the Middle East. Friday’s reading on the put to call ratio was its highest since September ’06 as investors put in place considerable downside protection against a much anticipated sell-off. My shortest term model covered shorts on Friday and is now on a short term buy signal. Perhaps we will see a near term short squeeze. Holding above the 1454 – 1456.00 (ESH mini- S&P) is supportive and recapturing the 1462 could ignite another round of fresh buying.

Today in what would be the largest private equity buy-out on record we have news that the board of TXU, the largest power producer in Texas met to approve a 45bn (IHT reports it is a $32bn deal while FT reports $45bn) takeover by Kohlberg Kravis Roberts and Texas Pacific Group. Part of the agreement is to sharply scale back TXU’s $10bn plan to build 11 new coal fired power plants that would produce noxious greenhouse gas emissions.
Everything is green – Al Gore, the Oscars and corporate America.

Commodities rose across the board lead by precious and base metals, crude oil and grains. Crude oil is now up 4.6% for the month with gold up 4.4%, corn up 6.6% and nickel up 12.3%. Even Jim Cramer is getting nervous about gold prices saying that higher prices could be “kryptonite to stocks if it goes to $710-$720.

It is a broad based rally in the commodity sector which is healthy, but it is stoking the inflationary fears. Treasury inflation-protected securities, or TIPS, have returned 1.15% so far this year, versus a loss of 0.3% last year. Investors are hedging their bets as inflation remains a “predominant concern” for the Fed. Higher commodity prices seep into everything – even beer! FT reports, “Blow for beer as biofuels clean out barley.” The demand for biofuel feedstocks such as corn, rapeseed and soybeans is encouraging farmers to plant these crops instead of grains, like barley. Heineken warned last week that the expansion of the biofuel sector was beginning to cause a “structural shift” in European and US agricultural markets.

While I have read a few articles claiming the commodity sector is running out of steam, I think it is beginning another leg up in its bull market. Billions of new people are entering the market and like all human beings, they want to move up the food chain, not down.

Market Timing

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Fari Hamzei

The pause that we talked about in our earlier reprots is in process now. To add positions, one should wait till the McClellan Oscillators are below the -100 area.

Then move in with select tech names.......we like the semiconductor sector here (QCOM, BRCM and MRVL having been mentioned here before, come to mind).

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Read more about why Market Timing matters in BusinessWeek, February 19 issue, pp 80-81: http://www.HamzeiAnalytics.com/docs/BW_TD.pdf

HOTS Weekly Options Commentary

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Peter Stolcers
February 23, 2007

The market was virtually unchanged last week. It is in a two-steps-forward/one-step-backwards mode. Over 90% of the S&P 500 companies have reported earnings and they have been positive. The earnings growth rate is just under 10% and the guidance has been good. The inflation numbers were released last week and the CPI came in a little “hotter” than expected. Humphrey-Hawkins and the FOMC meeting two weeks ago left interest rate sentiment “status-quo”. The market is flat and it lacks a catalyst. One could argue that we keep making new highs and the market is moving, however, the moves are relatively small and they lack follow through. The economic releases next week (Durable Goods, GDP) have recently produced minor reactions. From a technical perspective, you have to buy the dips and sell the rallies to make money. Next week, end-of-the-month buying should support prices. The easy money in this market has been made and the market will settle into its normal choppy mode until a material piece of news generates a breakout or a breakdown. We will continue to look for bullish opportunities since all of the major support levels are intact and the trend is still up. In this week’s chart you can see those support levels are converging at SPY 141.

Treasury Bonds & S&P

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Sally Limantour
February 23, 2007

Treasury markets have retreated with all of the inflationary talk and concerns off the CPI report coupled with the strong rally in many commodity markets this week has the bond bulls a bit spooked. It was interesting to hear Bill Gross of Pimco announce a change of heart in that he is reducing his bond holdings and raising cash. He has called for a weaker economy for quite a while and now is so disenchanted with US debt markets that he has raised his holdings of cash equivalent securities to the highest level in almost 2 years - up 26%, or now 43% of the 99.9 billion. Action: continue to sell rallies in the bond market

The S&P had a good range day yesterday but unable to hold the highs. For the majority of the week the smart thing has been to buy the breaks with the
market continuing to drift back to the “point of control” area of 1457.50-1458.00 (basis ESH- mini S&P). My shortest term model continues to flash a sell since last Friday, so selling the strong rallies here has been my strategy this week. Medium term model remains neutral but the risk adverse signal continues to build higher. It still appears the goldilocks theme is the background with money flows healthy and liquidity ample. Yesterday the Kansas City Federal Reserve Bank had a much stronger survey (+31) than expected reflecting strong new orders, employment and shipments. In addition, the IFO dialogue overnight suggests that growth in the Euro zone is not expected to end. The main threats going forward in the near term would be interest rate/inflation fears, geopolitical concerns (Iran jitters and another ship sent in yesterday) and anxiety towards the sub prime lending resurfacing after Lloyd’s TSB’s badly received figures. Rising oil prices too are on our radar.

Outside-the- range numbers for ES H7 are now 1475.75 on the upside and 1440.50 on the downside with today’s value area falling between
1461-1455.50

Proprietary Scanner: Two Short-Term Trades

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Fari Hamzei
February 21, 2007

Our Proprietary Scanner Report covering Sigma Channel Patterns, Dollar-Weighted Put/Call Ratios, and Market Cap-adjusted Volume Breakouts had six stock picks today for momentum players. We will discuss two of the LONG PLAYS here and tell you why. They are both traded on NYSE with liquid options.

This is why we like Cemex, S.A.B. de C.V.(CX):
1) All Time High in Price
2) Basic Materials Sector
3) Price action is still in its +1 to+2 Sigma Channel
4) Its $wP/C Ratio is 0.30 (the lower the better for stocks)
5) Daily Volume Breakout
6) Expanded Options Volume for the last two days both in contracts and premiums paid !!
7) Had another Outside Bar Reversal today
8) Our CI Indicator (Zero-lag Momentum/Trend) is positive for weekly, daily and hourly timeframes.
9) Intraday Volume Break out (IVBOs) -- those are the red bars in second subgraph.
10) Notice in the hourly chart we have not hit Weekly Resistance Level 2 or 3 yet (red lines). Use those price levels as exit targets while scaling out.

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We like Barrick Gold (ABX) because:

1) Precious Metals Sector
2) Price at +2 Sigma Channel
3) $wP/CRatio is 0.24 -- has closed less than that during the last five trading days !!
4) Daily Volume Breakout
5) Huge Options Volume Expansion this week
6) Our CI Indicator (Zero-lag Momentum/Trend) is positive for weekly, daily and hourly timeframes.
7) Intraday Volume Breakout (IVBOs) -- those are the red bars in second subgraph.
8) Notice in the hourly chart we have not hit Weekly Resistance Level 2 or 3 yet (red horizontal lines). Use those price levels as exit targets while scaling out.

Market Timing

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Fari Hamzei
February 21, 2007

Timer Chart tells us there is a good chance we would be taking another pause here (McClellan Oscillators and large cap index prices are diverging).

January FOMC Minutes just released half an hour ago are supportive for the market: economic expansion remains 'resilient', data suggest 'leveling out' in housing.

Stay LONG

Read more about why Market Timing matters in BusinessWeek, February 19 issue, pp 80-81: http://www.HamzeiAnalytics.com/docs/BW_TD.pdf

Margin Rules Might Make Development Stage Biotech Financials Matter

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David Miller
February 20, 2007

For development-stage biotechnology companies, quarter-to-quarter revenues don’t matter much because these firms – by definition – don’t have significant revenues. What revenues they do have tend to be expense reimbursements from partners or amortized partnership dollars (up-front cash and milestone payments).

This makes financial analysis of these companies a relatively easy bottom line affair – you largely ignore everything but the net cash burn.

That could change for customers of TD Ameritrade (AMTD). Some time before the end of February for “original” Ameritrade customers and at an unknown date between February and June for “original” TD Waterhouse customers, the firm is changing its margin maintenance rules on biotechnology stocks. Generally, maintenance requirements will increase for those who hold development-stage biotech companies. Those who have concentrated portfolios will be the most affected.

Thanks go out to a correspondent, who wishes to remain unnamed, for alerting me to this potential change and sharing his conversations with the Ameritrade people. I made a few calls and came up with the following information.

TD Ameritrade has had significant trouble with collecting on margin calls from investors who were overly concentrated in one biotechnology stock. Not everyone has the “benefit” of my constant harangue on diversification, so there are people out there who have sunk everything into one stock only to see it detonate. Telik’s (TELK) recent 70% overnight decline is probably one of the better recent examples of this sad phenomenon.

TD Ameritrade is addressing this by changing the maintenance requirements for holders of biotechnology stocks in margin accounts. This is more than a little complicated, but I’m going to lay this out in a series of tables. If you are a TD Ameritrade customer with a margin account, I can’t urge you enough to call them and get specific guidance about your account.

It is probably best to start with the current rules:

In addition to these requirements, TD Ameritrade has placed more stringent maintenance requirements on a few hundred individual stocks. The company is changing their web site to make the list of these stocks easier to find. Currently, select the “Trade” tab on the new interface and start looking for a link named “Special Margin Requirements.” Some users will find this at the top. I found it in the small print at the bottom of the page.

The first change applicable to biotechnology investors has to do with different concentration requirements. Concentration refers to what percentage a particular stock makes up of your entire portfolio. As you can see above, normal concentration requirements kick in at 70%. For biotechnology stocks, there are now three tiers with the first one beginning at 50% instead:

This is relatively straightforward thus far. The more concentrated your portfolio, the higher your maintenance requirements will become.

The complicated part is how TD Ameritrade is going to determine the margin requirements on individual biotech stocks. They’ve decided to use a price/sales ratio, the market cap of the company divided by trailing twelve-month sales. If you don’t want to do the calculation in your head, both the TD Ameritrade site and Yahoo! Finance list the price/sales ratio.

I think this is a particularly odd choice, likely made by people with limited understanding of the sector. It creates the odd situation where, for a given revenue level, low-priced stocks – arguably those the market has voted to be the most risky – have lower margin requirements than high-priced stocks the market has voted to be less risky. It’s backwards, really. Additionally, it doesn’t even make sense from TD Ameritrade’s standpoint. A 50% loss on a $5 stock is the same as a 50% loss on a $25 stock, the only difference is the number of shares involved.

I’ve written at some length how traditional valuation metrics simply don’t apply to the biotech space. This is a perfect example of that.

Nevertheless, them’s the rules. Here is how the maintenance requirements break down according to the concentration tiers noted above and the price/sales ratios:

For people with undiversified biotechnology portfolios, the change from the current maintenance rates can be as much as 30 percentage points.

I’ve pulled a few examples from our own coverage universe to highlight how reliance on price/sales ratios create some unexpected results.

Would an objective observer determine YM Biosciences (YMI) is a lower risk than ZymoGenetics (ZGEN)? Or that Targeted Genetics (TGEN) is less risky from a “could go to zero” standpoint than Repros (RPRX)?

Of course not. TD Ameritrade has chosen a blunt quantitative instrument instead of working on a qualitative analysis of the situation in the sector.

If you are a TD Ameritrade margin customer with significant biotech holdings, call the company and ask to speak with the margin department. Have them run the numbers on your account to tell you what your maintenance call will be under the new rules. This is especially important if you are over 50% concentrated in any one stock.

I’m interested to see if other brokerages will follow suit.

Disclosure: Positions in YMI, RPRX, TGEN

Interest Rates

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Sally Limantour
February 20, 2007

We had a long weekend to digest Mr. Bernanke’s statements and his views on unemployment and inflation were telling. The Fed’s forecast for unemployment for the next two years is for the rate to remain between 4.5-4.75 per cent –right where it is. My interpretation is that he feels the economy is in a sweet spot and employment is good enough to keep the politicians at bay while foreign wage competition is dampening inflation potential of strong employment.

While Bernanke spoke of the downside risks of housing, he also said, “To the upside output may expand more quickly than expected.” This translates to mean that there is a chance for a stronger economy. Had he left this statement out, Treasury Bond Futures (US H7) may have closed the week closer to or above the 11200 level.

We have a slew of Fed speeches this week (this could restore rate hike fears) and CPI due out on Tuesday. While the Fed will focus on the core PCE Index, it is interesting to look at expected CPI as a general guide. The difference between the yield on a 10-year Treasury Note and the yield on an Inflation-Protected 10 year Treasury Note is basically the bond market’s forecast of the US CPI’s future rate of change. According to Ray Hanson, of the Speculative Investor, over the last 3.5 years expected CPI has been in a range of 2.25%-2.70%. “In other words, over the past 3.5 years there has been neither a deflation nor an inflation scare” hence, the Goldilocks economy and the strong stock market. Were we to break out of this range on the upside, rates would tighten and the stock market would suffer. On the downside deflationary concerns would spark interest rates to fall and commodity markets would be spooked. This brings me to the central banks and the current problems they face today in assessing “stability.”

Historically, central banks attempt to achieve stability by looking at changes in interest rates against measures of the amount of spare capacity within an economy. If interest rates can be moved to set demand at a level consistent with “supply potential”, then central banks will achieve stability.

Another more familiar approach is for central banks to monitor money supply growth in order to gauge inflation. These two models have worked well in the past but with globalization the central banks seem to be having a more difficult time measuring inflation and determining stability. In The Independent, 02/20/07, Stephen King wrote about the problems central banks are having with measuring the economy using an old paradigm in a world of increasing globalization.

The first approach has inherent problems in that countries dealing with large scale immigration are trying to figure out the size of supply potential. “The Bank of England, for example, has to fret about the scale of labour immigration. It knows the scale of recent immigration has been big, but beyond that, information is sketchy.”

The second problem is with measuring money supply. At the touch of a button and with the speed of light capital is flowing across borders while bank deposits are switching from one jurisdiction to the other making it difficult to know the “real” level of money supply. Perhaps this is one reason why the Fed stopped reporting M3? It may also explain why it has been difficult for traders to get a handle on interest rates – remember how bullish the market was towards a decrease in interest rates only to see them move higher? Market expectations have changed often over the last 12 months and the transparency the central banks are offering may in fact, be “revealing the uncertainties” they are confronting.

Readers in the Hamzei Analytics' Virtual Trading Room know I have been a seller of Treasury Bond Futures since Nov-Dec 2006– selling rallies and buying back on dips. After trading down to the low 110 area I have been flat looking to sell 11200 – 11208. In the big picture I believe we are in an upward multi-year trend in interest rates which will take years to develop.

Keep a heads up this week with regard to Fed speakers, Govenors Kohn, Bies, and regional Presidents Yellen and Fisher. Tuesday’s CPI number and the BOJ rate decision are also potential market movers. In addition, stay alert to more talk of a potential credit crunch precipitated by the housing downturn and rising default rates.

PBS Interview -- Master Traders

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Fari Hamzei
February 20, 2007

We are thankful to AJ Monte and Rick Swope, co-hosts of Wealth & Wisdom with The Market Guys , who arranged for us to receive the master DVD of this interview recently. Last Fall, James DiGeorgia of Gold & Energy Advisor sponsored the W&W series. The interview was originally aired on October 20, 2006.

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