Don't Look Now: Financials Leading The Rally

A: Oh what a difference a few days make! On Monday, with the Dow closing under 10,000 and what seemed like 6-7 weeks of constant selling, everyone I know in the hedge fund world and the credit world started to get a bit nervous! The VIX fear index rose to above 30, representing a great buying opportunity for those that are willing to take the risk and buy when most smaller investors are 'throwing in the towel'. I discussed the trading theory tied to the VIX seven days ago, as it reached the level where I normally would cover my shorts and start to get long beaten down equities. It is comforting to see the rally in the banks, as earnings estimates were taken down too low and stocks in big cap financials are seeing a short squeeze & value investors buying in on better than expected earnings reports. Will it last? Unlikely, unless housing turns around, defaults stop spreading to higher quality debt classes, and toxic assets get a bid and trade again at more favorable valuations; and I just don't see this happening.

Disclosure: This is a discussion, not investment advice! Readers of this site have learned that content I write sometimes has a trader feel to it; because that is what I am and that is how I view the markets. I am currently fully long equities and disclosed to you guys a week ago that I covered my shorts and started to get long about 2-3 weeks ago; building up the long position as stocks continued to fall. Turns out I covered shorts about 10 days early and should have waited for the VIX to hit 28 to start to flip the position.

Now that the disclosure is out of the way, I feel like I can openly talk about what I see going on here. I see another fierce bear market rally, as the financials lead the way. It is SO IMPORTANT that it be the banks and financials that lead the way in any rally; and it seems like they are doing so right now. However, and its a big however, I urge you to understand that this is a trading market right now, and in no way, shape or form has the dreary fundamentals changed in the past two days.

Why am I long? Because its a trade, thats why. I don't intend to hold these positions for that long, and my focus is still on the short side and when the next entry point for that play may be. The reason for this logic is that the forces that are taking control of the credit markets continue to be negative: housing is still under pressure, defaults are rising, foreclosures are rising, defaults are spreading to higher quality debt classes and fast, the jobs market is very weak, the securitization model on wall street is all but dead, more write downs of toxic assets as price discovery reveals most recent valuations, capital raising will continue and get harder at the same time, deleveraging continues, credit deflation, commodity inflation, etc..

None of this has changed, and we did get some confirmation of this in the past few days or so:

1. MERRILL is forced to sell core businesses to raise capital
2. MERRILL write down far exceeds estimates and gets a lowered credit rating
3. JP MORGAN CHASE admits that defaults in PRIME are rising fast
4. FANNIE & FREDDIE still in trouble and will have to raise capital; FREDDIE leaning towards stock sale
5. HOUSING STARTS continue to fall
6. HELOC credit lines are being cut off, as defaults are rising
7. BUILDER CONFIDENCE continues to decline

So, we really need to look at what is going on with an open mind; credit/housing deflation. We did get some good earnings reports from Wells, JP Morgan & Citibank; but this came on the verge of lowered estimates and beaten down stock prices. And the drop in the price of oil is helping too. But when I see the CEO of JP Morgan come out and say (via HousingWire.com),

"Our expectation is for the economic environment to continue to be weak – and to likely get weaker – and for the capital markets to remain under stress," CEO Dimon said in a press statement.

In a surprisingly short conference call with analysts, Dimon suggested that losses in JP Morgan’s prime mortgage book could triple in the foreseeable future as the credit mess moves out of subprime and into Alt-A and jumbo loans. "Prime looks terrible," he told analysts on the call. "And we’re sorry, and there’s nothing else we can say."

...I take notice. Take a look at this chart showing the rise of delinquency trends for JP Morgans Prime Mortgage portfolio, via HousingWire.com:

Nothing goes in a straight line forever, and this rally is likely nothing more then an oversold bounce in a bear market. I think it will surprise most how long this rally lasts, if the financials continue to squeeze the shorts and drive higher. But it does not change the overall macro picture and I urge you to be wary of the false hope that a significant stock rally may produce.

The monoline problem is behind us and it seems most of the residual write downs from that event have been taken. So we must look forward again and now it is all about one thing: the spread of defaults to higher quality debt classes!

I have discussed this at length plenty in the past 12 months, and I'm afraid the next 12 months will show just how deep the problem has spread to. The amount of leveraged loans and debt out there in the near prime & prime category far exceeds those in the subprime arena. So, we must question the value of securitized assets held on the books of the financials should the problems spread to these higher quality debt classes.

In the end, we need housing to show signs of stabilizing and defaults to stop spreading to higher quality debt classes before we can declare ourselves in the clear. Problem areas seem to be HELOC's, option ARMS, credit cards, cosi/cofi loans, other negative amortizing loans, auto loans, etc..

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