Equities Edition
Week of July 6-10, 2009

CAPITAL MARKETS COMMENT | EQUITY FEATURE TRADE 1: Goldman vs. The Market | EQUITY FEATURE TRADE 2: Canadian Natural Resources | PREVIOUS TRADE RECAP/UPDATE | SUBSCRIBE via RSS | DISCLAIMER

CAPITAL MARKETS COMMENT

Last week we urged readers of the BHBGroupTrader Market Spread Report not to laugh – that I was temporarily shelving my bearish bias on the equity markets in favor of a one-week holiday-shortened pop. Turns out it appears the joke was on us.

Not only did the market not “pop” as I had suggested, it actually sold off more last week than during any other independence-holiday-shortened-week EVER. Serves me right for presenting a bullish case (even if only for one week) during what will turn out to be the greatest bear market in history. As the world’s greatest trader Jesse Livermore once wrote, “in a bull market stocks go up; in a bear market they go down. That is all anybody needs to know.” How beautifully simple. Lesson learned.

What caused the sudden and precipitous drop? The economic data, once again, was horrendous: the unexpected drop in last Tuesday’s Conference Board Consumer Confidence report provided the preamble; Thursday’s non-farm payroll number showing the US economy lost some 130,000 more jobs than expected proved to be more than any green-shoot theorist bulls (or more importantly for purposes of the ensuing discussion, supplemental liquidity-providing proprietary program traders) could handle.

Supplemental liquidity-providing proprietary program traders? Now that’s a mouthful. If you are aware of exactly what these proprietary trading programs do, then simply put, you are ahead of the game. But for those of you in the majority, who have little idea, allow us to enlighten you.

In response to the Market Crash in the Fall of 2008 (and the specter of reduced trading volume that typically accompanies market tumult), the NYSE launched a new program with Goldman Sachs called Supplemental Liquidity Providers to attract liquidity to the exchange. As an SLP, a financial firm employs a trading desk which essentially functions to make markets in NYSE stocks. These divisions often engage high-frequency computerized trading (which is simply auto-quote market making) where they send out hundreds of “baskets” of stocks at one time (program trading, as defined by the NYSE, is any strategy that sends out a “basket” of 15+stocks at one time). According to data published on a daily basis by the NYSE, proprietary program daily trading volumes over the past few weeks have represented more than half of the entire trading volume on the exchange. Indeed, since the launch of the SLP Program in October, the market-making activities of trading desks have become major profit centers for major broker-dealers participating in the program (of which Goldman Sach is by far the largest). A report released Friday in the Wall St. Journal suggested Goldman Sachs is on track to pay out over $20 billion in employee bonuses this year, or about $700,000 per employee, largely on the back of the mind-blowing profits it has made through its program-trading division. One kink in the armour for Goldman Sachs (and one which may shed additional light on the last week’s market tumble): last week Goldman Sachs asked the NYSE to suspend the reporting of its proprietary program trading, as Goldman went from being the perennial first-overall in the NYSE trading volume report to a no-show. That’s right. No proprietary trading whatsoever. Apparently, as a Reuters report suggested Sunday night, a former Goldman Sachs employee was arrested by the FBI this weekend, charged with having copied the proprietary trading software – software which Goldman itself described as one that gives it substantial competitive advantage over the rest of the street – and making it available to its competitors. If the Reuters report is indeed true, this represents a very negative development for financial system liquidity, and for Goldman Sachs share price in particular.

In February 2009, as the market was busy making its descent, we happened across the work of one Irving Fisher, economic scholar of the Great Depression. We urged all our clients to read Fisher and made a link to his primary text available, as we believed (and still do today) that Fisher’s treatise Debt Deflation Theory of Great Depressions, although written in the 1930s, provides investors with the best roadmap for navigating the capital markets for the next year or so. In the treatise, Fisher describes ten stages of the debt-deflation cycle. To recap, these stages are: 1) mild gloom and reduction in confidence; 2) widening of credit spreads; 3) distressed selling and associated fall in securities and commodity prices; 4) rise in real interest rates (fall in inflation); 5) contraction of deposit currency; 6) reduction in net worth, increasing bankruptcies; 7) reduction in volume of stock trading; reduction in industrial production, trade, industrial capacity; 9) hoarding and dollar enlargement; and 10) bank failures.

In February, we had been able to identify passing through stages 1 through 6 of Fisher’s treatise, and were alerting clients to pay attention to daily stock market volumes for a signal that we were moving into the next phase. But as the months passed and the market rallied, and while there was considerable evidence of reduced industrial production, trade, and industrial capacity (stage 8), hoarding of dollars, particularly by Euro-bloc banks (stage 9), and bank failures (seven banks failed last week bringing the 2009 total in the US to 52) (stage 10) there seemingly was no reduction in trading volume. While admittedly this had us puzzled and questioning the validity of Fisher’s thesis, it has now become clear to us that the reason why we never witnessed a reduction in trading volume was because of the relatively recent inauguration of the NYSE SLP program.

Does the fact that we have now experienced each of the ten stages identified by Fisher mean that it is now time to buy stocks? Fisher would respond with an unequivocal “No.” For Fisher, the stages themselves do not represent milestones on a linear-progression timeline, but rather they are stages within a spiraling cycle that begins anew once the last stage has reached completion. According to Fisher, the only way that society can break free from the debt-deflationary cycle he describes is by resolving the very debt loads that caused the cycle to begin in the first place – by either defaulting on the debt, or by paying it off. The latter takes a considerable amount of time – years at the least.

But neither defaulting, nor servicing the debt seems to be a priority for the Obama Administration. Instead they continue to choose the opposite course of action: to increase the debt burden. As equity analyst Robert McHugh writes in his weekend letter, “The problem is, there have been trillions of dollars printed and spent since last autumn, but none of it to speak of has landed in the hands of consumers, no major income tax rebates, no new meaningful jobs from infrastructure projects, no repeal of property taxes, no health insurance reform such as allowing a cheap “catastrophic only” insurance protection option to families for $200 a month. Has anyone seen anything tangible result from Central Planner intervention? Bridges getting rebuilt? New highways? New supertracks for high speed trains? Energy technology? New parks? Jobs programs? It has all gone to large corporations, to government purchases of corporations. This foolishness virtually assures that a catastrophic economic collapse is coming.”

Indeed the debt-deflation cycle identified by Fisher some 70 years ago has begun anew since the early-June high. We already have seen evidence (last week alone) of waning consumer confidence, and have already seen the widening of credit spreads (manifested by widening credit default swap spreads). From a technical standpoint, broad equity markets have near-term support at current levels. A break of the support would suggest much lower equity prices going forward. Commodity markets – oil in particular — has already broken price support. It could be the sign that more asset deflation is just around the corner.
Is your portfolio ready?

FEATURE EQUITY TRADE 1: GOLDMAN vs. THE MARKET

Long: S&P 500 Index (SPY)
Short: Goldman Sachs (GS)

While it is unclear at this point in time how exactly the industrial espionage perpetrated by Sergey Aleynikov (the former Goldman employee who was arrested by the FBI on Sunday for stealing Goldman’s “secret sauce” for its automated stock and commodity trading program) will affect the profitability of Goldman Sachs, we believe that time will show it to be substantial. As such, I am opening a long-term short position in Goldman Sachs versus the broad market.

To say that the competitive environment on Wall Street is cutthroat is an understatement. When Long Term Capital Management collapsed in 1998, its management team resisted revealing its open positions for fear that other Wall St. firms would see those positions and would cause a run on the hedge fund. A similar thing occurred during the failure of Bear Stearns in 2008, when the knowledge of Bear Stearns’ (in) solvency issues became known, other Wall St firms acted quickly to make sure the firm did indeed need a bailout. It is not only possible that Wall St. firms will conspire to learn everything they can about Goldman’s proprietary trading software and profit from it, but given the history of Wall Street firms, highly likely.

From a technical standpoint, the trend-line that acted as a multi-year support for the stock’s share price has now shown to be a veritable resistance. The double-top formation that has become apparent since the beginning of June is also bearish from a technical perspective.

FEATURE EQUITY TRADE 2: Canadian Natural Resources

Long: ishares TSX 60 index (XIU)
Short: Canadian Natural Resources (CNQ)

The oil and gas complex is seemingly leading the Canadian market lower. For those equity traders wishing to participate in a decline in the energy sector relative to the broad market, we are advising a trade whereby the he is long the TSX through and ETF such as the iShares TSX 60 Index (XIU) and short Canadian Natural Resources (CNQ-NYSE or CNQ-TSX) against it.

CNQ just has completed a 50% price retracement from the high in 2008 to low of 2009. Iam using the price of CNQ based on its NYSE quoted value for charting purposes. As we can see from the chart for CNQ, it has broken a key up-trend line from the past few months. The stock has filled the gap at the $60 area and is now looking to retest the first area of support near $40. We see a trading range developing here now between and $40-$60 a share. It will be important for $40 to act as support and $60 should act as resistance on the stock for the next few months. Any move outside of these given areas will direct us as to where we see the price trending for the next little while. Another important factor that we can garner from the chart is how volume has been trending lower while the stock has been moving higher.

PREVIOUS TRADES RECAP

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