On StockTock.com, StockJock made a compelling case for a capitulation bottom. It certainly looks that way. However, I am not yet sure that this is THE bottom. For full disclosure, on Friday I closed all my puts and bought calls on Apple.

On Friday, all three major indices closed with a bull-flag formation (see e-mini chart for Friday). Currently futures are indicating a 4% higher open on Monday. I would like to trade during this week with a cautious but bullish bias. However, I am concerned about the market based on the Friday’s action in two stocks: Morgan Stanley and Goldman Sachs. Both stocks closed BELOW their Sept lows. I cannot emphasize enough how troubling this is. If the market rallies on Monday morning and these stocks don’t participate, I WOULD GET THE HELL OUT of this market.

What Seems to be the Problem?

What we are witnessing is a derivatives melt-down accelerated by deleveraging. On the debt side the biggest culprit seems to be credit default swaps and on the equities side naked puts on indices. The domino effect definitely started with Lehman’s bankruptcy. Credit freeze and deleveraging accelerated the equity sell off. On Oct 1st and 2nd several primary dealers issued margin calls to several hedge funds and rised margin requirements from 15% to 35%. The sell off during the last week was so severe because the funds rised cash to meet the margin calls. I read a report which indicated that margin-call related selling couldgo on even on Monday as some funds have time till Oct 13 to meet the margin calls.

Little did I know that these biggies are trading with only 15% margin. This is utterly silly and dangerous. What I can’t understand is that all the protections put in place after the Market Crash of 1929 and the Great Depression were essentially negated during the last decade. Margin rates prior to 1929 crash were 10%. Until recently margin requirements in equity accounts is 50%. What were they thinking? Also, we all know how the repeal of Glass-Steagall Act (which was originally enacted to prevent another Great Depression from happening) contributed to the development of shadow banking system via the Bear Sterns, Lehmans and Goldmans of the world with as high a leverage as 50 to 1. We know what happened with this kind of leverage and unregulated

The Problem of Dynamic (Delta) Hedging

What is dynamic hedging? There are two sides to each trade. A buyer and a seller. Buying and selling underlying assets like real estate or bonds or even shares is never a problem to the health of any market.

Not so with derivatives market. If the options sellers sell covered calls and covered puts, the risk is limited. However, it is the naked sales of puts (or even calls) on major indices is something that can wipe out even the big houses when the indices move too much and too fast against them. The guy who sold the puts naked might have done so thinking that it is easy money. His original strategy might have been to short the market if and when market goes down to certain level. This is called dynamic hedging or delta hedging. Under normal corrections, the houses and big hedge funds will have enough liquidity to turn things in their favor and make the options they sold worthless.

What we are witnessing is no ordinary correction. Even big houses are broke. Heck, even the government is broke. Unless this market quickly turns around, those sellers of naked puts on indexes will be broke.’

et tu, Buffet?

None other than Warren Buffet (through his Berkshire Hathaway) is stuck in this derivatives mess.  When I first heard rumors about Buffet getting stuck in derivatives trade, I dismissed the rumors. This week Barron’s had an article on this.

Buffett’s Berkshire, meantime, fell sharply last week, as its class A shares dropped over $25,000, or 18%, to $113,100. Berkshire’s equity portfolio, which stood at $69 billion on June 30, is falling in value, although it’s ahead of the major averages this year. Berkshire has written, or sold, long-dated put options on some $40 billion of equity indexes, including the S&P 500. Those put sales, which amount to a bullish market bet, are deep in the red, although Berkshire doesn’t have to post collateral against any paper losses. We estimate those puts could have cost Berkshire as much as $2 billion in the third quarter and several billion more dollars this quarter, with the S&P down over 20%. Berkshire ultimately may score with these puts if they expire worthless at maturity between 2019 and 2027. But the normally savvy Buffett made a mistake investing in financial derivatives, about which he has long warned. Berkshire had no comment.

Buffet gave several lectures on the ill effects of the monster called derivatives. Apparently he didn’t take his own advice. Are the put premiums too good for him to pass? This explains why he is so heavily pushing for the bailout. He called this sell-off an “Economic Pearl Harbor.” Now I know why. There goes my respect for the man whom I thought is the most honest man in America.

Closing remarks

It is very likely that Buffet’s news is already priced in to the market. Also, the powers that be may have one more trick to prop the markets during the expiration week. That is why I am cautiously bullish for this week.

Don’t forget, if the market goes up on Monday morning and if Goldman Sachs and Morgan Stanley don’t participate, there is a high probability of 20%+ single day crash within the next 10 days.

BE CAREFUL EVERYBODY. PROTECT YOUR CAPITAL FIRST.

For the time being, long term investors should stay away from this market. I think this market is going much lower in October. Every rally should be sold.

For the next couple of weeks, be quick on your feet. Follow the news. Be on constant alert and be ready to pull the trigger. Keep in mind, a lunch trip could cost you dearly or make you rich.

Weekly charts as of market close on Oct 3, 2008:

• Recent high flyers like the agriculture stocks, tech leaders like Apple, Google and Research in Motion, solar stocks have imploded.
• Morningstar large cap core and growth are broken (Large Cap value seem OK)
• Charts of Dow Jones and Russell midcap growth and value indices are broken
• Russell 2000 indices are also looking dismal (Russell 2000 Value looks OK, for the time being)

Macro picture to keep in mind for trading in the week/month:

• Derivatives markets face big test in October (Financial Times, Sept 30) 

The $54,000bn credit derivatives market faces its biggest test in October as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled.

Highlighting the opacity of this market, it is still not clear how many contracts have to be settled, and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.

According to dealers, insurance companies and investors such as sovereign wealth funds, which are widely believed to have written large amounts of credit protection through credit default swaps on financial institutions, could have to pay out huge amounts.

“There is a lot at stake,” said an executive at one big dealer. “This is a crisis time, and if these auctions do not go well, or if the amounts investors and dealers have to pay is seen as not being fair, it could have further negative repercussions on the CDS market.”

[Full Article from Financial Times]

• Get this – LIBOR, Bid only!!!!!! Financial and Corporate System is in Cardiac Arrest: The Risk of the Mother of All Bank Runs (Nouriel Roubini, Oct 3, 2008)

Yesterday Thursday a senior market practitioner in a major financial institution wrote to me the following:

Situation Report: So far as I can tell by working the telephones this morning:

• LIBOR bid only, no offer.
• Commercial paper market shut down, little trading and no issuance.
• Corporations have no access to long or short term credit markets — hence they face massive rollover problems.
• Brokers are increasingly not dealing with each other.
• even the interbank market is ceasing up.

This cannot continue for more than a few days. This is the economic equivalent to cardiac arrest. Then we debated what is necessary to restart the system.

I believe that the government will do another Hail Mary pass, with massive guarantees to the short-term commercial credit system and wide open short-term lending by the Fed (2 or 3 times expansion of the Fed balance sheet). If done on a sufficient scale this action will probably work for a while. But none of these financial measures affects the accelerating recession — which will in turn place more pressure on the financial sector.

Another senior professional in a major global financial institution wrote to me:

Today, in our trading room, I could see the manifestations of a lending freeze, and the funding hiatus for banks and companies, with libor bid only, the commercial paper market closed in effect, and a scramble for cash – really really scary.

Do you think this is treatable without a) a massive coordinated liquidity boost and easing of monetary policy and b) widespread nationalisation of some banks, gtess to others AND a good bank/bad bank policy where some get wiped along with their investors? The Treasury Tarp plan is an irrelevance if we are at a major funding crisis.

[Click here for full Article at RGE Monitor]

• Germany Races to Save Hypo Real Estate After Government Deal Fails

Chancellor Angela Merkel vowed that Germany’s government would not let the failure of any company disrupt Europe’s biggest economy, and the government said it would guarantee all private savings accounts as feverish talks to keep Hypo Real EstateAG afloat moved forward.

“We will not allow the distress of one financial institution to distress the entire system,” Ms. Merkel told reporters while talks between government and business leaders continued in the capital. “For that reason, we are working hard to secure Hypo Real Estate.”

Ms. Merkel said the plan would ensure that anyone who made reckless market decisions would be made to answer for their actions. “The federal government will make sure of that,” she said. “That is our debt to the taxpayers.”

[Source: 10/05/08 WSJ Article]

• European central banks failed to come together to protect banks, jawboned to protect the banks, and called for a bureaucratic economic summit. What part of ‘urgent’ don’t they understand?

PARIS, Oct. 4 — The leaders of Europe’s four largest economic powers vowed Saturday to protect their banks from the continuing reverberations of the increasingly global financial crisis but could not agree on a common Europe-wide strategy.

Unlike the United States, which last week committed $700 billion in government money to shoring up Wall Street, Europe plans to continue dealing with its financial problems on a case-by-case basis. That approach, which has involved tens of billions of dollars at a step, is complicated by the transnational presence of so many large European financial institutions.

But the European leaders did call for a global economic summit by year’s end aimed at revamping the international financial system, which is a legacy of a conference held at Bretton Woods, N.H., in the waning months of World War II.

[Full article from WSJ]

• Why is nobody talking about Russian Economic problems? Is this 1998 redux?

MOSCOW — Russian regulators shut down one of the country’s leading stock exchanges three times Friday to stem rapid declines in shares after investors took fright at growing concerns over the global economy.

After shares plunged in early morning trading, the federal regulator ordered the suspension of trading on the RTS, the country’s benchmark index. The regulators have used similar moves to stem rapid share declines in recent weeks – usually to positive effect.

Stocks had opened lower on Friday morning in Russia, after a torrid trading session Thursday in the United States amid fears over the success of a federal bailout plan to stave off a recession. U.S. stocks plunged on the back of disappointing economic data, including signs of rising unemployment. Oil prices dropped overnight to below US$94 a barrel.

By the close of trading, the RTS had shed seven per cent to 1070.9 points. It was closed down twice in the afternoon and then shut early for the weekend. The MICEX exchange – where most of Russia’s trading takes place – plunged by 5.3 per cent to 924.6 points, paring back steeper losses mid-afternoon.

Last month, Wall Street turmoil and sliding oil prices contributed to Russia’s worst stock market collapse since 1998, triggering a domestic crisis of confidence and a shortage of liquidity, or ready cash for operations. Since its May peak, the RTS has lost 57 per cent of its value.

[Full article]

Bottomline:

The picture looks really, really bleak. Massive coordinated effort to save banks and markets could begin as early as Monday. Treasuries are indicating a 50-75 bps interest rate cut. Don’t go overboard with shorts because a massive short-squeeze may be (will be) orchestrated with a global coordinated effort. On the other side of the trade are the most powerful Central Banks in the world, the governments of major countries in the world. Expect manipulation and rule changes as it unfolds. Remember that you are no match to them.

Chances are, most of the people who are correctly bearish for the right reasons can and will lose a lot of money in this market. I am trying to be not one of them. I have the following guiding principles:

1. I want to protect my capital (sell and ask questions later)
2. Couple of years worth of moves will occur in hours. I want to try to take advantage of the situation. But, I won’t hesitate to take quick profits

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