The Crash Report-----April 16-----------Issue # 39
Part 1 Introduction
Part 2 The week that was
Part 3 Part I: Derivatives
Part 4 Weekly Forecasts
Part 5 Closing
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----Part 1---------------Introduction---------------------
Welcome members. The Crash Report is for information purposes and should not be regarded
as investment advice. What I try to focus on in the report is the current and future
psychological and fundamental state of the worlds largest equity markets; the DOW and
Nasdaq. If you wish to support the web site please visit a sponsor.
----Part 2----------------The Week That Was----------------------------
Quick Look: - .
The theme for last week was "Tempered Sell-Off Leads To Rally". I focused on how the a
dense sell-off led the averages to a rally on Friday due to key support levels holding.
This weeks theme is "Mini-Crash Could Change Landscape"
Recap
Last Friday history was made as the two primary U.S. equity markets suffered their worst point
losses ever.
Believe it or not, everything appeared fine until Friday morning. Both markets were above
critical support levels and analysts (including myself) were looking for the rebound rally which
has unfolded hundreds of times in this market environment. It wasn?t as if a meltdown was
imminent, but everything changed on Friday April 14, 2000.
The 8:30 AM release of CPI rightfully spooked investors. Even with the price of oil dropping
in March the new weighting structure by the BLS, which is tailor made to discount any
volatility in the data, finally broke and registered its highest reading since January 1995. Bonds
sold off immediately and stocks began to sell off at 9:30 AM, even though a vague rally attempt
in S&P futures materialized before the morning bell.
After trading began it didn?t take long for margin calls to begin to impact psychology. One
person I spoke with said "people were selling nearly everything because they knew margin
calls would keep coming if they did.". It was apparent that no significant rally was possible
with and the record $279 Billion in margin was taking its toll.
By 2:00 PM the washout had intensified. The Dow had busted its 200-day and 50-day moving
averages, and the Nasdaq, which struggled to head below its 200-day, had little hope of
recovery as maintenance margin calls were placed and tech selling picked up.
To cap off an incredible day, Mr.Greenspan decided to voice his concern about bailouts at 2:00
PM
"Hundred-year floods come only once every hundred years,? Financial institutions should
expect to look to the central bank only in extremely rare situations?the dangers of too much
leverage are all to evident".
You have to hand it to Mr.G, he sure does have an impeccable sense of timing. In 1987 when
the crash occurred Greenspan cut interest rates and handcrafted a one sentence statement which
was released roughly 1 hour before the next sessions bell:
"The Federal Reserve, consistent with its responsibilities the nation?s central bank affirmed
today its readiness to serve as a source of liquidity to support the economic and financial
system." Oct 20, 1987
Before Monday mornings bell there will be no cut in interest rates, and no encouraging
statement. To make matters even more ominous the Fed may even be raising rates come May
16 to chill the economy.
Last Friday was a dose of reality for investors and new economy loyalists. Stock options have
gone from gold to dirt, "buy on the dips" investors were crushed and hedge fund debacle
rumors persist. Although the financial world is turning extremely negative, I will take a different
approach and say that Friday did not have one important element needed for a mind-numbing
change in investor psychology, that being sheer panic. I still believe Fridays mini-crash totals
will be topped before the final nail in the bull markets coffin is in place. It may take some time
or it could happen this week, but it will happen. Too many people are still involved in this pass
the shell game called U.S. stocks for last Friday to have been the climatic ending.
----Part 3--------Part I: Derivatives-------------
Derivatives, in the simplest of terms, are spin-offs from an underlying investment instrument.
The financial planet has become so involved in the derivatives market that it seems almost a
certainty that when economic concerns arrive some major players are going to be crushed. As
recently as 1998 the risks in OTC (over-the-counter) derivatives market were exposed by the
Long Term Capital Management (LTCM) debacle. The Fed, at least in small part, admitted to
everyone that OTC derivatives were responsible for LTCM, even though as many as 6
regulatory initiatives had been undertaken since May 1994 to control crisis.
OTC derivatives transactions are privately orchestrated, and primarily deal with forwards and
options. Underlying this is an intricate layout of swaps, futures, and call and put options which
can represent every financial instrument under the rainbow. Banks could be buying and selling
futures on who wins the next superbowl, we wouldn?t know since most of the transactions are
completely hidden.
The major concerns in the OTC derivatives market is that since 1990 it has expanded
exponentially and until up until today still remains highly unregulated.
With any instrument what is most needed to successfully hedge an investment is liquidity and
capital. We are all familiar with the Fed?s printing press which ran 24 hours a day in late 1999,
but what may not be so familiar to everyone is the fact that no matter how intricate and scientific
the risk aversion programs are at OTC derivatives desktops, crisis and credit is a nature of the
beast. These two C?s may become more important in the weeks and months to come.
At the end of June 1999 the notional amount of outstanding OTC contracts stood at $81.5
trillion, as estimated by the Bank of International Settlements (only major G-10 countries). The
bulk load of these contracts is in the interest rates variety, which makes up 66% of the $81.5
trillion total. This is why when the bond market began to capitulate in early 2000 fear ravaged
many of the larger dealers and banks. As spreads begin to widen someone is getting hurt,
period. Lawrence Summers didn?t take long to try and cool the pot with his buy back plans
and subsequent revision of his buy back plans two weeks later. And Greenspan knowing full
well that the OTC derivatives market has become too huge to regulate with success, continues to
stand by the stance that regulation would only take money out of the U.S. economy.
--
The death of index arbitrage trading in the 1990?s in large part is why the OTC market has
exploded. The hedging instruments used to offset market volatility and uncertainty are based
on the premise of liquidity, and as liquidity and credit reach unsustainable excesses inevitably
someone?s credit (which backs OTC derivatives contracts) will fail or become in question.
The one mainstay in the OTC market, in my mind, when dealing with particular equities (a
small percentage of the action) is that speculation is hidden. It is nice for shareholders to read
about investment gains made by Solomon Smith Barney each quarterly report, but to a large
extend trades in equities not made on an SEC regulated exchange are hidden. And if
transactions are hidden in the OTC market it must be for a legitimate reason, one reason being
that it is speculative position.
If speculation and leverage was involved prior to last weeks sell-off (it was) one can only
estimate the hidden damages. The only rumor I have heard if of is of the forced liquidation at
Pequot Capital (rumor from a trader from New York, also re-iterated at Mr.Fleckenstien?s the
Contrarian page).
There is legitimate opinions which conclude that the OTC derivatives market has facilitated the
ease at which U.S. corporations can access global markets, lower funding costs, and manage
exposure to interest rate fluctuations, foreign exchange rates and commodity prices. There is
little point in arguing against this train of thought, because it is clearly true; U.S. corporations
have benefited from this arena because the tools to control exposure in any market have
widened.
But don?t let the good times and excesses fool you. The size and fluidity of leverage and
credit is what can turn a rose garden into a pile of dirt in one felt swoop. The derivatives story
is an ongoing concern for many years ahead.
----Part 4-----Weekly Forecast------------
Last Week
Web Site: "The markets are a ticking time bomb waiting to explode."
Crash Report: "Don?t assume that a serious economic hardship is needed for stock prices to
head lower (4th quarter GDP in 87 topped 6%). All that is needed is a healthy does of
reality."
Quick Look: I am bearish on the global equity markets and awaiting some key developments
in the currency markets for further pessimism. A rally is likely soon but the strength of any
such rally is what is important to watch.
Nasdaq: Last Week: "I don?t think the Nasdaq has to go back down to 3648 to confirm
a bottom before a break higher.". I thought wrong.
I maintained a cautious stance last week until Friday when the Nasdaq broke support and
didn?t rebound. The events on Friday didn?t convince anyone that a rebound rally is due and
the action in the upcoming week will most certainly be unpredictable.
My year end target on the Nasdaq as stated on Jan 2 is 1,300-2,160. A rally could unfold
before further selling but it is time to understand that the landscape may be changing. It is no
longer three steps forward and one step back on the Nasdaq, it is two steps back and a ? step
forward. I would be astonished if the Nasdaq could mount a rally back to 5,000 and surprised
even by a 4,000 attempt.
Psychology took less than one week to change from slightly optimistic to overly pessimistic,
and many companies are getting set to report record breaking earnings. What an amazing
market.
Monday morning could be ugly, and there is little chance of it being pretty.
DJIA: Last Week: "International Paper could become another Alcoa by Friday and it will
be up to JP Morgan?s earnings to get the financials roaring."
JP Morgan tried hard to prop the financials up, but by Friday the lack of optimism in the
marketplace weighed on everything related to the bull including financial stocks. International
Paper did do a reenactment of Alcoa and is proving to everyone that old Dow components are
over valued because record growth predictions in the future are crumbling after each trading
session.
-- This weeks Alcoa and IP could be Caterpillar which reports earnings on Tuesday.
Glen Barton (Caterpillar CEO) told stockholders at the company's annual meeting last week
that Caterpillar expects to "grow our business in the future by more than 50 percent.". After
a quick laugh when reading this, it is safe to say I have placed this quote in the vault for future
reference 12 months from now. CAT earnings estimates this week are for 47-63 cents this
quarter and they should be beat. Earnings estimates for this year are slightly over 14% and for
next year are 20%.
Other prominent companies to report this week include Coke, Johnson and Johnson, Gillette,
McDonald?s and Microsoft. Buying Microsoft at $74 1/8 could be a good opportunity, not
necessarily because of the earnings growth going forward in respect to its valuation and court
uncertainties, but because any development or switch in psychology and the stock could rocket
higher. Microsoft is an important element to overall market confidence.
We are nearing 10,000 again (third time this year) and all bets for a rebound are once again,
off. The March 8 low of 9731.81 on the Dow is in serious jeopardy and a rally back to 11,000
seems unlikely with the action in JP Morgan (quite fond of OTC derivatives by the way) and
related issues last week. The Dow had recently responded in a positive manner to a tech sell
off and rallied above 11,200. But previous divergences have lead to one convergence, that being
people are selling big cap stocks at every turn.
----Part 4-----Closing Comments--------
Reality is an painful word for a bull market to comprehend, and reality has just begun to
captivate stocks. Lets us not forget that until unbridled panic combines to profoundly change
the investment culture that the pillars of excess, while battered, are still standing. Last week
may begin to profoundly change the U.S. economy and equity markets for many years to
come. Consider yourself lucky to be living during such an extraordinary period of change, and
just like all the crashes and horrible ends to manias of yesterday, most will think "it will never
be this ugly again". Reality tells us otherwise.
Sincerely,
Brady Willett
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