The T Report: Falling Knives, Dead CATs & Strikeless Puts

Falling Knives

Europe has played a dangerous game of catching falling knives. Do nothing. Markets weaken. Have some meetings and vague plans. Markets turn more negative. Complain about speculators. Market starts to panic and economies constrict. Politicians and Central Bankers talk more. Markets swing up and down between hopes of some new solution and fears that they don’t do anything. Big summit, big announcement, big rally then back to doing nothing.

It is a cycle we have seen over and over in Europe. It seems as though we are entering another phase where we likely see some weakness. The summit was disappointing, but the market will take some time to challenge the resolve of the EU and ECB. The “whatever it takes” pronouncement culminating in the OMT “modality” was too painful for shorts.

I think the bailout of Spain is largely priced in, which means that even in a perfect world, most of the upside is there, and more and more, it looks like we won’t get some big plan, but another set up modalities and conditionalities that leave the bailout in constant doubt.

Eventually Europe will act too late and the falling knife will really hurt someone. The other problem is the growing number of politicians who seem to think that exits won’t cause contagion – I think they are horribly wrong, but we move closer to the day one of the people in power thinks they can pull it off.

No need to be long Europe here, and I would be short Spanish and Italian bonds here. Greek bonds remain more interesting just because the next phase really has to be write-downs of the official sector debt, which should benefit the PSI bonds.

Dead CAT’s

Markets are starting the week with what looks a lot like a dead cat bounce. Maybe initial strength is real, but I don’t see it. Europe is not fixed, and if anything is further from being fixed that I thought a month ago.

Earnings have been horrible and CAT isn’t helping this morning. This might be the first time that a CAT stopped a dead cat bounce. Last week started weak, but was able to stage a strong rally, with last Tuesday having a very 2010 feel to it – opening up, grinding higher all day, with a surge into the close. But that rally ultimately failed and I think we have more pain. I am looking for 1,400 and for the first time, think we could see 1,375 on S&P, so I am more bearish than I was this time last week when I was cutting shorts. This early morning strength is an opportunity for anyone who thought we might bounce late Friday to take off some risk.

This morning, while stocks have been doing well, there has been no follow through in credit. MAIN and IG19 are both unchanged this morning, and I continue to believe the market is under hedged, and the street which suffered by being too short too early, capitulated and is now very long and about to add to the problems in these indices. With IG19 now 4 bps rich, I am looking to get to 98 and possibly 100 before seeing a meaningful bounce.

Strikeless Puts

The great thing about the “Bernanke Put” is that is there. Everyone knows about the put, heck, it is even bigger now and is a global “Central Bank Put”. The problem the market always has with these puts is that there is neither a strike, nor a maturity. If I own a real put, with a 1,425 strike, I know that I can be long at 1,425 and am fully covered. I know at 1,420 I better get long unless I really want to run a short position. But we don’t know the real strike.

This is a problem I have mentioned before but think it is worth repeating. The entire market is running around telling each other that they own these central bank puts. It is very comforting, particularly as stocks go up. Making money every day and thinking you own a put is about as good as it gets. But as soon as the markets turn down, people start to get nervous. They don’t own 1,425 puts or even 1,400 puts. They own some new liquidity provided by central banks in some form at some time in the future. Not only do you not know where the floor is, you quickly realize everyone else owns the same thing and has the same concern. Not a single investor on the planet has a position right now without having carefully considered what central bank policies do. Both longs and shorts have thought about this, and right now, all of us who decided QE wasn’t a panacea in the aftermath of the last Fed decision, now feel vindicated (and have pretty much since it happened). The longs are getting more nervous.

Pumping liquidity into a market is not the same as setting a strike or a floor. Certainly not at recent highs when the money is still a long way from making its way into the system. The old saying “you can lead a horse to water, but can’t make him drink” come to mind.

Fortunately, there is no risk of actual government action, except for maybe in China. Japan and the UK are doing about all they can already. The EU isn’t close to agreeing on anything and we have more risk of going over the fiscal cliff as launching some new beneficial program (about zero probability of either of those things happening).

Performance Protection rather than Performance Chasing

For every fund that is going to “performance chase” into year-end, there are 2 or 3 that just want to protect what they have. They are just as happy to try and convince clients that next year will be better and this year “wasn’t so bad” as they are with trying to have a great last quarter. Many in fact are more risk averse than ever. If you are sitting around 3% to 5%, which doesn’t seem uncommon, the risk of going negative is very scary. Since the recent trade has been to be long, and long some favored sectors like high yield and apple, we are more likely to see stop loss selling (or selling to lock in gains) than big new positions being added. In fact, the best thing for an underperforming hedge fund (at least if you view them versus the S&P 500) would be for them to get a little short and the S&P 500 to go down. That is the best and lowest risk way for funds to close the performance gap.