Hirst's Dealer Denies 'Mountain' of Unsold Works Before Auction, Bloomberg.com, August 28, 2008

Soaring inventory is always a tell-tale sign that a parabolic market is heading for trouble. Art seems destined for the "alternative dustbin" along with several other (mis)allocation strategies.

Russia has been our least favorite Emerging Market for several weeks and the structural weakness that we sensed was present has become obvious to all in recent days. The USD-denominated index is down almost 5% today at 1567, a drop of 930 points (37%) from its all time high that was recorded just a few months ago on May 19th. Note that the RUB currency (a very popular trade with the Hedge Fund community) has also started to weaken markedly against the USD, losing almost 5% in the last few weeks. It is thus fair to assume that the first serious capital flight by international investors is under way and the danger remains that there simply be no price that some investors are willing to pay to leave their funds exposed to what is becoming an exceedingly treacherous investment environment.

Today's New Home sale data includes a very interesting piece of data regarding the inventory of unsold homes. Unsold homes dropped by the largest amount ever for a single month falling by 23K to 416K, a drop of over 5%. The annual rate of decline is now almost 23% and the level of inventory is closing in fast on the 35-year average of 350K homes. As we have argued on many occasions the market for new and existing homes are really quite distinct at this point in the cycle. While the inventory of existing homes continues to creep up to new highs the new home market seems headed for a healthy level of stock by the end of 2008. It is important to remember that provided the original cost of land was low enough, or (more likely) the current cost has been written down aggressively then a new home-builder has a significant pricing advantage over an existing home owner who cannot sell for less than the current mortgage without the restructuring the loan. As a result we would expect the new home market (excluding condominiums) to start to stabilize and even moderately improve well before the overall market.

We have been following a series of troubling news stories emanating from the US commercial real estate sector in recent weeks with a number of high profile disputes between lenders and borrowers coming to light either in the courtrooms or media. It would seem that this steady drip of news has started to destabilize the CMBS market and, as the attached chart shows, there has been a very rapid widening of credit spreads across all grades.

It is particularly telling that "A" grade CMBS spreads are now far higher than they were at the height of the BSC crisis in March. Note that back then, and in the initial spike last August, the prevailing viewpoint was that commercial real estate fundamentals had never been better and that CMBS were being unfairly "tarred with the same brush" as RMBS. This time there can be no such wishful thinking. We believe that a large number of projects (both development and purchase) have reached the end of the "forbearance road" and we would expect to see a steady acceleration in foreclosures over the coming weeks. This is unlikely to be good news for equities that either rely on the commercial mortgage market for funding or have a significant legacy exposure to CMBS on their books.

FDIC Will Modify Mortgages for Some IndyMac Borrowers, Bloomberg.com, August 21, 2008

We think this is quite an important story that highlights the likely important "interventionist" role that the FDIC will have in producing an eventual solution to the rolling mortgage crisis. While it is probably widely understood that the FDIC has just commenced a wave of forced shutdowns of troubled banks (we would expect to see dozens of institutions follow IMB), the ability of the FDIC to "cut a deal" with a homeowner that a troubled bank cannot afford is less widely recognized.

Combined with a US Treasury-controlled GSE industry, you begin to see the shape of a mortgage industry dominated by governmental and quasi-governmental agencies, with the might of the US taxpayer base utilized to stabilize this troubled market. While the eventual waste and expense involved may be horrific, it will almost certainly "work" in the end. The one piece of the puzzle that is yet to be put in place is a replacement for the RTC (Resolution Trust Corporation) that was formed in 1989 to liquidate the assets of busted Savings and Loans. We would expect to see its successor created within the next 6 months.

It looks as if we have started the first recovery rally of what we believe will be a protracted commodity bear market. If we are correct, this rally will represent one of the last great opportunities to aggressively cut holdings. With the end of August in sight, the importance of institutional flows into passive commodity indexes should not be underestimated (even in a summer month). A reasonable potential target for this rally would be 780 (marked in blue) which represents the brief recovery high recorded on August 1st.

Note the importance of the 200 day ma in terms of acting as support; we doubt this is the last time this indicator will be asked to perform this function in the weeks ahead.

While 5-year swap rates remain extended into "crisis" levels at 103 bp (upper chart), 5-year FNMA spreads are starting to moderate considerably (currently 92.9 bp). It would appear that the market is starting to respond to the growing likelihood that the GSE's are about to be forcibly rescued and while there may be some doubt as to the eventual value of the junior subordinated debt (we belong firmly in the "next to nothing" camp), any settlement seems bound to involve a formal recognition of the "implicit" US Treasury guarantee.

As such, FNMA spreads nearly 100 bp above Treasuries make absolutely no sense and as the imminence of the Treasury "rescue" becomes clear, we would expect to see spreads collapse rapidly. Readers should be aware that GSE paper typically traded in the 20-40 bp range from 2002-2007 - as such a drop in spreads back down to at least the 60 bp range seems quite feasible - and this correction would probably happen very quickly once a formal plan was announced.

The chart below shows FNM's equity price (red) together with 5-year Agency spreads to Treasuries (black) and the spread between these 2 measures (green, lower chart).

While some may quibble the validity of comparing these 2 differing measures, we feel this chart paints an accurate picture of the rolling 18-month credit crisis. Note that in the first months of "containment," both FNM's equity and Agency spreads remained stable before the acceleration of concerns in July 2007. The initial moves by the FRB to calm the markets in August and September 2007 briefly worked but by late October, FNM's equity was falling rapidly and Agency spreads were starting to widen. In retrospect, the "crossover" point (reached on November 1st) represented the last chance for FNM equity holders to get out reasonably whole and it is interesting to note that each subsequent spike in Agency spreads resulted in sequentially lower equity prices (note the series of "higher highs" by the green line). In other words, the viability of the GSE's as ongoing private concerns became increasingly questionable to market participants.

With the endgame apparently near at hand, we would now expect to see the difference between these 2 measures narrow since while the equity value is almost certainly zero. Agency spreads at 90.8 strike us as far too wide for paper that is about to be assumed in some manner by the US government. We would therefore expect the green "spread" line to move sharply lower in the days ahead.

The IBOV index has broken down today below its January 2008 low and is now some 21,000 points below its May 29th high (73,920), a drop of 29% in under 3 months. This move has taken the index below its 100 week ma (54,750 - not shown) which is one of our favorite indicators for the confirmation of a bear market. While the large "round number" at 50,000 can be expected to act as good support, the odds of the index eventually testing its August 2007 low at 45,000 look quite high.

The lower chart shows Brazil's performance vs. the SPX, with the familiar pattern of extreme outperformance that abruptly ended in the middle of the 2nd quarter. Prolonged outperformance of this type draws in tremendous amounts of capital and in the case of Brazil, this overcrowding is compounded by the dominance of its 2 largest companies comprising over 25% of its benchmark index. We continue to advise that any recovery rally be used to cut positions aggressively, particularly in stocks with commodity exposure.

Although this was clearly a very difficult debt sale, with the spread paid reaching 113 bp for 5-year debt - a comfortable premium above even the extended spread in the secondary market - news of the sale's completion seems to have been met by a degree of relief. 5-year swaps have moderated to 102.8 bp (down from an intra-day high of 107.38) while 5-year agency spreads are indicated at 101.2 (down almost 3 bp on the day). Whether this represents a brief pause before another blast higher or the beginnings of a stabilization remains to be seen.

It is interesting to note how stable the BKX index is today in the face of Treasury swaps and Agency spreads blowing out to "crisis" levels and GSE equities falling to new multi-year lows. As of 2 pm today, the index is down 2.37 to 63.80 ("only" 3.61% - a fairly normal perfoemance in these troubled times). As we have commented before, the large banks have become very crowded shorts and it would seem that it increasingly difficult for non-stock specific news to force this group lower. Even so, it pays to watch support at a time like today and we would highlight the 50 day ma (blue line) at 62.85 and then the key 60 "round number support" as the levels to watch. If the BKX were to break below 60, we would become concerned that a test of the July low at 46.52 was about to develop.

An interesting article in today's FT claims that both Goldman Sachs and Morgan Stanley have developed contingencies that would dramatically restrict margin lending to their clients in the event that market confidence in the broker (as measured by CDS spreads or bond prices) became impaired. While post-BSC it is easy to understand the motivation for the Prime Brokerage units to make this change, the sudden restriction of margin to clients could potentially have a very disruptive effect on those portions of the asset class spectrum that remain dominated by leverage. Hopefully we will never get to see the effect of this in the marketplace but it is a reminder that these remain extremely complicated times.

The swaps market continues to exhibit considerable stress and this morning 5-year swaps have traded above the key 100 bp level that we take to signal a probable forced unwind is taking place. In order to put the current spread in perspective, we have included a ratio of the Swap Spread to the underlying 5-Year T-Note yield (see lower chart). As this demonstrates, we are still some distance below the level this ratio reached at the height of the BSC crisis when swaps blew out and the underlying T-Note yield also fell sharply. Interestingly, while Treasuries have been generally firmer (something we ascribe to a stronger USD as much as anything), there has yet to be any clear sign of a flight to safety developing. Agency spreads (not shown) have also risen, with the 5-year FNMA spread curently reading 97.8 bp.

The stress in swaps and agencies is starting to translate into demand for Treasuries. Treasury yields are down across the curve by 3-5 bp. This renewed strength has taken 10-year yields down to test key support at 3.80%. A break below 3.80% should be taken to indicate that a "flight to safety" is underway and there is little further support to stop yields falling until they reach 3.60%. Other key levels to watch are 5-year yields below 3.00% (currently 3.05%) and 2-year yields below 2.25% (currently 2.34%).

Back in the dark days of the Technology meltdown, we found that using a weekly chart with a 100 week ma produced an excellent indicator of when a stock or sub-index had passed the point of no return. Since we believe that we are at the start of a significant bear market for commodities, we decided to resurrect this screen last week, just in time to catch the remarkable performance of Silver in recent days.

The chart below is a weekly chart of Silver (spot) drawn on a Logarithmic scale. The blue line is the 100 week ma. Silver had been under pressure for several weeks but totally collapsed last night at the start of the Asian session. Given the speed of the move, we would suspect a forced liquidation took place but it should be realized that a violation of this magnitude has longer-term implications. Since Silver is very much the "small cap" brother of Gold, we would be concerned for this wider-held commodity in the days ahead. We suspect that this is not the last time we will be publishing a note using the 100 week ma in the weeks ahead.

After several weeks of doing nothing, the US Treasury market is starting to get interesting. 10-year yields have come in a long way in recent days and are now at 3.83%, within touching distance of key support at 3.80%. Interestingly, the catalyst this time does not seem to be a "flight to safety" (although as we noted earlier swaps remain elevated). Instead it seems that USD strength may be translating into a renewed appetite for US Treasuries. Whatever the cause, a breach of support at 3.80% would point 10-year yields firmly downward in the short term although we would not consider this breach to be definitive until the July 15th low of 3.76% was surpassed.

As this article demonstrates, the sell-off we are witnessing in commodities and related equities is as much about mis-(or over)-allocation as about a deterioration in fundamentals. The rush into commodity stocks in the 2nd quarter seems likely to go down as one of the great examples of market malfunction in recent years.

While we are more optimistic regarding the state of the US equity market than we have been for several weeks, we are continuing to keep an eye on swap and agency spreads, which remain at elevated levels, for signs of trouble in the financial sector. As the attached charts shows, 5 year swaps (top graph) have just crossed above the key 100 bp level that we take to indicate a level of distress in the financial sector that is causing a forced unwind of positions. While our favorite cause would be another FDIC-led shutdown of a savings bank given the awful reported performance of a number of large HF's in July and continued dislocation in commodity and currency markets, it is certainly possible that the current trouble is located somewhere within the HF space.

ECB Lending to Spain Rises to Record 49 Billion Euros, Bloomberg.com, August 14, 2008

Spain remains very much at the heart of the meltdown in European property markets and this story highlights the somewhat schitzoid nature of ECB policy which is simultaneously keeping short term rates (too) high while massively expanding the lending operations of the central bank. The long term implications of this are not hard to fathom and are clearly negative for the EUR going forward.

Thus far this quarter has been a sorry story of misallocation as the sectors that participants have loved have performed dismally while popular shorts have rallied. Looking around for sectors that could inflict more pain, we have started to concentrate on the US Retail sector. This sector has been a favorite of shorts (open Put interest in the RTH ETF stands at a record 276K contracts - up from about 90K this time last year) while sector Short Interest stood at 7.6% of float as of July 31st (compared to average S&P 500 sector Short Interest of 3.7%). At the same time, "long" investors have sought to avoid exposure to this sector due to the fear that the US consumer expenditure is about to "fall off a cliff". This process of liquidation reached a crescendo at precisely the same time that the US banking sector made its low (July 15th) but since this time retail stocks have performed strongly and the reports out of the stores themselves show some weakness, but nothing like the apocalyptic reports many anticipated.

Looking technically at the sector, we can see that the RELX Index has managed to get back above its 200 ma for the first time since July 2007 and is now targeting resistance at its 2008 high (approximately 6% above today's level). Interestingly MACD (lower panel) has broken out to a level not seen since late 2006, suggesting that momentum now exceeds the sort of reading typical in a "dead cat" bounce. A break-out through the 425 level is certainly possible at the current time and such a move would probably be reinforced from a combination of short covering and long investors re-entering the "forbidden zone" of retailing.

There has been huge drop in UK LIBOR rates following a very cautious growth forecast issued by the BOE this morning. The market is clearly anticipating the BOE cutting rates in the near (30-60) days - something that is clearly long overdue. Regular readers will be aware that this is something that we have felt was inevitable for several months and we believe that once the BOE starts cutting rates, they will end up bringing them significantly lower over a period of months (calls in LIBOR futures out a few months probably still make sense). While this development is obviously negative for Sterling, it is clearly positive for a number of sectors - particularly those connected with the consumer. We would recomend taking some exposure to UK retailers in particular at the current time.

There has been a rapid reactionary bounce in the XOI/BKX ratio (see Speculator Extra from August 4th for a longer discussion of this ratio). Thus far this has been caused mostly by the BKX retracing a portion of its powerful July gains but there are some signs that the XOI Index is threatening to make some upward progress, at least in the short term. It would therefore not be surprising to see this ratio recover to somewhere around the 22 level. Note that this ratio has become very correlated with HF returns and there will be great efforts made to recover August's ugly start by the time performance needs to be reported at the end of the month. It is interesting to note that the 200 day ma of this ratio proved to be good support that withstood two distinct challenges - something to watch for whenever the downtrend re-exerts itself.

US banks' month-long recovery seems to have finally run out of gas (which is another way of saying the shorts have been run out of their crowded positions). Note that the rally failed slightly short of our (ambitious) target of 75. In recent days, banks have lost ground and important support at the 50 day ma failed to hold this morning. The key level to watch is now 60. If this manages to hold, then this storm may blow over but if support gives way, we would be looking at a potential retracement of a good portion of the rally from July low at 46.52. While there does not yet seem to be a catalyst for the decline (other than the continuing damage from the credit crisis), we would remain alert for the possibility of another FDIC intervention following the abrupt demise of IMB last month. In this regard, it is worth noting that while the swaps market remains elevated (5Y at 98.1 bp), it is yet to break out to the level that has been associated with the imminent demise of a major player.

Commercial Real Estate Values to Fall or Stay Flat, Survey Says, Bloomberg.com, August 12, 2008

An interesting survey that suggests that CRE professionals remain far too optimistic on the future market conditions. Tellingly, their comments on the availability of financing are far more realistic and show a willingness to admit that this has dramatically worsened in recent months. How a total drop-off of credit cannot deeply impact prices remains to be explained - but this sort of wishful thinking is quite common at this stage of a cycle. Readers with good memories may recall that back in 2006, the NAHB Confidence data persistently showed a willingness of Homebuilders to forecast improving conditions even as survey data showed a reduction of current sales and foot traffic.

So many people had cut their allocations to the United States that there was nowhere else to go. It's like a fire in an empty theater. If there's no audience, you're not going to find a stampede to the exit. (Read the full Bloomberg article.)

There is ample anecdotal evidence that the recent breakout in US equity indexes has caught many participants by surprise and poorly positioned, whether it be the strangulated comments denying its validity or the very poor returns registered by a number of large mutual funds after Friday's powerful session. One key piece of data that demonstrates this is the VXO index (see lower chart) which has hardly dropped since last Thursday's close despite an advance of over 45 points (over 3.5%) by the SPX index (upper chart) since that time. The VXO currently remains at 21.65, firmly in the 20-22.5 "consolidation" range. It would have to fall below 20 to register that participants are starting to get aggressively long, and fall to the mid-teens before they would be considered "complacent".

One possible explanation of the relatively high VXO may be that with the market moving higher in the last week of an expiration cycle, there is a large amount of forced call-purchasing from traders who were either outright short or using buy-writes to boost returns in a range-bound market. Either way, the VXO suggests that this market could make considerable further upside progress.

India Car Sales Fall for First Time Since 2005 on Loan Rates, Bloomberg.com, August 11, 2008

A smaller drop than Pakistan but a far more important EM.

Corn, Soybean Report May Show Less U.S. Flood Damage, Bloomberg.com, August 11, 2008

Hardly surprising the hysteria of early spring time was quite unwarranted - but this is not good news for agricultural commodity prices that are already under great pressure.

The NDX index has enjoyed a good start to the week, building on Friday's powerful gain and consolidating its breakout above the 200 day ma. It is interesting to note that this recent move has created a new 7-year "relative high" vs. the SPX index (see lower chart). We view this as a significant piece of data that backs our view that the Technology sector is starting to offer key leadership to the overall US equity market. With this week marking the expiration of the August option cycle, it is worth noting that there is significant call open interest at both 1975 and 2000. As a result, both levels will act as resistance through Friday but also any successful breakthrough will be accelerated by option-related hedging.

Another piece of anecdotal data regarding a slowdown of EM consumer demand. It is becoming increasingly apparent that EM economies are significantly elastic in BOTH directions. Pakistan has been particularly hard hit in recent months and its local stock market index (KSE100) is down 27% in local currency, 43% in USD.

Ignoring all the turmoil in emerging markets and commodities, the NDX has quietly continued to make progress and is now challenging its 200 day ma. It is extremely important that a major sector steps up and claims leadership in the US equity market and our favorite for this role is the Technology sector. If the index can close above its 200 day ma this week, the stage will be set for a strong performance next week with option expiration potentially adding some fuel to the fire.

Putin Says 'War Has Started,' Georgia Claims Invasion, Bloomberg.com, August 8, 2008

Quite why any institutional investor finds it prudent to continue investing in Russia at this time is simply beyond me.

RUB has been a very popular trade with the HF community. A combination of weakness in commodity complex, resulting weakness in equity market, political intervention, and now a war in Georgia (nicely timed to coincide with the Olympics opening ceremony) would seem to have overwhelmed even the seemingly limitless resources of the HF community.

Crude oil continues to break down (currently $115.91) and there is little doubt that we are witnessing a simultaneous collapse of commodities, emerging market equities and currencies - with tremendous negative implications for investors with concentrated positions in this combination. We have set $110 as key support for crude - as a reminder, this combines round number, 200 day ma and a 38.2% retracement of the entire Jan 2007 - July 2008 rally. We would expect to see this level tested in the near future.

Time and again we have found that a prolonged period of quiet in one of our "benchmark" charts is eventually followed by an explosive move out of the constraining range. The price action in the DXY index in recent days is an excellent example of this and most readers will by now be aware the USD has broken out against virtually all major and emerging market currencies. This morning saw the EUR (by far the most important USD cross rate) fall below its 200 day ma following the somewhat conciliatory comments made by Mr. Trichet (see yesterday's note on EURIBOR futures). Needless to say, the breakout in the USD has caught the world's investors completely misallocated and will significantly increase the losses being experienced in EM equities and commodities. The great medium/long term winner out of all of this should be the broad-based US equity market which has been starved of foreign investment for much of the last 3 years. Unfortunately it is typically an underweight component in the average investment portfolio.

An interesting article from today's NY Sun. The effect of the sudden lack of commercial RE funding has yet to make itself fully felt on the NY RE market. We would expect to see a significant number of forced sales and halted developments in the coming months. One point the article does not mention is the fact that CMBS spreads have started to widen very rapidly in recent weeks after tightening in the aftermath of the BSC crisis. This does not bode well for commercial RE or for the REIT sector. Note that we believe that the author's conclusion is much too optimistic - these sorts of corrections tend to gather pace rapidly once they commence.

Yet more anecodotal evidence of demand destruction in the energy complex. Large increases in mass-transit usage is becoming a recurrent theme out there - I am sure there are some investment implications of this apart from simply selling energy exposure.

Following today's ECB statement, the implied yields for 90-day EURIBOR futures have moved down by 8-12 bp across expirations in the next 18 months. While no rate cut is yet priced in before the middle of 2009, this is quite a change from the pricing in further hikes we saw a couple of weeks ago.

Deutsche Bank Foreclose on $3.5 Billion Vegas Casino, Bloomberg.com, August 7, 2008

Highest profile commercial foreclosure so far this cycle. Bruce Eichner was a prominent developer who became overextended in the last real estate debacle as well.

The DXY (US Dollar) index is once more testing the top end of its range at the key 74 level. Note that the importance of this level is greatly magnified by the fact that it now coincides with the index's 200 day ma. The DXY has now been range-bound for almost 6 months and has stabilized against a steady background of extremely negative commentary. A breakout through resistance would therefore be a significant accomplishment.

The NDX Index is just breaking out of its 6 week consolidation range. If sustained, this would be a significant achievement and should lead to further short-term gains. We would mark the 200 day ma (1924) as a reasonable short-term upside target.

Gold has dropped decisively below its 200 day ma. A close below this indicator would suggest that we have begun a deeper correction of the powerful 2007/8 rally.

Jiangxi Copper Says Appliance Makers' Demand Falls, Bloomberg.com, August 5, 2008

There is growing anecdotal evidence that Chinese growth is decelerating considerably. Friday's PMI data was one piece of data no one was expecting and is echoed in today's comments from Jiangxi. It would appear that conditions in the "world's workshop" have taken a significant turn for the worse - clearly bad news for the commodity complex and emerging market equities in general.