Daily Market Reports | Sep 23 2008
By Greg Peel
The Dow fell 372 points or 3.3% while the S&P fell 3.8% and the Nasdaq 4.2%. We basically wiped out Friday and landed back at Thursday.
Before we get into the detail of why, we must first address the situation of last night’s move in the oil price. Last night Nymex oil futures opened at US$107.60, shot to a high of US$130.00, and then settled at US$120.00/bbl, up US$15.45 on the session. Such a move is unprecedented in either dollar or percentage terms.
You must ignore this price.
It is true that a fall in the US dollar overnight provided impetus for an oil rally, and that following the fall from US$147 to US$91 in a hurry a decent rally back was always on the cards. However, last night’s closing price was nothing to do with any form of fundamental or even technical consideration. It was all to do with last night being the expiry of the October delivery contract.
The benchmark price the world uses for oil is the West Texas Intermediate futures price as traded on New York Mercantile Exchange (Nymex). The reason a futures price is considered a benchmark, and not a spot price, is that firstly there is no such thing as “oil”. Rather, every oil field puts out a different grade from sweet to sour, light to heavy, WTI, Brent, Dubai, Tapis etc. West Texas became the benchmark because that’s where the oil industry started and then the US is the home of the futures markets we know today.
Secondly, while we may have chosen WTI, there is still a difference in “landed’ spot price dependent on exactly where that oil is delivered. (Consider iron ore in a similar vein). Thirdly, because the trade in oil – and oil represents the world’s largest commodity trade – involves sending enormous tankers around the world to massive storage facilities, it is impossible to set up a hedging/speculation business and provide liquidity to the market unless that market can be traded on paper. Futures contracts fill that role.
But unlike spot prices, futures prices are subject to monthly “expiry”. At expiry all contracts must be made good, meaning the oil one has sold must be delivered. If you do not happen to have a loaded oil tanker sitting in your front yard ready for delivery, then your only choice is to buy back your sale contract before the expiry bell. Most oil markets traders don’t have tankers on standby, so some 97% of oil futures contracts are closed out before delivery is required.
As oil fell from US$147 through US$120, the market went from selling out long positions to going short. The bounce from the US$91 level has sent many a short scrambling to cover ahead of expiry, but not everyone was smart enough to get out before the last day. Last days can be very volatile as those holding longs try to push against those holding shorts for an expiry price that is profitable. As it was, only a handful of open positions were left in the market last night, but the cowboys had a look and decided those positions represented the last of the speculative shorts. Those shorts would have to be bought before the bell. So the cowboys put on what is known as a classic “short squeeze”. With hardly anyone else wanting to trade a contract which was about to expire, there was no one for the shorts to buy back from. That is why we went all the way to US$130 in one go.
What this means is that the expiry price of the October contract must be ignored. The November contract, which tonight becomes the new “front month” and thus the new benchmark, last night rose only US$6.62 to US$109.37/bbl. The volume of trade in the November contract was ten times that of October. This means that on the open, and all things being equal, oil will register an apparent “fall” in price of around US$11. So the real overnight move in oil was a rise of about US$6. Bear that in mind today.
Now, on to the stock market.
The fall in stock prices can largely be put down to two factors: (1) political bickering is already putting the Paulson Plan at risk, and (2) the Plan ultimately means that the US financial sector will never be able to return to previous levels of profitability for a long, long time.
There are few in the market who disagree that something had to be done, and that the Paulson Plan will go a long way to doing whatever it is that needs to be done. But the restoration of stability does require the rapid passage of the bill through Congress. Wall Street was hoping it would be passed by the end of the week, but now the politicians are all getting in for their dime’s worth.
Invoking the usual “moral hazard” argument, the Left is seeing this bail-out as a bail out of Wall Street at the expense of Main Street, being the US taxpayer. They want a similar package to be implemented to “save” US mortgage holders from going into foreclosure. Quid pro quo. They believe it is the greedy banks that are being saved here, not Little Americans. They are naive.
They are naive because not only will US mortgage holders enjoy an immediate indirect benefit from the successful implementation of such a package (mortgage rates will come down) but for the banks in question the package only prevents bankruptcy, it does not prevent losses. However, if the bickering continues we will no doubt see the bill held up in Congress and more global volatility will ensue as the world wonders what the final Plan might entail.
On the point of banks not preventing losses, that is largely the reason the financial sector led down the stock markets last night. Under the Paulson Plan, banks will be forced to sell off all their toxic assets, and no doubt another huge round of write-downs will occur as a result of low prices finally being set. Even more significant is the fact that those “write-downs” can now never become “write-ups”.
We are once again reminded that “write-downs” imply a mark-to-market paper loss on securities that, for the time being, do not have any willing buyers. As the lack of buyers is due largely to uncertainty and fear, those assets are most likely being marked well, well below what might one day be their value at maturity. Mortgage-backed securities, for example, still contain many, many high quality, prime, non-delinquent, serviced mortgages. Indeed, such quality mortgages make up the vast majority of the mortgages behind the dreaded CDOs. The problem has only been in the nature of the CDO that Wall Street created (and the ratings agencies signed off on) that these CDOs can default on a cascading effect from the default of the handful of subprime mortgages in any one CDO.
Break them up, and there is still plenty of value inside. And all the while the various holders of CDOs knew this, and that is one very good reason they have been reluctant from Day One to write down the value of these securities, and concede to a frozen buyers’ market. They were all looking for the day the dust would settle, and these securities would begin to rally back in value. Unfortunately, that day has never come.
Now it will never come, at least not for the banks. Because now the opportunity to reverse those write-downs, and to start booking big paper profits again instead of big paper losses, has been lost – to the American taxpayer. Those financial institutions who are left standing now have to start again from scratch. And now that the concept of leveraging capital to 30 times is dead, it will take a long, long time before financial institutions can make anything like the sorts of profits they once enjoyed. And that their shareholders once enjoyed.
That is why the financial sector was sold down in the US last night.
The epitome of all of the above is the fact that we entered 2008 with five large, imposing, historical, super-profitable US investment banks, and today there are none.
Late on Sunday night in the US it was announced that the last remaining investment banks – Goldman Sachs and Morgan Stanley – would become “bank holding companies”. In other words, commercial banks. The investment bank model in the US is now dead. By becoming banks, Goldman and Morgan can now enjoy a greater access to assistance from the Fed – the lender of the last resort. But in exchange they will also be subject to greater regulation, greater scrutiny, and greater capital adequacy requirements. They will never again be able to make the sort of extraordinary profits of the last decade by taking qualified risk.
In light of the debacle that has played out over the last twelve months, one could only suggest this is a good result. However if you are a shareholder, it’s not so great in the long term. At least Goldman and Morgan have been stopped from going out the back door. Both entities will now have to actually work on becoming deposit-taking banking operations. For Morgan, the wheels have already turned. Ironically, 24 hours ago Morgan was desperately trying to sell itself to Wachovia (America’s fourth biggest commercial bank at the beginning of 2008) to avoid insolvency. But now, not only has it simply become a commercial bank by decree, it was just announced Japan’s Mitsubishi Bank will take a 20% stake for around US$10bn.
Goldman will also need to do something, but Goldman is by far the largest of the ex-investment banks. It might invite another player into the structure, buy an existing banking operation, or simply start one from scratch. Either way, the glorious success of a company which listed in 1999 has now been relegated to mere history. Today Goldman Sachs is just a boring old bank.
As an interesting aside, Bank of America is now having a hard time hanging on to the team of brokers and traders it acquired from Merrill Lynch, given it has had to explain to those poor souls that the sort of bonuses they were used to at an investment bank are not paid by commercial banks. Gee, that’s tough.
So to sum up on the stock market front, the Dow was down 376 points last night because the details of the Plan are still not set, the timing is uncertain, it is uncertain as to exactly what will happen to the shareholders bases of existing financial institutions, and it is clear those financial institutions, while saved from the abyss, will take a long time to return to any healthy level of profitability.
Then recall that the selling in the financial sector last night was not due to anyone going short. What we did see, however, was a surge in put option volume. Because market-makers are exempt from the short selling ban, those traders legitimately wanting to go short because they believe the market will still go down (as opposed to those who go short because they are trying to profit from destroying a company) can use only puts as a proxy. Then it is the market-makers who sell the stock as they implement a hedge against the put options they have sold.
However – and this is why the whole short selling ban thing is a complete fiasco, a reactionary folly that needed to be properly thought out – options market makers are, in theory, not allowed to sell to a client who’s intention is simply to knock down a share price for illicit gain. They can only sell to those with some sort of legitimate intention. But how on earth anyone is ever meant to figure that one out is anyone’s guess. It is a complete joke, and only leads to more volatility.
[Before I get all the emails, here is what I would do: (1) ban all “naked” short selling for evermore and a day; (2) allow “covered” short selling; (3) reintroduce the up-tick rule that was in place from the Depression right up until July last year in the US. In Australia, the same goes for (1) and (2) but (3) is already the case. The reason I would allow (2) is because going short is a legitimate aspect of a free market if, and only if, that stock is borrowed on the day, and is an important part of market liquidity. To not allow any short selling is to risk over-inflating share prices too rapidly and then setting up for another, even more dramatic, fall.]
Enough on the stock market. The other feature of last night’s overseas trade was the biggest one day fall in the US dollar since 2001. This is not a surprising result, given the biggest bail-out package in the history of mankind must be implemented with money the US government does not have. Even if the government ultimately turns a profit on that money, it is gambling with debt, not savings.
One result of the collapse of the US dollar was the surge in the oil price, but consider that surge to be US$6, not US$15. Then there’s gold, which, as the realistic offset to a fiat currency, rose another US$28.70 to US$900.50/oz. That is spot gold, and that is not an artificial move. Nor were the moves in base metal prices in London based on any expiry vagaries, although short-covering was very much a part. Copper was up another 4%, as was tin, with nickel up 3%, zinc 4%, and lead 7%, with aluminium the only wood duck (didn’t fly the pond).
Base metals and other commodities are running as the US dollar falls, and as shorts are being bought back. But any notion that base metals should be stronger because the Paulson Plan will immediately halt global economic weakness is sadly misguided.
The Aussie dollar continued its fight back, rising another cent to US$0.8454.
The SPI Overnight fell 111 points.
This volatile period is not going to end in a hurry. Unless you are a day-trader with experience and plenty to lose, stay well away.
