Monday, November 28, 2011

Tripwires to a market crash

The title, which refers to a possible "market crash", may seem untimely on an occasion when ES futures are deeply in the green, but the newsflow from Europe is getting more and more confusing.

I would like to create a framework for assessing the likely future course of the markets rather than to just come to a prepackaged conclusion. On one hand, Fitch downgrade Portugal last week, then Standard and Poors downgraded Belgium soon after, which are bearish for the market. On the other hand, Bloomberg reported that the IMF is readying a loan facility of up to €600 billion to Italy, though the story leaves many unanswered questions and sound more like a trial balloon than an actual concrete plan. Moreover, there are reports that eurobonds are back on the table.

To summarize the current European situation, imagine that a man (the "eurozone") experiences severe chest pains and looks like he is headed for a heart attack ("Lehman moment"). The protocol is well defined in these circumstances. Take steps to stabilize him ("inject liquidity via the ECB") and then address the causes with a program of diet, exercise and medical treatment ("longer term solutions such as balanced budgets, pro-growth policies, possibly closer fiscal integration, two-speed eurozone, etc."). Berating him about being lazy and overeating ("you lazy Greeks, Italians...") and making him get on the treadmill to work off his Thanksgiving feast ("more austerity and IMF monitors") while he is on the verge of a heart attack ("Lehman like financial crisis") is less than helpful under the circumstances.

The question for investors is, "How far away are we from the heart attack, or Lehman moment?"

Listen to the market
My inner technician tells me to listen to the message of the markets.

Here are the four main "tells" that I am watching for as signs of a Lehman-like event. First of all, let's look at the yield on the 10-year Treasury Note as it is one of the bellwether safe haven plays. The 10-year yield, while it is in a downtrend, moved down through support on Wednesday but rallied through resistance (turned from support) on Friday and is now testing the downtrend line. I would watch for a significant violation of this initial support and if the September and October lows hold. If they don't it would be a definite indication that the "bang" moment is upon us.

The 30-year yield is looking more bearish than the 10-year yield. Unlike the 10s, the 30-year yield broke down through initial support and it's in an obvious downtrend. Violation of the lows seen in September and October would be a definite sign of trouble.

Since Italy has been the one of the sources of weakness in the eurozone, it would be instructive to watch the FTSE MIB Index of Italian stocks. The MIB tested the 2009 lows in September, rallied and it is in the process of testing that support level again. Violation of this key support level would be a sign that a market crash is coming.

Finally, I watch the Euro STOXX 60 Index as a barometer of market stress, and that index is behaving better than the MIB Index in Italy. The Euro STOXX 60 is in decline, but watch for how it behaves at initial support offered by the September lows and failing that, the 2009 lows.

Canaries keel over in the coalmine
As investors well know, the source of stress is coming from the eurozone banking system. I have been watching the price charts of European banks as secondary indicators to tell me about systemic banking risk. Indeed, John Hussman wrote that much of the European banking system and will need to get recapitalized or nationalized:
I suspect that before this is all over, much of the European banking system will be nationalized, much of the existing debt of the European banking system will be restructured, and those banks will gradually be recapitalized, post-restructuring and at much smaller leverage ratios, through new IPOs to the market.
The European banks are the canaries in the coalmine of investor confidence and some of the canaries are starting to keel over. Consider, for example, the price chart of Banco Santander, a large Spanish bank. SANT is in a multi-year downtrend that began in early 2010 and it is now testing a key support level. Violation of that support would be a sign of rising stress levels in eurozone banks.

The story goes from bad to worse. Here's the chart of Royal Bank of Scotland, a UK-based bank that should be somewhat more insulated from stresses in the eurozone. Apparently, it's not that insulated as the stock has violated near term support. A test of the 2009 lows is next and should those lows not hold, there's going to be trouble.

Moving back to the Continent, the price chart of KBC Bank shows a dramatic violation of near term support as the price plunges towards the support zone offered by the 2009 lows.

Moving to France, the share price of Credit Agricole has already violated the 2009 lows. More recently it has broken down through near term support of the September lows. This canary is on the ground and barely flapping its wings.

The chart of another French bank, namely Societe Generale, is displaying a technical pattern of the violation of 2009 lows. It is now testing the support level from the recent September lows. The shares of Italian banks Intesa and Unicredit (not shown) are also showing similar price patterns of violating their 2009 lows.

Even worse, there's Commerzbank. The price chart shows that the shares have violated its 2009 lows and continues to go into freefall. Should Commerzbank fail, will it be the new Creditanstalt?

To be sure, not all European bank charts look as dire as the six that I have shown you so far. Most are in the pattern of Deutsche Bank, which is holding above its September lows and well above its 2009 lows.

'Tis only a scratch?
Holding up the Deutsche Banks as the poster boy for European banking stability and ignoring the rest is like the Black Knight in Monty Python's Holy Grail dismissing a chopped off arm as "only a scratch."

Where there's smoke, there's fire. Should any of these aforementioned six banks fail, then other banks will inevitably lose their interbank overnight funding, which would then lead to a cascade of bank failures.

Imagine a scenario where Commerzbank has failed. If you were a depositor or another financial institution, would you leave money with Societe Generale, Intesa, Credit Agricole, KBC Bank, RBS or Santander at any price? If the answer is "no", then what happens next to global banking funding? At which point, you can count on the FTSE MIB, the Euro STOXX 60, the 10-year and 30-year Treasury yields to plunge through their key support levels.

The IMF Italy rescue plan and the eurobond stories are indications that the eurocrats are panicking. Whether the authorities can act in time to prevent the Lehman/heart attack moment is another. Watching how the markets react will give us the real answer of this race against time.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Anonymous said...

I do enjoy every article you write.
This article, as usual, is a great analysis of the actual market.

Macro Rants said...

Mr Hui -- your heart attack analogy in the first section is incomplete and misleading. How about this for a more accurate analogy:

* Patient was admitted to the ER for the 10th time in two years, with yet another heart attack

* Patient admits that he was told to switch to a more healthy diet again and again and again for years... and while he claimed to agree, he continued to eat donuts on the couch.

Now, the ER budget is stretched. We cannot afford to treat every patient that comes in -- we have to make some choices.

Should we use finite resources on this fat lazy bastard? Or should we use them to treat a patient that actually wants to get better?

Mr Hui -- you must acknowledge that resources are finite, and giving more resources to a basket case explicitly means denying them to someone else.

Every dollar, Euro or Yen you propose wasting on the EU is a dollar, Euro or Yen that is being denied to a new business and new jobs.

In short, you are screwing over younger generations in a vein effort to preserve a failed status quo.

WimpyInvestor said...

Scary charts. Which of the following is the best hedge for this market crash scenario?

1. Long UUP
2. Long TLT
3. Long VXX
4. FXE Puts
5. SPY Puts


Tiho said...

Haha when retail investors start planning for a crash, the market starts putting up a 3% movements to the upside hahaha!