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Countdown to Stock Market Armageddon?

Friday, November 9, 2007 | Teeka Tiwari

So Chairman Bernanke came out yesterday and delivered a sobering reality check.  The long and the short of it is that he said housing's going lower and inflation’s going higher.

Not the most reassuring guy in the world, is he?  Boy, I miss the convoluted Fed-speak of old that Alan Greenspan used to regale us with.  All this straight talk is just too much for this market to handle!

Stocks like Merrill Lynch (MER) and Citigroup (C) look like they got hit by a Mack truck.  Some very smart guys that I talk to are telling me that things at Merrill and Citigroup are far, far worse than they are letting on.

The good news is that the entire market is now incredibly oversold; it doesn’t mean it can’t get more oversold, but the chances are good that we will see some type of reflex rally here.

Tech stocks like Apple (AAPL), Cisco (CSCO) and Google (GOOG) got taken out behind the woodshed yesterday for a beating that would make an old world mother proud!  The move down in tech is definitely ugly, but unlike the financials, it's one that I think you can buy into.  The long-term picture favors growth over value, indicating that growth stocks should be bought on pullbacks.

There are some great ETFs out there that offer a lower risk way to play the growth sector.  One such vehicle is the Internet Holders (HHH).  (Strictly speaking, HHH is not an ETF.  It’s a depository receipt issued by the Internet HOLDRS Trust which represent ownership in various internet-related stocks.)  HHH has been as high as $68 this year, and got as low as $58 and change yesterday.  For those of you looking to gain some internet exposure, you might want to take a look. The HOLDRS website can be accessed here.

If Small Cap Growth is more your style, then you are going to want to take a look at Vanguard Small Cap Growth (VBK).  This ETF seeks to mimic the performance of the MSCI US Small Cap Growth Index.  Over the last year, this ETF has been up over 20% and has been very resilient during the recent market pullback.  It traded as low as $71.72 yesterday, but closed at $73.31.  It’s down only five points from its annual high of $78.50 and is showing great relative strength.  For more details on VBK, check out the Vanguard website here.

I want to give you a heads up on a story that you will be hearing more about soon.

Structured Investment Vehicles, or SIVS for short, are off balance sheet investment vehicles operated by major banks and funds.  SIVS issue billions of dollars of bonds in the commercial paper market at low 90-day rates.  They then use that money to buy long-term bonds.

Typically, long-term bonds will have a higher yield than short-term bonds, because the buyers of the bonds need to be compensated for the extra risk they take for going out years instead of days on their maturity.  The banks catch the difference between what they pay out to the commercial paper holders and what they receive from their long-term bonds.  It’s this spread that the bank is chasing.

The problem with an SIV is that every 90 days, they have to pay back their commercial paper bond holders.  To solve this problem, the operators of the SIV simply issue another round of 90-day commercial paper.  They take the money from that offering and use it to pay off the holders of the old offering.  They do this every single quarter.

Here’s where it gets sticky.  The SIVs employ MASSIVE leverage.  They leverage their bond portfolios anywhere from 10 to 15 to one.  The SIVs invest in many different bonds, and some of those bonds are mortgage-backed securities that are secured by subprime loans.  Needless to say, these bonds have become digital concrete, meaning that they can’t find a buyer for them at anything approaching a reasonable price.

It's bonds like these (as well as others) that act as the collateral for this entire 90-day commercial paper house of cards.

The commercial paper players aren’t idiots; they know that their principal is at risk if they buy paper from an SIV.  That’s why the commercial paper market has frozen up.  No one wants to get left holding the bag.  That’s also the reason why we are seeing bank syndicates being formed to bail out the SIVS.

The SIV operators can’t raise the money to pay back their commercial paper holders because their long-term bond losses are HUGE.  (Even if they wanted to take the loss, they can’t because there are no buyers.)

Rather than face the crisis of confidence which would ensue should a trillion dollars worth of commercial paper get defaulted on, the banks are pumping billions into the SIVs to help finance them through this liquidity crunch.

It’s the potential for systemic risk that these SIVs possess that has the market so rattled.  Much of this fear has already been priced into the market so at least short-term, we should get a bounce.  Longer term, though, if the commercial paper market doesn’t get unstuck, we could see another leg lower in the financials that could be horrifying.

Conclusion


Short term, we have a great trading opportunity shaping up in the form of an oversold bounce in the techs and the financials.  Long term, though, the financials look broken, but the techs look like stars.
Teeka Tiwari signature
Teeka Tiwari
Chief Investment Officer
ETF Master Trader
285 votes
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Comments:

barbara

4/9/2009 3:54 PM

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