The Canary is chirping… weakly

On Friday we noted that Morgan Stanley CDS would be worth watching as a sort of “canary in the coal mine.”  At the time, the CDS were selling for around $455 (that is, it cost $455, 000 to insure $10 million in 5-year bonds).  Today the CDS continued to widen, closing  just north of $490.  For those keeping score, that’s nearly a 10% increase in one day.  The canary doesn’t look so healthy…

In other financial news, Bank of America’s stock price is approaching the monthly fee they are now charging for debit card users — $5.  Sometimes irony is awfully ironic.  Maybe BAC will accept 1 share of its stock for payment of the fee.  That would be a unique stock buyback program!

Goldman Sachs is down nearly 5% today and Citi is down over 10%.  Pre-reverse split, Citi is trading at $2.31.

It seems to me that investor fatigue may soon set in.  Investors will be quantifying their September losses upon receiving statements from their brokers, and the seemingly endless string of  200 point down days (followed by brief, convulsive rallies)  may finally trigger capitulation.

Or not.

There is so little predictability in a market trading as monolithic as this, that such prognostication has value only as an entertainment vehicle.

I think I heard the canary say something about keeping net exposures low…


Leave it for the Groundhog… well, maybe not.

There’s really no point in going into deep detail about the markets’ returns in the third quarter.  Simply put, they were awful.  All indexes were down double digits while some, like the Russell 2000, were down over 20%.  Macro fears have dominated the market since early August when US debt was downgraded, and ongoing disjointed responses to the European crisis moved the markets daily.

Perhaps most troubling in the short term, are the high correlations among all stocks.  Right now, correlations are in excess of 97% (with 100% meaning all stocks move identically).  The problem with these high correlations is that there is no differentiation between good stocks and bad stocks.  In the long/short universe this makes adding alpha incredibly difficult — as great longs and weak shorts are treated nearly identically.  Such is the side-effect of macro driven markets, but it should afford some nice opportunities once the correlation breaks.  Meanwhile, it’s merely an exercise of trying to avoid “death by 1, 000 papercuts.”

It also requires locating asset classes that inherently can’t get locked up in this correlation accident.

On another thought, buying insurance against Morgan Stanley’s 5-year bonds got very interesting recently.  So interesting, in fact, the pricing would indicate that Morgan is now less creditworthy than banks in France and the UK.   At these pricing levels, the market is saying Morgan is as risky as the banks in Italy.  Take a look at the graph below for a sense of how quickly the CDS (insurance) went parabolic:

There are a few reasons Morgan may be in the cross-hairs.   First, they are rumored to have a lot of gross exposure to French banks.  Morgan, in their own defense, would tell you that exposure is hedged to nearly zero.  The problem the market has with those hedges is its inability to determine if the counter-party is solvent (ie. will the hedge ever be able to pay off?).  Second, Morgan has large exposure to China.  The slowdown in China is not good news to Morgan.  And finally (and possibly most dangerous), Morgan is a retail broker; not a bank like Goldman or Bank of America.  The difference is material.  The banks have a lot of liquidity available in the form of customer deposits.  Brokers, on the other hand, rely on short-term borrowing for liquidity.  If that market were to dry up, Morgan would become… well…  Lehman.  I’m not predicting that’s how things will come down, but these CDS are worth watching.

I’m not in the business of prognostication.  That is best left to the groundhogs.  Yet, I can’t help but think the equity markets are due for a short-term rally.  It’s nearly impossible to find any pundit talking positively about the market.  Further, October is generally not the best month for the market (he said in a massive understatement).  Finally, indicators like Morgan’s CDS are pricing in Armageddon.  The contrarian in me can’t help but look at these things and sense that the market is oversold.  Those wanting out of stocks are (or are nearly) out of stocks.  When there are no sellers left, short-term prospects are bullish.

Have a great weekend and an even better 4th quarter!