Date: Friday, February 19, 2010

Market Commentary

Under the cloud of Fed tightening following yesterdays close, stocks managed to recover early losses and finish the day very near the unchanged mark, suggesting that today's options expiration influenced the closing prices.

Yesterday's curious tightening by the Fed right after the markets closed was apparently a well thought out market timing decision by the Fed officials.

In previous updates I have mentioned repeatedly that evidence is strong that the Fed / Treasury has manipulated the equity market through after hours trading in the futures market during most of the 2009-2010 rally. Did it happen again?

Well, I don't think most people saw the Fed move coming yesterday. While the Bond market has been signaling that a Fed hike was on its way, the timing of yesterday's decision was curiously ahead of schedule, according to most analysts.

Yet, the markets managed this first tightening decision with apparent grace . . .

. . . let's dig a little deeper.

This week is options expiration week, with the settlement of all option "bets" based on today's closing prices. But what is unique about the options market and the Fed rate hike was that all trading for the options that expired today ceased yesterday, right before the Fed announcement, meaning that if you had a put/call option there was absolutely nothing you could do about it during today's trading.

As a side note, it has been revealed by several market watchers that right before yesterday's close millions of SPY shares were sold in the equity market and similar numbers of new puts (short positions) were made in the futures market. The timing of these two huge stock transactions just moments before the Fed announcement should spark an SEC investigation into front running and/or insider trading . . . betcha it doesn't happen.

The Fed normally makes rate change announcements during their FOMC meetings or on weekends, so it doesn't roil the financial markets as much.

So why would the Fed raise the discount rate last night, of all times?

First of all, recognize that it was only the discount rate and not the fed funds rate that was changed. The discount rate is an "emergency" rate that only applies to large banks that need to come to the Fed discount window for an emergency loan. Banks haven't been doing that for a while now (remember, they were bailed out and then profited handsomely on the 2009 manipulated rally).

So, all in all, this was mostly a political move by the Fed rather than an economic move. In other words, the Fed funds rate is still 0.25%. As the Fed explained it, they were merely returning to "normal operations", now that the emergency of the late 2008 financial crisis is well in the rear view mirror. The better question might be, why did they wait so long?

But it does bring home the fact that the Fed is being forced into a tightening policy. Some have said the last Treasury auction was terrible and that the Fed has essentially been the only buyer for quite some time. As a point of fact, the Fed has become the largest owner of U.S. Treasury securities.

Earlier this week, China sold so many U.S. securities that they took themselves out of the number one foreign holder spot and moved Japan up into the number one foreign spot. That makes the Fed at #1, Japan at #2, and China at #3.

I think it is fair to say that China has made its point and the Fed has begun to reply, "Uncle . . . we get your point."

With the next Treasury auction coming up soon, the Fed knows they must take steps to create more demand. At some point the Fed can no longer be the only buyer.

By announcing this first tightening decision last night, the traders for this month's options were prevented from any type of hedging or trading on today's options, since options trading for today's options ceased prior to the Fed's announcement.

I suspect the Fed jumped in the markets today (via their dealer banks, etc.) and after the initial sell-off provided funds to the dealer banks to get the prices back to the unchanged level by day's end, to ameliorate the "tightening effect". They were successful.

Option writers were only too happy to oblige, as well. This can clearly be seen if you examine the Options Maximum Pain thresholds for nearly any equity symbol. Closing prices today were almost perfectly at the point where the largest number of options expired as worthless, giving the maximum profit (premiums) to the options writers and maximum pain to the options holders (buyers of puts/calls).

The pressure to keep prices at a particular strike point today is now over with today's options expiration. Next week begins anew, with foreknowledge that the Fed has begun a tightening phase, the obsessive and enormous Fed quantitative easing (purchase of mortgage backed securities) is in the last of the eleventh hour, and the technical condition of the equity market sits in highly overbought territory.

So far in 2010 we have seen the 2009 bull rally reach a high, we have observed an initial correction and have seen a multi-day rebound rally. What happens next? Is there anything historically similar to where the stock market is today?

The 2003 bull rally led up to a similar 2004 correction. In fact, if you only casually observed the charts of 2003 through early 2004 and the charts of 2009 through early 2010, you might not be able to tell a difference - they are eerily similar.

Look at the S&P 500 during 2003-2004:

From mid-2003 to March of 2004 the S&P 500 experienced a rally not much different than what we have seen the last seven months. Prices began to correct in March of 2004 and retraced to a 38% pull back in less than a month. Then prices rebounded from that level back up to the top of the upper Bollinger Band.

If you also notice, the stochastics indicator was in the high 90's on the rebound rally. From that point prices retreated once more setting a lower low. This process repeated itself multiple times over a 6-month correction, eventually retracing 50% of the rally from the August 2003 lows.

Now look at the S&P 500 during the last seven plus months:

You can see a similar strong rally up through the first several days of January, 2010. Then the 2010 correction began. Similar to 2004, prices have retreated 38% of the rise since the July 2009 lows and have now rebounded up to the upper Bollinger Band line.

This is almost identical to the 2003-2004 period shown above. Notice the persistent sell offs when the stochastic indicator gets up to the 90's, like it is right now (at 94.71 on this chart).

Does this mean that the 2010 correction will also last 6 months and become a new volatile trading range as lower lows and lower highs are created? I wish I knew . . . it would make trading so much easier.

Suffice to say, risk remains high, in spite of the multi-day rebound we have seen. In some respects, risk of a pull back is even higher given this rebound push. Several different oversold indicators that I monitor remain strongly at overbought levels, suggesting the probability of a decline at this juncture is quite high.

Be cautious if you are a momentum trader and have bought into this rebound rally as evidence of a return to the 2009 run of the bulls. I feel it is much different now, with a clear contraction of the money supply, a returning strength to the dollar, and crude oil starting to show signs of political manipulation upward.

Add in the fact that sovereign debt is on the rise and the dollar begins to look even stronger - at least for the time being. While the Fed may eventually trash the dollar completely, right now a bunch of sovereign bonds are being considered for downgrading from their eternal AAA ratings. If country bonds turn into junk bonds, the dollar is going to be bought up in spades, precious metals will take a beating, and the stock market will suffer as well.

Stay out - let's make sure we know who gains control . . . the bears or the bulls - it's not clear yet.

Dennis Slothower