April 21, 2009: Morning Call

The S&P and NASDAQ futures are both 5 points below fair value at 8:15am ET, reversing earlier gains (S&P futures were 8 points above fair value at 5am ET). In Monday’s session, the financial sector finally reversed the powerful short-squeeze that was triggered by WFC’s detail-free preannouncement of “record” earnings. Although CNBC emphasized a New York Times article about additional preferred equity conversions in the banking sector as the primary cause for weakness in bank stocks, the group closed lower because the quality of earnings released thus far has been very poor. Market participants finally called bullshit after the BAC earnings report; BAC’s earnings included a big one-time gain from the sale of their China Construction Bank stake and a 2.0 billion dollar mark-up of Merrill Lynch assets (CNBC repeatedly called BAC's earnings phenomenal ahead of Maria Bartiromo's soft-ball interview with Ken Lewis). With the benefit of hindsight, it is pretty clear the financial sector benefitted last week from dislocations at "quant" hedge funds and an option expiration fueled short squeeze. European markets are down 1.5% at the lows of the session. Copper is down 3.6% and nickel is down 5.2% in London. The euro is trading flat with the dollar giving up solid gains following stronger than expected German confidence data (13.0 vs. street at 2.0). Asian markets closed lower on concerns about the economy and the quality of corporate earnings (Japan down 2.4%, Hong Kong down 2.95%, Australia down 2.3%, India down 0.74%).

In terms of strategy, traders should maintain a large cash position or stay completely on the sidelines. The path of least resistance is lower but it is extremely easy to get whipsawed and chewed up in this market given the illiquidity and increased gap risk due to a number of escalating cross currents: Commodities have come under significant pressure, FOREX volatility has increased, the VIX has jumped 15%, and rumors are circulating that several large hedge funds that engage in high-frequency trading have lost 15-25% of their capital in the last 2 months. Trade small and maintain a tight stop-loss discipline given the factors I cited above will increase slippage due to decreased intra-day liquidity.