Shift Of Focus for Stocks

Given that we now have a resolution to the banking problem, the stock market will likely shift its focus to normal indicators such as earnings and macroeconomic releases. These are still going to be bad, but not quite as bad as they used to be. In fact, I look forward to an improvement in the economy. I'm not expecting any growth until next year but I do think that the economy will not look quite as bad as it has in recent months. This shift of focus should push stocks higher still.

Black Swan Event in the Bond Market

The Fed announcement caused a black swan event. To put today's events in perspective, the 10Y yield 20 day chart looks like this:

Since 1962 the 10Y yield moved by more than 0.47% ten times out of 11960 days. So the probability of this occurring on any given day is 0.084%.

Needless to say, inflation expectations are going to go up:

Consumer Mood Improved Last Week

From Gallup:

Gallup’s Consumer Mood Index rose sharply over the last week, to -90 for March 13-15. This is up from -120 a week ago and is the most positive the Index has been since mid-September 2008. The increase is commensurate with the four-day consecutive gains in the Dow Jones Industrial Average, beginning last Tuesday, and also with the Obama administration’s recent emphasis on more positive views of the economy.

This may translate in improved readings on retail sales and PCE as well. It is a bit difficult to find reasons to sell stocks in the short term. We should be seeing more positive news as the stimulus impacts the economy some time soon.

Credit Conditions Improving

Credit conditions have been improving and will likely continue to do so over the next few weeks. This is likely to put upward pressure on stocks.

A lot will depend, however, on how well the plan to fix the banking system is received.

Update on Eurodollars Trade

I've discussed a couple of interest rate trades here. Since the model projects zero growth in about 12 months, being long bonds with short maturities should work out well. A good way to go long short maturity bonds is to simply go long Eurodollar futures contracts. These trade actively on the CME. Since I suggested going long the Mar'10 Eurodollar contract (EDH0), it has rallied slightly. Back on March 8th it was trading at yield of 1.67%. On Friday it closed at 1.625%.

Keep in mind this trade has a horizon of six to twelve months.

There is a risk here of LIBOR to treasury spreads moving higher in the short term, but I don't think this risk is significant in the long term. The LIBOR to treasury spreads have edged higher lately as banks still seem worried about lending to each other. The difference between LIBOR and treasury rates is called the Treasury Eurodollar (TED) spread shown in the figure below.



If you want to avoid exposure to the TED spread you might want to buy the two year note (T 0 7/8 02/28/11) yielding 0.956%.

Disclosure: I could be long or short Eurodollars or treasury futures at any point in time. I do not trade the 2Y note.

Update On the Inflation Trade

Just a quick update on the inflation trade I recommended here. On March 8th, the index stood at 0.1910, as of Friday's close it was at 0.3170.



Based on the model inflation is poised to move to at least levels prior to Aug of 2008.

Disclosure: I do not own inflation indexed securities.

The Uptick Rule Makes Buying More Tricky

I have seen a lot of press lately that the uptick rule will be brought back. In short, Wikipedia defines the uptick rule as follows:

The rule limits the timing of short sales. It mandates, subject to certain exceptions, that, when sold, a listed security must either be sold short at a price above the price at which the immediately preceding sale was effected or at the last sale price if it is higher than the last different price.

The key here is that the uptick rule can limit the timing of short sales, but not short sales themselves. I have not seen any in-depth analysis of what effect the up-tick rule has on the price discovery process if any. But lets take a look what it could potentially mean.

As a market participant you have basically two choices when you place an order. You can place your order at the best offer (BO) price or higher, or you can place it at the best bid (BB) or lower. If you place it at BB or lower, you should get filled almost immediately. If you place it at BO or higher, you will have to wait until someone else places a bid your price.

Now, with the uptick rule in place, if you place your offer at BB or lower, and the last trade was at a price higher than BB, the exchange will not execute your order. I'm not sure what they would do with it, I imagine that they will either reject it or defer it until the price ticks up. It is quite possible, that because the exchange will wait for an up-tick, you will be able to sell at a price that is one tick better. Does your action of selling at slightly better price have smaller negative impact on the market? No, I don't think so. It doesn't matter how you sell, as long as you can sell you will have some negative impact on the price.

The uptick rule creates a share of problems for the buyers as well. If you are interested in buying at a given price, you want to know that there are enough people interested in selling to you. However, if you happen to want to buy at a price that is not an uptick, the short sellers will not be able to sell you to. You may then have to wait for an uptick and buy at a higher (worse) price.

It is not true that the uptick rule prevents bear market or stock market crashes. The uptick rule has been in place during the recessions of '74, '81 and 2001 and the crash in '87. To suggest that without the uptick rule any of those episodes would have resulted in smaller market declines is absurd. If anything the opposite is true.