The American Home Mortgage admission served to sever the gap between perception and reality, putting the shark front and center.
--Mayor Vaughn, Jaws
On the Monday following the last week in July, investors were quick to slip back in for a dip. By the time Tuesday's wave of selling stopped, they realized that they would likely need a bigger boat.
After the worst week since 2003, the weekend press was flush with caveats and causes for the sudden reversal of fortune. The mainstay proxies were suddenly off five percent, technical levels were broken and shell-shocked traders quietly drew comparisons to 1987.
The market, true to the path of maximum frustration, finished the session smartly higher as the bovine raced to the podium to issue an "all-clear!" Brokerage houses upgraded the banks. The pre-market futures raced merrily ahead. Pundits screamed that the next 1000 points would be higher.
Out in the distance, however, a big fish was ready to attack. Its name was American Home Mortgage (AHM) and, while it was ominously halted throughout the Monday run, it was patiently waiting for those who had wandered back into the water.
It opened 80% lower in late Tuesday trade and immediately issued a reminder that mortgage woes weren't contained to the subprime space. Institutions with exposure to this company read like a 'Who's Who" on Wall Street, from Bear Stearns (BSC) to Goldman Sachs (GS) to UBS (UBS).
It hit home in a hurry and it is going to hit their bottom lines.
The great financial debate to date has centered on the risks of contagion and whether the heretofore decline in the banks (BKX –9%) and brokers (XBD –12%) adequately reflected the risk associated therein. It's a delicate discussion given the $500 trln in underlying derivatives that weave together our financial fabric and one that the powers that be have been quick to dismiss.
Those supposedly in the know have tried mightily to keep investors at the beach and lathered up in exposure. From Alan Greenspan's endorsement of adjustable-rate mortgages to Hank Paulson's assertion that the subprime fall-out was contained, the vernacular has been consistent and reassuring, encouraging debt assumption and steady consumption at any and all costs.
They understand that the market, as a forward-looking discounting mechanism, trades on perception. As Mayor Vaughn famously offered in the 1977 classic Jaws, "It's all psychological. You yell barracuda, everybody says, "Huh?" You yell shark, we've got a panic on our hands in the middle of July."
Mortgage-related selling and "mark-to-market" induced redemptions have been the barracuda, seemingly contained to Wall Street circles and those who understand the nuances of the structural metric. The American Home Mortgage admission served to sever the gap between perception and reality, putting the shark front and center.
The upside of anger, if there is one, is that the supply side of our current equation is different than what we saw in the spring. Back then, The Phantom of the Market was perceived deflation, a culprit that knows no allies on an absolute price basis. With the bulls-eye on the back of the banks, as it is now, the potential for sector rotation is a possible, but not probable, escape.
We often say in Minyanville that "As go the piggies, so goes the poke." It's a cutesy way of offering that the banks, the top weighting in the S&P, are a microcosm of the U.S.' finance-based economy and a leading indicator of the broader market. That's why we've been focusing so intently on the space and why it will continue to serve as an equity proxy.
And it's why we must continue to respect these developments, whether or not we're invested in the group.
Last night, while giving a radio interview, I was asked if I was suggesting investors make sales and steer clear of the choppy waters. I responded that, while I can't offer advice without knowing individual time horizons and risk profiles, the potential of deeper downside dislocation is higher than most individual investors have factored in.
"Don't be penny-wise and pound-foolish," I told a listener who was waiting for DJIA 14,000 to reappear before he made sales, "and appreciate the context of time." The industrials nearly doubled since the 2002 low and, through that lens, five percent (either way) shouldn't dictate investment decisions if you're over-exposed and overly stressed.
As I attempt to see both sides of every trade, I also offered that the flight to quality that has pushed treasury yields lower could conceivably offer a respite to consumers tied to adjustable-rate mortgages. I'm unsure how to quantify that potential upside catalyst but I certainly see it. That is why risk remains two-sided and market timing is such a devious endeavor.
Identify your time horizon, synch your exposure to your investment endeavors and educate yourself in the virtues of risk management. For if a company as seasoned as American Home Mortgage needs a "better understanding of how it will be affected by a weak mortgage market," chances are that we will as well.
- So Newscorp (NWS) is gonna grab hold of Dow Jones (DJ)? This is going to shake up the financial media mojo in a big way. Prof. John Succo taught me (17 years ago) that options are good. That relates to the market, life and, in this case, sources of information.
- Could the carnage in the financials be a function of funds paring exposure into month end? Sure, that's viable in the least and possible at the margin. Watch them closely today for any signs of traction. If they catch a bid, the tape will follow.
- I've heard several unconfirmed rumors of a massive hedge fund failure. I won't name names but it's a top ten global player. Do I believe it? Yes and No --I think there will be several high profile casualties of war but yesterday's melt was a function of three letters. A. H. M.
- After trading both sides of the market ride this past week, I faded (read: sold) yesterday's rally into former support and current resistance at S&P 1490. I pared some of that downside exposure into the bell as S&P 1460 came into play.
- Why? If S&P 1460 holds, the "double bottom crowd" will emerge (after the fact, as many seem to be doing these days). That, and my desire to bat for average rather than swing for the fences, lended itself to baby steps on the broader journey.
- The ultimate market litmus test is the self-proclaimed 5% stress test. If you're uncomfortable with your P&L five percent in either direction, chances are that you're not properly positioned. Don't wait for bad tapes to address your risk and always remember how you felt once the market provides a respite.
- Good luck today and remember to breathe.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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