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The Real Reason for Yesterday's Rally


The rally we saw yesterday was a phenomenon of high option prices.

As TV announced the end to all economic problems with the stock market rally yesterday, I caution Minyans to stay tuned.

The rally was apparently precipitated by Wal-Mart (WMT) not guiding down (as the recession deepens more people will shop at Wal-Mart) and banks writing down less than was feared (until the next time). Of course this is hogwash.

The rally in stocks yesterday was technical in nature, just like the crash of 1987. The rally we saw yesterday was a phenomenon of high option prices. Prof. Succo has explained this to me before and it makes perfect sense. Options with high prices have a lower gamma, requiring traders who are short options (like ones that sold put options to money managers who paid high prices to protect their portfolios) to dynamically hedge their positions less. As we learned from the 1987 crash, dynamic hedging causes traders to sell more into a declining market and buy more into a rising one. When traders buy or sell less, volatility drops, taking options prices down with it. So when volatility drops – like it did yesterday – money managers who panicked and paid high prices for puts get nervous that their puts will erode in value. If their puts expire worthless it will cost 5% in returns they cannot afford to lose so they start selling their puts. This causes the market to rally and option prices to go down. As option prices go down the gamma goes back up and the whole thing begins again and over in fits and starts

Let's not mistake a technical rally, the most vicious of which tend to occur in bear markets, for changing fundamentals. I have described those fundamentals several times. This is not just a shallow profits correction; it is a credit crunch caused by years, if not decades, of easy credit created from banks with the Fed at the helm. The US' international trading partners learned the same trick and have been doing it too. With so much debt in the system and too little real income to support it, the only way out is for that debt to be destroyed.

That is what banks are doing when they announce "write-offs" -- they are destroying debt. So far these write offs are being characterized as "one time" by the banks and insurance companies that own that debt. This is delusional. Are you going to believe the same institutions that tried to convince everyone that there was no problem in the first place?

What if I told you that trillions of dollars would eventually be written off? Well, unfortunately it is a real possibility given the magnitude of debt in the system.

This does not mean go out and short stocks. As you can see from yesterday, stocks are driven by emotion in the short run and anything can happen. If you are going to short stocks, you have to do it within the context of controlling risk. Not many people can do that well.

It does mean be prepared for worsening conditions. It means be conservative with your money and stay out of debt.
No positions in stocks mentioned.
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