August 13, 1999

The bulls had their way with us bears this week, as the Dow gained 260 points, or 2-=%. The S&P 500 and Morgan Stanley Cyclical indices gained 2%, as did the small cap Russell 2000. The Morgan Stanley Consumer index underperformed, rising just 1%, while the Transports dropped 1% and the interest-rate sensitive Utilities were hit for 2%. It was a buying stampede throughout the technology and financial sectors. The NASDAQ 100 gained 4%, increasing its year-to-date gain to 26%. The Morgan Stanley High Tech index and the semiconductors both rose 5%, bringing their 1999 gains to 33% and 48%. The Internets also rallied strongly late this week, with The Street.com Internet index gaining 6%. Despite all the talk of the big Internet sell-off, the Street.com Internet index sports a 30% gain for the year. The financials also had a powerful rally with the S&P Bank index gaining 4% and the Bloomberg Wall Street index surging 7%. At least for a few days, the market was able to ignore the darkening storm clouds encircling our financial system.

As we have written previously, US banks currently have off-balance sheet derivative obligations in excess of $33 trillion. Of this, fully $25 trillion are interest rate-related instruments. The growth of these products has been truly astounding. From less than $4 trillion at the end of 1991, interest rate derivatives swelled to $9.9 trillion by the end of 1994. Many of these derivatives proved quite problematic for many, and disastrous for some, in 1994 when the Federal Reserve began tightening policy after a long period of extraordinary low interest rate accommodation. There were heavy losses and even bankruptcies in the hedge fund community, some big losses and lawsuits from corporations stung by derivatives, and the Mexican financial meltdown. And who can forget the sad situation where leveraged positions in structured notes issued by Fannie Mae, Freddie Mac and Sallie Mae led to the bankruptcy of Orange County. Yet, none of this seemed to dampen the enthusiasm for derivatives. Although total interest rate derivative growth did slow to $1.1 trillion in 1995, derivatives were right back in vogue in 1996 with $2.3 trillion additional interest rate derivatives created. Growth further accelerated in 1997 with an additional $3.7 trillion. Nothing, however, compares to last years derivatives explosion, especially in the interest rate area. Indeed, interest rate derivative positions expanded by an amazing $7.7 trillion, more than the total interest rate derivatives outstanding at the end of 1993.

Inarguably, the system went absolutely nuts beginning last summer. During the second half of last year, in the midst of a heightened global crisis, the collapse of Long Term Capital Management, and a near financial debacle, total derivative positions grew almost $5 trillion. And it was certainly not a coincidence that this happened concurrently with the greatest explosion of credit growth in history. In particular, there was an unprecedented expansion of financial credit as many major financial institutions, including Fannie Mae and Freddie Mac, aggressively borrowed in the money markets or used other short-term financing vehicles to leverage mortgages and other financial assets. Digging further in to the details, we see that interest rate swaps increased $3.5 trillion during last years second half, an annualized growth rate of 65%. Total interest rate swaps ended the first quarter at $14.6 trillion, and it is precisely here that we see what we believe is at the heart of todays problem: A major dislocation in the interest-rate-hedging arena. As history has proven time and again, all one needs to do to spot an upcoming financial problem is to recognize the area that has been most prone to egregious credit and other excesses. In this regard, we have a keen eye on interest rate swaps.

First, lets look at the definition of an Interest Rate Swap  "a contract in which two counter-parties agree to exchange interest payments of differing character based on an underlying notional principal amount that is never exchanged." Basically, a swap just allows the exchange of interest rate risk from one party to another. While there are many variations of swaps, their recent spectacular growth is certainly associated with the proliferation of leveraged speculation that has become endemic to our financial system. Whether it has been the over-enterprising hedge funds and securities firms that leverage mortgages, asset-backs, junk bonds and agency securities in the repo (repurchase) market, or Fannie and Freddie that aggressively use money market borrowings to finance their bloated balance sheets of mortgages, or companies such as GE Capital and GMAC that borrow in the money markets to finance holdings of various loans and receivables, these strategies of borrowing short and lending long create significant interest rate risk. And in this vein, remember that our financial sector increased borrowings last year by more than $1 trillion, in what largely amounted to one massive interest rate arbitrage.

Many speculators incorporated the use of swaps and other interest rate derivative products, thus basically shifting some of their interest rate risk to the writers of these swaps and helping mitigate interest rate exposure. The writers of these swaps were more than happy to book the premium charged for these products right to the bottom line, expecting that they would hedge their risk if rates began to rise. A particular type of instrument became very popular, a so-called swaption. "A swaption is a contract on an interest rate swap. The contract gives the buyer the option to execute an interest rate swap on a future date, thereby locking in the financing cost at a specified fixed rate of interest. The seller of the swaption, usually a commercial bank or investment bank, assumes the risk of interest rate changes, in exchange for payment of a swap premium."

Valuing these types of swaps with embedded options can be very tricky and writing such exceedingly volatile derivatives is a most risky endeavor, as many have learned this year. Another risky instrument that has become quite commonplace is the inverse floater. An Inverse Floater is often a mortgage-backed bond, usually part of a collateralized mortgage obligation bearing an interest rate that declines as an index rate, for example, the LIBOR rate, increases. The agencies have made these quite attractive, particularly to the speculators, with enticing, above-market yields. However, with interest rates rising and spreads widening sharply, there have been significant losses suffered in this area. Remembering how many of these types of instruments blew-up in 1994, we wonder when we will again hear the term "toxic waste". Putting all of these derivatives and instruments together, there should be little mystery as to why our credit market has become so unstable.

Today, the key point to recognize is that with interest rates moving sharply higher after a period of unprecedented credit excesses, leveraging, speculation and financial engineering, the massive, virtually systemic, interest rate arbitrage has faltered badly. Huge losses have been suffered and our acutely vulnerable credit system is today impaired. Now it will just be a matter of time until we find out how these losses will be shared among investors, financial institutions, the leveraged speculating community and their insurers, the derivative players. Actually, however, we do tend to lump the derivative players in with the leveraged speculating community. All the same, we just cant shake our nervousness when we compare todays $25 trillion of notional interest rate derivatives to the $7 trillion that existed at the end of 1993. After all, there were certainly enough derivative-related fiascoes in 1994 with $7 trillion outstanding. Here, the old mountain versus a mole hill adage seems appropriate. Also, keep in mind that to this point the Fed has only raised rates 25 basis points, so we could potentially be very early in this process. Today, there is simply so much uncertainty weighing on the credit markets as to the health of the key derivative players as well as general confusion as to how this will all work. With $100 trillion of derivatives globally, we are much in uncharted territory that is reflected in heightened risk premiums.

In this context, today there is absolutely no transparency to judge how some of these major players are weathering the storm. Combined, Fannie and Freddie have $500 billion in derivatives, but one can discern little from their financial statements in determining if they are indeed adequately hedged. They could be in fine shape or in big big trouble, but there is simply no way to know. Looking at Chase Manhattan, with the largest notional derivative exposure of any institution, they had $10.4 trillion of total derivative positions at the end of the first quarter, including $5.4 trillion of swaps and $3 trillion of forward contracts. Is their book properly hedged or is their derivative portfolio an accident waiting to happen? Again, there is absolutely no way to know. All the same, there is no doubt that many players in the marketplace have suffered great losses and this has led to a general dislocation in the swaps area with players left pondering the soundness of the entire market. Yesterday, 10-year swap spreads increased to as wide as 112, the highest since 1987. For comparison, this spread had not traded above 100 this decade, even during last falls near financial debacle. This spread began June at 79 and was 71 at the beginning of May. Additionally, the key TED spread, or the interest rate differential between Treasury and Eurodollar yields, widened almost 8 basis points yesterday, a quite notable one-day move. Even today, with a bond market rally and major stock market advance, the TED narrowed just 1 basis point to 85. The TED began June at 52.

But we will be the first to admit that all this seems rather moot on a day where the Dow gained 184 points and the S&P Bank and NASDAQ100 indices advanced 4%. And while the bulls and the pundits will celebrate todays benign inflation report, it is largely irrelevant to the big picture. The bottom line remains that we are in the midst of unfolding financial turmoil with a dislocation in the credit markets. We believe that the credit environment has changed and that we are in the process of witnessing a dramatic slowdown in the great Wall Street money spigot that has provided a virtual unlimited supply of easy credit for any borrower. Moreover, our economy is an over-heated bubble economy and, combined with our vulnerable financial system, is leading to the reevaluation of the long-term health of the dollar. And each month the bubble lingers only leads to more problematic distortions.

Yet, with one week to go until option expiration, todays news provided a fantastic opportunity to run the market. Certainly, derivatives played a key role in todays buying melee. However, one of these days derivatives will not be so helpful and, in fact, we fully expect that they will play a major role in a selling stampede. For now, however, and as we stated in a recent commentary, the bull has only been wounded and maintains quite a proclivity for particularly unruly and violent market action - the type of wild volatility that often proves a harbinger of a change in trend. In this regard, this is all rather "textbook" but that doesnt make it any easier to play. With todays announcement, the bulls took full advantage and gapped stocks open and forced the bears and derivative players to rush to unwind positions. With five days to go, a rally like todays does wonders for the writers of put options that would have been on the hook without a rally. They certainly won the battle for the day, and the week for that matter. But, over the coming week and months, it will be fundamentals that dictate who will be the big winners. With this in mind, we will not let todays market be too discouraging.

David Tice

prudentbear.com

-- Andy (2000EOD@prodigy.net), August 13, 1999

Answers

It's such a bummer, just when Apple is kicking butt (60+), the market has to fail.

Apple - compliant from birth to dust.

-- dw (y2k@outhere.com), August 13, 1999.

Hey dw,

at least they've got THE BEST y2k ad so far! :)

seen during the Superbowl

HAL...

anyone got a link?

-- Andy (2000EOD@prodigy.net), August 13, 1999.

So Andy finally finds something worth quoting -- the third sentence in the ninth paragraph. Of an article that basically says, well, we got our asses kicked again this week, and our inflation prediction was wrong again, sorry for all the money you pissed down the rathole listening to me, but hey, we'll get 'em next month, you bet.

-- Flint (flintc@mindspring.com), August 13, 1999.

Flint you gigantic ass,

you obviously haven't read any of the economics articles I've posted recently, you know, the ones that address the financial calamity about to hit circa the same time as y2k...

wassup, eyesight failing you in your doddering premature senile dementia???

-- Andy (2000EOD@prodigy.net), August 13, 1999.

By the way, despite Flint's know-nothing wibbling,

the Prudent Bear fund went up this week from $3.97 to $4.19 (peaking at $4.35), not at all bad in view of the imminent market collapse and the manipulation of the PPT and options expiry players...

-- Andy (2000EOD@prodigy.net), August 13, 1999.

Today's market action

Blast off in the morning - mini blast at the close.

It was the desperate sort of panic buying on moderate volume that characterizes a bear market rally. The psychology is important. The institutions were desperately buying as if they might miss something. Fear of being left behind. You could smell it all day.

The producer prices show more substantial increases for the crude and intermediate goods. That trend accelerated with this release. Indeed, inflation increases only very gradually. It takes years for PPI and CPI to go from 2% to 5%. But because what cannot happen in the statistics did not happen the market went wild. A classic reaction. Today's money managers have never seen accelerating inflation before and simply have no clue what to expect.

Many bears on this thread accuse the government statisticians of cooking the numbers. In truth they don't have to. The politicians have already done it for them by deciding what items to measure. Thus, a big component of finished goods are "computers." The game is even more egregious in the CPI. They removed home prices in 1982 and substituted "rental equivalents" which are, of course, a proxy for falling interest rates. Despite the fact that only 50% of the population use PC's, they are a part of the CPI, while the increasing items for that same population, such as college tuition, are excluded. The index is loaded with stereos and other appliances imported from Korea and Thailand, while things like domestically produced autos are adjusted for "quality improvements." A new Chevy Camaro costs only $7,800 in our CPI because of these improvements. To contain food costs, we have "substitution effect adjustments. As people shift from beef to less expensive chicken, the price of beef counts less. Inflation will stay contained if, because of rising food prices, we all switch to dog food.

A math Ph.D. friend who has worked on the CPI assures me that the CPI number is honest. "It is exactly what it is". Indeed, but it has little to do with inflation. And that is why Greenspan never speaks about PPI or CPI as a leading indicator of inflation in his testimony before Congress, but prefers to focus on the Employment cost index, import prices, commodity prices and other more relevant measures. He knows that the headline PPI and CPI numbers are political artifacts, a 20th Century equivalent of "let them eat cake", or is it dog food?

The mystery is why the market could care about such things. It stretches the imagination that the market could care about such a pure social ritual. It is as if we must have a screaming relief rally because the headline number will not scare people away from sending more money to Wall Street. It is about spin and the ability to manipulate the perceptions of Joe Sixpack. It has little to do with the real return on securities, but perhaps such things as discounted returns simply don't matter any more.

In any event, the NDX is now in overbought territory, and is due for a slide. The S&P is close. The NDX has retraced slightly more than 50% of its recent slide, and might make it to 61.8% or 2330 on Monday. The S&P looks like it could reach 1340.

Several pieces of interesting news. The gold stocks don't buy the idea that inflation is dead. The went down only very modestly today.

More important, the Semiconductors, the group that has been on a wild ramp since the beginning of June, has underperformed the Nasdaq 100 for the past few days. This is important, because we cannot have any meaningful Tech sell off until the SOX starts moving south. Its weakening RS relative to the NDX is an interesting portent.

Finally, today's tape action shows us that the bullish sentiment is alive and well. Volume tells us that the bulls do not have the money they had in January or April.

But the sentiment also tells us that bond bulls waiting for deflation must be patient. With sentiment still in such and agitated and euphoric state, the arket is going to have to go down several thousand Dow points before the economy will begin to weaken and bonds gain. And once the market does tank, you must be on the alert for panic at the Fed. If they flood the economy with money, gold is likely to do better than bonds.

from prudentbear.com

-- Andy (2000EOD@prodigy.net), August 13, 1999.

andy and others,

So how dose one protect his assets? Say you have paid off your house, Dont have any debt. Have preps done. Liquidated equities, and have money left to protect. Now what? How much in metals? How much in treasuries? How much in Cash? How much in ??? I have friends that tell me I would be a fool to put anything of substance in Gold or silver. To risky. Even if the derivatives explode, the banks run, the banks computers get fouled up,the market crashes big, they say Fed paper will always be good. Any good ideas out there. I just want to try and keep what I have in tact, don't need to make a killing. Help! Also if you recomend gold, why gold over silver? or vis-versa.

-- Gambler (scotanna@arosnet.com), August 13, 1999.

Andy,

I heard of a block trade of 50,000 shares of IBM took 45 minutes to sell today. The source was CNBC the sheeples network. They said generally this type of trade goes off in seconds. Market liquidity is drying up. Overall the market has been in a bear since March of 98. The Declining stocks are beating out the advancers day in and day out at a ratio of 5:1.

If the Producer Price Index (PPI) numbers were not fabricated as they were the market would have declined today. I am sure that the Consumer Price Index (CPI) numbers will come out positive on Tuesday also. They got to keep the herd in a little longer. Its really wild that last weeks numbers showed a decrease in hourly production per worker and an increse in wages and this gives us positive PPI numbers. Its laughable that the masses can't see whats happening.

Andy, you ought to buy some December Dow puts at the 7000 strike that are selling for $225.00 per contract. You won't regret it. Check out BOHL and Associates to follow options.

-- flierdude (mkessler0101@sprynet.com), August 13, 1999.

know of a foundation that is involved with the derviatives market, had several of those devices unwind on them. The principles are starving waiting on the feds and bankers to unlock their portion of the monies in the 100s of millions. Derviative failures if not addressed soon by a global economic sumit to stop the meltdown in progress will make 1929 look like a minor wind storm compared to an f6 twister. It will cause a wipeout of unimaginable consquences. They have to stop the addiction to bad paper. If they want to continue using these instruments they have to set a world wide limit and rules and stick to it. It will serve nobody any good if the world finaical system tanks, It,s in nobodies best interest. It needs serious rehabilitation and fast, They need to balance debt instruments with debt free instuments as the only way to solve the coming crunch.

-- y2k aware mike (y2k aware mike @ conservation . com), August 13, 1999.

flierdude:

Advances beat declines 2:1 today, and I think came out slightly ahead for the week. This is a very far cry from your claim of a 5:1 declines over advances "day after day".

Oh well, the market is going down, dammit. Pay no attention to all those numbers behind that curtain.

-- Flint (flintc@mindspring.com), August 13, 1999.

flierdude,

Which December 7000 puts, 1999 or 2000? From the price you mention, it would seem Dec 2000. If so, you might consider nearer term puts, perhaps June or even March.

Jerry

-- Jerry B (skeptic76@erols.com), August 13, 1999.

Flint, maybe you can write an essay on all the people who have written books predicting a stock market crash, bankruptcy, money panic, etc., Here's a few authors to start with: Howard Rush, Dr. Ravi Batra, Martin D. Weiss, Harry E. Figgie, Jr., Stephen M. Pollan & Mark Levine. Some of these authors are Ph.d's of Economics at some of the top universities in this country. For the past twenty years I have read some of these authors' writings and NONE of their predictions have come true. They were intelligent enough to write a book on doom and gloom in hopes that the fearful public would zone in on how to protect themselves from POTENTIAL financial ruin. They played on people's fears, and perhaps that's why so many Y2K entrepreneurs are so successful today. However, Y2K like any other predicted diasaster is short lived and these vultures wait for the next nonevent.

-- watching it all happen (watchjingitallhappen@watchingitallhappen.com), August 14, 1999.

"the Prudent Bear fund went up this week from $3.97 to $4.19 (peaking at $4.35), not at all bad in view of the imminent market collapse and the manipulation of the PPT and options expiry players... "

..... not at all bad, leaving aside the fact that the fund went from $9.50 to $3.80 over the last 11 months. Tice (the fund manager) seemed constitutionally incapable of steering clear of the most disastrous short picks, month after miserable month.

However, things have looked up the last several weeks; e.g. today BEARX lost only a dime, on an explosive NASDAQ rally. BEARX is supposedly roughly the inverse of NASDAQ. However, over the past 10 months or so, when the NASDAQ has tanked, BEARX gains little, while when the NASDAQ explodes, BEARX takes a beating. But, as I say, this (unsustainable) situation has improved in recent weeks.

-- alan (foo@bar.com), August 14, 1999.

credit where credit is due: I forgot to mention that Tice (BEARX fund manager) has an OUTSTANDING intellectural grasp of the current mania and financial bubble, and is very articulate. He writes truly excellent market commentaries. Many of them I save myself; great stuff. However, his record as a fund manager..... well, it speaks for itself.

-- alan (foo@bar.com), August 14, 1999.

Alan - LOL, yup you are right, I'd be crying into my beer if I had been in over the last year or so, however I've only just got in to BEARX at current levels so I'm keeping my fingers crossed...

Gotta put the 401k somewhere so Tice it is...

Every bear has it's day... :)

-- Andy (2000EOD@prodigy.net), August 14, 1999.

Prudent Bear gets a lot talk action around here. Is there an equal consensus 2nd or 3rd choice for bear types? Any favorite leap puts?

-- Carlos (riffraff1@cybertime.net), August 14, 1999.

Carlos,

maybe RYDEX ultra, USPIX too, if you look in the archives there was some good stuff from freddie the freeloader on LEAPs into the year 2000, he assures us all that we will retire rich,

damn, wish I could find the link...

-- Andy (2000EOD@prodigy.net), August 14, 1999.

The Prudent Bear fund is a fund which always stays short. People who invest in it and who read the prospectus know that. Therefore, don't blame the manager when the fund declines in a bull market. If someone wants to evaluate its performance, it should be compared against the Rydex and Profunds short index funds.

-- Dave (dannco@hotmail.com), August 14, 1999.

Check out this Freddie thread:

http://www.greenspun.com/bboard/q-and-a-fetch-msg.tcl?msg_id=0012Ru

hotlink

-- Puddintame (achillesg@hotmail.com), August 14, 1999.

Jerry B.

Mine are December 99's. I'm not interested in farther out dates as I am afraid at this time of computer failures that won't allow me to sell them after January. If the market does not crash by then and Y2K does not cause major problems I will explore those possibilites.

Flint,

ROTFLMIU, Rolling On The Floor Laughing myself into unconscienceness. This is the first time and last that I will ever even acknowledge you.

-- flierdude (mkessler0101@sprynet.com), August 14, 1999.

flierdude,

December 99 DOW 7000 puts at $225???? You could get DJVXN, Dec 99 9200 puts for less than that even before Friday, and by Friday's close, DJVXR, Dec 99 9600 puts were less than that. Something seems amiss here.

Jerry

-- Jerry B (skeptic76@erols.com), August 14, 1999.

Jerry, Mike (flierdude), freddie,

I think I'm going to take the plunge and allocate some cash for some puts on the DJX and maybe calls on gold and/or silver.

I already am in the process of setting up an account with Lind Waldock.

I have very big reservations over whether the banking system and indeed the CBOE will make it and continue to function.

At the same time, should they stay up I will be kicking myself for not following my hunches.

Can any of you point me to any previous links on how to read the CBOE tables, the mecanics of placing the trades etc. ?

I am sure all three of you have put this on various threads but I can't find them for the life of me. I'll continue looking but in the meantime...

thanks for all the advice :)

-- Andy (2000EOD@prodigy.net), August 14, 1999.

Andy,

The CBOE has a web site at:

http://www.cboe.com/

from there, the PRODUCTS link will take you to a list of links to the specifications each of their various options.

Since options have many "strike prices" and expiration dates, it may be useful to get an overall view of a set of options, such as DJX, and how they respond to each day's market moves.

Using DJX as an example, here is my "canned" description of how to get and read a set of CBOE option data.

Starting at:

http://quote.cboe.com/QuoteTableDownload.htm

Enter DJX in the entry field and press the download button, etc.

If you download the DJX info, you will see, among other things, three sets of December options. The first is for December 1999, the second is for December 2000, and the third is for December 2001. A new set of the info is available each trading day, and includes prices on about 160-170 DJX options. Sometimes that site is very busy right after market close, so I wait an hour or so before trying to do the download.

4. Here is what an entry looks like (this is from July 8 when the DJIA closed at about 11,127):

Mar 90 (DJV CL-E),24 3/4,pc,25 3/8,26 1/8,0,200,Mar 90 (DJV OL-E),2 1/8,pc,2 3/16,2 9/16,0,12164,

The Mar 90 (DJV CL-E),24 3/4,pc,25 3/8,26 1/8,0,200 part on the left is a call, and the Mar 90 (DJV OL-E),2 1/8,pc,2 3/16,2 9/16,0,12164 part on the right is a put. The parts in ( ) contain the symbols. Throw away the blank and the -E, and for the put you get DJVOL.

Parsing the put info: the Mar is the month that contract expires. The 90 is the "strike price", in this case meaning that that contract will be "in the money" if the DJIA gets below 9,000. The 2 1/8 is the last price at which it traded. The pc means it did not that day (if it had traded, that space would have shown the difference since the previous closing price). The 2 3/16 was the closing bid, and 2 9/16 was the closing ask. When you buy, you pay the ask times 100, when you sell, you get the bid times 100 (in both cases you get to pay broker fees). The 0 is the volume, the number of that contract that traded that day. The 12164 is the "open interest", i.e. the number of DJVOL contracts that existed as of the previous close.

Meanwhile, I believe that gold futures and options are traded on the NYMEX, which has a web site at: http://www.nymex.com/

From there you can pick the futures and options link, and from there page down and pick the gold link.

I do not follow any NYMEX options, so I don't know much more than that about getting nitty gritty details on them.

(A personal comment: unless you are very wealthy, stay away from futures! With options, you can lose every penny you invest; with futures, you can lose more than you invest.)

Some day when (if) I get organized, I may try to put together some of the statistics that I've been collecting on the DJX, with some comments on respones of different specific options to market moves, and some general comments on strategy. But not today. :-)

Jerry

-- Jerry B (skeptic76@erols.com), August 15, 1999.

Banking news.

Monte Paschi launches millennium bug bond

-- (M@rket.watching), August 15, 1999.

Jerry,

you are a scholar and a gentleman! - thanks for taking the time to explain things - cheers!

-- Andy (2000EOD@prodigy.net), August 15, 1999.