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Tuesday, October 9, 2007

Earnings Season Begins

I hope everybody had a happy (Canadian) thanksgiving weekend.

Northern Rock Wins New Guarantee From U.K. Government (Update4): “Northern Rock Plc, the U.K. mortgage lender bailed out last month by the Bank of England, said the government will guarantee deposits until financial markets become less volatile. The shares rose the most ever.

Chief Executive Officer Adam Applegarth is struggling to keep the company in business as buyout firms including J.C. Flowers & Co. consider bids. A surge in borrowing costs forced the company to seek a rescue from the Bank of England on Sept. 13. Customers withdrew more than 2 billion pounds ($4.1 billion) in the next three days, the first run on a U.K. bank in more than a century.

“This may make Northern Rock easier to sell,” said Philip Shaw, chief European economist at Investec Bank in London.”

Its probably not a good sign when you have to guarantee deposits in order to find a buyer. Keep a close eye on how this turns out. Pricing Northern Rock will illustrate just how good or bad things are for the bank.

Ellington Freezes Withdrawals From Two Mortgage Funds (Update3): “Ellington Management Group LLC, the Old Greenwich, Connecticut-based hedge-fund firm that focuses on mortgage securities, suspended client redemptions from two funds because it's too hard to value their assets.

Investors won't be able to withdraw money from New Ellington Credit Overseas Ltd. and New Ellington Credit Partners LP, according to a copy of the letter posted on the Internet blog There's been little or no trading in some low-rated or unrated securities backed by subprime home loans, making valuations difficult, the Sept. 30 letter said.”

Another hedgie in trouble. Note: “…it’s (still) too hard to value their assets.” Brackets are mine. Even after record liquidity injections and a euphoric rally in equities, certain credit derivative markets are still in a deep freeze. Proceed with caution.

U.S. Stock Market Stumble Presaged by S&P 500 Options (Update3): “Skittishness over the U.S. stock market's record-setting rally is reaching a crescendo among options traders who are preparing for a crash.

Investors are paying the most ever to protect against a drop in the Standard & Poor's 500 Index, data compiled by Morgan Stanley show. The gap between the price of so-called put options on the benchmark for U.S. equity and the cost to wager on further gains has averaged about 8 percentage points since August. That's more than the previous high in July 2001, before the index dropped 34 percent and fell to the lowest this decade.

The widening spread is a warning for OppenheimerFunds Inc. and Harris Private Bank, which oversee more than $300 billion and say the bearish bets indicate stocks may fall. The S&P 500 rebounded 10 percent since Aug. 15 on speculation the worst is over for banks and homebuilders hurt by the collapse of subprime mortgages. Shares in developed markets outside the U.S. have done even better, climbing 14 percent from their trough.”

As I’ve mentioned many at time: The fundamentals have continued to deteriorate and the rate cuts and liquidity injections did not magically fix the most serious of problems. Looking at equity prices at new records highs, ask yourself: Are things really this GOOD?

“Last week's advance hasn't dispelled concern among traders in U.S. options. They are pricing in the highest risk of an equity-market decline since the technology-stock bubble burst at the start of the decade, according to Carl Mason, head of U.S. equity-derivatives strategy at Morgan Stanley in New York.

Mason says implied volatility, a measure that calculates expected price swings of an underlying asset and is used as a barometer for options prices, shows many investors are betting that stocks may fall.

Since Aug. 15, the implied volatility of put options that lock in gains should the S&P 500 drop at least 10 percent in six months has averaged 24.08 percent, according to data from Morgan Stanley, the second-largest U.S. securities firm by market value after New York-based Goldman Sachs Group Inc.

The implied volatility on puts is 8.1 percentage points higher than for call options, enabling investors to profit if the index rises at least 10 percent in the same period. The so-called implied volatility skew climbed as high as 8.53 points since mid- August. That's steeper than 99 percent of all readings since the start of the decade, Morgan Stanley said. The median difference is 5.9 percentage points.

The gap shows there's “an awful lot of nervousness,” said Mason. “A lot of investors don't want to get caught out.”

It looks like the smart money will be selling into rallies to lock in their gains. This kind of option behavior does not suggest investors are looking to put new money to work on dips. Remember, its earnings season. While expectations have been ratcheted down substantially and are therefore most probably ‘beatable’, it is guidance that will make or break the stock.