Stock Market Needs To Pump Up The Volume

Monday’s record day is going to lead many investors to think the bottom is in. Maybe so, but the trading volume was suspiciously low. On one hand, the trend day buying was remarkably resilient, and world markets have continued the rally overnight. But we need to see institutional investors put their money to work in earnest for the rally to stick. This action appears to create more opportunities to short the market rather than go long.

Not that I am diving into the short side right away. We could see volume start to increase today, especially on the heels of continued rallies in Asia and Europe, and additional interventions by governments. On the plus side, yesterday was extraordinary, and volume increased at the end of the day. However, I moved out of long positions by the end of day yesterday, and will be waiting for stocks to set up for more advantageous trades. As I noted here, I started going long on Friday morning. However, most of my commodity-related positions that did so well from Friday afternoon have skyrocketed on decreasing volume. I will look for some day trades, and may miss out on some of the extended rally, but profits will be preserved.

Truth be told, the dark clouds are still quite ominous, despite government efforts. The danger is not so much that governments lack the will or talented people. I hear a lot of angry people wanting to replace the entire Congress, for example. But these people, for the most part, did not create the problem. The true danger is that world governments may not have adequate capacity and resources. As the New York Times reported on October 10, The World’s Banks Could Prove Too Big to Fail - or to Rescue. Be sure to check out this graphic as well. As the Times notes, this is less of a problem for the US than for other countries, particularly some in Europe:

For countries in the euro zone, there is an additional consideration. They do not have the right to print money. That may also be true for some other banking systems, if the liabilities are primarily in currencies other than their own. Those countries could face special problems if they needed to come up with huge amounts of cash to rescue banks.

Finally, the leverage ratio gives a rough indication of how risky a nation’s banking system might be. It is the ratio of total bank assets to the net worth of the bank. That could be misleading if the assets are very safe - government bonds, for example, versus subprime mortgage loans - but in general the higher the ratio the smaller the margin of safety.

There again, the United States appears to face a relatively small problem, with an average leverage ratio of 12. The figures range up to 52 in Germany. Theoretically, a 2 percent drop in the value of all German bank assets would wipe out the net worth of the banking system.

These figures will be meaningless if the governments retain the trust of depositors and creditors. “It becomes a matter of psychology,” Mr. Prince said. If governments say the deposits are safe “and the market believes them, then they don’t have to have any money to back up their promises.”

I still hear plenty of people making comments projecting when a recovery is going to occur, as in “we expect the recession to last into the third quarter of 2009″, or, “Stocks are now at fair value”. I’ve got news: they are pulling this out of their you-know-where. Nobody knows the true magnitude of the problems in all their complexity, nor can they truly project the chain of events that will transpire as a result. Expect to start hearing more about credit default swaps.

Shah Gilani reports:

Credit default swaps are not standardized instruments. In fact, they technically aren’t true securities in the classic sense of the word in that they’re not transparent, aren’t traded on any exchange, aren’t subject to present securities laws, and aren’t regulated. They are, however, at risk - all $62 trillion (the best guess by the ISDA) of them.

…risk speculators who wanted exposure to certain asset classes, various bonds and loans, or security pools such as residential and commercial mortgage-backed securities (yes, those same subprime mortgage-backed securities that you’ve been reading about), but didn’t actually own the underlying credits, now had a means by which to speculate on them.

As Gilani notes, “A credit default swap is, essentially, an insurance contract between a protection buyer and a protection seller covering a corporation’s, or sovereign’s (the “referenced entity”), specific bond or loan.” Because credit default swaps are subject to minimal regulation, protection sellers have not been required to keep reserves to cover their contracts. Gilani goes on to say that both Bear Stears and AIG were bailed out because the market could not afford to lose the insurance provided by their CDS.

Be safe.

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