Trade in Groups

Black Monday, 2008, was a day when nothing was safe. The numbers – Dow down 778 points, 499 of the S&P 500 stocks down – are going to be remembered for a while, but the story is that in a credit constrained environment, selling can beget selling to the point where nothing is safe. The consistent downward price action hit tech and energy/materials stocks particularly hard, as funds that are down were forced to sell stocks in stronger sectors to raise cash. While I continue to urge a capital-preservation-first mindset, that does not mean to blindly sell holdings to cut long exposure. Panic is not a state that helps in making rational decisions, and the ability to make rational decisions in stressful markets can make or break a portfolio.

At a time like this, there is enormous uncertainty surrounding the very foundations of the financial markets. Credit is scarce and extremely expensive when available, Congress could pass a monumental relief bill, and the contagion has started to cause European casualties. There is much to be worried about, but that also means there is much that could improve. How to handle this state of affairs?

On a micro level – focusing on specific stocks or industry ETFs – the mindset has to be one of aggressively defending what can be defended. Do a threat analysis analyzing the liquidity and debt maturities, asking questions about how a company funds their operations, and how the market perceives their creditworthiness. General Electric (ticker: GE), for example, is one of only a handful of Aaa-rated companies… but are they truly Aaa? The bond markets say GE is a Baa credit, or barely investment grade; the credit default swap market says GE is a single B credit, or far into junk territory. Over two months ago at the end of July, when GE was still nearly a $30 stock, the CDS market was saying that GE was barely investment grade. The bond and equity markets followed, and now the CDS market is saying things are going to get worse for GE from here. By expanding the toolkit of analysis, investors and traders could have foreseen the wariness with which the markets would treat a complex, heavily financial company like General Electric.

Interestingly enough, this is not an isolated example. My dataset of implied bond and CDS ratings from the end of July shows that the most skepticism was displayed toward – surprise! – Wachovia (WB), followed by Morgan Stanley (MS), AIG, and Citigroup (C). There is always going to be a degree of uncertainty with the markets, but by monitoring crucial measures like liquidity and the credit markets, the chances of an adverse surprise like owners of BSC, LEH, AIG, WM, and WB experienced can be minimized.

On a more macro level, much of the market’s problems come down to a lack of trust, because trust is what’s required to extend credit. There are too many executives in the financial arena who have sacrificed their credibility by publicly denying truths that would only be realized later, under pressure, and at a greater cost to shareholders. Now that we’re finally starting to see large capital raises from surviving (so far) institutions like GE, Goldman Sachs (GS), and JP Morgan (JPM), it’s a sign of progress… but not necessarily a bottom fundamentally. The only individual stocks I feel comfortable issuing a blanket blessing on are companies with zero liquidity risk, or with substantial free cash flow, a high cash/no debt balance sheet, and a large stock buyback in place. Accenture (ACN) fits the latter bill.

From a trading perspective, I still side with an institutional trade note I received after Monday’s close saying to be long the S&P 500 on a very short-term basis; though I won’t believe a larger rally can be sustained until all the short-term lending metrics come down.