Irrational Exuberance Revisited

Stocks continue to ignore what bonds and commodities are screaming at them.

Equities sold off sharply this morning after creditors seized the assets of a big private equity fund managed by the Carlyle Group. The fund had defaulted on nearly $17 billion of debt after failing to meet multiple margin calls on its borrowings. Its collapse led to increased speculation that other LBO companies and hedge funds may collapse, which will prove the Fed's $200 billion credit program to be the drop in the bucket that it is, given the $1.9 trillion hedge fund industry.

The sell-off - which at one point saw the Dow down more than 200 points - had strong fundamental underpinnings, and was made worse when Hank Paulson announced his ideas for salvaging the credit markets, which were universally panned as either unworkable or of little to no consequence.

Then, exuberance set in. The market rebounded. And the Dow closed up 35 points. Why?

I saw two different Bloomberg headlines attempting to answer that question. One attributed it to a rally among commodity producers, as oil and gold hit new record highs, because the dollar hit new record lows. I love it when the markets rally on record oil prices because it's good for Exxon. Never mind that it's bad for the rest of the economy, and for every non-oil stock trading. Remember the good old '70s?

The second reason was this: "U.S. Stocks Gain as S&P Forecasts Subprime Losses Will Slow." Oh, really? Is this the same S&P that totally missed the mark in rating billions of dollars of subprime toxic waste AAA? The same S&P that still won't follow its own ratings guidelines, for if it did, another $120 billion or more of AAA bonds would be downgraded, which would probably get the ratings agencies collective backsides sued off? Sorry, I'm not drinking any flavor of Kool-Aid S&P chooses to pour. (More on ratings in a future post.)

This silliness comes after a rally Tuesday morning - later corrected - that was reportedly driven by two stocks, Bear Stearns and Caterpillar. The stock price of Bear - once Wall Street's most respected bond house, now its village idiot - had fallen from more than $170 to $60ish. With rumors swirling that the company had a liquidity shortage, buying of put options on Bear's stock, which are bets that it will fall to a given level (called the strike price) became frenzied, with speculators buying puts with strike prices as low as $30 - in other words, betting the stock would fall by half again.

So why the Bear-led rally Tuesday? Bear's new CEO Alan Schwartz (they fired the old one) told CNBC interviewer David Faber that the liquidity rumors were just that - rumors. That's what Bloomberg says, anyway. Well, I watched the interview, and Schwartz looked incredibly uncomfortable. My wife commented afterward, "I'll bet he never wants to go on CNBC again."

Faber challenged Schwartz's assertion, saying, "So if I told you that a hedge fund manager, whom I know well, told me they were trying to sell a position, and Bear Stearns was the low bidder, and Goldman Sachs, who was the swap counterparty, refused to let the fund accept Bear's bid because Goldman considered Bear an unacceptable counterparty risk, you're telling me that's a rumor?"

Ouch. Schwartz replied with some Hank Paulson-esque stammering, eventually saying in effect that that was just one transaction, and that they've been able to get other transactions done. Kudos to Faber for his original thrust, but I'd have parried back with, "Really? Can you give me one example?"

During today's morning sell-off, Bear's stock dipped as low as $50.48. Those $30 put buyers might be onto something. I wonder if they're Bear employees.

As for Caterpillar, it rallied because it "boosted its sales forecast ... by 20 percent," according to Bloomberg. Yeah, that's cause for a rally, at least in that one stock. Except the part I replaced with the "..." read, "for 2010." Caterpillar can't realistically forecast its sales for the fourth quarter of this year, much less 2010. Show me some orders, and I might buy it.

The last time we saw a big fundamental morning sell-off reverse in the afternoon to close within 50 points of the Dow's previous level was March 4, and the afternoon rally that day was for equally silly reasons. As is always the case in a bear market (maybe we should say Bear market?), the false-hope-driven rebound was soon reversed, as trading was pretty much sideways March 5, then the bottom fell out.

The ensuing three days saw the Dow shed 515 points. Even Tuesday's irrationally exuberant 417-point rally wasn't enough to recoup those losses.

So if history repeats itself - and mark my words, it will - the next few days should bring a return to reality, meaning another big selling spree. Also, the Fed meets Tuesday, and they're widely expected to cut rates by 75 basis points, but inflation pressures could force them to hold at 50. If that happens, look for a blood-bath the rest of the week.

Note: tomorrow I'm headed off to the sunny Caribee for a family spring break trip, so posting will be light, unless I find myself unable to sleep nights. Which is unlikely, as I'm sleeping much better these days, having taken advantage of Tuesday's silly rally to cut my losses (or, more accurately in the long-term sense, lock in my gains). Now, I'm out of equities altogether, save for a couple of leveraged inverse bets that should pay off handsomely.