October 16, 2008: This Should Be An Interesting Show...

SPONSOR: House Oversight and Government Reform Committee

AGENDA: Full committee hearing on "The Regulation of Hedge Funds."

WHO: John Alfred Paulson, president of Paulson & Co., Inc.; George Soros, chairman of Soros Fund Management LLC; Philip Falcone, senior managing director of Harbinger Capital Partners; James Simons, director of Renaissance Technologies LLC; and Kenneth Griffin, CEO and managing director of the Citadel Investment Group, testify

DATE: October 16, 2008

Short Selling Ban, Part VI: Volatility Eruption, The VXO has gone over 90% intra day...

You may recall that I drew a chart of the VXO (the simpler cousin of the VIX, which tracks volatility levels in near month index options instead of the more sophisticated basket used by the newer benchmark) for H2 1987 vs. our current market at the beginning of the month. The following day on Bloomberg television a young reporter chuckled when asked about the “charts of 1987 vs. today going around” and assured the anchor that they “aren’t really the same thing” –it’s different this time.

I agree that this is different –every market distortion is unique:

The VXO hit an intraday high approaching 172 in '87. Let’s put things in perspective: In '87 the markets weren't freely trading. There weren't enough stocks in the underlying index (The VXO was based on the OEX) to open even open the options initially so there wasn't free trading in OEX until around 11:00 in the morning on the day of the crash. They were only able to get through the opening rotation before the underlying index itself closed. With every market order hitting ridiculous premium levels, and the disorganization of the pre electronic trading environment I (for a single series of option there may have been a quote of 2 - 2 1/2 on one side of the pit and 3 - 3 1/2 on the other side of the pit).

The levels we see today, by contrast, represent the conviction of traders globally who are linked in a technologically efficient, much more transparent market. Simply put, with the asymmetrical liquidity distortions of the short selling ban now behind us these volatility levels are more “real” than those in 1987.

I am sure that that young Bloomberg reporter is a very bright person, but I have actually managed volatility real-time as a trader and my professional mentors include some of the sharpest minds that market has ever produced –It was my great fortune to learn lessons from their experience.

I am not predicting that the VXO will reach the same levels it did in 1987, but I am predicting that in the wake on this crash investors start listening more to experienced market participants and less to lapdog talking heads on TV who repeat propaganda of their hedge fund patrons.

If any customers have questions regarding options strategies in this environment I will do my best to address them. Feel free to contact me at

Andrew Barber

Morgan Stanley (MS): Traded through Our Target Price

At $8.95/share (our target was $9.03), MS traded at it's intraday low this morning. The writing is on the wall. John Mack and Chris Cox created their own "uncertainty and fear" that Bush is blaming this market decline on right now.

Dear John,
Be accountable. Quit blaming everyone else for your firm's lack of proactive risk management. This is embarrassing for our country.

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DPZ –The credit crunch hitting Franchisees

According to the Detroit News the global credit crunch is forcing some Domino's Pizza franchise owners out of business, as banks cut off loans even to long-standing customers with solid credit.

"The problem has gotten a lot worse," since the passage of the $700 billion bailout, said David Brandon, chairman and CEO of Domino's Pizza Inc. Brandon was in Detroit to speak to a group of entrepreneurs at Wayne State University Wednesday. But the bailout package has done nothing to ease the credit crisis that's slamming many Domino's pizza franchisees, just as it's hit owners of other chains. Tightened credit means it is much harder for franchise owners to borrow money for both short-term credit lines and longer term loans.

"It's a major crisis. We are talking about people who 20-year relationships with their banks and suddenly they are being turned away," Brandon said. "Many of our owners have three or four franchises. It's a very tough situation."

“Brandon wouldn't say how many stores Dominos has lost in the past few weeks, but acknowledged that the Ann Arbor-based pizza chain has lost stores at a far higher rate than in the recent past.”
Footnote Editorial Sources

EAT – For what it’s worth….

Not that I matters, but I just need to go thru this exercise anyway.

Last night EAT announces that the company expects fiscal 2009 earnings per diluted share, before special items and excluding the results of Macaroni Grill, to decline between 15 -25%.

I now get EAT’s NTM EBITDA around $380 million. Using last night close of $13, that implies EAT EV/EBITDA at 5.7x. Normally, I could argue that the stock reflects the negative pre-announcement. I can’t say that today.

If the market takes EAT’s valuation down by 1 multiple point that would equals a decline of $3.75 or 25%. Unfortunately, that seems about right!

Firing The Tank

“If you can’t explain it simply, you don’t understand it well enough”
-Albert Einstein

The US Treasury, and most market strategists alike, were not explicitly calling for a market crash post the removal of their socialist supported and un-American “short selling ban.” Therefore it is very hard to rationalize why you should be looking to them this morning for solutions to this mess.

If your strategist, broker, or money manager is just coming to realize that managing risk in an interconnected global market of risk factors requires getting their feet on the floor before 5am, shame on them. They were not prepared to take advantage of this opportunity. Now they are reacting to it. If their “business model” is prefaced on getting rich by levering up your money, they should at least be at their desks when the game is on. Japan was down another -9.6% overnight, taking it down -24% for the week – that’s a crash that needed to be proactively managed towards and understood.

All of the losers in this industry will be pointing fingers this morning, tomorrow, and the next day. That’s what losers do. There are plenty of people who need to be held accountable. That will happen, trust me. If no one wants to call them out on to the mat, I will. Hank “The Market Tank” Paulson went out and hired an associate level banker from guess where, Goldman Sachs, to manage your government’s $700B bailout program. Hank hired another ‘Yes Man’ for the job. He should be embarrassed. Hank, it’s time for you to resign.

The US government’s resolve is to cut interest rates like Japan did, to negative, on a real basis. This is why the market goes down every day. People get it. Letting John Mack and his ‘Investment Banking Inc.’ cronies borrow free money at the Fed’s discount window at a record weekly pace does nothing but put more of your money into the hands of people have no proactive risk management process. Rather than American capitalism, this sadly reminds me of Denzel Washington’s recent movie “American Gangster”. Hank Paulson is playing Frank Lucas, and he is signing off on the issuance of “blue magic” bailout packages to the addicts. Morgan Stanley revealed yesterday that they are on the hook for a $2B casino in Atlantic City that they ingeniously committed capital to at the top of a global economic cycle! Maybe Mack, Lucas, and the Pandit Bandit can all head down to AC tonight and roll the bones with some of that tax payer money!

Never mind “understanding it well enough,” the said leaders of our financial system didn’t understand it at all. We need to get these people out of their reactive decision making seats immediately. On CNBC’s “Fast Money” last night, said trading “guru,” Joe Terranova, started the show off saying that Paulson should “step up and buy US stock market futures” this morning. C’mon Joe. That was beyond embarrassing. It also provides a metaphor for how ridiculous this global stock market mania became. We are speaking with our friends at InTrade about getting odds on the board for the date of “Fast Money” being taken off the air. These entertainers should not be able to broadcast their perpetually reckless bullish views to our children.

“Emotion has gripped this market”… “Fear and rumors are driving everything now”… “This market is no longer moving on fundamentals…”

Now that the S&P500 has dropped -42% since last year on this very same day, that’s what the revisionist historians are saying. Ignore these addicts, and find someone you can trust. We need transparency and accountability. We don’t need excuses and finger pointing. The market is moving on fundamentals. Those who do not have a fundamental and repeatable investment process are going to go away. It’s your money they are managing. You are their boss.

As I indicated on the Portal into the close yesterday, “I BUY.” I have moved our ‘Hedgeye Portfolio’ allocation from 96% Cash on 9/19 where we called this unfortunate crash (see “Beware October 3rd, 2008”, 9/19/08) to a 70% Cash and 30% Equities position. Let’s be clear, with 70% of my family’s hard earned money in cash, this doesn’t mean that I am bullish. This means I am less bearish.

There are 3 positions we take on stocks and markets alike here at Research Edge: Bullish, Bearish, and Not Enough of one or the other. For the better part of the last 12 months, I have been of the “Not Bearish Enough” camp. Now I am Bearish, but moving toward Bullish, for an immediate term “Trade”. I wrote to one of our smartest clients last night that my max downside level in the S&P 500 is 821.56. That’s another -9.6% lower than last night’s close. On the way down, our equity allocation will be moving up.

Have a process. Be patient. If you can’t explain your investment style simply, “you don’t understand it well enough.”

Have a great weekend,

Early Look

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