Some of the best trades come when everyone gets very panicky.  The crowd can often act very stupidly in the markets.  You can picture price fluctuations around an equilibrium level as a rubber band being stretched - if it gets pulled too far, eventually it will snap back.  As a short term trader, I try to wait until the rubber band is strecthed to its extreme point.

- Linda Bradford Raschke, quoted in The New Market Wizards (1992) by Jack Schwager, pg. 300 

I think that’s enough for now.  I bought SPY at the very end of the day at $116.40 and I added to my Goldman position at $100 midday.  I think a bounce is coming and here are some reasons why:

• The Dow has dropped 812 points (-7.11%) and the S&P 95 points (-7.59%) so far this week. 
• Volume has been really high on the NYSE and in major ETFs like the SPY and XLF.  In fact, I believe the SPY set an all time record today with 624 million shares trading hands. 
• Both Monday and today (Wednesday) were 90% down days where more than 90% of the volume traded on the NYSE was on a downtick.  These types of days, on the up or downside, are thought to be climactic.  Two this week suggests to me the selling has reached a climax.
• The Fear Index (VIX) spiked to 36 today and closed there - the highest closing level since 2002.
• The selling in Goldman (GS) and Morgan (MS) has just been insane.  In spite of releasing a pretty solid earnings report before the open yesterday, Goldman is down 26% on the week.  It was down 14% today on volume of 112 million shares - out of 394 million outstanding.  That is BY FAR the biggest volume day in Goldman’s entire history as a public company dating back to 1999.  Same story at Morgan Stanley which is down 42% on the week and 24% today with 330 million shares trading hands - out of 1,109 million oustanding.  Again that’s BY FAR the highest volume day for Morgan Stanley in the last 10 years.
• In another sign of complete panic, according to the WSJ Markets Data Center the 3-month T-Bill closed today yielding 0.036% - down from 1.475% at the close on Friday.  That compares with a low of 0.518% on March 20th in the wake of the Bear Stearns bail out.  To be clear this means that investors are willing to lend money to the Treasury for 3 months without being paid ANY interest just for the security of knowing that their principal is safe.  It’s a sign of capitulation because it shows that everything else is being sold, nothing is trusted.
• The SEC came out today outlawing “naked shortselling” on ALL public companies.  If you recall, they did the same thing back on July 15th except for it just applied to the largest financial stocks - and it worked as that day marked the bottom for financials.  In other words, the government is sort of making it illegal for stocks to go down.  Socialism anybody?

For all these reasons, I think stocks might have bottomed today, or at least they’re real close, and a bounce should be coming.  I don’t think the bear market is over by any means but for the short term it might take a little break.

Disclosure: Top Gun is long the S&P 500 ETF (SPY) and Goldman Sachs (GS).

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act.

- FOMC Statement on AIG Credit Line

At the time of economic crisis, when critical extensions of governmental power are likely to occur... there is little opportunity for a meaningful vote on whether or not, as a matter of principle, the powers of the state should be extended.  Instead, there is likely to be an insistent demand for emergency action of some sort and relatively little consideration of what the permanent effect will be.

- Calvin Hoover, The Economy, Liberty, and the State (1959), quoted in Robert Higgs, Crisis And Leviathan: Critical Episodes in the Growth of American Government (1987), Chapter 1

This evening at 9pm EST the Federal Reserve announced that they will be extending an $85 billion line of credit to troubled insurance giant American International Group (AIG) at a rate of 3 month Libor plus 850 basis point and in exchange for a 79.9% equity stake in AIG.

The government now owns Fannie Mae and Freddie Mac, which own or guarantee $5 trillion or 50% of the national mortgage market, and Dow component AIG, one of the largest insurers in the country.

The market is probably going to love it tomorrow.  But this is Socialism!

That said, the statement (FOMC Sept 16 Statement) is definitely more dovish than the one from August 5th (FOMC Aug 5 Statement).

The August 5th paragraph on the economy starts off: “Economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports.”.  Today’s statement starts out: “Strains in financial markets have increased significantly and labor markets have weakened further.”  It continues: “Economic growth appears to have slowed recently, partly reflecting a softening of household spending.”  So the tone of the economy is more dovish.  (Also note how last month they were saying consumer spending was growing and this month they are saying it’s softening.  Economists!).

The inflation paragraph is the same except they removed the phrase “and some indicators of inflation expectations have been elevated.”  So, again, the tone on inflation is more dovish.

Finally, the tone of the policy paragraph has changed as well.  August 5th read: “Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.”  Today’s statement goes: “The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee.”  Both statements are essentially neutral between concern with growth and inflation but the emphasis of the August 5th statement tends to fall more on inflation.  This is a fine point of literary analysis but it’s there and it’s there for a reason.  So, again, the tone is slightly more dovish.

I know, I know: It’s ridiculous.  On this see my “A Role For Ancient Sanskrit Scholars in Today’s Market”, Top Gun FP, March 21, 2007.  But as the kids say: it is what it is.  No doubt.

But, as far as I can tell, Goldman is okay and they will get through this whole crisis just fine.  They might not be minting money like they were during the boom but they don’t appear to be in any danger of going under.

Goldman divides their business up into three segments: Investment Banking, Asset Management and Securities Services, and Trading and Principal Investments. 

Investment banking revenue, which consists of the fees they receive for advising on mergers and acquisitions and for facillitating the sale of equity and debt to the public markets, was down 40% from the record setting period a year ago.  But it’s fine.  It’s still holding up okay.

Asset management and securities services revenue, which consists of fees they receive for managing money and the commissions and fees they receive from their “prime brokerage” for hedge funds, was up 4% from the year ago period.  Great businesses here.  Very solid.  Nothing to worry about.

All the worry and fear centers on their Trading and Principal Investments segment.  This is where they use their own balance sheet to trade and invest.  It’s where all the mortgage backed securities, leveraged loans, Level 3 assets and derivatives exist.  Of their $1.088 trillion in total assets as of May 30, 2008, $724 billion are held in this segment. 

Revenues in this segment were down 67% from the year ago period and 52% from a quarter ago.

The fear is that there are some toxic assets that are going to blow up Goldman the way Bear, Lehman and Merrill got blown up.  In their 2nd quarter 10Q, they list $38 billion in mortgage assets, $36 billion in bank and bridge loan assets and $120 billion in derivative contract assets. 

Nobody really knows for sure how solid this stuff is.  But my feeling is that Goldman is okay.  Their business isn’t going to be as strong as it was in the boom years but they’ll still be profitable or at least breakeven and they will almost certainly survive.

The stock saw panic selling yesterday and this morning but it’s rallied today (GS 1 Year Chart).  These represented good buying opportunities.  Goldman is okay.

Disclosure: Top Gun is long Goldman Sachs (GS) shares.

This is important because a lot of traders and investors watch these levels to get a feel for how other investors are feeling and how the market is likely to trade.  When support holds, they feel like maybe a short term bottom has been put in place.  When it fails, the bias is to expect markets to continue moving lower. 

To the average investor, closing 7 points below 1200 might not seem like a big deal.  But it is a big deal.  That means a lot of investors didn’t want to hold stocks, even at what was presumably support.  That means they believe that the support is not reliable.  My own feeling is that this is not yet a short term bottom.  We’re going even lower in the near term.

The Fear Index (VIX) spiked up almost 24% today to close around 32.  All five of the major short term bottoms during this bear market (Aug 16 2007, Nov 12 2007, Jan 22-23 2008, March 17 2008 and July 15 2008) have coincided with spikes in the VIX above 30.  That suggests were getting close to some kind of short term bottom.

My overall feeling, however, is that this could be the start of another big leg down.  The recent short term bottoms in July and March didn’t take us much below the previous lows from January.  But the January low, which was really an inflection point as sentiment shifted massively towards there being a bear market/recession, took us well below previous support.  I think this move could be more like that one.

To speculate a little, I think the financials could make one final, panic stricken lurch lower, testing and even breaking the current low of this bear of $16.77 on the XLF (the XLF closed today at $19.09).  At that point, the financials will have put in THE low for this bear market and that will be something significant.

At this point, the S&P has given back half of the gains from the bull market.  The bull market took the S&P from around 800 in July/October 2002 to around 1600 in July/October 2007.  At around 1200 today, that’s a 50% give back.  As I wouldn’t expect the S&P to trade all the way back down to 800, or even approach that level, one positive thing is that most of the damage has already been done.  Even if the S&P trades all the way back down to 1000, 400 of that 600 point descent has already been made.