Recently, I have become a little alarmed about the health of the banking sector. There are several reasons for this.

First, on the fundamental side, there have been a number of stories that lead me to believe that we could be headed for another round of mortgage-debt problems, and not only on the subprime side!

Out of the 'Shadows'

A couple of weeks ago, David Faber of CNBC reported on something called "Shadow Inventory." Shadow Inventory refers to the amount of homes that have mortgages that are behind on payments and are facing potential liquidation.

These are all homes that are currently 90 days in arrears. In 2005, that number was around 1.2 million units taking an average of 15 days to sell. A study today shows that number at around 7 million units with an average of 50 days to move.

When you combine this with the current unemployment rate and the future outlook on unemployment, it is the belief of the study that most of the loans on these homes will be of little value with a high percentage of them being worth nothing.

If this is accurate, and I believe that it is, the banking industry’s balance sheets are in BIG trouble!

Even More Bad News for Banks

Many regional banks, and some big ones, are going to have trouble and will need to raise even more capital to keep their doors open. We have seen the clues to this in the current earnings of every bank that has reported numbers so far this quarter.

They ALL have declared larger losses in the mortgage-based-debt securities market than last quarter and are increasing their loan-loss provisions for next quarter to the highest levels they have been yet.

Added to this is the story that came out on Friday, predicting another fall in home prices as much as another 30% in the hardest-hit areas and a 12% drop in median home prices overall.

106 Failed Banks ... and Counting

The accompanying story was on the banks themselves and the amount of failures predicted next year. On Friday, the number of bank failures eclipsed the 100 level. Projections have more like 300 going under next year.

The FDIC is already overwhelmed and trying anything it can to get refunded as-is. If 100-plus bank failures this year got it into trouble (that is, out of money), then 300 next year should put the proverbial last nail in the coffin.

You may say that, with all this bad news out there, how could the banks have rallied like this? Well, it is because of the government.  According to reports, many of the regional banks, along with a few money-center banks, should be seized.

The only reason they haven’t been seized yet is because is the government does not want a large group going under in a short amount time, thus creating another (and bigger) panic. At some point in time, however, there must be reality!

A Troubling Pattern

The final piece of this puzzle is in the technicals. Although the technicals have not shown a break in the current uptrend, (at least, not yet), a disturbing pattern has started to form.

It is the same pattern I noticed in the summer of 2007. It is a divergence between the market and the banking sector.

Take a look at your charts. In this last rally off of 9,500 in the Dow Industrials (Symbol: INDU), a 600-point rally, the banks have not really participated. In particular, the regional banks have definitely not participated!

The divergence has occurred; now all that is needed is for the technical break to occur.

How to Take Advantage of a Break

But, what should we do if it the technical break does occur?

Well, we can sell off any long positions in the banks we currently have to prevent loss, but how do we make money on this movement?

The answer is simple ... the use of the put option.

And with volatility this low on an overall basis, as seen in the Chicago Board Options Exchange's Volatility Index (Symbol: VIX), puts are very affordable.

But before you run out and blindly tell your broker to buy you puts, you had better learn all about them. Not all puts will fill your need.

Further, without understanding how to choose the right put and then manage it the right way, you could find yourself in a losing position even if you were right about the sell-off.

'Putting' Capital to Work Before a Pullback

Here is a brief and very basic explanation of the put. For a complete education on options and their proper use, look into our new options-education system, Options GPS!

A put option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right, but not the obligation, to sell a specific underlying security at a pre-arranged price by a specified date.

The buyer of a put option has the right of selling the stock (or other underlying instrument) to the seller, should the buyer wish to exercise his option. The put is known as a "short" instrument, which means that the buyer profits from the stock going down.

For the buyer of the put to profit, the stock must be trading below the strike price of the put in question plus the cost of the option. This point is known as the breakeven point.

Now, we must realize that this definition applies at expiration. Between now and expiration, the put could trade up, creating a profit without the stock trading down to the breakeven.

(Remember: Put breakeven price = strike price – cost of put.)

An Example...

Suppose you buy the Wells Fargo (Symbol: WFC) April 35 Puts for $7 because you think Wells Fargo is going to trade down in the next few months. (Keep in mind, this is just for illustration purposes.)

This put option that you just purchased gives you the right, but not the obligation, to sell Wells Fargo stock at $35 at any time between now and April expiration. To obtain this right, you had to pay a price of $7 per share per contract.

(Total dollar cost of option = cost of option x 100 x amount of contracts purchased.)

In this example, we are looking at a total dollar cost of $700 per contract. That will be the total dollar cost of each contract.

If you purchased more than one contract, you would then multiply that $700 times the amount of contracts you want to buy. So, if you wanted to buy five contacts, it would cost you $3,500.

In order for you to make money, the stock would have to trade down below $28 by expiration. This is because the stock has to trade down below the strike minus the cost of the option.

If the stock traded down to $20, you would make $15 because you have the right to sell WFC at $35. However, because you paid $7 for the put, you must subtract that from your $15 profit for a total net profit of $8.

You would have just made $8 on a $7 investment. That is a very good return.

Stand Tall With Great 'Short' Plays

One of the nice things about buying a put is that, instead of shorting the stock (and that is if you can short the stock), the put buyer has limited risk and unlimited potential gain risk/reward scenario.

The put buyer’s risk is limited only to the amount of money they spent in purchasing the put.

The unlimited potential gain comes from the fact that the stock has an unlimited ability to trade down. However, we know that the stock cannot trade below $0, so the profit that can made on a long put is really limited in the reality of the stock market.

As an individual investor, you must understand how to use puts. They are the ultimate, perfect hedging tool for individuals to use for protection and a tremendous offensive tool that is far superior in risk, reward, affordability and viability for profiting from the downside!





Ron Ianieri
Chief Investment Officer
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TUESDAY, OCT. 27

8:30 a.m. Durable Goods Orders

    * Importance (A-F): This release merits a B.
    * Source: The Census Bureau of the Department of Commerce.
    * Release Time: 8:30 a.m. Eastern around the 26th of the month (data for month prior).
    * Raw Data Available At: http://www.census.gov/ftp/pub/indicator/www/m3/index.htm

The durable orders release measures the dollar volume of orders, shipments, and unfilled orders of durable goods (defined as goods whose intended lifespan is three years or more).

Orders are considered a leading indicator of manufacturing activity, and the market often moves on this report despite the volatility and large revisions that make it a less-than-perfect indicator. These problems can be minimized by looking at the breakdown of orders.

The total number is often skewed by huge increases in aircraft and defense orders. An increase based solely on strength in one sector tends to be discounted, while the market is more-impressed with broad-based increases in orders.

Highlights

    * Durable goods orders were a disappointment in August. New orders declined 2.4% in August after increasing 4.8% in July. The consensus expected an increase of 0.4%.

    * Nondefense capital goods excluding aircraft fell 0.4%, which was the second consecutive month-over-month decline.

    * Excluding the transportation sector, durable goods orders posted no growth. The consensus expected orders to have increased 1.0%.

    * Defense spending was the primary reason why durable goods orders didn't decline in August as defense capital goods orders increased 1.1%.

    * Durable goods shipments fell 1.4% in August. Excluding transportation, shipments declined 1.2%.

    * Shipments fell in most sectors as capital goods shipments declined 1.6%. Shipments of nondefense capital goods excluding aircraft declined 1.9%. Defense capital goods shipments rebounded with 2.9% growth after declining 4.0% in July.

    * Inventories remain weak. Total inventories fell 1.3%.

Key Factors

    * The durable goods orders data does not bode well for a strong recovery.

    * The decline in the headline number wasn't completely unexpected. Most of the increase in orders in July was due to a large jump (98.2%) in new aircraft orders. We expected a massive correction in this sector.

    * The big surprise was in the auto sector. Car sales rebounded in August due to the Cash for Clunkers stimulus program, and industrial production in the motor vehicle sector picked up as the manufacturers rushed in to replace depleted inventories. However, the increase in sales and production did not result in a massive increase in new motor vehicles and parts orders. Instead, the data shows orders only increased 0.4% after increasing 1.6% in July. The lack of new orders in the face of a massive decline in inventories provides further evidence that the motor vehicle sector is in much worse shape than previously thought.

    * The decline in nondefense capital goods excluding aircraft signals a very weak nonresidential investment component in Q3. Further, investment would begin to rebound if firms believe consumers will re-enter the market place. Firms do not trust the consumer sector to grow in the near future.

    * We have been expecting a reversal in the inventory cycle for the last few months, but it continues to look far on the horizon. The order data suggests firms are waiting for consumers to show a sign of life before entering into new inventory purchase contracts.

Big Picture

    * Durable goods orders trends were very weak in late 2008 and early 2009.  That reflected a collapse of confidence in the business sector and poor credit market conditions.  The rate of decline has eased and there has been some intermittent increases of late that suggest the worst of the downturn is over.  Still, the business investment outlook can be considered weak.


9 a.m. Conference Board Consumer Confidence

    * Importance (A-F): This release merits a B-.
    * Source: The Conference Board.
    * Release Time: 10 a.m. Eastern on the last Tuesday of the month (data for current month).
    * Raw Data Available At: http://www.tcb-indicators.org

The Conference Board conducts a monthly survey of 5,000 households to ascertain the level of consumer confidence. The report can occasionally be helpful in predicting sudden shifts in consumption patterns, though most small changes in the index are just noise. Only index changes of at least 5 points should be considered significant.

The index consists of two subindexes -- consumers' appraisal of current conditions and their expectations for the future. Expectations make up 60% of the total index, with current conditions accounting for the other 40%. The expectations index is typically seen as having better leading-indicator qualities than the current conditions index.

Highlights

    * The Conference Board Consumer Confidence Index unexpectedly dropped 1.4 points in September to 53.1.

    * The consensus expected the index to have increased to 57.0.

    * The present situation index declined to 22.7 from 25.5 while the expectations index dipped slightly to 73.3 from 73.8.

Key Factors

    * It is difficult to comprehend why consumer confidence would have declined, especially since the University of Michigan Consumer Sentiment Index for the same month posted its highest reading since January 2008.

    * Further, the confidence index is highly correlated with unemployment, gasoline prices, and news reports. During September, gasoline prices have stabilized and drifted lower, initial claims have ticked downward, and the news has talked about a strong economic recovery, all of which point to a higher confidence number.

    * These factors would suggest a stronger present situation index.

    * It is important to note that the consumer confidence index is not correlated with consumer spending. The lower reading in September should not be used as a signal that spending will decline in September or October.

Big Picture

    * Consumer sentiment indices get way too much attention.  The simple fact is that sentiment does not correlate strongly with consumer spending and thus has little predictive value.  Consumer spending correlates more closely with income.  Sentiment tends to reflect well known factors such as unemployment rates and gas prices more than it predicts future spending patterns.


THURSDAY, OCT. 29

8:30 a.m. Gross Domestic Product (GDP)

    * Importance (A-F): This release merits a B.
    * Source: Bureau of Economic Analysis, U.S. Department of Commerce.
    * Release Time: Third or fourth week of the month at 8:30 a.m. Eastern for the prior quarter, with subsequent revisions released in the second and third months of the quarter.
    * Raw Data Available At: http://www.bea.doc.gov/bea/dn1.htm

Gross Domestic Product (GDP) is the the broadest measure of economic activity. Annualized quarterly percent changes in GDP reflect the growth rate of total economic output.

The figures can be quite volatile from quarter to quarter. Inventory and net export swings in particular can produce significant volatility in GDP. The final sales figure, which excludes inventories, can sometimes be helpful in identifying underlying growth trends as inventories represent unsold goods, and a large inventory increase will boost GDP but might be indicative of weakness rather than strength.

The broad components of GDP are: consumption, investment, net exports, government purchases, and inventories. Consumption is by far the largest component, totaling roughly 2/3 of GDP.

Highlights

    * The final release for Q2 GDP exceeded consensus expectations as GDP declined only 0.7% quarter-over-quarter annualized compared with a forecast of -1.2%.

    * The breakdown of the GDP data is shown below:

1. Personal consumption expenditures declined by 0.9% in the latest release compared with a -1.0% decline in the preliminary data.
2. Nonresidential investment was revised up to -9.6% compared with -10.9% in the previous data. Residential investment fell 4.9%, up from -8.4% in the last revision.
3. Export growth fell only 4.1% compared with -5.0% in the last report while imports were revised up to -14.7% from -15.1%.
4. Government spending was revised up to 6.7% from 6.4%.
5. Finally, inventories contracted by $160.2 billion, up slightly from $159.2 billion recorded in the last release.
6. The inflation numbers were not revised as headline inflation held at 0.0% quarter-over-quarter annualized while core PCE prices stayed at 2.0%.

Key Factors

    * Overall, the report was very positive. Every sector of the economy with the exception of inventories posted positive gains in the final release compared with the previous revision.

    * Since all the data is known prior to the release, it is strange that the consensus missed the strengthening in the GDP data.

    * The higher revision for Q2 GDP bodes well for the recovery and puts the economy on track for showing positive growth in Q3.

Big Picture

    * The trends in the economy were moderately poor through the summer of 2008.  Then, in September, the trends tanked along with the stock market. 

    * Some tech firms noted a significant drop-off in demand right after the mini-panic of mid-September.  These worsening trends were readily apparent in the fourth-quarter GDP numbers, and in the first-quarter 2009 GDP numbers as well. 

    * Consumer spending is weak and will only take a significant turn for the better once the declines in payroll moderate.   Business investment is weak, too. 

    * A lot now depends on overall psychology and perceptions of how well the government responds to the financial market and other problems such as exist in the auto industry. 

    * The economic outlook is now as much a function of government action as it is of the traditional correlations and trends among macro-economic variables.


FRIDAY, OCT. 30

9:45 a.m. Chicago Purchasing Managers Index (PMI)

    * Importance (A-F): The Chicago PMI merits a B.
    * Source: Kingsbury International, Ltd. and Institute for Supply Management-Chicago Inc.
    * Release Time: Typically the last business day of the month at 9:45 a.m. Eastern

In Brief

There are many regional manufacturing surveys, and they tend to be ranked in order of timeliness and the importance of the region. The New York and Philadelphia Fed's surveys are the first each month followed by the Chicago purchasing managers' report on the last day of each month. A few, such as the Atlanta and Richmond Fed surveys, are released after the Institute for Supply Management numbers and are of little value. The purchasing managers' reports can be of some help in forecasting the national ISM.

Highlights

    * The expansion in the manufacturing sector hit a major speed bump as the Chicago PMI declined 3.9 points to 46.1 in September, well below the consensus expectation of 52.0. The drop below 50 signals a contraction in manufacturing.

    * The drop in PMI was mostly due to a severe cutback in both new orders and order backlogs as new orders declined 6.2 points to 46.3 and order backlogs declined 9.1 points 36.7. Other components of the index showed problems in manufacturing including:

1. Production declined from 52.9 in August to 47.2.
2. The prices firms paid expanded for the second consecutive month as the index rose to 51.3 from 50.0.
3. The contraction in employment held steady as the index increased only 0.1 to 38.8.
4. Supplier deliveries reentered a contraction phase as the index declined to 49.3 from 54.6.
5. There was one positive sign from the data. While inventories are still contracting, the rate of contraction slowed as the index increased from 27.5 to 38.9.

Key Factors

    * It seems that manufacturers had bought into the economic recovery scenario and decided to ramp up production in August. At the same time as production revved up, the contraction in new orders had ended and most firms expected growth to continue into the future. The increased production was used to work off the backlog along with the new orders that arrived.

    * Unfortunately, at same time as production ramped up, consumer demand in September seems to have stalled and along with it, the recovery effort. Wholesalers and retailers did not need any new goods and orders dropped precipitously. Production in September tumbled.

    * As long as consumer demand continues to stumble, the recovery effort cannot be sustained. Instead of multiple months of expansion, we may see these PMI indices becoming highly volatile as production meets a fluctuating order schedule.

    * Eventually inventory levels will shrink enough to force manufacturers into production just to restock the shelves. Unfortunately, the consumer will dictate when this will happen. 

Big Picture

    * The Chicago PMI has little overall economic value, and is only watched by the financial markets because it is usually released one day in advance of the similar national ISM manufacturing survey.  A significant move in this regional survey will therefore sometimes be seen as having predictive value for the ISM index.

9:55 a.m. University of Michigan Consumer Sentiment Index

    * Importance (A-F): This release merits a B-.
    * Source: The University of Michigan.
    * Release Time: Preliminary: 10 a.m. on the second Friday of the month (data for current month); Final: 10 a.m. Eastern on the fourth Friday of the month (data for current month).

The Michigan index is almost identical to the Conference Board Consumer Confidence index, though there are two monthly releases, a preliminary and final reading. Like the Conference Board index, it has two subindexes -- expectations and current conditions. The expectations index is a component of the Conference Board's Leading Indicators index.

Highlights

    * The University of Michigan Consumer Sentiment index reversed direction and fell to 69.4 from 73.5 in October. The consensus expected sentiment to decline slightly to 73.3.

    * The expected sentiment indicator dropped to 67.6 from 73.5.

    * The current sentiment index fell to 72.1 from 73.4.

    * Consumers are also getting more worried about inflation as the 1-yr inflation expectation rose to 2.8% from 2.2%. The long-term consumer inflation expectation (5-yr time period) increased 0.1 percentage point to 2.9%.

Key Factors

    * While a drop in sentiment was expected by the consensus, it goes against the typical methods for predicting sentiment. The sentiment numbers are highly correlated with gasoline prices, unemployment, the stock market, and media reports. Over the last several weeks, unemployment growth has weakened as initial claims numbers have fallen, gasoline prices have held steady, the stock market has continued to post strong growth, and the media has constantly talked about the emerging economic recovery. Given all this data, consumers "should" feel better about themselves.

    * Instead, consumers seem to be giving more weight to the idea that the economic recovery is not occurring fast enough. While the data is showing the economy is getting better, consumers are not seeing day-to-day changes in their communities.

    * The increase in inflation expectations is slightly worrisome for the Fed as it puts pressure on the Fed to raise rates before they are ready.

    * Please note, the decrease in consumer sentiment does not necessarily translate into decreased consumption spending. The main drivers for consumption are current/expected income and available credit. The consumer still faces difficult constraints in both sectors which will make future consumption growth difficult.

Big Picture

    * Sentiment readings are a reflection of a variety of events rather than an accurate tool for forecasting consumer spending.  Gas prices and political events can have an outsized impact on sentiment.  In general, these data are of very little economic value.


10 a.m. Employment Cost Index (ECI)

    * Importance (A-F): This release merits a B-plus.
    * Source: U.S. Department of Labor, Bureau of Labor Statistics
    * Release Time: 8:30 a.m. Eastern, near the end of the first month of the quarter for the prior quarter.
    * Raw Data Available At: http://stats.bls.gov/news.release/eci.toc.htm

Since the employment cost index was mentioned by Fed Chairman Greenspan in July 1996, it has risen into the upper echelon of economic reports in the eyes of the bond market. Its lagging nature still leaves it as a less-timely indicator of employment cost trends than the monthly hourly earnings data in the employment report.

But the ECI does add something to this picture: an adjustment for shifting employment between industries, and a look at benefit costs. These additions are interesting, but typically do not alter the view of the employment cost picture which was left by hourly earnings. ECI will be much less closely watched during periods when wage inflation is not a serious market concern.

The market focuses on the quarter/quarter and year/year changes in each of three categories: total employment costs, wages and salaries, and benefit costs. The figures are sometimes skewed by large year-end bonuses in the financial industry; analysts often exclude the sales commission component of wages and salaries to adjust for this factor.

Highlights

    * The employment cost index for the second quarter rose 0.4%.  That was slightly higher than an expected 0.3% increase, yet it continues a trend toward smaller increases in costs to employers of compensation.

    * Wages and salaries, which make up 70% of compensation, were up 0.4%.  Benefit costs rose 0.3%.

    * The year-over-year increase in the total index fell to just 1.8% from 2.1% through the first quarter.  The year-over-year increase for the 12-month period ending in June 2008 was 3.1%.

Key Factors

    * Compensation costs for private industry workers increased 1.5% for the 12-month period ending June 2009.  That is the smallest increase since records started being kept in 1980.

    * With compensation costs very much under control, overall inflation pressures should be held in check.

Big Picture

    * Employment costs are the major component of business costs.  The trend in these data therefore have important implications for cost-push inflationary pressures and for profit margins.  In recent quarters, the trend has been relatively steady to lower.  The year-over-year total increase in the ECI is now below 2.0%. Weak overall demand in the economy should keep the ECI cost index on the current trend.  At 1.8% this does not represent much inflationary pressure.

Source: Briefing.com