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Pisani's Trader Talk: Why the Markets Have Been So Volatile

CNBC's Bob Pisani reports on what traders were telling him near the market close:

There is a belief developing that the elimination of the up-tick rule, has been a major factor in the market's recent volatility. The up-tick rule prevented traders from shorting a stock on a downtick; they instead had to wait for an uptick or a zero plus tick (any trade at the same price as the previous up-tick trade). This rule was eliminated on July 6th.

Bob Pisani on the floor of the NYSE.
Bob Pisani on the floor of the NYSE.

It's easy to see why traders blame the elimination of the up-tick rule for the market's volatility: 1) its elimination roughly corresponds with the highest volatility levels we have seen since 2003, and the highest volume ever on the NYSE, and 2) traders are eager to blame some "regulatory" change that warped their carefully managed investment plans, rather than on something as "esoteric" as the subprime collapse.

Their blame is likely misdirected. Doug Kass of Seabreeze Partners, who has many years experience shorting stocks, notes that 1) futures and ETFs have been able to be sold on downticks for years, and 2) short positions always create additional long positions; shorting is never a one-sided transaction.

Bill Fleckenstein, of Fleckenstein Capital, noted that while some portion of the volatility may be laid at the door of the up-tick rule elimination, it is likely a small portion. He notes that traders eager to blame the elimination of the up-tick rule for the volatility are likely the ones who would have the least understanding of the real cause of the problem: volatility in the structured credit market initiated by the subprime collapse.

Phil Erlanger, who tracks short selling very carefully, notes that while there has been an increase in short selling, this has occurred over the past four to five months, and not since July 6th when the rule was eliminated.

Still, some have argued that elimination of the rule came at an inopportune time. Even those who say the effect of the elimination is negligible concede it may have created some "transitory shorts," i.e. traders willing to trade more often because it may be marginally easier to do so.

Bottom line: keep your eye on the real reason for the market volatility. Bulls should be particularly thankful because we are seeing bear market volatility without the bear market. The S&P 500, for example, is only 6% off its historic high of one month ago. This, in a month--August--that is a seasonally weak period for stocks (the worst month for the S&P, according to the Stock Trader's Almanac).

Pisani reported on what traders were telling him in the morning:

Financials up on positive comments from Goldman and Blackstone this morning.

However, banks are also up on comments from Mike Mayo, a respected bank analyst at Deutsche Bank, who this morning upgraded JP Morgan to a buy on valuation. He also upgraded Comerica and US Bancorp to hold. He noted that:

1) Market disruptions were an opportunity to gain share.

JPMorgan has the financial strength to benefit from recent market disruptions, such as the ability to act increasingly as a financial intermediary given capital and balance sheet strength. We estimate it has $5 billion to $10 billion of excess capital.

2) Higher-risk subprime and leveraged lending are a small part of the firm. We estimate that U.S. fixed income and mortgage comprise 20% of the company, of which subprime and leveraged lending - the greatest areas of concern - are estimated to be only about one-fifth.

Symbol
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BX
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CMA
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GS
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USB
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Most importantly, Mayo issued a general note on the state of the major banks, and he was optimistic. Here's an excerpt from the report:

"The positives seem intact, such as what we feel is once-in-a-lifetime incorporation of emerging markets into the global capital markets, which creates new liquidity and growth. Also, major financial firms, such as JPMorgan, are more diverse vs. times past. We estimate that the main area of concern - U.S. fixed income - is one-eight to one-fourth of revenues at the main brokers."

Before the market opened, he had this to say:

Having just returned from a week in the wilds of northwest Montana, where the biggest concerns were raging wildfires and an increase in the grizzly bear population, two things struck me about the current market action in:

1) the stock market.

If, as the Bears are saying, doomsday has finally arrived, why were the major indices UP last week, despite historic levels of volume and volatility?

Indeed, who are all these crazy people buying stocks at a time like this? Are they insane? Don't they know there is a global crisis underway?

They are indeed aware of the crisis--but it is a crisis of confidence, not of fundamentals. This doesn't make the current issues less real or more dangerous, but serious people are obviously making serious bets that this will pass. They are the people who track the Chinese and Indian GDP as carefully as they track the U.S. GDP. The people who watch Chinese consumer spending with the same interest as European consumer spending.

There are other things going on besides long-term bets. Short-term, there are some serious short squeezes that have developed. New shorts are reportedly harder to get--short rates are skyrocketing, according to traders I have heard from--and there is little capacity in single stock names and even some secondary ETFs.

This morning: markets stable as bank interventions appear to have calmed nerves. Retail sales were higher than expected giving a brief boost to markets. Japanese Economic and Fiscal policy minister Ota said the economy will keep expanding driven by corporate and consumer spending.

China July CPI up 5.6%, stronger than expected vs. previous up 4.4%.

Banks generally higher this morning; J.P. Morgan, Comerica, and US Bancorp upgraded at Deutsche Bank on valuation.

2) the credit markets.

Once this liquidity crunch subsides, watch for the fallout. In the short term, traders are calling for a rate cut from the Fed, but more interesting to watch is the call to allow Fannie Mae and Freddie Mac to increase its investments in home loans and mortgage bonds. This would go a long way toward easing the concerns, but the conservative elements in Washington are wary of allowing these two to expand their domain. This is a HOT political topic right now.

Long-term, there will definitely be changes in the way the securitization business operates. Global investors will develop better methods for more clearly sorting out their exposure to different risk levels.

They will start with this question: how did this stuff get rated so highly to begin with?

Recall how all this started: investors have been buying and selling Mortgage Backed Securities (MBS, pools of securitized mortgages) for 30 years. The problem came when investment bankers took the MBS debt and repackaged them into Collateralized Debt Obligations (CDOs). These CDOs split the debt into different risk levels--called traunches. The riskiest traunches received the lowest ratings and had the highest yields. Those deemed "safest" (i.e. those investors would be the last to take the hit) got very high ratings (sometimes AAA--as good as government debt) and lower yields.

Here's where the problem came: once the initial losses from subprime defaults wiped out the riskiest traunches, the market for the less risky traunches seized up as well. How did that happen? The main problem was there was little liquidity in this paper to start with. The market for CDOs were often created for specific clients and much of this paper has rarely--if ever--traded.

OK, so it rarely traded and so it wasn't easy to price in a normal market, and impossible to price in a panicky market. But a lot of very smart people--including Bear Stearns CEO Jimmy Cayne--have voiced doubts about the rating methods used for this paper, implying much of it should never have been rated as high as it was.

There will be big fallout over this, with the result that there will be greater spreads between the highest and lowest rated traunches. This has already happened, but more changes will occur after all this is over and, if history is any guide, will be little noticed by general market observers.

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