Spotting Tops

One of the really good clues that the indicies were topping out was found in internal volume numbers.  The blue oscillator is called four volume.  It’s a combined average based on the up/down volume ratios of the Dow, S&P, Nasdaq, and Russel 2000.  The area marked in yellow shows a divergence.  As the S&P pushed to a one year high the market’s internal volume was not confirming the move up.  The prior weeks had consistent selling during the opening hour.  That was a clue that big money was bailing.

One Year Lows

The question now is whether this is a change in trend or a spot for dip buying.  Bank of America is one of the leading NYSE stocks.  It and several banks compose more than 50% of NYSE trading volume.

Using linear regression we can see BAC is at a one year low and looks due for a bounce:

BAC 1yr

However, the two year channel still shows plenty of room to the downside.  The overriding bear market is clearly visible:

BAC 2yr

Lastly, the five year channel appears more bullish with upside potential:

BAC 5yr

There is no definitive way to know where the market is heading.  In the short-term many stocks look poised for a bounce.  Spotting sector trends with linear regression is often useful.  Right now banks, retailers, and gold miners look poised to resume upward gains.  The leading names like BAC, M, and FCX are mean reversion candidates.

Taken out of a pool of over 400 names here is a list of 70 bounce candidates.  They are at or near one year linear regression lows.  To see so many names at a range extreme is quite compelling.

Gallery of 70 Longs

Using mean reversion these stocks should return to a median price.  Is a one year low a good bounce point?  Not if the market is preparing for a two or three sigma move down.

Inflection Point Update

This strategy is similar to one used in Oct. 2009  (see story).  Back then a handful of stocks were at 60 day lows.  Here is where those 14 longs sit as of Friday’s close:

The maximum profit/time was 5 days after entry.  That exit earned 13% or $19,000.  A more patient exit was three months later.  At the peak this portfolio reached $40,000 profit.  Holding from Oct. 2, 2009 until Jan. 19, 2010 would have seen those gains.  Without profit stops the last three days of selling wiped out $14,000.

Retail HOLDRS

Here is a five year chart of the RTH:

We can see price is near the first regression line.  Volume is also getting thin as price pushes higher.  This is a good clue to look for other inflection points in retail names.  Current names in the Retail HOLDRs.

Nine Month vs. Two Year

Right now it appears the nine month and two year channels are in play.  There are many retailers near nine month lows.  Macy’s is one example:

The caveat is the broader market.  Right now retailers are a mixed bag.  Many of the smaller names are at two year highs, and several of the larger names are near nine month lows.  Also, dip buyers have been getting weaker.  What has been consistent is to short stocks as they near two year channel highs.

Looking at Macy’s on a two year chart shows a clear downtrend.  It’s also at a one sigma regression line.  So the question is:  Does Macy’s rally to the upper channel or slide back to the middle?

Timing

So the trick is to find that slice of time where you have a 95% chance of being right.  Mean reversion traders look for price near high/low channel lines. Price matching on multiple time frames can provide some great low risk entries.

Gallery of 37 Retail Names

Here is what a scan of 113 retailers produced.

Retailers for Xmas

A list of 37 names near various inflection points.  The two year charts trump the nine month charts for longer term swing trades.  Hopefully this will be useful to you in your trading.

Wishing you a wonderful winter season!  -GTM

Finance is a closed system.  It’s not run by a perpetual motion machine.  So the famous up arrow always stalls somewhere.  What we want to know is just where is price in relation to time? The probability of price correcting back to an average value eventually becomes more and more certain.

The chart above is that last two years of the Dow using linear regression.  Here’s a list of the current Dow 30 names.  Out of those thirty companies some are stronger and some are weaker.  So this isn’t a definitive science.  It’s an art, but it is finally a spot to take notice.  Let’s dig more into linear regression to see why it can be so useful.

68-95-99.7 Rule

In statistics, the 68-95-99.7 rule, or three-sigma rule, or empirical rule, states that for a normal distribution, nearly all values lie within 3 standard deviations of the mean.

About 68% of the values lie within 1 standard deviation of the mean (or between the mean minus 1 times the standard deviation, and the mean plus 1 times the standard deviation). In statistical notation, this is represented as: μ ± σ.

About 95% of the values lie within 2 standard deviations of the mean (or between the mean minus 2 times the standard deviation, and the mean plus 2 times the standard deviation). The statistical notation for this is: μ ± 2σ.

Nearly all (99.7%) of the values lie within 3 standard deviations of the mean (or between the mean minus 3 times the standard deviation and the mean plus 3 times the standard deviation). Statisticians use the following notation to represent this: μ ± 3σ.  (Wikipedia)

Timing

So the trick is to find that slice of time where you have a 95% chance of being right. Year to date we are approaching a two standard deviation move in three months. Mean reversion traders look for price near high/low channel lines. Price matching on multiple time frames can provide some great low risk entries.

Here’s the Dow for the last two months.  You can see it’s in a nice up trend, but the larger two year trend is going to put pressure on this short term trend.  There’s obviously wiggle room here.

Catching a reversal near an extreme is key.  Like after a 200 point Dow day.  Two weeks ago there were 22 stocks aligned at 20/40/60 day lows.  Three months of price coalesced into a single inflection point. From that list the 14 cleanest charts were picked.  And these weren’t cherry picked later.  These names all came from charts posted here on October 1st (see gallery). This method made 13% in a week.  Going long the Friday after a -200 point drop (see story) was a low risk strategy using linear regression.

Went long Friday’s open on Oct. 2nd and sold at the close on the next Friday:

Referring back to the two month Dow chart we see there was still plenty of upside after the Oct. 2nd push off the lower channel.  Price ran back to the median line and moved higher.  However, holding two weeks into the next Friday’s close on Oct. 16th did nothing for the portfolio.

Trailing every name that made more than $500 profit with a $500 stop would have grossed $16,000 in one week.  That left only RIMM and CAKE as open positions.  The risk of holding for one extra week would not have made much of a difference.  The ultimate intraday high of this portfolio was $20,000 which happened five minutes before the close on Thursday the 15th.  Good luck timing that exit!

Note: these are examples of trading a mean reversion strategy.  They are theoretical and not trading advice.

Sixty Names

Going through two year charts tonight shows a ton of potential shorts coming. A push or another 200 point day to put the market near the top of the two month channel would be an ideal setup.  The more time frames that line up the better odds for a reversal.  A scan of roughly 400 active stocks shows there are sixty near two year highs:

Gallery of 60 Stocks Near Two Year Highs

At or very close to two year channel highs:

BLK IOC CLNE BZH JADE SRZ PCLN GOOG BAC GE CAT CBI SLB

Just hit two year line and failed:

BIDU WDC WYNN

Pattern to Watch

The stock NTES has already completed a move we’re looking for.  Price reached a two year high, failed, then returned to the median line in a clean trend with a clear exit.

NTES 2 year

Price tested the two year high twice then failed back towards the median line.

NTES 20 day

This one month chart is an example of how to stay in the trend. Price failed on every one sigma test with a nice clean exit on the lower channel.

NTES 3 month

Using 20/40/60 day LR lines shows an inflection point to short the stock. The spike above the channel was a great low risk entry. The spike below was a great exit.

Note: There is an art to the best time frame entry using this trading style. Also, shorter term channels adjust constantly. There’s wiggle room on the sixty names. What LR channels clearly show is the trend and where price lies within that trend.

Shorting the extreme high/low is often a low risk entry. The odds of price gaining more momentum to push above a two year channel are less than the odds of price reverting back to an average.  Mean reversion is going to come into play soon with every major index. Because there are so many names setting up this points to shorting certain highs as a very good risk/reward.

As stated before there are no guarantees in the market.  It can do anything at any time.

Valid at close Wed. Oct 7th

Clues to Exit

So where do we exit these trades?  The first is break even profit stops.  Some of these names are barely holding on after a three day push in the overall market.  It’s prudent to put tight reins on them and not let a small gain turn into any kind of loss.  The bigger profits can be given wiggle room.  When price runs back to the median line of your preferred time period a profit stop should be tightened.  The optimal exit is when price runs to the top of the channel.  Look at FCX:

For short term swing trades the 20 day channel is very useful.  A tight profit stop here at the top of the channel is often ideal.

Shorting Gold Miners

Using this method several gold miners look ready to go short: AEM TLR VGZ THM and KGN are all at new year highs.  The trick is getting price and time to align for maximum profit and minimum risk.  Let’s look at AEM:

YTD

Price is near the top of the year to date LR2 channel. It's a 2 sigma move that should come back down, but there's some wiggle room.

60 Day

The lowest risk entry would be around $76 at the top of the channel. On a smaller time frame there's much more finesse to maximize the setup.

More Names for this Week

Keep an eye on FCX.  It’s a great industry leading stock that will give clues to how gold and the miners will trade.  The following names might be a little early to short.  They are junior players that all made new highs today.  Gold is a very difficult sector to trade and there’s lots of wiggle room.  On the first sign of weakness these low risk trades could turn into quick profits.

KGN

THM

TLR

VGZ

 

Caution

These are probabilities not known outcomes.  The market can do anything at any time.  This concept assumes there will not be major news events or supply/demand shocks to upset the concept of mean reversion.  The odds of price retreating from range extremes outweighs the risk of shock events.  However, a maximum loss market stop is always necessary to protect one’s capital.  It’s vital to use concrete money management discipline.  Many swing traders will not risk more than 2% of their cash per week.  If you’ve got $50,000 taking a $1,000 draw down is the max loss per week.  That’s the cutoff point.  It proves the trading edge for that week is wrong.

Dow 200 days

Legend

• TDU Trend Day Up
• TDD Trend Day Down
• x:x positive/negative NYSE Adv/Decl ratio (Yahoo)

Twenty-two Names

Out of a couple hundred active stocks today there are 22 names sitting on 60 day LR2 lines. This means they’ve had a 2 standard deviation move down and should return to the middle of their price channel. Half the names line up cleanly on all three (30/60/90 day) time frames. There are also several (not as clean) at the 50day sma. This is a clue that we either resume business as usual tomorrow, or early next week, or this is a major trend change. From this scan there are few juicy shorts other than these same names. Often the best swing shorts are stocks at their lower channel line.

We’re looking for a return into the channel or acceleration out of it. It’s make it or break it time!

See Chart Gallery

Cleanest symbols: CAKE HIG LEN LNN LVS LZB MA OII TNA V ZN
50day smas: DVN EGO FCX OII TNA

Examples

Here you can see all 3 time frames line up: 90bar 60bar 30bar

V didn't close cleanly on the line, but that's one fat hammer on x2 avg volume. Looks like a strong reversal might come.

Linear Regression Channels

Parallel and equidistant lines are drawn two standard deviations above and below a Linear Regression trendline. The distance between the channel lines and the regression line is the greatest distance that any one closing price is from the regression line. Regression Channels contain price movement, the bottom channel line provides support and the top channel line provides resistance. Prices may extend outside of the channel for a short period of time but when prices remain outside the channel for a longer period of time, a reversal in trend may be indicated.  (Prophet.Net TA Glossary)

Watching oil last week there were many names that looked overextended.  We’re talking about short-term trading here.  Using a 50% linear regression channel can give us an idea of just how far price has gone.  The beauty of LR channels is price reverting to the mean.  There is finesse on entering with the most powerful time frame, but these give high probability setups.

The previous Friday RIG closed above a three month channel line.  Then it collapsed on Monday with a gap down open.  That was a missed trade.  Tuesday gave another opportunity to short RIG at the close and it worked on today’s open.

So on Tuesday it couldn’t close above the prior high, even with volume coming in.  There is a divergence in OBV on the 60 day chart, which trumps the 10 day trend in on balance volume.  The larger time frame also shows declining volume with higher prices.  Usually a good warning sign.

Here is the intraday chart for reference.  Price tested the prior day’s close and immediately failed.  It was fast easy money.  Low risk traders took their profits.  Does RIG have more downside potential?  It’s probable, but the easy trade is now over.

ThinkScripter Indicators

If you use the ToS platform visiting ThinkScripter is a must.  The /ES chart uses these indicators:

http://www.thinkscripter.com/2009/05/13/four-volume/
http://www.thinkscripter.com/2009/03/12/previous-days-regular-hours-highlowclose/
http://www.thinkscripter.com/2009/02/23/tick-trin-indicator/
Heikin-Ashi bars

S&P 500

This chart should be fairly self-explanatory.  One of the things that stands out is the Four Volume divergence.  As the market was pushing higher, after the FOMC “no change” announcement, internal volume was turning down.  This was a very good clue to look for a reversal.  A low risk countertrend entry was to short at the 1075.75 pivot. Heikin-Ashi bars are useful for staying in the trend or seeing a trend more clearly.

Using LR channels we’d know that TNA was getting overdone and could look to long TZA soon.  Check out that hammer on TNA’s weekly chart.  The small yellow circle is from Sept. 1st when TNA touched the lower three month channel (see chart).  That coincides with the median line on the entire price history channel.  Pretty sweet huh!

Here’s the TZA intraday chart for trading FOMC news.  The first entry was right off a Person’s Pivot.  The tick high at 1300 also gave a low risk countertrend entry.  The sharp upturn on CCI was also a good clue to get long.  Lastly we see Alexander Elder’s famous “kanagroo tail” pattern.  That’s four strong signals to get in the trade.

This site’s database failed late at night on Sept. 11th.  The admin was on vacation and unfortunately the site was down for a week.  It is still unclear whether the database failure was organic or malicious.  However, an unauthorized admin account was created listing:  jyoti_anju2000@yahoo.com.

Just before the site went down an unresolved IP (that didn’t include Bulgarian, Indian, or Chinese net providers) was:

(unresolved ip)    Pages    Hits    Bandwidth    Last visit

217.169.236.12    25    408    4.75 MB    11 Sep 2009 – 03:22
ISP:    Defensie Telematica Organisatie
Country:    Netherlands
City:    Maasland

What is also interesting is the high level of hits received on Sept. 17th while the site was inactive:

89.111.144.26    67    442    9.54 MB    17 Sep 2009 – 13:17
ISP:    Garant-Park-Telecom
Organization:    Garant-Park-Telecom
Country:    Russian Federation
City:    Moscow

12.47.208.86    111    369    7.42 MB    17 Sep 2009 – 02:21
ISP:    AT&T WorldNet Services
Organization:    GOLDMAN SACHS COMPANY
Country:    United States
State/Region:    NY
City:    New York

This marks another record month for Dutch spies visiting GTM.    Read all about them here.  So was the database crash accidental or intentional?

[Update: 9/20]

After going through months of logs it appears an RSS error caused a recurring failure that eventually overloaded the database.  This doesn’t explain the peculiar email address fixed to a new admin account, but it explains the crash.

I can calculate the movement of the stars, but not the madness of men. -Sir Isaac Newton

There are five zombie banks that control between 20%-40% of NYSE daily volume. It started earlier this year with Citigroup and Bank of America. They equaled 10% of NYSE total daily volume. Now the trend in High Frequency Trading (HFT) is on the rise. This begs several questions. If this is a healthy bull market, why are just five stocks running the exchange? Is it possible the bailout money is being funneled into just a few stocks? To get a really good answer we’re going to visit London England in the year 1720. Let’s explore how history is repeating itself with the new South Sea Bubble. The goal by the end of this article is to draw connections between the greatest financial bubble of all time and what’s happening today. Hopefully it will be so obvious you’ll feel sick.

One Chart to Rule Them All

There’s actually 315 years of stock market data available. People think DOW 4,000 is impossible, but look at this 315 year chart and how juicy DOW 1,000 is.

Here’s the theory. The country has nearly run out of credit forming the end of a Grand Supercycle. The money issue is obvious with state budget problems. So what is the most expedient way to generate credit in a corrupt system? A Ponzi scheme. Make it really big and complicated so no one can figure it out in time.

Here are some of the basics. The global financial markets, which are primarily run by New York banks, are being propped up by the Federal Reserve selling Treasuries. The money that is placed in Treasuries is then built out with leverage and funneled into the most wounded names in the banking system. These names get pumped up to create a cash machine that is used to cover debts of the United States of America. This is just a basic model, but understanding how this works will open windows into our corrupt financial system. A system designed to tax and steal without our knowledge.

Look at the stocks moving the market:

Volume continues to be concentrated in just a few names. Today, in a universe of over 5,000 stocks in the U.S. equity market, only 4 stocks contributed 20% of the volume.

Citigroup (C), Bank of America (BAC), Fannie Mae (FNM) and Freddie Mac (FRE) traded a total of 2.041 billion shares. Overall volume in the U.S equity market was only 10 billion shares. -Joseph Saluzzi

There is some variation to which names lead volume for the week. The PPT cash machine cycles through several names during the month. Read Themis Trading’s white paper, Toxic Equity Trading Order Flow on Wall Street: The Real Force Behind the Explosion in Volume and Volatility. This gives a concise explanation for current market mechanics. Here’s a section most of us don’t think about:

High frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.

What HFT Looks Like

The main HFT stocks are C BAC FNM FRE AIG and CIT. During Fed POMO days, where they’ve recently been injecting $30B into the market on a weekly basis, these names will cycle through large cash inflows. This is the new PPT vehicle. Check out the chart of AIG during a heavy week where $197B in Treasuries were on auction.

Note the blue shaded area on the chart. This is classic HFT or program trading where a stock churns shares within a very small range. Liquidity rebates are also happening where dealers like Goldman Sachs earn a quarter penny on every share traded. Everyone gaming the stock makes out. Shareholders looking for organic growth get chopped to pieces. It’s a giant cash machine and the stock goes nowhere, much like the S&P 500 intraday.

Then something happens… The PPT shows up. This move in AIG is a classic PPT push where a massive amount of capital is pumped in during the last hour of the market. HFT algorithms can see it coming and get out of the way. Here’s part of the reason why these moves come at the end of the day:

The directives of the FOMC are carried out in the context of two week maintenance periods. The Manager of the System Open Market Account is charged with achieving those objectives via the daily operations. (source)

Step One (08:30am):

• gather information, macroeconomic news
• desk telephones primary government security dealers
• large banks inform the desk about their reserve needs
• NY Fed gather data to provide forecasts of reserves

Step Two (10:30am):

• call to the Treasury concerning its forecast of its balance for the day

Step Three:

• formulate the actions for the day
• forecasts from Treasury, NY Fed, and Fed BoG combined
• interventions are formulated
• trading plan is formulated

Step Four (11:15am):

• conference call links…
• Manager (and staff)
• Director of the Division of Monetary Affairs at Fed BoG
• a Federal Reserve Bank president who sits on FOMC
• proposed actions for the day are detailed

Step Five (11:40am)

• desk traders contact primary dealers and execute day’s program

See our story Anticipating PPT Days for ideas on what these moves look like and how to trade them. This same move was seen in ABK AIG CIT FRE FNM during the last couple weeks. It is reminiscent of the moves seen prior to the September 2008 market crash. It used to be a safe assumption to put your money where the government puts theirs. Now that money disappears, in more ways than one.

Myth of Savings Accounts

Citibank (and many others) have a program called Deposit Reclassification. This is a relatively new financial scheme you won’t find on Wikipedia. It was invented for credit unions and banks to put dead money to use. That dead money comes from your savings accounts.

For accounting purposes, all Citibank consumer checking accounts consist of two sub-accounts; a transaction sub-account to which all financial transactions are posted; and a holding sub-account into which available balances above a pre-set level are transferred daily. (source)

What this means is banks using this program do not have to maintain a 10% deposit reserve on cash in savings accounts. So how do they guarantee cash that isn’t there? Banks use this sub-account loophole to circumvent all retail deposit reserve requirements. Under normal Federal Reserve System rules banks can leverage $100 in deposits into $1,000 of credit based on a 10% reserve. This is virtually free money for them. The more deposits they have the more credit they can create out of thin air.

With a 0% actual reserve–who knows? This nullifies what the FDIC says about the safety of the banking system and deposits. What deposits? Check out this presentation by the New Jersey League of Community Bankers on how it’s done.

Note that in July 2008, the banking system’s vault cash EXCEEDED both required and total reserves. [Vault cash is the physical banknotes that banks keep on hand to meet withdrawals; the vast majority of dollars exists in the form of electrons, and only a tiny sliver is metal coinage.] Now, in July 2009, the required reserves and vault cash have been relatively unchanged.

Over the same period, the monetary base has almost doubled from $847 billion to $1,681 billion while reserves grew by about the same amount, from a scant $45 billion to $803 billion. Where did this money come from? It is likely just FED “liquidity” or newly created currency. We would need to audit the FED to really be sure, but the timing and amount coincides with the Banker Bailout of October 2008. (source: Jake Towne for Congress)

Software also exists that allows banks to move money on a whim. There’s SWIFT that nearly everyone uses and fi-linx for Deposit Reclassification. These systems run a, “Now you see it. Now you don’t!” form of financial engineering. They can move money undetected in and out of accounts. One day the bank will have 0.6% cash on reserve, and the next they exceed the Fed 10% requirement. This is part of the reason bankers do not want the Fed to be audited. It’s also part of the reason we’re seeing enormous credit injections.

Banks and Bubbles

Current HFT names could be a modern version of the South Sea Company. In 1720 Britain had the equivalent of roughly $2T in debt and was nearly bankrupt. The South Sea Company was used to service that debt. Roll all of the debt into private stock, dupe everyone and their grandmothers into buying it, then sell for a profit. The public gets left holding the bag. Sound familiar?

A senior Bank of England official today compared the banking system over the last 20 years to the South Sea bubble of the early 18th century and said bankers had merely “resorted to the roulette wheel” to keep up with each other. (Guardian UK)

The South Sea Bubble was an enormous scam conceived after a costly war where Spain and France tried to control all of Europe. The stock became a vehicle for Britain to offloaded their war debt upon a naive investing public. Even Isaac Newton got soaked speculating in this stock. The South Sea Company was a Ponzi scheme. They were initially slave traders with one boat that did one trip a year. They never turned a legitimate profit. It is the original event that coined the term “bubble.”

Here’s some more good stuff from Ashley Seager at the guardian.co.uk:

The Bank’s executive director for financial stability, Andy Haldane, said in a speech in Chicago that having been stable over much of the 20th century, returns in the banking system relative to the wider stockmarket shot up after 1986 until 2006.

“Banking became the goose laying the golden eggs. There is no period in recent UK financial history which bears comparison,” he said. He said bankers and policymakers became seduced by the excess returns available: “Banks appeared to have discovered a money machine, albeit one whose workings were sometimes impossible to understand.

“One of the South Sea stocks was memorably ‘a company for carrying out an undertaking of great advantage, but nobody to know what it is’. Banking became the 21st-century equivalent.”

“For a number of diseases, 20% of the population account for around 80% of the disease spread. The present financial epidemic has broadly mirrored those dynamics,” he said, adding that the failure of a core set of large, interconnected institutions such as Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers and AIG contributed disproportionately to the spread of financial panic.

How the South Sea Company Operated

Keep the Fed pumped AIG chart in mind while reading the following. Excerpts from Harvard Magazine’s “The Damn’d South Sea” by Christopher Reed:

On January 1, 1720, the price of a share of South Sea stock stood at £128. On June 24 it hit £1,050. In September came the crash. By December the stock had returned to £128. Thousands declared themselves ruined. Banks could not collect loans on inflated stock and failed. Specie was in short supply. Work stopped on half-built homes. Investigations and revenge ensued, and a long struggle to restore stability.

Sir Isaac Newton, scientist, master of the mint, and a certifiably rational man…sold his £7,000 of stock in April for a profit of 100 percent. But something induced him to reenter the market at the top, and he lost £20,000. [roughly £3 million today]

To put these sums in perspective, Carswell points out that a middle-class family could live very comfortably at the time on £200 a year.

The maxim that credit was not wealth unless it rested on a wealth-producing asset had been ignored…,” writes Carswell (former secretary of the British Academy). Greed blinded many, but not all. One unidentified observer saw clearly: “The additional rise of this stock above the true capital will be only imaginary; one added to one, by any rules of vulgar arithmetic, will never make three and a half; consequently, all the fictitious value must be a loss to some persons or other, first or last.

“In order to pay out profits, the South Sea Company needed both to raise more capital and to have the price of its stock moving continuously upward,” writes the economist and MIT professor emeritus Charles P. Kindleberger in his classic work Manias, Panics, and Crashes: A History of Financial Crises (Wiley, third edition, 1996). “And it needed both increases at an accelerating rate, as in a chain letter or a Ponzi scheme.” The company repeatedly raised cash through new issues of stock as its price spiraled upward in the summer of 1720.

“It was clear that the Company could only pay the £7,500,000 to the government if they exchanged South Sea stock for government obligations at prices far above par 100. And, the higher the price of stock at the time of conversion, the greater the profits which would accrue to the Company. In addition to the profits the directors could make by holding South Sea stock were those available through stock manipulation which, in this case, included transactions in non-existent stock. The directors could create and purchase stock at a low price and sell it for an inflated price. It was a foolproof way of making a large fortune and it proved to be an irresistible temptation.

“Carswell employs a hydraulic metaphor to describe the action. The company first created £2 million in new South Sea stock, at £300 a share, and let investors pay for it in installments. Subscribers eagerly bought it up, and the company covertly issued £250,000 more for good measure. Then it announced that its cash position was so strong that it could lend shareholders money on the security of their South Sea stock. The price of the old stock at once rose to £325. The company issued yet more stock and made more loans, again and again.

“So Blunt…had constructed a financial pump,” writes Carswell, “each spurt of stock being accompanied by a draught of cash to suck it up again, leaving the level higher than before.” Success required that the level keep rising.

The South Sea Company was a confection of politics, commerce, and finance. None of its governors or directors had any experience of trade with the New World, but John Blunt, who wrote the charter and was the company’s dominant director, had been a scrivener and then director of the Sword Blade Bank. He and cohorts had a fine understanding of financial manipulation.

The company had the further splendid purpose of relieving the government of its burdensome unsecured public debt–obligations for which Parliament had assigned no funds–which then amounted to £9,000,000. South Sea was organized under the newish joint-stock principle, as a corporation with transferable shares. Holders of the national debt were obliged to exchange their government securities for shares at par in the company. The company could raise working capital–a huge amount of it–by borrowing on the security of the debt due from the government. In addition to its trade monopoly, the company would get an annual payment from the Exchequer of £568,279 10s., or 6 percent of the debt taken over. Stockholders had no promise that they would see any of this as dividends, but who could blame them for thinking that capital gains based on trading profits were a certainty?

Final Thoughts

Fortunately we now have technology that can dig under the surface. What does it mean again when the stock goes up while institutions are bailing?

A quick review of why the South Sea Company stock failed and why it’s like AIG C BAC etc:

1. Government funded stock secured by government debt
2. Stock operates in a monopoly environment
3. Corrupt system with unknown sums and fake shares
4. Depends on an infinite increase in value

What’s amazing is the South Sea Company stayed in operation for almost 100 years. However, the South Sea Bubble ended with purges, the Napoleonic wars, and about sixty years of total misery. It is partly responsible for the U.S. emerging as a new world power though. Here is some parting irony:

Historians wishing to study the company and the era can be awash in source material if they go to the right place–the Kress Library, Harvard Business School’s rare-book collection, housed in Baker Library.

Almost all of it was assembled by Hugh Bancroft, A.B. 1897, A.M. ‘98, LL.B. ‘01, president of Dow, Jones and Company. After his death in 1933, his wife presented the Bancroft collection to Harvard. It offers true value to scholars wishing to explore a seminal lunacy.

Lastly, Robert Prechter is very vocal about these connections. Check out the July issue of The Elliott Wave Theorist.

We have two big auction days for Treasuries coming up. The 10 year note on Wednesday and the 30 year bond on Thursday. The thirty year is the big one that makes everyone nervous. It’s a barometer for the willingness of other countries to service U.S. debt. There is intense pressure on this and the question is, “Will China continue to float the U.S.?” (see prior story)

There is a way to play the ETFs for a quick profit. Here’s how to place resting bids on Treasury auction days (calendar).

The various Treasury auctions happen once a month at 1:00 p.m. ET. The notes range from 4 weeks to 30 years and their auctions are spread throughout the month.

Let’s use last week’s auction as an example for setups. Sometimes clear levels of resistance are made before the auctions. One can then place a low risk buy-stop-market order above the day’s range, right before the auction happens.

So we don’t know which will pop TBT or TLT. These ETFs track the 20 year Treasury bond. They are the most liquid and popular way to play Treasuries. TLT is long the bond and TBT is short.

Place a resting buy-stop-market order on both names. The name that pops will trigger the order. This won’t catch the entire move, but it’s a low stress partly automated way to make money. It also saves focus to manage the exit. Exits need to be on the same time frame as the entries. The risk of holding these trades past 30 minutes is large. The idea is to catch the first big impulse move and get out.

These are 3min charts on TBT and TLT for the same two day period last week. You can see that TBT would fill for a quick profit and TLT would never fill. So you only have to manage the winner.

TBT

The green arrow indicates the resting bid. Brokers call them different things. Some are called buy-stop-market orders. When the price is touched a market order is executed to buy. This assures an immediate fill. We want to catch the impulse move.

Say an order for 500 shares of TBT was placed at 52.75. This is $0.05 above the day’s high. We want a little wiggle room to lower the risk of being faked out. Price must get an impulse move to execute the order. It fills 52.80 at the market. The move stalls 10 minutes later. A sell at the market around 53.55 is $375 profit.

TLT

These resting bids are placed at the same time on TBT and TLT. We’re looking for a new high to enter the trade. TLT didn’t work that week. No big deal. The order never fills and focus is shifted to the one that did.

Background Manipulation

Here is more of the bigger story underlying these trades. GTM wrote about this last March (see story). This is old news, but nothing has fundamentally changed. Here is a snippet:

President Obama and his new government have adopted a series of measures to deal with the financial crisis. We have expectations as to the effects of these measures. We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried. -Wen Jiabao 03/13/09

On Sunday Bernanke does the first national interview a Federal Reserve chairman has ever done in 96 years. He says everything is fine and we’ll be back to business as usual by the end of the year. Then on Wednesday the Fed announces they will buy Treasuries until the end of days. So…

1. China warns about the financial stability of the U.S.
2. Bernanke goes on national television
3. Says he’s from Main Street, just like you and me
4. Then boldly lies about the economy

Three days later…

• FOMC announces a final push of a desperate crisis management plan
• U.S. dollar sees its 3rd biggest one-day decline ever
• Fed is now matching all of China’s $1 trillion in Treasuries

The Fed Buys Last Week’s Treasury Notes

Chris Martenson just exposed the way the Fed buys Treasuries under the table (see story). Here is a snippet:

Good grief! Just last week, when the auction results were announced it was trumpeted to great fanfare that there was “more than sufficient” bid-to-cover, “strong demand” and all the rest. And now it turns out that 47% (!) of the bonds that were taken by the primary dealers in that auction have been quietly bought by the Fed and permanently secreted to its balance sheet.

They didn’t even wait a full week! A more honest and open approach would have been for the Fed to simply buy them outright at the auction but this way, using “primary dealers” and “POMOs” and all these other extra steps the basic fact that the Fed is openly monetizing US government debt is effectively hidden from a not-too-terribly inquisitive US press and public.

The speed of the shell game is accelerating.

This immediate repurchase of newly auction bonds by the Fed tells us that demand for these bonds is not nearly as high as advertised, and that things are not quite as strong as represented.

Caveat Ursi 3.0

Mole at EvilSpeculator has been following POMO activity for a long time. He drew up an awesome chart showing each burst of virtually free money the Fed pumps into the market (see story).  It’s not free to you and me. We pay the interest on it through inflation.  It is essentially free to prime brokers who use it to gun index futures while everyone is sleeping.

As you are probably aware I have long been keen on learning more about the inner workings pertaining to the NY Fed’s repo auctions and I have occasionally reported on the slosh available to preferred primary dealers. After a very pertinent article posted by ZH earlier this week I carefully combed through the recent POMO calendar, which due their traditional rarity I had foolishly ignored for several months now, and to my surprise arrived at highly interesting results:

Coincidence? You be the judge of that – I however took the liberty to highlight and mark each day a POMO operation was held.

Conclusion

There will be a day, maybe this year, when Treasury auctions don’t get enough bids. We know demand has been slipping, which is being inflated by the Fed. There are limits to how long the Fed can pump the market. When that day comes, this strategy on TBT/TLT will pay out in a massive and immediate way.