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“THE SELLOFF CONTINUES”

Many times I have commented about the greatest risk to the market is liquidity, stating further the next crisis will be a liquidity crisis, perhaps the result of rising interest rates.  The vast majority of academics and ETF sponsors will vehemently deny such claims utilizing volume as evidence.

JP Morgan wrote a provocative research report stating liquidity is indeed absent, a fact that anyone who has worked on a fixed income desk will easily acknowledge from first hand observations.

The Bank stated “there are fewer orders resting at the tightest bid-ask prices for the S & P 500 e-mini futures” further writing “weakening liquidity is feeding a market decline” and the data shows “a more persistent decline in liquidity than simply justified by market volatility.”

JP Morgan continued stating such a decline in liquidity “implies great vulnerability because any small selling in S & P 500 futures can be propagated by illiquidity.”  The Bank concludes not only has market depth for the S & P 500 futures contracts deteriorated in October but is also “much lower this year on average relative to either last year or previous years.  This persistently low market depth leaves US equities vulnerable from here.”

Wow!  Because 60% of the volume is now done from algorithmic or trend based trading, selling [and buying] can be easily exacerbated.

Speaking of which, six weeks ago oil was at a four year high and “oil longs” were at a near time record.  Six weeks later oil short selling has jumped to a record according the Commodity Futures Trade Commission, assisting in the drop of prices of almost 30%.

What happens if OPEC does reduce production by 1.5 million barrels or more at its December 6 meeting?  Will crude stage a similar advance in quick order?  Goldman thinks yes.

What will be the ramifications if oil does stage such an advance?  In the last two weeks a natural gas ETF that had shorted natural gas futures failed because prices surged.  Conversely an oil hedge fund that was long oil futures failed because of the sudden implosion of crude.

Both were viewed as one off insignificant events but I think both examples demonstrate the potential risk of the current market mechanics.

Changing topics, corporate bonds in the aggregate are having their worst year since 2008, a selloff that commenced about six weeks ago.  Rated bonds are underperforming non-investment grade bonds, an environment many should question especially given the Treasury market has rallied.

As stated above and noted many times, the bond market is illiquid.  Depending upon the source, the bond market is two or three times bigger than 10 years ago but money center bank inventories are down over 90%, the result of regulatory fiat.

I will argue that it is because of this collapse of bond inventories prices will fall more than which would be expected, an environment which is perhaps today is unfolding.

The issue at hand is how will equities respond if yields unexpectedly surge?

Horribly.

What will happen today?  Trading is expected to wane as the day progresses because of the upcoming holiday.

Last night the foreign markets were up.  London was up 0.59%, Paris up 0.25% and Frankfurt up 0.55%.  China was up 0.21%, Japan down 0.35% and Hang Sang up 0.51%.

The Dow should open moderately higher as oil is rebounding about 2% on a surprise reduction in inventories, the perception the Fed might change its monetary stance given recent volatility and the belief the averages are vastly oversold.  The 10-year is off 3/32 to yield 3.08%.

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Ken Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.