Credit Markets Deteriorating

Stocks continue to dance on the edge of oblivion this week as investors busily analyze President Obama’s new homeowner assistance plan.

For the most part, they like what they see. After Tuesday’s rout, it’s as if someone called a timeout to review field conditions as the market reached critical support levels.

We would expect a reaction rally here, so the failure of one to materialize is a sign the bulls have been rendered inert for the time being.

One possible explanation has been the tightening of margin terms by many prime brokerages as they shore up balance sheets and reduce risk exposure.

Banks like Goldman Sachs (GS) and JP Morgan (JPM), which provide clearing and custodial services to the hedge fund industry, are the critical links to the market for high-horsepower funds including Steve Cohen’s SAC Capital Advisors and Ken Griffin’s Citadel Investment Group. Without ample borrowing power, the whole game falls apart.

There were some surprising pockets of strength in traditional early-cycle plays. Commodity names like miner Freeport-McMoRan Copper & Gold Inc. (FCX) and oilfield service provider Halliburton (HAL) found buyers this week. Agricultural names like seed producer Monsanto (MON) and fertilizer maker Mosaic (MOS) are also working well.

Attack of the Credit Bears

But with the energy sector still lagging in general, and with weak market internals, I’m not ready to sound the all clear. Plus, according to WJB Capital Group analyst Brian Reynolds, while everyone has been distracted by stocks, the bears have been putting serious pressure on the debt markets via credit default swaps.

U.S. Credit Default Swaps Chart

Reynolds believes much of Tuesday’s weakness was caused by equity traders’ realization that the credit situation is deteriorating: Central and Eastern Europe governments are at risk of defaulting on debt as their currencies continue to slide, Britain’s sovereign debt could lose its AAA rating, and General Electric (GE) is fighting for its AAA rating.

As stocks swooned, the credit bears expanded their attacks into the corporate debt market, which are already pricing in a level of 600 to 700 for the S&P 500. Credit spreads continue to widen just as stocks tried to stabilize near critical levels. That’s bearish.

To see how I recommend trading on these ideas, check out my Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.


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