Prepare for Another Plunge as Fear Recedes; Why the Wall Street "Occupy Movement" should Protest the Fed instead of Bank of America

Fear as measured by the cost of options and also by the $VIX remain elevated but well off the upper end of the range seen multiple times since August.

Bloomberg reports Bank Puts Fall Most in S&P 500 as Profits Reduce Crisis Pessimism

The cost of options protecting against losses in financial companies is falling faster than any other industry as earnings reassure investors that banks and brokerages will avoid a repeat of 2008.

Three-month puts on the Financial Select Sector SPDR Fund (XLF) cost 10.15 points more than calls, according to Bloomberg data on implied volatility. The price relationship known as skew has narrowed 16 percent since Oct. 3, the most among nine ETFs tracking Standard & Poor’s 500 Index industries, as the gauge jumped 11 percent.

Results from Bank of America Corp. (BAC), Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM) are reducing pessimism after concern Europe’s debt crisis would spread sent price-to-book ratios on financial companies to the lowest level since April 2009. Bank shares have gained 14 percent since Oct. 3 after falling 31 percent since the S&P 500’s April 29 peak, data compiled by Bloomberg show.

The 10 financial companies that have reported results so far this season have exceeded the average analyst estimate by 14 percent, with Citigroup in New York and Charlotte, North Carolina-based Bank of America beating them the most.

Implied volatility, the key gauge of options prices, for the financial ETF’s at-the-money options expiring in three months fell 30 percent since its Oct. 4 high to 39.18 yesterday.

The VIX, as the Chicago Board Options Exchange Volatility Index is known, declined 31 percent from its Oct. 3 peak to 31.56 yesterday. The volatility gauge remains above its 21-year average of 20.49.

“Financials haven’t done well recently, and valuations are coming to a good level -- they’re becoming more attractive,” Giri Cherukuri, head trader for Oakbrook Investments, which manages $2.7 billion in Lisle, Illinois, said in a telephone interview yesterday. “Earnings reports are coming out now, so we’re getting some clarity about the financial position of all these companies.”

“People were protecting against cataclysmic losses,” Alec Levine, an equity derivatives strategist Newedge Group SA in New York, said in a telephone interview yesterday. “The worst-case scenario was more than priced in -- now that we’re past the earnings events people are taking their protection off.”

The Earnings Lie

It's difficult to know whether to start with a rebuttal of nonsensical comments by Giri Cherukuri, head trader for Oakbrook Investments or a rebuttal of the equally nonsensical "worst case scenario" statements of Alec Levine, an equity derivatives strategist at Newedge Group SA.

A mental flip of the coins says let's start with a look at earnings.

Most of the recent bank "earnings" are totally fictional. No one still knows what bad assets banks are hiding because assets are not marked to market.

During the financial crisis in 2008, the FASB issued a ruling that allowed banks to record a profit when the value of their debt collapsed. In other words banks report a profit when their credit-worthiness sinks.

In theory banks can buy back their debt at a profit. In practice, banks are so capital impaired they can't. Common sense alone says recording a profit when credit-worthiness drops is ludicrous.

Citigroup and Bank of America both used this gimmick to inflate profits.

Citigroup also took a gain by lowering provisions for writedowns. Zerohedge breaks out the Citigroup farce in his report $3.8 Billion ($1.23/Share) In Reported "Earnings" Really $0.5 Billion Or $0.16/Share.

Yesterday I noted that Bank of America just shifted $83 trillion in derivatives exposure to an insured deposits bucket. For details, please see Bank of America Moves a Merrill Lynch Derivatives Unit to an Insured Deposits Unit (Putting FDIC at Risk); Fed approves Move, FDIC Doesn't

I added an addendum to that post today.

Aaron Krowne at Ml-Implode replies ...

Interesting to note this was done under the auspices of a 23A exempt that had already expired, then which the Fed renewed to give fait accompli for such a move.

Totally demented; this is bailouts and propups exacerbating the original problem at its worst.

Obviously, BofA is now a de facto ward of the state, with the government allowing them to put deposits (and hence the public deposit insurance "fund") at stake simply in order to keep from unwinding derivatives.

Worst Case Scenario

The worst case scenario for Bank of America is a share price of $0 with bondholders wiped out. Indeed that is what should happen.

At the very least a retest of the 2009 low below $3 seems likely enough.

Value Traps and Mush Thinking

Those buying Bank of America and Citigroup based on PE valuations are not thinking clearly because bank earnings are fictional. The same can be said for the entire stock market.

Many alleged "value plays" are going to get cheaper, much cheaper. Here are some pertinent posts about value traps and earnings expectations:

February 07, 2011: Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think

March 15, 2011: Anatomy of Bubbles; Negative Returns for a Decade Revisited; Is Gold in a Bubble?

June 20, 2011: Value Traps Galore (Including Financials and Berkshire); Dead Money for a Decade

August 17, 2011: Earnings Collapse Coming Up; Don't Worry Companies Will Still "Beat the Street"; Value Traps and Road to Ruin

August 23, 2011: Another "Lost Decade" Coming Up; Boomer Retirement Headwinds; P/E Expansion and Contraction Demographic Model; Negative Returns for a Decade Revisited

Why the Wall Street "Occupy Movement" should Protest the Fed instead of Bank of America

The "Occupy Wall Street" Movement would be better advised to protest the Fed and Congress rather than protest Wall Street and Bank of America because the Fed and Congress are responsible for the bailouts.

Moreover, and more importantly, the Fed and Congress are responsible for the housing boom-bust in the first place!

Wall Street profited, but the Fed and Congress are to blame.

Meanwhile, with fear receding even though structural problems remain in the US, in Europe, and in Asia-Pacific especially China, the markets may be ready for the next leg lower.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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