What Dennis Gartman Remembers Most From "Black Monday"

Excerpted from the latest Gartman Letter, and presented without commentary (but with some highlighting).

ON THIS HORRIBLE ANNIVERSARY AND WHAT WE REMEMBER MOST:

Everyone seems to be writing about what they remember about the Crash of ’87 and we remember it well… very… and breaking with our common use of the “royal we” in our commentary and using the personal pronouns instead, from this point onward…what I remember is the sheer irrationality of the day in question; the utter and sheer panic by those who had in the past never panicked and the effect it had upon me.

On the Friday before the “Crash” I was in Raleigh, North Carolina with close friends from my days at the CBOT of several years earlier: Brian O’Doherty, who played football for our beloved NC State University and who traded in the bond pit… and Carl Boraiko… one the best floor traders in T-notes, Bonds and the NOB spread I’ve had the privilege of knowing… and several others. We were there to go to the NC State v. lemson game on Saturday and  were playing golf at the Duke University Golf Course on Friday when one of us noticed that the Dow was “Down a hundred!!” that afternoon as we checked our phone pagers that were suddenly paging us all, for there were not Iphones then. The Dow had never been down 100 point before… ever! It was shocking, to say the very least. As a former floor trader and having been writing TGL for three years at the time, and having warned previously about the dangers of “portfolio insurance” I was fearful… very… about what might happen on Monday’s opening as a result.

Going into Monday’s opening, I’d written myself a note to buy KC Value Line Futures and to sell S&P futures in equal dollar sums, knowing/believing that the real selling by the portfolio insurers would be in the S&P futures. Normally I traded only 5-10 “lots” when trading net open positions, however I chose that morning to buy 50 Value Line futures and to sell about 50 of the S&P futures because the “risk” on the spread was obviously less than the risk on outright positions… usually.

The violence of the opening caught everyone wholly off guard and the position moved against me by several thousands of dollars initially but was moving back in my favor quickly by 9:30 a.m. as the NYSE was about to open. However, I got a frenzied phone call from my clearing firm at the time wanting 100% margin on both sides of the trade by 10:00 to be wired to them or they were going to sell me out… immediately! They did not want regular futures spread margins; nor did they want full futures margin on each side; they wanted full 100% payment for the face value of both sides of the trade… in effect about $5 million or so, which of course I did not have. I was sold out… at 10:01 when I phoned to say I could not meet their demand. I lost several thousands of dollars that day… a meaningful sum of money then..

A few hours later as the panic truly began in earnest and as the selling in the S&P futures reached a frenzy, the trade was “worth” several hundred thousand dollars… or would have been worth several hundred thousand dollars… in my favor for what I had expected to happen was in fact happening. The spread between the S&P futures and the Value Line moved violently in the latter’s favor. By Tuesday morning’s panic opening it would have nearly doubled again, but it made no difference to me. I was out!

In retrospect, the clearing firm in question was doing what it needed to do to make certain that its own solvency was assured and in retrospect this was rational.

What did I learn? I learned that markets can indeed be irrational; I learned that one has no choice but to expect the irrational and to prepare for it. I learned that amidst panic anything… absolutely ANYTHING… is possible and I learned to be prepared. Oh, and I learned that I never, ever, EVER want to go through that sort of day again… ever!

Chinese Companies Ask Employees To Buy Their Stock, Promise To Cover Losses

Just when we thought there were no surprises left in the world"s foremost incubator of "financial engineering" that is China, we got a stark lesson in never underestimating China"s market manipulating ingenuity.

According to Caixin, around two dozen Chinese companies recently offered their employees a deal: buy company shares while guaranteeing that any losses would be covered.

While employees think they may be getting an unbeatable deal - who can say no when your employer promises you all the upside and no downside - the reality is that any participants in such scheme are merely locking in their fates with that of their soon to be insolvent employer, who desperately needs to raise the price of their stock to fend off collateral calls on stock-backed loans usually made by founders and other major sharehholders.

As Reuters points out, attracted by guarantees that their principal is "safe", workers have eagerly stepped up to take advantage of the "offer" even as it remains far from clear how these guarantees would work, with employees in some cases being asked to buy shares and hold them for at least 12 months. Details aside, many of the companies that resorted to this drastic stock price manipulation were quickly rewarded and saw their share prices spike.

The entire farcical episode is reminiscent of what happened in 2015 when China"s stock bubble grew exponentially, then burst just as dramatically. At the time, there were similar efforts, but then it was the government appealing to major shareholders" patriotism to buy and hold shares in what Beijing said was as a battle against speculators, both domestic and foreign. This time, with the proposal centered entirely on the private sector, the motive is different and is the result of companies using their own stocks as loan collateral, a practice that according to Reuters" estimates has quadrupled in China over the past two years, and which is driven mostly by founders and major shareholders posting large batches of stock as loan collateral in recent months.

Fundamentally a ponzi scheme, this works without a glitch during rising markets but falling prices especially among small and mid-cap companies, have eroded the value of that collateral, raising the specter of forced liquidation - where lenders, often Chinese brokerages, make borrowers sell the pledged shares. Selling the stock adds more pressures on share prices, triggering a downward spiral.

Shenzhen Fenda Technology, a maker of speakers and electronic accessories, was among the first to encourage staff to buy shares one week ago. At the end of March, Xiao Fen, the company"s chairman and top shareholder with a 44.5% stake, or 416.4 million shares, had put up 84% of his holding as collateral for a loan, the company said. It did not say what the loan was for. Trading in the company"s shares was suspended in late December pending a reorganization, but resumed in mid-April, when the stock price slumped to near their 2015 market crash low.  Last Friday, Xiao promised any employee who bought shares in the company by June 6 and held them for at least a year would be shielded from losses.

What he did not say is that any employee who took advantage of the "generous offer" was effectively providing a bailout lifeline to the chairman. This probably should have been explained to the workers who participated in the offer simply because they saw their co-workers jump right in. "A lot of colleagues I know have bought shares. I have too," said one worker, who gave only his family name, Li. "The company is quite good and the chairman has guaranteed principal, so, of course, we"re interested. I know some colleagues even bought shares with borrowed money."

Shenzhen Fenda Technology shares jumped by a tenth after the announcement, but have since edged back down.

Also last Friday, Shenzhen-listed Hunan Kaimeite Gases launched such on offer with a four-day deal. Other companies offered similar deals but for different lengths of time. Kaimeite justified the ludicrous proposal by saying its stock was - what else - "undervalued": “The company is undervalued due to recent volatile trading of the market,” according to Kaimeite Gases’ announcement, filed with the Shenzhen Stock Exchange on Friday. “The buyback plan is to boost investors’ confidence, and it’s based on our bullish view on company’s outlook."

Immediately after the buyback proposal, shares surged: Kaimeite Gases jumped by the legal daily maximum of 10% to 8.86 yuan ($1.30) last Friday. It closed at 8.98 yuan on Tuesday — the day the employee deal ended. As of May 31, the prices of shares of Kaimeite dropped 26.1% since this year’s peak of 10.94 yuan on Jan. 25.

Many others quickly piggybacked on the idea.

The price of Guangdong Biolight Meditech stock fell by a quarter this year, undercutting the value of the 14.6 million shares that its chairman Yan Jinyuan posted as collateral as of the end of the first quarter. On Monday, Yan made a promise like Fenda"s Xiao, and the share price also rose.

With the idea spreading fast, about 100 notices on share buybacks were filed by companies’ major shareholders to A-share markets from June 1 to Tuesday, according to financial data provider Wind Info. By comparison, the number of notices on reducing shares stood at 26 during the same period.

* * *

In a sign that at least someone in China is paying attention, some analysts criticized the practice as a “bailout style” buyback for struggling companies. Xu Yang, chief analyst from HuaAn Securities Co., said it is hard to argue that paying for losses is a smart move for the market over the long term. “Buyback from major shareholders usually provide support on sentiment during market downturns,” Xu said. “But this kind of buyback notice could lead to potential risks of market manipulation.”

Wu Kan, head of equity trading at Shanshan Finance, said that however well intentioned these efforts are, usually by the companies" founders or big shareholders, there is a question mark over their financial ability to make such guarantees. "It could be driven by the genuine belief that the stocks are worth investing in. But it could be a desperate move to prop up share prices to avoid margin calls," he said.

Furthermore, the promise to take any losses "isn"t legally binding and largely depends on big shareholders" virtue. And you can"t rule out insider trading during the process, which is why regulators are demanding better disclosure," he added.

* * *

Growing concerns about the lunacy of this latest ponzi scheme to manipulate stocks higher have failed to prevent gullible employees from rushing in. Sun Xishan, a sales worker at Biolight, said he missed the chance to buy stock on the day of the announcement, but would try to get in on the shares later. "I know the company well, it"s in pretty good shape and its performance is growing. The chairman promised to cover losses if any, so it"s hard not to be interested if one has money," Sun said, cited by Reuters, who is about to lose all the money he puts into this "guaranteed" profit scheme.

The scheme however unveils a deeper threat facing China"s smaller publicly-traded companies.  If markets continue to slide, there could be a surge in margin calls on these loans, potentially triggering a vicious cycle of share selling, increasing the risk of broader financial instability. "If stock prices fall, but shareholders don"t have enough capital to replenish their collateral, the pledged shares would face forced selling," said Meng Shen, director of Chanson & Co, a Beijing-based boutique investment bank.  "That would develop into a negative spiral; as the more you sell, the lower the stock price, which would then trigger more forced selling."

Of course, China has a broader issue with collateral that could endanger the health of its financial system – as discussed last week, fraudulent or "ghost" collateral, where pledged products either don"t exist or are already sold or pledged to multiple lenders.

BofA strategist David Cui warned that a potential "vicious selling circle" could lead to a replay of China"s mid-2015 market crash. "As the 2015 experience shows, with high leverage, a vicious selling circle can quickly develop," he said, noting a "moderate" risk of broad-based financial instability. At that point either Beijing will have to step in with another bailout, or scenes such as this one which emerged during the 2015 market rout, will become the norm once again.

Lance Roberts: This Market Is Like A Tanker Of Gasoline

Lance Roberts, chief investment strategist of Clarity Financial and chief editor of Real Investment Advice has authored a number of impressive recent reports identifying potential failure points in today"s financial markets. 

In this week"s podcast, Lance explains how the massive flood of investment capital into passively-managed ETFs, along with record amounts of margin debt, has the potential to set the markets afire:

Fundamentally, there’s nothing different in today"s markets because, at the end of the day, they are about evaluations, earnings -- those types of things. Technically, the market is very different today because of quantitative easing, computerized trading etc.

What we see are two things happening, in particular, that people should be paying attention to. One is that investors are herding into passively-managed ETFs now, which is creating a dislocation between the underlying realities of individual stocks and their prices, because the piling into ETFs is requiring stocks like Facebook, Amazon, and Google to be bought in much greater volumes than they otherwise would. And people are making an assumption that there will always a buyer for every seller in the market.

Now that’s absolutely true. But it"s often argued by the mainstream media that "For every buyer there’s a seller, so it doesn’t matter when the market turns. You’ll be okay." But you won’t, because, yes, at some point there is a buyer for every seller, but it always begs the question: At what price? And because of all the piling into these ETFs, when the market eventually breaks, yes, there will be a buyer; but that buyer could be at many percentages lower than where prices were before. We could very well see a vacuum appear in prices, with a gap down so sharp and so fast that it not only paralyzes most investors who may be hoping to get a little bit of recovery to sell into, but then will start triggering margin calls.

There’s been numerous articles written about margin debt: "margin debt is not a problem; don’t worry about margin debt." Well, margin debt is not fine. We’re at record levels of margin debts. It’s like a can of gasoline. If I set a can of gasoline in the middle of a room and nobody touches it, it"s fine. But drop a match into that can of gasoline you have a different story.

So, the only thing that’s been missing up to this moment right now is the herding of individuals into a specific type of investment. But just like with real estate in the past, we have now people herding into ETFs. And now, with all these computers basically acting on the same set of information pushing stocks in the same direction because they’re all working off the same set of information, the market is like a tanker of gasoline. And somebody’s going to put a lit stick a dynamite into it because when this all reverses, you have these passive indexers become panic sellers. And then that beings to immediately trigger a reversal in the algorithms, which all feed on themselves in a negative direction. And the gap that opens up between the bid and sell prices will be staggering.  

Click the play button below to listen to Chris" interview with Lance Roberts (45m:28s).

Equity Funds Buy Gold - Careful What You Wish For!

Equity Funds Buy Gold Now, 1987 Redux?
SUMMARY
written by Vince Lanci for Marketslant.com
Be careful what you wish for. More equity funds are buying Gold as a hedge against stock exposure. That is a 2-edged sword.

OVERVIEW
Gold is reflecting many basic worries that have no seeming resolution on the horizon
Eurozone elections,
Problems in Venezuela,Greece,Italy,
Currency changes in India

GOLD AWARENESS INCREASES
We"ve noticed more stock market "hedgers" buying the rally. This growing number of buyers hedging their stock market exposure would appear to be solid evidence of a changing view towards Gold. And for sure it does reflect anxiety and raised awareness to Gold and Silver"s qualities in the broader markets.
We want to add an important historical caveat that should not be ignored. Ever.

THE CRASH OF 1987 WAS A DISASTER FOR GOLD
In 1987 on the morning of the Stock market crash, Gold was called to open "limit up". When the Comex actually opened, futures were trading Limit Down. This was almost entirely a function of margin calls being issued for funds who had bought stock on margin and had to raise cash immediately.
The first thing these funds did was liquidate all other holdings in subservience to their stock positions. That meant Gold, their hedge, got dumped.

SIZE MATTERS WHEN THE EXIT LIGHT GOES ON
Fund managers did not understand the size of the Gold market then and the resulting stampede killed Gold. In the end they had to puke their stock positions to, but not until they and their advisors told them to liquidate their winners first. Gold went from being a winning effective hedge to a loss.
Many funds still do not understand the importance of exit liquidity. We strongly advise you as a Gold Investor to brace yourselves if Stocks drop precipitously again. It would be a buying opportunity for sure. But only if you are not leveraged.

BE BULLISH STOCKS
History may not repeat itself. Many Funds understand the risks now. But newer funds run by managers who only know the world of Bernanke and Yellen may not.
Just know that more people are using Gold as a stock market hedge right now. That is not a bad thing in and of itself. It is a horrible thing if those buyers are long stocks on leverage. And if recent history of funds using Gold as a hedge for "event risk", like the Brexit Gold Exit are any indication, the risk to Gold is real.
If stocks were to plummet, we"d like to see gold hold. Seeing this, we could reasonably assess the market as balanced between sellers liquidating to handle stock margin calls and buyers expecting a QE 4 or in the least another "non-rate hike" quarter.
What a Gold investor should want is for stocks to not selloff, but trade sideways now. This will be a sign of market balancing future economic expectations, which includes high values due to inflation"s effect on earnings. This in turn makes Gold the undervalued asset for those stock longs looking for something else to buy.

We are on the road and writing with less than ideal graphic capabilities. A thank you to George Gero for some of he data below.

THIS MORNING:
Gold pausing recent rally, ahead of President Trump speaking tomorrow night
Traders considering March Open Meeting of the FED as well
Friday"s WSJ had a gold story. Assume more buying with headline watchers at least initially

TAPE WATCHING:
Open interest near year high 456,473 in futures
Funds added as 1250 area was reached.
Momentum funds now buying alongside genuine "worry money"
Copper 276018 also good amount OI.
Silver open interest is 210,996.
Gold-silver ratio 68.35,
Gold-plat 228.80
Dollar index 101 and change
April-June spread gold 330, as rollover not a factor yet.

Silver story next as the market has indeed started its climb to the $21 area where that big chunk of calls was sold last week as reported here previously.
Good luck
Vbl

Massive Silver Options Block Trade in June $21 Calls

Via Soren K. and MarketSlant

We received an interesting note from George Gero at RBC today for which we thank him. First the facts.

• Today, someone traded a large block of  Silver Options


• The options were June $21.00 calls


• Number of contracts traded was 3,100 lots at a price of 16.3 cents


• Volume is approximately 2.56% of the aggregate open interest.


• Initiating interest was apparently from the sell side as the price was a full Vol under previous.


• Option delta was 15 and  is not typical of vanilla producer hedge  choice. 


• Strike price is right where Silver miserably failed last July.

Heres the Tape:

Here"s the Option Value Charted. OUCH 

Here"s The Market

Interactive Chart HERE

Analysis

If the initiating interest was from the sell side, the knee jerk reaction from people is to call it a bearish trade. This could be true. But history and experience tell us that is not the case in a large majority of the instances where calls are slammed. Frequently we test the strike at least before dumping. Here are the most probable reasons someone would sell silver calls in this fashion and a quick analysis in italics after each

1. Bearish Speculation- this is not a smart thing to do. Silver options are a roach motel, and it is almost impossible to exit when one has to. 


2. Informed Player Trade- a dealer with flow on his book like a massive sell order in futures. He  can take a punt knowing he has a brick wall above the market to use- this is unlikely as prop desks do not take that kind of indirect risk these days. Selling calls because of a futures sell order is not advised 


3. Informed Flow Trade 2- a client has options to sell or did sell on a deal to hedge production, the dealer merely added an implicit fee and scalped his client- less likely than in the past, due to screen transparency. If true, more likely from a foreign client with no tech or option savvy.


4. Bullish Fund- a long fund with a price target of (say..) $20.00 decides they will sell $21 calls to create a dividend and if the market spikes above their target, they will either hold their futures or roll their short call higher- covered call writing essentially

 

Here are the Leading Candidates Based on Experience and Info

The Strangle Seller:

For years there was a Fund/ CTO/ CTA who made his living selling strangles and collecting premiums. This "fund" would grind out a decent return for years at a time for his investors with no real accounting for VaR of his clients. Every 6 months or so, he"d blow up. Then he"d raise new money and start over.Here is how he"d execute/manage risk

• ??sell calls at an opportune moment- sometimes in a rally, sometimes in a sell-off


• Sell puts using the same approach, thereby legging into a strangle short


• If an option became dangerously close to blowing him up, he"s roll the short higher (calls) or lower (puts)


• He would sometimes sell more puts in a rally to raise premium while rolling his short call higher. essentially a 3-way trade.


• He would throw in the towel by just covering the short option causing him grief and hoping the other leg was worthless.

What to watch for: If a similar size block trades on the put side, you have your confirmation that this is a strangle seller. And you have a likely path of future behavior if things go poorly for the short.

The Massive Futures Sell Order By Captive Client or Fund:

No conspiracies here. a fund, dealer, or some player is long (or not). There is a sizeable order above the market near $21.00 to sell futures. Even better, a Market-if-Touched type of order. An options trader at the firm decides to sell calls knowing this, and he has access to take the other side of the sell order if the market gets away from him. Classic "non conflict" flow trade (if a dealing bank) as the futures desk is not selling in front of the CAPTIVE client order.

What to watch for: the market hits $21.00 and several things may happen. 1) a massive selloff at least the first time up. 2) if no options trade then assume the short does not care 3) next time up, the selling might not be there as the short option guy took it out, and now wants the market to go higher so his negative gamma doesn"t force him to turn seller.

The Investor Covered Call Game

Nothing happens.

The Smart Producer Hedge

Miner wants stock to continue to perform on upside with Silver price and has large operating leverage. Therefore he decides not to hedge production in futures but instead sells calls. Likely candidates include miners whose CEO gets stock as bonus. Also not uncommon for producer  to buy teeny calls against a sale of meaty calls to participate in the Armageddon trade.

The Player Covered Call Game

Or alternatively, this is a Player who is long futures from a much lower price, and 3,100 calls are a tiny portion of his long position. A firm like PhiBro in the past would be happy to buy those calls back as sloppily as they could, knowing the marketmaker hedges would drive their futures up substantially. They made their living in energy doing things like this. They also liked to buy calls hard when they were selling their long futures to create exit liquidity. In the end they"d be long synthetic puts, and short an additional boatload of futures.

The Producer Hedge Trade Pinned Strike:

We will pin 21 at expiry at best. Why? Because the seller had a ton of futures more to sell than the calls he sold. And the chart suggests that may be the case still.

The Producer Sap Trade

This is a fun one, but very rare. The producer has decided to not hedge production via futures but instead sells calls to lower his cost basis. Simple idea. Usually makes sense if the miner has free cash flow.

Problems arise in a rally when he has the silver for delivery but can"t make the margin call on the short options. A classic example was the Ashanti-Cambior fiasco in 1999. These miners needed financing and the banks that gave it to them also took the other side of their short calls. Then, Y2K nonsense caused a rally. Ashanti can"t make the margin call, their credit line is closed, the bank prop desk buys futures for itself, and the client pays 99% vol covering its short options through the same bank. Bonus: The bank oversees the liquidation and sale of Ashanti to its new owner, Anglo Gold. At least Vampires can"t drink the blood of the dead.

Unknown Unknowns and JP Morgan

To be sure we do not know every possibility. The most important thing to know is the type of seller.Producer, Intermediary, Fund, or Player. The future market behavior helps narrow the choices of the trader. Right now, we"d assume nothing and look for a massive put sale. If one comes in, then we know that the short is a non-Player spec susceptible to being wrong, and will act if he is.

One should also remember that if a massive trade in Silver goes down, JP Morgan either is involved or knows about it. So watch their behavior, and assume nothing directionally.

Good Luck