Confused Market Mechanics

Someone posted today that market signals are conflicting. It might just be the commodity sell off and the side effects on the rest of the market, but only time will tell. What's interesting is a lot of commodity company stock prices are close to where they were in 2008 when the world as we know it was about to end. For more details and some links to market indicators, see our post on Seeking Alpha.

A Funny Thing Happened On The Way To The Treasury

Looks like the United States Government is officially over it's debt ceiling limit. More interestingly, the world financial system hasn't come crashing down [yet]. Here are a few excerpts from today's Publication of Daily Treasury Statements. A footnote on page 7 informs us:

* Act of February 4, 2013 temporarily suspended the debt limit through May 18, 2013.

We find that rather funny in itself. Did anyone (even in Congress) actually know they voted to pretend we don't have a statutory debt limit? <waiving parts=hands>Ignore that, look over here.</waving> Moving along now, just above that line we are given an important piece of information:

Statutory Debt Limit    *    *    *    $ 16,394,000

Ok, I hope you aren't laughing yet, because here comes the real punch line. Just above that informative piece in the column labeled 'Closing balance today':

Total Public Debt
   Subject to Limit        $ 16,710,017

If you aren't accustomed to high finance and really big concepts like "national debt", look carefully at the two numbers. Which one is bigger, the statutory limit or today's closing balance?

Yes indeed boys and girls, your illustrious leaders have blasted right on past the national debt limit and spent an extra $316 BILLION of your hard earned money. And of course we are to believe they'll have it all fixed before May 18th

If you have access to this article on a smartphone, you might want to bookmark it and pull it out when some cop pulls you over for speeding. Showing her the details, assure her with, "It's ok officer, our federal government has provided precedence for putting aside the rule of law for the expediencies of the day." Then present your expediency and assure here no one is harmed by your driving, so you should both just go on your way as you'll be complying with the speed limit tomorrow after you've had time to fix things.

I mean seriously, you've just read this and that's exactly what you are going to do, right? No harm, no foul, screw the law. It's a dumb law anyway.

For more fun, mark your calendar to watch the security markets in the third week of May. Option expiration for May is on the 17th. You might want to buy those June puts now while they are cheap.

Shoot, Can't Get Free Money for Leverage Next Year

On one level, the subject statement is reasonably true. On the other level, the entity that does have access can simply make a loan to another entity that doesn't, using discount rate as 'cost basis' and some absurdly small spread as 'retail pricing'. Then, being a majority or sole owner of this separate entity's equity, provide profits back to the mother ship as dividends from it's equity stake in 'Best Year Placement Assets Selection Systems'

Never mind, as long as politicians retain bragging rights, regulators have something to toast, and investment banks can keep making markets, we can all sit back and make money on the next bubble adventure of the global bastardization of capitalism.

Three federal financial regulatory agencies on Friday issued guidance clarifying that the effective date of section 716, the so-called Swaps Pushout provision, of the Dodd-Frank Wall Street Reform and Consumer Protection Act is July 16, 2013. The guidance is being issued by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency after receiving inquiries seeking clarification about the effective date. Section 716 prohibits certain types of Federal assistance, such as discount window lending and deposit insurance, for certain uses to a swaps entity, subject to specified exceptions, with respect to its swap, security-based swap, or other activity.
Source: Federal Reserve Press Release

The Democratic Process of Money Meddling

"...it is prudent of the central bankers to get a feel for where disappointment would actually set in."
(Source: E-piphany)

Our friend Mr. Ashton picked up the hints from a Bloomberg report. It is important to realize prices are never objective. It's true for houses, cars, and even U.S. Treasurys. So while one can despise the actions of the central bank, it's not exactly honest to claim they are stupid. As Bloomberg reports:

The New York Fed survey ... asks about expectations for the initial size of any new program of debt purchases and the time over which it would be completed. It also asks firms how often they anticipate the Fed will re- evaluate the program, and to estimate its ultimate size.

That appears to be a pretty good line of questioning! Before they make any announcement next week (or not) they better figure out what kind of a statement is least likely to create a panic. One might even consider the expectations are so strong, if they don't announce QE2 next week we'll have a clear and noticeable collapse in something on Wednesday afternoon and on into the week. It is the fall, after all.

So it looks like the fed is actually working out the plan by getting surreptitious "feedback". It's prudent to presume an event has already been priced in by the time it happens. Even if one is skeptical of that principle, given this kind of clear signaling, the pros obviously know and are already preparing their portfolios.

Therefore, the fundamental questions investors need to get right are these:

a) What prices will rise when this happens? Obvously Treasurys, except the inflation factor may counter the whole supply/demand factor.

b) If profit taking kicks in at the announcement, where have those profits been accumulating?

Without the results of the survey, we peons are at a grave disadvantage trying to get those answers right. The one thing we can be sure of though, is that at 2 pm EST on November 3rd, being at your terminal with fingers nimble and ready is the wise plan.

Hindenburg Omen - Not!

It would be hard to find someone or group that can beat the quality of data that comes out of Bespoke Group. Today they made an astute observation that trumps the low quality blogosphere hype about the Hindenburg Omen. In typical fashion, Zero Hedge made another biased emotional appeal:

"Today, we just had another (unconfirmed) Hindenburg Omen."

As Bespoke Group points out, the facts of the matter refute the present perceptions.

"Call us crazy, but an indicator that measures the internals of the equity market should probably avoid using fixed income securities in its analysis."

The problem we see all too often in the internet world of truth is few people bother to actually take the time to understand the basis for these long-standing fundamental or technical indicators, nor take the next step to actually vet the information to see if in fact the data is in conformance with the statistical presumptions, requirements, a priori, and other critical factors.

We think one can take solace in knowing the low-quality data monitors who perpetually cry "the sky is falling" can be ignored more often than not. Notice Bespoke confirms the 2008 instance of the Omen, while Zero Hedge gets it wrong when they say the last Omen occurred during 2009. Not only is it statistically wrong, you can see from a chart if it had occurred it would have undermined it's reliability.

Our conclusion is that Bespoke is right and that Zero Hedge isn't filtering out fixed incomes, and therefore wrongly attributes an instance of the Omen to a point at which it never actually occurred. This is a good thing as it suggests the Hindenburg Omen is still a reliable indicator, if one can first learns how to read data and understand the meaning and abstractions of the words that make up the theory.

Program Trading In A Falling Market

Look at SPY on March 3rd & 4th, 2010

The high on the 3rd was 112.80
The low on the 4th was 113.10.

That gap wasn’t filled before today.

Look at today’s one-minute intraday chart gradual falling off up until 14:21 EST.

The low was around 112.97 at which point it tried to bounce up but couldn’t hold. The steep sell off got really bad just about the time that false rally crossed back below 112.97 and took out the gap.

It appears there just happened to be a lot of mathematical models around that price point, whether because of the gap or something else. Volume started picking up at 14:00 EST, and then at 14:35 when the support was broken volume really took off in a free fall to the day’s bottom.

There’s no particular spike in volume, just this surge of selling and then buying over the last two hours of the trading day. A lot of stop losses were filled today which probably precipitated the free fall.

Forget the silly rumors of an order error. It's just someone making a joke that a bunch of simple minds believe and repeat until everyone believes it. Today's market action was driven by algorithmic trading and people with day jobs having their risk management strategies triggered by the machines.

Investing on The Edge of a Precipice

Today we highly recommend the March 8th weekly comment by John Hussman, The Rubber Hits the Road. Hussman makes some good points about history, comparing post-war economies with financial-crisis economies, relates that to this present period we face, and describes the human psychological factors that come to bear on security prices. The discussion of pending mortgage resets and how that may play out is particularly relevant.

It is interesting to see someone actually point out how and when we may rely on the irrational exuberance of speculators to make informed decisions of our own:

As we move through the coming months, resolving the "two data sets" issue will help us to determine which set of historical precedents is relevant. If the current economic environment produces fresh credit strains similar to previous periods of credit difficulty in the U.S., Japan and elsewhere, valuations and margin of safety will remain the most important consideration in determining investment positions. If the economic situation reveals itself to be more like typical post-war cycles, valuations will still be an important consideration, but we'll be better able to assume that speculation (provided sufficient evidence from market internals) will be reliable even in the absence of clear fundamental support from valuations.

If you are a Graham-Dodd fan, you'll particularly like how Hussman builds upon their foundation in presenting the expectations of investors in the current environment. Our conclusions is that with the infatuation Americans have with entertainment and personal emotions and opinions over facts and substance, we are unlikely to see any sound behavior by the general public with regard to investments.

The one thing he didn't mention in March 8th were the fundamental factors pointed out in a previous weekly comment, which contribute a third influence on the confluence of forces affecting the markets: the Fed quantitative easing policy coming coming to an end, just about the time we may begin to receive some clarity on his "two data sets". Add to that the potential for more debt issues out of Europe in the next few months, and the security markets may very well be resting on a weak precipice.

Metals and Mining

Today we discovered Wildebeests, a web site devoted (in their own words) to the four M's: Minerals, Metals, the 'Merican economy, and Mathematica. They have some very good research and writing skills on the subject matter dear to our hearts, hard assets, and as such have earned a place in our investor links.

For some dialog between us, see the topic "Investing in Copper — What You Need to Know"

How Can Stock Market Asset Prices Fall?

For the stock market to drop in value, something else has to be in greater demand. In the realm of paper assets, the only competition for equity is debt or debt-money, and the non-paper competition is commodities and real-estate. Let's look at each one, except real-estate, which should be clear without saying in the spring of 2010 is a non-starter.

It's been clear for about three years now that money does not flee to hard assets when paper assets are in jeopardy. Those hard assets experience a sell off, too, as money flees in a crisis for the stability of U.S. dollars. This should be expected for some of the reasons we pointed out in November. So if the stock market has a significant sell off, don’t expect a commodity price spike. Whether one thinks it should or shouldn't is irrelevant. That fact is it hasn't done so for the last three years. If you think it should, then take the sell-off as a chance to take a position at steep discounts. We address the fallacy of the counter-argument for deflation at the end.

We are then left with the realm of paper-assets: debt-money (currency) or debt instruments. Debt instruments can get very complicated because there are many types with a variety of risk and valuation models. However, we can simplify that into a few commonalities: short term and long term, corporate and government. There is another debt instrument that doesn't quite fit that simplification: debt derivatives. Of the collateralized debt types, they essential represent the same fundamentals as bonds, except risks are slightly lower as default risk is diversified among autonomous entities. The other common derivatives can be grouped as options, futures, or credit default swaps. Virtually all of those by definition are relativity short-term bets.

If one is worried about equity valuations (the theme of this writing) corporate bonds would be of interest to some as bonds receive the first-fruits of cash flows and stand ahead of stock in bankruptcy (government usurpation notwithstanding). But if equity prices are at risk, corporate default risks rise, too, so prudent investors won't flee to corporate bonds in a crisis. We find ourselves left with short and long government debt, or debt derivatives, competing with equity for capital investment.

Let's take debt derivatives now, particularly the CDS type. The only intelligent reason to sell equity for CDS is a credit crisis. This is in fact exactly what we saw in February. As the credit crisis that precipitated the change subsides, money flows back out of short term CDS instruments and back into longer term assets. While we don't have access to CDS price charts, we can certainly see the equity markets didn't stay low for long, which is consistent in fact and in theory with crisis of the past. So CDS competition is necessarily sudden or short lived, especially as CDS contracts are temporal by nature.

The next type of debt instruments we look at are short term parking places: short-term government bonds, and short-term derivatives other than CDS. All are havens for capital in times of uncertainly. All are temporary parking places where one then reallocates into something of greater risk with more reward potential as the precipitating event subsides. The certainty of that movement is assured by monetary low-interest rate policies of central banks. No serious money manager can sit on ROI assets below 2% for long unless in fact the world experiences price deflation of all asset classes across the board. The Austrian theory of inflation arising as a consequence of money creation suggests in this season of 2010 that is an absurd expectation. The arguments to the contrary are addressed below.

Like real-estate, it should go without saying that holding long term government bonds in an era of Keynesian expansion with extremely low interest rates as one of the most high risk (to asset price) low-yield investments of capital. Just as rolling short term bond holdings into short term bond holdings for an extended period is only sensible in an era of broad-based systemic price deflation, holding fixed rate long bonds when currencies are threatened by increasing debt, and interest rates have no where to go but up, is asking for capital loss.

Finally, the last paper asset vying for attention of investor and speculator capital is currency. In a crisis, even after all the liquidity measures and deficit spending in the U.S., the U.S. dollar is still the target of those fleeing for safety. Again, we aren't concerned about whether that is a long term good bet, but simply recognize it as the status quo. If indeed one believes such moves are unwise in the long run, take it as an opportunity to buy more reliable dollar based assets at a discount if it should transpire. But keep in mind, when this flight to safety takes place, money that isn't secured in currency derivatives will be parked in government bonds of the currency of choice, and we’ve demonstrated those arguments only have temporary extremely short value propositions. So the fundamentals of holding "cash" (pseudonym for currency), is really just another name for a bond position, and hence currency moves will follow the fundamentals of bond investments. Since bonds of all substantive nations are basically in the same boat, we don’t expect significant changes in currency price ratios as much as we’ll see in equity positions, and of course foreigners’ demands for equities ultimately translates into foreigners’ bias for currency price ratios. We covered that topic to some degree in our September piece titled "Where is the Next Bubble?"

Given the choices money managers have in allocating capital, there appears to be only one reason to expect any kind of significant decline in equity prices in the near term, and that's a flight to safety. Just as the financial crisis of the past faded into history, there's every reason to believe this one will play out the same. We pointed out some of those reasons in November under the title "Contagion: Been There, Done That"

In that piece we also point out how the latter sub-crisis had less effect than the instigating crisis. We've seen this take place recently with Greece's crisis, where there was some quick and noticeable reaction to flee to dollars and push down equities and commodities, but it was short lived and of little significance. Many have tried to build the case that "this time it's different" and pull some data out of a hat that appears different. Typically what we find is that they simply were unaware of similar data that did appear last time, or they miss the similarity of essence and difference only in nomenclature of the old and new data.

So we are left with the only variable that could explain a protracted equity bear market - positive or negative inflation. Positive inflation usually gets improperly discounted by the established world view in one of two ways -- they pick a measure of money that hasn't grown well and then conclude we'll see tame inflation or deflation, or they pick a secondary influencing factor (velocity is popular these days) and argue that it will overcome the creation of money. We've provided some links on the velocity argument back in July '09 and revealed how money supply and velocity can take some interesting forms. It is our belief that the contradictions between the Austrian school theory that inflation is a monetary phenomena, and the new school that it is a velocity issue, is simply missing the point that the Austrian school theory carries with it an inferred premise that the time between the money hitting the street and the prices showing up at retail are delayed by several months to a few years. In order for monetary inflation to not eventually show up in price inflation (either consumer or capital asset price increases), one has to permanently and systemically keep the velocity low. For nations whose people have consumer goods in abundance, inflation most likely appears in financial asset prices. For nations whose people have a higher portion of earnings going toward basic goods and services, inflation most likely appears in consumer goods.

One could achieve low monetary velocity with an economic collapse, but no substantial and influential market participant in the global economy is working toward that goal. Every policy choice and operation is designed to get people to dump their cash for something that will provide a return. All policies are designed (intentionally or accidentally) to make holding cash a losing proposition. It's the essence of both kinds of capitalism; traditional theoretical capitalism and corrupted modern capitalism. The former objective is to use one's financial capital to produce value in goods and services to reap a return on investment. The latter objective is to use one's financial capital to make other people's money work for you. The latter is the fundamental basis of the debt-money system used by every nation on earth: leverage. With every segment of every population save a few fringe radical thinkers working toward the same objective (i.e. maximum return on investment) something global and earth shaking will have to occur to put everyone off their agenda. We aren't suggesting that can't happen, just that the most likely expectation is that it won't happen until this next round of business cycle expansion pops sometime in the teens of the 21st century.

For the stock market to drop in value, something else has to be in greater demand. At this juncture in 2010 it goes without saying that real-estate and long bonds are non-starters. Other hard assets have proven themselves unattractive as replacements (albeit good co-equals) for equities. Being left with nothing other than short-term non-performing parking places and short term quick gains made attractive by temporary sudden shocks, there simply isn’t any real long-term asset class competition to distract the global investment community from demanding more equity positions. The prudent scholar, historian, and investor should be prepared for another cyclical equity bull market in the coming few years.

Insider's view of the business cycle

What does the business cycle look like after a bust when you're the one on the inside looking out at the investment horizon? According to Bloomberg, it looks like half a trillion dollars.

"Buyout funds sitting on half a trillion dollars committed by investors may need more than a decade to put the money to work if mergers and acquisitions continue at the current pace."
(source: Bloomberg)

As readers should be well aware, nothing stays the same. The rate of M&A spending of the last year or so won't be the rate of spending in the future. As the business recovery solidifies the evidence of a "good buy" will change for the better and this money will start flowing. But notice this key point from the same article:

"“Investors only give the fund a particular investment period, typically three to six years, to invest the capital,” said Michael Harrell, co-chair of Debevoise & Plimpton LLC’s private-equity funds group in New York. “If you don’t use it, you lose it.”"

So there are two strong human factors at play there. First, those entrusted with the money don't want their clients to take it back. They will find a way to put that to work, and they have only two or three years to do so. What a coincidence this lull in M&A just happens to coincide with the first signs of recovery. (NOT!)

Second, if they don't put that capital to work, the clients who take the money back are going to have a lot of pent up demand as they seek out someone who will put the money to work for them.

No matter how you slice it, the business cycle is alive and well with capital left over from the recession looking for something to buy. 'Buy' is the operative word there. The only unanswered question is what will be in demand, and you can be sure it won't be cash and cash equivalents. After all, we're not talking about a world of Warren Buffett money managers. These are sharks looking for a kill.

But lest one gets too excited, temper the emotions with an interesting chart from the Bespoke Group. Looking at that 2009 March low, which was the bottom of that bust of the last business cycle, one should expect the 68% number will stick. Not only is the potential from here much less than the potential from 'there', but we still have a wave of news about to arrive regarding the mortgage reset wave of 2010.

We don't personally expect the news to crash the market or the economy, and don't expect a double-dip recession, but we do expect a wobbly stock market too jittery to make a firm run in either direction, albeit with a bias trend upward as happens with any business cycle boom phase.

As an aside, the astute reader should be careful to differentiate a boom from a bubble. Bubble talk won't be appropriate until about two or three years from now.

Can demand for credit derivatives really lead to economic decline?

If we read the attempted implications of "Bond Market Vigilantes Sink Stocks" right, Mr. Mirhaydari claims the surge in the CDS market is threatening to raise interest rates on sovereign debt, which will force governments to cut spending and raise taxes to counter the cost of debt, which leads to a double dip recession, which leads to a falling stock market.

It makes perfect sense except for the part about politicians giving any hoot at all about the cost of their debt. Europe certainly has rules about limited deficit spending, but does anyone else that matters to global growth have such constraints?

Still, if the rush for CDS instruments is really the impetus behind recent market movements, that money flow will eventually unwind as the speculators take their profits and look for another ride to get excited about. Maybe the only real connection that makes sense is that institutions that have the clout to speculate with CDS, bonds, equities, and commodities all over the world have found a nice little emotional roller coaster to take out for a spin, after which they’ll whipsaw the markets and ride something else up to hysterical levels when they are ready to take profit out of the CDS markets.

If Mirhaydari is correct we'll see people talking about S&P 500 at 600 within a few months. If our secondary supposition is correct, we should see a strong rebound in stocks and commodities before summer. According to Jim Jubak's analysis of leading and lagging indicators, the latter appears more plausible.