Monday, February 28, 2011

Size Matters

"Every thief has an excuse."
--Jacob Moore (Wall Street Money Never Sleeps)

Peter Atwater notes the bifurcated nature of the US banking system. Large firms deemed too big to fail have benefitted from govt largesse in the form of bailouts, favorable accounting regs, and uber low interest rates.

Small banks have not been privy to the same special treatment and remain in rough shape following the credit collapse.

The sad thing is that many of these small firms made the right decisions ahead of the crisis and were poised to reap a huge windfall when the big guys failed.

Instead, the big banks who took too much risk were rewarded, while the little banks that were prudent were penalized.

position in SH

Friday, February 25, 2011

Bond with the Wind

We can dance
We can dance
Everybody's taking the chance
--Men Without Hats

Treasuries have been getting hammered since the Fed commenced QE2 last fall. However, long bonds have been catching a bid over the past week as people reduce equity risk (at least temporarily).

From a technical standpoint, the multi-month downtrend in the ishares Barclay's 20+ Year Treasury ETF (TLT) has been broken. Should prices continue higher, it appears that near term resistance resides a couple of points above in the 94-95 range.

position in TLT

Thursday, February 24, 2011

Badger State

I never saw you look like this without a reason
Another promise fallen through, another season passes by you
--Big Country

Challenges to collective bargaining policies between government and public sector employees raised last week by the state of Wisconsin are now migrating to other states including Ohio. Teacher's unions have been a particular focus so far, although the issue applies across all govt sectors.

Reaching this point was inevitable. Government has been socializing sectors of the economy for years. As we have constantly noted in these pages, this process leads to predictable consequences. Resources get misallocated. Lower standards of living drive bureaucrats to borrow or tax to fill the void. Declining real incomes are unable to pay back the ever growing mountain of debt. More resources are misallocated. Standard of living declines further. More debt. At some point, further iterations are impossible and the system falls apart.

The proper solution to this problem, of course, is for government to get out of the various lines of economic activity that they have meddled in (e.g., education). The bubble needs to pop, and the boundaries of government need to regress to Constitutional limits.

Unlikely you say? Well, the current situation in Wisconsin is laying bare the existing system for the public to inspect and absorb. And it takes no genius to recognize the corrupt cycle currently in place. Public sector workers, who are also voters, group together and elect politicians who kick back sweet labor packages to those special interest groups (SIGs) that got them into office.

In the private sector, profit motive motivates employer to prudently manage labor negotiations. If employers agree to overly generous concessions to labor, then the employers will lose property. Indeed, the future viability of the enterprise may be jeopardized (see GM).

In the public sector, the risk associated with labor negotiations is socialized. There are no market forces to govern the decisions of bureaucrats. Instead, we have a classic agency problem, where politicians (the agents) act in their own self interest while the public (the principals) are incapable of influencing the content of the resulting contracts before they are enacted. And the public is on the hook for agents imprudence and mischief.

Until, of course, the system locks up...which it is doing now...

no positions

Monday, February 21, 2011

Borderline Chaos

Just try to understand
I've given all I can
'Cause you got the best of me

Have been out of pocket for a few days and will likely remain on the periphery for a while. Out here on the borderline, however, it's easy to spot a unifying theme to the headlines--headlines which include out-of-control federal government debt/spending, the spectre of govt shutdowns, states on the verge of bankruptcy, private and public pension plan insolvencies, protests over proposed state budget cuts (e.g., Wis), EU nations on the brink of default, unrest in the Middle East.

What is the theme surrounding all of these? Chaos.

Mises said it best. It is not a question of whether capitalism or socialism will 'win' in the end. Socialism, he observed, can never be reached in its entirety before the system falls apart. Chaos, Mises claimed, is the endpoint of socialism.

Socialistic practices have been increasing world wide for the last century with all the predicted problems. Perhaps that stack of problem has now become so large now that it is unsurmountable with even more socialistic prescriptions (such as borrowing and spending in already over-leveraged system).

Perhaps we're on the verge of the chaos endpoint astutely forecast by Mises.

Friday, February 18, 2011

Silver Streak

A cloud appears above your head
A beam of light comes shining down on you
Shining down on you
--Flock of Seagulls

Break out on silver yesterday and pretty follow thru today.

Former technical resistance now becomes support. Any pullback toward the $30 breakout level is likely to be bought by traders.

position in silver

Thursday, February 17, 2011

Bass Master

Drivin' home this evening
I coulda sworn we had it all worked out
You had this boy believin'
Way beyond the shadow of a doubt
--Bryan Adams

Kyle Bass is a managing partner at Hayman Capital Management and one of my favorite reads. I found his recent letter to investors very interesting. He hits on some of the more central macro issues around the world.

His final section 'Does Debt Matter?' provides a nice overall view and how he is positioning accordingly.

Wednesday, February 16, 2011

Budget Talk

Can't spend lots of time here today but wanted to record a thought about President Obama's recently released budget proposal. This is a budget that reflects more spending and debt rather than less.

As we've noted before, this president knows how to talk. But actions speak louder than words.

My sense is that the president wants to force the hand of Republicans who have also been talking a good game related to austerity. If Republicans do get tough here, then Obama can paint them as the bad guys who want to take away people's entitlements, or who want to tank our 'nascent recovery.'

Will be interesting to see if Republicans truly step up. And how the American people respond.

Tuesday, February 15, 2011

Inflated Expectations

So glad we've almost made it
So sad they had to fade it
Everybondy wants to rule the world
--Tears for Fears

David Rosenberg of Gluskin Sheff thinks that inflation expectations may be pretty well priced in by the markets. He offers some interesting evidence to support his thesis.

As we have noted in class, when consensus builds on a subject that has helped to trend markets, then a trend reversal may be pending...

Monday, February 14, 2011

Credit, No Credit

Paranoia strikes deep
Into your life it will creep
--Buffalo Springfield

Wondering about the composition of consumer debt in the US? The below graph shows a breakdown. Mortgage debt is by far and away the largest.

Many observers like the fact that credit card debt has been ticking higher (squint and you may actually see it!)--which suggest more spending on the horizon.

The other side of the trade is that more consumer credit is the last thing we need given the degree of leverage in the system...

Sunday, February 13, 2011


"Have you ever had a dream, Neo, that you were so sure was real? What if you were unable to awake from that dream? How would you know the difference between the dream world and the real world?"
--Morpheus (The Matrix)

Vids like this rekindle the feeling that we're living in the Matrix. We 'see' a derivative of the world that is vastly different from the underlying.

The question is whether we take the red pill or the blue pill...

Saturday, February 12, 2011

Egypt, Democracy & Freedom

Meet the new boss
Same as the old boss
--The Who

Many people are hailing the overturn of the Egyptian government as a great day for freedom. In the sense that a mob was able to successfully throw off an undesirable dictator, it can be said that some Egyptian citizens were exercising freedom of choice.

However, this by no means suggests that the future of Egypt will be supportive of freedom in the classic liberal sense. More likely, the current power vacuum invites a new oligarchy, whatever its form, that will exercise a new brand of control over the country.

Calls are loud for democracy in Egypt. If by democracy it is meant that decisions are made by majority rule, then democracy is no friend of freedom. Democracy is mob rule. Whatever group can marshal enough votes in its favor rules the day. Interests of the minority are necessarily compromised.

The Founders understood the dangers of democracy. Their study of history told them that democracy creates instability rather than stability. This instability tilts the system toward chaos, and is a constant threat to liberty.

The word 'democracy' does not appear in the founding documents of the United States. Instead, the US was founded as a federal republic, to be governed by the rule of law rather than by the arbitrary rule of men.

If Egypt employs a democratic decision rule to decide their next form of government, then chance favors the advent of another ruling elite elected by whatever group can marshall the most votes. Mob rule and tyranny, rather than the rule of law and freedom.

Friday, February 11, 2011

Irreversible Course

Today I found a message floating
In the sea from you to me
You wrote that when you could see it
You cried with fear, the point was near

Can the Fed reverse monetary policy fast enough should signs of significant inflation appear? In a recent 60 Minutes interview, Fed chairman Ben Bernanke said that he was '100%' confident of the Fed's ability to withdraw stimulus.

But inflationary signals are already surfacing, and some commentators doubt the Fed's responsiveness based on historical track record.
One thing working against the Fed is the considerable time lag between policy changes and outcomes. In other words, once policymakers recognize the need to reverse course and take corrective action--it may be many months before that corrective action takes effect.

One thing working against the Fed is the lag between policy changes and outcomes. And given the size of the stimulus injected into the system, it seems unlikely that it can quickly be pulled out.

By the time the signals are evident, we may be past the point of no return...

Thursday, February 10, 2011

Who's Time Horizon is Shorter?

Movin' in for the kill tonight
You've got every advantage when they put out the lights
It's not so pretty when it fades away
'Cause it's just an illusion in this passion play
--Pat Benatar

It is often the claim of Big Government proponents, and of the current administration in particular, that private enterprise makes decisions that are too shortsighted. They suggest that businesses prefer short term profits to long term investment that have paybacks far out in the future. This purported shortsightedness is then used by bureaucrats to justify government sponsored 'investment' projects.

These claims do not stand up to reason.

We should observe at the outset that people generally prefer satisfying their desires now rather than in the future (a.k.a. 'high time preference'). However, just how high that time preference is varies from person to person as well as temporally.

We can confidently posit that if resources were unlimited in quantity, then people would generally consume large amounts of them today in a quest to satisfy desires in the here and now. Unfortunately, resources are scarce, and left unrestrained, human efforts to satisfy desires in the here and now would deplete supply--leaving the future a barren place indeed.

Resources must therefore be economized, or rationed, so that a balance is struck between consumption today and adequately preparing a decent standard of living for tomorrow.

Unhampered markets offer an effective means for striking this balance--a means centered around the pricing mechanism. Prices provide signals that encourage various behaviors. High prices encourage supply and discourage demand. Low prices discourage supply and encourage demand.

The ebb and flow of human behavior, reflected in cycles of optimism/pessimism and of greed/fear, are kept in check by prices that periodically serve to restrain overconsumption today so that some resources can be invested in producing more resources for tomorrow.

Businesses invest in future supply when economic calculation enabled by the pricing mechanism suggests attractive reward per unit of capital (i.e., saved economic resources) put at risk.

Hampered markets destroy the signalling value of prices. A primary price manipulated by bureaucrats in hampered markets is the price of money and credit. Because of high time preference, there is constant political pressure to suppress the price of money and credit below the unhampered market value. This is because artificially low prices of money and credit facilitate living larger in the present. However, excessive borrrowing of resources for both consumption and investment purposes is likely to result in fewer resources available for future demand and supply needs. For example, borrowers are burdened with debt that must be repaid out of future income.

Stated differently, hampered markets stimulate overconsumption and overinvestment which squanders resources available for future use (which, btw, leads to the chronic boom/bust cycles we experience).

After decades of such squandering, we currently have few resources available for investment purposes. Low supply means that investors are less likely to put their scarce capital at risk. They are only prone to do so if those projects are perceived to deliver very high rates of return.

Therefore, to the extent that private enterprise currently does have an unusually low appetite for long term investment, we can be confident that it is a consequence of past government intervention.

But the real fallacy lies in the notion that government is a more prudent long term investor than private enterprise. Bureaucrats know little about economic calculation. They deploy the capital of others which insulates them from risk.

Moreover, it is ludicrous to suggest that politicians are more 'long term' oriented than private enterprise. The time horizon of the politician is the election cycle. This cycle drives excessive short term oriented behavior by politicians in order to win votes.

There is an overwhelming body of empirical evidence to support the claim that government inherently possesses a short, rather than long, time horizon. If politicians were long term oriented, then we would not be drowning in debt and spending in attempts to maintain an elevated standard of living that was obtained thru, yep, borrowing and spending.

The prudent long horizon thing to do would be to step away and allow pent up market forces to rebalance the economic system. Less consumption, less borrowing, more saving.

To be sure, present day standard of living would take a hit--perhaps a big one. But the long term oriented individual understands that deflating the excesses from the system today would build the savings necessary to fund healthy investment tomorrow.

As practiced today, government has little chance of operating with such a mindset.

Wednesday, February 9, 2011

Chamber Made

Welcome to your life
There's no turning back
Even while we sleep
We will find you
--Tears for Fears

President Obama's recent speech to the Chamber of Commerce provides another example of either his lack of understanding of how markets work, or of his attempts to divert attention from destructive actions of government. Or both, of course.

Jeff Tucker provides a nice critique of the 'regulation' part of the president's speech using Obama's ridiculous auto defrost refrigerator example as the centerpiece.

Toward the end of his missive, Tucker pinpointed the basic thought process that appears to occupy the minds of Big Government types. It goes like this:

Private enterprise comes up with a technology that, despite the technology's problems, can be forced upon the buying public.

Business doesn't care about the problems that customers have as long as profits keep rolling in. Status quo prevails.

Luckily, government regulators, who are constantly monitoring markets for ways to innovate and improve products, notice the problem and, thru threat of coercive force, mandate that businesses fix the problem or face loss of liberty and/or property.

Literally under the gun, industry scramble to improve the product only because government demanded it.

Thanks to central planners and wise government officials who know better than everyone else, we are all better off.

Right up there on the scale of folly. And on the scale of hubris.

Tuesday, February 8, 2011

Flinch and Frown

"When I asked for your advice, I didn't mean that you should actually speak."
--Bill Cabot (The Sum of All Fears)

I continue to wonder whether Big Ben and the Fed will flinch in the face of building commodity price pressures and their spillover into geopolitical unrest.

China just raised rates for the third time in an attempt to cool things off.

If the Fed signals that they are reconsidering QE, then domestic markets will likely frown...

position in SPX

Monday, February 7, 2011

Emotion in Motion

I would do anything
To hold on to you
Just about anything
Until you pull through
--Ric Ocasek

The Volatility Index (VIX, VXO) estimates the 'implied volatility' baked into S&P option prices. When market participants sense big pending movements in stock prices, they pay more for options, which sends implied vols higher.

Volatility indexes provide useful gauges of investor sentiment. When markets move higher, investors are often less willing to hedge their long positions with put options (when you buy a put against a long stock position, you are essentially buying insurance to protect your position against a price decline) or to speculate in puts outright. Less demand for options causes implied vols to fall.

Declining vols are commonly associated with conditions of 'complacency' in markets, as investors are less willing to pay for insurance to protect their long positions.

Typically, when market prices decline, investors suddenly wake up to the need for downside protection (or to speculate on lower prices by buying puts outright). The lower prices go, the more investors are willing to pay up for put options, which in turn drives implied vols higher. As such, rising vols commonly reflect 'fear' in markets.

Take a look at the two charts below. First is a chart of the S&P 500 (SPX) over the past five years.

Second is a chart of the VXO over the same time period.

Note the inverse relationship between the SPX and the VXO--particularly during periods where the SPX declined. The VXO hit its zenith during the waterfall decline in stocks in late 2008, early 2009--indicative of major fear in the markets. Note also that this fear was reactive--implied vols didn't spike until after prices began cascading lower.

Since the March 2009 stock market lows, the VXO has been generally grinding lower while the SPX has been grinding higher (interrupted by last spring's 'flash crash' phase). The VXO currently stands at multi-year lows--indicative of significant complacency.

Please note that the VXO is not an effective forecasting tool. For example, just because implied vols are relatively low today does not necessarily mean that a market decline is eminent.

Instead, volitility indices are better regarded as coincident indicators--more reflective of current levels of collective sentiment rather than of future sentiment or its consequences.

Nonetheless, smart market participants keep an eye on volatility indexes in order to gauge sentiment in the here and now.

position in S&P

Treasury Island

It was thirty days around the Horn
The captain says it's thirty five more
The moon looks mean, the crew ain't staying
There's gonna be some blood
That's what they're all saying
--Jay Ferguson

By the end of 2010 China held nearly $1 trillion in US Treasuries--making it the #1 holder of Treasury securities. Suddenly, in early 2011, China has relinquished its title to another entity. Japan? Brazil? Saudi Arabia?

Nope. The Federal Reserve.

The Fed now owns over $1 trillion in Treasuries. Since it began its QE2 program back in October, the Fed has been buying on average $5-10 billion per day via it Permanent Open Market Operations (POMO) program.

Make sure you understand the process at work here. The US Treasury sells Treasury debt. Banks buys the Treasuries using funds borrowed from the Fed. The Fed buys the Treasuries from the banks with money printed out of thin air.

Also make sure you ponder the consequences of this program in lieu our current market context.

position in Treasuries

Sunday, February 6, 2011

Ark of the Confidence

Satipo: "Let us hurry. There is nothing to fear here."
Indiana Jones: "That's what scares me."
--Raiders of the Lost Ark

Domestic markets resumed their upward trajectory last week after seemingly dismissing the uprisings in Egypt as a potential threat.

This weekend, however, it appears that confidence in the Egyptian financial system is suspect. The Egyptian stock market has been shut down for over a week. And people are lining up to withdraw funds from banks hesitant to open their doors.

Fiscally, government officials are signalling no end to subsidies and other goodies to citizens in the wake of rising food prices.

Confidence seems to be teetering on a delicate balance here.

position in S&P

Friday, February 4, 2011

Pied Piper Presidents

Something happens and I'm head over heels
I never find out till I'm head over heels
--Tears For Fears

The Left loves to listen to President Obama speak. He can certainly talk. And his supporters seem mesmerized by whatever comes out of his mouth.

The Right still loves to listen to Ronald Reagan. Since Obama took office, conservatives have been busting out old speeches by The Gipper, perhaps to revive the feeling of what it was like to have an inspirational orator in the Big Chair.

Admittedly, some of those old RR speeches have even caught my ear. That guy could sure talk a good game w.r.t. liberty and limited government.

Unfortunately, Reagan's record paints him as just another Big Government president. RR's contribution to the spending hyperbolic reflects hyperbole rather than substance in his words.

It seems that presidents w/ oratory skill become Pied Pipers, enticing their mindless subjects down the path toward chaos.

Job One

Ninety nine dreams I have had
In every one a red balloon
It's all over and I'm standing pretty
In this dust that was a city

The January unemployment rate printed at 9.0%, down from 9.4% last month and 9.8% in December. That's the largest two month decline in over 50 yrs.

On the other hand, the number of actual people employed increased by 36,000--the smallest increase in four months.

How can the unemployment rate be dropping so much while the number of people employed barely moves? It is because more people are leaving the workforce. As more people are labeled as 'discouraged', they are removed from consideration in the headline unemployment calculation.

If these discouraged workers were put back into the headline number, then unemployment rate would be in the 16-18% range. We should note that back in the 1930s discouraged workers were part of the headline number that consistently printed in the 20% range.

Of course, truthful disclosure is not the aim of government econometric reports. The goal of bureacrats is to spin the data in favor of those in power.

Seemingly, propaganda is Job One.

Thursday, February 3, 2011

Underestimating the Reflex

You've gone too far this time
But I'm dancing on the valentine
I tell you somebody's fooling around
With my chances on the dangerline
--Duran Duran

Back in late 2008 I began anticipating a big rally to balance out the waterfall decline in progress. Nothing prescient about that, really. After all, we know that markets don't travel in straight lines.

That rally began in March of 2009. And it has been powerful. 'Has been' is operative because the rally is still in motion--something that I did not anticipate.

What have been the key factors that I have not anticipated? One has been the conviction of the Fed and other central banks to manufacture inflation at all costs. I 'knew' that Bernanke had it in him but thought that he would flinch when it came to enacting extreme measures likely to destroy future prosperity. Seemingly, I have overestimated his intelligence and underestimated his political will.

The other thing I did not foresee is people's tendency to once again forget the past and jump back into the game with leveraged risk. In the past few months especially, I've observed risk taking reminiscent of 2007 before things fell apart.

I probably should have anticipated such. After all, prospect theory (Kahneman & Tversky 1979) tells us that people are likely to take more risk when they are behind. And when people are way behind, the reflexive behavior promises to be potent.

Mix cheap money with reflex for recovering losses, and you get a greed cocktail that works until the bar closes.

position in S&P


Kahneman, D. & Tversky, A. 1979. Prospect theory: An analysis of decision under risk. Econometrica, 47: 263-292.

Wednesday, February 2, 2011

Chilly Macro

I'm not expecting to grow flowers in the desert
But I can live and breathe and see the sun in wintertime
--Big Country

Richard Russell writes Dow Theory Letters, the longest running investment newsletter service in existence (he's been at it since the 1950s). I've subscribed to his service in the past and it has helped shape my thought process.

Snippets from RR's nightly missive occasionally appear in the public domain. This one provides a nice example of a 'macro' market issue. In fact, it may be the primary 'macro' issue facing the US (and the world, for that matter): government spending and debt.

Russell suggests that debt levels have risen past the point of no return, and that there is little political will to reverse course. He sees two possible endgames to this situation. One is for the US to default on its debt. Big debt default is akin to deflation. To many, including Russell, this seems unlikely. However, sovereign debt defaults, even among 'leading countries,' have marked world history. Investors, in my view, should not dismiss this scenario entirely because of the potential market consequences should it come to pass.

The other likely scenario suggested by Russell is for the US to debase the currency (i.e., print money) and to pay back debts in depreciated dollars. This, of course, is inflationary. Indeed, one could argue that this strategy is already underway via various Federal Reserve monetary policies. RR thinks that this scenario is far more likely because it is more palatable to politicians and to the public.

You may not agree with RR's thought process. But in the interest of 'seeing all sides of the trade,' prudent risk managers should be factoring such macro scenarios into their spectrums of possibility.

position in TLT

Tuesday, February 1, 2011

Another Positive Step

In violent times
You shouldn't have to sell your soul
In black and white
They really, really ought to know
--Tears for Fears

In a case brought forth by 25 states, a Florida district judge ruled that the Federal health care law is unconstitutional.

Similar to the Virginia ruling in December, the Florida judge focused on the law's mandate to purchase insurance. He said that the law oversteps the limits of the Commerce clause. He observed, correctly, that if the Commerce clause can be employed as a justification to force people to buy insurance, then it could be evoked to justify any program of coercion enacted by government said to be 'in our best interest.'

We know that the Framers did not intend the Commerce clause to be interpreted in a manner that granted all-encompassing power to the federal government. The clear intent was to grant the central government limited authority to facilitate the flow of trade between the federation of states. Prior to the Constitution's inception, trade had struggled due to interstate trade barriers that had been raised during the early days of the federation.

The Florida ruling represents another positive step ahead for liberty. It reinforces the Virginia ruling, it places the Constitution and its principles more squarely in the public consciousness, and it demonstrates that capacity remains in our judicial system for upholding the rule of law over discretionary rule by tyrannical force.

Let's hope this trend continues, as it offers a means for reversing course away from chaos and toward prosperity.