Traderbill's Financial Markets Weblog

…TB has frequently compared the current global financial crisis to a game of Whack-a-Mole, which John McCain effectively used at one point. We are treating the symptoms on a triage basis instead of treating the problem(s). There are actually three: leverage, volatility, and velocity, a fourth would be unbridled greed but we all know about that.

Every time one of these problems rears its ugly head we take some kneejerk action…TB has lost count of how many failed plans Treasury Secretary Paulson has had. None have been well founded while those taken by the Fed have been anti-Darwinian. That is not to say TB is totally opposed as something had to be done…and he is not opposed to the bailouts because there was simply no choice…but what he is opposed to is how nobody except the taxpayers is paying for it.

It is interesting that overnight the global financial markets are rallying sharply on Obama’s plan which is just that…and TB feels we are setting ourselves up for failure since even FDR’s plan took years and finally a world war to solve the problem…and that was not in an era of massive debt at every level: public and private (both corporate and individual). Now here is something for the supply-siders to ponder: why, when Obama refused to be pinned down on whether he still planned to raise (restore to prior levels), taxes on the wealthy, but gave a hint saying “it is the patriotic duty” of those who have to pay taxes…are stocks rally globally, the dollar and yen are losing ground against the weak Euro and Sterling currencies, and commodities are rallying? But already, the supply-siders are saying we must make the tax cuts permanent, thus insuring the highest wealth gap in more than a hundred years will continue?…until it doesn’t! How we were so blind to this for so long is a tribute to this Administration. Oh, and meanwhile bonds are being trashed globally!

The first of the three problems is leverage…unlike any seen before. The U.S. deficit has been growing rapidly and about to do so explosively. The phenomenal growth of derivatives of every imaginable sort  added to that leverage as they too are a form of leverage…instead of producing 10 widgets you now have effectively produced 100 widgets. But when the demand for widgets fall it is the leverage-backed derivatives that suffer the most. Now if you really want to create a volatile mixture throw money into hedge funds that further increase leverage beyond our wildest dreams. But you know what? It’s all good…yep, the originators (creators, traders, salemen) of derivatives, just like the others further down the food chain (mortgage brokers, real estate salespeople, apparaisers, etc.), all get rich…and it isn’t even inflationary…so long as it keeps growing. TB likens this to ‘same-store sales’: so long as a company is growing and opening more stores while shuttering the low productive ones, a company (Starbucks), looks good and if it could grow forever it would look good, but why do we go through this drill over and over with Levitz Furniture, Litton Industries, Whittaker Corporation, International House of Pancakes, Boston Markets, Krispy Kreme Doughnuts…but we do, we simply never learn because it is impossible for any company to grow at rates five or six times the economy indefinitely…else they would eventually exceed the GDP of the rest of the nation, right? The bigger you get the more difficult it becomes to maintain the growth rate which in turn supports the stock price and when it does fail it falls with a big thud. Google has perhaps the best chance of beating this while Apple would be number two but is constrained. As the economy weakens however it will be harder for even these companies to continue to grow…and in the case of Google, like Microsoft showed IBM, it can happen when you least expect it.

So should we be all excited about any economic stimulus plan? TB thinks no, because we have to retrain and restrain ourselves. We cannot go back to our old ways, yet the solution is apparently just that. Compare and contrast what the current Administration has done and how the next one will handle the problem and then ask yourself why the markets are so giddy today:

Commerce Secretary Carlos Guittierez was interviewed on CNBC Friday and asked why Bush isn’t pushing for infrastructure investment like Obama. They hit him from every angle but he stuck with the party line: we feel that the best way to get the economy back on its feet it to provide capital to the financial institutions (he was also asked why GE didn’t qualify and he said their bank application is working its way through channels…unlike Goldman and Morgan Stanley which were approved in hours, and Cit who has been bailed out at least three times with no concessions…unlike the auto manufacturers who are being reamed and now it appears at least one CEO must go). Yet that money was given to them (force-fed in some instances), with no requirement of how it is to be used) and lending is getting tighter not easier…so how does this help the economy? Arguably, a lot better then a slew of failed banks would!

Meanwhile the Obama plan would put people to work…but we have to train or re-train these workers…some have even mentioned the Carter plan on 1975 to subsidize cities and counties to hire workers…if they do it better be set up differently as they had to hire the unemployed and it could not be used as a credit against layoffs so they laid off existing employees to have the feds foot the bill for the new hires…that does nothing! Infrastructure plans take time, but one of his proposals is to take shelved plans due to budget shortfalls and immediately implement them Again, a great idea but it also means some white elephants will be created…heck in San Francisco we are still doing an emergency retrofit of a bridge from an earthquake NINETEEN years ago with five more years to go! Still, this proposal is the best we have and we, like with the bailouts, have no choice.

This brings us back to leverage as how else are you going to pay for it but print money and borrow? California says it desperately needs $7 billion…a pittance compared to the automakers (where 60% of those surveyed, including in Michigan) are opposed to it…but California is the sixth largest economy in the world after the U.S. Think about that will ya? One states collapse could push us into the worst recession ever. But the point here is this: why are stocks rallying? When hedge funds are imploding in their worst year ever, private equity sees loads of opportunities but can’t get the financing, retired and those contemplating retirement along with younger people have all seen their wealth evaporate and are forced to rethink everything. Nobody is immune and if you think you are…pity. The truth is that to get the economy back on its feet quickly means it will only be in trouble that much quicker. The key is to encourage savings or at least higher wages…but how do you get a corporation to pay more money when it is hurting and laying off people and god forbid, even CEO’s are thinking about taking paycuts?

The second area is volatility. There are many kinds of volatility (which is another name for risk) but the one TB thinks most critical is options volatility as measured by the VIX Index. Consider that from the stock market rally’s inception in 2003 until July 2007 (the peak) it ranged from about 9 to 21 which is historically very low. This is a measure of the ratio of puts to calls (it is more complex than that but will serve our purposes). That low ratio allowed stocks to continue to rally consistently, but then in 2007 the range moved to 15 to 30 with occasional blips to 35 or so. Meanwhile, it shot from 18 to an all-time high of 89.53 in October and even the 40 day moving average is at 64 which used to indicate a major catastrophe…at 64 and above they are practically giving away calls! This brings us back to hedge funds again who use options strategies extensively along with algorithmic trading programs to ‘game’ the market…only now it is they who are being gamed, except for the few with incredibly fast and constantly updated systems. Want to see what volatility does? Barrons’ Mike Santoli this week containe two telling observations:

1. Vince Farrell, a veteran strategist, notes that since 1950, 15,000 trading days there have been 68 times that the S&P 500 has gained or lost 4% or more in a session (33 down, 35 up). Of those 68 days, 28 have occurred in the past three months! You can’t game that!

2. Art Cashin, the veteran UBS floor trader on the NYSE showed what happened to the Dow last Wednesday: 10am -149; 11am +6; Noon +130; 1pm +64; 2pm -117; 3pm +28; Close +172.  TB offers some key numbers from Thursday and Friday:

Thursday: 9am -429; 1:30am -520; 2:30 -357; 3:30 +273; Close -616

Friday: 9:45am -31; 10:45am  -261; Noon +893; 12:30pm +808; Close +259   

Let’s assume the market is a buy as they are telling us this morning…at what point during any of the three days was it a buy. Also note that despite Friday’s powerful rally, albeit from a low level and still a down week.(-196), when is it a buy? This is from TB’s closing stock summary Friday:

The NYSE Energy Index plunged then recovered to close up slightly but well below the 40 day as was the Russell 2000 and the SOX. One other thing of note: only four movers today closed above their 40 day moving average (WMT burst above it), while MCD is trading above its 200 day m/a, and XOM is trading between the 40 and 200 day. Looks like a huge bear trap to TB.

TB does not rule out that this could be a massive countertrend rally, but he also cautions on options expiry on 12/23 and the closing of the books for the year (T+3) for hedge funds on 12/26…that bodes for another sell-off as we saw at yearend 2007 and every quarter since due to massive liquidations required for withdrawals…stay awake.

Lastly, is velocity. That is the other part of the equation where nominal GDP equals growth of the monetary base times velocity (turnover) and is why Milton Friedman who saw velocity stable said the Fed should not mess with the money supply but let it grow constantly at the desired rate. This is the basis for those who are wringing their hands about massive inflation from all of this money being pumped into the system (actually most of what has occurred thus far has not been inflationary as it has been ‘swapped’ for assets…worthless assets but none the less assets. Meanwhile Velocity which had been stable from 1959 to 1978 averaging 1.67x…in fact it averaged that since 1900 thru 2007.  

Ranged from 1.8x to 2.1x from 1992 to the present and is now about 1.85x and declining. With velocity falling you don’t get inflation, in fact if you don’t increase the money supply and velocity declines it is disinflation until it becomes deflation…and that there is no monetary cure for as Keynes reasoned, calling it a liquidity trap and ‘pushing on a string..’ This is very simplistic and some may cite errors in it but if you read John Mauldin, he did a piece Friday, much of which was from Lacy Hunt with Van Hoisington Associates. You can access it at www.frontlinethoughts.com or TB can forward to you.

The point is that without treating the three causes…and controlling greed through proper regulation of financial institutions…we are pushing on a string. But the solution will be long term not short. In the meantime, existing debt becomes expensive and obtaining credit will be difficult. Thus the interest in companies with little or no debt that are selling with a market capitalization less then the net assets…be careful however of how those assets are valued, especially if they are financial institutions.

TB is no guru…there are a lot of wiser people out there, but there are also scores of professionals that are either talking from position or ignoring the facts. Don’t fight the tape but have a good exit strategy…you may need it quickly!