3/16/11…back home in Minn-e-so-ta

Yesterday’s 1.15% decline on the Dow, 1.1% on the S&P 500, and whopping 1.9% decline on Utilities (remember some are nukes), was not only coming back from the dead on the third straight lower low, but pure and simple a ‘dead cat bounce’ or DCB as TB prefers. The high was about a gain of 50% from Monday’s low on the Dow, and the low was the worst since January 12th. TB knows there are those who mock his using volume as a barometer but yesterday’s NYSE was 1.29B shares, highest since February 23rd, not coincidentally another down day. To make something relevant how many times must it happen?…or do you prefer to gauge the stock market off quarterly earnings and if so you must drive your car while looking thru the rear view mirror!

The Dow had only one up stock Chevron (CVX), not surprisingly an oil company! The S&P 500 had 6:1 declining! TB pointed out Robert Schiller’s comment that following both Chernobyl and Three Mile Island it took a week for the stock market to bottom…that is because these things are complex – and the current one is the most complex of all, with the most ramifications for the global economy.

Overnight, the BOJ pumped in another $33 billion to the system bringing the two day total to nearly $170 billion…you convert that to yen! Heed TB’s warning on JGB’s (Japanese treasury bonds), that have artificially low yields (currently 1.2%) due to demand by Japanese citizens who do not trust their stock market for what happened 30 years ago and has repeatedly struck them since. Coincidences don’t happen but in this case we have a population in Japan over 60 years old growing rapidly, the savings rate having fallen to zero and had already been predicted to turn significantly negative meaning less to invest and outright redemptions of their JGB holdings. Also, TB pointed out that IF the JGB’s then have to tap the outside market, which they most certainly will, the yield would have to rise to at least that of the U.S. 10 yr (3.3%), which would result in a loss of 19%, which would not only require more redemptions but could cause panic selling by thoughtful Japanese individuals. This is a very ugly scenario and is the worst case.

It is also not good for the U.S. and U.K. because if their yields become attractive it will draw buyers (if for no other reason diversification purposes) from other bonds just as we are ramping up issuance. Not a pretty picture!

Overnight, global stock markets were mixed with Japan up for the first time in four sessions. Up a normally strong 5.7% but against a 17% decline, not even a DCB!

In this environment you would think Gold would be drawing interest, yet it continues to oscillate around $1,400 (now $1403.70 +$10.90). Crude meanwhile is below $100 and hovering around $99 (now $99.04 +$1.86), and a very treacherous market to play…both commodities were rife with speculators to begin with! Meanwhile bonds continue to struggle with the exception of the 2 yr note which is at 0.60%! What’s a mother to do???

U.S. stocks were off slightly prior to Housing Starts and Producer Prices. Housing Starts FELL to the lowest level since April 2009 and permits slumped to a RECORD LOW in February (normally in a recovery these should be taking off well before this!). Meanwhile wholesale prices jumped 1.6% in February, the most since June 2009, and clobbering the consensus of +0.7%. But not to worry, Bernanke and NY Fed President Bill Dudley say as the core only rose 0.2%. Oh yeah? Well get this: FOOD prices surged by 3.9%, not that that will effect the wealthiest in this country – unless their favorite restaurants begin to fold, and Energy costs rose a much smaller (sic) 3.3%, led by a 15% jump in HOME HEATING OIL. TB agrees that these are only short-run and thus not included in the core but isn’t the long run merely a series of short runs? IMHO though we will see exactly as we did in 2008 where those prices cannot be passed on to consumers and stick, therefore the Fed duo is correct, but at what cost?

Little market reaction to the above – in fact stock futures are now FLAT…but TB bets that will not stand…and don’t forget Friday’s options expiry! …or do so at your own peril. TB got stopped out yesterday on some of his positions, but does he care? Noooooooooooo! You decide!

…great flight home, with a connection in Denver that we barely made, but hey, who wants to sit around all day in an airport? Was able to finish All the Devils are Here and am more enthusiastic – if one can feel ill and stirred at the same time.

What is so important about the book is the trust in young kids to design programs based on quantatative analysis, and that senior management of the biggest, most powerful firms and banks didn’t even understand. Worse, no one – NO ONE – understood that if everyone is using the same models and positioning accordingly you have a precursor for disaster! Nothing is ever so simple as a model that works perfectly.

One of the worst things about statistics is they are so easy to understand, and bet accordingly. Yet, we forget that the most elementary, the coin toss, can bankrupt you, so why do we believe in our ability to outsmart others? It is like doubling your bet every time you lose at Blackjack – you will eventually lose your money.

Years ago, while working for a now defunct money manager, Goldamn Sachs made a presentation to a coworker (who went on to head a department of quants at JPMorgan if memory serves – who is smarter though an Indian or a Pakistani…the most prevalent quants?). Anyway, the were arguing that for our bond mutual fund (Montgomery Street Income Fund) that we issue commercial paper and then use the proceeds to buy MORE bonds! They showed a Monte Carlo simulation (recall that is just another form of backtesting and why do we care about that when ‘past performance is not an indicator of future performance?’ (Yet, the brightest minds in the financial sector continue to do this and do it for one and only one reason: to sell product!)

While we passed on it, and by the way Monte Carlo simulations are very useful – in scientific problems where there are few or no exogenous variables…they do not work well when you have an infinite number of ones that cannot even be comprehended…witness Japan!

Which then brings us back to normal distributions. Every time some whiz kid comes up with a system, backtests it, gets some sucker to implement it, has success causing more investors to plunge into it, it then BLOWS UP – partly due to exogenous variables but also collapsing under its own weight. Consider Long Term Capital Markets.

LTCM was probably the greatest brain trust the financial sector has ever seen, yet it collapsed in 1998 by thinking they were smarter than the market. In fact, they were so good, yet so blind, that they didn’t even consider that the dealers they were buying from and financing from would mimic their trades and then front-run them as they exited them…no one is better at this than Goldamn, although it was largely Bear Stearns in this instance the ‘screwed the pooch.’

Here is the problem: they were playing heavy and leveraged in issues that had a 99.85%  chance of working out. In other words, what could go wrong? TB has been told that earthquake insurance is a bad bet, but like all insurance it is a bad bet – unless you need it, and it is expensive…until it becomes cheap in the wake of a disaster.

Throughout All the Devils are Here are examples of stupid statistics. Relying on historical default rates on subprime mortages while they went from less than 5% of the mortgage market (and at that time required skin in the game), until they became the market. Also, ignored was the decline in credit quality…if there was any credit quality at all but so long as everyone was making money (especially the mortgage brokers and Wall Street), no one thought it could blow up, which caused it to only become a greater catastrophe.

The saddest thing is that the GSE’s, Fannie and Freddie, got so caught up in ‘market share’ and lining their own pockets (and despite the protests, the full blessing of the Bush administration and the GOP controlled Congress…the Dems were already in their hip pocket…only increased homeownership to…and this will shock you…69% of the population – from 66%! At what cost??? How could this happen with all those subprime loans? Because nearly all the subprime loans and Alt-A’s (and B’s and C’s) were REFI’s!!! That is what we sold America’s future for: too keep the economy going (and never strong, except the financial sector) thru lending on future income, and enriching thousands at the expense of hundreds of millions of people. In other words, we camoflauged three decades of declining REAL wages thru mortgage and credit card debt, and in a bubble you have to return to where you started…ask the Japanese!

Meanwhile we have the GOP crowing while jousting at windmills (at least Don Quixote ‘believed’ he was doing good), by mindlessly cutting pennies from the budget, when the economy is about to (TB predicts) return to recession or at least go flat…for years.

Hope that cheered you up…but seriously, it is time for all of us to wake up, and stop believing in fairy tales, just because they make us feel better.

Hope you have a great day!

TB

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