Trice Burned

I wonder...

If it take three fails to learn a lesson.

And as I used to say, "We have the right to fail, try again and then quit."

And hope triumphs over expectation.

There is less quavering retail money in this market than ever before.

Everyone is committed.

We are going to see a higher low.

Breathtaking...

cf. November 20, 2009

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Live! Tonight! The Depressions feat. D.J. Demand Destruction

. . . . . . . . . . . . . . .

Dear Dad,

The recent developments in the global economy are terrifying. The risk to the economy now is entirely political-- trust in politicians worldwide is low, and by the look of recent events, I fear this is morphing into something new all together. In America, Europe, and the Middle East, it's no longer just people hating their politicians-- it's people questioning the very nature of government's authority, right to exist, and place in society. Society has become, I'd say, significantly less civil in the past eight weeks. You see this in the riots in London, you see this in the riots in Greece, you see this in the downright dangerous political language being bandied about in the US.

Gov. Rick Perry of Texas, candidate for President of the United States, stated yesterday at a fundraiser that Ben Bernanke's actions were equivalent to treason and by extension that Federal Reserve should be abolished. That this is possible right now... that that could even be possible given our country's obvious problems, and the tremendous body of literature showing how bad it was back in the day. (c.f. "Fifty Years in Wall Street" Clews, 1908) and the practical steps one could take fiscally... in conjunction with a little bit of swagger, charisma and monetary policy. Insane. Rick Perry is insane and unfit to be president. (Not that bashing the Fed is without historical precedent) As a result, the Europeans woke up to an America that looks way more dangerous than they anticipated. More and more, we feel the same about them. Repeat, Rick Perry should be shot for treason.

This feels really, really bad to me. This is not the same situation as when we spoke 5 weeks ago and I advised you to do nothing because the debt ceiling debate was a foregone conclusion. Indeed I was right, but many horrible things have happened since. For one, in the most recent GDP report, the final numbers for quarter 1 & 2 came in and they were horrible. Not something like 3.5% & 1.5% as previously reported, but something like 1.5% & 0.5%. Furthermore the Q4 decline in 2008 was newly revised down in light of more complete data, from -4% to -9% with similar adjustments to Q1 of 2009. And S&P downgrade of America. America is like, whatever, we just approved a bunch more NRSROs and we're gonna sue your ass for the "sub-prime crisis." Remember that the sub-prime crisis? Ben Stein's simple 200 billion dollar problem. God... those were the days. So much easier back in summer 2007 when I thought everything was going to turn into a combination of the the Great Depression and 1970s stagflation overnight or at least definitely by Christmas. Remember? I had just started dating Sadie Stein and I called you after our first date and told you I wanted to marry her? Its funny, I never told you this cause you'd would have been furious but that summer I stole a copy of Bernanke's textbook on the Great Depression from the Border's Books in between the NYSE and the American Stock Exchange. Sort of a performance-art piece. Actually that piece is getting more poignant all the time. Wow... Oops. Remember the ASE? Such a pretty building. I was there, walking by, freaking out about paper money and gold's potential potential, the day they announced its closing. Heard about it from a trader smoking a cigarette. January 2008. So sad.

We were freaking out back then too... alongside long suffering Mr. Greg Robb: Fed Watchers at a Loss: 01/27/08

And all of this feels really especially bad.. because all of these things taken together are ancillary, just colorful background to the slow motion banking collapse ripping through European Union as we speak.

[Insert current ten year DB chart as well as ten year soc gen, ubs, west lb, bank of america, j.p. morgan, kbe and XLF and the european equivilent, vix, the euribor-ois, dollar basis swaps, euro, gold, gold:spx, & maybe the ted spread though i don't know if there's action there yet.]

[And also my unrequited dream chart of the moment, GLD price v. GLD tonnage.]

* * *

I believe that the amazing recovery of corporate profits has masked a cancerous deterioration of the broader economy over the past 2.5 years. These profits are due to permanent efficiency and productivity gains realized by the corporations. Gains that have elevated unemployment structurally and to lasting effect. Maximum employment, thought in the 1970s to be 3-4% is now very likely to be 6.5 - 7.5% at best over the next decade. This is bad.

Furthermore the return to healthy corporate profits has masked a truly disturbing fissure in wealth distribution, one which has occurred almost silently over the course of the past 2.5 years of economic recovery. There are now only three classes of people: those without retirement savings, those with retirement savings, and the rich. The return to healthy profits has torn a massive rift between the approx. 50% of the population with and the 50% without. This is bad for stability and probably has contributed to the decline in civility amongst our politicians.

You know what this adds up to once the stock market figures this out? Bad. To reduce all of the above to an equation: too little Demand + too much industrial capacity = ^ odds of Depression

And this overcapacity is a worldwide phenomenon right now. Keep in mind that things were not scarce during the Great Depression. There was a ton of nice things, new exciting inventions and technology, at amazingly cheap prices, with eventually --by corporate necessity-- ample financing, just no one had any money to buy or desire to finance anything. Sound familiar? Indeed, perhaps the brilliant promise of globalization has temporarily (i.e. for the past 4 years and for the next 10 or so) overheated. To put it another way, we are a victim of our own success, because we did not recognize and correct the tremendous global imbalances while they were building. I don't know how you feel but I blame, Alan Greenspan, Dick Cheney and the Chinese first and foremost.

The worst part of everything is that the Fed is probably going to announce a certain brilliant technocratic innovation/experiment at their meeting next week, one which they've been hinting at recently. As far as I can tell from watching and reading a lot of CNBC and NY Times, WSJ, etc. the market has no idea this move is coming and is not going to understand it one bit. It's confusing and scary sounding to the lay man, and involves the Fed imposing a negative interest rate on the deposits Banks have placed on reserve with the Fed. Its insanely complicated actually, and indeed, actually takes economics about as far towards metaphysics as... I can't even start to get into this, it a long lecture... but basically, its an attempt to force the weird/ethereal money created during QE1 and 2 into the real economy. I have no idea if it will work, but it fucking brilliant and definitely on the cutting edge of the current research coming out of academia. People are either gonna love it, or hate it. Its definitely the right thing to do, but people might fucking panic. I don't know.

If you agree that the latest developments politically worldwide are scary and that this could go terribly terribly wrong... I have a plan which, had I been more knowledgeable in 2007 before all this started, could have saved us a lot of aggravation over the years. Here is what I would like you to do. Agree to wager up to 5% of your retirement savings on a truly catastrophic decline occurring in the stock market by December 2013. If shit gets really bad, you will probably suffer only half the loss you would otherwise take on your portfolio. If the economy recovers, the most you could lose is that 5%.

You would get Justin to purchase a contract from the stock exchange. This particular type of contract is widely utilized and called a "put option." It states, for instance, that if the S&P is below 900 at any time before December 2013 you are entitled to redeem your contract for the difference in between the two prices. For instance, if the S&P is goes to 700, your contract is worth $200. Now because the market is currently at 1120 and the lowest it hit in 2009 was 666, the price for you to buy that contract is likely to be pretty low, perhaps a few dollars or so. If you take 5% of your portfolio and agree to risk it on this contract, you are likely to insure a good proportion of your savings in the outcome of a true disaster. If the economy just muddles through or recovers and takes off, the maximum you can lose is that 5% you used to buy the contract. Pretty slick. That's why the options market exists. To provide insurance. It started to help farmers manage their commitments. Interesting, no?

What you would be doing is a very routine operation employed by every CFO on the planet, everyday, to manage macro-economic uncertainty. Justin is definitely well versed how to execute this strategy, its a qualification for his license.

If this sounds plausible, send me the go ahead. I'll explain the concept to Mom and if she agrees with our assessment, she can call Justin. I know i've fucked this stuff up in the past, but I've had 3 years to study up since the last time. If I could quantify the risk, I would be less alarmed. But because the risk is entirely political, and because humans have been bad at politics domestically and abroad for their entire history, I am fucking' terrified.

FYI, I know you're performing eyeball surgery in the Namibian bush, but if you have the time, these articles from ftaphaville.ft.com lay out the outline of what the Fed is going to announce at Jackson Hole next week:

The High Powered Money Problem

The Fed's Secret QE3 Equivalent

The Fed's 1.6 Million "Somethings"

Love,

Matthew

Finance is awesome.

Swap contracts for Saudi Arabia, used as a measure of confidence although the country has no debt to insure, jumped 11.5 basis points to 138 last week, the highest since July 2009.

The $124,000 Query

"Ahh... I don't know about that," is the answer to most questions.

Especially the really hard ones. Like, some really stupid shit someone says to put you on the spot. It works because no one who is fucking with you thinks two steps ahead.

Seriously. This will be the only thing I will teach my children.

Weighing the US Dollar

Debt is the New Equity

The relationship between the yield on stocks and the yield on bonds is inverting in a way that hasn't been really since before the 1950s. But the concern regarding this "strange" behavior should stop. The strength of bonds (both Corporate and Government alike) is a reflection of a healthy and necessary shift in the capital structure of our economy.

Investors have pulled 50 billion out of the US stock market this year. This money has gone into cash (both Savings Accounts and Gov't Bonds), corporate bonds (Junk and Investment Grade), and ex-first world equities.

The foreign equity story is simple. Countries with strong property laws, stable governments and a youthful demographic, will see an increase in economic growth as people compete to raise their own standard of living.

But the massive amount of money that has moved into fixed income, has bewildered many market commentators. The extremely low yield of both regular and inflation-protected Government Bonds has many people worrying about deflation. They are right to worry. Cash parked with the government is money not spent. The momentum of money is slowed down.

This adjustment is part of a larger system of balanced interactions. The shifts in money flows cause prices to change. These prices act as signals, encouraging shifts in the behavior of participants. These behavioral changes in turn, affect money flows and the process is repeated.

Lets trace the path of these signals. Falling stock prices scare people. This is because these prices telegraph signals about the health of an economy. People decide to hold more cash, which means either directly or indirectly purchasing government bonds. This allows the government pay a lower rate to borrow money.

But message contained in Gov't Bond rates is more multi-faceted than simple warning of deflation . It is also a reminder to investors that if they want to earn any return on their money at all they will have to take some risks. If they are forced to invest in something, their best option is to choose the second safest thing to cash, loaning their money to corporations. We can confirm this behavior signal by observing the large money flows into Corporate Bonds beginning about a year and a half ago and continuing to the present day.

This behavior shift has lowered corporate borrowing rates to the lower range of their historical levels (and when I say historical I mean as far back as two hundred years.) We have seen an enormous shift in the cost of borrowing for corporations since the darkest depths of the financial meltdown. In December 2008, the price at which an investor could be persuaded to lend money to riskiest corporations hit a level which implied he figured his risk was 50/50. Even the rates on the best run corporations were implying defaults of nearly 10%.

This flow of money, signaled by the extremely low corporate rates (I.B.M. just borrowed some money for less than two years at a rate of 1%) is telling us that the best run companies in their respective fields are going to be allowed to continue to do good work. Times will get tough in the months ahead, the stock market will fall. But the necessary shifts in our economy will now have the chance to occur. The process of creative-destruction will remain in balance and the engines of creation will not be helter-skelter destroyed.

All we are witnessing is a cyclical transformation in our economy from its recent youthful speculative exuberance to a more considered, mature and frankly world-weary countenance. Keep hustling, and it will be ok.

Knees and Toes

The U.S. Stock Market is currently tracing out the final part of a head and shoulders pattern. While I've stated before that most technical analysis is bunk, the H&S is a common "topping" pattern that can occur at major tops and bottoms of long market trends. It begins when an asset is bid up to unsustainable levels. A correction follows, encouraging the types of people who "buy on dips" to enter the market. The asset then rises to slightly above the previous peak, but runs out of steam as no further buyers enter the market. It then falls again to around its previous lows. I suppose the same buy on dips argument could be made for what drives the asset to rally a second time. I also feel however that the movement of stock prices often tends to take the path that would most frustrate the largest number of people. So perhaps the second rally simply exists to frustrate the less sophisticated short sellers. Perhaps the professional short sellers close their bets in anticipation of this pattern forming. This is the great thing about the markets, there is never one explanation.

I can tell you that three weeks ago I felt there was a large chance of this pattern forming. (A fact which I conveniently failed to mention on this blog.) Here's why. The stock market tends to never behave the same way twice. People's observations of the market's past behavior cause them to change the way they react when they encounter a similar situation. The last time the Dow Jones Industrial Average broke through 10,000 in 2008 it smashed through it. Its that simple. It was unlikely to do so again. The stupidest money would bet on the same thing re-occurring facsimile.

If this sounds like bullshit, I assure you, it is. You cannot approach something that acts so irrationally, rationally. But I can also assure you, if I've learned one thing in the past four years, the market and its participants are seldom rational. And the more obviously an effect should follow a cause, it almost never does. This, mind you, is not the same as being contrarian. It is more subtle than that. But now there I go... more bullshit.

There were two other reasons it was unlikely to smash through 10,000 three weeks ago. There was very strong resistance around 10,000 due to the fact it marked the previous low from February 2010, and the fact that big round numbers tend to act as psychological landmarks and consequently many people make decisions around them. (Furthermore, many world indexes were battling up against large psychological resistance numbers, the FTSE 100 @ 5000, the Shanghai Composite @ 2500, Gold @ $1250, Euro/USD @ 1.20, Copper @ $3.00) Secondly, large lasting trends do not simply reverse course on a dime. A trend reversal is a large scale battle between two groups with opposing opinion. It takes time for them to fight it out and a victor to emerge.

The Dow will most likely stall before 10,800 (just north of the first peak in the pattern from January) There will be a lot of congestion, as people start to recognize this pattern and the market moves to frustrate the greatest number of people possible. But then it will fall and not stop until at least slightly south of 8000.

Here are a few head and shoulders examples... (Click to view larger.)

The Large Cap (Dow) 2007 Peak:










The Small Cap 2007 Stock Top and 2008 Gold Bottom:

















A possible long term H&S?!? (I saw this theory advanced by some quack but who knows...):










Of course, this is the true underlying picture. (Inflation adjusted, Log Scale, 1950-2010):

Inflation

The wide ranging criticisms of the ECB's performance are bullshit. An inflation target necessarily implies restraining deflation.

There are several independent, but non-mutually exclusive causes of inflationary pressure. Academically, the two classical causes are termed demand-pull and cost-push. Additionally, one must consider the Milton Friedman fallacy that "inflation is always and everywhere a monetary phenomenon."

Demand pull inflation is always and everywhere a monetary phenomena. People can ask for all of the increases in wages they want... But in totality, if the central bank doesn't print enough money to keep up with economic growth, an employer's ability to increase wages will be constrained by their employee's ability to increase his productivity. There will simply not be enough money in the system to stimulate the economic growth needed to encourage an additional consumption of products.

This goes both ways. When Arthur Burns ran the Federal Reserve, he allowed Richard Nixon to bully him into printing money. The continuation of Johnson's "Great Society" push to appease the opposition to Vietnam through increased social spending coupled with the credit creation abetted by the Burns Fed. This double-whammy over-stimulated a strong economy already close to its natural limit of unemployment. The additional money in the system temporarily drove the unemployment rate below 4%. As people were driven off their couches by rising wages, so to were people driven to ask for higher wages to stay at their current jobs. With rising wages came higher expenses, and the demand-pull wage spiral took off.

This is not at all the case today. Europe is on the verge of a terrific period of stagnation and deflation. (inflation=up, deflation=down, dis-inflation=steady) We will see no economic growth, and no additional jobs in the periphery of the Eurozone until the artificially uncompetitive wages of the peripheral economies come back down. America is going to be relatively okay, but with lackadaisical wage growth, stagnant real-estate prices and impressively high unemployment for four years at a minimum.

The price mechanism is a powerful signal. Despite the extremely bearish situation in the world economy, the prices of many key commodities are at extreme levels. This tells us several things: Coffee and cocoa are expensive. Global income/consumption is rising.
Oil is expensive. We are running out of oil.
Coal is somewhat expensive. We will find more coal.
Wheat, soybeans, and corn are cheap. We have had three years of excellent harvests worldwide... we also have powerful subsidies in the U.S. for these crops.
The prices of many rare earth metals have been relatively unaffected by the panic of '08/'09. Global income and the consumption of advanced technological goods is rising and perhaps we are running low on these metals.

Get it? We will find more of the things we are short of globally, except the things we are running out of, namely oil. But on a macro scale, the developed countries are printing more money, and the developing countries are consuming more products. The deflationary impulse of the developed world is being countered by both the printing of money (Friedman inflation), the demand pull of economic growth in the developing world, and the cost push of the world transitioning from an oil based economy. Add in a few years of bad harvests and we will move beyond academic disputes over the nature of the Phillips curve (the reciprocal relationship between rate of inflation and and the rate of unemployment) into a general acceptance of Gregor Macdonald's concept of compartflation...

Basically we are talking really shitty stagflation in the developed world, with the slim possibility of outright deflation if we get a trade war, or a real war, or a European banking collapse, or a revolution in China... etc, etc. In either case, developed world real estate prices will not appreciate in nominal terms for 8 years at least. Stocks and and paper stores of value look terrible.

It is essential to recognize that the dichotomy between deflation and inflation is false. They can easily coexist as a growing differentiation between assets values intensifies along the classic lines of supply and demand. As we enter into a world where the values of the dollar and the euro depreciate together due to both the decreased demand for currency and the increased supply of money, we will see the price of many assets in high supply (real estate, stocks) stay stagnant. Thus the inflation of the money supply will cause a subtle but dramatic deflation in the price of over-abundant assets. However, as we run of of cheap energy the price of oil and coal will continue to inflate with drastic consequences for the world economy.

This will of course work itself out. Indeed, as these events come to pass, market prices are no more than the manifestation of this process of self renewal.

Stop freaking out, you know you're okay.

The Dow is going somewhere just south of 9000. The Euro is going to $1.15. Gold is eventually going to $2400, once the dollar turns around.

Will everyone please calm down? The markets are working.

The only present concern is the fact that everyone who can is bailing out of long-term European peripheral-economy debt by selling it to the European Central Bank. The amount the ECB is actually purchasing is the only relevant data point. If they are forced to purchase excessive amounts, they will not be able to sterilize their purchases, turning so called "credit easing" (I've also heard the nonsense term "qualitative easing" used) into "quantitative easing." In fact, the Federal Reserve fell into a liquidity trap when they attempted their form of "sterilized" quantitative easing, and were forced to print money to prop up the falling money supply.

If their hand is forced there is a real danger the Euro will hit parity to the dollar. (Or as my fiancee suggested, falls below parity... "It's only fair.") So far the adjustment is in line with events, and the re-balancing of the Euro is equating supply and demand of money and goods judiciously. But if parity happens, America and Europe will be in deep shit.

Moody Blues

Moody's downgraded Moody's Investment Services today, in response to Moody's receipt of a Wells notice from the S.E.C. which threatens to revoke its NRSRO status.

God I wish this were true. Who knows?... stranger things have happened.

Re: Letter to Trichet

Uh... so I guess he got the memo. I was thinking something more on the order of 2 trillion dollars, but $962 billion sounds reasonable. Glad I could be of service.

Letter to Trichet

At the risk of sounding brash, I believe that Jean-Claude Trichet made a major tactical error Thursday morning by muting calls for the ECB to initiate quantitative easing.

The argument against QE in Europe is that the ECB's actions would necessarily be political, possibly opening up the ECB to scrutiny and jeopardizing the central bank's independence. However, the exigencies of the crisis necessitate bold action and I am surprised that Trichet would allow himself to be caught flat footed on this issue. He was unique amongst central bank governors in the summer of 2007 when he (by fax from the beach) provided unlimited liquidity to the European banking system. This bold action ameliorated the onset of the panic of '07.

Trichet is attempting to restore normality to the markets by withdrawing this liquidity support. This is a mistake. Trichet should have said that the ECB was prepared to come into the market with overwhelming force to drive down the unproductive interest rates on European government debt. With the TED spread and the LIBOR-OIS spread approaching panic levels (in plain English, European banks are no longer lending to each other overnight) he should have reiterated his commitment to provide unlimited liquidity.

If he feels that the "traditional" QE is unpalatable or unworkable, he should initiate a political process by which German bunds (the yields on which are currently plunging do to "safe-haven" searching) are issued and the proceeds used to purchase the debt of weaker European countries (which are in danger of being priced out of the lending markets due to their surging yields.) If this were implemented on a significant scale, it could go a long way towards driving a convergence between bond yields on the debt of European countries.

This may be a good opportunity to raise a domestic issue I've been kicking about in the back of my mind. The political separation between the two control levers of the economy, Fiscal Policy (the Spending and Taxation decisions made by Congress) and Monetary Policy (the control of overnight interest rates by the central banks) is necessary but unworkable. If I were in charge, I would make a commitment to restrain overnight interest rates around 0% for three years. Any adjustment necessary to restrain inflation by choking economic activity should be made on a quarterly basis by manipulating the tax rate on corporations and individuals. This is of course politically impossible, however, it cuts to the heart of the biggest danger facing the economy today, the surging national deficit and the possibility, however remote of a U.S. sovereign default. By increasing taxes temporarily if necessary to restrain economic growth, the government would bide its time by funding the exploding national deficit. This would increase its ability to maneuver by stocking some dry powder in the case that additional Keynesian stimulus is required. Which it will be.

Dance Casa

Also, what the fuck happened at the art sales this week?!? Excuse me for swearing three times in three posts within this hour, (I'm sorry, I got bored and stopped paying attention for three weeks worth of trading days) but $25,842,500 for a 28 inch forearm/hand by Giacometti???

Felix Salmon had an excellent post a few weeks ago. He suggested that works of art produced in limited multiples had a higher value than a unique work of art. That the cache derived from the narrative surrounding the provenance of the sister pieces would speak to the sophistication of the new buyer... to brutally paraphrase his excellent article.

But the fact of the article was that a huge Giacometti had just sold for something like $50 million dollars.

So here we have: the beginnings of bond vigilantism in the European Debt markets, the beginnings of a"1930s U.S. depression style" overproduction thing happening in China, massive surpluses of oil and basic industrial commodities, shortages of rare earth metals and soft commodities (such as coffee, cocoa, orange juice), a severe long term shortage of oil, a short term shortage of coal, Japan done and borrowed twice its GDP, excellent harvests several-years-running depressing the prices of agricultural products, and a tiny fucking Giacometti selling for half the price a monumental sized Giacometti sculpture.

Again. What is going on???

Here's the deal. We are, luckily, not going to have a post-banking system collapse how the fuck do we pay the police if the ATMs don't work kind of situation. But things are very bad. Terrible in Europe. Terrible in New York. Terrible in China.

Less than perfect in L.A., Austin, Brazil... but go to any of these places if you need to. There is oddly enough work.

Thirty-Nine Percent

39% of investors in the iShares/FTSE Xinhau A50 China Index ETF have lent their shares to short sellers. In the words of the immortal Drake, "Who the fuck are y'all?"

Holy shit.

(Update 5/6/10) Yep...

Strong demand for U.S. Debt Auction

The liquidity trap has a floor. It also apparently has a ceiling.

Bids for the $21 billion auction of 10-year U.S. government debt attracted the highest demand on record today, as investors, scared, bet on deflation or couldn't think up any better use for their money.

Homage to Clyfford Still

The depreciation of the Euro (blue) and the Dollar (orange) against Gold.
[The purple has no significance in itself. It's simply caused by the overlap of the two colors. Sometimes it's the Euro and sometimes it's the Dollar. It depends on which currency is stronger and thus in the background.]

From Gregor.us

The most disturbing thing here is the breakdown of the price mechanism- the contraction in non-OPEC oil supply despite the 2008 price surge.

It is clear that oil supply is plateauing. The price surged for coal in 2008 as well, but its discount relative to oil encouraged adoption. Gregor Macdonald predicts recapitulation into a predominately coal-biased global economy within five years.

Luxury Goods

"Luxury is a necessity that starts where necessity stops."

- Coco Chanel (attrib.)

The story of civilization, if told with economy yet in all its comprehensive beauty, can most cogently be explained through the evolution of the unnecessary goods of society. These are the most interesting aspects of civilization and in many ways the quintessence of peaceful society. Civilization is the story of the specialization of labour, the rise of trade, and the creation of a leisure class of scholars and artists and dissipated wealthy. All of these narratives revolve around the unnecessary good.

The unnecessary good exists outside of the dynamic equilibrium that governs supply and demand because its logic befuddles the balancing power of price. Sadie and I have a toast to the unnecessary. It's simply, "Fearless luxury."

If you wanted to ask my 17 year-old self his opinion, he'd tell you, "The moment a good's fundamental utility disappears, it becomes art."

These days I'm more of a Pierre Bonnard man.