Santa Claus came to town!

Santa Claus is coming to town. The last trading week of the year is typically bullish and this anomaly is called “The Santa Claus Rally”. The momentum is usually strong heading into year end and Asset Managers bid up the market. On very light volume, stocks creep higher.

Traders will not stand in the way of this move and they lift their offers. It is almost as if stocks defy gravity and they float higher. This environment serves a purpose. When investors open their fourth quarter statements, they are pleasantly surprised. They have confidence and they plow retirement money into equities at the beginning of the year. Hedge funds also benefit. When new high water marks are reached, bonuses expand.

On occasion, traders use this strength to unwind long positions. That selling can catch on and profit-taking sets in. A decline in the last week of trading signals trouble ahead. I don’t see any signs of that happening this year.

As January goes, so goes the year. This indicator has a 91% accuracy rate in the last 60 years. The third-year of a presidential term is also bullish and it appears that both parties are willing to compromise.
If not for massive debt levels, the market would be off to the races. Earnings, interest rates, economic activity, quantitative easing and taxation are all “market friendly”. Unfortunately, the foundation is cracked and this castle is ready to crumble.

When a heroin addict wakes up, it’s a good day. It means that they haven’t killed themselves and they get busy lining up their next fix. After they shoot up, life is grand again. They live day-to-day and they don’t worry about tomorrow. Kicking the addiction would be very painful and they promise to stop – tomorrow.
Americans are addicted to credit. Over 70% of our economy is based on consumption. As a country, we produce very little (manufacturing is 20% of our economy) and we rely heavily on imports. We used to finance our own habit, but now foreigners hold more than half of our debt. We elect enablers and politicians make this lifestyle possible.

Right now, we are “high” and life is grand. In the absence of a credit default, the market will continue to push higher. In the early stages of a credit crisis, the EU will pull out all of the stops to keep it from spreading. The ECB/IMF/Fed will be scrambling to “hook us up” and their actions will be “unprecedented”. You might remember that phrase from the spring of 2009 when the Fed through the kitchen sink at the credit crisis. We will see declines and snap back rallies. Eventually, the bottom will fall out and that’s when it gets scary.

I don’t know when this flashpoint will be reached.

I’ve been long in the money calls in commodity stocks (FCX) and heavy equipment manufacturers (CAT) into year end. Those positions are up very nicely. I still like the stocks, but I don’t want to be greedy. I am taking profits this week with the goal of being in cash by the end of the week. I will start 2011 with a clean slate and I suggest you do the same.

Is the writing on the wall?

It is widely known that empires who hold the global reserve currency are also normally net foreign creditors and net lenders. The British Empire declined—and the pound lost its status as the main global reserve currency—when Britain became a net debtor and a net borrower in World War II. Today, the United States is in a similar position. It is running a huge budget deficit and an even more huge trade deficit. We are currently relying on the kindness of restless foreign creditors who are starting to feel uneasy about accumulating even more dollar assets. The question is to where do they turn for a new global reserve, and when they do find somewhere else to go what will that mean for the US dollar? 

Investing is an Art not a Science

Here's a dirty little secret of Wall Street: Risk management isn't a science. Who exactly is this a secret to? To the professionals practicing it, and the innocent people who believe them. Wall Street blew itself up a couple of years ago with excessive risk and irresponsible leverage because practitioners and their “quants” either didn’t know or didn’t care about this secret. And Main Street paid the price, and part of the tab.

As the dust still settles from the subprime mortgage crisis, maybe most of us now accept that risk management isn’t a science. But we’re no better off today than we were two years ago just because Wall Street somehow totally revamped its models. Things are stable and growing again because Washington provided a “get out of jail free” card, and some pocket money, to Wall Street.

So, why does it matter that “risk management isn’t a science”? Because those who act like it is can get in lots of trouble with their capital … and yours. And we had lots of warnings before 2007 that this was true. The best example was 1998’s blowup of quantitative hedge fund Long Term Capital Management (LTCM for short).

Myron Scholes, a Nobel Prize-winning financial theorist, was a partner in LTCM. Along with his equally quantitative partners, he made sizable leveraged bets on interest rates in the late 1990s that got creamed when Russia defaulted on some debt and devalued the ruble, sending shockwaves through global markets.

The Federal Reserve decided to bail out Long Term Capital Management to the tune of about $3.5 billion because it believed that not paying LTCM’s derivatives obligations would create “big” losses for too many Wall Street firms. How ironic that the phrase “too big to fail” may have originated with this now-tiny fund collapse. Roger Lowenstein’s 2000 book on LTCM, When Genius Failed, chronicles the missteps in strategy and risk management that brought the fund to its knees.  Moral hazard is a dangerous business. Perhaps because the Fed bailed out LTMC this led others to believing the Fed would do the same for them, but thats a different subject for a different day.

Now before anyone thinks I am completely discrediting volatility as a risk management and trading tool, let me clarify where it is useful and powerful. In options trading, you need a baseline for comparing the perceived risk of positions. It works for options because you are dealing with two elements where the variability of inputs is strictly limited.

First, you are valuing options and their risk on one security. Second, you are doing so to a specific forward date, usually less than one year. Mortgage-backed securities were infinitely more complex than this. By reducing the complexity of your risk analysis, you quickly make volatility a more useful measure.

But option traders don’t pretend they are doing science here. They know it’s still all about probability and that conditions change constantly. They go beyond recognizing that today’s implied volatility number is still only a 68% chance "guesstimate" at what is likely to happen. And they know that this is not a poker game with finite outcomes. When a company or market event elevates the risk measurement (implied volatility) by a factor of two in one day, they take it in stride -- because they never promised themselves or others with massive bets that it couldn’t happen.

There’s hope for Wall Street to learn to use financial modeling and quantitative strategies for good, as long as we learn from our mistakes and don’t let ourselves become seduced by the latest equation from a math whiz promising great returns with low risk. Probably the best teachers here will not be the universities, but the firms that survived the crisis with better, more robust models that took all the money from the illusionists and fools. 

Asset Bubbles Presentation

     The recent world wide recession has focused attention on the role of asset price bubbles and what, if anything, policymakers should do to stem their effect on the global economic landscape.  The boom in home prices around the world from 2000 to 2006 is our most recent bubble bursting episode. House prices rose far more than the underlying fundamental drivers of home prices such as family income and rents. The bursting of the bubble then lead to a sharp rise in international foreclosures and massive declines in the values of mortgage backed securities which then lead to a broader sell off in most every asset class as investors rushed to safety. The collapse in prices led to the weakening, and in some cases, the collapse of major financial institutions around the world. All of this has led to one of the most serious recessions in the entire post World War II period. 


Here are my slides for my presentation Asset Bubbles