Fickle Market Sentiments

Every time I think about posting I promise myself to focus on being "concise", and, I admit, every time I fail.  The markets always offer up news that needs to be interpreted, and each new event demands to be encapsulated within a theoretical framework.  Anyhow, without further disclaimers:

This is the last week in February, and it's hardly started, but does anyone remember the positive market sentiment that marked the first week this month?  I suppose that we should all become chartists and technical analysts and rise above the grimy world of headlines - leaving the world of sentiment driven investing to the masses, but, apart from attaining a Zen like state of mind, would it serve us better than striving to develop a robust theoretical framework based on fundamentals?

In the midst of the current market chop, it would be great to give some space to competing market analyses, and I would especially welcome commentary by advocates of technical analysis.  Right now, US Treasuries are trading up while oil is down - which makes perfect sense since the IMF just managed to convince everyone, again, that it's in a muddle when it comes to sorting out some type of effective European stability fund.  But, from a macro perspective this is not news, IMF inaction is a "given", what's important, for the Euro area, is greater stability on the back of existing pledges coming online via the ECB this summer.  From a global macro perspective, sell the Treasuries on spikes and buy oil on dips - what do the chartists dictate?

Current weakness in European equity markets fits the global macro view, so today's action makes senses, but what about the lower futures for the US markets?  Current US taxation legislation proposed by Obama has given participants cause for concern.  The US is the home of many competitive, truly international companies (not just outsourcing one-trick-ponies like Apple), whose prospects would suffer if current double taxation provisions were changed (one day the media will wake up to the fact that this is what the recent discussions are actually about).  It is almost certain that market participants will lose focus and forget about the importance of such proposed taxation changes, so, for the short/medium term - buy the dip!  Unless, of course your charts tell you otherwise.

To conclude, feel free to throw some technical trading interpretations into the comments section - or make your own post!

Old Tricks and Future Headlines

We have lived through an era of revolutionary change. Everything is different now than it used to be. Examples are too obvious and plentiful to mention, but how about these future headlines: “US a net exporter of oil”, “Chinese property investments sound”, “US housing market recovers”, “Euro soars past Greek default”, “social media transforms markets”, and “inflation is not a threat”.

First, we can't have all this good news without making the last headline a lie. But it's this headline which ultimately is a the rallying cry for all market bulls; we hear everyone say that, “inflation is not a threat” and monetary policy confirms that, at the very least, inflation is not the number one concern (even China is easing again – while everyone thought they were tightening in an attempt to control a monstrous property bubble). Decreasing reliance by the US on foreign oil supplies will be held to support the low inflation argument, but the other headlines surely imply an inflow of funds into markets, the accounts of companies, and pockets of consumers, so, inflation is coming – watch out!

Not so fast, let's have a look at the likelihood of these headlines, and current assumptions and misconceptions. Is the US really going to be a net exporter of oil? The quick answer is no, in the last few years the US has decreased its oil consumption while increasing both gas and oil production. It's largely “new” cheap gas which has helped control the price of WTI, created banner years for the pipeline partnerships, and, combined with a weak economy, lowered the demand for oil. But, gassification is far from cheap, and a moderate rebound in the US economy will show everyone that the US is still very much addicted to oil, and confirm that the US is not going to be a net exporter.

Apparently, the Chinese government has decided to act with reckless abandon and puff up the property bubble even more. The official rationale presented for lowering bank margins goes along the lines that, since the bubble has not burst for a couple of years, there was no bubble to begin with. This rationale is pretty simple to follow, and, remember, we are living in an era of revolutionary change, and it's almost impossible to think of anything more revolutionary than the rapid rise of Chinese economic power combined with a rapidly liberalizing domestic market. While it's tempting to accept this argument and conclude that there's no property bubble, there's another way to look at the lowering of margin requirements in China – what if the Chinese banks are under pressure because their loan portfolios aren't performing? As property developers and buyers default, the banks only have two options, either carry the properties or sell them. The Chinese government is still facing the Herculean task of controlling the bubble, and decreasing margins will make it possible for the banks to not burst the bubble by flooding the market.

As we conclude that the Chinese property market is being doctored to prevent an implosion, perhaps it's natural to have a look at how the US market has fared after “operation twist”. Bernanke is used to being charged with being ineffectual when it comes to fixing the US housing market, but now there are signs of life in the US housing sector – could this be due to the Fed skewing the yield curve in favor of mortgage borrowers? While it's not possible to pass a final verdict, the fact is that current long term yields are the same as right before the “twist”. Lately, market participants have linked the yield curve more to European issues than Fed policies. As to the US housing market, some high profile hedge funds that have been investing for the past couple of years are now coming out “talking their own positions” - which tells us that they've filled up with all the cheap housing they can afford and now are looking for the rest of us to give them a profit. When you're a star fund manager this usually works, at least in the short run, and it sure looks like there's a causative relationship between some of these announcements/publicity and recent signs of life in housing market. Analyzing the situation on a different level, it seems there are added incentives for banks to allow “short sales” , this will lead to additional supply, but also additional demand, but on balance this is good for the housing market. Balancing this recent positive spin and increased liquidity, Ginnie, Fannie and Freddie are continuing to bundle foreclosed properties and attempting to sell them. In the end, these auctions combined with increasing short sales are all going to show up on the US tax payers' bills, but in the short run, yes, the housing market looks set to head up.

Talking about fixating on short term solutions and kicking the can down the road, Greece surrendered its sovereignty and was rewarded by another bailout. To talk about “'default” at this stage is very passe and best left for mainstream media – who in their right mind compares a 70% or more write-off to a “haircut” – imagine yourself 70% shorter than you are today, even sporting a 1970's afro wouldn't save your life! Anyhow, will the financial markets experience any more convulsions resulting from this Greek tragedy, and, specifically, will the Euro retain its valuation? Yes, there will be more convulsions, and, no, the Euro won't retain its valuation. The bond offerings by the rest of the PIIGS will now be even less attractive, leading to increased demands on the ECB which will directly result in Germany, and whichever other Euro area countries economists imagine might be fundamentally creditworthy, to provide more funds and bigger guarantees. The events unfolding are leading to a federal Europe, and Greece's surrender of sovereignty will prove the model. The EU is on its way to a unified tax code (pleasing the single market/level playing field adherents) – in the end, as the PIIGS agree to centralization and oversight, German rejection of the “European bond” will seem unfounded, after all, German demands are being met and these countries are no longer in control of their own economies. Anyone thinking that this may be a pyrrhic victory, as the creditworthiness of Germany et al is diluted, may be partially correct, but Germany would be much worse off with low interest rates, a strong Euro and crippled neighbors. Kicking the can down the road has been very costly, but considering the price paid by Greece, and everyone else in the Euro area, there's little chance that the can won't one day end up scoring a goal for the federalists.

Our last headline, will social media save the world? Without offering an argument for or against, here's our nominated indicator, NASDAQ:GSVC at $16 and change, after spiking above $20 after Facebook announced its IPO filing. Also, the company has done another secondary at $15 – which is roughly the same price as its IPO last April. Conclusion: institutional investors are hopeful, but, in a weak market, are able to drive a bargain. When it comes to social media, it's easy to agree that “hope” is nice but not a good guide.

Since the February 6 post calling for market consolidation, the Dow has added about a hundred points, the Footsie a little less, and the All Ordinaries are flat, while the Nikkei is up 600 points and the Hang Seng is up an impressive 800 points. Along the way there have been consolidations and the outlook is for a bullish continuation as fund managers buy the dips in an attempt to catch up to the markets, all the while shouting for all to hear that inflation is not a threat.   

The Real Fundamental (Rant Alert)

Whatever your strategy and however you analyze opportunities, nothing is more important than position management.  Whether you prefer to think of this in terms of risk management, money management, or some slavish compliance with an asset allocation model imbedded in an obscure black box, doesn't matter - in the end, it's all about position management.

Thankfully, for most of us it's hard to come up with a series of real day-to-day risks negatvely impacting our ability to manage our positions.  Robust markets pride themselves on providing liquidity and managing counter party risks, and participants quickly flee issues, markets and counter parties that don't perform.  Fundamentally, if these risks can't be managed we can't place our bets.

Now, how many of us have scrutinized our contracts with the clearing houses and examined all the exceptional provisions, and exclusions?  Thought so.  Well, as a public service I'd like to draw your attention to the fact that the US SEC specifically prevents the punishment of lenders facilitating short positions who decide not to perform.  This "held harmless" clause results in all short sales surviving at the mercy of counter parties who've been given the right, by the relevant regulators, to manipulate the market.  If we examine the situation we'll quickly see how broken the system is:

1. you borrow from someone who's long and wants a bit of fee income,
2. you effect strategies based on your short position,
3. your clearing bank earns commissions all the way around,
4. the lender decides to pump up demand and, in effect, announces that all borrowers are subject to a buy in,
5. buy ins occur at the opening of the market the next day,
6. following the buy ins everyone is exposed on their hedges and the markets experience a huge "unwind" manufactured by a few longs.

Not being able to hold your clearer to an obligation, for which you're paying and prepared to keep paying, because any and all regulatory provisions trump normal business practice (in this case with an "held harmless" clause), incentivizes market manipulation and makes even the most fundamental position management involving short positions an unreasonable challenge.  To conclude, I suppose it's now "incumbent upon us" to add the manipulated short squeeze to the margin short squeeze plays.

As an addendum, the short I was denied was in long term US Treasuries via NYSE:TLT; the hedge was a rolling short 2-3 month put.  This was a core position which I'd maintained to profit from option premiums while also earning a little from a decline in long term Treasuries.  With the disappearance of the short position I had to cover the puts.  This coming week we'll get to see the full effect of this manipulated short squeeze (which started Friday morning) - the following week (Feb 20th), I'll likely re-establish this position.  If I'm handed mark-to-market returns again then I'll have to flee from this manipulated ETF issue and seek solace in shorting the underlying.

Reconciling Irreconcilable Differences: Printing Presses and Inflation

Intentionally, the title of this post brings to mind the challenges of a marriage on the brink of divorce.  The marriage, in this instance, is the one between the "Money Supply" and "Low Inflation Environment".   In dark corners of the market, persistent rumors can still be heard about how this couple have some serious issues...

Before pointing to the empirical evidence and simply dismissing the rumors, try to recollect the hordes of inflationistas, when Bernanke first pressed the green button, screaming that crippling inflation was "right around the corner."  Fine, now that the inflationistas have been deprived of media coverage and are standing on shabby soap boxes in dark forgotten corners of the market, perhaps it's time to revisit their argument, incorporate the new data, and proceed to demolish their flawed theories and declare the marriage of MS and LIE a blessed union.

First, acceptance of basic economic theory would make inflationistas out of all of us.  It's obvious, if more money is around, then people will be able to spend more.  Equally obvious is the fact that as people have the capacity to spend more, both the demand and prices for goods and services increase, which, obviously, means we'll end up with inflation.  In turn, central banks wake up and crank up rates to control everyone's profligate spending.  It would be fair to say that pre-2008 economists would, as an aside, throw in a few caveats, they might talk about  "increased productivity", "velocity", and "liquidity" - they might even talk about how hard it is to actually quantify the various forms of money supply, but it's not credible to claim that anyone would have called for low inflation year after year even as the presses run short of paper.  How unimaginable the current situation is, is clearly demonstrated by the round of higher rates imposed by central banks after the first round of easing - to combat the "inevitable" threat of inflation.  

So, what went wrong with the inflation theory, or, from the perspective of the MS and LIE union, what went right?  The consensus is that the "caveats" grabbed their chance of stardom and stepped into the spotlight: in China, Apple have indeed made some new stuff which translates into "increased productivity" (if we look really hard we may find other examples of increased productivity too); and money really did not go very far or fast despite the red hot printing presses, emergency central bank and interbank facilities.  Basel, in its various national incarnations crippled leverage and transformed banks from conduits into sponges, and, by the way, since your company is not Apple and able to point to "increased productivity", you can't, under any circumstances, borrow any of the money.  Economists can now declare victory, pointing to the combined impact of decreased velocity and a liquidity trap of truly historical proportions.  This victory preserves MS and LIE while burying the inflationistas and their simplistic theory in a grave simply marked, "Beware the Caveats".

Now for something completely different, how about we decide to forget about the inflationistas, economists, and central banks - let's walk into the nearest public drinking establishment and try to convince people to invest.  OK, this might not be very professional, but in terms of discovering what people think about investing its better than listening to the news or economists - remember, these fellow drinkers are your primary sources, and if you listen they'll tell you what they think (sometimes they won't stop... but that's another issue).  At the end of the night, or several nights (depending on the value you place on your liver versus statistical significance), you might conclude that people are more afraid than greedy.  

If the markets are driven by supply and demand, fear and greed, and if the average person has somehow managed to influence politicians, regulators and investment managers - then the lack of market speculation can solely be attributed to "fear".  People don't want to lose again, and they've learned that no one is to be trusted.  Markets suffer as pension plans become defensive, and money is withdrawn and more sensibly spent at the bar.  Of course, there are indicators that deal with consumer sentiment, but they are statistics (remember, we've learned that no one is to be trusted).  

So what is the conclusion?  Well, the MS and LIE relationship clearly shows us the power of the basic market components, fear and greed.  The inflationistas were wrong simply because people were afraid and stopped spending and gambling (the economic theory caveats played second fiddle).  No doubt, experts, especially economists and media pundits, will turn away from this Occam's Razor inspired explanation and come up with more complex stories, or seek to incorporate this fear into some complex economic theory, but there really is no need for complexity when there's a perfectly good common sense explanation.

And, by the way, irreconcilable differences do lead to divorce.  When inertia ceases to define the trend we'll move in a new direction, and the LIE will cease to be and MS will misbehave.  Now, let's do some research and attempt to predict a change in direction.

Option Reminder or Primer: Comments for the Week Ahead

Just a brief post to make a couple of obvious points - why bother you might ask?  First, what's obvious to some might not be to others - so feel free to debate the validity of the statements.  Second, it's always a good idea to have a look at the mile markers as you drive along... and this market has passed a few in the last month.

Global equity markets have rallied since the end of last year leaving many participants on the sidelines.  It's been notable that this has, on balance, been a low volume rally with commodities left behind while the materials sector (companies) have joined in the rally.  Low interest rates, increasing access to capital (both debt and equity, and M & A activity) could justify the divergence. 

Managers booking gains have found a strong market, and they have been incentivized to continue to hunt for bargains.  With a very average earnings season, bargains have become harder to find and the indexes stabilized towards the end of January, before continuing to trend upwards.  This latest move up is now showing signs of exhaustion with markets failing to string together daily gains.  While there are other signs of exhaustion it's worth noting that long term US government debt has recently traded down; also worth noting its very high volatility further supporting the "exhaustion argument".

Psychologically, bullish managers have been blessed with good performance this year, and an increasing IPO pipeline (leading to excitement, discounts and fees in all the "right" places), but now they are faced with having to "pay up" to maintain their market exposures - which quickly leads to a feeling of "chasing the market".  To conclude this brief market analysis, a contrarian perspective can account for the flattening of the short term trend at the end of January, while basic human greed probably accounts for last week's continuing moves higher (as managers started to worry more about "missing out" than "chasing the market").

So, we're overbought again!  Getting all the indicators to tell us that we're overbought and still seeing markets trend higher is a sign of a bull market, but the highest probability trade now is consolidation.  Reflecting on the nature of secular bear markets, it's also a good idea to keep in mind that while we take the "stairs" up we like taking the "elevator" down!

Now for the options' reminder/primer.  Consider selecting issues that have shown solid strength, but which are not - under any circumstances - takeover candidates.  Sell a straddle (put and option) for a combined premium that gives a nice technical entry price for the underlying.  Technicals for most issues should now provide good short term support in a deteriorating market, and global headline risks ought to prevent an outright bull rush.  It may be tempting to have a look at ETFs (mostly to develop strategic industry/sector/country exposure while avoiding the risk of being bankrupted by a takeover), but please view ETF technicals with a high degree of scepticism.

Perspective

Grand prognostications are always problematic, but the November issue of Scientific American had an article by David H Freedman, A Formula for Economic Calamity, which, inadvertently, highlighted some critical problems with basic analysis. To summarize, the article contends that the 2008 crash was largely brought about by inadequate mathematical models which failed to correctly assess market risks and protect participants.  Specifically, current models are both insufficiently sophisticated and missing relevant data. Considering the source of the article, Scientific American, it's acceptable that there's a “science can fix it" bent to the argument, but the most important lesson to take away from the article is that Freedman, and probably the vast majority of readers, clearly view the financial markets as a natural ecosystem and expect science to one day find the correct model. 


Financial markets are always being compared to “nature”, and the attempt to transpose robust scientific models to the field of financial analysis is a temptation that neither Goldman Sachs or regulators are able to ignore. Fundamental to this quest is an implicit acceptance that the markets are “natural”.   As is pointed out in the article, it may be that the data available to us is insufficient and current models aren't up to the task; this leaves us with the assumption that one day we'll have all the data and a model capable of handling the task.

Critics of financial modeling, black box trading algorithms, and even the dismal science of economics, tend to unite in announcing that the quantity and complexity of the data will always surpass our ability to both gather the relevant data and arrive at robust models capable of accurate predictions. With economies and markets booming and busting, hedge funds imploding, bank bailouts, and a slew of other unpredicted events occurring on a daily basis, the anecdotal evidence obviously seems to support the view of the critics. And, even the most ardent believer, has to accept that we currently live in a world without access to the right formula.

It would be easy to join the critics and conclude that the only defensible perspective is that markets are unpredictable and nothing can be modeled, yet this is simply an excuse to stop thinking and analyzing data.  Also, active participants recognize that there are models which work dependent on “market conditions”.  Concluding that we're having a bull run in a secular bear market turns high P/E ratios into red flags for fundamental analysts. If market conditions change, and the most widely held view is that we're in a bull market, then the same analysts will largely ignore P/E and look at other indicators – perhaps revenue growth and market share become the new favorites. Technical analysts are happy to accept that a chart formation in one type of market is a sell signal, while the same signal in a different market, or perhaps just a different security, can be a buy signal. To market participants it's clear: the nature of markets and securities dictates which models are useful/correct, and it's futile to apply one grand unifying model and attempt to reconcile these differences. As we have witnessed: it's no good to say that book values of 1:1 makes for safe investing; it's no good to say that when volatility increases the markets are about to correct (up or down); and “broken” correlations shout out that markets and asset classes don't have the cozy causative relationships we wish they had.

So, back to the Scientific American article, the belief that the markets are a natural system and that it is worthwhile pursuing a “correct” model is the main problem. Clearly, markets trade based on the actions of its participants, and market participants (whether they are central banks or day traders) act in accordance with their chosen models – so let's adopt a fresh perspective. Let's forget about attempting to develop a master theory that allows us to model all financial markets.  Let's turn our analysis up-side-down and assess which models are in the ascendancy and predict where these models will lead the markets. Let's maintain that the fluctuations of financial markets are not the behavior of natural ecosystems, but, merely, natural outcomes of the dictates of fit (from an evolutionary stand point – remember, we're trying to “borrow” from hard science here) financial models (which exist in an ecosystem of ideas attempting to gain supremacy and followers).  Models rule – markets follow.

An easy example: in a world where generally accepted models tell us Japanese government debt is a safe haven investment, this prediction leads to high demand and the models are “correct”, but in a world where our models tell us that Japan is hopelessly indebted and in risk of default – capital flees, and Japanese debt becomes junk. 

Interlude

Global equity markets have risen dramatically these last couple of months and many active fund managers have already logged greater returns than they did all of last year. The markets have overcome the fear that decreased liquidity in China would collapse their speculative property markets and cause an economic implosion; ramifications of a troubled Euro zone, perhaps even a Greece in default, was “priced in” last October; US employment data continues to improve; central banks are telling us that interest rates will stay low forever; and, to top it all off, the imminent launch of Face Book, at an astronomical valuation, confirms that we're all ready to start huffing and puffing and inflating another internet bubble, AKA “social media”. So, are all conceivable negatives “priced in” and we're forced to participate in the social media bubble or forgo any chance of gain?

Surprisingly, there are a couple of “old school” indicators confirming that the markets are solidly in the ascendency: first, US and German government debt is trading at levels indicating that participants are already highly risk averse (supporting the argument that much risk capital is sitting on the sidelines); and during the last two months there has been a narrowing spread between German and other Euro area yields, indicating a greater degree of confidence in the peripheral economies. Before concluding that the markets are about to enter another “virtuous cycle” it's worth having a look at commodities, which have been left on the sidelines (and this includes gold) these past couple of months. The latest rounds of QE, and promises of more to come, might also change the way government spreads should be analyzed – after all, who has been instrumental in narrowing that spread?

Finally, there's a $100 million company called GSV Capital Corp (NASDAQ:GSVC) that might indicate the importance and fate of the new social media industry. This company has several non-listed sector investments; traded around $14 for the last half year and popped up to $18 once the Face Book IPO surfaced (now it's back to $17 and change). Seems logical to contend that if GSVC triumphs it will be because risk capital is flowing into the market – now, let's see if Treasuries and Bunds roll over and commodities trade up – confirming the advent of a new virtuous cycle and an end to the current market interlude.