Oct

5

Black To me the biggest assumption about financial markets is that history will repeat. The second biggest assumption is that the Great Depression won't.

At least in terms of volatility, it looks like we are going to test both these assumptions soon.

VXO is recently over 50, which has occurred infrequently since inception in 1986. But this is a short time when studying mass-extinctions, so to study volatility over longer periods I used DJIA daily returns 1928-present, and for every non-overlapping 10 day period I calculated the STDEV. This chart shows the recent 10 day/daily STDEV is >3%, which occurred recently only in 1997, 1998, and 2001. Prior to this, all the instances were in the 1920s and 30s.

Mark Isbic writes:

Today here in Israel, the mother of all swans started with the TA 25 and 100 down 7% and the Tel Tech down over 11%. If this is any indication, tomorrow will be very ugly unfortunately. I say to myself it will be a great time to jump in. Unfortunately I have been doing this for several months and have taken a beating!

Jason Shapiro remarks:

Anybody see the Bloomberg story about how current financial conditions are a black swan event? Statistically they say this is rarer than a comet's destroying the earth. And the data they used go all the way back to 1993!

May

7

When I worked in Hong Kong from 1990-1995 I witnessed first hand the great emerging market bubble of the early 1990s. At the time, paying any price for anything that had exposure to China, India, Russia or Brazil was OK, because the present value of the money everyone was going to make from four billion new consumers the world over was an almost incalculable figure. Alas, we all found out that it was going to take more than six months to set up shop in China and India to manufacture and sell our widgets to all of these eager new consumers, and the frenzy died down.

We are now about 15 years down the road. The economic progress in China over the past 15 years is something the world has most likely never seen. India, which Jim Rogers always accurately pointed out was a complete mess, has completely overhauled its cities, transportation systems, and infrastructure. Capitalism has taken hold and goods and services are exchanging hands at a ferocious rate.

Despite this being arguably the most robust economic time in the history of our planet, sitting at my desk listening to market pundits and looking at my favorite sentiment indicators, all I seem to find is global equity bearishness. The Commitment of Traders report released yesterday shows a net short position for speculators in the S&P 500 futures for the first time since November 2005. On Bloomberg, look at AAIIBEAR Index AAIIBULL Index HS which shows the spread between bears and bulls to be heavily weighted to the bear side right now, even as market indices approach or break through all time high levels. It is a common for these indicators to be so skewed, but only after market declines, not at new highs.

In asking myself why, I think back to a passage from EdSpec describing the experiences of Victor's relatives after the crash of 1929 when they lost quite a bit of money. It seemed that even more disastrous to them than the money they lost was the opportunity they missed over the next 50 so years because every time the market rallied they wanted to sell so as not to get caught up in the next crash, With the memories of the Internet bubble and subsequent crash still fresh the latest batch of Wall St. participants, its seems likely that this same psychology is what is dominating the scene right now.

Mar

23

Nothing bad ever happens.

The lesson finally being learned by participants in the financial markets is that even though there may be short-term problems, in the end everything will be OK. We constantly hear talk of recession, depression, inflation, deflation, and stagflation, but in the end none of them really happen and everything ends up OK. Then there are the Asian crisis, LTCM blow up, Internet bubble, terrorist attacks in New York City, and oil prices rising seven fold. In the end everything ends up OK. As for the current favorite crisis of pundits, that there is a housing bubble that was fueled by sub prime loans, I can really only say one thing. Don't worry. In the end everything will end up OK.

I think there are a few reasons for this, outside of the easy argument that America is the freest land in the world and therefore the spirit of the free human being will rise up to conquer all problems put in front of it.

First is central banking. This is a relatively new phenomenon in the world, and took 70 or so years to figure out. But since Mr. Volker stepped up the Federal Reserve has basically come to understand what needs to be done to keep the financial peace in times of crises. The '87 crash, the S&L crash, the devaluation of the dollar, a huge deficit, and an Internet bubble are just a few of the things the central bank has seen come and go and yet managed to help make sure in the end everything was OK.

Despite all this, I constantly am reading research from highly paid economic consultants criticizing the Fed and laying out how the latest Fed plan is doomed to send us all back to a farming economy. This has been a main theme since I started in this business 18 years ago. But over that time there has really only been one constant, that the Fed didn't mess up and in the end everything was really OK. The most contrarian trade you could have made over that entire time was to say, no, I think the Fed knows what it's doing and I'm going to stay long the United States of America and buy any dip I can get my hands on. This trade has worked pretty well.

My second argument has to do with the hero aspect. Nobody makes a name for himself in Wall St or any other street by claiming the status quo is OK. One must make an outlier claim and have it come true in order to move up in the mass respect line and increase one's bonus. For the S&P trader, there is nothing like making money on the short side since you get to strut around happy that you made a lot of money on a day the headlines are riddled with how much wealth was erased from the market that day. I've yet to hear anyone proclaim that they were so long here that it's coming out of their ears, yet it seems I hear that about being short on a weekly basis.

This is one of the reasons the markets do not follow through on the downside very long. Everybody wants to be the hero and as soon as there is any break in the market, they are all very short very quickly. There is a reason Dr. Mark Faber's Boom Doom and Gloom report still has subscribers and its writer is invited to every investing conference and is included in the annual Barrons round table discussion despite the fact that he has been bearish on the Hang Send Index since about the 6000 level in 1993. People love the hero mode, even if it doesn't work.

Now, let's think about the implications of this theory for the stock market. If the stock market is a current valuation of the discounted cash flows going out to just about infinity, then why would anyone ever sell? Certainly there will be blips along the way in terms of economic growth and the like, but if all is going to be OK in the end, then aren't these future cash flows on a constantly upward path? And if it's these total cash flows and not just some short term ones that are being discounted, then why ever sell?

The market has learned this over the past 25 or so years now, which helps explain why the stock market goes on record tears of X straight up months without an X% correction. The world has come to understand the reality.

For those contrarians out there, this writing should be the best thing you have ever read. You can now conclude that if the world has discounted the fact that everything will always be OK and therefore the market will never go down, then there is a lot of danger ahead. If no long term risk is being discounted into the market, then certainly there is a huge risk/reward in the favor of betting on that very downside. To this I say yes, be short S&P. I know I am. Because I can see very clearly that the credit bubble the Fed engineered in order to combat the undoing of the late 90s stock market bubble is now going to come back to haunt them as housing prices fall 50%. And the Fed will have to cut rates to sustain growth despite the fact that inflation is picking up (See CRB RIND Index). Also, let's not forget that Niederhoffer and the rest of the greedy vol sellers need to see the vix go to 40 so they can all blow up again. On top of that the USA is losing its dominance in the world as China is emerging with cheaper, better, and hungrier capitalists to replace us. The question remains however, will my P&L be OK?

Nov

6

The key to success in just about any endeavor is to have a process that works over time, adjusting this process to changes in the environment, and not letting short term noise get in the way of the long term success. As a hedge fund manager this process gets clouded when we get paid quarterly, and get marked and overly scrutinized on a monthly basis. This has a tendency for the manger to get off the long-term track and do things like book a good month for marketing purposes or book a good quarter for incentive fee purposes. This may get in the way of the long-term success of the process, but it feels justified when short-term money is involved.

I believe a baseball hitter can go through this same psychology. A hitter may have a great swing, practice habits, and a coach that helps him make changes as necessary, and this process over 162 game season or even 1620 games over 10 years will lead to great success. This success of course says nothing about any individual one week or 10 game period of time. Come playoff time these long-term numbers get thrown out as the fans and media (the investors) want great performance when it counts most. The hitter is now in the same dilemma as the end of month hedge fund manager. He forgets the process and tightens us trying to ensure short-term success even though he may suffer a short-term setback in his long-term success. This thinking certainly affects the psych of the hitter and in fact makes matters worse than just the short-term randomness may indicate. I think this helps to explain the A-Rod scenario come playoff time as well as the performance difference in hedge funds.

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