Monday, September 29, 2008

Expect Unintended Consequences From This Weekend

I am writing this on the weekend that various members of the U.S. Congress and their staffs (working with, and/or against, members of the outgoing administration) prepare a bill that would mandate the use of taxpayer funds to rescue our economy, and to a large extent the global economy from various governments’ past mistakes. The noisy minority of the public is clamoring for the scalps of the perpetrators. While Congress, for the most part, gives lip service to the crowd around the guillotine, they don’t want the blame game to gain momentum.

The truth is one of the biggest contributors to our current market-clogging problem is the government. This guilt does not stem from government’s malevolence to those who are trying to earn capital. The mistake made by these good people is that they did not fully contemplate the laws of unintended consequences.

The difference is that the government has so much power, few can be heard questioning its wisdom. History has shown however, that leaving economic issues for the most part to the private sector, produces fewer mistakes. These mistakes are often then corrected through the brutal, competitive system.

“Good” efforts by government powers has often led to bad results for our society. Some examples are:

Support for first time home buyers
Result: Questionable qualifications for social purposes.

The repeal of two sections of the Glass-Steagall Act
Result: The recombination of two very different cultures, compensation approaches and regulatory setups for clients.

Trading in pennies
Result: Much less expensive for large traders to take advantage of retail customers who have left the daily market.

The practical destruction of the specialist system
Result: Specialists are needed to support two-way markets during periods of stress.

Fair Value Pricing
Result: Only individuals can now buy without an immediate write down in declining markets.

Restricting Short Sales
Result: A curtailment of early identification of trouble and future required buyers

Whatever comes out of this weekend’s negotiations, if anything, will create its own mischief. These new constraints on the market place functioning is a further devaluation of the old trading (tactile) manuals on how to survive and profit from other people’s transactions.

There are at least two, somewhat related events that encourage optimism. First is Warren Buffet’s purchases of stock in Goldman Sachs on very favorable terms not available to others. In addition, his lock, stock and barrel purchase of Chesapeake Energy at a very depressed price due to rumors as to its solvency, is positive. (Point of disclosure- our hedge fund and I, personally have been long time holders of Berkshire Hathaway stock.)

The second event of note is that the stock prices of Financials, beaten-down as a group during the turmoil in September, continue to trade above their July or earlier lows.

Long-term strategic buyers should use this period to slowly begin additional buy programs and to be prepared that the lack of historic trading practices may give the investor even more favorable prices, interspersed with extremely sharp price spikes as the natural sellers into a rally are reduced in number.

> Sunday Morning Post Script (1)
5:30 am – Reactions to the announcement of the Agreement in Principle on what the press insists on calling “The Bailout Plan”
1. Making a dangerous assumption that the announcement is accurate, my first reaction was the plan would be viewed as highly inflationary.
2. My second reaction is that no matter who heads the next administration and more importantly the make up of the U.S. Senate, we are looking at higher taxes at the Federal level and for many states as well.

>Sunday Morning Post Script (2):
10:30 am - My reactions after some sleep and a brief look at the “talking heads” on cable.
1. Until we see the actual details of the law and the regulations, we do not know the size of the problem; thus we are reacting to shadows without knowing how far the silhouette is from the candle.
2. The plan recognizes the major issue is not credit which is weak in many places, but liquidity which is almost non-existent. The “brilliance” of the plan is that it is creating a low quality Treasury window. For some, the mere existence of this window may mean that private liquidity will come back - knowing that if necessary the questionable assets can be sold to the Treasury.
3. Wall Street/Bank equity owners do not benefit from this liquidity plan directly, the main beneficiaries will be those seeking credit which are beyond the financial community.
4. Congress is lousy at communicating to the public and this increases the likelihood of a more powerful than usual “law of unintended consequences”.
5. In some ways because of point 4, we are lucky that the plan did not address Paulson’s pleas for a clearinghouse for derivatives, which is a larger problem.
6. I expect a significant relief rally for stock prices because the absence of new short sellers and the destruction of the NYSE specialist system.
7. New tactical trading plays will evolve quickly, while longer term strategies will evolve more slowly. The need for liquidity reserves will grow.

Sunday, September 21, 2008

Keep Your View Long Term

Last week we saw the government outline in sketchy detail a massive financial support package for the ailing US economy. Some have questioned why it took so long to come to the rescue. Critics don’t understand either the complexity of the problem or how Washington works. In order to get both Congressional leaders and foreign dollar buyers to accept these moves as the complete solution, the apparent size of the problem had to appear to shrink. Neither group will be able to grasp the full situation before the program begins to unravel. While the economic problem is housing prices, the financial problem is much bigger.

The timing and the positioning of these events were dictated by the political season. Let's hope that the smoke and mirrors work until the next administration is sworn in.

In all of the chatter about solutions, both the Treasury and the Fed pushed for the creation of a clearinghouse for derivatives. The notional value of all derivatives outstanding in the US markets is in the hundreds of trillion dollar range. (Where is Carl Sagan when we need him to go the next higher level?)

We are not only unclear about the absolute size of this liability, but also the identity of the owners, as most of these trades are private or over-the-counter.

A simple mortgage packaged as a structured note can be briefly owned by ten different entities, each of whom has hedged their perceived risks through the use of derivatives of different natures and maturities. In some cases the participants in the derivative trade have had each other as a counterparty on other trades and thus have reduced their net risk. However the market does not know the net amount that is owed to which party and when. If there is a central clearinghouse, the marketplace would be aware every moment in time which player had a debit or credit balance.

Until we can size the problem we don’t know large the needed potential bailout needs to be. At this time I am guessing it to be over one trillion dollars.

When the global markets learn more about the approved bailout program and its impact on perceived inflation, we should monitor the rates that central banks around the world sell their gold reserves. If they slow down further, watch out.

For Us the correct short term investment strategy now remains elusive. No matter who manages to get the control of the Senate, (which is what is really important in the November election), the next four years may not be very satisfying. The stage could be set however, along with other developments for real global growth which will carry us forward.

If you are a long term investor as an individual or as a fiduciary for an institution, I would recommend closely following the drama addressed above, but not to change fundamental investment strategy. My book, Money Wise, is for those who are looking to evolve their lifetime investment strategies and perhaps extend them to multiple generations.

We should not make our primary focus the markets even after the election, the end of year, the first term of the new administration or even the second term. Instead we should focus on periods of ten years or longer. In doing so, I submit the prospects for the prudent investor may well be better than any other time in our lifetime.

Saturday, September 13, 2008

The Need for Speculators

The US Congress will soon be dealing with a report that allegedly points the finger at “speculators” being a principal cause in the run up in the price of oil. For Congress that means gasoline at the corner service station. In a knee-jerk reaction there will be a call to ban or curtail the activities of these devils even though the report does not conclude that speculators were the cause for the run up in gasoline prices.

Before condemning such a move by the Congress, I believe one should understand the essential difference between an investor and a speculator. An investor (perhaps this person should be called a historian) is comfortable projecting the future from an examination of the past. One might call such a person is a trend follower. As human behavior and weather cycles have not changed much for hundreds of years, the odds of a continuation of past trends are a good, but not perfect, guide to the future.

A speculator is someone that believes that the current time is different in some important respect such as product, people, or prices. The ultimate question for any market participant is who is going to buy (sell) this security when the current price has too much risk built-in?

Most investors are governed by their internal price disciplines. Often when one investor is worried that a price is overly generous or overly depressed they need to find a market participant who sees things differently. Thus after considerable upward momentum the investor needs to find a speculator who believes “this time” it is going to be different, and thus is a buyer of the investor’s securities.

In the same fashion, after a sustained decline an investor searches for a speculator who believes that the “normal” cyclical bounce will not follow, and that prices will continue to decline. In my examples the investor wins over the speculator, which is not always the case in practice. The speculator must win enough to be enticed into the game or they won’t play. That is why waves of speculation are dispersed in history to allow for new participants to follow their speculative urges.

Our sympathy is for our readers and clients who are long-term investors. We all need speculators to provide generous exits and cheap entry points. From a national policy perspective, speculation provides the grease that encourages markets to be efficient and aids in price discovery by often providing the other side of the trade.

Sunday, September 7, 2008

Thursdays Down, Fridays Up

Another Friday gain led by the financials after a Thursday decline again led by the financials. This is now a regular pattern at least in the late summer. This pattern may have no long term meaning, but I think it could be sending a number of messages. First, we are in a period of low volume mostly driven by prop desks and their kissing cousins, the trading variety of hedge funds. With very little capital in the hands of specialists and other floor traders, few are taking the other side of any momentum. The significance of this is that under these conditions the market will appear to be more volatile, but volatility with low volume is not likely to be of significance. What may be significant in the rise in prices for financial service securities (stocks, bonds, CDOs) is that traders do not want to be caught with short positions when a Sunday night merger or acquisition is announced before trading begins Sunday evening in the Far East or Europe in the early morning. This fear of the traders may also be affecting the run of the week pricing for selective issues such as Lehman, etc.

The significance to these patterns for the long term investor is this is not your grandfather’s market. Many of the tried and true techniques of the past just won’t work the same way in the current market. Perhaps long term investors should use a +/- 5% box around the current price and only look for significance when a price breaks out of this volatility prison. That way the investor is distinct from the trader and will not lose his focus on long term results.