Pot pouri 24 May 2006

With time getting difficult, I'll just note these items:

Black boxes: With so many hedge funds operating from black box models, and air disaster forensic people only using black boxes to try to understand after the fact how a crash occurred, I was a bit relieved to hear that the hedge fund industry poses no serious risk to financial stability. ANALYSIS-Could a hedge fund collapse shake financial stability?

Bird Flu: It appears to this uninformed person that the chances of finding an occurrence of human to human bird flu in these circumstances to be remote, notwithstanding that the mere possibility of it happening is being blamed for some of the caution in Asian markets today. Maybe it's just a case of emerging market enthusiasm having flown the coop. Avian influenza – situation in Indonesia – update 14

Relatively speaking of interest rates: Barry Ritholtz has a rare guest appearance who points out it is not the nominal rate of interest that affects markets but the relative change in direction of rates: "Let me say this: It is not the absolute level of the rate of interest that matters to those who allocate capital, it is the relative rate of change."

Bulls and Bears: The Kirk Report was looking for a muscle reversal, but lost his mojo. At least his rumblings gave as much credibility to the bears as the bulls.

John Hussman, who told us how to make money in stocks by getting out of the market, points out some factors that help to identify market tops and bottoms, some of which advise dovetails with the Barry Ritholtz guest post noted above:

Among the simplest truths is that market risk tends to be unusually rewarding when market valuations are low and interest rates are falling. For example, since 1950, the S&P 500 has enjoyed total returns averaging 33.18% annually during periods when the S&P 500 price/peak earnings ratio was below 15 and both 3-month T-bill yields and 10-year Treasury yields were below their levels of 6 months earlier. Needless to say, there are a variety of ways to refine this result based on the quality of other market internals, but it's a very useful fact in itself.

Similarly, market risk tends to be poorly rewarded when market valuations are rich and interest rates are rising. Since 1950, the S&P 500 has achieved total returns averaging just 3.50% annually during periods when the S&P 500 price/peak earnings ratio was above 15 and both 3-month T-bill yields and 10-year Treasury yields were above their levels of 6 months earlier.

It doesn't help the case for stocks to argue that, for example, earnings growth is still positive, because it turns out that the year-to-year correlation between stock returns and earnings growth is almost exactly zero. It doesn't help to argue that consumer confidence is still high, because consumer confidence is actually a contrary indicator, as are capacity utilization, the ISM figures, and other factors being used for bullish fodder. It doesn't help to argue that the Fed will stop tightening soon, because the end of a tightening cycle has historically been followed by below-average returns for about 18 months. It doesn't help that 10-year bond yields are still lower than the prospective operating earnings yield on the S&P 500 (the “Fed Model”), not only because the model is built on an omitted variables bias (see the August 22 2005 comment), but also because the model statistically underperforms a simpler rule that says “get in when stock yields are high and interest rates are falling, and get out when the reverse is true.”

Once stocks are richly valued, then, the burden of proof is on the case for staying in, not getting out (or in our case, hedging). Once interest rates are rising, that burden of proof ticks up. Once internals show “heavy” price/volume behavior, more burden. And once you get a huge leadership reversal, as we've seen over the past week, it's time to watch for falling rocks.

The Citigroup/ASIC inquiry: The story so far. The Citigroup rebuttal.