CYNIC writ large

Guambat is occasionally cynical, but he doesn't know the first thing about cynicism. For that, look to David Weidner:

The bar is high for WikiLeaks shocking us about banks

the worst that comes is embarrassment and minor tension.

Wall Street isn’t the Vatican. There isn’t much of a reputation to diminish.

Sure, some documents may lead to investigations and denouncements. It may require bank CEOs to issue apologies.

But really, what can shock us now? Mortgage fraud? Government influence? Hiding bad assets? Affairs? Name-calling? Market manipulation? Influence peddling?

There is no more game in shaming when shamelessness is the new norm.

Be that as it may, with BofA the apparent shamee, Zero Hedge finds insanity if no shame:

Following Wikileaks Revelations, The Tricky Dick Rushes To The Rescue, Sees Bank of America Worth $21 In Bankruptcy This is certifiably one of those days when the insanity refuses to end. The latest laugh out loud episode come from the lunatic who has outstayed his "analytic" welcome by about 2 years following his Buy recommendation on a soon to be bankrupt Lehman Brothers (sorry Dick, nobody will ever let it go):

The Rochdale analyst, continues to reprise the role of the evil grandpa-in-law who just. refuses. to. leave. even though it is about 12 hours past his credibility-time, now sees Bank of America as worth $21 in bankruptcy [that's per share, vis 11$ now].

You really can't make this shit up.

To wit: from a very funny Dick:

"In death, this company would be worth 91% more than it is worth in life." You may laugh now.

It's all the same to me

Once upon a time, investing in the stock market involved choices, selections, discrimination. Buying a stock was like planning a vacation.

That was then. Now, it's all the same to me.

Now stock selection is Fast Money. And Lightening Rounds of Mad Money.

Now all markets are linked tighter than the threads in fine hotel-count sheets. Liquidity, and liquidity alone matters. The rising tide of liquidity has unloosed tsunami-defined market movements. Tsunamis are, after all, just liquidity events.

Now, it is a rather quaint idea to buy "a" stock. The stock pickers gave way to mutual funds, which gave way to WTF ETFs, and all of them are bound up in aggravating algorithms, whose main purpose is to make sure money runs with the pack.

Jason Zweig writes The Intelligent Investor every Saturday for The Wall Street Journal. A couple of his recent columns touch on this development.

Are ETFs a Menace—or Just Misunderstood?

A report released this week produced by researchers at the Kauffman Foundation, the Kansas City, Mo.-based institute that supports research on entrepreneurship, argues that ETFs are "radically changing the markets," raising the prospect of a "panic-driven market meltdown." ETFs are funds that hold all the securities in an index and themselves trade like a stock.

The proliferation of ETFs, the report contends, raises at least three worries. First, these funds have overconcentrated the ownership of thinly traded stocks. Second, they have led to an escalating number of trading failures. Third, ETFs could trigger another massive market swing like the May 6 "flash crash."

Let's start with concentration. According to the report, a single ETF, the iShares Russell 2000 Index Fund, is among the 10 largest holders of 1,737 stocks—many of which also are held by other iShares ETFs.

Yet ETFs aren't traditional mutual funds. At an ETF, the manager's job isn't to make judgments on single stocks, but merely to keep the portfolio as close to its index as possible. And, in contrast to a mutual fund, "no one stock represents a large portion of the typical ETF," says Gus Sauter, chief investment officer at Vanguard Group.

Since ETFs must buy the stocks in the index they track, regardless of price, it is legitimate to wonder whether values aren't getting out of whack as ETFs come to dominate the market.

Why Your Stock Portfolio Is Acting Like a Commodity Basket

In the past few years, many investors have concluded that commodities like oil, corn and gold offer independent returns that can diversify away the risks of stocks. But the correlations between stocks and commodities—the extent to which their prices move together—are in many cases the highest they have been in nearly 30 years.

This year, about 40% of the weekly movements in the S&P 500 index can be explained by weekly fluctuations in energy prices, says Michele Gambera, head of quantitative analysis at UBS Global Asset Management. That is twice the level of similarity over the past five years and roughly 20 times the level of the past two decades.

Some of the linkages between stocks and commodities are looking bizarre. This Thursday, the monthly correlation between sugar futures and the S&P 500 hit 67%, more than 10 times its level just six days earlier, says Howard Simons, strategist at Bianco Research. That is the third time this year that the linkage between sugar and stock prices surged above 60%—much higher than their long-term average of under 20%.

How on earth did sugar and stock prices get stuck together? Sugar, says Mr. Simons, is now both an "energy commodity" and a "growth story," since much of the Brazilian crop is used to produce ethanol. That gasoline additive is linked to crude-oil prices, which in turn are sensitive to monetary policy and global economic growth—the same factors driving stock prices.

Of course, correlation isn't causation; this could be a coincidence.

But there is another, less visible force at work, Mr. Simons says. Algorithmic trading programs, or "algos," automatically buy and sell a wide variety of assets based on mathematical models.

An algo doesn't know or care why two assets are moving together; it merely is programmed to recognize that they are doing so. As soon as a computer places bets that such a linkage in prices will persist, other traders—computers and humans alike—tend to take note and follow suit. That can be true, Mr. Simons says, whether or not a correlation is driven by fundamental economic factors.

"We've gotten to the Frankenstein point where algos are self-programming, and they evolve to chase these relationships," Mr. Simons says. "That's created a sheer wall of money that is forcing other people's behavior into the same pattern."

What's more, quantitative easing—the massive purchase of bonds by the Federal Reserve—and the global recovery have been bullish for just about every asset. But at past economic turning points, the correlation between stocks and commodities were lower than they are today.

For the foreseeable future, there will be plenty of periods in which diversification will seem to fail as tidal waves of money crash in and out of all assets at once.

As Guambat wrote back in 2006, just as stock markets began to go parabolic and then alcoholic,

A black box is not some fatcat in a pin-striped suit and a big cigar. It is a streak of cyberdata, a stateless, motherless virus hellbent to ambush, arbitrage and retreat faster than a ninja.

And they are everywhere, in to everything. Their bytes permeate every conceivable market, like a monstrous whale seiving the nutirients and little, bottom-of-the-food-chain investors and small players from the oceans of cash that trade the world's goods.

They derive their gains from diverse derivatives of incalculable numbers and varieties, trading the shadows of what used to be a currency or a commodity or a stock or a bond, but now come under the most obtuse and arcane of names that only financial rocket scientists can understand. Their trade is in ideas and concepts and notions and algorithms, not things and companies.

Back when stock picking became more treacherous, due in no small part to the huge and creative gaps in GAAP reporting, Enron accounting and Swiss bank/tax haven black holes, Guambat gave up stock picking and took up nose picking. Didn't make any more money, but didn't lose any, either.

Then, for reasons not really very well rationalized, Guambat got into trading the Australian stock market futures contract. It went well for a short while, but around about the time he wrote the words quoted above, he began to be overwhelmed with market moves that utterly made no sense to him, as tsunamis often take us by surprise.

So he's been beached for a while now, and with the regular tides now turning into a series of tsunamis, with tsunami sized ebbs and flows, he has no desire to go back in the water. It's just too treacherous, too rigged, and plays by games too fantastically contrived to offer the likes of Guambat any latitude for entertainment, let alone success.

If Las Vegas treated its gamblers the same way the stock markets now treat the casual punter, it would be in worse shape than it already is. Markets are simply a no-go zone for hobby traders any more.

If Wall Street wants to entice the likes of Guambat back to its markets, its going to have to build a better sandbox, and leave the concrete mixers to the big guys.

The Stockmarket as Whack-a-Mole

With maybe 70% of stock "trading" now being only hotflashes and other black boxes of algorithmic electronic impulses, what is left in it for average "investors"?

Not much if history is any guide, which, of course, brokers tell us not to count (wink-wink, nudge, nudge) on as they spiff up the story of how this particular stock/fund/derivative-thingy has had spectacular results.

Why bother to "play" in a game that gets whacked down as soon as it pops up?

As John Hussman puts it: Lessons From a Lost Decade

Over the past decade, stock market investors have experienced enormous volatility, including two separate market declines in excess of 50%. Despite periodic advances, at the end of it all, as a reward for their patience, investors have achieved an average annual total return of approximately zero.

Put simply, greater risk does not imply greater reward if the risks that investors take are overvalued and inefficient ones.

Overall, the projected returns for the S&P 500 are now lower than at any time in U.S. history prior to the bubble period since the late-1990's (which has resulted in predictably dismal returns for investors). At present, investors rely on a continuation of this bubble to achieve further returns.

In our view, an additional round of quantitative easing will do nothing but to provoke a decline in monetary velocity proportional to the expansion in the monetary base, with little effect on either real GDP or inflation.

Bubbling along

The bubbles on the surface of the markets are from those drowning below.

The following two maps chart the percentages of "underwater" homeowners in Q4 2000 vs 2009:

(Hattip Barry)

(Hattip FT Alphville)

The Ides of October

Well here we are in the Ides of October and Wall Street's favourite stockmarket is powering triple digits higher. How does that make you feel?

Meanwhile Main Steet's favourite worker remains powerless and unemployable. And how does that make your feel?

And the only economic reason given for Wall Street's celebration is that it's been down so long it all looks up from here.

That and the Federal Reserve's lack of reservation in printing as many dollars as it takes to show Wall Street a good time.

Bernanke and crew, just like his predecessor, Alan Greenspan, friend not foe to bubbles of all types, especially low interest-derived ones, is beholden to and manned by Golden Wall Street bankers. To them go the Bread. To the rest of us go the crumbs, unless the birds and mice get to them first.

If there is one thing that agitates the working man and woman in an economic recession, it's the rigged way the bankers get stuff full of feed, while the rest of the country cinches in the belt and hunkers down. Everyone except Wall Street and its minions at the Fed and in Congress seems to accept the economic cycle.

In worst of times, best of times for Wall Street

A few weeks ago, an executive with a $7.4 billion hedge fund complained publicly to President Obama that he and his Wall Street colleagues were being treated like a pinata.

Poor baby.

Here we are, suffering through the deepest recession in 80 years, a recession caused in large part by the excesses, incompetence, greed and tunnel vision of Wall Street. Millions of Americans are without jobs, homes, health care and in many cases a future.

Yet according to the Wall Street Journal, bonuses and other compensation that Wall Street executives pay themselves this year will be the highest in history, breaking the record that was set just last year. In other words, the two worst years in the American economy in three generations are going to be the two best years in history for the Masters of the Universe who helped create this mess.

Fear and Loathing on Wall Street: Shareholders, Democrats in Crosshairs

After taxpayer-funded bailouts to prevent a total economic collapse, Wall Street firms are bellyaching about President Obama’s supposed anti-business policies, because he spearheaded reforms to curb their financial excesses. How soon they forget that they took the money from our pensions, and used it like Monopoly money to fund their trades in exotic instruments that also ruined the housing industry.

CNBC: Flaherty Says Bailouts Fuel Wall Street Pay

Larry Kudlow: Keith Boykin, why do we bother to play these silly games? Who is making what compared to who and how and why? Isn’t that just a little class warfare?

Keith Boykin: Well, I don’t think that it is class warfare. I think that it is just public information to know who is getting paid what. The reality is as was pointed out on the program before, there is excessive compensation on Wall Street. People understand that. It is outrageous. The American people, I think on Main Street are not happy about that. But you know, quite frankly Larry, I am over being outraged about it.

What outrages me is not that they are getting paid so much; they have the right to get paid whatever they want, especially for the companies that are not under TARP anymore, which is basically everybody. But what they don’t have the right to do is to collect billions and billions of dollars and then complain that the Obama Administration policies are somehow hurting business. Obviously they are not hurting if they are making this much money. It just doesn’t add up. I am tired of all the complaining and carping from Wall Street.

The profits and revenue of these companies have been boosted by a whole series of government protections and subsidies unavailable to people on Main Street. That is why people are so upset.

Wall Street's record bonuses: How outrageous are they?

Big banks must pay out to remain successful: Large banks need "top talent to stay with them," says Cheryl Casone at Fox Business, and that means big bonuses. Besides, it's not as if Wall Street isn't working hard. Thanks to the financial sector, the Dow Jones Industrial Average has recovered and is flying high. "Hate the idea of fat cats on Wall Street all you want, but take a look at your portfolio before you pass judgement." "Wall Street bonuses not the enemy"

GOP Groups Launch Massive Ad Blitz

An alliance of Republican groups is launching a $50 million advertising blitz this week in a final push to help the GOP win a majority in the House, representing the biggest spending blitz ever by such groups in a congressional election campaign.

The coordinated effort, which the groups have dubbed the "House surge strategy," tops what the official Republican House election committee expects to spend on television ads for the entire contest.

Democratic candidates, notably incumbents, have raised more cash than many of their Republicans rivals in this year's most competitive House races, according to a Wall Street Journal tally of Federal Election Commission data. In the 40 races deemed toss-ups by the Cook Political Report, a political handicapper, Democratic candidates had a combined $39.3 million of cash on hand as of June 30, the most-recent filing deadline. Republican candidates had $16.5 million in the bank.

Steven Law, who runs two of the Republican organizations, American Crossroads and its affiliate Crossroads GPS, said the effort was "aimed at putting Republicans over the top by evening out the financial disparities and dramatically expanding the field of battle."

American Crossroads was set up with the help of former Republican White House advisers Karl Rove and Edward Gillespie.

The spending campaign underscores a phenomenon that emerged with force in the 2010 elections: Outside political groups, most of which don't have to disclose their donors, are rivaling the traditional dominance of political parties' official campaign committees. Many of these groups, including those launching the ad blitz, are less than a year old.

"The scales have tipped from the political party to the outside political organizations," said former Rep. Bill Paxon of New York, who once led the National Republican Congressional Committee, the party's House campaign arm.

Evan Tracey, head of Campaign Media Analysis Group, which tracks campaign-ad spending, called the combination of ad outlays by the groups "historic" in its size, an assessment echoed by other campaign-finance experts and officials.

Mr. Tracey said outside Democratic groups were running ads in nine House campaigns while Republican groups are advertising in 70.

The record fund-raising and spending was made possible in part by a Supreme Court decision that allowed companies and unions to donate unlimited funds to such groups. The decision also allowed ads by such groups directly supporting or opposing candidates to run in the weeks before the election, which had previously been off-limits.

The sentiment is perfectly timed for an election. But so was the Conservative majority Supreme Court decision unlocking corporate campaign spending.

At last corporate America has a worthy investment proposal for all that cash sitting uninvested in its coffers. How about we buys us a guvmint?

UPDATE: The new corporate business model: increase profits, not jobs

DJIA giving a cold shoulder to bulls?

A feature of a classic head and shoulder reversal pattern is building volume in the (perceived)left shoulder and waning volume in the (perceived) right shoulder. The daily DJIA graph above includes a volume rate of change indicator (89 day average).

Looks to Guambat to fill the bill, so far.

Is the Baltic Dry Index all dried up?

At the end of 2008 Guambat began to take note of certain "anomalies" in the Baltic Dry Index and stock indexes. Then at the end of 2009, the Index proved its worth as a better index of economic health than, say, the DJIA. See the posts here.

FT Alphaville is noting that the further deteriorated Baltic Dry Index may have been a better harbinger of things in that former period than it is now. Or is it simply another case of denial?

Don’t panic, the Baltic dry is a rubbish indicator!

The Baltic Dry Index (BDI) — a measure of shipping costs for dry bulk goods — suffered its 29th consecutive daily decline on Wednesday, to record its longest losing streak in more than six years, according to Bloomberg.

It’s news that David Rosenberg at Gluskin Sheff, amongst others, managed to get pretty excited about on Wednesday. He, for example, thought it’s the sort of story that should have made the front pages by now:

The problem for the commodity complex in general is that the Baltic Dry Index, a usually reliable leading indicator, has plummeted by half since the end of May, is down now for 29 consecutive sessions and is at its lowest level in more than a year. Not to mention the fact that this is on nobody’s radar screen (page 21 news in the FT)!

And while many economists still view the index as an extremely useful barometer of global productivity trends — it appears there are some growing concerns about its usefulness today versus its usefulness say two years ago. And it’s all down to shipping supply.

Julian Jessop, chief economist at Capital Economics makes the case as follows:

The BDI is a composite measure of the cost of hiring a ship to transport dry bulk commodities such as grains, coal and metal ores. It is therefore understandable that the near-50% fall in the index since late May is attracting plenty of attention. However, there are two reasons to be wary of making big calls on commodities (or anything else) on the basis of the BDI.

But it doesn’t stop there. While the idea of a shipping index being a leading indicator might make logical sense, the BDI’s actual track record is pretty poor, says Jessop.

For instance, the best that can be said about the index is probably that it tends to move up and down at the same time as global commodity prices — hardly insightful.

For a start, fluctuations in the index could be driven by changes in the supply of shipping as well as in the underlying demand for commodities transported by sea. For example, a fall in the BDI could reflect an increase in the number of ships available to carry dry commodities (either new-builds or conversions from other uses, such as oil tankers). Similarly, the BDI might be distorted by temporary port closures, changes in the cost of fuel and insurance, and many other factors.

See Izabella Kaminska's post for more story and factoids, especially the comments.

Apocalypse Dow?

As the Dow (DJIA) continues to drift down towards 10,000, it is interesting to note a recent observation from a column of the Intelligent Investor in the WSJ personal finance section:


The 11-Year Itch: Still Stuck at Dow 10000

Last week, the Dow Jones Industrial Average rose above 10000—again. Since March 16, 1999, when it first touched 10000 in intraday trading, the Dow has bounced over that threshold and back 63 times. This Friday, the index closed 219.6 points below where it stood exactly 11 years ago.

This isn't the first time stocks have been stuck on a seemingly endless pogo-stick ride. On Jan. 18, 1966, the Dow hit an intraday high of 1000.50. It broke through the four-digit barrier three more times that January and February, then faded. The Dow cracked 1000 again in 1972 and 1976, then fell back both times. Not until December 1982 did the Dow finally hurdle above 1000 and stay there.

Will Dow 10000 turn out to be a long replay of Dow 1000?

Of course, financial history doesn't repeat itself—and even when it rhymes, the sounds can be almost unrecognizable. Inflation, at roughly 7% annually, was much higher from 1966 to 1982 than it is today, devouring all the return on stocks. And during the 1970s, according to an analysis for The Wall Street Journal by Wharton Research Data Services at the University of Pennsylvania, the Dow captured only about 15% of the total value of U.S. stocks, versus 30% today

Guambat once made some notes and observations about the prospects of a repeat of the Dow 1000 experience around the Dow 10,000 mark, back in 2002. But he did it one better (perhaps) by taking the idea all the way back to Dow 100, which was the pivot point around which the Great Crash in 1929 occurred.

The paper was discussed, and a link to the paper provided, in this post about a year ago: The battle of Bull Runs and Bear Runs

He even went so far as to state pages of historical events of the Dow 100 era and the Dow 1000 era, in chronological order, to emphasize the point that the historical facts and circumstances were sufficiently different as to give no clue that the stall in the Dow, otherwise called a secular bear market, would occur at any particular interval.

But he did note (back in 2006 in this post and the chart in it: Analagous?) that the technical consolidation that occurred at Dow 100 and again at Dow 1,000 looked to be occurring again at Dow 10,000, notwithstanding some interim cyclical bull and bear moves.

Here is an updated version of the 2006 chart. In this one, rather than using a rectangle, there's an ellipse, which is just a haphazard guess as to the shape the Dow 10,000 consolidation may take (if it does complete a secular consolidation here), and the time frame in which it might conclude. This is wild speculation, mind you. More Rorschach than prophecy.

(Click to enlarge; right click to enlarge in new tab.)

And while Guambat agrees with the WSJ article that history doesn't repeat and may not be recognizable when if rhymes, he is mesmerized by the possibility, however remote, that market behavior could be so simplistic as to predictably consolidate around a 10 to the 10th interval.

Why, if that were so, once this bear plays out, you could postulate Dow 100,000!!. As outlandish as that is, it is no more than to predict Dow 1,000 at Dow 100, or Dow 10,000 at Dow 1,000.

In the WSJ article, it was mentioned that this inability to shake off Dow 10,000 and move on was called "'quadraphobia', or the fear of a four-digit closing value for the Dow".

At least one Elliott Wave theorist will have none of that quadraphobia, however. This one fears a three-digit closing value for the Dow, in what can only be described as an Apocalyptic vision.

Elliot Wave predicts triple-digit Dow in 2016

An investment letter that called the Crash of 2008 said that this would be a bad year -- and it now says it will get worse.

A whole generation of investors think that Robert Prechter and his Elliott Wave Theory letters, Elliott Wave Financial Forecasts and Elliott Wave Theorist, are permabears. But Prechter was very bullish after the 1974 low

Elliott Wave Financial Forecasts (EWFF) makes recommendations specific enough to be tracked by the Hulbert Financial Digest. (The Elliott Wave Theorist is too, well, theoretical.)

The EWFF issue published in early May said flatly: "The topping process is over for the countertrend rally that started in the first quarter of 2009. The next leg lower that commenced in April should now deliver a decline that will ultimately be bigger than the 2007-2009 sell-off."

How bad? The clearest statement comes from the Elliott Wave Theorist, discussing a numerological technical theory with which it supplements the Wave Theory's complex patterns: "The only way for the developing configuration to satisfy a perfect set of Fibonacci time relationships is for the stock market to fall over the next six years and bottom in 2016."

"Stock market bulls and most economists think that a new bull market and economic recovery are underway. Most bears are looking for either a long sideways bear market à la 1966-1982, or a hyperinflationary run to infinity. Our Elliott Wave outlook opposes both of these scenarios. The most likely profile is a stock market crash of historic proportions."

Elliott Wave Theorist offers several reasons, including: "This bear market is of Supercycle degree, the biggest since 1720-1784. It should therefore include a decline deeper that the 89% decline of 1929-1932. A decline of 91.5% or more would carry it below 1,000."

There will be a short-term rally at some point, thinks Prechter, but it will be a trap: "The 7.25-year and 20-year cycles are both scheduled to top in 2012, suggesting that 2012 will mark the last vestiges of self-destructive hope. Then the final years of decline will usher in capitulation and finally despair."

Wow, and Guambat was ruminating about how bearish his view was getting. He's only thinking the apparent cold/right shoulder the Dow seems to be making these days will take it down but within the parameters of the last low, perhaps not piercing it, staying roughly in the bounds of the ellipse.

Guambat's money is on the side line for the time being. All two cents worth.

Hussman takes the Ponzi out of Mr Market

John Hussman's weekly Market Comment blog must be read from time to time, but not all the time, because his world moves glacially, not in squalls. His thinking and analysis is for the big picture. If Guambat had any funds to park, he'd park them with Mr. Hussman. Unfortunately, Guambat failed the parking part of the driving test.

Guambat was delighted with the way Hussman put the right finger on the right button when he discussed the illusion behind the illusive of Mr Market, when he talked recently about taking the Ponzl out of Mr Market.

The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue.

This creates a violation of what economists call the "transversality" or "no-Ponzi" condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future).

Without the transversality condition, the price of a security can be anything investors like.

However arbitrary that price is, investors may be able to keep the asset on an upward path for some period of time, but the price will gradually bear less and less relation to the actual cash flows that will be delivered. At some point, the only reason to hold the asset will be the expectation of selling it to somebody else, even though it won't be delivering enough payments to justify the price.

Transversality forces the price of the asset to be equal to the value of the discounted cash flows.

It's not enough for a borrower to keep the payments up over the short term, and it's not enough for price of an asset to be on an upward track for a while - over time, securities actually have to be able to deliver enough cash flows to justify the price that investors pay.

When investors abandon this requirement (as they did with dot-com and technology stocks during the runup to the market peak in 2000), the price they pay stops having any relationship with the stream of cash flows that will be delivered to them over time.

An increasingly large portion of the asset price represents real money that is being paid for a "phantom asset" in the distant future, that bears no cash flows, and yet gets assigned positive value because investors assume they'll be able to sell it to a greater fool.

Mr Market is inhabited by investments and Ponzis alike; things that are investments today can become Ponzis tomorrow. Be sure you know what's in your portfolio at all times, and what it is you're chasing.

Buffett talks up his book(s), drinks the koolaid

Topics today:

I. Financial Weapons of Mass Destruction?

II. “All-in wager” on the American economy?

I. Buffet's change of heart on FWMD:

Buffett warns on investment 'time bomb' (2003)

The derivatives market has exploded in recent years, with investment banks selling billions of dollars worth of these investments to clients as a way to off-load or manage market risk.

But Mr Buffett argues that such highly complex financial instruments are time bombs and "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system.

Derivatives are financial instruments that allow investors to speculate on the future price of, for example, commodities or shares - without buying the underlying investment.

Some derivatives contracts, Mr Buffett says, appear to have been devised by "madmen".

He warns that derivatives can push companies onto a "spiral that can lead to a corporate meltdown", like the demise of the notorious hedge fund Long-Term Capital Management in 1998.

Berkshire Hathaway, the investment group led by Mr Buffett, is pulling out of the market, closing down the derivatives trading subsidiary it bought as part of a huge reinsurance company a few years ago.

In his letter Mr Buffett compares the derivatives business to "hell... easy to enter and almost impossible to exit", and predicts that it will take years to unwind the complex deals struck by its subsidiary General Re Securities.

Warren Buffet on Derivatives -- excerpts from the Berkshire Hathaway annual report for 2002.

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose accuracy may not be exposed for many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them.

Those who trade derivatives are usually paid, in whole or art, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief.

As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time.

A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from companies B through Z.

Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Buffett boosts Goldman Sachs with $5-billion investment (2008)

Warren Buffett to the rescue: His Berkshire Hathaway Inc. agreed today to invest $5 billion in Goldman Sachs Group via a purchase of preferred stock.

Berkshire also will get warrants to buy up to $5 billion of Goldman common shares.

The deal, announced after markets closed, amounts to a huge vote of confidence by Buffett in the investment banking titan, at a time when investors remain spooked about the future of Wall Street.

"Goldman Sachs is an exceptional institution," Buffett said in a statement.

Buffett will earn a hefty 10% dividend yield on his preferred shares. The warrants, which are immediately exercisable, have a strike price of $115 a share.

The deal has given Goldman’s shares a pop in after-hours trading, to $135.87. The stock had gained $4.27 to $125.05 in regular trading, after falling as low as $113.

Goldman was down 15 points at $145 at last Friday's close (April 30).

The Buffett-Blankfein Alliance (current)

Goldman Sachs shares should pop Monday morning on the unambiguous support of America’s most renowned investor, Warren Buffett.

According to a Belgian fund manager who worked for seven years for Goldman in London, and who just arrived here in Pasadena for the Value Investing Congress this week, Goldman Sachs ( GS - news - people ) has an intrinsic book value of $111 a share and that book value should rise at least to $132 a share over the next six months unless disaster strikes.

Goldman Sachs has mounting legal woes

Shares of Goldman (GS, Fortune 500) have plunged 21% since the SEC first revealed its fraud allegations, including a 9% drop on Friday as news of the federal criminal probe prompted a pair of analysts to cut their rating on the firm.

The interesting thing to Guambat is how sanguine Buffett is about all that CDO Koolaid -- he's now apparently quite prepared to drink the stuff Goldman stirred up and peddled.

As Barry Ritholtz has pointed out, the WSJ has a take on just how toxic the CDO Koolaid can be, and how Goldman followed the recipe:

Senate's Goldman Probe Shows Toxic Magnification

In a memo last week, panel Chairman Sen. Carl Levin (D., Mich.) said Goldman's work "magnified the impact of toxic mortgages" by replicating mortgage securities in debt pools known as collateralized debt obligations as well as CDO derivatives, and also in an index that tracks subprime bonds.

This was a central finding of the Senate investigative panel probing Goldman Sachs Group Inc.'s actions in the mortgage market. In effect, the documents said, Wall Street was "copying and pasting" what turned out to be the worst-performing securities of the mortgage boom.

An important moment in the housing cycle came in January 2006, a year before the downturn of the housing market had crystallized. That month, a consortium of banks, including Goldman and Deutsche Bank AG, with the help of a London data firm, launched an index, known as the ABX, which served as a proxy for subprime loans.

By late 2006, Goldman had a large bullish position on the ABX, because it had taken the other side of bearish bets by hedge-fund clients, according to the Senate documents. Subsequent deals would help reverse that position.

Anthony Sanders, a real-estate finance professor and authority in securitization at George Mason University in Fairfax, Va., said the problem was that the same mortgage bonds ended up in many deals, potentially multiplying the losses.

"Serious problems with common [asset-backed securities] deals can decimate all CDO deals," Mr. Sanders said.

That last statement sounds very much like pre-Goldman Buffett:

"Under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from companies B through Z. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others."

But, by 2008, Buffett had finally learned enough about the direction of the economy that he was willing to make his own bet against it, by taking a position in Goldman, whose own derivative-based bet was about to pay off -- with a little bail out assistance at the net by Buffett's shareholders and other US taxpayers.


Topic II: Jumping the tracks

Buffett on right track? (2009)

The headline story was that Buffett was purchasing a US railroad. Not just any old purchase, this one was his largest purchase ever. The traders skipped right over the part where Buffett said the purchase was an “all-in wager on the economic future of the United States”, and landed on the notion that transports ultimately lead the industrials in the stock market race.

Feisty Buffett supports Goldman, high on economy (current)

Buffett cautioned policymakers not to artificially stimulate housing sales and perhaps derail a recovery.

Fingertips or foothold?

Dow Ends Above 11,000 for 2nd Day

Piling on mediocre returns

An interestingly juxtaposed two articles on Bloomberg, contrasting fundamental and technical analysis:

Don’t Expect Much From U.S. Stocks in Next Decade: Chart of Day

This quarter’s gains in U.S. stocks have made them so costly relative to earnings that returns for the next 10 years may be minimal, according to Dylan Grice, a strategist at Societe Generale.

The CHART OF THE DAY displays a price-earnings ratio for the Standard & Poor’s 500 Index that’s based on average profits for the past decade, as compiled by Yale University Professor Robert Shiller. Grice used the data to reach his conclusion, outlined in a report today.

Shiller’s cyclically adjusted ratio stood at more than 20 times earnings this quarter as the S&P 500 headed for a fourth straight quarterly gain, the longest winning streak since 2007. The index rose 5.2 percent through yesterday.

“The risk is there -- as it always is -- but the returns aren’t,” Grice wrote.

S&P 500 to Rise 13% on ‘Confirmed Breakout’: Technical Analysis

The Standard & Poor’s 500 Index, heading for its biggest first-quarter gain since 1998, will probably rise 13 percent in the next few months after staging a “confirmed breakout,” says Katie Stockton of MKM Partners.

The benchmark measure of U.S. equities closed above its January high of 1,150.23 for two consecutive weeks on higher- than-average trading volume, after failing to stay above that level in the previous week. That breakout confirms the S&P 500 has entered a new phase of its yearlong rally

Stockton based her new projection on what’s called the measured move technique, which says a security’s future advance tends to be equal in length to the rally that precedes it. She sees even more gains in the longer term: Using the S&P 500’s advance from its July low to its January high as the reference, Stockton said the index may gain the same amount, or about 270 points, from its February low of 1,056.74, in the next five to six months.

Stockton said she expects the market to retreat in the short term, because investors are too bullish. The ratio of puts to calls on U.S. equities dropped to 0.40 on an intraday basis on March 25, the lowest level since Jan. 11.

“Sentiment is still somewhat complacent and is supportive for a pullback,” Stockton said. “The confirmed breakout suggests the pullback will be more modest than I had originally expected.”

What's a poor Guambat to do but remain poor.

More of the same is not corrobative evidence

Guambat would really like to jump on this as a harbinger, a swoop, an "I was just saying". But reading the same thing several times is not corroboration.

BUT, just in case I might later be able to crow, "I told you so", there's this:

Swooning canaries, exploding debt

The FT’s Gillian Tett makes the point in her Tuesday column that the recent inversion of 10-year swap spreads could be heralding something important, namely worries over US sovereign risk.

It’s a theme that was picked up by Bloomberg on Monday, in relation to US Treasury yields generally, and again on Tuesday with its chart of the day, which is focused on what negative swap spreads might be saying about the US dollar’s fortunes.

[There's a quote and a reference to this Bloomberg article, which Guambat had read at the time, as well as that chart, and thought "hummmmm. There might be something in this." But then his mind went blank.]

Of course, correlation ≠ causation, and there are still plenty of people who think negative swap spreads have absolutely zip to do with how the market views US debt, and by extension, its currency.

But still, something to think about as the dollar slides for a second consecutive day.

Presumably, someone will at some point for no particular reason snap their fingers, and Guambat will come out of it.

Trixy divergence

Many stock jocks are at least passingly familiar with the MACD indicator. MACD is the acronym for Moving Average Convergence/Divergence.

It's essentially a momentum indicator. It takes two moving averages of an index, a longer one and a shorter one, and combines the net difference. Thus, because shorter term averages more closely follow daily movements, as the shorter one rises faster, say, than the longer average, the MACD shows positive movement. The stronger that correlation, the stronger the positive reading on the MACD.

It is trend following, obviously because it is a moving average indicator, but it also suggests the strength of a move. It's all a bit more complicated than that, as you can see here.

But it is not only the movement of the 2 averages against each other, but the movement of both of them against the index that provides implication for index strength or weakness. As prices rise when the MACD is falling, it suggests a weakening of buying strength, and vice versa.

The StockCharts link above includes several textbook charts on the predictive (or, more accurately, betting) value of that divergence.

Now, the MACD uses exponential moving averages to highlight the influence of recent movements, although it can be adapted to longer averages to smooth events. In a bigger picture, it may prove useful to take that a step further and smooth the MACD with triple exponential values, which is what the TRIX does. The TRIX is an exponentially smoothed MACD, basically.

The TRIX is not so much a trader's tool than an investor's, trying to capture, as it does, the bigger picture. As StockCharts describes it, "TRIX is designed to filter out stock movements that are insignificant to the larger trend of the stock".

Guambat, being the slothfully slow creature that he is, keeps a sloe eye on the TRIX.

This is what it looks like in the S&P index context at the moment:

Click on these charts for a larger version (right click and open in new tab to keep this place handy).

And to put that in a larger context, this is what the major indexes (Dow, Nasdaq, S&P, FTSE, Germany, France, Japan and HK) look like:

A kick in the tail winds

Some folks look at an empty glass and call it half full.

"The economy's 'tailwinds' (tame cost-of-living, less inventory disinvestment, recovering stock prices, and a still relatively low dollar) should offset the familiar 'headwinds' (jobs and the credit crunch) enough to support moderate 2010 real GDP growth of 2.6%," wrote Maury Harris, chief U.S. economist for UBS Securities, and as reported in Rex Nuttings' MarketWatch report.

That's, first, "tame" cost of living. It's tame because deflation is so rampant in the US that, despite unprecedented US fiscal stimulus, the cost of living inflation rate remains with hardly a heart beat. Cost of living is no tailwind when lack of income can't take advantage.

Less inventory disinvestment is simply the reality check that car companies and other consumer product sellers must, at some point, have something to sell or roll over. The operative and relative words are less disinvestment. That hardly counts for something positive. Which, again, ain't much of a tailwind.

The recovering stock price story, now that is the cynical part. It is so dissonant with the world outside Guambat's burrow that it has caused normally not deranged people to go somewhat paranoid. See "Analyst charges that government is manipulating markets", another Rex Nutting report. Suffice it to say that it has been a lightly supported, exponential spurt of deadly but dubious detachment from Main Street. In other words, business as usual for Wall Street.

Which leaves us with the last "tailwind", the weak, indeed moribund, US dollar. To a great extent that is simply a derivative of the first factor, which has been a low cost of living regime brought on and/or propped up by Japan-style low government interest rates. And the low rates are still not low enough to encourage banks to lend. They won't even lend money that is being given to them.

So, Guambat turns to the head winds, and where better than to a bloody whinging Pom, who looks at a glass overflowing and will only concede it is half empty.

Ambrose Evans-Pritchard writes America slides deeper into depression as Wall Street revels:

The [US] labour force contracted by 661,000. This did not show up in the headline jobless rate because so many Americans dropped out of the system. The broad U6 category of unemployment rose to 17.3pc. That is the one that matters.

Wall Street rallied. Bulls hope that weak jobs data will postpone monetary tightening: a silver lining in every catastrophe, or perhaps a further exhibit of market infantilism.

Realtytrac says defaults and repossessions have been running at over 300,000 a month since February. One million American families lost their homes in the fourth quarter. Moody's Economy.com expects another 2.4m homes to go this year. Taken together, this looks awfully like Steinbeck's Grapes of Wrath.

It takes heroic naivety to think the US housing market has turned the corner (apologies to Goldman Sachs, as always). The fuse has yet to detonate on the next mortgage bomb, $134bn (£83bn) of "option ARM" contracts due to reset violently upwards this year and next.

David Rosenberg from Gluskin Sheff said it is remarkable how little traction has been achieved by zero rates and the greatest fiscal blitz of all time. The US economy grew at a 2.2pc rate in the third quarter (entirely due to Obama stimulus). This compares to an average of 7.3pc in the first quarter of every recovery since the Second World War.

For the record, manufacturing capacity use at 67.2pc, and "auto-buying intentions" are the lowest ever.

The Fed's own Monetary Multiplier crashed to an all-time low of 0.809 in mid-December. Commercial paper has shrunk by $280bn ($175bn) in since October. Bank credit has been racing down a hair-raising black run since June. It has dropped from $10.844 trillion to $9.013 trillion since November 25. The MZM money supply is contracting at a 3pc annual rate. Broad M3 money is contracting at over 5pc.

[And note, US Consumer Credit In Record Drop, Biggest Since 1943 and US Home-equity delinquencies rise to record level.]

Europe is even worse.

Mr Rosenberg is asked by clients why Wall Street does not seem to agree with his grim analysis.

His answer is that this is the same Mr Market that bought stocks in October 1987 when they were 25pc overvalued on Shiller "10-year normalized earnings basis" – exactly as they are today – and bought them at even more overvalued prices in 2007, long after the property crash had begun, Bear Stearns funds had imploded, and credit had its August heart attack. The stock market has become a lagging indicator.

Tear up the textbooks.

Have a nice day.

Notwithstanding the likes of Cramer and Kudlow ...

"The U.S. stock market is wrapping up what is likely to be its worst decade ever." So says this article in the WSJ: Investors Hope the '10s Beat the '00s

In nearly 200 years of recorded stock-market history, no calendar decade has seen such a dismal performance as the 2000s. This past decade looks even worse when the impact of inflation is considered.

To some degree these statistics are a quirk of the calendar, based on when the 10-year period starts and finishes. The 10-year periods ending in 1937 and 1938 were worse than the most recent calendar decade because they capture the full effect of stocks hitting their peak in 1929 and the October crash of that year.

Investors would have been better off investing in pretty much anything else, from bonds to gold or even just stuffing money under a mattress. Since the end of 1999, stocks traded on the New York Stock Exchange have lost an average of 0.5% a year thanks to the twin bear markets this decade.

Many investors were lured to the stock market ... but coming out of the 1990s, the best calendar decade in history with a 17.6% average annual gain, stocks simply had gotten too expensive.

Of course, the usual talking heads and cheerleaders in the financial news and entertainment industry didn't say so; indeed, they baited the lure. Noughty, noughty.


SAME IDEA, OTHER PLACES:

Partisan Hackery

Submerging markets

Some of the emerging market darlings are submerging, but the love may linger anyway.

Mexico's debt is downgraded to just above 'junk'

Standard & Poor's lowered its rating on Mexico's foreign-currency debt to BBB from BBB-plus, after a cut of the same magnitude by Fitch Ratings on Nov. 23.

If Mexico were to fall to a BB rating, its debt would be considered non-investment-grade, or junk. That would wipe out the progress the country made regaining investment-grade status early in this decade.

Mexico has raised taxes this year to boost revenue, but the measures haven't gone far enough given declining oil production, S&P said.

But stock and currency investors continue to give Mexico the benefit of the doubt in the short run. Some investors may well wonder why the country deserves a lower debt rating than Greece, given the latter's far more desperate budget situation.

S&P's projection that Mexico's budget deficit will average 3% of gross domestic product through 2011 looks modest compared with Greece's deficit, which is expected to be near 13% of GDP this year. S&P still rates Greece A-minus, waiting to see what steps the government will take to rein in spending.

Meanwhile, back in the USSA:

US needs plan to tame debt soon, experts say

The U.S. government must craft a plan next year to get its ballooning debt under control or face possible panic in financial markets, a bipartisan panel of budget experts said in a report on Monday.

Though the government should hold off on immediate tax hikes and spending cuts to avoid harming the fragile economic recovery, it will need to make such painful changes by 2012 in order to keep debt at a manageable 60 percent of GDP by 2018, according to the Peterson-Pew Commission on Budget Reform.

The national debt has more than doubled since 2001, thanks to the worst recession since the 1930s, several rounds of tax cuts and wars in Iraq and Afghanistan.

A looming wave of retirements over the coming decade is expected to make the situation worse.

The national debt currently accounts for 53 percent of GDP, up from 41 percent a year ago. That's likely to rise to 85 percent of GDP by 2018 and 200 percent of GDP by 2038 unless dramatic changes are made, the commission said.

More than One-third of US stock market trading comes from unknown sources

Study Lays Bare Breadth of 'Naked' Access

The report by Aite Group, a Boston research outfit that tracks high-frequency trading, found that naked access — trading directly on exchanges using a brokerage's computer identification code — accounts for an estimated 38% of the U.S. stock market's average daily trading volume.

Naked access is one form of a more widespread practice called sponsored access in which brokers let trading firms operate on exchanges using the brokers' market participant identification codes. Overall, sponsored access accounts for half of the market's volume, according to the Aite report, which is likely to be released Monday.

Past performance and Shakespeare

Macbeth came to mind when reading the posts from a couple of regular spraying spots in Guambat's rounds.

First, Felix Salmon had a couple of posts, reiterating what Guambat has felt, thus finding those particular posts insightful and brilliant.

Mutual fund charts of the day

For the vast majority of actively managed funds, true alpha is probably negative; that is, the fund managers do not have enough skill to produce risk adjusted expected returns that cover their costs.

Which comes as no surprise, but it’s still good to see some relatively solid empirics here. Anybody wanting to make an intellectually-credible case in favor of investing in actively-managed mutual funds is going to have to attack this paper head-on.

Why bonds aren’t good investments

If you think it is reasonable to get a 5% return on top of inflation without taking risk, I have some oceanfront property in Nevada to sell you.

Investing is not about loaning your funds out to a government, completely abdicating responsibility for finding meaningful uses for the capital and then expecting a substantial return above inflation. Our governments are nearly bankrupt.

If you lend to a nearly bankrupt and profligate entity, you deserve to lose a lot of money. You are like a bartender serving a drunk who is drinking himself to death. You are not innocent. You are part of the problem, and your investments are making the world worse. You don’t deserve a good return for that

.
The points here, Guambat mulls, are not that neither stocks nor bonds are good investments, it's just that expectations of above average returns from either is too speculative to pay off for most of us. Therefor, rein in those horns or expectation and protect capital.

Which is the general line that John Hussman espouses. As he put it a couple of weeks ago, "we're doing our best to maintain equanimity about market direction, while keeping defense as our primary concern."

He's back this week trying not to get too disturbed by ("maintain equanitmity about") the consequences of not being in the chase in the stock markets that started last March and has not really let up since:

our year-to-date returns might now be into a second digit had I recognized that investors have learned utterly nothing from the bubbles and collapses of the past decade. That recognition might have encouraged a greater weight on trend-following measures versus fundamentals, valuations, price-volume sponsorship, and other factors.

Whether or not I have focused too much on probable “second-wave” credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a “miss” on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster.

Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear.

But what's the Macbeth link?

Obviously, that past performance or stocks and bonds is no guaranty of future performance, nor is the pursuit of today's alpha a promise of tomorrow's returns. Shakespeare of course put it this way:

"Tomorrow and tomorrow and tomorrow,
Creeps in this petty pace from day to day
To the last syllable of recorded time,
And all our yesterdays have lighted fools
The way to dusty death. Out, out, brief candle!
Life's but a walking shadow, a poor player
That struts and frets his hour upon the stage
And then is heard no more: it is a tale
Told by an idiot, full of sound and fury,
Signifying nothing."

But, back to Hussman:

One of the fascinating aspects of the past few months is the lack of equilibrium thinking with respect to what happened to the trillions of dollars in government money that has been spent to defend the bondholders of mismanaged financial companies.

Almost by definition, money given to corporations will show up most quickly as improvements in corporate earnings, and then slightly later, as executive compensation.

A few pieces came across my desk last week, hailing the ability of the corporate sector to bounce back from the recent economic downturn even though revenues have continued to suffer and employment has been steeply cut.

Why is this a surprise? Where else could the money have gone?

Labor compensation?

It is truly mind-numbing that a moment after a temporary surge of trillions of dollars, borrowed and tossed out of a helicopter (though to specific corporations and private beneficiaries), analysts would hail a subsequent improvement in corporate results as evidence of “resilience.”

What matters is sustainability, and unfortunately, it is clear that credit continues to collapse.

In the casino market of stocks, a casino stock tanks

So much for risk appetite. Let's hear it for bond apetite.

UPDATE 3-Sands China falls, casino party looks to be over

The first-day drop of nearly 14 percent -- the third-worst Hong Kong debut this year after China South City Holdings and Glorious Property Holdings -- was more than analysts had predicted

Sands China's $2.5 billion IPO also came amid global market skittishness in the wake of last week's sell-off over a debt crisis in Dubai, with investors leery of risky bets.

Hard to believe it was passed over. Why just a year or so ago it would have been oversubscribed:

Sands China, the Macau unit of Las Vegas Sands, the world's most valuable casino firm, offers investors a company that is heavily debt ridden, but which boasts a strong growth outlook in Macau, the world's biggest and fastest-growing gambling market.

Sigh.