Haircut Contagion

As Dave Barry would say, it sounds like a great name for a band. But really it's the name for what the International Monetary Fund says is going to kill this stock market. It ain't earnings, it ain't P/E ratios, it ain't declining margins -- it's haircut contagion. To wit:

"The IMF is particularly concerned about a phenomenon it dubs "haircut contagion".

A fall in value in assets in a hedge fund provokes a margin call, forcing the fund to sell assets to bring leverage back to its initial level. However, the lender now imposes a higher margin, or "haircut", as the assets are now riskier. This in turn forces further borrowing and further sales." (The Australian, 9/25/08)

Can you believe the IMF thinks hedge-fund managers will ratchet their leverage back up to previous levels? If the managers would just listen to the market and accept lower returns, we'd be OK. But the IMF rightly recognizes that hedge funds aren't structured to adapt to lower returns. They've promised big returns so they can get paid big. Lots of hedge funds will lose money if they have to accept lower returns. Then they're gone.

So the IMF apparently believes that hedge funds are inextricably linked to leverage. They have to have leverage, no matter what it costs. They can't trade lower leverage for lower costs. One more comment from the same article, then we'll tell you how we found it:

"The IMF believes there were $US300 billion in leverage loans planned in the second half of this year, although the market for them has now collapsed. "In the near term, financial institutions are exposed to potential syndication risks, with unsold bridge commitments contributing to an overhang in the market."

We found this article on http:/hf-implode.com. It's the best financial-news aggregator we've come across. It's the first website we check every day once we decide to get down to serious business. Highly, highly recommended.

I'll Sell My Gold Stocks to You

Last week the bonds were peaking and getting ready to revert to the mean. This week it’s the gold stocks.

Coming into today, Gold/Silver (XAU) was exactly two standard deviations above its 90-day mean price. And those standard deviations are quite large. With an implied volatility of 38, the options market sets the three-month expected trading range for the index at nearly 66 points. That’s 11 points per standard deviation, placing XAU among the most volatile sector indexes.

We like to buy into sectors when they’re two standard deviations below their means, then sell those sectors once they’ve risen to two standard deviations above their means. Here’s why: A full 96% of all price points are expected to fall within two standard deviations of the mean, up or down.

The key is obtaining a worthwhile standard deviation. We believe the standard deviation estimates delivered by the options market – in the form of implied volatility – are the best you can find.

Back to the XAU. The index bottomed during the day back on August 16, reaching a low of around 120. We even called a couple of our preferred customers to let them know XAU had fallen to two standard deviations below its 90-day mean. (These guys already knew, just like they already know now that it’s time to sell. But they appreciated the calls.)

Here’s part of our post on this blog on August 19:

“XAU touched Zone 1 during intraday trading Thursday and then rallied. We suspect you’ll get another chance to buy in the lower 120s before this is over. The index is still in Zone 2, so it’s already a good buy. Buy some now, save some cash for buying some more later.”

A month later, and the index is up 50 points. Yesterday, XAU sold off at the end of the day after a real nice rally. That’s an indication the speculators are getting ready to bail. We wouldn’t be surprised to see the same thing happen today. But we love the liquidity because it allows us to sell on the offer.

So we’ll reduce our risk by taking all our profits now, with the index up more than 40% since we jumped in. Nice trade.

In fact, we’ll buy some puts here. Just as we did it on the way up, we’ll buy some puts here while saving about half the money we want to invest in the position for buying more puts if the index continues to rise.

Two Sides of the Same Coin

Sub-prime mortgage sellers and hedge funds are inextricably linked. In fact, we think they're two sides of the same coin. Hence, we expect most hedge funds to follow the sub-prime sellers right on out the door.

Here's why. Both were new products, with no regulation. Once investors find out how toxic these products are, no one wants to touch them. It's happened to sub-prime sellers, and it's beginning to happen to hedge funds.

Case in point: Absolute Capital. Supposedly, the founder of the company quit because of a pay dispute within the firm. We don't believe it. Most of the guy's funds are impossible to value because of there is no secondary market for the investment vehicles they hold. Many investors want to withdraw their funds now that the guy is leaving. How convenient: Now he doesn't have to face the slow pain of watching his vehicles waste away to nothing. He can just claim the funds failed because investors withdrew their funds.

Now it's time to screw the customer. First, Absolute Capital has decided you can't take your money out now. Second, they're going to divide some funds up and re-issue two different types of stock. Apparently, one type of stock in will contain performing assets, while the other type of stock will contain the non-performing assets (sub-prime related stuff).

So instead of devaluing their portfolios by half, they're going to split each portfolio into a fund that has half the worth of the original fund and a fund that is worthless.

Man, that really sucks. But hedge-fund investors have signed away their rights like nobody's business. As long as the market rises, no problem. When the market falls, though, it's time to invoke those protective clauses their lawyers slipped in. Just like many sub-prime loan owners ignored the risk they were taking because they wanted in on the deal, so too did hedge-fund investors sign away their rights to the fund manager.

There will be no claims that people didn't read the paperwork, which is what most sub-prime investors are telling anyone who asks. Hedge-fund investors are supposed to be smarter than others, because they have a net worth of more than $1 million. So they can't say they didn't understand the contract, though I'm sure many will try.

But eventually, just like with sub-prime loans, the public will learn what a bad deal they signed into. And people won't want to do it again. At least for another few years, until they invent some new products that are ahead of all regulation.

We'll end with this: Marc Faber, a guy we really like, says the market could fall 30% before it bottoms. That's down to 10,000 on the Dow, and down to around 1,000 on the S&P 500 (SPX). If that happens, people are going to hate hedge funds as much as they hate sub-prime sellers.

Greenspan: The Perfect Patsy

Can you believe this guy? Wouldn't say anything but mumbles when he was employed by The People, but now that he has to make his own money he's full of opinions. Devoted to the ideal of the Virtue of Selfishness, now he can't believe where the selfishness has gotten us -- in debt up to our arseholes. Can't believe that lenders would take his free money and sell The People a pipe dream. Never heard of such a thing, didn't know it existed. Knows nothing of the "Observed Price" phenomenon Shiller wrote about 15 years ago. And the politicians -- don't get him started on what he's learned about those guys!

Overall, the perfect patsy for the hedge-fund era.

Now he's trying vainly to salvage his legacy by blaming the politicians. Why does this whole thing have a Sammy-the-Bull turns-on-John-Gotti feel to it? Disavowing his bosses now that he's joined the publicity-protection program (PPP). Here's what got me stirred up today:

To keep inflation under 2 percent, ``the Fed, given my scenario, would have to constrain monetary expansion so drastically that it could temporarily drive up interest rates into the double-digit range not seen since the days of Paul Volcker,'' Greenspan wrote. (Bloomberg)

Now, what if Greeny has said to The People four years ago: "Hey, we're gonna let the big boys borrow for a year at 1%, but it might result in 10% inflation in a few years. That OK with you guys?" The only thing we've ever asked of the Fed chairman is to watch out for inflation. Greeny always said he supported the strong dollar, and a year after he's gone it's at all-time lows. And poised to fall further.

Anyway, part and parcel to his flood-us-with-cash philosophy was his hands-off approach to the sorry state of government statistics. Everyone knows that official government inflation figures don't track today's true household expenditures. Unfortunately, I'm not in a position to develop appropriate figures to release to the People. Greeny was.

He should have waited until he got his Medal of Freedom before publishing his Bad, Bad Bush book.

Coast-to-Coast for Bonds

Bond ETFs and yield indexes appear to have completed another coast-to-coast move. In just three months, bonds ETFs have gone from more than three standard deviations oversold on a 90-day basis to more than three standard deviations overbought on a 90-day basis.

Yield indexes, which move opposite of bond prices, have gone from more than three standard deviations overbought on a 90-day basis to more than three standard deviations oversold on a 90-day basis.

(Actually, yields indexes usually move further from their means than do bond ETFs. We don't know why, because both long-term yields and long-term bonds trade with a pretty solid implied volatility of 9.)

Right now, long-term yield indexes are more than 150% oversold over both 90-days and 10-days. Long-term bond ETFs have moved to around 100% overbought over both 90-days and 10-days. These are extremes, and it is highly probable that these issues will begin to revert toward their respective means sometime soon.

Three months ago, the market was heavily overbought because bonds had slumped and yields had risen. Broker/Dealer (XBD) was more than three standard deviations above its mean price over both 90-days and 10-days. Here's what we wrote on June 4:

"10-Yr. Interest Rate (TNX) and 5-Yr. Interest Rate (FVX) each are more than 130% overbought over 90 days. (As a result, so is Eurotop 100 (EUR).) 20-Yr. Bond Fund (TLT), now deep in Zone 1, confirms the rate-index strength. Our experience is that there isn't long to go at this level. And there's so much trading liquidity out there. In three months or so, the bonds will be near Zone 6 and yields will be weak."

Of course, you know what happened from there. Two weeks later we were buying puts on the market and the financials. Wish you'd been there with us, it was fun.

Now it's different. Broker/Dealer (XBD) enters today at more than two standard deviations below its 90-day mean price, one of the weakest sector indexes on the planet. (Another really weak index is Retail (MVR), more than three standard deviations below its 90-day mean price.)

Bonds and yields are getting ready to revert to their means, and so are the financials. And the retails, too. We call that a fourth quarter rally. It should set up a wonderful opportunity to get short again in December. Next time, the rout will really be on.

5 Stages of Real Estage Grief

Lifted this from the comments in the LA Land blog of the LA Times. Thanks to Charles Wilson:

The Five Stages of Real Estate Grief

DENIAL: "Don't listen to those doom and gloomers. They're nothing but a bunch of jealous renters. Probably Democrats."

BARGAINING: "Okay, maybe things got a little out of hand. If I take a 15% haircut, is that fair?"

ANGER: "You traitors in the liberal media are driving down prices and killing the American Dream! And dammit, stop laughing at me!"

SADNESS: "I'll be ruined, I'll tell you! Ruined! Everything I've worked for will be gone! Just kill me now!"

ACCEPTANCE: "Honey, who knew that we'd be so happy in a trailer?"

Deadly Diversion

Another day in the bond market like yesterday, and the Fed will cut rates on Friday. Short-term interest rates and long-term interest rates are moving in opposite directions. When that happens, it's bad news.

We're tracking the divergence through yield indexes that trade at the CBOE. Yields move in the opposite direction to bonds. Right now, the three long-term yield indexes we follow -- 5-Year (FVX), 10-Year (TNX) & 30-Year (TYX) -- are more than three standard deviations below their respective 90-day mean prices. They're more than two standard deviations below their 10-day mean values.

But the short-term yield index -- 13-Week (IRX) -- is only one standard deviation below its 90-day mean. On a 10-day basis, IRX has been around three standard deviations above its mean price for the past couple days. Banks will not lend to each other over the short term, hence the divergence.

If the black-box hedge funds couldn't deal with CDOs, they'll never be able to withstand this incredible divergence for long.

We thought it was laughable that the Fed said it will look to "anecdotal" evidence of tight credit in the future. LIBOR rates are at seven-year highs, and that's what most scalable loans use as a reset touchstone.

So, either the Fed acts soon, or the stock market takes a serious hit. If they're smart, the Fed will try to help this thing settle down slowly by instituting a series of rate cuts. We think they are smart, they just needed to be reminded of it by the market.

The Barry Bonds Defense

Apparently Barry Bonds and Angelo Mazillo have the same spin doctor. Those close to Bonds are supposed to have told the press that he took steroids to keep up with home-run slugger Mark McGwire, who Bonds believed was using illegal enhancement substances. Now Mazillo is telling the LATimes:

"Most of the large bank lenders, as well as Countrywide, were limited, slow, reluctant followers behind the lenders who most aggressively relaxed underwriting guidelines," the company said in a written response to a question from The Times.

In other words, the McGwire's of the lending world were offering juiced-up packages, so Countrywide (CFC) was forced to as well. The company says that banks wouldn't loan them money if they didn't sell the juiced-up stuff along with the prime stuff.

A childish response, we know. Angelo, if you saw the other kids jumping off a bridge, would you do it too? Society isn't going to buy it.

But there are similarities between the regulating authorities, the ones we trusted to keep the games safe. In baseball, the commissioner's office had dismissed steroid abuse with a wink-and-a-nod for years. It was good for the game when home-run records were being trashed. Now we know why. The commissioner's lax policies allowed dishonesty to flourish.

Same in the housing markets. The Fed was asleep on the job, both in regulating mortgage sellers and in calculating the rate of inflation without properly considering housing appreciation. The lack of regulation allowed the market to flourish, and the lack of assessment in regards to housing prices led them to keep rates too low too long.

In both instances, the regulatory authorities appear to have been co-opted by the people who own the franchises. Who would trust either of them now?

"Observed Price Movements:" Buying High and Selling Low

I got into an on-line argument the yesterday with a guy who said the Case/Shiller numbers and the OFEO numbers were inconsistent, so you should ignore both. I couldn't believe the guy, an investment manager, could even compare pencil-pushing government figures with data from a brilliant Ivy League professor acknowledged to be at the top of his profession. I think Shiller is great, and I take every opportunity to read anything he produces.

For a quality article on how the government's inflation figures would look if Case/Shiller replaced rent-equivalency in the calculations, see http://www.iaconoresearch.com/. As usual, the government's numbers suck. Interestingly, the article shows that inflation was running at about 10% with Case/Shiller included, but that now it's dropped to negative if you include the Case/Shiller figures. A much more informative statistic than the one the government offers.

But it got us to thinking about one of Robert Shiller's best books, Market Volatility ('89). So we checked in on the chapter called The Behavior of Buyers in Boom and Pre-Boom Markets. In 1988, the authors sent about 20-page questionnaires to 500 people in four cities. Two of the cities, Anahiem and San Francisco, had booming real-estate markets at the time. One city, Boston, was starting to fall after it's boom. And the other town, Milwaukee, was neither boom nor bust.

Here's one of the main questions the authors wanted to answer:

1) "What causes sudden and often dramatic and sustained price movements? Although questionnaire survey methods can never provide a definitive answer to such a question, they can provide information that helps us begin to understand the process: What are home buyers thinking about, and what sources of information are used to decide how much to pay for a house? How motivated are they by investment considerations, and how do they assess investment potential? Is destabilizing speculation affecting house prices?"

Sounds like what we just went through, doesn't it? Remember, this was written almost 20 years ago. I'll check this week to see if they've done an updated study. Just check out the authors' conclusions. and see if those don't fit this time around, too. It should influence your opinion about where we're headed.

"First, virtually every buyer in our California cities and the vast majority of buyers in Boston and Milwaukee believe that prices will rise...The average annual increase for buyers in California was in the 15% range, while for Milwaukee and Boston, the figure was roughly half as high... Even in Boston, 77.8% reported that it was a good time to buy because prices were likely to rise in the future. For Milwaukee the figure was 84.8%, while it was well over 90% in both California cities."

Again, sounds like our situation. In California, prices took a turn for the worse the next couple years after this article. Now, over the 15 years since, I bet we've reached those expected returns (not compounded). For now. It took an amazing run the last few years to get there, and now we're due to give some back. Back then, they didn't have the loan-quality problems we're facing now. Here's more:

"Since most people expressed a strong investment motive, one would assume significant knowledge of underlying market fundamentals. The efficient markets hypothesis assumes that asset buyers make rational decisions based on all available information and based on a consistent model of underlying market forces...The survey reveals little knowledge of, or agreement about, the underlying causes of price movements. Rather than citing any concrete evidence, people retreat into cliches and images."

"In all four cities, interest rate changes are cited as a major factor...It is hard to understand how price changes in all four cities can be driven by interest rates."

"Second in overall frequency were general comments about the local economy, such as 'strong local economy' or 'growing regional economy'...The response to questions in this section leave the strong impression that people look to observed price movements to form their expectations and then look around for a logic to explain and reinforce their beliefs...Irrelevant stories that make a vivid impression tend to be cited."

"Among the most popular cliches were 'The region is a good place to live' and 'There is not enough land.' Neither of these is news and neither could explain the sudden boom...Very few people mentioned these cliches in Milwaukee."

You can expect Shiller's conclusion to hold when the housing market starts to retreat. When home prices start to fall, the "observed price movements" will cause more selling. Most people buy high, and sell low. Once this phenomenon starts spreading to the housing market, you'll see that we have a serious problem on our hands. We've done the buy high, there's only sell low left.

Genie Is Out of the Bottle

Haven't you wondered how the market could keep going up for four straight years, with barely a correction? No, you haven't. I understand, you've just been riding it. No concern about risk. Heck, you wouldn't even recognize stock-market risk if you saw it walking down the street.

I'm here to tell you that the risk genie has been let out of its bottle. Risk is back in the market, and at some point fairly soon it's going to be realized. You better start preparing now.

By lowering the Fed funds rate to 1%, the Fed allowed the risk in the stock market to be bottled up. Low rates let you borrow money to invest in long-term debt, which provides the collateral to let you sell short-term debt. You make the difference between the long-term debt you buy and the short-term debt you sell. Arbitrage allows you to deny the effects of risk for a period of time. When the arbitrages unwind, look out below.

Here's an example. The muni-bond market has been crushed. Funny, you'd think that investors would be running to those low-risk, no-tax funds as risk has increased. But it turns out that many funds were buying long-term munis so they could sell short-term collateralized debt obligations (CDOs). Now these funds can't sell short-term debt, so they don't need (and can't afford) the long-term debt. Down go munis.

Muni-bond sellers are telling you that munis are a bargain now. Some muni yields are higher than treasury yields. Muni-bond sellers are telling you that the market is somehow wrong. Who do you believe, the muni pushers or the market? The market is telling you to watch out. States and municipalities issued a record number of munis last year, 25% above the previous year's rate. In areas where foreclosures are highest, municipalities are cutting back on services left and right. You don't get paid enough by munis to take the risk of default. Stay away from munis at least until you start hearing about muni-bond defaults coming out of California.

Munis deserved to plunge, because the riskless arbitrage play that was responsible for at least part of their increased values no longer exists. That's a fundamental change to the value of those entities. Now you have to evaluate the securities based upon their own merits. And them merits are looking worse and worse each day.

Same thing is going to happen to stocks. The funds tell you it's a liquidity situation -- if we had more money (or could borrow more money), we'd support these prices. Money's gone. There is no more. So they're selling the things in their portfolio that have value right now. We see it differently. Risk is now seeping back into their portfolios, so they no longer are able to leverage their positions to the hilt. Banks see the risk, and they won't lend them the money.

As risk seeps back into the market, it will cause a repricing of assets going forward. And they won't be pricing these assets higher. Time to shake hands with the genie.