The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Good Evening: After once again plunging at the open, U.S. stocks were finally able to mount a rally on Tuesday. It took all day for the averages to claw their way back before finishing mixed, but given the poor headlines and the scope of the recent stock market sell off, most investors will gladly take it. The latest bit of geopolitical angst to affect global equity prices was a report that North Korea has severed ties with South Korea and is in the process of mobilizing troops. The frightening prospect of war on the Korean peninsula had investors shunning risk and fleeing to perceived quality until a rally during the final two hours of trading erased early stock market losses of approximately 3%. After seeing so many rallies fail in May, market participants were quite happy to see one finally stick. In an environment beset with so many negatives, the unchanged mark was welcomed as the new up.

It’s been two months since we first learned that a South Korean warship was sunk due to mysterious circumstances, claiming the lives of nearly four dozen South Korean naval personnel. It’s been many days since the world was first told of evidence that the Cheonan went down after being struck by a torpedo that was almost certainly North Korean. South Korea, the United States, and the international community were all rightly indignant about the incident, but what wasn’t known was how North Korea would respond.

The answer to this question came in two parts during the past 24 hours. First, a group of North Korean defectors told Western media outlets last night that Kim Jong IL has mobilized his military and ordered them to be “ready for combat” (see below). As the meaning of this bellicose action was be debated in the media, North Korea announced today that it was severing all ties with South Korea. While a full-blown conflict is unlikely, few investors enjoy the thought of war on the Korean peninsula, especially when the North is likely in possession of at least one nuclear weapon.

Stocks in Asia responded overnight with yet another of what has felt like a series of 3% down days. More rumblings about sovereign debt problems, economic weakness, and bank capital needs in Europe certainly didn’t help share prices on the Continent, nor did the latest opinion pieces about renewed banking problems in Spain (see stories below). It was all too much for U.S. equity futures, which had already been on the defensive after such a poor close yesterday. When stocks did open in New York on Tuesday, the indexes dropped approximately 3% and the VIX once again surged above the 40 level. The nervousness about what might happen next was palpable, and while many called the downdraft a buying opportunity, a few were citing the possibility of a crash.

After recovering a bit from the early whoosh, the major averages went broadly sideways during the middle of the trading session. Once a rally took hold during the final two hours, however, it didn’t relent until the closing bell rang. The levitation into the close was unaccompanied by any positive news that I could find, a situation which often leads to rallies that last more than a day — unless, of course, some fresh bad news comes along. The major averages all finished just about flat, with the S&P 500 (+.04%) nosing ahead of the others. In contrast to equities, Treasurys were sought this morning and then spent the rest of the day leaking lower before finishing with small gains. In a sign risk aversion may be peaking, today’s auction of 2 year notes fetched a Japan-like 0.769%, the lowest yield on record. The dollar index finished with a gain of 0.3%, while commodities couldn’t mount the type of comeback seen at the NYSE. Gold (and gold stocks) held in well today, but most CRB components suffered as the index itself declined 1.25%.

If not news-driven, what sparked today’s revival at the corner of Wall and Broad streets? Was it due to bargain-hunting, short-covering, or some new trading strategy by the mysterious “quants”? I have absolutely no way of knowing, but I hope the following imaginary conversation between two hedge fund traders is somewhat instructive. Just as following the momentum crowd and getting too long was an easy mistake to make in April, getting too negative may be a risk right now. The Head Trader (HT) in this fictional scenario has called over one of his junior traders (jt) during the lunch hour today to ask him about the trading positions he’s recently accumulated:

HT: Hey, junior, I see you’ve built yourself quite a short position in global equities.
jt: Yes, sir, I have.
HT: Mind telling me why it’s so large?
jt: Sir, haven’t you been looking at the screens? The news flow is awful, the fundamentals are horrible, and the technicals are even worse. This market could break wide open at any moment!
HT: Uh, huh. Tell me all the reasons why you are so bearish.
jt: Well, ever since the EU rescue package announced two weeks ago started to unravel, it looks like a number of governments might default and the euro currency could soon be history. Asia is also a mess, since North Korea might just start a shooting war with South Korea, and the U.S. might get into a trade war with China if the yuan doesn’t appreciate. Here at home, a slowdown in Europe could cause us to experience a double-dip recession, the appreciating dollar is going to hurt profit margins for our large, export-driven companies, and the Senate’s bank reform legislation looks like it might just crush our financial sector. Furthermore, the tape trades like death and all the momentum indicators are pointing south. Day after day, it seems like stocks are down 2% or more, and every rally keeps failing. Credit spreads are widening and the VIX is above the danger zone between 30 & 40. Being short isn’t just smart — it’s easy!
HT: And so you are short stocks, long puts, and short index futures — in size, right?
jt: Yes, sir, and just listing all the reasons why makes me want to press my positions even more.
HT: I’m sure it does. Now cover at least half of every position you hold — today.
jt; Cover! But why would I want to –
HT: Stop. Things might play out the way you think, but answer me the following questions: First, has any country in Europe actually defaulted?
jt: No, but…
HT: Has any country — voluntarily or involuntarily — left the euro currency?
jt: No, but…
HT: Has either North Korea or South Korea crossed the DMZ to attack the other?
jt: No, but…
HT: Has an actual trade war been started with China?
jt: No, but…
HT: Has the U.S. fallen back into recession, or have large companies started to report losses, or has bank reform legislation even reached the President’s desk?
jt: Not yet, sir, but…
HT: You’re right when you say the tape trades poorly, and stocks have indeed fallen and volatility has indeed risen, but don’t you think the momentum that is now your friend could turn on you in a New York minute?
jt: Yes, sir, but…
HT: What I’m trying to tell you is that none of the scary scenarios have yet come to pass. Stock prices are starting to reflect the risks that they could, but they haven’t happened yet. And what will happen to your positions if Mr. Bernanke panics and decides to push the QE button again? The short positions you have on need more bad news in order to keep working, so I want you to cover half of them — now.
jt: But, sir, my bonus is tied to my performance, and I think –
HT: Hang on, son; let me explain something to you. Your bonus is indeed performance-based, but this fund is a partnership and most of my net worth is on the line. What will hurt both you and me most at this moment is a big rally. Now start covering — you’ll thank me later. Besides, didn’t we have a similar conversation last month when you were out over your skis on the long side?
jt: That was the guy next to me.
HT: Whatever — the lesson is still the same. We need to be nimble in this environment, not dogmatic.

– Jack McHugh

U.S. Stocks Recover From Rout as S&P 500 Holds Above Year’s Low
Kim Jong Il Orders Military to Combat, Group Says
Pimco’s El-Erian Tells PBS Spain Stress Spurs Contagion Concern
Global Banks May Need $1.5 Trillion in Capital, Study Says
Gold Rising as Euro Weakens Spurs More Speculation
More Bank Regulation Isn’t Helpful, Wilbur Ross Says

Lest anyone doubt our stock selection approach is quantitatively driven, the following represents the positions of our Long/Short accounts:

QID $21.16 3%
BJ $39.14 5%
OSTK $22.64 5%
NAV $52.80 5%
ICE $122.08 5%
PCS $8.80 4%

We are 24% long, with a 6% short position in the QIDs. Hence, our net exposure is 18%.

Now, if ever you wanted evidence of the importance of being objective, you might note that the 3rd position above is none other than Overstock.com.

It is a testament to our lack of bias in stock selection in that we are long this 3rd tier retailer. Sure, the CEO is a loon, more interested with spinning conspiracy theories than running the firm. Yes, they have engaged in accounting fraud, probably are tax cheats, and have never truly been profitable.

Despite the fact that I personally think it is a steaming pile of shit, that the CEO is an asshole, and that the entire company is probably corrupt — it is in our portfolio. As a long position.

Go figure.

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UPDATE: May 25, 2010 10:55 pm

Apparently, Byrne  just dumped about 140,000 shares, or $3.2 million worth of the stock.  I do not recall any prior sales (might this be his first insider sell?)

Is Byrne in possession of material insider information? Would he be so stupid as to sell the shares? (I doubt anyone could be that dumb).

Perhaps he sees a favorable outcome to the SEC investigation? Maybe he is raising money to pay a fine?

John Clarke and Bryan Dawe calculate the cost of the European debt crisis (very funny).

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Transcript after the jump . . .

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Schematic of BP’s cementing plan:

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Source:
Costly, time-consuming test of cement linings in Deepwater Horizon rig was omitted, spokesman says
David Hammer
The Times-Picayune, May 19, 2010
http://www.nola.com/news/gulf-oil-spill/index.ssf/2010/05/costly_time-consuming_test_of.html

I’m sorry if this sounds too cynical. I’m actually a very happy person. Fed Pres Bullard in the Q&A of today’s speech said their quantitative easing program has been “very successful,” that they will remove it in a “reasonable time frame” and the Fed could use the quantitative easing tool again in the future. He also said deflation is not a risk right now as higher inflation is more likely than deflation (I’m quoting Bloomberg) Translation: money printing works to temporarily fix and paper over a financial crisis as we got a huge rise in asset prices, we don’t want to give it up so soon and if things turn south again, we’ll knock down more trees and ramp up the printing press again. Also, printing money will eventually lead to inflation and the more disinflation/deflation we see in the short term, the more we will print.

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Source:
Javers: The Politics of Reg Reform, “Dems Have the Upper Hand”
Aaron Task
Yahoo Tech Ticker, May 24, 2010
http://finance.yahoo.com/tech-ticker/the-politics-of-reg-reform-”dems-have-the-upper-hand”-javers-says-494359.html

This week we visit an essay from an old friend of Outside the Box, Paul McCulley, the Managing Directpr of PIMCO. This is a speech he did at the Minsky Conference sponsored (I believe) by the Levy Institute. It was also the same speech he gave at my conference mid-April that was quite well received.

Essentially Paul argues that the cause of the recent crisis was the creation of the Shadow Banking System outside the purview of regulation. And while he did not use the line in this speech, he did at my conference, which is one of the truly great lines I have heard this year.

“The rating agencies were like the man who went to an under-age drinking party and handed out fake IDs (identification cards). They were the necessary enablers as Paul shows. This is a think piece and one you should take some time to read as when you “get it,” you will have some understanding of what must be done all over the world to prevent the next crisis. Let me offer two paragraphs as teaser copy”

“And I think the first principle is that if what you’re doing is banking, de jure or de facto, then you are in a joint venture with the public sector. Period. If you’re issuing liabilities that are intended to be just as good as a bank deposit, then you will be considered functionally a bank, regardless of the name on your door. That’s the first principle.

“Number two, if you engage in these types of activities – call it banking, without making a big distinction here between conventional banking and shadow banking, as Paul Krugman intoned this morning – in such size that you pose systemic risk, you will have higher mandated capital requirements and you will be supervised by the Federal Reserve. Yes, I just told you who I think the top-dog supervisor should be. You will have tighter leverage and liquidity restrictions: You will have to live by civilized norms. In fact, a great deal of what is on the regulatory reform table right now proceeds precisely along those lines. If you’re going to act like a bank, you’re going to be regulated like a bank. That simple. And maybe you just might find the time to go back to working on your golf game at 3. That is the core principle.

(Note: Paul uses the following Latin terms a lot. For those not familiar with them,  Ex-post is Latin for “after the fact.”  Ex-ante is Latin for “before the event or beforehand”.)

Have a great week!

Your rushing to yet another plane analyst,

John Mauldin, Editor
Outside the Box

After the Crisis: Planning a New Financial Structure
Learning from the Bank of Dad

Thank you very much. It is an absolute pleasure and honor to be here. I gave the keynote a couple years ago and it was my first time to be at the Minsky Conference. I feel that I’m part of a church, and it’s a good church in that we’re on the right side of history. And it’s absolutely wonderful to be attending services with you again.

I want to open up with a little story that should make everybody in the room feel particularly good, and then we’ll get into discussing economics. Harry Markowitz has been a friend of mine for about a decade. I became friends with Harry through two channels. Number one, Rob Arnott of Research Affiliates has an Advisory Panel of famous academics, such as Harry and Jack Treynor, that he gets together every year. I’m frequently invited to speak. We spend two or three days over a weekend together. I’ve also gotten to know Harry because he and the late great Peter Bernstein were very close friends. Peter and I were also very close friends.

I’ve been preaching the Minsky Framework at Rob’s event for a number of years. And Harry’s always been very, very polite. I spoke again just this past Sunday morning. After I finished, we had a nice Q&A. And Harry said, “Paul, if I had to read one book by Minsky, which one would it be?” And I said, “Harry, please, tell me that you’ve read at least one book by Minsky.” And he says, “No, I haven’t, but I think I would like to, and I think I’m probably old enough now.”

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Given today’s volatility — we gapped down 2.5%, now are climbing to minus 1.5% –  today’s lunchtime chart is this fascinating look at the long term history of the VIX, below

As you can see, the Volatility Index is now above the levels it hit during the Bear Stearns collapse, Fannie & Freddie’s Fall, and Morgan Stanley’s wobble. It is near levels reached during the Asian Contagion, LTCM, and 9/11. The VIX remains far below the Lehman/AIG collapse.

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VIX 1990-2010

click for larger chart

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Hat tip Mike S.

Click for ginormous graphic

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Via GoBankingRates

Gold offers a negative yield, hasn’t historically been a good inflation hedge and isn’t even that much of a safe haven in times of market crisis. Indeed, it’s looking like a bubble. But in times when governments are distorting all asset prices, it’s nice to have something tangible to hand.

WSJ, 5/25/2010 7:11:19 AM