Category Archives: Stocks

Caveat Emptor

Bond guru Jeff Gundlach observed that the stock market has become a market for high-risk CDO residuals.

I must admit that I had not thought about this but he is exactly correct. CDOs (Collateralized Debt Obligations) were at ground zero in the last financial crisis. A CDO is constructed from a collection of assets, for example mortgages, and is divided into slices (“tranches”) which receive income in a priority sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. So for example, if $100 comes in, then slice 1 may be entitled to the first $25, slice 2 the next $25 and so on. But if only $10 comes in, slice 1 gets it all and nobody else gets any money. The last or lowest priority slice is called the residual, which receives whatever is left over after the other slices with fixed entitlements have been satisfied.

Gundlach’s point is that companies which have bought back shares with debt now have a capital structure essentially identical to that of a CDO, where the debt obligations have first claim on the company’s income and the equity investors must be satisfied with the crumbs. They are in the same position as the owner of the residual tranche of a CDO. So long as earnings are high and interest rates are low, all is well and there will be yachts and jets. But when the tide goes out, there will be naked swimmers as the ugly side of leverage becomes visible. Read Jeff’s piece and be very very scared.

Loose Cannons

In the days of fighting sail, the ship’s main armament typically consisted of rows of cannons lined up on each side of the ship. These cannons fired through ports in the side of the hull and were mounted on wheels so that they could be pointed and able to recoil when fired. Normally, they were constrained by heavy ropes. But from time to time one or more would get loose. Each cannon could weigh as much as three tons and would then roll around the gun deck as the ship pitched and rolled, crushing anything or anybody in its way. The gundeck would be crowded most of the time – each gun on a large ship had a crew of 14 men who not only worked but ate and slept near their gun. Needless to say, a loose cannon could do much more damage than any broadside from an enemy ship.

In the market, the black boxes or “algos” are the equivalent of the loose cannons of yore. They are out of control and roll around in herds, as many of them share similarly programmed rules. You can watch the “herding” in the stock market by watching the “Tick” as it moves to extremes in both directions – that’s the herd. You hear about “flash crashes” – that’s a herd of algos running over some security or asset class. They pose a huge danger to the financial system, and need to be reined in. The mistake that the regulators make is to only consider them as single entities, without comprehending the emergent phenomena arising from unintentional herding behavior.

Crispin’s Day (Not Henry V)

Crispin Odey, who runs the most bearish hedge fund and needless to say has done rather well this year, writes in his recent manager’s letter:

I have a lot of sympathy for your position, sitting on the other side of the desk.

This is late cycle economics. Consumers are sated and over-borrowed. Companies have extracted all the margin they can and have leveraged themselves as well. Cheap money has spawned competition. Populism risks playing about with prices and property ownership. Recessions will not be altogether unwelcome given that they deal with the problem of rich and poor and young and old. The rich lose money which pleases the poor. The old lose their jobs and the young are the first to be reemployed. Without recessions this redistribution has to be done through taxation and legal theft.

Too Tight?

Reportedly, President Trump is considering firing Fed chair Powell, blaming him for the recent stock market declines.

Ironically, in Sept 2016, Trump accused the the Fed of “keeping the rates artificially low so the economy doesn’t go down so that Obama can say that he did a good job. They’re keeping the rates artificially low so that Obama can go out and play golf in January and say that he did a good job. It’s a very false economy. We have a bad economy, everybody understands that but it’s a false economy.”

Of course, he then adopted the “false economy,” even though he apparently well knew that it was a bubble, going on to extend it with spending increases and tax cuts. Of course, this simply increased government’s value destruction and we will all reap the consequences. In my mind, this is the biggest disappointment of Trump’s presidency – that he knowingly continued to inflate the bubble.

Yellen was “too short.” It seems Powell is “too tight.” Firing Powell would probably precipitate a crash.

The right thing to do is to acknowledge that the Fed’s ability to control the economy is a myth. Their attempts just lead to an endless series of booms and busts, as anyone who has the least understanding of control systems theory could predict.

Volatility In 2019?

2019 could be like 2008, which featured nine rallies of at least 9.5% of which three were greater than 20%, totaling 142%. The corresponding declines totaled 158%. The total opportunity, if you like, was 300%. Not that it would have been possible to catch the spikes perfectly, but….

The top top to bottom bottom was a mere -50.3%.

The Tilted Playing Field

The stock market is supposed to be a level playing field for all participants. But it clearly isn’t, and the referee, the SEC, doesn’t care and actively favors the tilters.

Understanding the issue is straightforward. If, every morning, you got the day’s closing prices, do you think you could make money? Of course, it would be a no-brainer.

How about an hour from now’s prices? Or a minute? Same answer, although you’d have to be quick. If you’re a computer, you could be quick enough.

Well, the favored few have computers, and no they don’t get a day or even a whole minute but they do get fractions of a second and that’s plenty for a computer capable of billions of instructions in a second. They are allowed direct connections to the exchange computers and are often only a few feet away to minimize any network delays. So they see prices before you do, and can respond before you can. Making money consistently is easy-peasy. They do pay the exchanges for the privilege, but that’s nothing in comparison to the profits they reap at your and my expense.

What can you do about it? Not much. Just remember the SEC is the retail investors enemy. Like many government employees, SEC personnel are corrupted by the promise of lucrative sinecures after their stay at the SEC. It’s called regulatory capture.

So they go after visible but harmless and relatively defenseless prey like Martha Stewart.

Jawboning

Well Trump saw the market was down 300, more or less, so… he got on the wires and said that “China talks are going well” and he thinks “US will reach a trade deal with China.”

That’s a blatant attempt at jawboning the market higher. Of course the algos went berserk. What BS. But it shows how important he thinks the stock market is to electoral success, and that he will do “whatever it takes” to keep it up. Well until Tuesday’s close, anyway. After that he will likely be able to blame the Dems.

Meanwhile the ten-year is solidly above 3% and rising. Dems will need a miracle. Expect a panic soon.

Three More Days

Trump needs to hold this market together, if not continue the rally, for three more days, until the mid-term voting is concluded as the polls close on Tuesday of next week. More learned minds than mine have opined that the force behind the rally is short-covering by some large fund that is massively short gamma (e.g., has a short put position). Moi, I think that the explanation is more mundane and is closely related to Trump’s need to hold things together.

Supposedly the seasonality is positive after the mid-terms, but I have to wonder as the level of vituperation from the Dems would seem to bode ill for the political climate. The Dems seem to have no agenda but to oppose and/or impeach Trump and prove that Hillary was robbed. Time to move on, folks.

The employment report this morning included more than a hint of inflation, which is usually toxic to the stock market. Given the historically (hysterically?) extreme level of valuation, risk is off the charts.

Be careful out there.

Self-explanatory

Res Ipsa Loquitur