THE IMPLOSION AT AMARANTH, the multibillion-dollar hedge fund that dropped some 65% last week, has created a frenzy in financial circles. Politicians and pundits are already calling for an investigation, with many suggesting the massive loss as another example of why "unregulated" hedge funds1 need much closer oversight.
Any rational, knowledgeable observer knows that Amaranth didn't implode because it was a hedge fund2, or because it traded energy or dealt on the unregulated OTC market. The meltdown was caused for the same reason that virtually every other meltdown occurs, no matter if it's in a hedge fund, mutual fund or Aunt Tilly's E*Trade (ET3) account: huge positions, massive leverage and a stubborn trader who just had to be right.
Say it with me: Size kills. Amaranth got crushed because the manager lost his discipline, not because of the market he traded or the legal framework of the organization. What destroyed Amaranth was bad investment technique — not flawed regulatory oversight.
As we've been pointing out4 for years, you can bet long or short on any stock, bond or commodity under the sun. You could have bought gold5 at $700, Ford (F6) at $35 or Nortel (NT7) at $80 — or even natural gas at $14. Providing you didn't bet the entire farm, your lousy prognostication wouldn't have done too much damage to your portfolio.
In the coming weeks, we'll undoubtedly learn more about the events that led to the fund's $6 billion loss, but from early reports the story sounds fairly mundane. Wunderkind trader Brian Hunter appears to have made a recklessly large bet in a weak market. Regular readers know that as almost the definitive example of a low-probability trade. If you are going to risk it all, you must be prepared to lose it all. I don't know of any lucid being who'd willingly take that trade.
Given the size of the loss, media coverage and momentum stirring among politicians8 concerned about the "public good," you'd think the Amaranth implosion would have prompted major market upheaval or price volatility.
The natural-gas market, where the majority of losses occurred, continued uninterrupted, even as Amaranth sold its open positions to third parties. A few microcap SPAC companies, such as JK Acquisition (JKA9) or Star Maritime Acquisition (SEA10), were volatile on the news, although none have been severely impacted. The stock, bond and currency11 markets in which Amaranth operated haven't skipped a beat. A dynamic and free market12 allowed the risk to be dissipated, prompting no systemic threat.
Of course, the risk (and reality) of loss was born by Amaranth's investors, who have seen a massive, double-digit drawdown in a frighteningly short period of time.
Yet these investors, along with most people who don't sit on a Senate subcommittee, understand that any fund — hedge or otherwise — involves a risk13. No Amaranth investors are missing a meal tonight because of the fund's demise. They're surely not happy about the loss, but they are informed investors who were, without exception, diversified14 enough to withstand the loss.
Man Group, a large financial firm, had exposure to Amaranth, as did Morgan Stanley (MS15), which lost money. Goldman Sachs (GS16) estimated that one of its overseas funds could lose 2.5% to 3% in September as a result of the loss. None of this has affected their stocks — all are at or near either 52-week or all-time highs.
The San Diego County Employee Retirement17 pension fund invested $175 million with the fund, and is now tallying an almost 50% loss on the investment according to published reports. Yet the truth is it's a drop in the bucket for the $7 billion plan, which has successfully invested with numerous hedge funds in the past.
Similarly, approximately $25 million of New Jersey's $73 billion state pension plan had exposure to the fund through a diversified fund-of-funds. Assuming they write the investment off entirely, its small size will amount to no more than a rounding error for the plan. You don't think they lost many times that amount on Cisco Systems (CSCO1 as the tech bubble deflated? The City of Philadelphia's pension plan, which invested a total of $8 million in Amaranth, expects to be out some $5 million. Yet it's a tiny fraction of the $4.6 billion in total assets thanks to a diversified strategy that invests across many funds. I'd venture they lost plenty more on shares of GE (GE19) back during the bear market.
Moreover, while Amaranth (and its investors) lost big by betting on a rally, a large number of funds and aggressive traders had taken the other side of that bet. The New York Times reported20 that numerous commercial traders and public funds, including Andy Weissman's Energy Catalyst Fund21, were on the short (winning) side of the trades. Plenty of individual investors who were short energy made money as well.
The point is that what sunk Amaranth wasn't that it was a hedge fund22 or that it needed better regulatory oversight, but that its management permitted recklessly large positions. That sort of approach will eventually sink any investor, be it a "sophisticated" hedge fund or Enron23 worker's 401(k). And although the losses were disappointing, investors were protected by including the fund as only part of a diversified portfolio. The markets were unaffected and functioned flawlessly. Shortly put, no harm was done.
As the politicians begin to circle around the easy scapegoat of "unregulated" hedge funds, however, that paradigm could easily change. Greater governmental intrusion24 into a perfectly functioning free market25 will only lead to higher costs, lower returns and more inefficient trade. The smart, principled politicos will sit this one out.
Article Title: "Polls, Pundits Tout GOP Gloom, But Smart Money Bets Different " Author: JED GRAHAM Section: General Date: 9/20/2006 In handicapping the midterm elections, conventional wisdom and the smart money seem to have parted ways in recent weeks.
If you happened to catch "The Chris Matthews Show" on NBC on Sunday, you would've learned that 11 of his 12 panelists expect the Democrats to capture the House.
But those who put money behind their predictions see things differently. Quotes at TradeSports.com show that futures traders favor Republicans to retain control of the House.
Late Tuesday, TradeSports' futures contract for GOP House control was trading at 53.8 - a 53.8% chance. TradeSports gives an 80.3% chance that Republicans will hold onto the Senate.
Betting exchanges, or futures markets, are worth paying attention to because they have a track record that would put most pundits to shame.
In 2004 the Iowa Electronic Markets, a research vehicle operated by the University of Iowa, gave President Bush a 51.4% chance of winning re-election vs. a 48.6% chance for a Sen. John Kerry victory. Those totals were eerily close to the popular vote results.
The prediction markets tend to do better than polls because they are able to capture "the wisdom of crowds" and consider questions a pollster wouldn't think to ask, said Don Luskin, chief investment officer at TrendMacrolytics.
When real money is at stake, those making predictions are more likely to integrate and weigh all the evidence.
This generates "a holistic view" that isn't skewed by personal bias, he said.
Republicans shouldn't be breathing easily, however. Luskin figures the markets will have much better predictive power closer to Nov. 7. He notes current readings basically signal a 50-50 contest.
What's noteworthy is that these markets suggest Republicans have revived from "a near-death experience," Luskin said. In early September, the markets gave Republicans only about a 40% chance of holding the House.
Have futures traders spotted a shift in the electoral winds more quickly than polls or pundits?
It wouldn't be the first time. In a 2005 paper, University of North Carolina professors Paul Rhode and Koleman Strumpf wrote that the TradeSports market "appears to quickly incorporate new information."
They noted that Bush's market shares fell five points during a 2004 Bush-Kerry debate that pundits later said Kerry won.
Subsequent polls showed a Kerry bounce. Pundits who had seen Bush as the favorite began to see the race as a dead heat.
Futures traders now are likely responding to a sharp drop in energy prices, Luskin said, as well as a movement in Congress on earmark reform. That should lead to a less hostile climate for GOP candidates.
Retail gasoline prices have fallen 54.1 cents in six weeks to a six-month low of $2.497 a gallon. They'll probably fall an additional 30 cents or so in the coming weeks.
Other key developments include Bush's national address on the fifth anniversary of 9/11 and House action on border security.
Some polls are beginning to back up the notion that the election outlook has shifted. On Tuesday, a new USA Today/Gallup poll showed Bush with a 44% approval rating, up from 39% in August.
The poll also showed that 48% of likely voters would vote Democratic and 48% would vote Republican. Other recent polls give Democrats a 3% to 14% advantage.
Professional prognosticators - who have their reputations on the line - give Democrats the edge. Democrats need 15 seats to retake the House; the Rothenberg Political Report predicts a pickup of 15 to 20 seats.
By ROHAN SULLIVAN, Associated Press Writer 27 minutes ago
SYDNEY, Australia - "Crocodile Hunter" Steve Irwin always felt he would die early, but that he would be killed in a car wreck and not by an animal, his widow says. ADVERTISEMENT
In an interview with Australia's Nine Network that aired Wednesday, Terri Irwin said her husband, who died from the jab of a stingray Sept. 4, had an uncanny way with animals that both of them believed would keep him safe as he caught crocodiles, snatched up snakes and played with other dangerous beasts.
"I never thought it would be an animal, he never thought it would be an animal," Irwin said. "I thought he would fall out of a tree, he thought it would be a car accident."
Asked by interviewer Ray Martin if Irwin believed he would die early, Terri Irwin said, "He had a very strong conviction that he would. To the point where I'm grateful in a way, because we're prepared."
Irwin, 44, died minutes after a stingray's barb pierced his chest while he filmed a TV show on the Great Barrier Reef. His death prompted an unprecedented outpouring of grief in Australia and among millions of fans of his TV show, "Crocodile Hunter."
In an interview with ABC's Barbara Walters that was to air Wednesday in the United States, Irwin she said she hasn't seen the film of her husband's deadly encounter with the stingray and that it won't ever be shown on television.
"What purpose would that serve?" the American-born Irwin said. Excerpts of the interview were released in advance by ABC.
Irwin's friend and business partner, John Stainton, has seen the film. He told Walters he never wants to see it again and doesn't want anyone else to see it. "It's just a horrible piece of film tape," he said.
Terri Irwin was on a research trip in Australia with the couple's two children — 8-year-old daughter Bindi and 2-year-old son Bob — when her brother-in-law reached her with the news.
"I remember thinking, `Don't say it. Don't say it. Don't say it,'" she said. "I looked out the window, and Bindi was skipping, skipping along outside the window. And I thought, `Oh, my children. He wouldn't have wanted to leave the children.' And I knew it was an accident. It was an accident so stupid. It was like running with a pencil."
She said it's important for her family to continue the work her husband did in teaching the world about wildlife.
Irwin told Walters she is getting through her grief "one minute at a time."
Success is a State of Mind - - Tommy Bahama Profits always take care of themselves but losses never do. The speculator has to insure himself against considerable losses by taking their first small loss. - - Jesse Livermore The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the man of inferior emotional balance, nor for the get-rich-quick adventurer. They will die poor. - - Jesse Livermore
Today's announcement that ESPN is leaving the mobile-phone services business is no surprise. I've pounded the table about the futility of this model on RealMoney and TV repeatedly. The fact is trying to rent the infrastructure for a telecom-services business is a horrible model. I used to sell services like this in my former life as a telecom-services wholesale manager. I helped model out these businesses, and the models just never really worked, as they are simply based on marketing. I actually sat in on one of the earliest meetings when ESPN was considering getting into this business in the late 1990s.
Neither ESPN nor its parent Disney (DIS - commentary - Cramer's Take) own the network -- they call this venture a mobile-virtual-network operator -- that they sell their services on. They simply try to brand the services and hope that they can sell the services for a little bit more than they pay to rent them from the wholesaler, in this case Sprint (S - commentary - Cramer's Take). Retail is a hard business when all you have to differentiate yourself is a brand.
And what was the point of ESPN's branded phones and service anyway? I can watch ESPN, ESPN Classic and ESPNews on my Motorola Q phone using Verizon EVDO broadband services and my Slingbox tied into my Time Warner set-top box made by Cisco's Scientific Atlanta. Ironically, ESPN never offered such services to its subscribers.
Disney's going to have to write off its Disney-branded MVNO next, but luckily for shareholders, the impact of doing so will be about equivalent to the impact of when it writes off this ESPN MVNO business. I sure wish the stock had gotten hit today so I could finally start buying some. Not chasing it though.
i just thought this was a great story and some excellent quotes (i love " "We both know some people who own more than a billion (dollars) and they're not any the happier. They also need bodyguards," he said." too funny
Craigslist founder says he won't cash in Thu Sep 28, 2006 9:13 AM ET
AMSTERDAM (Reuters) - The founder of craigslist, the free social networking and classifieds Web site, said on Thursday he is not interested in selling out, a few hours after social networking site MySpace was valued at $15 billion.
"Who needs the money? We don't really care," Craig Newmark said in an interview at the Picnic '06 Cross Media Week conference here.
"If you're living comfortably, what's the point of having more?" Newmark said.
Just a few hours earlier, RBC Capital analyst Jordan Rohan said MySpace could be worth around $15 billion within three years, measured in terms of the value created for shareholders of its parent company, News Corp.
MySpace was acquired by Rupert Murdoch's News Corp. for $580 million less than a year ago. It now boasts more than 90 million active users, against 10 million monthly users of craigslist.
Craigslist, despite its no-frills layout, gets more than four billion page views per month with just 22 employees.
Measured as a proportion of the number of employees, it claims to rank seventh amongst English language sites, behind Yahoo, AOL Time Warner, Microsoft, Google, eBay and News Corp.
Newmark said raising the money to subsequently give it away to good causes also did not interest him.
"Finding a good cause is incredibly hard and time-consuming," he said, adding that he and Chief Executive Jim Buckmaster agree on not cashing in.
"We both know some people who own more than a billion (dollars) and they're not any the happier. They also need bodyguards," he said.
Craigslist is 25 percent owned by eBay after one of the shareholders who helped to set up the site in the 1990s sold his stake in 2004. Newmark declines to specify exactly who owns the remaining shares
ANNANDALE, Va. (MarketWatch) -- In one sense, Doug Fabian should be feeling pretty good right now about the 39-week moving average system that is the basis of his newsletter's market timing. That timing system, made famous by this decades-old newsletter that used to be called Telephone Switch Newsletter, is simple, elegant and mechanical: It calls for being invested in stocks whenever the market is trading above its average level of the previous 39 weeks, and otherwise staying in cash. This system turned bullish in mid August, when skepticism was running high and many advisors were worried that September would live up to its historical reputation as being the worst performing month for the stock market of the calendar. Yet, just as followers of the 39-week moving average expected, the stock market has risen smartly since then, with the Dow Jones Industrial Average ($INDU $INDU ) now just four points shy of a new all-time high. But in another sense, Fabian is probably feeling the blues. He chose to ignore the dictates of the 39-week moving average, at significant cost to his newsletter's model portfolio. First, he insisted that he wouldn't consider the 39-week moving average to have issued a buy signal until the stock market rose 5% above it. It took the market a month to jump over this additional hurdle. Yet even when that did happen in mid September, Fabian chose to continue ignoring the buy signal, staying not only out of the market but also sticking with a 25% allocation to the short side of the stock market, in the form of the Proshares Short MidCap ETF (MYY proshares tr short mdcap400 The investment lesson I draw from this experience has to do with the virtues of patience and discipline in mechanically sticking with an investment strategy even when we are inclined to second-guess it. Let me hasten to add that I would not draw this lesson from Fabian's experience if what has happened over the last six weeks were the only occasion on which his deviations from the 39-week moving average system ended up costing his portfolio. It is not. Furthermore, let me add that Fabian's overall market timing record is one of the best of any of the market timing newsletters I have tracked since 1980, when the Hulbert Financial Digest began monitoring the industry. So it really means something when someone with Fabian's track record has difficulty deviating from a preset mechanical system. After starting my newsletter performance monitoring service in 1980, I quickly became acquainted with the virtues of a mechanical approach to the 39-week moving average. At the first investment conference at which I was invited to give a seminar, my workshop was scheduled for the same time as one led by Richard Fabian, Doug's father and the newsletter's founding editor. I think a grand total of just four people showed up for my seminar, while Fabian's was standing room only, with people spilling into the hallway outside the ballroom where he was speaking. I don't recall for sure, but I think that I took the four attending my workshop and we all went next door to listen to Richard Fabian. There he extolled, repeatedly and in many different ways, the virtues of a mechanical adherence to the 39-week moving average. He conceded that this moving average system might not be perfect, but he claimed that it was simple and easy enough for investors actually to follow through thick and thin. My wife, who is a clinical psychologist, wonders if there might not be some Oedipal issues involved in Douglas, the son, choosing not to follow in his father's footsteps. Regardless of the unconscious motivation, however, Doug's deviations have cost his newsletter's model portfolio, according to the Hulbert Financial Digest. Since 1992, when Doug took over the running of this newsletter from his father, until the end of this past August, his newsletter's model portfolio that focuses on the domestic equity market would have made 1.0 percentage point per year more, on an annualized basis, had Doug more closely adhered to the 39-week moving average. This portfolio's performance would have been significantly better on a risk-adjusted basis as well. Fabian's experience is not unique. From my tracking of more than 200 newsletters over the last 27 years, I have found that, more often than not, advisers regret deviating from their pre-established strategies. Note carefully that this does not necessarily mean that you should be a buy-and-hold investor. You could be, of course; buying and holding does have a good track record. But it is not the only possible decent strategy. There are many others, some of which involve shorter-term trading. If you do choose to be a buy and hold investor, though, patience and discipline will be just as important as if you instead pursued a shorter-term strategy. In my experience, just as many so-called buy-and-hold investors end up deviating from their strategy as shorter-term investors, if not more. The lesson I draw from Fabian's experience cuts across the debate between buying and holding and market timing. The key is that, regardless of the approach, you should stick with it through thick and thin. This does not mean that you never fire your adviser, however. There are occasions when you should do so. But just as you should have a preset strategy in the first place, you should also have a preset rule about when, if ever, you give him the boot. Don't wait until he performs poorly, when your bruised ego is easily trumping your intellect, to try to decide what is best. End of Story Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
Schwab Chief Trading Officer Greg Miller sat down and talked with one of the most respected names in technical analysis, Martin Pring, to get his thoughts on how active traders can improve their trading outcomes in today's volatile markets.
The way I see it, trading smarter can lead to trading profitably, and to do that you need to have a disciplined and consistent focus on two key trading objectives--reduce risk and boost profits. Given the way the markets have behaved in recent years, and how the markets are likely to continue to behave, there is perhaps as great a need for traders to employ strategy and discipline as ever. Martin Pring, who was described by Barrons as a "technician's technician" and is the author of several books on technical analysis, spoke with me about the essentials to trading smarter in today's markets.
GM: What should traders think about first when entering a new trade?
MP: I'd recommend each trader start by taking a look at the overall condition of the market, then looking at the technical position of each market sector. After performing this "top-down" analysis of the markets and sectors, the trader should then turn to looking at individual stocks.
GM: Tell me about some of the pitfalls traders face when it comes to trading smarter.
MP: A key requirement for trading smarter is to become totally objective. When committing hard-earned money to any investment, it's real easy to also commit your emotions. Emotional trading is probably the most common pitfall that traders face today. Generally, by letting emotions rule your trade decisions, the market has a funny way of finding and exposing this weakness. My experience has shown me that stock prices are determined by investor psychology, and both psychology and stock prices move in trends. These trends can be visually captured on price charts, and objectively analyzed using various technical tools and indicators. Once you know the trend of a trade candidate, you can then begin to look at optimal entry points, as well as identify risk levels and profit targets. This can all be done prior to entering a trade to help you mentally rehearse a trade's potential outcome ahead of time. If you don't mentally rehearse your trades before entering them, it is far easier to allow your emotions to take control when events go unexpectedly against you.
GM: How might a trader go about identifying a risk level ahead of time?
MP: Traders should always focus first on risk, then on profits. Risk represents the level where a trader might set a stop order in order to exit an unprofitable trade with minimal losses. By setting stops ahead of time you have already made a major effort at mentally rehearsing trades in case things go wrong. For a long position, I would advise the trader to first identify the support level on the price chart then place the stop order just below this support level. I define support as a level where a declining price trend can be expected to halt temporarily due to a concentration of buying demand. Support levels are not predictors of where prices might go, but they do indicate possible or probable points where they might bounce. Potential support points include previous highs and lows, the upper and lower areas of gaps, trendlines and reliable moving averages. Once the price falls below a support level, then the trader should immediately minimize that loss and quickly liquidate the position. Minimizing risk is important because statistically it is very difficult to come back from a big loss. For example if you lose 50% on a trade you will have to make 100% on the next one just to break even.
GM: What should traders look for when identifying a profit target?
MP: Always consider a trade's risk-to-reward ratio. While identifying risk involves setting a stop to minimize risk in a losing trade, identifying a trade's reward involves setting a target where you will look to take profits from a winning trade. I typically look for trade candidates where there is at least a 3 to 1 reward versus risk. In other words, if I were to enter a long position at $20 and determine my risk/support level to be at $19 (a $1 loss per share), I would want to target a minimum price of $23 (a $3 profit per share), or three times the risk per share. If through my use of technical analysis price pattern forecasting I determine that it is probable the price may reach $23 or higher in the timeframe of my trade, I may elect to enter that trade. Also remember to never risk more than 5-7% of your trading capital on any one trade. If you risk say 20% of your trading capital on each trade and proceed to lose this amount on five consecutive trades, you then would find yourself nearly out of business (actually, you'd still have about 1/3 of your capital left). It is important to note here that by capital at risk, I am referring to the maximum amount you'd be willing to lose on any individual trade and not the total amount of capital committed to any one trade.
GM: Let's say you do enter that trade, and the stock goes up but stalls under $23, what might you then look to do?
MP: Seeing as you want to maximize profits, wait and look for signs of a reversal before giving up on the stock hitting your initial price target. There are many types of reversal signals to look for. CyberTrader Chief Market Strategist Ken Tower and I talk at length about some of the most well-known of these patterns in the two upcoming Swing Trading seminars. The real key is to accumulate a "weight of evidence approach" that a trend is reversing before making the decision to exit the trade. By weight of the evidence I mean the trader should consider the technical position using a consensus of four or five indicators. Never trade with one indicator because even the best ones fail from time to time. Using a consensus approach increases your odds of being successful. If you follow too many indicators, this will likely lead you to a state of confusion.
GM: So far we've only focused on the long side of the market. What about the short side?
MP: I'll first say that it typically takes a lot longer for a stock to go up than it does for it to go down. The advantage a short trader may have over a long trader is that the short trader's profits can come much quicker. However, trading the short side of a given stock can also expose the trader to other risks such as the stock suddenly becoming a takeover candidate. If such an event occurs, the stock may shoot up in response, requiring the trader to cover the short position at a price much higher than where it was initially sold short. To protect against such risk, the trader should avoid shorting stocks where there is even the remotest possibility of a takeover.
GM: What style of trading does your educational training best support?
MP: I typically like to focus on momentum or “swing” trading by analyzing price trends and patterns and combining this analysis with overbought/oversold indicator readings. Popularly known as "oscillators", overbought/oversold indicators swing from one extreme to another. As such, they are an excellent reflection of crowd psychology. As we all know, it is better to buy when everyone is bearish. We can use oscillators as a proxy for such emotional extremes.
GM: One final question--can you provide us with a simple but effective swing trading strategy?
MP: A good strategy would be to look for stocks where price is breaking out on the upside, while at the same time the oscillator is bouncing from an oversold state and heading to overbought. I would hesitate to buy a price breakout when the oscillator is in an overbought state, as this is an indication that the stock may be running out of steam.
GM: Short and sweet! Thanks for your time today Martin.
• Manage your risk – Always look to set stop orders to protect against big losses. Practice placing stops by using the demo mode on CyberTrader Pro®.
• Mentally rehearse your trades – Before placing each trade, identify your stop and profit targets and confirm that the reward versus the risk is sufficient to place the trade (Martin looks for candidates where there is at least a 3-to-1 reward versus risk).
• Analyze price trends and patterns – Make use of the advanced, interactive charting capabilities in CyberTrader Pro.
To learn more about how to trade smarter, take advantage of the interactive, educational, online CyberTrader Live service! Download it today!
Martin J. Pring
Martin Pring, best known for his book Technical Analysis Explained (now in its fourth edition), is President of Pring Research, Inc., a company devoted to educating traders and investors. Martin is also editor of a monthly financial forecasting newsletter called The Intermarket Review and is the chairman of Pring Turner Capital, a money management firm. For more information, visit pring.com.
Morten Lund, the guy who was (one of -H.)the earliest backers of Skype is at it again. He has financed Zecco, a start-up that will allow consumers to trade stocks for zero commissions, versus $10 to $20 that many online brokers charge today. Other investors in the company include former Dutch Coca Cola CEO Pier Baarsma and Soren Kenner former chairman of McCann Erickson MRM Europe
CEO Jeroen Veth, a 37 year old entrepreneur and former Merrill Lynch Vice President is heading up the company ... "
Success is a State of Mind - - Tommy Bahama Profits always take care of themselves but losses never do. The speculator has to insure himself against considerable losses by taking their first small loss. - - Jesse Livermore The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the man of inferior emotional balance, nor for the get-rich-quick adventurer. They will die poor. - - Jesse Livermore
Inverted Yield Curve Mixed Signals Does a recession loom? My indicators say no.
By Michael T. Darda
One issue that continues to split Wall Street economists, confound financial analysts, and bedevil Washington politicians is the degree to which the inversion of the Treasury yield curve portends a slowdown or recession ahead.
Typically yield curves invert when short-term interest rates rise above equilibrium levels, triggering a liquidity squeeze, falling commodity prices, a higher currency on the foreign exchanges, slackening profits, and a tendency for actors to shift into longer-dated securities based on the expectation that short rates will soon drop.
There are other explanations for today’s inverted yield curve, including “the global savings glut,” which creates an environment in which savings exceed “intended” investment. This is said to exert a downward tendency on market interest rates. The “global savings glut” is a theoretical construct with a Keynesian genesis.
In his 1930 Treatise on Money, John Maynard Keynes posited a “profit deflation” following in the footsteps of an imbalance between savings and investment (the so-called savings glut), courtesy of central bank rates being held above the “natural rate.” Sub-trend output, employment, and profits were the stated result.
If we fast-forward from 1930 to the present, a yield-curve model developed by the Federal Reserve Bank of New York now pegs the probability of recession in 2007 at nearly 40 percent, given the current disposition of the Treasury spread. Many Wall Street economists and analysts — with one eye on the intense “correction” in residential real estate and the other fixed to the inverted yield curve — have guillotined their growth forecasts to below 2 percent, with some even calling for outright recession by early 2007.
However, there is a third explanation for low long rates and the inverted yield curve — one that is far less ominous for the growth outlook, at least in the near term.
The argument is based on the emergence of a global liquidity glut following the 2001 recession and terror attacks, which has ballooned valuations on everything from commodities to small-cap stocks to emerging-market credits to Treasury securities. This is the explanation I tend to favor.
The liquidity glut argument makes sense in light of the fact that today’s yield-curve inversion has taken shape against the backdrop of accommodative global financial conditions: Credit spreads remain tight and real short rates are at levels typically associated with normal (upwardly sloped) yield curves, not inversions or recessions.
In other words, there aren’t many signs of restrictive monetary policy available save the Treasury spread.
A simple model I developed, which simulates the Treasury spread based on real short rates, suggests the yield-curve slope should be around 100 basis points with real short rates at current levels (using the Fed’s preferred measure of core PCE inflation to deflate the nominal funds rate). If we apply the New York Fed’s recession probability equation to my model, the chance of a recession four quarters out falls from nearly 40 percent to less than 10 percent.
Circling back to the Keynesian condition of savings exceeding investment such that the natural rate of interest falls and profits deflate, I find little evidence that this is the driving force behind low long rates, or the “bond market conundrum.” If we use 2002 as a benchmark, TIPS yields are indeed lower today then they were four years ago, but inflation-linked bond spreads are wider, measured inflation expectations are higher, commodity prices are much higher, the dollar is lower, and profits have compounded at a rate several times faster than growth in the nominal economy. This supports the liquidity-glut argument.
While monetary policy clearly is less accommodative today than it was two years ago, I continue to believe that excess global liquidity and an expectation that short rates will fall due to weakness in residential real estate are the proximate causes of low long yields and the recent inversion of the Treasury yield curve. A bond market drunk with rate-cut optimism and ballooned by the aphrodisiac of excess liquidity has nothing to fear but the fundamentals themselves.
Looking beyond the absurd valuations in the Treasury market, real short rates in current ranges remain consistent with real GDP growth “slowing” from the torrid 4.1 percent pace seen during the first half of 2006 to a range between 3 and 3.5 percent through 2007. Credit spreads are sending the same message while a lower marginal tax wedge on capital, in place through 2010, also should support growth.
— Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.
Success is a State of Mind - - Tommy Bahama Profits always take care of themselves but losses never do. The speculator has to insure himself against considerable losses by taking their first small loss. - - Jesse Livermore The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the man of inferior emotional balance, nor for the get-rich-quick adventurer. They will die poor. - - Jesse Livermore
Morten Lund, the guy who was (one of -H.)the earliest backers of Skype is at it again. He has financed Zecco, a start-up that will allow consumers to trade stocks for zero commissions, versus $10 to $20 that many online brokers charge today. Other investors in the company include former Dutch Coca Cola CEO Pier Baarsma and Soren Kenner former chairman of McCann Erickson MRM Europe
CEO Jeroen Veth, a 37 year old entrepreneur and former Merrill Lynch Vice President is heading up the company ... "
Success is a State of Mind - - Tommy Bahama Profits always take care of themselves but losses never do. The speculator has to insure himself against considerable losses by taking their first small loss. - - Jesse Livermore The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the man of inferior emotional balance, nor for the get-rich-quick adventurer. They will die poor. - - Jesse Livermore
Success is a State of Mind - - Tommy Bahama Profits always take care of themselves but losses never do. The speculator has to insure himself against considerable losses by taking their first small loss. - - Jesse Livermore The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the man of inferior emotional balance, nor for the get-rich-quick adventurer. They will die poor. - - Jesse Livermore
as the tech bubble deflated? The City of Philadelphia's pension plan, which invested a total of $8 million in Amaranth, expects to be out some $5 million. Yet it's a tiny fraction of the $4.6 billion in total assets thanks to a diversified strategy that invests across many funds. I'd venture they lost plenty more on shares of GE (GE19) back during the bear market.
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