Speculation – Page 39 – The Aleph Blog

The Problems of Ruin, Near-Ruin, and Decay

Posted on 1 November 2007 by David Merkel

Many investors, both institutional and individual, take too much risk. Taking too much risk can take a number of forms:

Buying companies with weak balance sheets.
Buying companies with high valuations.
Inadequate diversification, whether by number of companies, number of industries, or some risk factor like buying only high-yielding stocks.
And more…

There are three ways that problems can manifest themselves.? The first way is ruin.? An investor is so certain of himself that he uses a large amount of leverage to express his position.? When the bet goes wrong, he loses it all; he is ruined.? The second manifestation is near-ruin.? As ruin is threatening, the investor sells everything to preserve some of his assets, often near the local bottom for that set of assets.

The third manifestation is decay.? In this case the investor says, I will never take losses greater than x% of my position.? Nice intention, but it raises the spectre of the death by a thousand cuts.? Many assets fall before a significant rise; why get stopped out?? Instead, use falls in price to re-evaluate positions, and consider adding if the original thesis is still valid.

To be a little more controversial here, I don’t trust the bold claims of most technicians who place stops on their positions, and claim to have good performance.? Once one places stop orders, the probability rises for multiple small losses that exceed the few larger gains in the portfolio.? Call me a skeptic, but I would rather re-evaluate my positions than automatically sell, which seems to me to be a recipe for decay.

How Powerful or Wise is the Federal Reserve?

Posted on 30 October 200731 October 2007 by David Merkel

This post will be a little controversial. I believe that most investors over- or under-estimate the Fed. There are two ways to mis-estimate the Fed: power and wisdom. With respect to power, the most common errors are to overestimate the Fed in the short run, and underestimate them in the intermediate run. With respect to wisdom, the errors are to think that they are the wisest player in the market, or that they are less wise than the average market player.

My hypothesis is that the Fed is one of the brighter players in the market, top quartile, but not top decile, and that their power is quite great toward the end of the cycle, but modest until then.

My first contention stems from the lack of scalability of intelligence in a bureaucracy. You can gather large amounts of information, and have bright people interpret it, but the large numbers of Ph.D. economists insures that the result will tend toward consensus, and not be that much different from the consensus of economists outside the Fed, which means that the Fed will miss turning points. Also, in a bureaucracy, political pressures often dominate those near the apex of the organization, which twists the interpretation of the data, as well as what is deemed to be data. (M3 is no longer data worthy of being calculated.? A mistake in my book; the cost savings were minuscule, and the measure told us a lot about credit that M2 does not.)

Also, because of our political culture, there is a bias toward making it look like you are doing something, even when doing nothing is the optimal policy.? (We would likely all be better off by having Congress be a part-time legislature.? Okay, sorry, formally a part-time legislature… they have a lot of vacation already.? The same would apply to the Executive branch, but it would mean reducing the number of regulations enforced.)? So, even if the Federal Reserve is correct about the right long-term strategy, political pressure can force a different policy action, at least in the short run.

The Fed is a political creature, and it prizes its independence.? The funny thing is that it often preserves its independence by giving in to the political pressures that threaten its independence.? E.g. employment is slightly weak, but present policy is adequate to handle it if we wait 12 months?? No problem, we’ll loosen policy further.? (We can always take it back later, right?)

I would argue that no, you can’t take it back.? Yes, the Fed can reverse the cut later, but the effect is not the same as if they had not done the additional cut.? Here’s why, and this speaks to the power of the Federal Reserve: when the Fed lowers rates, more assets become financable at the lower short-term interest rates.? The lower rates go, even if for a time, the more economic players think that they can afford a given asset.? The effect is slow at first, because there’s a threshold to be met for psychology to change.? Changing the financing cost by 5% is dust on the scales; it’s not worth the fixed costs and effort.? Changing it 10, 20, or 30% is another manner, and cheap short-term capital will lead many to speculate and bid up asset prices, whether the assets are housing or businesses.? Economic activity accelerates accordingly.

It also takes a while for policy to bite when rates are rising.? Homeowners and businessmen make adjustments as rates rise, but it takes more of a rise to make their free cash flow go negative, forcing unpopular decisions that may have large fixed costs.? Asset prices normally decline in such an environment, slowing down economic activity.

My contention is that in order for Fed policy to have real impact it has to move the short rate significantly.? Time is not what does it, but the amount of the move.? Because the Fed moves slowly, the two effects become confused.

Back to my original questions.? How powerful is the Fed?? Very powerful when they move rates far enough, but weak before then. How wise is the Fed?? Pretty smart, but hamstrung by politics and bureaucracy, which keeps them from implementing the right strategy even if they have it.? They don’t always have the right strategy; they still miss turning points the same way that external economists do as a group, and often their actions add to economic volatility by being accidentally pro-cyclical.

The question that I have at this point in the cycle is how low the Fed will get before they get scared about inflation, and flatten out policy to see which effect is larger — deflation from overvalued housing assets purchased with debt, or inflation of goods and services prices.? They are separate phenomena, and can occur at the same time.? If they do occur simultaneously, what will the Fed do?? The US has almost always been debtor-friendly, so I would expect inflation, but that is just a weakly held opinion for now.

Society of Actuaries Presentation

Posted on 13 October 200720 June 2017 by David Merkel

Finishing off the presentation proved to be harder than I estimated, together with all of my other duties.? Well, it’s done now, and available for your review here.? For those looking at one of the non-PDF versions, you might be able to see the notes for my talk as well.

I’m writing this before I give the talk.? If I had it to do all over again, I would have made the talk less ambitious.? Then again, of the four topics that I offered them, they picked the most ambitious one.? When you look at the talk, you’ll see that it is a summary of the macroeconomic views that frame my investment decisions.? The presentation will run 40 minutes or so, plus Q&A.? Reading it is faster. 🙂

Enjoy it, give me feedback, and I’ll be back to normal blogging Monday evening.

If Hedge Funds, Then Investment Banks

Posted on 10 October 2007 by David Merkel

I’m still flooded by my workload, so just one comment this evening.? The Wall Street Journal posts an article on overly favorable (and smoothed) returns at hedge funds through securities that are mismarked favorably.? It was no surprise to naked capitalism, and no surprise to me either (point 26).? I’ve been writing about this issue off and on for three years now, because economic processes are messy, and tend to generate messy returns, not smooth returns, particularly once the easy arbitrages are glutted with yield-seeking investors.? Also, I know what the temptation is to mismark illiquid bond positions when incentive payments may be riding on the result (which is why we took the marking out of our hands at a prior firm).

Having been an actuary in financial reporting for twelve years, I know what the pressure is when someone above you in the hierarchy asks if your reserve is wrong.? It is rarely asked when the reserves are too low.? Few managements are so farsighted.? It is always asked when income is too low, and adjusting reserves downward is so convenient.? And who will notice?? Few, I’m afraid, but most actuaries I know are highly ethical, and resist these pressures.

My target here not insurance companies, though, but the investment banks.? Actuaries have detailed rules for setting reserves.? We have societies and ethics codes.? Those who work at the investment banks are not typically CFAs, which is more of a buy-side thing, so there is no industrywide ethics code there.? Also, the value setting rules for many investment banking assets and liabilities are far more squishy than for insurance liabilities.? Finally, investment banks frequently hold the same instruments as the hedge funds, and get their pricing marks from the same sets of sources.? I suspect that the positions are similarly mismarked, and they are big enough to hide it, because derivative books are never unwound.

Well, almost never.? Buffett phrased it well in his 2005 Annual Report: (pp. 9-10)

Long ago, Mark Twain said: ?A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.? If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.

We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re?s derivative operation. Our aggregate losses since we began this endeavor total $404 million.

Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

Remember that the rationale for establishing this unit in 1990 was Gen Re?s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It?s difficult to imagine what ?need? such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for ?imagination? when traders are estimating their value. Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B.

You can bet that the valuation differences ? and I?m personally familiar with several that were huge ? tend to be tilted in a direction favoring higher earnings at each firm. It?s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re?s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were
particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.

So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered ? and improved ? the reliability of New Orleans? levees was before Katrina.

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, ?My wife ran away with my best friend, and I sure miss him a lot.?

I could go on about this, but it’s late.? There are other weaknesses in the system as well.? A good rule of thumb is that whenever there is a lack of natural counterparties, there will be pricing difficulties.

Closing comment: When I was at a Stable Value conference in 1994, I ran into some investment bankers and talked to them about this topic.? I asked them how they hedged their synthetic wrap exposures.? They said they didn’t hedge because it was riskless “free money.” I pointed out the scenario under which they could lose money, and asked how their auditor could sign off on the lack of the hedge.? Their comment went like this: “When we find an auditor capable of auditing our derivative books, we hire him and pay him ten times the salary.”

In a world like that, who knows what problems may lurk in the derivative books, because the auditors stand a better chance of figuring out the truth than the ratings agencies and regulators.

Tickers mentioned: BRK/A, BRK/B

Swamped With Work, but Here’s a Dozen Observations

Posted on 9 October 2007 by David Merkel

I’m swamped with putting the finishing touches on my talk for the Society of Actuaries, so this post will be brief.? When it’s done, I’ll be posting it here for all of my readers.? When the transcript gets published, I’ll post that as well, but that takes a while.

A few observations, some of them obvious, because we’re at an interesting juncture in the markets now:

The equity markets are near new highs.? Who’da thunk it?
Equity implied volatilities have returned to a semi-normal state, and corporate credit spreads have tightened, but lagged.
Fixed income implied volatilities look high.
Fed policy, if LIBOR, narrow money, or the monetary base is the measure, hasn’t worked that well.
Fed policy, if the stock market or total bank liabilities is the measure (credit expansion), has worked pretty well.
The dollar has bounced, but I would expect it to retrace the losses.
We’re experiencing a small period of macroeconomic quiet amid the start of earnings season.? Earnings season should be good overall, with weakness in housing-related areas, and strength in export-related areas.
Banks should be able to end the logjam in the LBO debt markets.? The cost is feasible.
Residential real estate prices are still weakening, and provide most of the drag on the US banking system and economy.
Inflation is rising with many of our trading partners; the US may begin absorbing some of it.
Our trading partners are going to have to choose between controlling their interest rates, and following US policy, or letting their exchange rates rise further.
In this environment, I am trimming my equity portfolio slowly as positions hit the upper end of their trading bands.? 20% of the portfolio is within 5% of the upper rebalance point.? Almost nothing is within 10% of my lower rebalance point, so I’m not likely to add anytime soon.

Ten Notes on Our Funky Federal Reserve

Posted on 4 October 200722 June 2017 by David Merkel

1) Fed chatter has gotten a little quieter, so maybe it is time for an update.? Let me begin by saying in an era of detailed press releases from the Fed, many analysts spend more time parsing phrases than looking at the quantitative guts of monetary policy.? This article from Mish, which cites this article from Gary North is close to my views, in that they are looking at what is happening to the critical variables of the money supply.

2) For another example, Look at the discount window.? That has faded as a factor over the past two weeks.? You have to dig into Dow Jones Newswires just to hear about this.? The discount window is back to being a non-entity.

3) Review his book.? Cite his article.? Though I think the FOMC will loosen more, I agree that it should not be loosening.? The Fed will overstimulate healthy areas of the economy, while sick areas get little additional credit; that’s how fiat monetary policy works.? (Maybe I should review James Grant’s The Trouble With Prosperity?)

4)? I may not vote for him, but I like Ron Paul.? He is one of the few economically literate members of Congress. Thus I enjoyed his question to Ben Bernanke.? I favor a sound dollar, and risk in our system.? It keeps us honest.? Without that, risk taking gets out of control.

5) Now, onto the chattering Fed Governors.? Consider Donald Kohn, a genuinely bright guy trying to spin the idea that the Fed is not to blame for residential real estate speculation.? He argues that much of the speculation occurred while the FOMC was tightening.? Sorry, but the speculation only cut of when the FOMC got rates above a threshold that deterred speculation because positive carry from borrowing to buy real estate disappeared, which finally happened in September of 2005, when the FOMC was still tightening.

Or, consider Fed Governor Frederic Mishkin, who thinks that troubles in the economy from housing can be ameliorated by proactive FOMC policy.? If his view is dominating the Fed, then my prediction of 3% fed funds sometime in 2008 is reasonable.

But no review of Fed Governor chatter would be complete without the obligatory, “Don’t expect more rate cuts.”? They don’t want their policy moves to be impotent, so they verbally lean against what they are planning on doing.? This maximizes surprise, which adds punch to policy moves.

6)? Consider foreign central banks for a moment.? I’ll probably write more about this tomorrow, but a loosening Fed presents them with a problem.? Do they let their currencies appreciate, slowing economic growth, or do they import inflation from the US by cutting rates in tandem?? Tough decision, but I would take the growth slowdown.

7) What central bank has had a rougher time than the Fed?? The Bank of England.? When push came to shove, they indicated that they would bail out a large portion of the UK banking system.? Northern Rock financed a large part of their assets via the Bank of England during their crisis.? This just sets up the system for greater moral hazard in the future.

8) Now the CP market is returning to health; almost all of the questionable CP has been refinanced by other means.? Now, money market funds are better off than they were one month ago, but all of the issues are not through yet.? Some money market funds contain commercial paper financing subprime CDOs.? Now, the odds are that the big fund sponsors would never let the ir funds break the buck.? They would eat the loss.? That’s not a certainty though so be aware.

9) This article is the one place where the Fed lists most of the Large Complex Banking Organizations [LCBOs — pages 32-33].? Some suggest that this is the “too big to fail list,” though by now, it is quite dated.? On the bright side, it correlates highly with asset size, so maybe a list of the 20 largest bank holding companies in the US would serve as well.

10) We end with Goodhart’s Law, which states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”? My way of saying it is that trying to control a system changes the system.? The application here is that when the Fed tries to affect the shape of the yield curve by FOMC policy, it eventually stops working.

Too Many Vultures, Too Much Liquidity

Posted on 3 October 2007 by David Merkel

About a month ago, when the financial markets were more skittish, I saw a series of four articles on more interest in distressed debt investing (One, Two, Three, Four).? In this market, it didn’t surprise me much because we have too many smart people with too much money to invest.? It reminds me a bit of a RealMoney CC post that I made a year and a half ago:

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples. In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

We are still on the side of the demographic wave where net saving/investing is taking place, and that forces pension plan sponsors to find high-return areas to place additional monies.? Away from that, the current account deficit has to be recycled, and they aren’t buying US goods and services in size yet.? That’s why there will be vultures aplenty, outside of lower quality mortgages.? Even the debt market for new LBO debt is slowly perking up.? The banks pinned with the loan commitments may be able to get away with mere 5% losses.? Away from that, investment grade and junk grade corporate bonds are looking better as well.

Now, don’t take this as an “all clear.”? There are still significant problems to be digested, particularly in the residential real estate and mortgage markets.? CDOs still offer a bevy of credit issues.? There will be continued difficulties, and I don’t expect big returns.? But with so many willing to take risk at this point, I can’t see a big drop-off until they get whacked by worsening credit conditions.

The Four Rules of Currency Intervention

Posted on 29 September 200729 September 2007 by David Merkel

With the US Dollar Index taking out an all time low previously set in 1992, I thought I would take this moment to discuss my thoughts about where the dollar is going, and what we might see along the way. If the dollar gets much lower against the major currencies of our world, I would expect to see some currency intervention to try to raise the value of the US dollar.

There are rules to effective currency interventions. There may be more than four, but here are the four that I know.

Do the intervention on a day when the economic releases favor a stronger US Dollar.
Do the intervention when traders are overconfident, and pressing their bearish dollar bets too aggressively. Catch them leaning the wrong way.
Don’t do it alone. You will fail. You must get the central banks of most of your major trading partners to go along to create an impression of unanimity.
Do it BIG. This is not a time to hold back; either do it BIG, or don’t do it at all. You want the currency traders to wish they had never taken up the profession.

You want to have at least three of these in play for an effective intervention. You want to create a genuine panic that feeds on itself, leading everyone to readjust their positions on the US Dollar, pushing it up, and winning the psychological battle against a lower US Dollar.

Easy, right? Well, no. In the short run, interventions work if done properly. They don’t solve the macroeconomic problems underlying the weak Dollar, though, and so toward the end of the shock move upward in the Dollar, I would be inclined to buy more foreign bond exposure. Why?

During the intervention, the participating central banks suck in US Dollars, and pump out their local currencies. In the case of the Fed, they sell foreign currencies and buy US Dollars. Most of these central banks have all of the US Dollar assets that they want already, and they understand the fundamental situation regarding the US Dollar. So, like OPEC in their ineffective days, where they would announce production cuts, and then everyone cheats, in this case, the Central Banks do the intervention, but then quietly recycle the US Dollar assets that they never really wanted to hold.

That leads to a slow retest of the levels that the intervention happened at, and eventually, breaking through the level, at which point, the Central Banks can try again, or give up.? Eventually the response is a “give up,” after which, the US Dollar slowly overshoots and then finds a new temporary equilibrium level, and the rest of the world adjusts to it.

I’m leaving out a lot here.? The internal political pressures to keep the Dollar from falling.? The effects on export industries.? The slowly growing willingness to buy US Goods and services.? Rising interest rates in the US.? Rising inflation abroad.? And more.

The investment implication is this, though.? Until an intervention happens, the path of the US Dollar is down.? After it happens, the path of the US Dollar is down, until a new equilibrium is found.? Economies are bigger than governments, and in the long run, governments can’t affect exchange rates.

Just stay on your toes, and be ready to buy non-Dollar assets after the coming currency intervention.

So Where Are We Now — Normal?

Posted on 29 September 2007 by David Merkel

Maybe things have normalized.? After all:

Implied volatilities have fallen below long-run averages for equity indexes.
The equity market is within spitting distance of a new high.
The Fed is loosening (will they do more?)
The discount window is largely vacant.
Away from real estate, and real estate finance, things seem pretty chipper.
The yield curve is normalizing.
Inflation as measured by the government is low.
Long term interest rates are low, for investment grade borrowers.
Commercial paper problems are gone.
LBO debt difficulties will be solved soon, through a combination of losses to the banks, and canceled deals.

Or maybe not:

Inflation is rising globally.
The dollar is weak.
US inflation should start to rise as a result.
Housing prices are weak and getting weaker.? Default and delinquency statistics are rising.
The CDO [Collateralized Debt Obligation] problems are still not solved.
Defaults should begin to increase significantly on single-B and CCC-rated corporate debts in 2008.
The TED [Treasury-Eurodollar] spread is still in a panic-type range.

I’m seeing more of my stocks get closer to the upper end of my rebalancing range.? I will begin reducing exposure if the market run persists.? I’m not crazy about the market here, but I am not making any aggressive moves.

A Note on Contrarianism and Bubbles

Posted on 25 September 2007 by David Merkel

There is a misunderstanding about contrarianism, that somehow if a lot of people think something, it must be wrong, so take the other side of the trade.? We can make an exception here for some financial journalists, because they are often late to catch onto a story, and thus, the magazine cover indicator often works.

My point here is that intelligent contrarianism does not work off of what market players think, but how much they have invested relative to their investment policy limits, and the capital that they have available to carry the trade.? When there are many investors that have gone maximum long on a given company, that is a situation to either avoid or short, because unless new longs show up, the current longs have no more buying power — it is a crowded trade.

I saw this with housing in 2005, as I wrote a piece on residential real estate that proved prescient.? It drew a lot of controversy, but my point was plain.? Where would additional buying power come from?? In September of 2005, I concluded that we were at the inflection point.? One of my theories about inflection points is that there is no good numerical signal of an inflection point, but qualitative chatter undergoes a shift at the inflection points.? In that case, I had a series of googlebots trawling the web for real estate related chatter.? The tone shifted in September/October of 2005, but it was largely missed by the media and the markets.

Though I have nothing written on the web on the Internet Bubble, the qualitative chatter change that happened in March of 2000 was commentary from a variety of companies that had relied on vendor financing were turned down by their vendors.? That was new, and it indicated a scarcity of cash.? My rule of thumb on bubbles is that they are primarily financing phenomena; bubbles pop when cash flow proves insufficient to finance them.

Now, with both the residential real estate and internet bubbles, there were a bunch of naysayers prior to the bubbles.? Most were way too early.? Keynes observed something to the effect that markets can remain irrational longer than an investor can remain solvent.? Risk control is a key here, as well as cash flow analysis. When does the financing fall apart?? What will the inflection point, with all of its fog, look like?? Where is the weak spot in the financing chain?

Those naysayers were an inadequate reason to take a contrarian position; many of them didn’t have a dog in the fight, aside from intellectual bragging rights.? Rather, the contrarian position was to ask what side had overcommitted relative to their ability to carry the positions, and the ability of others to get financing to buy them out.

Where I differ with many permabears is that I am usually unwilling to extend my logic to second order effects.? Just because one area of the economy is falling apart, doesn’t mean that a related area will of necessity get blasted.? There are dampening effects to almost any economic phenomena, such that you don’t get cascading effects where failure in one area leads to failure in others, leading to a failure of the system as a whole.? The exception is of course the great depression, and that was a situation where the whole economy was overlevered.? We’re not there today, yet…

Okay, one semi-practical application, and then this article ends.? I get a certain amount of pushback for being bearish on the US Dollar.? I’ve been bearish on the US Dollar since mid-2002, when I saw that our monetary and fiscal policy were shifting to aggressive levels of ~~debasement~~ stimulus.? Today I heard someone dismiss further US dollar weakness because “everyone knows that.”? Well, if everyone knows that, tell it to the foreign investors who are stuffed to the gills with US dollar claims (bonds), such that their economies are beginning to suffer higher inflation.? I see a continued crowded trade here, and I am waiting to see where the pain points are, such that foreign central banks begin to intervene to prop up the dollar.? It hasn’t happened yet, and we are within 20 basis points of taking out the all time low in the dollar index, set back in 1992.