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The Simplest Explanation?

In over 30 years on Wall Street, I cannot remember such a prolonged period of time
when the Bulls and Bears were in such agitated disagreement.
Zero Hedge has an excellent collection of specific factors suggesting that the economy
and the marketsare going to get worse. There is a blunt force of impact to such ZH
topics as Quant Divergence, Backup Liquidity Providers, Volatility, CRE, Stress Test
Shenanigans, Bailout/Stimulus Alphabet Soup, Administration Thuggery, Breakdown of
the Rule of Law, etc. “Why I am Freaking Out” is a good summary of how this affects
the regular reader, and Lira correctly argues that much is explained by self-fulfilling
prophesies from the Main Stream Media (not to mention CNBC - poster-boy for the
Green Shoots and Mustard Seeds advocates), and correctly points out that that is
neither good nor bad. “Gonzalo Lira” also very effectively ‘lifts the veil’ on the
arguments of the optimists to examine their sorely lacking fundamental underpinnings.
But while entertaining, Lira’s arguments have the feel of debating points, and the ‘self-
fulfilling prophesies’ view of macroeconomics doesn’t fully explain Mr. Market driving
into the camp of the optimists. While also a Bear, I have been searching for a more
comprehensive explanation, and this exposition is an attempt to connect more of the
dots (albeit with the usually disclaimer that such an exposition must skim the wave-tops,
and of course, most of the topics covered are outside my sphere of expertise), without
concluding that we should all head into the bunker. In other words, can a Bear with
conviction still have Hope?
Occam’s Razor suggests that we find the simplest explanation, the one with the fewest
unsupported assertions.
The simplest explanation, it seems clear to me, is that THE BULLS AND BEARS ARE
BOTH RIGHT. Certainly this is simpler thanone or the other being right. Of course,
another simple explanation is that BOTH ARE WRONG. More about that later.
Is it even possible for both to be right? To test this, I break the process into three
steps. First by reducing the competing arguments to simple statements (which
reduction is necessarily subjective), Second by laying out a conceptual framework for
the markets, and Third, by suggesting a set of behavioral rules that – possibly - ties
everything together.
FIRST. Reducing the arguments sets to a minimum.
BEARS:
1. The real values (the new low ones) and credit losses are not properly reflected in
the markets
2. The economy has not turned the corner and may be getting worse, and the
stimulus plans won’t work
3. Government expansion will lead to higher interest rates, currency deflation and
commodity inflation
BULLS:
1. The market always anticipates a recovery, there are reserves of liquidity, and
credit is flowing
2. The World Economy is fundamentally strong, and the stimulus plans have
worked (and indomitable human spirit, etc.)
3. The necessary evil of deficits will be cured by growth and nudging the economy
into more productive and efficient directions

SECOND. A conceptual Framework of the Markets.


In what might seem like a diversion, let me next try to sort out a rough picture of the
market landscape. I have been thinking about this primarily because I get a headache
when I can’t organize a problem into easy-to-understand pieces. Although I am
comfortable with complex reorganizations of corporate capital structures, the
instruments in the structured/derivative world give me a headache every time I try to
understand the relationships (if any) between diverse things like SPY, DIA, JPY, USD,
EUR, LCDX, IG12, M1, UST30, UST10, VIX, LIBOR, Gold, Oil, etc.
So I tried to stuff all financial instrument ‘Primary’ Markets and their derivatives
into the smallest number of categories. 1. Commodities (Minerals, Food, Energy)
The real answer is Two: Things and a. Cash/Spot Commodities
Entities, but the rest of the list is a lot i. Futures
easier if the answer is Four: Commodities, ii. Options
Real Estate, Corporations and iii. Mutual Funds
Governments (list at right). iv. Index Funds
v. ETFs
The point of the exercise is to observe all vi. Royalty Trusts
the derivative instruments that have 2. Real Estate (Resid., Comm. & Indust.)
proliferated over the last 30 years, and a. REITS
where they fit in (would love sector experts i. Options
to expand and fill out the list, especially if ii. Mutual Funds
they can supply market sizes). Please iii. Index Funds
note that since Government is arguable a b. Mortgages
first derivative, Currency Options could be i. MBS/CMBS
argued to be third derivatives. Why does ii. Collateralized Debt Obligations
this matter? Because all derivatives have (CDO, CLO, CDO^2, etc)
one thing in common: their essential iii. Credit Default Swaps
purpose is TO CREATE LEVERAGE. iv. Reference Index Derivatives
(Markit)
Hedging you say? Sure that is the v. Mortgage REITS
marketing pitch, but I have never heard of 3. Corporations (including Financials and
a derivative market with only hedgers, Capital Equipment)
there are ALWAYS speculators (as there a. Corporate Equities
should be), and hence leverage. OK, i. Options
perhaps a simple Mutual Fund does not ii. ETFs
directly introduce leverage, but in fact the iii. Mutual Funds
‘diversification’ attracts more individual iv. Index Funds
investors, and more capital to the markets, v. Royalty Trusts
marginally inflating the equity capital base, vi. ETC
hence permitting more corporate leverage. b. Corporate Debt
And if an innocent index fund indirectly i. Credit Default Swaps
introduces leverage to the system, you can ii. Collateralized Debt Obligations
just image what iTRAXX or IG12 do. (CDO, CLO, CDO^2, etc)
iii. Index Derivatives (Markit)
We all know how financial entities were iv. Interest Rate Derivatives
forced to deleverage over the last 18 (LIBOR, Prime, etc.)
months, and the raging argument over 1. Spreads
whether it is complete, or not, or merely 2. Swaps
transferred to the balance sheet of the 3. Options
Federal Reserve and the Treasury. But 4. Governments
the sheer size of the derivative markets a. Debt (incl. State/Municipal)
means that even when (or if) the de- i. Options
leveraging is complete, there is systematic ii. Futures
leverage imbedded in all of these financial iii. Money Market Funds
instruments. iv. Mutual Funds
v. ETFs
So What? So if there is really more and vi. Interest Rate Derivatives
persistent leverage out there, then our 1. Futures
instinct about the correct level of values 2. Options
(assets, securities, or derivatives) may be 3. Spreads
significantly skewed by our lack of 4. Swaps
understanding of the true structure of the b. Currencies
markets. i. Options
ii. Futures
Has anyone tried to add up all of the iii. Mutual Funds
known equities (you can get it on iv. ETFs
Bloomberg), corporates, mortgages, commodities, currencies and governments, and
then tried to correlate that with all of the know owners of financial assets (individuals,
pensions, mutual funds, financials and sovereigns)? I can never get close to an answer.
And when you get the inevitable delta, is the answer leverage, derivatives, or both?
So my conclusion about the markets is that they are significantly more complex than
ever before, and while experts can understand each market sector or sub-sector, it is
not possible to grasp the ENTIRE market. Certainly not for someone at Treasury or the
Fed. But more importantly, even if people had a grasp of the markets when working,
certainly nobody could grasp them when major parts are broken. And then introduce
changing rules, and the prospect of new changing rules, and we have a problem.
THIRD. Elementary Behavioral Rules
Apologies to people who actually know something about this. Just as Lira said, the
markets and economies are a mix of Rational and Irrational. Neither is right or wrong,
good or bad. Nor can one ascribe short-term or long-term to either.
1. Humans explain their decisions as Rational and explain their detractors as Irrational
2. Human nature expects that over time:
a. asset values will rise
b. depleting resource prices will increase
c. production will become more efficient
d. there will be a reversion to the Mean
3. Humans are comforted by:
a. known rules
b. the ability to predict outcomes
4. Most investing is governed by Fear and Greed, but humans are essentially optimists
Unfortunately, humans make a lot of mistakes, so their ability to discern Rational from
Irrational is very subjective. They are also often wrong about time series: not only do
asset values constantly deteriorate without maintenance, but they frequently become
obsolete; while truly depleting resources ought to rise over time, humans are not the
best at estimating the extent of the resource, and they are bad at predicting
technologies for increasing production, conserving, or replacing the commodities;
although it is true that production generally becomes more efficient, humans are usually
too optimistic about this. And since they don’t know where the Mean is, anyway, you
can never tell when it is reverting (or where to). Regarding rules and outcomes,
humans frequently fail to observe that the rules are constantly changing, and are
shocked when they notice the changes, and while they joke about the inability to predict
outcomes, this is in fact their favorite sport. And because humans also have trouble
telling when they are reacting primarily out of Fear, or primarily out of Greed, they are
often overreacting.
But this environment is different for several reasons:
A. There HAVE been a series of shocking events that MUST make it more difficult
for people to differentiate Rational/Irrational and Fear/Greed.
B. NOBODY’S long term expectations can withstand a DOWN 60%, UP 30% swing.
C. The RULES have been changing faster than ever.
D. The structural framework of the markets makes them impossible to understand,
with new untested securities that act in non-intuitive ways, and with hidden
structural leverage in many layers of the markets.
E. Not only can you lose your job for being wrong, but in this environment, you can
lose your job for trying to do the right thing

Weaving it all together


How can everyone be right? We have extremely diverging opinions, driven by
extremely unusual events, in an extremely complex and untested market, with rules
changing faster than ever, subjecting humans to the WORST POSSIBLE environment
for their REALLY BAD skills of prediction. The only consistent answer would seem to be
that each side has been driven by isolatedfact sets to draw extreme conclusions. All (or
most) of the facts are correct, and the conclusions must be modulated to become
consistent.
Real Values. The Bears are right that there are more bad things coming: credit losses,
unemployment, demand destruction and earnings disappointments. But the Bears are
not suggesting that the Dow will drop to 5,000 and stay there for 10 years. Nor are the
Bulls suggesting that the Dow won’t drop (or even drop to 6,500). Shorting the market
is too dangerous with all the rules changing. So make selective long investments and
accumulate slowly.
The Economy. The Bears are right, the stimulus won’t work. However, they are not
suggesting that the wheels will fall off again, nor are the Bulls suggesting strong growth
starting in August. The answer is that the economy is fundamentally sound to have
stood up to the shocks of the last 18 months, and it will recover, but starting in mid-
2010, and it will be gradual.
Deficits and Interest Rates. The Bears are right here too, but are over-stating the
case. The Administration will not drive the deficits over a cliff in each of the next ten
years. There will be cuts, and there will be taxes. And the economy will grow out of the
deficits eventually.
And what if the Bears and Bulls are BOTH WRONG?
(the second most simple solution).
That is really suggesting that we repeat Japan’s bad experiment from the 1990’s to
present, or that we need WWIII to pull us out of the Second Great Depression. It really
seems hard to imagine, UNLESS, two things happen (both of which are not impossible):
A. The RULES keep changing in a volatile fashion
B. Capital starts to flee in frustration and fear
However, even the MSM has picked up on the Administration tactics, and Chrysler, GM
and Health Care should represent (we hope) a peak in the ability of the new President
to make radical changes.
How would I handicap it?
Both Right 45%
Bears Right 25%
Bulls Right 15%
Both Wrong 15%

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