This week we’ll review the markets and see if we can catch a glimpse of the future.  We’ll also talk about another potential booby trap to watch out for.  But before we do, we’ll try and get some historical context.  As is our custom, we shall look beyond the traditional world of economics and politics to see what we can learn.

30,000 years of barbarism

The First Galactic Empire had endured for tens of thousands of years.  It had included all the planets of the Galaxy in a centralized rule, sometimes tyrannical, sometimes benevolent, always orderly.  Human beings had forgotten that any other form of existence could be.

-Isaac Asimov, Second Foundation

Let that sink in for a moment.

Remember the days when none of us could fathom a U.S. economy that barely grows or a housing market that never goes down?  Remember when we thought 5% unemployment was where we’d always stay and that the stock market would go up every decade?  We forgot that things could be different, despite centuries of evidence to the contrary.  We have learned our lesson now, yes?  Our history is a history of unforeseen change.

If you’re unfamiliar with Isaac Asimov’s Foundation trilogy, you need to know that it’s one of the most important works in the world of science fiction.  If you’re a fan of literature, it belongs on your bookshelf.  The story centers on Hari Seldon, a genius mathematician who develops a new science that can accurately predict the broad path of the future.  He foresees, against all popular opinion, that the mighty Empire, having enjoyed tens of thousands of years of unified peace and prosperity, is actually on the brink of collapse, a collapse that will thrust the entire galaxy into 30,000 years of chaos and barbarism.  Averting the collapse is impossible, but Seldon proposes a plan to reduce the coming Dark Age from 30,000 years to a single millennium.  Exactly how this happens is told in Foundation and subsequent books.

Like all great science fiction, Asimov’s works are a comment on society.  In fact, he drew most of the inspiration for his Foundation series from Edward Gibbon’s The History of the Decline and Fall of the Roman Empire, the definitive chronicle of the dark years that followed one of history’s greatest empires.   Asimov wrote the original trilogy in the early 1950′s, a time when the U.S. was finally emerging from it’s own miniature Dark Age.  A lot of major stuff was published during that era which today is recognized as the golden age of science fiction.  It was a difficult time for the world, a time when a lot needed to be said about society.  Sci-fi legends like Asimov, Robert Heinlein, and Arthur C. Clarke did the philosophical heavy lifting and taught us about the world and ourselves in the process.

If you’ve been reading The Draconian for any length of time, you know that it’s our belief that we are at the beginning of an era of hardship.  For lack of a more precise estimate, we think it will last for a decade or so.  During this period everyone will sacrifice, and the sacrifice will take different forms depending on how much money you make.  If you make a lot of money, you’ll have to contribute in the form of higher taxes and tougher policies on top-decile pay.  If you don’t make a lot of money, you’ll have to contribute in the form of reduced entitlements and benefits.  All of us will have to contribute in the form of a more difficult, more competitive job market and a permanently higher natural rate of unemployment.  Business will be slower; incomes will stagnate.  The risk of inflation is still quite a ways out, and that will be another way that we all pay.  That might be the final way we buy our departure from this debt-fueled gravy train.

This is not a popular view at present.

Unfortunately, we are not geniuses like Hari Seldon and we don’t have a plan to shrink this decade of hardship into just one year.  You may have noticed that the leaders of the U.S. Empire think they are geniuses and have been trying with all their might to soften this forthcoming decade of hardship through bailouts, stimulus, and good ol’ fashioned money-printing.  Those of you that are paying attention will also notice that these actions are exacerbating many of the problems that brought about the crisis in the first place.  We have treated the symptoms but have made little attempt to cure the disease.

Elder wisdom

It’s been a full generational cycle since our last era of major hardship and sacrifice, the one that Asimov wrote about under the guise of distant galaxies, alien spaceships, and sentient robots.  There have certainly been no shortage of books on the economy in the last couple years.  A few are even pretty good, but sometimes I learn a little more about where we are today by going further back and revisiting some of that classic science fiction.  It’s why I read Isaac Asimov.

It’s also why I read Richard Russell.

Richard Russell was part of the GI generation, who grew up during the Depression and fought in WWII.  There aren’t many of his kind still around.  Even fewer are actively writing about the markets today.  Russell certainly has his share of critics, most of whom harp on his never-ending pessimism of fiat currencies and undying love of gold, but he brings a perspective that’s unique.  In short, he has seen things that the rest of us haven’t.

Something he wrote over on Dow Theory Letters last week really stuck with me:

I’m aware that many of my subscribers are skeptical of my warnings regarding the years ahead.  The generations since the end of World War II have never experienced hard times.  I’m aware that it is difficult to envision what you have never experienced.  If I have one unusual talent, it’s the ability to envision vast change.

I’ve been reading his newsletter since 2003.  I’ve read enough to know that he’s right about as often as he’s wrong (the best any of us can hope for, I suppose).  But I don’t read his newsletter for specific recommendations on this or that.  I read it to be reminded of all that came before me and the generations that currently populate the country.  It’s one of the few places I can go to get that.  For the most part, we have lost our tangible, living connection to the last era of national crisis.  The folks who have real memories of the Depression and War, whose values were permanently re-shaped by those dark times, have almost died out.

It’s worth mentioning that the dawn of the Great Depression crisis was a time when those people who had actual memories of the Civil War, the previous major national crisis, had mostly died out.  Very few people in the late 1920′s had the capacity to imagine life being any other way.  And when the Civil War cleaved the nation in two, there weren’t many still around who actually experienced the chaos and barbarism of life in Revolutionary America.  Things had been going pretty well for about 70 years; who could have possibly imagined such a traumatic affair was right around the corner?

I’m sure there’s a reason why history writes itself this way.  Just as we all forget the lessons we were supposed to have learned, something happens to teach us again, something that will keep us from ever forgetting.  But then we die, and the cycle repeats for a new wave of generations.

I guess this is why I cling so tightly to living perspectives from that era, perspectives like Richard Russell’s.  My grandfather on my mother’s side came from a wealthy family that lost everything in the crash; as a young adult he was shipped off to Germany to fight on the ground.  I know little beyond the facts I’ve been told and little about the kind of person he was, evidence that has now been swallowed by history.  He died when I was very young, but what I wouldn’t give to really get to know him today.

He certainly wasn’t the only young man to have an experience like that, to lose everything and risk his entire future in a bloody war.  If you’re fortunate enough to know someone in the family — a parent, grandparent, or maybe a great great-uncle — ask them about eras of sweeping change.  Ask them what they think of things today and if the rest of us are too narrow with our view of the present and future.

When I was a child, my parents instilled in me a genuine respect for others, particularly my elders.  I suppose that is the kind of thing that one can teach, but we really have to learn for ourselves the true value of our elders’ experience.  Unfortunately, most of them are gone by the time we mature to an age where we recognize the importance of this.  When we are finally ready to drink from that fountain of wisdom, it’s all dried up.

One of the great ironies of life and history, I guess.

Risks that few are talking about

If you follow John Hussman, you’ve noticed that in the year since the crisis he has been talking primarily about two things:

1. The U.S. policy of defending bondholders who made bad loans.
2. A second round of credit strains triggered by a second round mortgage rate resets.

As for the defense of bondholders, I continue to believe it’s a policy of madness.  People that make risky loans should have to pay the price if the loans go bad, not the taxpayer.  With those kinds of consequences, maybe your bank and your pension fund will think twice before making risky moves to pick up another percent or two of yield.  I know that sounds common sense, but an idea like that apparently qualifies as too draconian for our pain-sensitive society.  Heaven forbid a large financial institution makes a loan and doesn’t get 100 cents back on the dollar!

The bailout reaction of the EU debt crisis is an extension of that mindset.  They avoided a panic, yes.  But they made the problem worse.  Within the sphere of politics, I will be paying close attention to trends toward any reluctance to make bondholders whole when the debts go bad.  I’ll let you know if I identify anything on this front.  It will be a step in the right direction for our system.

As for the second round of credit strains, all you regular readers should now be familiar with this old chart:

Here’s a revised version:

As you can see, 2009 was a lull for mortgage resets.  In retrospect, that was probably the best thing the credit markets and financial system could have asked for.  It did a lot to temporarily calm things down on the credit front.

Keep in mind that what first broke the back of the market was the resetting of all those subprime loans.  All those subprime borrowers initially got their loans with awesome terms like low teaser rates, 0% down payments, and the option to pay only the interest each month.  Those awesome terms only lasted for a couple of years, not that the bankers really talked about what life would be like once their mortgage reset.  That didn’t start happening until 2007.  The fantasy terms disappeared and those borrowers’ monthly payments went way, way up.  They could afford the fantasy terms but real-life terms were way too expensive so they stopped paying their mortgage, a decision made much easier after they’d seen their house lose 20, 30, or 40 percent of its value.  ”Screw this!” they said.  ”This is the bank’s problem now!”

Then the whole financial system fell apart.

I know you guys have all heard that story before, but get ready to hear it again through this fall and winter of 2011.  It won’t play out exactly as it did, nor will the system react in the same way.  The Fed & Treasury have made clear through their policy that they will not let systemically important firms implode and will inject them with enough capital to keep them solvent (aka Japanese Zombie Bank Policy).  The new, surprisingly-soft financial regulation measures won’t interfere too much with the way of life that large banks have recently enjoyed.  So there won’t be an industry meltdown a la Fall 2008.

But there will be some effects.  I know everybody is desensitized to Really Big Numbers right now, but if you think a TRILLION DOLLARS of resetting mortgages in the next year or two — mortgages that are resetting from awesome terms to considerably less-awesome terms — won’t have an effect on the system, then I don’t think I can’t help you.  Loans that are good right now will go bad, and these new delinquencies will have systemic and economic consequences.  The market will react accordingly when one day it wakes up and realizes that this could pose a threat.  Recall that Greece didn’t go bad overnight, though the market’s reaction to it would indicate otherwise.  One week the market thought it wasn’t a big risk and the next week it did.

We talked about booby traps a couple of weeks ago. This new round of resetting mortgages is a booby trap that the market hasn’t stumbled into yet.

The good news is that things will be looking much better on this front by 2013!  A few years after that, we might actually have a normal mortgage market again.

Market recap

In short, volatility continues:

For all you technicians out there, I’ve got my eye on a few key levels:

1220 – We’re still a long way from the high.  A close above that level would be positive, indicative of a resumption of the cyclical bull market that began last spring.

The 200 day moving average – Since we violated the 200 day moving average, I would be much less inclined to buy on dips now.  If you still haven’t taken profits on any gains on your equities yet, look to do so on the next rally.  What’s most disturbing is that the market has rallied twice right up to that 200 day moving average, bumped its head, and sold back down.

1040ish – This is where most of the technical support is, and this is the level at which the market has recently rallied off of.  A decisive close below this level would be very, very bad.

976 – This represents a 20% decline for the market from its cyclical bull peak.  While 10% is the level that generally describes a “market correction”, 20% is the level that generally describes a “bear market”.   If we break 976 on the S&P it will officially be a cyclical bear market (within a secular bear market).  As you can imagine, that’s not a good sign.  There is little technical support beyond that, so the market will sell off until it finds a new low.  The only significant price is 666.79, the bottom of the market last March.  The closer we get to that level, the more I’d want to buy higher-flying growth stocks that will most likely be beaten down on fears of a sluggish economy.

In the last couple of weeks I’ve mentioned that I’m starting to see some semi-compelling values in specific stocks.  Things aren’t as cheap as they might get over the course of this year and next, but more sensible valuations are a good sign.  If you are bored and desperate to invest in something, there are far worse places you can go than strong, stable companies trading at fair multiples, especially if they have prospects for growth.  Especially if that growth will be happening in Asia and not Europe.  All the better if they pay a dividend.

McDonald’s is a name that fits those criteria.  Colgate Palmolive is another one to look at, as well as Du Pont, Verizon, and Becton Dickinson.  Same with the integrated oil & gas companies that have been unfairly dragged down with BP.

Are these boring companies?  Yes, these are boring companies.  Does that make me a boring guy?  Yes, it makes me a boring guy.  But that doesn’t bother me because I think I’ll make more money over the next decade with boring strategies than the guy who goes all in on the bank stocks or chases other hot, shiny sectors.

In 2020 or 2025 when we’ve worked out real solutions to our economic problems and the dark times have officially passed (don’t worry, they will).  When the future is once again filled with hope and optimism, my goal is to have a few bucks at the ready so I can waste no time getting out there and having some fun.

After such sacrifice, we’ll all certainly need it.

There’s little I can add about what’s going on in the Gulf of Mexico right now.

This video is the single most interesting thing I’ve seen so far about the oil spill.  I understand that there is an emotionally-charged human dimension to this story, as there are also highly-contentious political and environmental dimensions.  To be honest, little of that interests me; I’m just not sure what do with stories like that and how to process them.  The situation sucks.  It’s tragic.  A ton of people screwed up and some bad luck intervened.  Let’s not sensationalize any more than we need to.  Does the worst man-made environmental disaster in history require additional dramatization beyond the absolutely staggering facts of the matter?

Probably not.

Not that that will stop us from dramatizing it so.  The always-hilarious XKCD offers a pretty accurate look at how that might go:

Back to the real issue…

Part of the reason why all this discussion is lost on me is that I cannot get over the raw complexity of the problem.  I’m not an engineer, but I’ve hung out with enough to know that my brain operates in similar fashion.  And the engineering dimension to this problem is mind-boggling.  I’m surprised that there does actually exist a group of people in the world who do actually have somewhat of an idea of how to solve a problem like this, one that starts mile under the ocean and stretches for several miles beyond that.  A problem that cannot be solved without robots.  The conditions of this problem are way beyond what 99.9% of us can even comprehend.  That doesn’t stop the rest of us from having opinions about it.  Nor does it stop us from expressing them.

If you feel the way I do, you’ll understand why engineering discussions like this are so interesting and geeky webcomics like XKCD are so funny.

All right, what on earth does this have to do with investing?

I bring BP up as a specific example that’s illustrative of an important generality.  Lately, a bunch of people have asked me whether BP is a good investment right now.  The same thing happened with Toyota a couple of months ago.

As you can see, BP’s stock has been shellacked:

That’s about $60 billion of market cap that just evaporated.  When it’s all said and done, will the total cost of this – the cleanup, the lost revenue, the ill will, the forthcoming litigation – really exceed $60 billion?  The rest of  BP’s revenue stream hasn’t really been impacted by this.  They continue to pump and refine oil and gas all around the world.

So is BP stock a buy?

It depends on how sturdy your stomach is.  Yes, there’s upside.  I think that upside is pretty easy to quantify but may take a long time to realize.  Until then?  It’s up to you whether or not that limited upside is worth totally unknowable risk.  A week ago, things seemed to be slowly getting under control.  Now?  Who knows.  Are you cool owning BP stock if this spill drags on ‘till August?  What happens when the first major lawsuits start popping up?  What if BP loses a rig or two during hurricane season?

Know this: markets are pretty good at pricing things like this.  They’re better at it than you or I.  Everything the world knows about BP says that it’s worth $37.50 per share.  This price is correct today, but it will be wrong tomorrow.  When I look at the October put options contracts on BP I see fairly large premiums, an indication that there are a bunch of people who think BP may actually trade at $30 or even $20.  That’s another 20-50% of risk that could be lurking on the downside.

Getting a feel for BP’s true value is like nailing down the position an electron.  It involves things like “probability spheres”.  I guess this is why so many quantum physicists have joined hedge funds in the last decade.  These are probably the same people trying to figure out how much banks like Citigroup are truly worth.  Do they have those answers?  I don’t know.  Quantum mechanics has probably given the world more questions than answers.  Same with hedge funds.

This analysis doesn’t just apply to BP.  This applies to any scenario where you might have an eye on a distressed asset, one that you think has hidden value.  Maybe it was Toyota when the recalls were spiraling out of control.  Maybe it was some of those GM bonds before they went into bankruptcy.  Maybe it’s the foreclosure down the street.

In all of these cases the investor is anchored to where things were.  They look at the asset and say, “Hmm… yesterday this thing was worth $1 and today it’s selling for 50 cents.”  Who doesn’t want to buy a dollar for 50 cents??  The problem is that yesterday’s valuation no longer has meaning.  Using it as a reference point can get you hurt, especially if the knife is still falling, as in the case of BP.  Markets look forward and so should you.  Past performance and valuation is most definitely not indicative of future results.

How to play it

If you want to take advantage of the uncertainty caused by the oil spill, why not play it more generally?  Use this disruption to scale into other energy positions.  Because of this latest deflationary scare (from the EU debt crisis) and the oil disaster, a lot of these energy companies have been thrown out with the BP bathwater.

Total (TOT), the French oil giant, is trading at a little over 6 times next year’s earnings.  It pays a 6.7% dividend.  Royal Dutch Shell (RDS.A) is trading at a little more than 7x next year’s earnings and pays a 6.3% dividend.  Exxon (XOM), Chevron (CVX), and ConocoPhillips (COV) are a little bit more pricey but still pay fairly robust dividends.  Or you can also get a whole bunch of energy names through an exchange traded fund like the XLE and knock out all the idiosyncratic risk while you’re at it.

There is still a lot of uncertainty with this sector right now and the risk of more deflationary scares.  But over the long run, I think it’ll work itself out.  Each year the world consumes more additional oil than gets discovered.  There may still a bunch of crude out there, but every year it gets more expensive to tap into.  Since the price of oil went nuts a couple of summers ago the U.S. has sort of given up on seriously pursuing alternative sources of energy.  Hopefully, this oil spill will change that mentality.  I know that the folks in Washington D.C. have a hard enough time looking past the next election, but in the century to come, the nations that build an efficient infrastructure of new energy will be the nations that dominate.

My favorite?  The Japanese construction company that wants to put solar panels on the moon.  If you’re laughing, you haven’t read George Friedman’s The Next Hundred Years.

Market Recap

The crisis in Europe seems to be slowly moving out of the headlines.  The markets are still talking about it, though.  We’ve been following the Euro/Yen cross for a while, and so you all know by now that it’s a pretty good global gauge of investors’ willingness to take risk.  It goes up when investors have an appetite for risky assets and goes down when they want something safe.

Here’s a chart:

As you can see, it totally fell apart in May when everybody around the world got really nervous all at once.  But what I find interesting is that it was trending down for a while before that.  I think that explains some of the intuitive caution that we’ve felt since last fall.  Most people just look at the stock market for a sense of what’s going on, but there are better indicators to turn to.  Some of them are a little obscure, but they really aren’t that difficult to understand.  We talk about them here at The Draconian because even a basic understanding of these things can give you a gigantic advantage when it comes to your own investing.  When you talk to your friends about the market, tell them about the Euro/Yen cross and how that’s a really important thing to watch right now, a proxy for global risk appetite.

The LIBOR-OIS spread is another of our favorite esoteric indicators:

Remember that this one is a general measure of how banks feel about each other.  It’s calmed down a little bit in the last week, but it’s still trending upward and hasn’t put together two consecutive days of contraction since early April.  Regardless of what the market does, I won’t feel good about the EU debt crisis until LIBOR-OIS starts to come back in.

Banking crises invariably follow sovereign debt crises, and an EU banking crisis may still be a little ways away.  That would undoubtedly be a catalyst to send global markets lower, as would a double-dip recession over there, another thing that appears to be a near-inevitability at this point.  Keep your eye on LIBOR-OIS, because it’ll go bananas right before any banking crisis starts to metastasize.  If you’re in the market right now and want to know when to step to the sidelines, that will be a signal you’ll want to pay attention to.

And for our final chart of the day, we’ll look at the CRB Index.  This is an index of commodity prices, stuff like cotton , copper, soybeans, and natural gas.

All you technical analysts out there will notice that it seems to be putting in something of a “rounded top,” a possible reminder that deflation presents a bigger concern right now than inflation.  That’s not a chart you want to get long, my friends.

I think there’s still plenty of opportunity in the market, but you have to take a stock-by-stock approach.  This is what pretty much all of the equity-oriented hedge funds I know are doing in this environment.  It’s hard work.

We spend a lot of time around here on philosophical, introspective stuff like understanding who you really are as a person and investor.  Do you want to do a lot of work with your investment portfolio?  Many people don’t.  It’s OK.  If this is you, don’t try to be an active investor.  Have someone you trust do it for you or focus more on passive strategies.  In the world of passive strategies, I think one of the best ones right now is simply “hold a bunch of cash.”  We’ll let you know about all the longer-term opportunities that we see.  In the meantime, go back and check out If You Try Sometimes, especially if you missed it back in April.  I received more comments on that newsletter than any other to date.  That tells me that investors really are interested in this under-appreciated dimension of investment strategy, this journey of internal self-exploration.

And if you are comfortable doing all the legwork or enjoy the work like we do, go at there and get after it.  Right now I like boring stuff that’s a good value or pays me a nice dividend.  But if you’re the kind of person who isn’t satisfied unless there is action and excitement, make sure you’ve got a little corner of your diversified portfolio that gives you what you need.  Go ahead and try and play the Euro or bank stocks.

Or BP.

We’ll get to the markets in a minute.  For the most part, little has changed in the last week.  Europe is still the biggest and most relevant risk, especially now that focus is shifting towards Spain.  The market is still full of booby traps.  The mild economic recovery continues, and still, nobody seems to care.

So I hope you guys don’t mind a brief diversion as we share with you our experience with a few social networks so far.  Odds are your business uses at least one of these networks or you use one personally at home.  Perhaps you’ll find some of this interesting or relevant.

Thoughts on Social Networking

Like many of you, in the early days of social networking I thought all these websites were the same and was convinced that none were for me.  I had my preconceived notions about each, and this kept me from joining for a long time.  I was one of the last of my friends to join Facebook; I did so reluctantly and cautiously.   But now that I understand the rules and the culture, I’m much more comfortable with these various networks.

They’re each very different from each other.  I think of them as different types of parties.

LinkedIn is the formal cocktail party.  Everybody fancies up in a suit or a dress, trying to make themselves look more appealing and interesting than they actually are.  There’s a lot of “What do you do for a living?” conversations at these kinds of parties.  There is also a lot of chatter about what your peers are up to.  “What’s Bob been doing since graduation?”  “Did you hear Jane got laid off?”  I’ve always been a mess in social situations like this and am woefully inept when it comes to small talk.

This kind of thing obviously isn’t for everybody.  LinkedIn only has about 65 million users, fewer than its peers.  But the demographics of LinkedIn are impressive: almost everybody has a college degree and nearly 40% have six-figure incomes.  It skews much older, which isn’t a surprise.  LinkedIn isn’t a party for kids, it’s one for working professionals, one where they serve alcohol and drive expensive cars.  For what it’s worth, I know people personally who have used it to advance their careers.  If that’s the sort of thing you’re in to.

Our company has a LinkedIn page, but so far I haven’t found much of a use for it.  My LinkedIn profile is public, so anybody can view it.  If someone clicks on our company, they can see the people I work with and also see our website.  If some old classmate or former coworker out there is wondering what in the heck Jeffrey Dow Jones is up to (and why in the heck would they care?), they can find their way to our website and newsletter.  In theory, that expands our reach.  But in practice, I’ve noticed I’ll probably need to get more aggressive about it and promiscuous with new connections – something to consider if your website or business makes money from its visitors via ads or products for sale.  You’ll want to connect with basically everyone you’ve ever known and many others you’d like to know.

So join the party!  You don’t even really need to be my friend if you want to “connect” with me, Kyle, Trini, or Kelsey.

Facebook is a backyard BBQ.  It’s friendly and casual and there are more meaningful conversations take place, sometimes between two individuals, sometimes with a small group.  This is where people talk about the final episode of Lost or what they thought about the themes of The Grapes of Wrath.  It’s OK to talk about sex, politics, and religion here.  This party is more private – your backyard has a fence, after all – and you get to decide who gets to come over.  But if a nosy neighbor wants to peek over the fence, they can.  Facebook has been the subject of a lot of criticism lately over their privacy policy.  It’s because they’re building backyards that have split rail fences that don’t offer much privacy by default.  If somebody wants to build their own brick wall around their backyard, they certainly can, but it isn’t always easy to do so.

Facebook has over 400 million users, the majority of which log on every day.  It has a much broader demographic than LinkedIn or Twitter, which isn’t a surprise.  Who doesn’t like backyard BBQs?  In theory, this is a great spot to hold an open discussion about the topics of the week, and maybe this is something you’re interested in doing if you manage a small business.  But in practice, few seem interested in discussing the things we talk about.  That could just be the subject matter, though.  I love talking about this stuff, but accept the fact that others are less comfortable chatting about the nuances of high finance.

So far, I’d say that our experience with Facebook has been a great success.  We have about a 140 fans on Facebook, and every week we get about 10-15 clicks that come over from Facebook.  It’s a pretty good referral engine.  If you read The Draconian, there’s really no reason not to join our Facebook page.  Later this summer we’ll be posting a virtual tour of our office and trading room on there, and you’ll need to be a member on the page to see it.  Also, I’ve been thinking about running a promotion for all our fans over there, which will mean free loot if you’re a fan.

It’s easy: join here.  Go on.  Click it.

There you go.  Doesn’t that feel good?  Welcome to the backyard BBQ!

Twitter is sort of like the mezzanine during intermission at a hockey game.  It’s loud, there’s a lot of echo (retweets), and it’s very difficult to separate the signal from the noise.  It’s open and public, so there is no distinction of class, but I’ve found that it sorts itself into loose sub-networks along various interests and topical common denominators.  While waiting in line for a hot dog in the mezzanine, it’s perfectly acceptable to strike up a conversation with any ol’ stranger about the goal scored in the last period.  The discussion tends to be rather bite-sized and dogmatic, “Man!  Our goalie sucks!” or “It’s lookin’ pretty good for the Sharks!”  This brevity, of course, has everything to do with the 140 character limit on tweets.  You either can get down with discussion like that or you’re happier just ignoring it and getting back to the game.

In theory, Twitter is a good way to have a quick conversation with a lot of people at once and meet a lot of strangers with common interests.  That might be something your company is interested in, actively engaging your customers and audience.  But in practice, I’ve found it works much better for me as a realtime newsfeed.  I use it as a place to get interesting news that I wouldn’t find in my usual channels.

We don’t have many followers on Twitter, so I’m still kind of half-assing it over there.  But I do try and make a point to do at least one tweet per day, an interesting article or relevant thought about the markets.  I think the relative lack of structure and coherent etiquette is why I’ve had such a hard time fitting in on Twitter.  For the most part, my experience has been one of a quiet observer, which generally matches my behavior at any public gathering.  I see some people on there that are really engaged with their fellow Twitterites, and I think that’s really cool and something for us to strive towards.

If that sounds interesting to you, follow along.  I promise to be engaging and post additional articles of interest.  Send me a message or question and I will respond.

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There’s room for all of these networks to coexist.  This was another misconception I had back in the day.  Some people like cocktail parties, BBQs, and hanging out in the mezzanine at hockey games.  Some people only like certain types of parties and some people prefer to just stay at home.  I still know a few people that don’t participate in any of these social networks.

As a business, the real question is how to use these things.

Thus far, it has been a work in progress for us.  I think it’s been this way for a lot of businesses.  For every Starbucks on Facebook or Ashton Kutcher on Twitter, there are a bazillion other small businesses out there trying to figure out this still-evolving landscape.  I think a lot of businesses got on these networks just to be a part of them and not get left out.  But being on a social network is now something of a de facto condition, as normal as using email or a cell phone.  Today I assume that pretty much everybody or every business has a presence on at least one of these networks.

That’s only the start.  The winners are the ones who use the technology in the most innovative and effective ways.  Let me hear it at Feedback@TheDraconian.com if you guys have any success stories with your own social network presence or if you have suggestions on how we can improve ours.

Market Recap

Last Thursday the S&P 500 dipped below its 200 day moving average.  This means the medium term trend is now down.  So long as the market stays under this level, we think that for active traders, the better trade is to sell short into rallies and cover on dips.  This is a simple strategic principle that a lot of professional traders adhere to.

That 200 day moving average (the blue line) obviously bears watching, but I’ve got my eye on a few other levels.  The first is 1220 on the S&P.  We’re due for a relief rally, probably somewhere to around 1150.  But 1220 represents the recent high, and should the market climb back above that, it could be an indication that what’s happening in Europe really won’t affect us.  That, or the market will be telling us something else altogether, something undeniably positive.  That might include something as simple and short-term as an increased willingness for investors to take risk again, a common result when we take a “kick the can down the road” approach to solving economic problems.

As you can see, there’s decent support around the 1040ish area on the S&P.  Should the market decisively fall through that level, I think it could trade all the way down to 900-950.  For the record, that’s another 15% drop from here.  It could do it rather quickly, too.  We could be there by summer.  Or during an uncertain autumn, as the market starts to peek around the corner into 2011.

Should that happen, I think that might be a good level at which to begin initiating more constructive, long-term positions.  The market as a whole might be a mess, but I’ve been building a radar screen of good companies that are priced at very sane valuations.  For example, Microsoft trading at about 11x next year’s earnings and paying a 2.1% dividend is the kind of thing that makes me take notice.  Everybody in the world seems to hate Verizon, currently trading near a generational low.  But utility-esque earnings, a cheap multiple, and a 7% dividend has to be a little bit compelling, no?

Companies like this are neither sexy nor popular but that kind of stuff suits my personality, and that kind of stuff usually performs better in tough economic environments.

Banks as an indicator

I’ve mentioned before that because we work in the hedge fund industry, we’re on the leading edge of financial trends.  Stuff happens here first, and then trickles everywhere else.  It’s sort of the center of the economic world.  This is a space where a lot of large financial firms exist.  What are the big banks saying right now?

Now, it’s true that some of this poor performance of the financial stocks may be due to regulatory reform.  But honestly, this proposed legislation that’s floating around is still pretty friendly towards Wall Street.  It might impact their earnings a little bit, but isn’t going to fundamentally change the way these guys do business.  The legislators have done a lot of tough-talking with their populist, anti-Wall Street rhetoric, but these actual measures are pretty easy to live with.  The guys over at The Baseline Scenario have been doing an excellent job covering this in an objective, non-partisan manner.

A Wall Street victory on financial “reform” shouldn’t surprise you.  The banking industry spends well over a million dollars per day lobbying for preferential treatment.

What’s most interesting is that these stocks peaked last year.  Remember, I’ve said before that the U.S. financial crisis actually began in 2007, not September 2008 as most people believe.  If this European debt crisis impacts the global economy, we should point to late 2009 as the true beginning, when rumblings emerged from Dubai, and Greece restated a bunch of its accounting.  Scary thought: the Lehman-style tipping point that the public will confuse with the beginning of this new crisis probably hasn’t even happened yet.

Oh, and here’s another thing that peaked last year: China.

The politics of government borrowing

I’ll close on a somewhat random note.  The following chart was just too interesting to pass up.  I caught it over at Barry Ritholtz’s excellent blog, but it originally came from Doug Short, who maintains some seriously snazzy charts over at dshort.com.

I’ll let it do the talking:

To a certain extent, this chart is a Rorschach test.  It says a whole lot more about the viewer than the actual data being presented, and it’s a better centerpiece for conversation than source of conclusions.  With respect to the major political parties, there is little that can be ascertained.

A few things do stand out, which may reveal something about my own psychology:

• This isn’t the first time we’ve had an epic level of debt.  We borrowed a whole bunch back in the 40’s to pay for a World War.  Debt as a percentage of GDP is a much better way to look at things rather than absolute levels, but I will admit that 13 trillion dollars of debt!! does have a certain ring to it.
• It takes a lot longer to bring down gigantic debt levels than to accumulate them.  It could be 30+ years before we get gross debt down to where it was before Bush the Younger took office, and that’s assuming we get back on a track of sustainable economic growth and that D.C. decides that fiscal profligacy isn’t in our long-term interest.
• I had no idea how dominant the Democratic party was during the middle half of the century, both in Congress and in the White House.  Did the Republican congress and trio of Harding/Coolidge/Hoover really do that much damage to their party during the 1920’s and subsequent financial collapse?  Those three are regularly ranked among the worst of modern U.S. Presidents.
• With this historical perspective, you can see now exactly what is at stake for the Democratic party and why they’re so concerned about not screwing it all up this November.  This also might help you understand the current Republican strategy of “just say no” and disassociating themselves from all this new legislation.  Coming together might be a nice way to solve the real world’s problems, but from a politically strategic perspective, bipartisanship makes absolutely no sense at this juncture.  It is all-or-nothing for both of these parties.  The next 30 years are at stake.
• Might this be a new permanent plateau for gross federal debt?  It was after the stimulus in the 1930’s.  Japan can tell you a thing or two about permanently high levels of federal debt.

Ultimately, I think this chart just reinforces my view that our servants in Washington D.C. are all the same, regardless of their political plumage.  Both parties like to spend and rack up debt and both have presided over eras of quasi-responsibility.  It depends more on the times, which are always subject to change.  Most of the work these guys do is posturing and chest-thumping to make themselves look different from their opponents on the other side of the aisle.  It’s a never-ending war of perception.

That’s their real job.  And keeping their job has much more to do with managing your perception of them than what they actually accomplish.  Remember that political ideology is normally distributed.  All the meat is in the middle, and so they have to appeal to the middle if they want to get a job.  The Gaussian curve is the reason for their relative homogeneity.

Perhaps that’s just what I see in the colorful ink blotches.  How about you?

When I was growing up, I was a huge fan of the Indiana Jones movies.  I mean, how could a boy not idolize someone so unbelievably AWESOME!

It wasn’t all fun and games and childhood dreams.  I learned some important lessons from Indiana Jones.  Like how to crack a whip or where to find the Ark of the Covenant, for example.

But I also learned that one should always watch out for booby traps.

You see, booby traps are designed to lull you into a false sense of complacency.  They don’t work if you know where they are and how to avoid them.  So they’re hidden.  Everything looks fine and then… whoosh! You fall into a pit full of poisonous snakes.

Just like the lost Peruvian jungles or the Temple of Greece Doom, there are a lot of booby traps in the market right now.  The market action over the last year or so backs that up, too.  Everything seems fine, the market drifts on up, and then… whoosh! It sells off by 10% out of the blue when it discovers somebody important is hiding a new pile of stinky assets.

We can use the VIX (volatility index) as our official Booby Trap Indicator.  You probably don’t need an indicator that tells you when you’re in a pit of poisonous snakes, but the VIX does an admirable job:

I can look at the horizon and make a pretty good guess about some of the booby traps that might be out there.

For example:

• Pretty much all of Europe is an accident waiting to happen, obviously.
• Economic growth looks OK right now, but what happens if things slow down in the U.S.?  What if the coming double dip in Europe trickles over here?
• China could be a gigantic booby trap.  Yes, they’ll keep cooking their numbers so things will look fine, but they can’t force domestic consumption.  (or can they?)
• Another dip in real estate.
• Unintended consequences of higher income taxes.
• Failed reform i.e. “reform” that fails to actually reform.

You and I might see those booby traps, but I don’t think the market does.  At least not fully.  It’s also possible that you and I might be wrong.  That might not be a pit of poisonous snakes that we see ahead.  It could be a hot tub and a cooler of beer hidden beneath some palm fronds.

The scariest and most effective booby traps are the invisible ones.  There are a lot of things lurking in the jungle night that I can’t see.  That the banking system and our current administration can’t see.  That not even Nouriel Roubini, the Grandaddy Bear of them all, can see.  We can only hypothesize about these things and spin spooky economic yarns around the campfire.

When I look at a market that’s littered with pitfalls, loose boulders, and meteors falling from the sky, I adjust my investment stance accordingly.  Sure, I could reach for yield in riskier debt or by chasing rallies in the equity markets.  I could do those things to try and make 10% per year.  If I was awesome as Indiana Jones, I might even be successful at it.  But I’m not.  And so rather than expose myself to all those risks, I’ll chart a more cautious way through the jungle.

I know I’m not going to find the lost treasure while on the cautious path.  I see that superstar hedge fund manager John Paulson now owns 168 million shares of Bank of America.  Clearly, he sees something I don’t.  Perhaps he has a treasure map.  Perhaps “X” does actually mark the spot.  I don’t know.  I can tell you one thing, though: he is more likely to get eaten by snakes.

And as you can see, he is no Indiana Jones!

He actually looks more like the bad guy, Major Toht.  Paulson was the guy who made billions shorting the housing market, after all.  Super-villains separated at birth?

Anyway, I’ve written several times before that it won’t always be like this.  I remember as recently as 2002 things were starting to look OK.  The recession had worked its way through and the dot-com bubble was gone.  The 9/11 healing process was underway.  Unemployment was low, taxes got slashed, and the Three Amigos were all pointing to recovery.  There weren’t any toxic CDO-squareds lurking in the system and Greece was actually a pretty cool vacation spot.

Don’t worry, we’ll get an environment like that again.  The problem has always been that when those environments do materialize, everybody’s out of money.

Patience won’t pay dividends tomorrow but someday you’ll be glad you waited and had the capital at the ready.

Continuation of Europe’s debt crisis

We talk about Reinhart & Rogoff’s This Time is Different a lot around here because it’s a very relevant body of work, a detailed roadmap for the terrain we must navigate up ahead.  Another of the conclusions they came to after sifting through 800 years of financial data: banking crises follow sovereign debt crises.

There hasn’t been much talk about a banking crisis over in Europe.  That’s OK, because LIBOR is talking about it.

I brought this chart up last week to show that while the equity markets were sending one message, rallying on the trillion-dollar “Le TARP”, the LIBOR-OIS was sending a different message.  Remember, the LIBOR-OIS spread is a fancy-shmancy way of measuring how much banks trust each other.  It’s an early indicator; debt markets are jittery things.  It probably won’t really spike until some large bank somewhere teeters and looks like it might actually fall.  No clear frontrunner has yet emerged, but there are plenty of candidates in the Eurozone, starting with any bank that has “Greece” in its name.

LIBOR-OIS first started going haywire back in August of 2007, on fears that Countrywide Financial (remember those guys?) might have some seriously stinky stuff in its mortgage portfolio.  A lot of people think that the U.S. financial crisis started in September 2008 with the fall of Lehman Brothers.  It didn’t.  It began a full year before that.  A couple of hedge funds blew up in late 2007 and a few unpopular voices started voicing concern about firms like Countrywide.  The backdrop was still noisy and very bullish, but funky stuff like the LIBOR-OIS and Ted Spread broke out to levels unseen in years.  This is why we pay attention to these obscure indicators.  Try mentioning “a widening LIBOR-OIS spread” at your next cocktail party; watch your guests ooh and aah at your prescient financial knowledge.  It’s also possible they’ll laugh at you.  Or walk away.

Make no mistake, this is a new crisis that’s unfolding in Europe.  As the mighty Stephen Roach discussed on Bloomberg not too long ago, these crises are occurring faster now, with less time in between them.  It’s a side effect of an abnormally low interest rate environment and increased global capital flows.  The last major crisis was only 18 months ago.

I can tell you that in the hedge fund community right now, there is a big shift away from risk.  Last week we moved entirely to market neutral strategies in our own trading (50% long / 50% short).  The consensus amongst hedge fund managers seems to be that this is the only beginning of trouble in Europe.

This is different from any of the other speed bumps we’ve had since March 2009.  It could be the dip that keeps on dippin’.

What is Crude saying?

And on the subject of stuff that keeps on dippin’, check out crude oil.

Yowza.  To me, this is pretty strange action.  One might think that with this gargantuan oil spill in the gulf and the future of offshore drilling gravely threatened, that might drive prices up.  Not so.  It’s being overridden by even more powerful forces.

On the fundamental front, lower future supply is only one half of the equation.  Slowing demand has been the dominant force behind this drop from almost $90/barrel to $70.  Apparently, the market thinks that recession fears in Europe will translate into decreased consumption of crude oil.  I buy that.  Crude is telling us something about the broader global economy right now.

And then there are the speculators.  As we’ve noticed with nearly every stock market correction since 2007, most of the other commodities and risk assets have correlated with one another.  When stocks sold off, so did all the commodities, emerging markets, and corporate bonds.  A lot of the crude oil market is driven by speculation from large, institutional-class investors.  When things look scary, they sell bits of everything in their portfolio.

They sell this stuff because they’re nervous about the future.  If anything, crude oil might now be acting as a hypersensitive proxy for future economic demand.  This creates problems because excessive speculation on crude oil prices translates to real economic effects.  A few of you may have just had flashbacks to summer 2008 when crude oil ran to $147/barrel.  A lot of that was driven by pure speculation, and that speculation had real side effects.  The car companies shifted their strategy toward the development of hybrids.  Exxon had the most profitable quarter in the history of the corporate world.  People started biking to work.

It’s George Soros’ Theory of Reflexivity in action.  You all know Soros as one of the greatest investors of all time, but he’s also a pretty deep thinker.  In simple terms, the concept of reflexivity is that what people think about things affects the way they actually are.  For example, if people think Greek debt is risky, they sell it which drives up interest rates.  The higher the interest rates get, the more difficult it is for Greece to service the debt, which makes the existing debt riskier to hold.  That causes people to sell more of it, and the cycle continues.  In the meantime, Greece goes out of business and a feedback loop of perception is partly to blame.

For you quantum physicists out there, it’s sort of an extension of Heisenberg’s Uncertainty Principle.  The mere observation of a particle actually affects the particle’s behavior.

When watching crude oil, a market that today is driven in large part by speculation, these are important concepts to keep in mind.  Typically, when virtuous/vicious cycles finally break, they do so quickly and severely.  That leads us right back to our view of a market laden with booby traps.  Everything seems fine for a while and… whoosh! All of a sudden you’re in a pit full of poisonous snakes wondering what happened to half your investment portfolio.

Something to keep in mind as we look at gold.

Gold starts bubbling

I’m not gonna lie.  I am amazed that gold has run up against the global pullback that started in late April.

Its recent action sounds commonsense, right?  The EU announces that it’s going to have to fire up the money printing presses, hurting the value of the Euro.  The US continues to print money and spend.  Isn’t gold is supposed to go up in situations like that, where paper currencies go down in value?  It is.  But in the last few years, it hasn’t exactly done that.

At least since 2008, gold has tended to rally along with the market and other risk assets and then sell off when people get nervous.  But in the last few months that relationship has broken down.  I guess I’m just surprised that gold is actually doing what it’s supposed to be doing.  Go figure.

You guys may remember that one of our 10 Predictions for 2010 was that Gold would start to bubble, or specifically, chatter about it being in a bubble would heat up.  So far I wouldn’t say that has happened, though I think things are definitely now moving in that direction.  It got up to new highs, almost 20% from its lows back in February.

But it isn’t so much the market action I’m looking at, it’s the ads to buy gold during every commercial break on CNBC.  It’s the fact that more people ask me about gold than anything else.  It’s stuff like this, which Kelsey sent me earlier in the week:

No, that’s not just a gold plated ATM.  It’s an ATM that dispenses gold bars.

Let that soak in for a moment or two.

People: this is the kind of thing you only see during the crazy times.  We are now officially entering the speculative third phase of the gigantic gold bull market that began back in 2001.  I even heard Erin Burnett on CNBC use the “b” word during a segment on gold.  That’s exactly the kind of talk I was looking for this year.

Who knows where it goes from here.

I have always liked gold and will continue to like it because it’s different.  Most people think of it as an inflation hedge, but when you look at the data that assumption isn’t really correct.  Gold is better thought of as a “neutral currency”.  I like thinking of it as an “anti-investment”, the kind of thing that performs well when no other investments do well.

In case you missed our 6 Things You Need to Know About Gold, go back and give it a read.  I know it’s from last year but I just re-checked it and it’s all still relevant.

It seems like the higher gold prices go, the more people want to know where it will go from there.  I think a lot of people are buying gold right now because they feel like they’ll get left behind if they don’t.  That virtuous cycle can continue for a while.  But don’t forget that that’s why a lot of people were buying houses in 2003 and dot-com stocks in 1998.  Nobody wanted to get left out of the party.

I’m done buying gold for the time being and am content with what I bought back when.  There are still plenty deflationary mini-scares out there and when we trigger some of those booby traps, gold will be something I take another look at.

But forget about what boring old me thinks.

What you really want to know is what INDIANA JONES would do!

Come on, do I really need to answer that?

There’s really only one thing to talk about this week: the gigantic WTF in the market over the last 7 days.

We’ll get straight to it.

Canaries dropping dead

A while back I promised that I’d keep you all updated on early indicators of market stress, possible canaries in the equity coal mines.  In the last week a few more have dropped dead.

First, every single one of you needs to watch this video.  It’s David Letterman, so it’s short and funny.  But Brian Williams is his guest so he puts the situation in terms that should make sense to everybody.

Here’s a link in case that video didn’t embed.

In the last week I’ve noticed that a lot of people are trying to decouple and dismiss  the market crash and the fundamental breakdown in Europe.  These two events are inextricably linked. The former never happens without something like the latter.

For the record, I don’t think the language Mr. Williams uses is hyperbolic and I don’t think the 9/11 comparison is inappropriate.  No, this market crash wasn’t anywhere remotely close in terms of damage or loss or duration, but there was a feeling we all had last Thursday, those of us that were watching it unfold in real-time, that we haven’t had since September 11th.

I’m not going to forget that image of angry mobs hurling stones at police in full riot gear, of human beings on fire in the streets, of the ticker at the bottom of the screen showing the market crash 600… 700… 800… 985 points in a matter of minutes.  And the feeling in the pit of my stomach.

How long until something like that happens somewhere else.  In Spain with its 20% unemployment?  In Portugal with a budget deficit of 9.4%?  In Italy with public debt 115% of GDP?

What about California with its untenable budget situation?  How long until laid-off workers or retirees facing austere reductions in their entitlements start to gather in downtown Sacramento.  Demonstrations like this often start peacefully, but mobs are emotional and unstable things.  (So are markets, by the way.)

These aren’t simple glitches, hiccups that quickly resolve themselves and disappear.  These are very real risks, massive structural problems the likes of which we haven’t seen in more than a half century.

Ghosts in the Machine

Last Thursday, for about 15 minutes, all the bids disappeared.  Buyers everywhere said “no thanks” and turned into sellers.  Computer-driven high-frequency trading shops simply switched themselves off.  So much for their promise of supplying the market with liquidity!  Last Thursday, these guys either demanded it or simply disappeared.

Schwab went down.  Other brokerages were paralyzed with transactions they couldn’t effect.  I tried to get on Yahoo Finance, and even their servers had melted down from the traffic.

There is no other way to say it: the market failed.

The most disturbing thing about it was the willingness of investors to simply view the crash as a “glitch” driven by computerized trading.  Listen, illiquidity is very real and is a common denominator in any type of panicked market.  Illiquidity is no glitch.  Panics are panics.  Check out this guy’s analysis of the crash if you think this was human or machine error.  The “fat finger” theory is ridiculous.

There were people, real people, who had stop-loss orders in on their stocks that got filled at levels far below where the stops had been set.  Some poor bastard actually got filled at 39.37 on Proctor & Gamble.  That stock opened the day at 62 and closed at 61.  That was a real trade.  What good is a stop loss if it doesn’t work in an illiquid market panic?  It’s like buying a life insurance policy that won’t pay out if you die.  I think AIG sold a couple of those.

I’m concerned this won’t be an isolated incident or will manifest itself again in a slightly different way.  How are we supposed to trust a market that can do this?

Speaking as an insider, I can tell you that the consensus amongst active traders is one of caution and distrust.  I heard more than few floor traders on Bloomberg mention that this was the most volatile, the most nerve-wracking market they’d ever seen.  Worse, even, than anything during the crisis of 2008.  The thing about trust is that it’s psychological in nature.  It’s something that is earned slowly over time and has a tendency to evaporate at once based on a single event.

But since last week we’ve seen pretty good market action.  A week ago, the financial world was coming to an end (again).  Today the market has forgotten all about it.

Should I feel reassured by that, or more afraid?

Like the crash of 1987, what happened last Thursday will be studied and talked about for a while.  Computerized trading was a common denominator in both.  After the ‘87 crash, the market stabilized and continued on a bumpy ride back up.  Might that happen again today?

Well, unlike the crash of 1987, the economic fundamentals today are a mess.  Back then we were in the middle of a monstrous growth cycle.  Today we’re in the midst of an epic contraction in private credit, the unwinding of global asset bubbles, and powerful economic headwinds.

The context matters, as do the root causes.  This is why I am hesitant to dismiss this event as meaningless and am disturbed by the majority that is doing so.

The fundamental problem

What started the cascade of selling last Thursday was fears of Greek contagion.  Whether Greece is even the biggest source of the problem is difficult to say.  I’m not sure it matters.  Remember what we said last week – the problem isn’t Greece specifically, but rather what Greece represents.

The last round of the crisis in 2008 was about private sector liabilities: people, banks, and businesses had more debt than they could manage.  The next round of the crisis will be about public sector liabilities: countries, states, and cities that have more debt than they can manage.

The market rejoiced when the European Central Bank promised $1 trillion of loan guarantees should it be necessary.  I’m one of those people who have a tough time understanding how the problem – countries with more debt than they can manage – will be solved by shoveling more debt on top of them.  This bailout facility, dubbed “Le TARP”, is sort of like the bank giving you a home equity line of credit when you are having trouble making your initial mortgage payments.  You guys all know how that story goes, right?

Eventually, the problem will be resolved.  Until then, keep in mind that over the short run, markets do crazy things for crazy reasons that nobody can understand.  Your thesis and ours may ultimately be correct, but the market can remain irrational for a long time.  However.  Over that long run, only one thing matters: fundamentals.  A share of stock is nothing more than a claim on future earnings and growth.  That’s all it is.

I can’t see how all these bailouts aren’t a claim on future growth.  And while they may stabilize the situation for the time being, I can’t see how they make these economies grow faster in the future.

Crisis Canaries

There many other things to look at aside from the equity markets’ reaction to the problems in Europe.

One of my favorite “crisis canaries” is the LIBOR-OIS spread.  Remember, this is an indicator that basically measures how much banks trust each other.  Currently, it’s flashing a yellow light and the massive European bailout isn’t making it feel much better.

Also, the Euro.  Check this thing out.  People can’t convert their Euros to Dollars fast enough!  Apparently “Le TARP” hasn’t fixed that problem either.

Back in January we talked about the Euro re-testing that support level of 1.24 by the end of the year.  Shoot, we’re almost there now.  More European debt and more Euro-printing paints a pretty ugly picture for their poor currency.  To complete that alliterative thought: people, prepare for parity!

Let’s also not forget that it’s a global economy now.  A whole bunch of U.S. companies sell stuff to Europe, and when their currency falls apart, that’s really bad for our companies’ sales and earnings.  Do you guys remember back in 2001 and 2002 when the economy was in recession and everybody was blaming the weak Euro?  If you’re wondering how a weak Euro affects us here at home, this is how.  It hurts U.S. exports and earnings.

A Euro at or below parity is awesome if you like to travel but less awesome if your business is selling stuff overseas.  On top of a weaker currency, this gigantic EU bailout and all the austerity measures that will go along with it all but guarantees a double-dip recession in Europe.  A Europe that’s in recession is not a Europe that buys the stuff your business wants to sell.  Bad for our economy, bad for our markets.

The stock market may continue to rally for a while.  That’s fine.  It will do it without me.  When the market gets cheap again, I’ll put more risk on.  I think that could be a while, though, so in the meantime I’ve made my peace with fundamentally lower rates of return than we all got cozy with in the last few decades.  I have sworn an oath not to get caught up in this mad dash for yield.  5% is the new 10.  And 10% is the new 20.

If you want to play this market, go ahead and do so.  Buy on significant dips and use other tactics to enhance your return.  I’d suggest putting on some stops, but honestly, with the amount of shadow volatility and hidden fear in the market, I’m not sure it will make any difference.  You might be the sucker whose Proctor & Gamble stop gets filled at 39.  From a risk management standpoint, you’ll probably be better served by just trading lightly and watching closely.

You can use the options to hedge your risk, too.  But those cost money, and they cost more when everyone is afraid.  Generally, people only want to buy insurance when they’re afraid.

And if you have a gigantic time horizon and want to be involved, go right ahead and buy some top-tier companies and forget about them for 10-15 years.  I’m with Jeremy Grantham that those are about the only decent values out there now and the economic future won’t always look this bleak.

The Fourth Turning

All of this instability would be one thing if the public mood wasn’t what it currently is.  Americans are more anxious now than they have been in a long time.  Investor confidence and optimism are way, way below historical norms.  Unemployment is as high as many of us have ever seen it and nobody in their right mind expects that situation to significantly improve any time soon.  The political climate is as fractious as it’s been in generations and global relations are slowly deteriorating.  A couple of weeks ago we talked about how the economy is legitimately improving!  I think the fact that so few are excited about it speaks volumes.

This is, as Neil Howe describes it, the Crisis Turning.  This is the decade or two where we sort through the mess we’ve made in the last 60 years.  It isn’t just a Wall Street mess.  It’s a global, psychological, emotional, financial, political mess.  It isn’t the sort of thing that disappears overnight or is solved by a trillion dollar ECB credit facility.

If you want to know what that process will look like, read his book, The Fourth Turning.  Or check out this excellent interview.  For the last year the following exchange has haunted me:

Interviewer: If I’m understanding you correctly, we are not very far into this Fourth Turning.  So that the actual Crisis, the Crisis that is really going to test the mettle of humanity, if you will, is still very much ahead of us.  Is that a fair statement?

Neil Howe: Yes, absolutely.

Interviewer: On a scale of 1 to 10, if the worst it is ever going to get during the Fourth Turning would be a 10, where are we today?

Neil Howe: I would say 2 or 3.

Keep in mind that that conversation came from early summer of last year.  That was a time when things looked pretty bleak.

What Neil Howe talks about is really, really big picture stuff.  It’s a generational cycle that lasts 80-100 years and has repeated in an eerily similar pattern for centuries.  You can also learn more about it at his website, LifeCourse.com.

Don’t be afraid; we’ll get through it.  As an investor, there’s plenty you can do.  It’s one of the reasons why we launched The Draconian, to talk about this stuff in a public place.

A gospel of caution

Since day one we have been preaching a gospel of caution.  That will continue for the foreseeable future.  Someday, that will change.  Someday the political, social, and economic fundamentals will all look better and it will be a time where the ratio of risk and reward is much more friendly.  When that happens, we’ll write about it, and my guess is that we’ll probably be in the minority (once again).  It’ll be a world in which few want to take risks and have the means to do so.  But the potential benefits will be tremendous.

In our own trading, we are moving almost entirely to market neutral strategies, those that can profit regardless of market direction.  Just about all of our money is invested in the hedge funds that we manage, but we each have a little bit on the side.

Here’s what else I’m doing:

• I continue to hold a fair amount of cash to guard against cash flow troubles.  No, cash doesn’t pay much, but cash is king.  I like cash.  Or, I will like it until the Inflation Chupacabra gets a little closer.  This is why…
• I hold a lot of TIPS (Treasury Inflation Protected Securities).  These don’t yield much either, but they carry zero risk and are guaranteed to rise in value in accordance with the official rate of inflation.
• I own some gold, both coins and through GLD.
• I own short-term, high-quality corporate bonds.  (Check out our Totally Thinkless Super-Low Risk Bond Strategy if you missed it last week)
• I have some equity mutual funds, but they’re alternative-style mutual funds and their movement doesn’t always mirror that of the market.
• I have zero debt beyond my mortgage and if my house was the type of dwelling that could more comfortably accommodate an expanding family, I would pay down that debt as well.  I like concrete goals, and my number one goal for the next decade is to own my house free and clear.  That might sound like a noble, common-sense goal, but it was just a few years ago when people who didn’t borrow against the equity in their homes were laughed off the financial roundtable.

Like a lot of members of my generation who every day grow more skeptical of things like social security and state pension plans, I have few thoughts about retirement.  I’m lucky to have a job I love.  I hope to work in some capacity as long as I am physically and mentally capable of doing so and balance that work with my life at home; work is necessary for me to feel fulfilled and self-actualized.  Richard Russell is something of an industry hero of mine (and was one of my father’s as well).  The guy is 86 years old and writes about the markets every single day.  Plus, he gets paid to it.  What a swell gig!

Last year I wrote that there’s nothing more valuable today than a good, stable job.  I continue to believe that.  So make sure you’re covered on that front as well and direct some resources that way if you have to.  A lot of people don’t think of their jobs as financial assets in a diverse portfolio, but they are.  A $50,000/year job may not sound like anything special, but you’d need a million dollars to reliably generate that kind of cash flow.  Who thinks of their job as a million dollar asset?

Probably not many.  But in the world that lies ahead, my guess is that may change.