Leveraged ETFs

Decent demo of the slippage or tracking error that occurs when holding leveraged ETFs over time. While these vehicles may be useful for trading, the tracking error erodes long term returns, making them undesirable for investors with long time horizons.

no positions

More Gold Weakness

Action in precious metals continues ugly. New lows for the move today. Peering thru a longer time horizon lens, however, finds the yellow metal just now touching its multi-year uptrend line--a defined risk set-up for bullish traders.

One apparent takeaway from a macro perspective is that gold is not buying the thesis that the financial system is reliquifying--particularly w.r.t. the EU. Instead it is behaving like a wave of deleveraging, deflation in in the cards.

position in GLD

Euro Rumblings

Am continuing to pick up chatter like this that the situation in Europe is worse than appears. The EU version of TARP, the Long Term Refinancing Operations (LTRO), has seen a commensurate jump in bank funds with the ECB Deposit Facility to a record high half trillion euros.

The implication is that interbank lending in Euro is largely frozen. Banks are instead choosing to keep funds w/ the central bank.

Deja vu pangs here, as this is very reminiscent of the risk averse behavior we saw stateside in 2008.

Which probably shouldn't be surprising. After all, the situations are largely the same. Risk seeking behavior and easy credit ran up massive debt and leverage. Now risk appetites are waning. And price declines threaten leverage systems with insolvency.

position in SPX

Inverse Head and Shoulders Pattern

Back in early November technicians were eyeing the pennant patterns forming in the major indexes, and largely opining that the resolution of that pattern was likely to be higher. As we now know, the bulls were fooled as prices moved lower.

Now, technicians are eyeing a forming inverse head and shoulders pattern with similar optimism.

Will Hoofy's heros bring home the bacon this time? That seems to be the growing consensus.

Personally, I'm not playing it that way. There is far too much macro overhang for my tastes, not to mention overvaluation at the micro level, to merit holding a bunch of long equity risk.

Am currently about 10% net long, but that long exposure is in commodities. It is offset not quite one for one with an index equity short. This hedged position has not proven to be as effective this time around because of recent weak commodity performance relative to stocks.

Currently, however, my MO remains the same. Use price to my advantage to a) add exposure at lower prices and b) unload exposure at higher prices. All the while, I want to maintain sizeable dry power (read: cash and short term fixed income).

position in commodities, SPX

Hyper Hypothecation

On top of hypothecation and re-hypothecation, there is also hyper-hypothecation. Hyper-hypothecation is basically the re-hypothecation process done multiple times between various trading partners.

HH creates systemic counter-party risk in a leveraged system. If one trading partner in a chain fails to make good on a contract, then the entire system freezes up because there is not enough capital to meet all the margin calls.

Conceivably, prices may be in error if participants fail to understand the counterparty risks that cascade thru a market system. Once those risks are understood, prices are likely to drop...significantly.

This pretty much describes our ponzi-esque condition...

Hypothecation and Re-Hypothecation

The MF Global meltdown has brought the words 'hypothecation' and 're-hypothecation' to the forefront. Hypothecation is the relatively common situation where a buyer pledges collateral to secure a debt. The borrower retains ownership of the collateral, but in the 'hypothetical' case that the borrower defaults, then the creditor can take possession of the collateral.

In the US, the right of a creditor to take ownership of collateral if the debtor defaults is called a lien.

The lion's share of home mortgages reflect hypothecation. The home 'buyer' pledges the property to be purchased as collateral to secure a mortgage from a lender. Until the house is paid off, the creditor retains the right to take possession of the property if the borrower fails to keep up with mortgage payments.

Re-hypothecation occurs when financial entities pledge collateral that has already been posted by clients to support their own borrowing and trading. If a broker dealer such as MF Global puts up assets held by clients in 'margin accounts' as collateral to, say, speculate in Euro sovereign bonds, then this broker dealer would be engaging in re-hypothecation.

The immediate consequence of re-hypothecation is that it increases systemic leverage. More assets can be borrowed and controlled with less amounts of underlying equity.

As we noted many times on these pages, leverage becomes problematic when price moves against you. The higher the leverage, the smaller the change in price necessary to wipe you out.

Thus, when Euro bonds tanked over the past few months, MF Global was wiped out.

In the case where leverage is built on re-hypothecation, then the question becomes one of property rights. Whose property is lost when MF Global was wiped out? If re-hypothecation is in fact a legal aspect of a contract (e.g., a client of MF Global agrees that a condition of maintaining a 'margin account' at the firm is that holdings can be re-hypothecated for MF's own trading endeavors), then it is the client, not the firm, that is on the hook.

Thus, clients of MF Global may be out billions of dollars...

More Bass Thoughts

A couple of interviews w/ Kyle Bass that I have yet to chew fully thru. Similar themes to recent commentary. The end of ponzi in Japan, EU on fire, dysfunctional US govt. One new dimension was his bullish take on Canada--which is tempered by his bearishness elsewhere which will spill over in a negative way to the Knucks.

Interesting stat: value of bank assets worldwide: $87 trillion. Value of bank assets in Europe: $40 trillion. Euro bank balance sheets are 3x levered as the US.

When asked why ECB won't just print the debt whole, Bass said "Your question should be do they print before or after they default. In my opinion, they have to just print afterward because the number that they're going to have to print is so large that they all know this going in."

Not sure I understand exactly what he's saying here. Perhaps the transcript that I'm reading is out of context, and I'll know more once I watch the actual interview.

USD Trade Closed

Sold my small UUP call position this am into this morning's spike higher in the dollar.

Resistance is approaching dead ahead. Plus possible double top.

Just tradin' 'em...

no positions

The Problem with Fractional Reserve Systems

Nice overview of the Corzine/MF Global dynamic. As the author points out, the borrowing and levering of client assets is at the heart of this problem. And it is nothing new. Banks do it every day.

The leverage in a fractional reserve system means that the system is fragile. Fragile to small downward moves in price. Fragile to declines in confidence.

He's right. MF Global seems a chirping canary.

position in SPX

Lightly Buying

Buying some gold and silver this am into the continued smeltage. Support is coming up fast. Stochastics getting there as well. Stated differently, risk/reward is getting more attractive.

Nothing crazy, just some incremental adds. Truth be told, would welcome lower prices for more substantial buying.

position in GLD, SLV, CEF

Hussman's Hard Negative

Another weekly letter by John Hussman that contains several nuggets of insight. Right off the bat, he makes it clear that conditions have turned decisively negative, in his view.

The current situation is "characterized by an extremely unfavorable ensemble of conditions across valuations, sentiment, economic factors, and other conditions. Current conditions cluster with periods such as May 1962, October 1973, July 2001, and December 2007, all of which produced 10-20% market losses in extremely short order."

Dr J notes the increasing disparity between the leading indicators that his firm and ECRI tracks, which now signal an extremely high probability of US recession, and the prognostications of mainstream forecasters and pundits.

He notes some exchange between a Bloomber interviewer and ECRI's, Lakshman Achuthan:

Bloomber interviewer: [ECRI recently made] a recession call. What happened?
Achuthan: It's happening.

Suggests significant cognitive dissonance out there regarding recession chances.

He also notes that the EU summit last week did (and can do) little to avert the central condition of credit crisis: solvency. Solvency is a shortfall between money owed and the resources needed to credibly repay it. Emphasis on 'credibly.' Printing money to pay back debts in devalued currency is not a credible strategy--at least in the eyes of creditors...

John suggests that perhaps one credible means for relieving stress in the EU is for countries to issue convertible sovereign bonds as they roll debt. The bonds would be convertible into the currency of the issuer at the option of the issuing government. Those countries with shaky fiscal houses would be required to pay a significant premium in order to compensate bond buyers for the commensurate risk.

Over time, John suggests, convertible debt might relieve the acute pressure that has built in the EU system. EU members would need to achieve sufficient financial credibility to remain in the EU system, lest they be subject to huge premiums on debt issued. The need for questionable bureaucratic enforcement mechanisms would be reduced. John suggests, "If the system can be saved, it will be saved" under such an arrangement.

One problem, of course, is that the significant discount that many EU countries currently enjoy by issuing debt under the implicit backing of the EU umbrella would vanish. Those countries would be forced to pay up and/or get their fiscal houses in order.

Market forces hate moral hazard...

position in SPX

Gold Moving Lower

Never got off a comment last week on the head-and-shoulders (bearish) pattern setting up in gold. This morning gold is down nearly $50, which essentially validates the 'dandruff.'

Why the thrust downward in the yellow metal? Not sure, cookie, as there is no 'obvious' gold-related news on the tape. Over the weekend, however, there were some rumblings that last week's EU summit outcomes 'did not go far enough' in resolving the debt crisis. Swap spreads are generally widening today, with Greek spreads crossing the 10,000 bps mark--implying a 100% chance of default.

Am starting to sense that gold may be a leading indicator of another round of 'risk off' in the markets. Added to my short equity position this am, and may do more in the upcoming sessions depending on how things unfold.

position in GLD, SPX

Kyle Bass Macro Discussion

After a very interesting exchange last year, Kyle Bass returned for another insightful panel discussion this year (the actual discussion starts about 3 mins in).

I follow my fair share of macro discourse. I find the thoughts presented here as among the most interesting that I've heard. Bass' grasp of the sovereign debt and leverage situation is on a different level than most.

He is convinced that a EU crack up is imminent. From a silver lining standpoint, he suggests that, after observing the pending Euro collapse from front row seats, US policymakers might actually be stunned enough to proactively reverse course. Interesting thought.

On the other hand, he notes that capital flight into US Treasuries might lull policy makers into thinking that there is actually no crisis in our future.

In any event, this 1+ hr dialogue is worth your time. Personally, I plan to take it in a couple more times in the next few days.

position in USD, SPX

Bail Out Mentality

Another sage letter by Dr J. In the front half he makes a compelling argument for a recession given the position of his forward looking indicators.

In the back half he discusses the EU situation given last week's 'coordinated' move by central banks. He reminds once again that the issue is one of solvency rather than of liquidity. Last week's coordinated dollar swap program is a short term measure aimed at boosting liquidity.

To remedy the solvency problem, it is likely that either banks fail or non-bank holders of EU debt must take haircuts. Thus far, no one wants to do that.

John ends with a section called "We represent the Lollipop Guild." His thoughts here are so wonderfully collected that I want to capture them here in their entirety:

"Frankly, I am concerned that Wall Street is becoming little more than a glorified crack house. Day after day, the sole focus of Wall Street is on more sugar, stronger sugar, Big Bazookas of sugar, unlimited sugar, and anything that will get somebody to deliver the sugar faster. This is like offering a lollipop to quiet down a 2-year old throwing a tantrum, and expecting that the result will be fewer tantrums.

"What we have increasingly observed over the past decade is nothing but the gradual destruction of the ability of the financial markets to allocate capital for the benefit of future growth. By preventing the natural discipline of the markets to impose losses on the poor stewards of capital, and to impose interest rates high enough to force debtors to allocate the capital usefully, the world's policy makers are increasingly wrecking the prospects for long-term economic growth. The world's standard of living (what we can consumer for the work we do) is intimately tied to its productivity (what we can produce for the work we do). That productivity requires scarce savings to be allocated to productive physical capital, and to productive human capital (primarily education).

"Nietzsche famously said, 'What does not kill me makes me stronger.' The corollary is 'What constantly rescues me makes me weaker.' The world will only stop looking for bailouts when policy makers stop handing them out."

Re-read until you understand.