Friday, October 19, 2012

Humpty Dumpty

Humpty Dumpty Sat On a Wall,
Humpty Dumpty Had a Great Fall.
All The King's Horses and All The King's Men,
Couldn't Put Humpty Together Again.

Today is the 25th Anniversary of the October 1987 market crash, so everyone is piling onto the "it can happen again" theme.  

When I read Cashin's recount of that notorious day, there were a couple of key points that I found resonated with today's set-up.

He starts out by saying that up until the late summer, 1987 had been a very strong year (up 43%) for the stock market - this year, the S&P was up 17% through September.  1987's rally topped out on August 25th, whereas this year's rally topped out on September 14th.

He also talks about the use of "portfolio insurance" which is what Bill Gross referenced in his rambling Tweet from above.  It was a new futures-based derivative that obviously did the exact opposite of what it was supposed to do.  Today there are many more ways that portfolio managers can hedge their portfolios, but the key point is that there is no free lunch, so if one party is reducing their risk, then as we were reminded in 2008, another party is increasing their risk.  I would also take this opportunity to point out that hedge funds are not really hedged.  They generally use put spreads to hedge the first 10% of downside, beyond which point they return to a net long position.  So if all of these hedge funds decide to reach for downside protection at the same time into a hard down market, then things will get very interesting indeed.

Cashin also says, that in the first part of 1987, "Fear seemed to disappear. Junior traders laughed at their cautious elders and told each other to "buy strength" rather than sell it, as each rally leg was soon followed by another."  I won't bore you with yet another of my diatribes on today's similar level of complacency.

On a side note, he then says that the market took a shit because Nancy Reagan was hospitalized.  Which only confirms mine (and others') conspiracy theory that she was the real President and that Reagan himself was just a Neo-Con installed sock puppet, or to put it more accurately he was an actor playing his greatest role.

Then Cashin describes the Monday Meltdown sequence which was surreal.  Our situation will be similar except accelerated by 10x due to the actions of High Frequency Trading (HFT) algorithms - which we saw in 2010 dropped the Dow 7% in seconds.

Then he describes how all of the brokerages and banks pulled back from the market (similar to what happened in 2008).  In the event, authorities eventually stepped in and the first major Moral Hazard market event of our era was born.  Just the first in many missed opportunities to learn from our mistakes.

As you know, I expect something very similar in terms of the sequence of events, I just highly doubt that our current set of policy-makers given their depleted set of tools, can keep the "wheels from coming off the locomotive" this time.  Beyond the structural aspects and incentives of the financial markets which have in no way changed since 2008, Central Banks, in their terminal fealty to Wall Street, have found creative new debt monetization based alchemies for enabling Wall Street to massively increase leverage over what obtained prior to 2008.  When these various leveraged carry trades get unwound into a one-sided sellers-only market, we should expect a velocity of decline far exceeding the Lehman crash, encompassing all risk assets.  And yes, I still like short-term U.S. Treasuries (and the dollar) at this juncture primarily because many of the aforementioned carry trades are funded by shorting treasuries which is why Wall Street takes every opportunity to bash them i.e. Central Banks have created what Wall Street believes is a one-way bet.

So unless one believes in infinite luck in the face of repeat overwhelming stupidity, this will likely be the Humpty Dumpty crash that we should have prepared for long ago.

Wall Street is Attempting to Hop Scotch Through A Mine Field
For those who have better things to do than read earnings reports, the reports so far this quarter have been abysmal.  As we expected, Wall Street is face down in the Central Bank feed bag and overwhelmingly preoccupied with maximizing year-end bonus.  So it must come as a major irritation that so many companies are confirming that the global economy is slowing precipitously.  Historically Wall Street heeded the pre-announcements and reduced equity exposure going into abysmal earnings seasons like this one, so this is Exhibit A of dangerously oblivious behaviour.  The list of companies and industries reporting disappointing earnings is growing by the day, with each revelation resulting in the stock being taken out to the woodshed e.g. Google, Cummins, McDonald's, GE, IBM, Microsoft, Fedex, Chipotle just for starters.  In other words the number of safe stocks and industries is dwindling quickly.

p.s. There has already been major technical damage to the markets to date, but the Idiocracy at large and the markets are still overwhelmingly complacent as indicated by the VIX options fear gauge (black line).  The index depicted is the Nasdaq 100 which similar to 2000 is bearing the brunt of far.  The big spike in the VIX is from last summer through October 2011.  As expected, Apple (second chart) is leading the way down, and made its peak with the debut of iPhoney 5: