Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 5-Mar-07
Last week on Wall Street

Web Log - March, 2007

Last week on Wall Street

Investors are disappointed that the market didn't "feel some panic."

After three days of massive swings in the market, things settled down a little on Friday morning, giving pundits a chance to debate where the market is going.

My interest on this web site is mainly in analyzing attitudes how of pundits and investors change. In particular, I want to track the developments predicted by the Principle of Maximum Ruin -- that the maximum number of investors will be ruined the maximum amount. The Principle of Maximum Ruin is really starting to kick in now.

The big debate among the pundits on Friday was this: How much further will the market fall? Some said 7-10% of the next few weeks, and others said it had already bottomed out, and would be hitting new highs within a couple of weeks. There was one person, Doug Kass, who was predicting a "crash," but he was quickly ignored. However, he had some very interesting analysis, so I'll come back to his remarks later in this article.

The lovely CNBC anchor Erin Burnett explains why the "big money" is disappointed that the market didn't go lower. <font face=Arial size=-2>(Source: CNBC)</font>
The lovely CNBC anchor Erin Burnett explains why the "big money" is disappointed that the market didn't go lower. (Source: CNBC)

The other interesting remark was this, stated on Thursday and Friday by CNBC anchor Erin Burnett, in answer to the question, what do the "big money" investors think of what happened this week:

"The bottom line is that 'big money' wants more selling. They want to see and feel some panic in the market before they feel that it's over. They haven't liked the rally over the last couple of days."

Now think about what this means. First, the "big money" thinks, with absolutely certainty, that the worst will soon be over, and that the worst that will ever happen is that the market will lose 7-10%. Furthermore, these experts will KNOW when it's over because they'll "see and feel some panic" in the marketplace. They're really confident of themselves, aren't they? As the old saying says, "Pride goeth before the fall."

This is important -- the "atmospherics" changed drastically on Friday -- much different than on the preceding three days.

On the preceding days, the discussion was whether the market was having a complete meltdown.

By Friday, the only discussion was whether the selloff would be 7%, 10%, and 20%. Furthermore, the rest of the discussion was over whether the market would be reaching new highs again in two weeks, two months, or six months.

Before Friday, no one had any idea what was going to happen; by Friday, there was no longer any doubt that things would quickly return to "normal."

It took only three days for pundits and investors to completely forget the lessons of Tuesday. Then the "cant and incantation" that I described was operating in full force.

Entertainment Break #1

Now, let's take an entertainment break. I'm grateful to the Housing Panic Blog for pointing out two interesting videos, both well worth viewing.

Suzanne Researched This Commercial

This was a sickening commercial when it first aired, and it's even more sickening today.

Housing Bubble vs. Great Depression

This is an excellent comparison of today's world with 1929.

Feel free to sing along with the second video:

    I'm forever blowing bubbles,
    Pretty bubbles in the air,
    They fly so high, nearly reach the sky,
    Then like my dreams they fade and die.
    Fortune's always hiding,
    I've looked everywhere,
    I'm forever blowing bubbles,
    Pretty bubbles in the air.

These two videos show the creeping perniciousness of the Principle of Maximum Ruin.

This is what's going on today. It doesn't matter how bad things get, you will always get politicians and analysts telling you how good things are and economists telling you whatever you want to hear.

Douglas A. Kass, Seabreeze Partners Management

Douglas A. Kass, Seabreeze Partners Management <font face=Arial size=-2>(Source: CNBC)</font>
Douglas A. Kass, Seabreeze Partners Management (Source: CNBC)

Douglas A. Kass of Seabreeze Partners Management was the only analyst I saw who predicted an extremely negative outcome.

Kass runs a "short fund," meaning that his fund is for people who believe that the market is going down. That gives him a reverse bias from all the other analysts. However, since the he's the only person with this bias, it's worth seeing what he has to say.

Kass had a lucky break this week. His fund normally is 60% "short" (bets that stocks will go down) and 40% "long" (the standard stock ownership, bets that stocks will go up). But he appeared on television on Monday and said that things looked so bad that his fund was now 100% "short." The big stock market selloff occurred the next day, so he appeared on CNBC on Friday morning to explain why he had been so prescient.

Here's what he said:

"I think that there's a very good chance that the market, rather than test its low, crashes in the next several months.

[Asked, how big a drop?] I don't know, everyone's definition of "crash" is a little bit different. [what's yours?] but certainly a decline of well over 10 or 15 -- ten percent, let's say."

I want to pause here and describe the body language. Anyone who's believes that there'll be a "crash" and has done all the math knows that the the market will fall 50-75%. Kass must have known this. But people who give a figure that high are treated as crazy (as I can testify from personal experience). So Kass really hesitated on this answer, then mumbled "10 or 15," and then finally settled on "10%, let's say." But there's no doubt in my mind that he had a much higher figure in mind.

He said that there were "three catalysts" that led him to believe this, and he listed them.

Here's the first catalyst:

"Everyone's looking at China - I was looking at the developing bust in the Indian equity market. I was looking at what appeared to be a clear second leg down in housing; thirdly, a further erosion in the fungus among us subprime credits, which would lead to less mortgage credit availability, and on Monday night you'll remember, Freddie Mac tightened their lending standards.

Credit is the lifeblood of our economic well-being. and mortgage availability correlates very well with personal consumption expenditures. So that consumer that spent up, not pent up, and very levered, is going to get hit over the very short term."

Kass's first catalyst mentions three factors. The BSE (Bombay Stock Exchange in Mumbai, India) had started falling rapidly after reaching a high of February 7 of 14643. By Monday it had fallen 1000 points to 13649, and by Friday it as 12886, a total 12% decline within a month.

The other factors have to do with housing boom bust, and the collapse of the subprime mortgage. These are going to have major impacts on the availability of consumer credit. This will heavily impact consumer spending, and that will have a major effect on the stock market.

Here's his second catalyst:

"But there are other considerations. Every bull that comes on, Joe, says the same thing: the S&P is cheap at 15 1/2 times '07 earnings, but he doesn't take into account the heavy weighting of finance and energy stocks, which have inherently 10 or 12 multiples which weigh down the number. I prefer to look at a broader slice, and I look at Value Line's medium P/E of 3000 largest companies, and that's at 20 1/2 times, compared to the secular peak in the fall of 2000 when the market peaked at only 14 times."

Now this is very interesting.

Regular readers of this web site know that I'm constantly complaining that pundits, journalists and analysts out-and-out lie about price/earnings ratios, usually by exaggerating earnings enormously.

Pundits also err by ignoring the law of "Mean Reversion," which says that even if it were true that P/E ratios had returned to their historic averages (which they haven't), then they still have to make up for 12 years of being far above average by going far below average for a number of years.

But Kass raises a different issue that I've never considered before: That the S&P 500 are heavily weighted to financial and energy stocks, and that they've had lower P/E ratios. He says that when you look at 3000 stocks, then P/E ratios are 20 1/2, which is very high. This is a question that needs further investigation.

Here's his third catalyst:

"The final thing is, everyone's looking at hedge funds. Hedge funds have increased their net long invested positions to the highest level since 2004. Sentiment studies have the lowest level of bear since December 2004. But what is even more important, and what you'll pick up in the next several weeks, and what could serve to take the market down, just like portfolio insurance did in October of '87, is the fund to fund communities which provides the equity capital by and large to hedge funds. And they are much more levered, particularly over in Europe, and particularly in Switzerland into these hedge funds. They multiply their equity investment in Pequot or SAC by multiples, and they're gonna start pointing to the shoulder of these guys, and they're gonna say, we're getting destroyed because we've multiplied your performance."

I don't completely follow this, but if a chain is as strong as its weakest link, he appears to be saying that he's found the weakest link. The hedge fund industry is a worldwide pyramid scheme (or Ponzi scheme). Any pyramid scheme has to collapse sooner or later, and Kass appears to be saying that the point of collapse is going to be in Switzerland, and that it could "take the market down."

He adds:

"Look to the people who are supplying to these hedge funds - that's where you should look at supply and demand. That's where you see forced selling. And that's what takes markets down, and that's what makes markets crash."

That's a pretty startling scenario. It's something to watch for.

Entertainment Break #2

A reader sent me this joke:

Three high school students are taking an exam that requires a mathematical computation.

The mathematician's son does the entire computation, and finds the correct answer. He writes the answer at the bottom of the page, and draws a circle around it.

The engineer's son doesn't do the computation, but performs an estimate, and comes up with a possible range of answers. He writes the range of answers on the bottom of the page, and draws a circle around it.

The economist's son just writes the following on the bottom of the page, "Anything you want the answer to be."

Morgan Stanley's economist Richard Berner

On Friday, one of Morgan Stanley's top economists, posted an article called "Does Market Turmoil Change the Outlook?"

This article illustrates everything that's wrong with economists. This is an incredibly shoddy piece of work. It's so bad that I was tempted to name Richard Berner this week's Idiot of the Week, but I decided that it would be unfair to single him out, when so many economists are idiots.

Berner fills an important role at Morgan Stanley - the role of saying that everything is going to be OK, so that clients will still pay for Morgan Stanley's services. Someone has to do that because Berner's boss is Morgan Stanley's chief economist Stephen Roach, who is well known as a "bear." So Berner has undoubtedly been ordered to be Pollyannaish at all costs.

Berner wants to prove that there's no reason to modify his previous rosy outlook, even after the week's turmoil on the stock market.

To do this, he discusses his preferred macroeconomic model that proves that everything is all right. So when you read Richard Berner's Friday column, where he discusses different macroeconomic models, you quickly realize what nonsense mainstream macroeconomics is, and what charlatans mainstream economists are.

Look at this paragraph:

"How do we calibrate that financial stimulus? Some compile a financial conditions index as a weighted composite of changes in asset prices. We prefer a combination of models assessing interest rate, currency and wealth effects, and judgment. Financial conditions indexes do help us cross check our judgment and models; for example, a model-based index from Macroeconomic Advisers was still in positive territory at the end of 2006. But even such sophisticated indexes may understate the financial prop to growth, because they miss the contribution from tighter lower-rated credit spreads and credit availability."

Here's what Berner is doing: He's saying that various macroeconomic models produce results that he doesn't like, so he's going to devise a different macroeconomic model. A "weighted composite of changes in asset prices" isn't good enough for him. Neither is the computerized model developed by Macroeconomic Advisers.

So he's made up his own model -- with "interest rates" and "currency" and "wealth effects" and -- wait for it -- and judgment!! The macroeconomic model he likes is the one that lets him say any damned thing he pleases.

And where did he develop that judgment? During the 1990s when there was a stock market bubble? During the early 2000s when there was a housing bubble? How can he have developed "judgment" that applies to a time when the housing bubble is bursting and the subprime mortgages are melting down? It's not possible.

In fact, this is a problem that's wrong with all mainstream macroeconomic modeling, as I explained in last October's article, "System Dynamics and the Failure of Macroeconomics Theory."

Have you ever watched TV when there was a hurricane headed for the southeastern coast of the U.S.? They have a guy from the NOAA come on, and he typically explains how they use three different computer models: one model predicts that the hurricane will make landfall in Virginia, another predicts Florida, and another predicts Louisiana. Those computer models were developed by modeling hundreds of hurricanes over a few decades, and even so, the model isn't very good.

Well, at least the hurricane models are based on the earth, and the earth tends to stay the same from year to year and decade to decade.

But that can't be said of macroeconomic models. The underlying assumptions are constantly changing. Today's economy, with the hedge fund explosion, the housing collapse, the mortgage industry collapse, and America's huge global debt is completely different from the underlying economy when the current generation of macroeconomic models were built. Macroeconomists are always fighting the last war simply because their models are all from the last war.

So now let's come back to Richard Berner. What he wrote is total, utter nonsense. He sat down at his computer and he typed in a piece of crap. There's no other way to describe it. It's meaningless garbage.

And now get this for the real kick: Bloomberg has just published an article saying that Morgan Stanley, Goldman Sachs and Merrill Lynch have just had their bond ratings lowered to Baa2 -- almost "junk" status. Why? Because these investment firms had invested in mortgage banks that have now gone bankrupt. And Berner's a top economist at Morgan Stanley.

Well, if these guys are so stupid that they drive themselves into junk status, then what reason do we have to believe that they're any less stupid now?

If these guys define their "Macroeconomic" models, then I'd like to define the Xenakis "Macroeconomist" Model. Go back and determine the results of each economist's predictions, and use those results to estimate how much of a moron he is.

Most of these people have a fiduciary responsibility to their clients. That means that if Berner thinks that the market is going down, he has a fiduciary responsibility to say so. Professionally, these guys don't have the "right" to make up macroeconomic models that bring in the greatest levels of income. I call these people stupid because I hold them to a much higher standard than I hold an ordinary person. They're supposed to be experts. So either they don't know what they're talking about, which makes them stupid, or they know what they're doing and thereby risking going to jail, which also makes them stupid.

History shows that by the time that this is all over, a lot of these people will indeed be in jail. (5-Mar-07) Permanent Link
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