from Davio redrock@peternavarro.com

The market rally seems to be thinking maybe, just maybe the Fed won't overextend its rate increases. They overdid it by cutting down to 1% but maybe at this point the right trade for the Fed is no trade. Maybe the real inflation increases we have seen will force people to slow down consumption and save over the next year. Popping the RE bubble is not what Joe Public with 10 Trillion in Debt needs right now. They need interest rates to be contained and slow down their spending. I believe higher prices across the service and production sectors are being felt by the consumer and they will slow down their consumption if given the chance. Maybe, just maybe, the market knows the rate rises are done. If that is the case, the market should continue up. Speak to us with a whimper Fed . .

from Davio redrock@peternavarro.com

Once again, stocks have bounced sharply after the seventh failed breakdown of the last two years. The Nasdaq has broken to a three-year high, and the S&P is likely to follow at some point. I have pointed out after most of the surges of the last few years, these rallies after a stressful drop in prices provide an opportune time for investors to perform some self-evaluation.

The most important part of investing is the ability to stay in the game no matter what the market environment. An analysis of the moves of the last month and a half, and your reaction to them, can yield a wealth of insights.

If you are generally bullish, were you sweating bullets and panicking as we broke to a lower low, or were you able to stay calm and map out a plan to take advantage of others’ panic? Since August, I pointed out how ugly sentiment among equity traders was and that if we were to fall below support at S&P 1190, it would likely produce a scary drop, but only a temporary one if the corporate bond market remained optimistic.

That script is playing out, but that didn’t stop people from beginning to panic as it played out. While I think higher stock prices are the most likely outcome for at least the next few years, if you were panicking as we broke to new lows, then the odds are that you too were exposed, for a number of reasons.

First is that the global political environment has not changed. We know there are people who want to destroy us. We’ve written numerous times that the time to think about terror and plan for it is when stock prices are rising and when investors seems to be unconcerned with it (like now), not when terror strikes.

The second reason is the general disbelief in the rise in stock prices of the last few years. While the S&P is up 50% from the low of 2003, the biggest factors in the rise have been companies buying stock back and from short covering, not from people “getting long”. My view is that this negative outlook amongst the investing public makes it more likely that the trend will be up, but it also means that we are likely to have many more of those nasty dips along the way as traders try to jump on every perceived breakdown.

Third is that the economy is highly leveraged. We know that at some point credit cycles turn bad and wash out the excesses of the past cycle. It’s likely that that won’t happen for years, but the penalty for being wrong (in either direction) in a leveraged environment is high, which is why investors must remain vigilant and always prepared for things to move against them.

If you are generally bearish, were you cashing in on some gains as we hit new lows, or were you pressing your bets as we broke down and are now sweating at the prospect of having to cover as we hit new highs?

We’ve acknowledged that there is plenty to worry about in the world. But, bearish investors must be able to separate what they think “should” happen from what is happening. The GM/DPH and Refco situations did provide a lot of headlines and, in a leveraged environment, did have the potential to cause economic turmoil. The easiest thing to do, with the media jumping on stories like that, is to connect the dots and say that if x breaks down, then it could lead to y breaking down with the result being a spiral into market contagion.

It’s hard to take a step back and see if the events of the day are having an impact on the big picture. From my vantage point, the corporate bond market had nothing more than a slight hiccup during those events, which made it likely that the drop in stock prices would only be temporary.

Bull or bear, I've found that one of the most important attributes is to be able to focus on what could go wrong while things are going your way, so that you don’t have to panic when they go against you. Self-panic is the enemy of all investors.

from Davio redrock@peternavarro.com

We have GM @ 18 year old lows, GOLD @ 18 year highs, and the futures are gapping up again. Show's how big the divergences are and how the big boys are pushing as hard as they can on the wire to bring the bonus babies into the barn by taking the prices up. There are no sellers out there right now, whether right or wrong, the market works its way out. The boat is heavily skewed short short term, still,so the easy way for the market to move is against them. Come xmas and beyond the upside is still very limited in my eyes. I am still eyeing somewhere in the 1260-1270 SPX target to be hit. So we have another 20-30 pts or 2-3 % up side in my eyes left. Downside much riskier still. Same old Same old. Let's watch the markets and learn from the price action!

from Davio redrock@peternavarro.com


This just in from a local Sacramento, California paper this morning: New home sales in the area dropped by over 40% in the last three months, the largest decline since 1989.

Cancellations of pending home sales have spiked as speculators and homeowners are caught up with a slow-moving home resale market and a large buildup in condos for sale.

from Davio redrock@peternavarro.com


The yield curve (on the two- to 10-year notes) has flattened to only 8 basis points today as we head into a weakening economy in early 2006.

(The spread is only 1 basis point between the three- and five-year notes, and 2 basis points between the two- and three-year notes).

from Davio redrock@peternavarro.com

The market is overbought; the MacLellan Indicator is diverging from price action in overbought territory.

# The put/call ratio is no longer bullish and at levels that indicate complacency.

# The breadth reversal on Tuesday.

# The latest AAII data shows a large increase in bulls and a decline in bears.

# We are moving into heavy resistance area at 1235-1240 on the S&P 500 Index.

# A possible upwards reversal of crude and energy prices.

from davio redrock@peternavarro.com

big Misses from BCSI with the stock down about 22% today. CME downgraded by BAC so they are a leg off versus GOOG with the race to who can hit 400 first. I guess GOOG is back in the solid lead with CME off about 2% on the downgrade this am. Expecting some pinning action of stocks at the most actively traded options. Always the game with 3 days to go to full expiration. Keep your head up as this market continues to tread water.

from davio redrock@peternavarro.com

"We believe the market has peaked."

So says Doug Duncan, the Mortgage Bankers Association's chief economist, referring to the expected record 8.3 million new and existing home sales in 2005. Thats up up 4% from 2004, but Duncan's projections are for the record setting four-year streak of higher prices to end next year with a sales decline of 3.5%.

We noted back in July, that Real Estate had begun to Cool. This front page WSJ article, while significant, may even be understating how rapidly a cooling could occur. I suspect that Duncan's estimate may be accurate for Q1 or even the first half of 2006, but if the slowdown accelerates, we could see the drop become even more dramatic. And, if rates go appreciably higher and/or GDP decellerates even more rapidly, a 5-7% drop is quite possible (in the first year). The next recession could see home purchases (initial) drop of 10%.

From a trader/equity investor perspective, there is a fascinating quote in the column that offers up great insight. Consider the Psychology of Markets and how sentiment impacts behavior:

"The [house-buying] frenzy is over," says Steve Murray, president of Real Trends, Littleton, Colo. Mr. Murray says it may take six to eight months before sellers accept that the market has softened and reduce their asking prices. He said some of the brokers surveyed were surprised at how rapidly the market seemed to be cooling in recent weeks.

That's quite the parallel to what occurs when stock markets suffer rapid price decrease: sellers have a very hard time accepting the new reality, and take quite a while to become intellectually and emotionally comfortable with lower prices. In other words, they do not sell as markets crash, until way late in the process.

Do not get the idea its all doom and gloom as to home sales. The Journal notes that "home sales remain strong by historical standards, and prices in most of the country are at or near records." But the Real Estate market is no longer in the "boom phase" that saw prices move up more than 50% over the past five years, and in the frothy coastal urban markets, more than double.

Quoth David Lereah, chief economist for the National Association of Realtors as saying, "The air is coming out of the balloons."

The key macro impact will be the end of the home equity extraction as a source of consumer spending. The $2 trillion housing market has been the primary driver of economic activity in the US. It accounts for "one-third of households' net worth."

The Journal points out that "there hasn't been a sustained drop in housing prices in any major part of the U.S. in a decade or more, and housing has become a vital barometer for the financial, retail and homebuilding industries."

from davio redrock@peternavarro.com

8:30 Core PPI -0.3% vs +0.2% consensus


08:30 PPI +0.7% vs 0.0% consensus


08:30 Retail Sales ex-auto +0.9% vs +0.3% consensus


08:30 Retail Sales -0.1% vs -0.7% consensus

from davio redrock@peternavarro.com

Reflation is a monetary policy undertaken by a central bank in order to head off a perceived deflation. Unfortunately, this is happening today because we are saddled with a problem that economists call Stagflation.

The policy tools of the central bank are two-fold: increase the money supply or decrease interest rates.

These two do not have to go hand in hand.

There is actually another central banker’s tool, one that is often used by government as well, which is called moral suasion. And just like the case of government, you will see that a central bank can say one thing, but actually do another.

Today, that’s happening at the Federal Reserve Bank of the U.S. As the Fed sends out the “tightening” message, which they do in conjunction with the FOMC decisions to increase interest rates, they have also been increasingly accommodative via increases in money supply.

Interested readers should learn all they can about the “reserve ratio” and the “required reserve ratio”, which is sometimes called the “cash reserve ratio”. You just need a cursory understanding because it is a simple concept.

The core of the issue is the velocity of money. A healthy economy needs money turning over at a certain rate. Unfortunately, for the Fed today, that is not happening in the U.S. because too much money has been leaving the U.S. economy to flee into emerging economies (China and India for instance) or offshore to tax havens, where there is a zero tax rate.

In both cases, for different reasons, that money is coming back into the U.S. via the fixed-income market, which is keeping bond yields lower than the risks that exist in the economy today. That is Greenspan’s conundrum.

Another is the U.S. government conundrum, which is that, years ago the U.S. decided to be the biggest tax haven in the world (by far) by not taxing interest earned in U.S. fixed-income investments by foreign investors. This is the sham of all time because it was based on the premise that foreigners could finance the growing U.S. government debt, but that’s another story.

In any event, what is happening today is that foreign money is keeping domestic interest rates too low, causing overheating in the housing real-estate market via ultra-low mortgage rates. That situation has sparked a large amount of mortgage-related cash-backs, which many say is a problem, but I would disagree with – up to a point. We are quickly reaching that point, where the ability of the mortgagee to continue to service the added debt is now in doubt.

The bigger problem is what is called the wealth effect of rising real estate prices. If people say that a house is worth 2x, when the rental value of that house then drops below a fair cash on cash return that is above the income level needed to exceed inflation rates, then the 2x price is itself inflationary. And that is what has happened. People think they are in good shape financially, but it’s only because of inflated value of real property.

Now with concern about the “real estate bubble” spreading, the so-called “wealthy” are turning to other kinds of property to sustain the wealth effect. They are turning to diamonds, gold and collectibles. Again this is all inflation because there is no economic increase in wealth. By that I mean the owner of a diamond or a gold bar or collectible cannot rent them out to earn a fair return.

So the Fed needs to put its foot down by raising interest rates, and through moral suasion with government and commercial banks.

The Fed chair goes to Washington frequently to ask the VIP’s to cut spending, but they ignore him (increase spending actually). He then goes to the commercial banks to say please don’t worsen the real estate bubble, but they ignore him (increase the creation of Mortgage-Backed Securities of dubious credits).

The Fed really does try to get commercial banks not to lend for purposes that end up as an inflation-push. The Fed would simply like to see all commercial bank loans go to corporations and individuals who would use that money to create wealth, because that creates sustainable jobs and, like I say, a healthy economy.

Higher interest rates discourage many people from borrowing in order to spend their money on inflation-inducing goods. Unfortunately it is not such an effective tool for government because government isn’t spending their own money, they spend yours and mine. It's a free bar, and they are enjoying the drinks.

But as I said, the biggest egg laid by government years ago has now grown up to be a serious problem. Too many large capital pools in the U.S. and in other high-tax jurisdictions are now using zero-tax offshore jurisdictions to hoard their assets, and shield them from domestic tax authorities.

In a sense you cannot blame them. If we could all get away with it we would because who wants to fund a group of self-serving, ineffective, governments that cannot seem to run a budget prudently like the rest of us have to (both personally and in the corporate form). But what’s good for the goose seems not to be required for the gander, and some of us (those with the resources to do this effectively) protect ourselves in the legal aspects of tax avoidance, and some get involved in money laundering.

But, I ask, who is really at fault?

International monetary agencies recognized this situation in the 1990’s and organized groups like the Financial Action Task Force to combat money laundering in the tax havens. But the problem continues because, at the core of the problem, government allows foreign money to finance domestic budget deficits.

Cut out domestic debt, and these offshore accounts are forced to put their money with foreign dictators. They will, but only to a point, because the first rule in money management is to protect your capital before trying to earn a return on it. And foreign dictators have this proclivity to stealing other people’s money.

So the Fed now has the difficult task of putting enough money into the U.S. economy to circulate through the system, turning it over on the car lots and in the movie theaters, etc, to an extent where consumer demand grows enough to crank up domestic production of autos, Hollywood films, beef for the steakhouses, and so forth.

Right now, America is dying in these areas, and the Fed recognizes the seriousness of the problem. My “no tickee for laundry (or cars, etc)” description is apt. The consumer is in trouble, and needs a boost.

Ergo: the Fed decided to print money. The Fed H.6 report is freely available. Check the massive increase in money supply in the past quarter.

I didn’t make up these numbers; so please don’t shoot the messenger.

What we have today is a Fed that is reflating because it knows that to kill inflation in the real-estate sector will lead to deflation. They need to give us on the one hand a drug to fight one problem (inflation), and another drug with the other hand to try to remedy the anticipated side-effects.

The patient is confused. And there are money doctors like me who are starting to question the contra-indications of the medicines that are being forced down our throat.

Life is getting tougher. People are getting in the way.

Well, it’s been a slice, but I have to get back to work now. Too much wealth to be made; too many taxes to be paid.

And I can't be watching my gold and keep typing at this rate. Sorry.

from davio redrock@peternavarro.com

Another sleepy day means another day to sit and await the next move. We would be better in the bull scenario to base or consolidate down some, but the market doesn't always do what we want, when we want. This market seems to want higher, so let's have it show us its stripes weather bullish or bearish. When markets bide time, I bide with them as I don't have the predictive crystal ball. I am willing to play the side that makes me money, that's the bottom line in this game, making money, not being right or wrong!!

GP is going private at a hefty premium. $47 a share. Call me crazy but if this isn't a sign of an infaltionary environment I don't know what is. There's a reason to take a commoditized firm private. That would be higher costs to the consumer which in turn I read as inflationary profits are on the rise. Just another sign of the inflationary times we are deep in the heart of.

We fire up the options expiration of November with a few more economic events this week. We have Retail Earnings and PPI tomorrow. Wednesday brings CPI. Thursday brings initial jobless claims and housing starts/building permits along with the Philly Fed. Futures are flat and the bond market is back open. Let's see if the bulls can keep the pedal gunned or if the many divergences and bears take back over.

from davio redrock@peternavarro.com

It is good to see that 23% of pension fund managers are trying their best to climb out of underfunded status by allocating to more sophisticated methods of investing money and managing risk. But the real worry here is that 77% are NOT. Presumably these same people eschew email and travel to work by horse while they cling to their beloved assumptions of market efficiency and that stocks go up over time.

Negative compounding and low interest rates devastate a portfolio. That is why, despite recent strong markets, the markets of 2001/02 hurt pensions so much. Long term performance means avoiding a heavy loss; if the market drops 50% it has to climb 100% to get back to even. A hedge fund that drops 50% is out of business - period. Index funds carry on collecting their high fees; a portion of which ends up in the pockets of pension "consultants".

However you measure it, the vast majority of hedge funds are safer than long only passive or active funds. Drawdowns, volatility, risk management, alpha generation, beta dependence...any measure. Sure there are crooks and incompetents as in any industry but that doesn't reduce the essential value of hedge funds to a portfolio. I am not saying that hedge funds are a complete solution to pension solvency but they are a lot closer to the answer than holding only stocks and bonds.

from davio redrock@peternavarro.com

Compounding is important but avoiding negative compounding is the real key. Even in the go-go 20th century the market only compounded at 8% with several devastating drawdowns. And inflation hurt a lot of what was left. There is also no reason to assume future returns will be as high as past returns.

Drawdowns mean negative compounding. Let's say you invest $100 in an index fund and the first year it is up 20% and the next year it loses 20% and this up/down cycle repeats for 20 years. (Such a scenario is not as extreme as it sounds - check out the stock market since 1995). How much will you have at the end?

The surprising and counterintuitive answer is you would have a grand total of $66 and inflation kills whatever purchasing power $66 will have 20 years from now - a stick of gum, a can of soda but definitely not a gallon of gas. Avoiding down years is absolutely critical to future wealth. Or as Warren Buffett puts his investment strategy 1. Don't lose money and 2. Don't forget rule No.1.

Even positive compounding only really gets interesting at higher return levels. Over 20 years, which is more realistic than 60 years for most investors, at 4% risk free $100 grows to $219 for a double. At 8% to $466. However at 15% to $1,636 and at 30% to the princely sum of $19,004, which is why hedge fund managers such as Warren Buffett, Jim Simons and George Soros are billionaires.

So avoiding negative compounding is actually the key. And that is why index funds are unsuitable and much too risky for conservative investors hoping for a comfortable retirement. And why pension funds have only themselves to blame for obeying conflicted "consultant" advice and following the index fund mania.

Why do so many people hate hedge funds? Five ideas among many...

1. Many people fear the unknown. They don't want to know their ancestors were apes or that the sun doesn't revolve around the earth. They also need to blame someone else for adverse market movement. In the 1970s every market fluctuation was due to "Middle East petrodollars" and in the 1980s the blame usually fell on "the Japanese". In recent years, "the hedge funds" have apparently been the cause of every market downturn. The fact that they each trade differently, add liquidity and are highly likely to be the BUYER of last resort seems lost on most people. Hedge funds represent change and people detest change. Hedge funds are a disruptive technology to the investment product industry status quo.

2. Hedge funds are the counterexample to the random walk and efficient markets delusion (formerly known as the efficient markets hypothesis). A disproven hypothesis is no longer a hypothesis, strong or weak. In the past the oustanding performance of a tiny number of funds could be explained by statistical fluke - the millionth monkey beats the market. But now thousands of hedge funds deliver; a situation utterly untenable in classical financial theory. The sustained success of hedge funds over 50 years means much of this content in economics and MBA courses must be thrown out. Teaching the efficient markets hypothesis or the Capital Asset Pricing Model to finance majors is like teaching the flat earth theory to astronomers. The hedge fund counterexample means much of the work of Paul Samuelson, Harry Markowitz, William Sharpe and the LTCM - always losing money trading options but give them a Nobel anyway - jokers is wrong. People don't like the idea of expunging countless papers from academic journals, the revocation of Nobel prizes or refunding the tuition fees of students unfortunate to have had their heads filled with nonsense. Better to criticize hedge funds than admit to the fallen house of cards of rational, continous self-interested utility. Paraphrasing, Warren Buffett once commented how he was so glad the random walk hubris was still taught in schools as it provided another generation of investors for him to arbitrage.

3. Vested interests. Whether it is institutional or individual investors there is a large, powerful advisory lobby under threat. Pension consultants get nice fees for not doing very much other than recommending traditional equity and bond portfolios and conducting a search or two. Financial advisers love mutual fund loads and other bribes. Neither group has the expertize to evaluate hedge funds or fund of funds. Neither group has the best interests of their client at heart if they continue only with traditional assets. Neither group receives compensation from hedge funds to be put on short lists or invited to beauty parades and investment "conferences" but they do from many traditional funds. Magazines carry paid advertisements from mutual funds, but hedge funds can't buy commercials.

4. Envy. It is ok for movie stars, golfers and entrepreneurs to make large amounts of money, but for some reason not hedge funds. Firstly hedge fund managers ARE entrepreneurs and if it is OK for Bill Gates to make $50 billion and the Google guys to make $12 billion for delivering products people like, what is wrong with entrepreneurial hedge fund managers making much lesser amounts for also delivering what people need - RELIABLE INVESTMENT RETURNS AT LOWER RISK.

5. SEC regulations. The "unregulated" hedge fund industry actually IS regulated. Hedge funds are not allowed to promote their business. Pity the journalist trying to put together a balanced article; they get inundated with on the record quotes from the anti hedge fund lobby and then a wall of silence from the hedge funds themselves because their General Counsel advises against speaking to the media due to SEC rules. As for disclosure, hedge fund investors now demand far more disclosure than mutual funds deign to provide.