Thursday, December 07, 2006

The End-of-the-World Trade

Intro to Conspiracy Theory

Anyone who's traded the gold sector as much as I have is fluent in doom-and-gloom, End-of-the-World financial prognostications.

Skepticism towards government abounds in every populace and has in every period. Are the pols lying to us? Surreptiously lining their pockets? Abusing their power to suppress dissent? Are they manipulating the garb of reality through parades, rhetoric, or scapegoats?

Of course they are - ask any random person on the street. Open almost any history book.

Now ratcheting that cynicism up a notch it follows that government must be recklessly manipulating the financials to further its own devious interests.

What are those interests? And how are they doing this? Well the details of a conspiracy theory are inherently unimportant. Conspiracy theories fend off factual probing with a Hydra-headed resilience.

Oil companies manipulate prices up; later they fall. It couldn't be market forces moving the prices, the greedy oil execs decided to soak the little people. Then they got scared of Bill O'Reilly's populist handwringing and used their omnipotence to lower gas prices back down. Every price move or industry development has a knee-jerk cynical explanation. Supposedly we went to war in Iraq just to get oil. Since we have gotten that oil and increased world supply, prices, against all economic logic, have risen. And that brings the nutjobs back to their oil industry greed/manipulation lemma.

I am not kidding. The who, what, when, and how of a conspiracy theory are fluid to the point of irrelevance. The vaguer the accusation, the wider the net to cast.

In 1755 a horrific earthquake ravaged Lisbon, Portugal killing between 60,000 and 100,000 people. The absence of seismologists opened the door for any and all opportunistic speculators. The Church took occasion to blame it on immorality. Jean Jacque Rousseau blamed it on depravity of urban living. (If people didn't live all jammed together on 5 story buildings there'd have been much fewer casualties). Ignorance has always given license to conspiratorial conjecture.

Make no mistake, there will be a financial earthquake in your lifetime. We'll all have personal scapegoats lined up to blame: oil companies, Alan Greenspan, George Bush, Bin Laden, Wall Street, politicians, hedge funds, "greed", the national debt, China, outsourcing, illegal immigrants, the "rich", etc. Amid the crossfire of blame, genuine culpability will be quite beside the point.

So why all this talk of doomsday and conspiracy theories?

The reason I write this post is that my trading positions at the moment look like I am predicting the end of the world.

Long gold and silver.
Long oil.
Short the Nasdaq.
Short the 30 year bond.

Of course, trades are inherently short-term; conceivably I could cover and reverse them all before lunch. But if oil exploded and the dollar collapsed, I'd make a small fortune. Frighteningly, these scenarios are two key ingredients in any viable End-of-the-World prediction.

Now do realize I am not simply trading off a doomsday conspiracy theory; my positions are dictated by empirical price action and economic theory. Any legitimate economic textbook will tell you that cheap money (low interest rates) sows the seeds of inflation, which then erodes the currency. The only question is of timing.

Look at it this way, if the dollar lost value, our way of life would be turned upside down, and perhaps a shudder would be felt globally. Those dim ramifications demand we consider everything that could possibly cause the dollar to devalue.

Inflation of course is suspect numero uno. It can arise from the government simply printing too much currency; it could come from a sudden spike in prices (leaving aside for a moment the relationship between the two). Lastly, dollar weakness could arise from a fear of fiscal solvency, i.e. the national debt.

Oil is arguably the oxygen of the global economy. Jack its price up and Goldilocks won't long be able to breath. Almost every single necessity of life will cost more - at least theoretically. Ergo, rising oil must play a starring role in The End of the World.

The other co-star, previously alluded to, is your Federal Government. So how much money is it really printing? That's a question not exactly dominating your local news now is it? Here we are getting into more esoteric financial stuff that I admittedly don't fully understand such as the velocity of money, M1, M2, etc. What I do know is that the government owes lots of money and unfortunately for its creditors, the Feds are the ones who print it.

Should we just trust the slimeballs on this one?

I just did a google search for "growth of money supply" and found this nugget on the Federal Reserve's website.

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money supply growth expired, the Fed announced that it was no longer setting such targets, because money supply growth does not provide a useful benchmark for the conduct of monetary policy.

Our government is so compassionate...It doesn't want to confuse us, the fretful public. As is plain to see, tinfoil-hatted conspiracy theorists don't exactly have nothing to point to.

I am sure some people monitor the Fed's printing of greenbacks, but I think it's safe to say that it gets about 1,000,000th of the public scrutiny given to say the quality of cous cous at Guantanamo Bay.

So after the "trust us on money supply" policy piques your cynicism, next take a look at the Federal Reserve's interest rate machinations. At the slightest sign of weakness they drop rates to artificially revive the economy and buffet political incumbents. They arrogantly feel that such fine tuning steadies the ship. I disagree.

In the long run, the economy is going where it's going no matter what the Fed does. Long term interest rates (set by markets) and technological innovation trump the short term borrowing cost of money. The Fed's manipulations create large distortions which preclude the vastly more efficient free market from allocating capital. All the Fed really did in the last few years by lowering rates was encourage debt-laden consumers to borrow and spend more money. Sure Fed defenders can find GDP growth numbers or other convenient metrics that allegedly justify their "ship steadying" mission. But I say, look at havoc of the Nasdaq dropping 70% from its high. Did they really need to lower interest rates in the wake of Long Term Capital or the Asian financial crisis? Or later on after 9/11?

Note also they raised them in 1999 partly to entice people to not make a Y2K run on their banks. The criteria for their manipulations are unbounded.

Devil's Advocate - But wasn't Greenspan trying to deflate the Nasdaq bubble in 1999? Wasn't he doing the right thing?

You mean deflate a bubble that he arguably helped create (by lowering rates in 1998 under the guise of Asian woes)?

That would be like machine-gunning a guy and then wanting credit for calling an ambulance.

Okay, for the sake of argument, say they were correct to raise rates in 1999. Since the Nasdaq doubled anyway, from 2,500 to its 5,000 zenith, clearly they were too late to the rescue. This brings us to our present day analogue.

Right now, the Federal Reserve is literally praying that their recent rake hikes not only slow the economy, they are praying that a cooler economy will then a bite out of inflation. This may be the largest parlay bet in history.

Remember, a tightening Fed couldn't ground the dot-coms in 1999.

What if the economy slows but commodities march onward and upward?

Lowering rates will just aggravate the inflation. So what then, raise rates in the face of a breaking economy? That will never happen.

The Fed simply does not have a tool to crack open the stagflation nut - which is what we could be looking at if the Fed's parlay busts.

Congress could theoretically crack that nut BUT it has a record of making things worse.

Here's what it could do to stem inflation, strengthen the dollar, and invigorate the economy:

1) Lower taxes.
2) Start phasing out Medicare. Push HSAs.
3) Privatize Social Security.
4) Shrink the size of government. Deregulate more industry. Decentralize government schooling.
5) Attack hidden taxes on business like the tort lobby, ethanol mandates, etc.

Here's what they will most likely do:

1) Raise taxes on income, capital, and perhaps oil companies.
2) Expand Medicare (or leave it alone while demographics expand it).
3) Will do nothing positive with Social Security. They will means test "wealthy" people off of it. They will increase the cap beyond the first 90k of salaries. They will make 11 million illegal immigrants retroactively eligible for benefits - even though the "trust fund" is already underfunded and also ravaged by unfavorable demographics.
4) They will expand the size of government. Regulate more industry, e.g. hedge funds are up next. The socialists will keep pushing for nationalized healthcare.
5) They will add more hidden taxes on economic activity.

If you don't think econo-illiteracy pervades America from Joe Blow on the street, all the way through the highest political offices, then you haven't read enough of my blog. Any financial earthquake will be met with the crossfire of blame mentioned above but the ignorant finger-pointing will pale compared to the damage wrought by the political "solutions". Be sure to thank your local Congressman.

I am covering a lot of stuff here but this is no disjointed diatribe.

If the dollar is fundamentally in trouble, the only place to hide is in precious metals. Sure you could convert your dollars to euros, yen, or other currencies but then you're opening another can of worms - especially with the euro. The European Union is more concerned with global warming and world government than they are with economic vitality. The Japanese have their own problems as well, e.g. an inflexible banking system.

Devil's Advocate - So how does the dollar weaken if you don't see other currencies strengthening?

Finally DA, you ask a good question. I don't necessarily see the buck weakening versus other currencies - at least not to the extent of other goldbugs. My argument for dollar weakness focuses more on a loss of purchasing power from inflated commodity prices (and debt).

Gold is THE SAFE HAVEN from dollars, euros, and yen. While currencies have come and gone, the yellow metal has held value for 4,000 years.

Sure you could demonstrate how horrible of an investment gold has been over many time periods BUT I can always fire back my 4,000 year argument. How'd the dollar do during the Civil War? How'd the German mark fare with Hitler? Didn't Oscar Schindler use diamonds as a currency while fleeing for safety?

The conspiracy theories will never, ever go away. In fact, I think they will gain steam for the foreseeable future.

Some of these goldbugs are indefatigably nuts. They believe the government has sold all of the gold at Fort Knox. They believe you have to own gold coins instead of gold futures because banks will never be able to deliver your metal in the wake of a financial catastrophe. Others live in cabins with stockpiled food, firearms, and bomb shelters. As nutty as I am, I am not quite there yet.

There's so much more I could say on this topic but I am going to end it here for now.

Tax Shelter asked in advance for a "What if I am wrong?" consideration. I am sure he'll fine tune the question in the comment section but I'll give it a go now.

If I am wrong about these trades, I will lose some of my hard earned money. My positions are not very large but are quite levered in the sense it looks like one big End-of-the-World bet. Should oil drop, not only will I lose on that position, but it's likely that gold and silver dip as well. And of course stocks and bonds may rally some more.

I want to emphasize again that these are "trades" not investments. Aside from the 30 year Treasury, I have been both short and long gold, silver, and the Nasdaq more times than I could count just this year.

I am "wrong" every single day. Today I bought Apple too early. Yesterday I lost 7 points on Gold. I got run over shorting the Nasdaq in November. The game I play is not about being "right" all of the time or even 51% of the time. It's about cleaning up on your winners and having small losers. I don't like the term "diversification" - I much prefer "a basket approach". It really has taken me 10 years to learn how to trade smaller. As a fearless youth I swung a big bat on single positions and had to numb the losses with inebriation. Maybe that's why there are no trading firms in Boston, because bars won't sell you more than three drinks before cutting you off?

I am fully aware that my blog spouts a formidable negative vibe. I have the End-of-the-World trade on and of course I am short the housing market because I rent. When I say I don't believe in long term equity investing remember I am speaking for myself only and about the stock universe as I see it today. I have a hunch that Tax Shelter wants to know the long term bull arguments for stocks and perhaps real estate but I'll wait for him to clarify.

If the economy keeps roaring, interest rates stay low, and real estate starts ascending again, I will get hurt financially - no question about it.

But if I am right and play the right side of coming trends, not only will I earn some good money, but I will vault up the wealth ladder.

It's one thing to get rich when seemingly everybody else is, like in internet stocks or in real estate, but quite another to make bank while others are bleeding. Something like 69% of Americans own a house and at least 50% own stocks directly. I am not really that bearish on the stock market because its valuation is not that high. I am however very strongly bearish on housing and on the long bond because of their stratospheric prices.

Okay that's it. I am ending this post because the concept of me making money on this trade is just too depressing.

Maybe I'll renominate it as the schadenfruede trade...


Tax Shelter said...

Is your strategy to start small and then pyramid? If so, what if the market went your way for a few weeks and then reverse course just after you piled it on?

Long gold and silver.
Long oil.
Short the Nasdaq.
Short the 30 year bond.

This looks like a bet on stagflation to me. Many factors drive the price of oil and gold, and dollar exchange rate. It won't be hard to imagine that more than one combination of these factors would produce the condition for raising oil and gold prices and declining dollar exchange rate, and certain combinations are just traps for a lot of investors. Does the condition for stagflation exists today, or do we have the illusion of stagflation?

CaptiousNut said...

All gamblers look to parlay their winnings into larger bets - the key is to keep your risk under control. It's very easy to underestimate your risk. Math dictates that if you double up on each victory, your first loss could wipe it all out. What you described about the market moving in your favor and suckering you in for a larger bet happens all of the time. It hurts.

I would like to short more of the bond. Probably if the Nasdaq dropped 30-50 points soon I would cover that and short some more of the bond.

As for stagflation, that's more of a semantic question. Would 0% GDP growth and $85 oil be considered stagflation? To some people it would.

The billion dollar question is how leveraged to low and declining interest rates is everything. To me, a stagflation debacle could only be caused by a butterfly effect from upticking rates.

As I hinted at in the post, politicians could make an economic slowdown worse and aggravate a death spiral of higher taxes and lower growth.

Watch Don Luskin on this YouTube clip.

Tax Shelter said...

It is possible that the Fed would raise rates, but I think the probability is small although not zero. It's also possible that politicians would raise taxes, but to me, the probability of that in the next two years is also small. If I have to bet, I would bet on a stronger dollar, stable to lower fed funds rate, stable to lower gold and oil prices, and higher Nasdaq. This is the scenario with relatively higher probability at this time, in my opinion. In this case, one can say that the bond market and I are in agreement on the future outlook of our economy.

Luskin looks and sounds like a very smart guy, but such perception makes him very dangerous to his investors and clients. I think he is smart indeed, but he has major blind spots. One has to keep in mind when watching Luskin that he, like everyone else, makes plenty of mistakes.

Taylor (sologue) said...

C-Nut, your posts are, as always, quite fascinating for me, but I have a few gripes.

I agree with your point about the conspiracy over oil... the whole "war for oil" argument is logically baseless. I wanted to point one thing out, however. You say we've got that oil now. Do we? The US has no national oil company (thank god), so invading an oil rich nation doesn't exactly give us the oil. Besides that, I am pretty sure oil production in Iraq fell as a result of the war and the frequent sabotage following the war. I'm not sure if it's back to pre-war levels or not yet.

Either way, the invasion of Iraq is hard to explain. What kind of a conceivable threat did we face in the region (that wasn't of our own making?) Why are we building permanent fortifications there, etc. (I see some large scale terrorist attacks on these bases making the news in the decades after we pull the majority of our forces out and finish "occupying" as we are right now).

Obviously, there is a lot of geopolitical strategizing going on... boxing Iran in from the East and West, removing Saddam as a threat to the Saudis and Israelis. Of course, I still don't get WHY we must do any of this. I feel like we stir up a lot of hornet's nests internationally and then find ourselves committed to "peacekeeping" when the bill comes due years later. It's analogous to the way the gov must intervene to correct it's interventions in the markets.

One thing I did find interesting, that I was unaware of at the time, was that the first executive order Bush signed once we had installed the interim gov in Iraq was one which reverted the official currency for Iraqi oil exchange back to the dollar. Saddam had changed it to the euro shortly before the invasion. A bit of economic imperialism to help prop up the dollar, I guess. Funny, people think the Fed is truly independent of the rest of the government... this is just one piece of evidence among many that everything is interrelated at some level.

Your analysis of the Doomsday economics behind your current trading positions, and the conspiracy theories about the gov's role, were interesting. You sound like an Austrian.

"You mean deflate a bubble that he arguably helped create (by lowering rates in 1998 under the guise of Asian woes)?

That would be like machine-gunning a guy and then wanting credit for calling an ambulance."

Holy shit! Ludwig von Mises, is that you?

I forget if I remember you mentioning the Austrian school in any of your previous posts before or not, but if you have never read any of their thinking on economics you sure sound a lot like them despite that fact. I am very fascinated by this.

Also, you said you could hide in other currencies if you're worried about the dollar... but if the dollar collapsed that catastrophically... it'd probably take a lot of currencies down with it. Remember, China holds almost $1trillion now, and the US is still the world's largest economy. If that just stopped being true overnight, I think it'd have devastating ramifications in the other world financial markets (re: Great Depression), so gold and other precious metals still sounds like the only way to go.

"As nutty as I am, I am not quite there yet."

Give it some time, ;)

Okay, that was the extent of my beef as far as I remember. I really don't entirely understand what you do exactly as a securities trader, or what some of your "long" and "short" jargon means. I figure you're a pretty busy guy, but you're also very thoughtful and experienced with this stuff, so if you ever have some time I'd love to exchange a few e-mails with you, maybe you could better explain to me what it is you do so that I can follow along a bit better on some of these posts.

Keep up the great work!

Taylor (sologue) said...

Oh okay I remember one more thing. I highly suggest this article about Social Security reform by George Reisman. I think you will reconsider your "privatize" position once you read it.

CaptiousNut said...

I already addressed Reisman here. He's a good example of a theorist in over his head when talking about the micro-workings of stock markets.

Iraqi oil production is above pre-war levels and has been for a while (I think).

As for whether we should have gone into Iraq in the first place I plead ignorance. Anyone with strong opinions on this subject is speaking out of bounds. History has taught us both the wisdom of confronting fascism and the folly of foreign entanglements. Iraq is a boring subject for me and I hardly don't even think about it no less post on it. Though it will be mentioned in my next post.

The pricing of oil in dollars or euros makes absolutely no difference at all. It's a talking point for econo-illiterates. The euro-dollar exchange market is deep and liquid, It means nothing to "price oil" in a particular currency.

I have never read any of the Austrians economic theory. In fact I barely knew they existed until maybe last year.

The dollar can't really collapse and take other currencies down, they must inherently rise for the buck to roll over and die. But as I said, commodity inflation can erode its value with no movement against other currencies. Of course a pegged currency like the yuan will move with the dollar.

Taylor, I can't emphasize enough that you need to learn about financial markets. The reason I can annihilate Greg Mankiw is that he is trapped in theory and I am armed with an empirical arsenal (plus I am much smarter than him). The textbooks are like training wheels - they just get you started. My advice is to immerse yourself in real world economic studies. Learn about individual companies and their markets. Forbes is a must read. For primers, read about Andrew Carnegie, Michael Dell, Den of Thieves, The House of Morgan, Jack Welch's book, Liar's Poker, and especially Reminiscences of a Stock Operator and Market Wizards.

As you gain more and more knowledge you won't be quoting others (Riesman or the Austrians) to further your own arguments.

You can email me at any time but as for the intro trading stuff I recommend auto-didacticism.