Tag Archives: investing

It’s a buyer’s market for greater fools

If there’s one thing we’ve learned from the financial crash, it’s that the efficient market hypothesis is utterly bogus. As a corollary, just as dead is the idea of buy-and-hold investing as a rational way to make money. Stock market results from Japan over the past two decades, and now America and Europe, are making it increasingly clear that the relatively steady returns of the last century were an anomaly begetting complacency.

Moreover, I’d especially be wary of long term investing in an environment with nearly 10% unemployment and an economy entirely propped up by war-level deficit spending when (a) there is no war and (b) we already have more debt* than the entire private wealth of the country. The financial system crashed because we had unsustainable levels of credit being issued, pulling future demand forward in a way that had to end sometime. So, what did we do? We simply pulled demand forward by using a bigger lever, the United States Federal Government. When debt levels became untenable for individuals and corporations, we simply shifted them to the government, an entity with a higher credit rating by dint of its ability to steal with impunity to pay its bills. But that’s the end of the line, folks, and even the US government has its (credit) limits. At the end of day, to paraphrase Charlton Heston, it’s all just people. The day of reckoning is drawing near, as the Chinese have made clear, and it won’t be pretty. I’m not predicting apocalypse, just extended tough times as we finally have to start paying the liquor bill for the long party.

So, if buy-and-hold is out, should you trade the market short term? Well, unless you’re a investment bank like Goldman Sachs, with the ability to access privileged order flow information and front run trades, you’d also have to be insane to try it. At this point, our stock markets are a farce, a rigged game for the benefit of a few elite financial firms. Spreads are huge, and people are getting scalped right and left by manipulation and high frequency computer trading games.

I’ve always looked with skepticism at the stock market. It’s a giant zero-sum game, for the most part, since dividends and stock buybacks have largely disappeared. Despite all the pumping of the market as a way to make wealth, it’s a mathematical fact that the stock market is essentially just a mechanism for transferring money between people and institutions. But lately, it’s also an empirical fact that it’s largely a way for money to be moved into Goldman Sachs’ trading accounts.

The stock market has become a Persian bazaar, and yet another example of the hubris and unchecked greed of Wall Street. It’s time the average person says “enough is enough” and quits playing. The only way Wall Street will get the message is if enough of us decide to quit being patsies, and leave the market. The truth is, your broker doesn’t care if you make money. They don’t offer their stock advice or “trading tools” because they give a damn about helping you. You’re the trading tool. They know, by definition, that their customers will lose money on average by taking their advice (it’s a negative sum game when you factor in commissions, even before considering that it’s a rigged game). They just need you to play the game, because the only way Wall Street stays alive is by skimming from the streams of money flowing through it.

If you haven’t thought about it yet, just ask yourself where money goes when it “goes into the market.” In truth it just goes from one person’s cash account into another’s. There is no such thing as money “in the market” or “on the sidelines.” It would be just as ridiculous to talk about money being tied up “in oranges” when people buy produce. Money is always going from one bank account to another. The market is just a way to transfer money and shares, and rather than money “moving in” from the sidelines it’s really more accurate to say that at any given point, dumb money is moving in or out of the market in the opposite direction of smart money. If you’re a short term trader, you have to wonder if you’re on the right side of this transfer if you don’t have access to a thousand CPU cluster computer center and direct exchange connections. If you’re a long term investor, you have to wonder if you’re on the right side of this transfer when you see investment banks make bets with their own money in exact opposition to what their retail research advises.

I know you might miss the fun of trading stocks, but consider taking up gambling on sports, instead. At least it’s a fair game.

(*including government entitlement promises as debt)

Investment gains may become harder to find, long or short.

I had an interesting discussion with some folks last night. The question was whether it is possible for all investments to go down in the short term if things get bad enough. One conclusion was that it’s a harder question to answer than you might think. Do you consider perceived value, or just market price? If you buy a farm, and the market collapses for real estate, that farm might still be the best thing you’ve ever bought (high value), even if the price plummets. So, while the general question is interesting philosophically, it quickly unravels into a debate on definitions, so I’ll just limit the discussion to what people normally think of as investments: things you can hold in a brokerage account.

My theory is that it is certainly possible for every conceivable investment to lose value, where no matter if you’re short or long you lose money. Just consider the absurd case where everybody becomes clinically depressed agoraphobics, sitting at home wasting away. Clearly, financial markets will freeze, and you’ll find out that your assumptions on value were predicated on the Wall Street showing up to work, the computers which record your trades running, and people holding out enough hope in the future to bother trading anything but cigarettes. Every asset, no matter what, has some finite counterparty risk. You may be right about everything, but the universe doesn’t owe you a bid. There probably weren’t a lot of good places to put your retirement funds during the declining Roman Empire, for example.

Granted, total collapse of financial market functioning is a rather extreme, and seemingly academic, case to consider. But as I thought about it a bit more after the discussion, I realized that this isn’t academic at all. Between fully liquid bull markets, where everybody makes money (on paper) and the macabre situation I posited above, is a continuum of completely plausible scenarios where it gets harder and harder to make money in any asset. In fact, this is already happening right now.

Bid-ask spreads on options have been widening in the past few months, which makes it harder to hedge either direction as liquidity dries up. While derivative markets are zero sum if you average out to expiration, in the short term both parties can have losses on paper due to wide spreads, and if you can’t close your short option position, you are forced to tie up cash as collateral, which could cause you to lose money. Thus, in a way both parties to an option contract can lose out if liquidity dries up.

Certain stocks are becoming impossible to short (nobody is willing to loan out any more shares). Others (such as Sears) are starting to require short holders to pay interest. It’s quite likely for somebody to go long Sears, somebody else to go short at the same time, and for both people to lose money.

Is this discussion of any practical value? I think so: if the market continues to deteriorate, even those that correctly predict it will have trouble making money from it. For example, it will become increasingly difficult to make money in inverse ETFs, no matter how brilliantly you predict the underlying stock market trends. The counterparties to the derivatives owned by the ETF will become so adverse to risk that they will insist upon prices which are less and less favorable for the ETF. This will manifest as extreme slippage in the ETF relative to the index it inversely tracks. Again, this is already happening. Consider the following plot of SKF versus the Dow Financials Index, which it is supposed to track the inverse of times two:

FXK: How to lose money both long and short.

SKF (green) versus Dow Financials (black): How to lose money both long and short.

The underlying index went down about 25%, but so did the ETF (there were no distributions from SKF in this time frame). Everybody lost money, long or short! Some slippage is inevitable as a “cost” of leverage and shorting, but my point is that the slippage is getting worse. Six months ago SKF was tracking much closer to its target. It might be useful to consider an index of inverse ETF slippage as an indicator of the health of the financial markets, or at the very least a index of how crazy you’d have to be to remain in the market. So, the ETF slippage, the option spreads, tight short supply: they might all be subtle hints from the market that the market is no place to be right now, long or short.

Are long bear market rallies history?

I have no clue what’s going to happen on the market, but I’d just like to point out something that I haven’t seen anybody really talk about yet. For all the talk about comparing this present market to the bear market of the early 30s, there is one huge, obvious difference: information moves a lot faster today, and we have much more extensive “instrumentation” on the worlds economies. Not only does the flow of information mean that markets will adjust quicker, but the liquidity provided by ubiquitous electronic trading and derivatives means that market swings will occur on a much shorter time scale. Perhaps most importantly, we have much more universal access to economic data than ever before. This means that price information and the beginning of deflation have become apparent much quicker, and to a wider audience, than they did during the great depression.

The upshot of all of this, if I’m right (which is a big if), is that we may never see the kind of extended rally that occured during the bear market that started in 1929. Maybe they’ll just last a few days, or maybe a few weeks. A corrolary of this is that volatility will be much higher than in the aftermath of the 1929 crash. This may be one explanation for why we’ve seen historic levels on the CBOE volatility index (VIX). Usually the VIX peaks around 40 or 50, but these days we’re seeing sustained levels around 70.

So, while I’m going out on a limb, if you’re sitting on cash and tempted to try to time the market and ride the rally we’re currently in, you might want to rethink it. In this day of electronic data and trading, I think the aftermath of the financial crisis will be an extended period of volatility that will eclipse anything the market has seen in its entire history. This crisis may have put the final nail in the coffin in the foolish academic theory of “efficient markets,” but that doesn’t mean the markets can’t be inscrutible and chaotic for an extended period.

Gold will not necessarily go up during deflation

Many financial commentators, including the usually on-the-spot Mish Shedlock, have been saying for quite some time that gold will go up in a deflationary environment. Their argument is that gold is money and money does well in deflation. I would be willing to wager that Mish has more understanding of economics while half asleep than I will ever hope to have, and so I assume he’s just being simplistic and inprecise with his words. However, people then repeat it often enough, and it takes on a life of its own. There are many people explicitly claiming that the price of gold should rise during both deflation and inflation. Empirical evidence to the contrary gets brushed aside by either (a) claims that the gold paper market (COMEX) is being manipulated or (b) we’re in a temporary period of gold falling due to hedge fund deleveraging.

However, straightforward logic will tell you that gold should not neccesarily go up in price during deflation. Yes, it’s money, but so are dollars! And since gold is always priced in units of somebody’s money, why should it always go up? Sure, it will increase in value, relative to other assets, during deflation, but without other factors to consider there is no reason to expect it will increase in price. After all, the Yen is money, so shouldn’t it go up during deflation? Obviously, every currency cannot go up relative to every other currency, and so, too, the price of gold will not automatically go up during deflation.

So the real question is this: is gold an attractive currency relative to the dollar? I’d argue it depends on the stuation. If you expect the deflation to be caused by lower demand for goods despite an increase in the money supply, you might consider gold a more stable value. But there are inherent disadvantages to gold, such that all things being equal, cash wins: You can’t pay debts with gold, and none of your future expenses are priced in units of ounces of the stuff. There’s no way to make gold disappear, but in our fractional reserve system, fiat currency can vanish during a period of debt destruction. If I were confident of such a monetary deflation persisting I’d personally want to keep my wealth in the ever scarcer fiat currency, not a form of money that’s dug out of the ground and hoarded by metric tons in central bank vaults around the world.

I certainly agree that it’s possible for gold to go up during deflation, and that if ever there were a situation where it should, it’s perhaps now. All I’m saying is that the idea that gold will always go up during deflation is as nonsensical and meaningless as saying the Euro will always go up during deflation. It depends on the situation. I think the best argument for holding gold during a period of deflation is simply the expectation that the government will soon do everything in its considerable power to reinflate the currency.

(Disclaimer: Lest anyone think I’m the typical antigold zealot sniping at the bugs, I’m actually long a significant portion of my meager grad student portfolio in GG and DGP.)

A tax tip for people with online investments

If you use E*TRADE or Ameritrade, be warned that they don’t provide correct cost basis information to online tax software such as TurboTax. I tell you this after I just spent four hours fixing the useless data they provided. However, despite being completely useless, they are listed in TurboTax as providing investment tax information, so you might be tempted to import the data from them. If you do, you’ll be amused to find that you may owe more in taxes than you made that year, because your cost basis for each trade will be entered as zero and each will be counted as a short term capital gain.

If you make a lot of trades, and use a brokerage that doesn’t provide cost basis information, your best bet is to just download a TXF file from your brokerage website and import that into the desktop version of TurboTax. (For some reason, the online version doesn’t accept this kind of file.) You can still import the 1099-DIV and 1099-INT data from E*TRADE or Ameritrade, but just make sure to disable the importing of brokerage sale (1099-B) data. Otherwise, you’re better off just entering each trade manually from your online history.

And in case you’re looking for an alternative brokerage, I can heartily recommend Fidelity. Apparently, they are fairly unique in managing to achieve the highly elusive technological feat of exporting correct cost basis information online.