May 7th, 2010

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

  1. Echoes of 1987’s Black Monday? Computer program trading or “Portfolio Insurance” is what they called protective stop loss selling back then, but have we really changed?  The question more than a few people have asked us today is: How can the market fall by that much in ten minutes?  (An extra 650 points on top of the already lost 350) Several variables need to be looked at.  As we have observed for over a year, nearly 70% of all volume traded in the markets today is from computer banks running trade models.  These models bend and flex with new data inputs.  This results in blocks of shares being bought and sold in light of those inputs.

These kinds of portfolio’s can turn over 5, 10, even 100 times or more per day.  This is like day trading on steroids, but without a person driving the decisions.  The real muscle is in the quantitative math used to map relationships, measure probabilities, and move into or out of positions as a result of logical conclusions.  We give pause . . . and observe:

  1. The market is not always rational.
  2. All your assumptions have to be valid for your conclusions to be correct.
  3. The market is more vulnerable than ever to downdrafts in the context of automatic trading models, which dominate volume and thus dictate the direction of the market, either up or down (in the short term).
  4. Everyone is interested in how the market went down, we are interested in how the market has climbed so high on rotten fundamentals (over the last several months), and even more intrigued by how 650 points was recovered in the last few hours of trading.

We are sure you are by now familiar with the President’s Working Group on Financial Markets, or Plunge Protection Team (PPT). Now you’ve seen their handy work.  Final observation:

E.   Asymmetrical central banking is what leads to unstable markets. We are prone to massive overcorrections, particularly when too many people, institutions, and models are betting in one direction. If for any reason these various investors are proved wrong or question their bet, prices will rapidly decline as they seek to get out in time.  (Preview of coming events in the Dollar and US Bond market)

2.  “Beggar thy neighbor” – This term was originally devised to characterize policies implemented to cure depressions and unemployment at the expense of other countries (they never worked).  In the past, it was usually an economic policy that entailed protective tariffs, quotas on imports and/or competitive devaluations.  This dynamic has also been called the “tragedy of the commons,” and appears as early as the works of Plato and Aristotle.

Today the term might serve to warn us of a coming storm, again of our own design.  Easy money policies implemented by the U.S. to protect itself from financial collapse have also been adopted by Europe, Japan, and China (among others).  Currently, those policies have kept the U.S. out of trouble, but they are beginning to place our creditors between a rock and a hard place – between the crippling effects of inflation and immediate bankruptcy (as Japan and Greece find themselves today).  Our point is: If we rely on these countries for trillions each year to support our currency, what happens when they no longer have savings or surpluses to do so?

MWM: More dollar weakness and higher interest rates to come?

Staying the course……

Have a great weekend!
David McAlvany

David Burgess
VP Investment Management