The Bush Presidency and Stock Market Returns

The blog "Infectious Greed" reports:

As of about 1:30PM EDT [9/18], we just blew through a Dow round-trip for the Bush Administration on the Dow. The Dow closed at 10,578 on January 22nd, 2001, and we are currently at 10,512, for a -0.6% decline overall, or -0.07% decline compounded annually.

Inflation Measurements - A defense of the "core inflation" metric

From the Wall Street Journal, this is the best explanation I have found to the Fed changing their methodology to measure consumer price inflation. Read the entire article here.

Shouldn't the Fed react more to the currently high inflation numbers by tightening policy, a view often advocated on this page, or at least not further lower the fed-funds rate if the economy looks like it might go into a tailspin? The answer is no.

It is certainly true that central banks should be worried about high headline inflation caused by high commodity prices. After all, households daily pay for energy and food items, and they are a big chunk of people's budgets. But central banks cannot control relative prices for food and energy. When a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices for fresh orange juice or for gasoline at the pump that lead to high inflation in the short run. Particularly volatile items like food and energy, which are included in headline measures of inflation, are inherently noisy and often do not reflect changes in the underlying rate of inflation, the rate at which headline inflation is likely to settle and which monetary policy can affect.

This is why the Fed pays attention to measures of core inflation, which attempt to strip out or smooth volatile changes in particular prices to distinguish the inflation signal from the transitory noise. Relative to changes in headline inflation measures, changes in core measures are much less likely to be reversed, provide a clearer picture of the underlying inflation pressures, and so serve as a better guide to where headline inflation itself is heading. Of course, if a particular shock to noncore prices turns out to be more persistent, then the higher costs are likely to put some upward pressure on core prices.

I have been critical of a fed that ignores swiftly increasing energy and food prices in their analyzes in the past. This is a good explanation of their rationale.

Are We There Yet? - Peak Oil and $500/bbl

A good explanation of Hubbert's Curve and the Peak Oil Theory. Also, here is a good piece on the "Twilight in the Desert" author (note: not for those without strong stomachs - $500/bbl oil is his forecast).

Q and A on the meltdown

This is the best simple explanation of "what the hell happened" that I have found.

Warren Buffet Can Predict the Future...Why Can't I listen?

This is from Seeking Alpha, and was copied to my site in its entirety because i think it is very good reading.

---------------------------

Warren Buffet foresaw the current financial disaster more than five years ago. I pulled out his 2002 Chairman’s Letter, wherein he addresses derivatives and their potential to scuttle the entire financial system. Here are some key passages:

“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”

“In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.””

“Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.”

“Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.”

“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

There’s much more, available on the Berkshire website. Warren and Charlie have made some additional comments at the 2007 annual meeting (courtesy of Whitney Tilson). Munger:

“As sure as God made little green apples this will lead to big trouble in due time. This will lead to a result we have been expecting for some time.”

On the math models used by Wall Street:

“They’re all crazy.” “Very smart people do very dumb things” and that just because people “have high IQs” does not prevent them from creating financial models that are “at least 50% twaddle.”

On Berkshire’s underwriting standards:

“We only write fire insurance on concrete bridges that are covered by water.”

Buffett:

“Not too many years ahead you will get disruption. Predicting when is something we can’t do…(It will reward) those with cash and guts.”

Munger:

“Will Rogers said, ‘Learn not to pee on an electrified fence without actually doing it.”

Alas, heeding that last one would’ve saved Wall Street many times.

The financial system is built upon leverage. Its very existence depends on lack of correlation - the requirement that bad things don’t all happen at once: that depositors don’t make a run on the bank, insurance liabilities aren’t all claimed at once, derivative contracts don’t all go the same way at the same time, mortgages don’t all default at once. However, as Buffett says and I also heard Bill Ackman paraphrase, when the stuff hits the fan, everything correlates. That’s where we are now.

If you took on too much risk, levered up too much, didn’t prepare for the day when everything correlates… well then adios. See ya. Buh-bye.

Buffett and Munger were not so much prescient as good students of market history and innately conservative. They’d seen it all before in one form or another. I return to Galbraith from his book “A Short History of Financial Euphoria”:

“The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.”

Obviously Bear, Lehman, Freddie, Fannie, AIG, WaMu, Countrywide, on and on, went with the “lesser adequacy” model.

The Death Knell for A Business Model - Because of a Risk Model

As I write this, AIG has been downgraded by Fitch and S&P. So the abridged list of failed financial institutions reads: Bear Sterns, Fannie, Freddie, Lehman, Merrill, and (maybe) AIG - with WaMu ready to follow in IndyMac's footsteps within the week. Some analysts are now predicting that no investment bank will make it out of the crisis as an independent entity - that they will all be swallowed up or bankrupted before we reach more tranquil financial times.

These firms have been some of the pillars of Wall Street. They are sizable, too, Lehman is approximately 10 times the size of Enron when it collapsed 7 years ago. Likewise, from the Wall Street Journal: “[AIG] is such a big player in insuring risk for institutions around the world that its failure could undermine the global financial system.”

For me, the amazing part is not that any one of these firms has fallen on troubled times (certainly, it is possible for any one firm to have a significant negative occurrence - such as Barings Bank) but rather that they ALL have.  It is the industry's vulnerability to systemic risk that is so concerning.  There are two primary reasons why the industry has fallen systemically into this treacherous territory:

1) Over-reliance on a financial model that does not effectively capture the impact of the once-in-ten-years kind of event

2) A lack of appreciation for how much credit exposure would grow if a once in ten years event forced a change in credit ratings

Extreme things happen in financial markets. Without the true wisdom to understand that possible outcomes can vary drastically from possible modeled outcomes, business managers place large bets in particular asset classes or trades (such as mortgages) - in blackjack terms, they "double down".   A good blackjack player knows to double down on an 11 when the dealer has a 6.  Statistically, it is a solid bet.  However, as seen at every casino table, just because an opportunity is statistically solid does not mean that it can't lose. Since last summer, mortgages have been losing bets, and the debt leverage used to enhance returns has created a vulnerabilityof dramatic proportions.

These bad and leveraged bets make banks lose money.  And when companies lose money, the loss shows on their balance sheet. As the balance sheet is tapped to fund the losses associated with bad bets, the balance sheet becomes weaker. When balance sheets get weaker, the overall health of the firm suffers. And the rating agencies are forced to react. They adjust the credit rating of the firm to reflect the firm's newly compromised position. The downgrade reflects a company that has a less healthy financial outlook.

This is where item number two comes in to play. Over-the-counter derivatives are backed by the company that originates them. When a company receives a ratings downgrade, the downgrade may trigger the firm to have to make payments to their trading counterparties to stay in good standing. When a firm has lots of agreements with lots of counterparties, the ability to come up with large margin payments is a real challenge, since the firm is likely already in impaired shape.

Here is the scary part....all those trading instruments - the CDO's and CMO's and derivatives - all are either in the money or out of the money with a counterparty.  In other words, they have either made money or lost money for the counterparty.  If they are "in the money" the customer wants the troubled contract writer to perform, but if they are "out of the money" the customer views the writer's insolvency as a blessing, as the customer is able to re-cover that commitment elsewhere at an advantage to where it was originally struck.  For those companies that are "in the money" - well, you hope that the loss of the money that they had anticipated to make is not a business-threatening occurrence. If it is not, then it is just an unfortunate circumstance and a bad quarter. If it is, then the crisis of Wall Street becomes the crisis of Main Street.

Yes, due to a lack of appreciation for the risks of these trades, an entire segment of our economy is being sacked. Say goodbye to Investment Banking. And maybe we can say "good riddance" to the myopic risk modeling that helped get us to where the market is today.

Lehman Employees = Selfless Heroes???

Here is an email (originally published by the New York Times) from a Lehman executive regarding the meltdown.

—– Original Message —–

From: XXXXXXXXXXXXXXXXXXXXXXX

To: undisclosed-recipients 

Sent: Sun Sep 14 18:52:29 2008

Subject: Thank You Everyone, Contact information below

The 1985 NFL regular season was ending for the 49ers. Ronnie Lott and Cowboys running back Timmy Newsome collided in such a gladiator-esque hit that Ronnie’s left pinky literally lay scattered on the turf in bone fragments and parts. Ronnie would have none of it. Pain was not the issue. Winning was. After a brief sideline trip, Ronnie endured all pain, returned

to the battlefield and moved on to the playoffs. He taped up his fingers against the Giants in the first round where the 49ers season ended.

Then Ronnie faced a choice … risk missing some of the next season and potentially reinjuring a surgically reconstructed hand or just cut the end of his finger off and get ready for the battlefield. The choice was obvious for Ronnie. His gut knew no other way. The end of the finger would be gone forever, and he would lead the 49ers into the playoffs the next year whilst

returning to the Pro Bowl for the third time. Nothing more need be said about this iconic professional, and all that he represents to the world that knows him.

Everyone in the Lehman credit business knows the Ronnie Lott story. His story and character encompass what goes on here everyday.

It actually carries beyond this floor and throughout the entire firm.

There’s a new season that starts on Monday.

Take my finger.

The email is compelling and colorful. However, the writer fails to understand the nature of self-sacrifice. Patrick Henry - the brave and patriotic American revolutionary who was hung by the British and said "I regret I have but one life to give for my country" probably performed the most significant act of self-sacrifice the US has ever seen. He died so that others might live, and so that a country might be born. Lehman died due to a flaw in an economic model. Someone assumed that paper contracts and a financial risk model made 30 to 1 leverage a prudent business decision.  

In my humble opinion, the metaphorical self-aggrandizement in this letter demonstrates the hubris that permeates Wall Street. (And really, isn't that what got us into this mess?)

What was the Most Bullish Market Driver is Now Insignificant Noise

Yesterday, the Chinese Central Bank lowered interest rates, loosening money supply and effectively stimulating an economy that has been the consumptive engine behind the rally of the last five years. China chose to cut this rate because the economy is slowing - the Chinese stock market index is down 30% off the highs for the year.

Two months ago, China goosing the engine of economic growth with a rate cut would have been the most bullish occurrence I could have imagined, when thinking about crude oil's price direction. A cut would encourage consumption, and drive prices higher from $145.00. Instead, the rate cut has been ignored by the market, with crude down $6 today.

It seems that the contagion that started on Wall Street has rippled out throughout the markets of the free (and not-so-free) world...and is affecting even the Chinese in ways we could not have even imagined even 3 months ago.

Check out these fun websites

I am on the road tonight, and spending the night with a dear friend in Minneapolis who is on the high tech fringe. He also has a great sense of humor. He shared two websites that I feel behooved to pass along...

www.failblog.org

www.yearbookyourself.com

Precient and powerful market commentary is promised once I get back to KC and off my blackberry as my lone updating tool. Till then, I hope you enjoy these fun sites.

Fair Value for Crude Oil?

I just found a fantastic op-ed article called  The Most Important Fact To Know About Oil Investing on the website Seeking Alpha.  I share it with my friends not because we are all invested in oil in our 401k, but rather because our professions necessitate us not only have a bias on crude and its constituent products, but to TRADE that bias by timing prebuys and by offering presales.   How unfair!!!  Especially on the Vomit Comet ride of 2008.  Let me draw out a few points for special emphasis:

"Only four months ago (May ’08), oil cleared $120 a barrel on its way to $145. Within a month, analysts were calling for $150, even $200 oil...Then Russia invaded Georgia, and oil took a nose dive falling more than 20 consecutive days from $145 down to $115 a barrel....So is oil going to go up or down?  The honest answer is that no one has a clue. We can talk all we want about worldwide supplies, Brazil’s latest discoveries, potential drilling in the US and other factors. But the reality is that an enormous slew of conflicting issues affect oil prices today..."

1. Geopolitical Issues
2. Speculation
3. The Over-Leveraged Financial System

(The complete article goes into much more depth)

Personally, I agree with this analysis but would choose to go further. With crude oil, no one knows what price represents fair market value. In other commodities, things are just easier.  For example, if there is a shortage of corn, during the next planting cycle marginal acres of things like cotton (in North Carolina) and sugar beets (in North Dakota) move to corn.  High prices incentivize more production.  In that case, high price cures high price.  

But there isn't a place on earth that can produce an extra 300k barrels per day of oil within a period of time as short as a year (not since the days of Spindletop, anyway). That type of output costs billions of dollars and manifests itself in the form of a pipeline through Azerbaijan or a super-platform in the Deepwater Gulf of Mexico.  In each of these cases, today's high price creates incremental supply 10 years from now!  

Are we running out of crude?  I don’t know.  But I sincerely doubt it.  I am not a proponent of Hubbert's curve, and I do not think the hydrocarbon century is over.  But I DO know that recent large discoveries have come in challenging topographies (mountains and oceans) and inhospitable climates (the Arctic and the North Sea).  That can make people think that we are running out of crude - and THAT is all that matters.  

So if you are buying or selling a commodity that is finite in nature and the exact remaining quantity of that commodity also happens to be unknown...how do you ascribe a fair market value to the barrel you are buying today?  Tomorrow?   It might be possible, but it is an estimation process fraught inaccuracy.  And when it feels like demand is growing uncontrollably or that supply is waning dangerously....well, price is off to the races. Price is the only rationalizing method that we have to rebalance these seemingly incongruous pieces of information.   

Previously in this blog, I have discussed how 15 foot corn isn't possible (but how - as we drive through the rearview mirror - it feels like it might be).   The market will trade from extreme to extreme again and again.  And the prevailing sentiment (however irrational) will carry the day. Dennis Gartman, the Canadian economist, says that "the market can stay irrational far longer than the individual investor can remain solvent."   Likewise, I have a Murphy's Laws for Commodity Traders on my desk that says "When the market is wrong, it doesn't pay to be right."   

Where's fair value for crude, you ask?  Today’s settle....plus or minus $100 per barrel. 

Closing a Hedge Fund

This is an excerpt of Ospraie Hedge Fund's "blow up" letter. Ospraie recently purchased Con-Agra's trade shop for sereral billion dollars. This is what they had to send to investors this week:

"The losses were primarily caused by a substantial sell-off in a number of energy, mining, and resource equity holdings during a six-week period characterized by some of the sharpest declines in these sectors in the past ten to twenty years. As the Fund's performance deteriorated, we made the decision - despite continued confidence in the Fund's positions - to reduce and de-lever the portfolio significantly due to concern of incurring even greater potential losses..."

(Other excerpts from fund termination letters available here)

Only two thoughts here:  1) If a company is going to outperform the market for 19 out of 20 years...but then not return my capital in the 20th...I think I will pass on investing - since "return OF my capital is more important than return ON my capital."  2)  "Most models are wrong, some are useful." Risk modeling works until something crazy happens.  Sounds like they were overleveraged and putting too much faith in quantitative trading models.   They were caught by a Black Swan.  More on this book (by Nasim Taleb) in a later post. 

The Vomit Comet

For the last 35 years, NASA has had a famous plane that simulates weightlessness. It is nicknamed the Vomit Comet, for the impact it often has on its rider's constitution. I can only imagine what riding that plane must be like. But if there is a terrestrial proxy to the Vomit Comet, then I think this market is it. For example, since the beginning of 2008, the average daily volatility in crude oil has been more than $2.00. That is the most volatile period in the history of the market by far. 2007 comes in in second, at just over $1.00 of average daily volatility change. There have been years where the daily price change has represented a larger percentage of absolute price - the period of 1997-2000 was the most volatile from a percentage of the underlying commodity because prices were so cheap. But this is a misleading statistic, because most folks feel pain associated with absolute dollar losses and not percentage ones. For example, someone might buy one contract and see it go down $8 in one day. That is a $8,000 loss, and it is very painful to most folks. Well, it really doesn't matter whether the one day loss represents 1.5% of the underlying or 3% of the underlying, the investor still has to realize a loss of $8,000. The $8,000 loss makes him feel like his has taken a ride on that famous NASA plane.

Here is a list of the last ten years average daily price change:

1999	$0.34
2000	$0.65
2001	$0.52
2002	$0.44
2003	$0.58
2004	$0.76
2005	$0.90
2006	$0.93
2007	$1.12
2008	$2.08

Damage from Gustav

This is the second post about Gustav today (not ideal), but this is a very good graphic that I could not pass up. From The Oil Drum:



Rigs/Platforms: Blue: evacuated only; Yellow will require inspection before restart; Red: damage requiring repair
Refineries: Black: operational impact (partial shutdown) Green: Operational impact (full shutdown) Red: Damage likely

Internet Corn and Driving with the Rearview Mirror

A few years ago, when streaming internet video was just taking off, a tech savvy Iowa farmer put a web cam in his corn field, so that folks from all over the world could watch his corn grow. I am sure it was riveting entertainment. Maybe there was someone (somewhere) that watched with great rapture on those few hot July days where the corn grew 2.5 inches. Based on the data points associated with the growth rate of that corn on those days, an uneducated person or economist might have predicted that the corn would reach 15 feet tall by October.

In truth, most folks (even economists) know that corn won't reach 15 feet tall. It's a genetic thing. But this type of error - extrapolation of past observances into the future - happens all the time when trying to predict commodity market supply and demand. Watching previous months' supply rate or demand rate and forecasting based on these occurrences is commonplace...and it is a lot like driving a car by using the rearview mirrors. When the road is straight, it works great. But throw in an unseen curve, and the trip gets bumpy - quickly. I wish I could remember where I heard the quote: "All [economic] models are wrong. Some of them are useful."

It is the same thing for oil markets. Today, I want to focus in on the bully on the block, China. China has received a large amount of credit/blame for the recent bull market. Economists point to the 1.3 billion people that live there and note that the consumption in China has been going up about 10% per year. They also note that the Chinese use about 1/20th of the oil that US citizens use on a per capita basis. Based on those two data points, they predict an unmercifully compounding future consumption trend. And the market, driven by supply and demand, has reacted. In my opinion, the main driver of price from July 2007 to July 2008 was the worry that demand in emerging nations like China would outstrip the capacity for the oil industry to supply it. Indeed, even after a little "demand destruction" the market is still concerned that the recent demand growth rate is unsustainable.

What doesn't make much press is that China has problems of its own. Lots of problems. The communist government has built its economy upon making things. And those things must be bought by people. People in the US (by far the biggest consumer in the world) and other economies throughout the world. But now about half of the world's economies are teetering on the brink of recession.

The behemoth that is the Chinese economy is in trouble. The currency is weak, the stock market is flagging, and inflationary pressures are nipping at the central banks heels. So, I find myself asking the question: "Does something as complex as the economic growth of China deserve a straight line?" Alternatively, one could ask "Do the backwards looking economists really think that Iowa corn will hit 15 feet tall?"

Hurricanes and Hydrocarbon Industry Infrastructure

With Gustav having just made landfall as a category two hurricane around Cocodrie, (home of some excellent fishing), I thought it would be appropriate to spend some time on the the types of assets that are in the Gulf and in southern Louisiana that can be bothered by wind and waves - and where these assets are located. With crude down close to $8 on the board this morning, clearly none of these assets were damaged.

First, there are production platforms in the Gulf of Mexico. Some of these platforms are very expensive, complicated pieces of equipment - especially those that are located in deep waters. They are all named, and there are several that you may have heard of, like Thunderhorse, Atlantis, Mars, and LaKika. These platforms run upwards of $1.0 billion to build. Here is a great map from The NEW YORK TIMES:

Those pipelines are connected to a vast array of interconnected undersea gathering systems - often times much more expensive than the platform. Violent seas have the potential to cause underwater landslides, that can damage pipelines and gathering systems.

Additionally, off the coast of Louisiana is an offshore import terminal called the LOOP (Louisiana Offshore Oil Port). The LOOP is the only port in America that can handle the very largest crude ships ULCC's (Ultra Large Crude Carriers) and VLCC's (Very Large Crude Carriers). The Hurricane came very close to LOOP and Port Fourchon, the port that serves to support the offshore facility.

The final image is from The Oil Drum, and it is an old image of the terrestrial oil industry infrastructure that is in southern Louisiana. The path shown in red is the path of hurricane Katrina.