Recent market action evokes the following from Pit Bull, a trading classic by Marty Schwartz:
“It’s the latest it’s the greatest, come on baby, it’s so easy to do. Oh, mashed potatoes, mashed potatoes, you can do it too. Mashed potatoes, mashed potatoes, yeah, yeah, yeah…”
It was 3:59. Hayes Noel and I were up on the balls of our feet, twisting our crepe-soled shoes in opposite directions, dancing around the floor of the American Stock Exchange singing Dee Dee Sharp’s 1962 hit. As my young son would later say, “It had been a big busy day.” Discarded buy-sell slips covered the floor and we were getting some good sliding action. We were hot. I was up ten grand on paper for the day with only a minute to go. I’d only been trading on the floor for a couple of months, and I was so happy that I was doing so well and that my positions were all marked up in my favor that I didn’t realize that I should have converted the ten grand into real money.
The market opened way down the next day, and because I’d been dancing instead of closing out my positions, I was locked in and lost the whole $10,000 in paper profits. From then on, I always fought back the temptation to start dancing before I’d heard the cash register ring. When you feel like doing the mashed potatoes, it’s a visceral clue that you’ve lost your objectivity, you’ve gotten too emotional, and you’re about to go into the shitter.
The other thing that’s stupid is that you actually think you’re dancing well. And, of course, you’re not.
Until last Friday’s gigantic bust of a non-farm payrolls report, investors had been doing the mashed potatoes over the prospect of a housing-led US economic recovery. While equity markets recovered from the shock of a +100K jobs whiff, a fair amount of technical and sentiment damage was done. Long-term treasuries took off like a bottle rocket as investors dog-piled into safe havens, and small caps were beat by the ugly stick.
It is an ironic fact of markets that the crowd is always wrong at turning points. The crowd is not wrong all the time, of course. There are great long stretches where the crowd successfully rides a trend.
By definition, though, a turning point will catch the crowd by surprise… because if the crowd had anticipated it and acted earlier, the turning point itself would simply have arrived earlier.
Crowds are also known for unimaginative extrapolation in straight lines. The trend, once sufficiently reinforced in the collective institutional psyche, is de facto assumed to persist indefinitely.
That makes the following especially juicy (via Reuters):
LONDON (Reuters) – Hedge funds set up to profit from huge market slides are falling out of favor, signaling that investors are increasingly confident leading central banks can avert the kind of meltdown that followed the Lehman Brothers’ collapse.
Investors are pulling out of such “tail risk” funds although economic and geopolitical bolts continue to strike from the blue, be they the messy bailout of Cyprus which has shown how the euro zone crisis can flare up when markets least expect it, or the U.S. stand-off with North Korea.
Despite such crises, shares have ploughed on to multi-year highs while volatility, as measured by the VIX or “Fear” Index, fell in mid-March to its lowest level since before the financial crisis when the U.S. investment bank went under in 2008.
Last year’s promise by European Central Bank chief Mario Draghi to do whatever it takes to safeguard the euro, along with bold measures by policymakers to stimulate economies from the United States to Japan, have undermined tail risk funds.
“If the world’s central banks have decided they are going to do whatever to support the economy then you are not going to have crazy volatility. You need a catalyst,” Nicolas Rousselet, Head of Hedge Funds at Swiss investor Unigestion, told Reuters.
In the aftermath of a hurricane, investors rush to take out insurance on their beachfront condos — just when premiums are the most inflated. Then, after a long season of sunshine and mild winds, their memories fade and they let the policy lapse… just as danger looms large again.
Here are the following reasons to extrapolate blue skies ahead (with no black swans in sight) — see if you can spot what’s amusing:
- The US housing market is healthy.
- Housing + Energy = economic recovery.
- Crisis in Europe is contained.
- Asia is on a solid, stable footing.
The irony is that all four of those factors were plausible reasons for bullish optimism as recently as a few weeks ago… and now they are all in doubt.
The housing market is indeed recovering. But how much of it is solid fundamentally, and how much is driven by falsehoods? John Hussman makes an intriguing argument that the whole thing is a classic misallocation:
While some observers will reflexively point to the housing market as a sign of economic recovery, it is important to recognize that the millions of homeowners with underwater mortgages (home values below the amount of mortgage debt still owed) have no ability to sell their homes even if they wish to do so, unless they can come up with the difference out of pocket. As a result, the natural flow of demand from new household formation must be satisfied from an inventory of homes for sale that is much smaller than the actual “shadow inventory” that would be available if losses did not have to be taken in order to sell those homes. So the demand for homes resulting from household formation is satisfied from limited inventory plus new home building, even though there is an ocean of distressed and unsold homes already in existence. From this perspective, it should be clear that the bounce we’ve seen in housing is not a sign of economic recovery, but is instead a sign of misallocation of capital due to what economists would generally call a “market failure.”
John Hussman, Taking Distortion at Face Value
We can also see, via Friday’s jobs report, that whatever is going on in housing, it isn’t helping the real economy in key ways — and millions of Americans are dropping off the radar:
Put out an all-points bulletin: Millions of Americans have gone missing from the workforce.
Every month that those would-be workers are gone raises the odds that they might never come back, dimming the prospects for future economic growth.
The vanishing trend is more than a decade old, but it accelerated during the Great Recession. Throughout 2012, economists held out hope that it had stopped. But then came Friday’s jobs report, and hopes were dashed.
The Labor Department reported that the U.S. labor force — everyone who has a job or is looking for one — shrank by 500,000 people in March. That brought the civilian labor force participation rate to 63.3 percent in March, its lowest level since May 1979. And it left the workforce several million members smaller than the Congressional Budget Office estimates that it should be, given the nation’s demographics.
Perplexingly, the driving force behind the decline does not appear to be baby boomers beginning to retire, an event economists have long predicted would shrink the size of the workforce. It’s people in the prime of their working years, ages 25 to 54, who began tumbling out of the job market in the early 2000s and have continued to disappear during the recovery.
That’s obviously bad for those people, who aren’t earning money in any way that would legally require them to pay taxes. It’s also bad for the economy for a simple reason: The fewer workers, the less growth produced…
Washington Post, Vanishing Workforce Weighs on Growth
Alongside housing, there is a belief that a new energy boom will power a US-led recovery. But this rationale is out of whack for two reasons: The timing cycle is all wrong, and cheap energy has not slowed the automation uptick and offshoring exodus that has made manufacturing jobs disappear. We may well have cheaper oil and gas in five to seven years. But that is no counter to persistent weakness here and now.
And what about the argument that crisis has been contained in Europe? Pardon me for a moment — HA HA HA HA HA — ok and we’re back.
Prior to Cyprus, it was possible to argue, albeit unconvincingly, that Mario Draghi had “saved” Europe and everything would be fine. Now, though, it is becoming clear that Cyprus was not some bolt out of the blue, but the thin end of a very large wedge.
What happened in Cyprus is representative of Europe’s unsolvable problems on the whole — problems that are already festering in Italy, Portugal, Spain, Greece, and even France. Europe is no closer to a solution now than it was in the throes of Greek crisis… and the odds of another “black swan” out of Europe are now so high (timing notwithstanding) the swan should rightfully be labeled gray.
Cyprus is also important as a form of throw-in-the-towel turning point for Europe. Up until Cyprus, there was still a large contingent of euro-optimists who thought the kinks would work out and the euro would survive as a viable currency. After the utterly ridiculous fiasco that ensued (and is still ongoing), many one-time “believers” switched over to the no-hope side.
And as for Asia: Just in case North Korea’s threat of nuclear war and Japan’s embrace of nuclear monetary policy were not enough, there is this:
China’s unprecedented run of better- than-forecast export growth has spurred deeper skepticism of the data at banks including Goldman Sachs Group Inc., casting doubt on the strength of the recovery.
Gains in overseas shipments exceeded forecasts by at least 7.5 percentage points in December, January and February, the first time that’s happened in three straight months in the eight years Bloomberg has compiled analyst estimates for the data…
Overstated exports would mean China is failing to get the boost from global demand that the data suggest as the new government under Premier Li Keqiang seeks to sustain an economic rebound. Theories include companies inflating the value of shipments to bring money into China, according to Nomura Holdings Inc., and exporting the same goods twice as local governments seek to boost data, Goldman Sachs says.
“The recovery in exports is there, but the magnitude probably is much weaker than the official data has been indicating,” said Zhu Haibin, chief China economist at JPMorgan Chase & Co. in Hong Kong…
Bloomberg, China Export-Data Skepticism Deepens From Goldman to Nomura
The traditional view of North Korea’s leadership has been: “They aren’t actually insane, it just pays geopolitically to pretend they’re insane.”
Vis a vis China – to the degree that North Korea actually starts acting nuts, then, it suggests some internal pressures could be forcing the regime’s hand. How does this story end? Barring the (small) possibility of an actual nuclear exchange, we have the further possibility — economically terrifying to China — of an imploding North Korean state sending millions of starving refugees flooding over China’s borders.
And if the whole North Korea thing dies down, there is the risk that China’s white-hot housing bubble is in the midst of popping anyway… and then of course you have Japan implementing perhaps the craziest monetary experiment in history (a QE plan that is effectively three times bigger than the United States)…
And as a piece de resistance, as observers like Hussman and Jeremy Grantham have observed, corporate profit margins are some 70% above historical norms — and as Grantham has said, if margins do not revert at some point it means capitalism is broken.
Basically, if investors had any sense they would be purchasing black swan insurance by the metric ton right about now (instead of shunning it).
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