Sunday, July 4, 2010

Why Mr. Market Seems So Moody

Why Mr. Market Seems So Moody

The old man's vision must be failing. Due to the risk taking and speculation of the past decade-plus, he doesn't seem to see major developments before they hit him in the face.

By Bill Fleckenstein | July 2010

From time to time, I think it's important to step back and look at the big picture of the financial world. This is one of those times. Anyone who has been an investor for longer than the past two decades grew up learning that the market was, in essence, a giant 'discounting mechanism'. Market prices for stocks generally (over time) reflected the long-term outlook for the businesses those stocks represented, and, collectively, those businesses— i.e., the "market"— tended to 'discount', or price in, future trends.

That's not to say it was precisely efficient. It wasn't, but it tended to discount important developments, good and bad, before they occurred. As Warren Buffett (and others) like to say, in the short term, the market is a voting machine, but over the long term, it's a weighing machine.

Yet from 2000 on, it seems as though Mr. Market has essentially gone blind. One even could argue that's been true since the last half of the 1990s. I attribute our friend's "condition" to the consequences of money printing— which has been so prevalent during the reigns of Alan Greenspan and Ben Bernanke at the Federal Reserve— because I think such policies encourage much more risk taking and speculation, which make prudence seem foolish. [[Well, for whatever reason, we can assign the blame to the great rise of short term Wall Street 'program' trading (scalping) and the proportionate decrease in 'Main Street', smaller investor trading.: normxxx]] This combination spurs excessive trading based simply on momentum, in various forms.

In addition, in the mid- to late 1990s, epic amounts of computer horsepower became cheap and ubiquitous, which helped give rise to the proliferation of 'trading strategies' based on increasingly complex 'quantitative' models [[no thinking by investors needed: normxxx]]. When the "quants" reverse-engineered what had previously "worked," they created ways to stay ahead of the momentum traders [[except for a couple of well-advertised failures, eg, in the summer of 2007 and the autumn of 2008: normxxx]]. Consequently, as a result of money printing, speculative/momentum trading and quants [[that first is arguable; the last two are unarguable!: normxxx]], the stock market now often seems 'shocked' when the obvious occurs, when in the past the obvious would have already been 'priced in'.

Of course, this is just a speculative theory on the cause of Mr. Market's myopia, but I don't think it is debatable that the old man doesn't see as well as he once did.

Market Delisting A Little To One Side

Part of what brings on this little rant was the recent "news" that Freddie Mac (FRE) and Fannie Mae (FNM) would be delisted from the New York Stock Exchange, causing their stock prices to plummet about 70% over the next few days. That they were nearly worthless and on their way to zero should not have been a surprise. So why should delisting from the club at Broad and Wall cause such a massive decline if the market was anywhere close to capable of analyzing eventual outcomes? [[Because of a misplaced perception that the Fed would eventually rescue those shareholders— much as they rescued their bondholders and those of GM.: normxxx]] It will be interesting to see how long it takes, and under what circumstances, for the system to get back to being the long-term discounting mechanism, or "weighing," machine that it is supposed to be.

Danger Is His Middle Name

Speaking of Mr. Market, this week a reader sent me a description from Janet Lowe's book "Benjamin Graham on Value Investing." I've read Graham's parable many times over the years, as I'm sure others have, but it's always useful to see again:

"Ben Graham explained that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but.

"For, sad to say, the poor fellow has incurable emotional problems. At times he falls euphoric and can see only the favorable factors affecting the business. When in that mood, he names a high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

"Mr. Market doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you. But, like Cinderella at the ball,
you must heed one warning or everything will turn into pumpkins and mice. Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.

"If he shows up someday in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker,
'If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.'"

I would just add to Graham's metaphor that high-frequency trading and the 'paid-to-play' investment community have made Mr. Market subject to even bigger mood swings that last far longer than they did historically. The net of that is that the old man we see today is still manic, just as Graham suggested, only more so— and not without reason.

The Housing Bubble Hangover, Part 2

A booming 'shadow inventory' in the housing market is almost certain to bring another wave of falling prices and another round of Federal Reserve stimulus. Economic and financial problems are now garnering more attention as the "Goldilocks" viewpoint that prevailed earlier this year has disappeared— which isn't surprising, as that view was only a mirage anyway. It looks to me as if we may be just a data point or two away from seeing the Federal Reserve launch a second round of 'stimulus', which is sometimes cloaked in the obfuscatory term "quantitative easing"or, as I've referred to it lately, "Q.E. II."

Who Caused The Housing Bubble?

If I may mix nautical and aeronautical metaphors, our illustrious Federal Reserve chairman, Ben Bernanke, may already be getting long aviation-fuel futures for his next helicopter mission. I say that because of a Bloomberg TV interview June 23 by former Richmond Fed chief Al Broaddus, who is considered by many to be a tight-money "hawk". (Watch the video here.)

Among other things, Broaddus said that he had expected the language in the Fed's June 23 communiqué to be "markedly more pessimistic, less optimistic than the corresponding statement after the April meeting." Of course, it wasn't markedly different; it was just somewhat weaker. Perhaps the Fed is trying to avoid spooking folks. Broaddus also noted that weakness in the housing market "increases the probability" that the Fed will be happy to let Q.E. II set sail.

Much of the blame for upcoming weakness can be laid at the feet of housing, although there are going to be additional culprits. As folks know, government incentives have mostly run out (though the time to close on a home and get a tax break was extended), and supply is building and liable to swamp demand. That should lead to lower prices, which will likely also impact psychology.

Scared Of Its Own Shadow

Recently mortgage banker Mark Hanson nicely laid out a handful of reasons for housing's excess supply, or "shadow inventory". Readers may recall from the real-estate bubble days that I used to refer to Mark as "Mr. Mortgage," before he revealed his identity. He understands the housing and mortgage markets better than anyone else I know, so I thought I would share some of the causes for pent-up supply mentioned in his recent report:
  • The 8 million loans in some stage of delinquency.

  • The 100,000 to 125,000 new notices of default being given out monthly.

  • Short sales, which are surging and are now government-endorsed through the Treasury Department's Home Affordable Foreclosure Alternatives Program, and may be the ultimate form of 'shadow inventory' due to the fact the borrower does not have to be delinquent and the property never has to be listed on the Multiple Listing Service. With almost 30% of the 57 million homeowners who have mortgages owing 95% or more on their property, the pool of more than 15 million homes that are 'short-sale eligible' is a mega-threat.

  • Modification re-defaults, which, according to Standard & Poor's, will occur at a 70% rate. Based on the national loan modification surge that began in earnest only in the third quarter of 2009, and the ultimate bubble we are experiencing now, we are seeing just the positive effects of modifications and not the negative re-default effects [[ie, "the can" has been kicked further down the road: normxxx]]. But the leading edge of the re-default wave is upon us now, and before long it will produce a new and substantial channel of mortgage loan defaults and foreclosures that few are modeling at this time.

  • An improvement in sentiment and price stability in some regions that has encouraged homeowners to sell after holding off for three years as the market crashed. In fact, as sales surged last month, thanks to the taxpayers' gift (the homebuyer credit), inventories rose sharply, catching even National Association of Realtors economist Larry Yun off guard. He commented on it after last month's existing-home-sales report. This is the first evidence of pent-up supply having a negative impact on housing fundamentals.

I agree with Hanson that the effects of all this are only just beginning to be felt. But it seems to me that the second leg of falling home prices is probably under way. That, plus high unemployment, ought to force the Fed to swing into action.

We Could Be Stuck Here Awhile

As for the stock market, I have shared my expectations for a somewhat "rangy" environment, in which the market neither crashes nor makes significant progress to the upside (versus the 2010 highs), supported on the one hand by money printing and stimulus but hampered on the other by immense fundamental problems [[also, not unlike the 1930s…: normxxx]]. Thus far, the range on the Standard & Poor's 500 Index ($INX) has been roughly 10% or so— i.e., from 1,020-ish on the downside, to 1,130 or so on the upside. I expect those "bookends" will probably widen over time, most likely on the downside, and I would not be at all surprised to look back in a few years to find out that the S&P [eventually] traded between 850 and 1,150.

To me, the probability seems high that we could experience an extended period where the market averages essentially go nowhere (they've done that for a decade already), much as we saw in this country from 1966 to 1982. For reference, during that entire period, the Dow Jones Industrial Average ($INDU) traded in essentially a 300-point range, with around 1,000 on the high end and about 700 on the low. In the past two weeks, the market has traded at both ends of the recent range but, prospectively, if a large, long-term trading range develops, I wouldn't expect both the upper and lower bounds to be touched every other week.

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