Sunday, January 27, 2008

Blame it on the traders

(Naked Capitalism) Here we go again. We have another Ben Stein column, "Can Their Wish Be the Market’s Command?" which says, I kid you not, that we have a bear because a whole bunch of traders got together and made it so.

Since undue contemplation of Ben Stein logic is bad for anyone's mental health, I will limit myself to the main outlines of his argument. The first half of the piece describes how Ben learned in law school that court decisions are completely arbitrary. Judges decide based upon personal prejudice and can always find precedent somewhere to justify their verdict. He then tells that a UK trader buddy described how his firm once ran IBM stock down even though it had just announced great results (note that this apparently occurred during UK trading hours, and some years ago since said trader is now dead, which means there was far less depth in the stock than there in the US, a not trivial detail).

Stein then goes on to say:
As I see it, this is what traders do all day long — and especially what they’ve been doing since the subprime mess burst upon the scene. They have seized upon a fairly bad situation: a stunning number of defaults and foreclosures in the subprime arena, although just a small part of the total financial picture of the United States. They have then tried — with the collaboration of their advance guards in the press — to make it seem like a total catastrophe so they could make money on their short sales. They sense an opportunity to trick other traders and poor retail slobs like you and me, and they generate data and rumor to support their positions, and to make money.

More than that, they trade to support the way they want the market to go. If they are huge traders like some of the major hedge funds, they can sell massively and move the market downward, then suck in other traders who go short, and create a vacuum of fear that sucks down whatever they are selling.

If the current market action is the manifestation of some sort of evil trader genius, they have executed it pretty poorly. Every major firm should have been net short, not just Goldman. The investment banks, with their sales forces and research arms, are in a much more powerful position to push rumors. If the market fall was by design, pray tell me how it benefited the Street? They have taken over $100 billion in writeoffs, and the fourth quarter results are still coming in.

Similarly, the charge that hedge funds are rolling in dough as a result of these gyrations is also badly misguided. It has been widely publicized how the quants have been whipsawed and taken big losses because the action in August were so out of line with historical patterns. November and December have been poor months for them also. Most other portions of the industry, for different reasons, are also not going to benefit from a bear market. As a post from Roger Ehrenberg pointed out:
The real question is, how will a persistent down market impact the returns of the hedge fund and private equity industries? My handicapping: most participants will suffer and suffer badly. Why? In summary:
The net long exposure of most hedge funds will weigh on returns. Historically it has been difficult for most hedge funds to add significant alpha on the short side, the side which may well be the key driver of returns for quite some time....

Bridgewater Associates had a very interesting report yesterday that addressed this very issue. Here are some of their thoughts as it relates to the hedge fund industry:
For the most part, hedge funds have gotten through the credit crunch relatively unscathed. For example, the average hedge fund generated a return of 12.5% last year and 2.5% in the fourth quarter. And private equity funds generated an average return of 11%. The main reason that these two groups held up as well as they did is because the equity market has not fallen nearly as much as the bond markets (i.e., spreads), and the majority of the risk allocation of these funds is in the equity market. And because their performance held up, they have not been forced into much asset liquidation to speak of. But stock market action is beginning to pressure the hedge funds and private equity players.

Hedge funds used to be a lot more hedged than they are today....hedge funds are now heavily long the equity market. Based on fund by fund holdings data we estimate that hedge funds are net long about $150 to $200 billion in U.S. equities (foreign equities are not included in this figure).

So who are these mysterious evil traders killing our collective prosperity? Stein isn't able to provide the name of a single perp.

The most successful, John Paulson, who was massively short the subprime market, was remarkably low profile until his trade reaped huge profits. He certainly wasn't trying to talk the market down; the fundamentals did it just fine on their own.

Yet we get stuff like this:
I know this because I know traders. They’ve told me that they love to sell into fear because fear is bottomless — you can make money selling all day, while buying eventually slows because enthusiasm has limits. The amount of money available to large professional traders is so large that they can overwhelm the market, at least for a while, anytime they want. And they like to do it when the market least expects it.

It is one thing to move the prices of single securities, quite another to move entire markets, particularly ones as big as the global equity markets and the US credit markets. We must have a simply staggering number of traders all conspiring together.

And then we get as close as Stein gets to analysis:
The losses in the stock market since the highs of October 2007 are about 14 percent. This predicts — very roughly — a fall in corporate profits of roughly 14 percent. Yet there has never been a decline of quite that size for even one year in the postwar United States, and never more than two years of declining profits before they regained their previous peak.

Aside from the questionable assumption, that the 14% fall is a predictor of a calendar year decline, Stein reveals complete ignorance of bear market patterns. Stock market falls are due to both declines in earnings expectations AND multiple compression. Seeking Alpha has a very nice table showing the change in the S&P during bull and bear markets since World War II. The average bear market was 393 days with an average decline of 30.6%. So we aren't even to the halfway point by historic standards. And the most recent bear market, in 2002, was less than a year but steeper, a 33.75% fall in the S&P.

Finally, I am not sure the correct comparison for our current situation is past US economic cycles . We are in the process of unwinding a large scale debt-fueled asset bubble, and the closest comparable is Japan in the early 1990s. Indeed, many of the policy remedies are going down the Japanese path of shoring up asset prices and socializing losses rather than letting the markets find a new, lower clearing price. The Nikkei has failed to since reach even 50% of its all time high of 38,957. I don't expect our trajectory to be as bad as Japan's, but the point is that US history may be the wrong place to look for precedents for our current credit woes.

Stein's certainty that there are faceless, powerful enemies in our midst called traders reminds me of Joe McCarthy's' conviction that there were commies in every nook and cranny plotting America's demise. That comparison quickly breaks down since McCarthy was formidable for at least a while and Stein isn't. But then again, Marx said that history repeats itself, the first time as tragedy, the second time as farce.

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