So when and where did it all go wrong?   If you are a fan of Henning Mankell’s eponymous hero, Inspector Kurt Wallender, as I am, it was the day we all stopped learning how to darn our socks!!

Dysfunctional and irrational markets continue and I have already said will continue until the end of this month as the need to raise cash and prop up various institutions intensifies.  Valuable assets will continue to be dumped as the financial chaos extends into unimagined and surprising parts of the global market.   The past week saw every major index make new multi year lows apart from the Swiss SMI and the Dow Jones.  However, it is not the fact that we are hitting new lows it is the extent of the decline which shows absolutely no immediate sign of ending.  This is hardly surprising given the extent of the bull run from which markets are now retreating.   There were also stunning declines across the board: silver falling to $865 on Friday, a loss of nearly 60% in value from the 2115 level posted in March.  Gold dropped to $681, down $367 from its all time high of March 18 and crude oil falling to $62.65, totally ignoring the OPEC threat of a cut in production.   Numbers this week will simply reinforce the view that the global economy continues to head south.  Forget a recession – the key word is depression and a new era has arrived.

The debate as to how and why we arrived at this state has started and will, no doubt, continue for many years to come.  Since last year the blame for the current mess has been levied at the door of the poor sub primers, the bankers who lent them the money in the first place, regulators too stupid to understand what was going on, hedge funds profiting from the fiasco, outright speculation and just about everyone else for being just plain “greedy” – so there.  Whilst there is an element of truth in all of these and sub prime mortgages may have been the trigger the seeds of destruction for this disaster of epic proportions were sown by the policy makers and their economic advisers some years ago. You may also have read that Bill Clinton is the latest culprit to be named  when back in 1994 he implemented the “The National Homeownership Strategy: Partners in the American Dream” http://www.businessweek.com/the_thread/hotproperty/archives/2008/02/clintons_drive.html   Clinton’s repeal of the Glass Steagall Act has also been indicted  http://www.investopedia.com/articles/03/071603 as a possible cause.   Also add in Alan Greenspan’s recent confession that he “may” have got things slightly wrong when interest rates were kept too low for too long!

However, the best explanation I have found so far and one I would like to share with you is the wholesale adoption of an economic theory known as New Keynesianism.  At its heart stands the so called dynamic stochastic general equilibrium model which nowadays is the main analytical tool of central banks around the world.  In this model, money, credit or a financial market play no direct role.   The model’s technical features ensure that in the long run financial markets have no economic consequences.  Central banks are told to ignore headline inflation and focus on core inflation excluding volatile items such as food and oil.  The model also ignores asset prices and only deals with the consequences of an asset price bust.  An economic model in denial of financial markets seems to me, not only totally bizarre, but is only going to continue to perpetuate the cycles of boom and bust which have brought us to this state in the first place.  It also ignores the global nature of the financial market and seems hardly fit for the 21st century.

If our current troubles are to be laid at the door of New Keynesian thinking then surely repeating those steps which got us into this mess in the first place:   negative interest rates, a rapid expansion of money, bailing out banks and  an ever increasing national debt will simply ensure that we will be doomed to repeat this cycle ad infinitum.   I will be dealing with market cycles in future newsletters and in particular, how to profit from them.  Trading Tip.  The Baltic Dry Index and why we should understand its significance?  This is the key barometer of global freight activity and therefore world trade.  The index fell 11% in just one day last week.   The reason, aside from a drop in demand, has been the total breakdown of trust between banks which is essentially what we mean by the credit crunch.  The shipping market has crashed because it is built on trust and credit which has completely dried up.  Many ship owners cannot get banks to issue letters of credit (trade finance) particularly on cargoes on price volatile commodities as they no longer look like adequate collateral.  Even those who can get letters of credit are finding that their counterparties may no longer trust the credit rating of anything other than large, well established banks, many of which are now charging huge premiums.  Letters of credit now cost three times the going rate of a year ago.  This is leading to grain cargoes piling up in ports in the Americas and has even led Brazil to use its foreign exchange reserves to increase credit lines for exporters in a bid to keep to keep trade moving.

Good luck and good trading.  Anna

Many apologies for delay in sending this week’s newsletter which has been due to technical problems.

Newsletter for w/c 3rd November 2008:

“Revenge is often like biting a dog, because the dog bit you” Austin O’Malley

Last week’s markets were characterized by an element of exhaustion as de-leveraging eased, allowing many instruments to bounce from extremely oversold levels while keeping volatility high.  For example the German Dax bottomed Friday October 24th at 4014 yet by Friday 31st October was up to 5066, a rise of 26..5%.  In the Americas both Brazil Bovespa and Argentina’s Merval fell to 29,435 and 819.36, their lowest in 3 and 5 years respectively, yet by the end of the week they had rallied 20%.   By the end of the week, India’s Nifty was back to 2921 for a gain of nearly 30% within the same week.  Commodities continued to make new lows as oil completed a 60% decline since its $147 dollar high back in July.   Silver fell to 840 on the overnight market on October 28 yet 2 days later was back up as high as 1064, a 25% gain over 2 days.

It was against this background that the ambush (or short squeeze to give it its correct term) of hedge funds by Volkswagen, Porsche and probably the German government was an extraordinary  event.  Over 100 hedge funds collectively lost a staggering £24 (approx $40 billion dollars) on a doomed gamble that Volkswagen shares would continue to fall because of the global economic downturn.  It was the “safest play in town.  In fact Porsche had been secretly building up a 75% stake in VW via intermediaries which must have been particularly galling to the “hedgies” given Porsche’s iconic status as the car of choice for many in this industry.

Regardless of the legality of the move by VW and Porsche there was scant sympathy for the hedge fund industry who many have blamed for contributing to the current financial problems, not least in their aggressive shorting of financial shares.

However, whilst hedge funds can certainly be held to account for contributing to the current financial meltdown the reason it has all gone so horrible wrong is that most so called experts in this industry do not really understand risk and have been using (and still use) inappropriate mathematical tools and models to measure and manage risk.  These tools and models are all based on the statistical device of the bell curve where the focus is on the norm, and any major departure such as a 1000 point drop in an index is seen as a rare event and its effect therefore negligible.   Listening to an investment banker earlier this year explaining that the reason their housing price model failed was because it did not take into account housing prices ever falling, was sufficient evidence that this approach is now wholly inadequate.

For me one solution has come from the world of fractals and in particular the work of Benoit Mandelbrot and Nassim Nicholas Taleb, the latter being the author of “The Black Swan”  which many traders and investors may have already heard of.   Commonsense tells me that all markets are much more volatile than the experts would have us believe and that this past year has not been a “once a lifetime event” but something which can happen at any time.   We have to accept that conventional measures of risk are not only outdated and outmoded but severely underestimate potential losses.  For better or worse our risk exposure to huge losses is actually much bigger than we think it is.  One only has to look at the risks when trading on margin where losses can exceed initial deposits to see this in graphic detail.  Professional traders (or at least those who should know better) are often horrified at the leverage offered by most forex brokers.  The maximum for retail traders should be around 1 to 5 or a maximum of 1 to 10 and yet the average offered by most brokers is around 1 to 100, up to a suicidal 1 to 400.  If you are trading anywhere near these levels I would strongly suggest you stop and reconsider.

Trading Term:  De-Leveraging:  After a long period of loose lending by institutions who should have known better (some banks lending at 40 to 1 by using little understood financial instruments and fancy paperwork and then moving the details of their financial misbehaviour off their balance sheets where regulators could not see it) the reduction of this debt is now a number one priority and will be the cause  of continuing turbulence.    This has had a big impact on the currency market as many of the debts were incurred in dollars and yen.  It is estimated that US investors alone were holding $5 trillion of foreign equities which are now being repatriated.   It is this which has contributed to the recent surge of the dollar.

As more and more investors and traders enter the currency markets in an attempt to find better and faster returns it is important to understand that this market is going to be even more volatile and unpredictable.  Also as it is also largely unregulated it is vital that anyone thinking of participating truly appreciates the extent of the dangers and risks inherent within it.

Good luck and good trading.

Anna

Good Morning here is your newsletter for w/c 10th November 2008.

“Regardless of how you feel inside, always try to look like a winner.  Even if you are behind, a sustained look of control and confidence can give you a mental edge that results in a victory” Arthur Ashe: 1943-1993.

While the 2008 US Presidential Election campaign will be discussed and forensically analyzed for many years to come, there is no doubt that a powerful combination of youth, first time voters as well as a spectacular harnessing of the internet (in particular Web 2 tools) were ultimately responsible for Barak Obama’s win.

The Obama Presidency also heralds a seismic shift for traders and investors as the heady days of laissez faire free market capitalism comes to an end and a more regulated, less speculative landscape emerges.   Stock markets around the world were momentarily energized by this momentous victory.  In Europe most indices had risen substantially by the 4th November.  For example the Dutch AEX, having fallen to 231.50 on October 27th surged to 291.13, a reversal of over 25%.  The German Dax rallied from a low of 4014 on October 24th to a high of 5301 on November 4th, a gain of 32%.  The London FTSE too rallied from its low of 3665 on 27th October to a high of 4639, a gain of almost 27%.  However, by the end of the week all had fallen back by an average of 10%.  Optimism may have entered the markets but volatility was far from dead.

Market volatility was even more pronounced in Asia and the Pacific Rim.  The Hang Seng of Hong Kong posted a one week gain of 43.5% from its multi year low of 10,676 on October 27th to a high of 15,317 last week.  India’s Nifty too gained over 43% during this same period.  Japan’s Nikkei too gaining over 30% but like the European indices these too failed to consolidate these gains and fell back almost 15%.  The US markets too rallied but like all the others failed to capitalise on their gains.  Hardly surprising as the October US Non Farm Payroll numbers on Friday put the US job market squarely into recession.  The speed and magnitude of the decline in the lack of new jobs underlines both the severity of the September credit crisis and the magnitude of the task facing the new President.

Elsewhere market falls were also the result of dramatic interest rate cuts.  In the UK the Bank of England cut base rates by unprecedented 1.5% while the ECB restrained itself to a 0.5% as central bankers and governments all try to avert an economic meltdown and attempt to steady the financial ship.   Neither cut in interest rate did much for either the British Pound or Euro.  The carry trade continues to unwind and investors and traders bail out of anything which smacks of speculation, hence the continued falls in oil and other commodities.  As has been mentioned before the worst is far from over for either the UK or Europe, with Asia and the Pacific Rim now catching the tail of this worldwide financial hurricane.

An interesting take on the entire credit crisis has been suggested by Liam Halligan whereby he suggests simply locking away all top bank executives regardless of type and refusing to let them out until they fess up to each other, admit their mistakes and reveal what toxic investments they are actually holding.  An AA meeting for addicted bankers – ie bankers addicted to debt and risk using other people’s money.    We can but hope!

In the meantime what of the future and how to profit from the enormous changes which will result from this Presidency?   If, as expected, governments bring in more stringent regulations for markets and financial instruments in an effort to avoid future asset bubbles traders and investors may have no choice but to look at conservative asset classes such as bonds and simple deposit accounts.    Calm, orderly market conditions with no volatility can appear seductive but dangerous as traders and investors soon become frustrated with little or no return from their safe haven investments.  Ironically it is at this point that many turn to trading and investing in more volatile instruments in an attempt to achieve higher returns.

Trading Tip:   It is often tempting when shares prices are falling (or in this market plunging) to be tempted to rush in and buy because they look cheap.  Beware and do not be tempted to rush in too soon – even though the likes of Warren Buffett and Anthony Bolton are now saying that this could be the time to buy.  The likes of Warren Buffett have such deep pockets he can afford the market to take a further turn for the worse.  He also takes a very long view.  Shares are always cheap for a reason.  Panicky investors have pushed prices down to unprecedented levels – the CBOE VIX recently reaching 80 while others are just plain rubbish.

Two classic tests for a cheap stock are a low price/earnings ratio (P/E) and a high dividend yield.  Falling equity markets quickly throw up “buys” on both measures.   For example a share priced at 100p with a full year dividend of 5p per share and forecast earnings per share for the next year of 10p, then the share price is 10 times  forecast earnings, so the p/e ratio is 10 while the dividend yield – the annual dividend as a percentage of the share price is 5% (5p/100p x 100%).  However, if the share price suddenly collapses to 50p with earnings and dividends remaining unchanged, the P/E halves to 5, while the dividend yield doubles to 10% (5p/50p x 100%).  The stock now looks much cheaper in relation to forecast earnings – a low P/E – but also offers a higher income return, but is it a buy?.  Not necessarily, as investors in supposedly cheap, high yielding bank shares, have been finding out to their cost.

The moral of the above is that when markets are in such turmoil and upheaval even tried and tested indicators are suspect and cannot and should not be used in isolation.     Patience is the virtue as we wait for the dust to settle on the fallen.

Good luck and good trading.  Anna