The Market's Biggest Idiots

Well…?

Yesterday, the Dow bounced back 93 points. Did that mark the end of the correction? Or did last week’s big decline mark the end of the bull market?

We don’t know; and we don’t really care.

Remember, in the short run, the stock market is a "voting machine." And the voters can do any fool thing they want. Just look at Congress.

In the long run, though, it’s a "weighing machine." Eventually, it puts companies on the scales…and finds out what they are really worth.

More on this…tomorrow…

We start today’s issue on a sad note.

Mr. John Devaney is an idiot. But without idiots, the graveyards and barrooms would be empty; and then, what kind of a world would it be? Thank god for them all.

And so, we sympathize when an idiot runs into trouble…fully aware that we could be the next ones to do so!

Poor Mr. Devaney is selling his 142-foot yacht for $23.5 million. But that is not the source of the discomfort. There are only two happy moments in a boat-owner’s life, or so it is said – the day he buys his boat…and the day he sells it. So, may Mr. Devaney will probably enjoy getting rid of the thing.

Especially since the boat’s name is "Positive Carry," and therein lies a tale. For the reason that Mr. Devaney is in the news is precisely because his carry went negative…and his hedge fund, United Capital Markets, went into losses.

This is not the first time the man has made the news. He was quoted in the papers as describing people who took out subprime mortgages as "big idiots." A moment’s reflection might have brought the opprobrium closer to home, for Mr. Devaney’s fund was buying up these big idiots’ subprime mortgages, on a grand scale.

That is the problem with today’s markets; it is so hard to figure out who is the biggest idiot. Surely, the fellow who buys a trashy barrack in a bad part of town using a subprime ARM is an idiot. Buying more of a house than he can afford, he’s just asking for trouble. But so is the fellow who buys a whole inventory of these packaged mortgages – collateralized debt obligations – asking for trouble. If they were bad for the borrower, sooner or later they’re going to be bad for the lender too. Making a loan to a guy who can’t pay you back has never been good business. But then, in order to buy more CDOs than he can afford, the hedge fund sharpie borrows money. Often, he’ll get even more leverage by means of the carry trade – borrowing yen or Swiss francs at a low rate and using the money to buy high-yielding subprime debt. As long as everything works out as planned, he’ll have "positive carry."

And then, along comes an investor who puts his money in the hedge fund! And, get this, he pays the manager fees of "2 and 20" for the privilege of taking part. Is this guy an idiot, or what?

Everyone is passing the blame buck, as Strategic Investment’s Dan Amoss points out:

"Rating agencies are now in the cross hairs of politicians seeking irresistible targets to blame for all of society’s woes," This is an attractive populist issue for ambitious politicians; it pits ‘greedy Wall Street financiers’ against the constituents whom they argue are the victims of the "predatory" lending business, including all of its key enablers, like the rating agencies.

"In the midst of all this finger-pointing, it’s important to remember that nearly everyone lauded the glories of the great housing bubble, thinking that everyone could get something for nothing and we could all get rich by selling houses to each other. But now that it’s payback time, few want to admit the reality that we’re still in the early stages of a prolonged housing recession."

The mathematician, Daniel Bernoulli, described why he was sure to be a loser, hundreds of years ago. On even odds, 50/50, if you keep betting you’ll win sometimes and lose sometimes. If you go double or nothing each time, sooner or later you’ll be wiped out.

If the hedge fund manager were merely making 50/50 wagers…he’d win some, lose some. Each time he won, he’d join you in the winnings. Each time he lost, you’d be alone. Eventually, you’d have nothing left. But hedge fund managers have an incentive to take much bigger gambles. Because, the bigger the bet, the more he stands to win…and you stand to lose. If it goes right…he’ll get 20% of the pot. If it goes wrong – which it will, sooner or later – you’ll take all the loss.

We don’t know exactly what went wrong with poor Mr. Devaney. Sounds like he was a bigger idiot than most; he seems to have invested in his own preposterous fund. Word is, he’s put his house in Aspen up for sale too. For only $16.25 million, all 16,000 square feet of it can be yours.

What happens to these guys? Our friend, Nassim Taleb, took up the question in Vancouver.

"Don’t worry about them," he said. "A hedge fund manager who blows up his fund isn’t out of work for long. He just takes a vacation. The bigger the blow-up, the longer the vacation. Maybe he goes for a hike in the Alps if it is a small fund. A medium fund manager who blows up goes to climb Kilimanjaro. And a really big fund manager has to go to the Himalayas. But he has already sent out his resume, telling of all the great success he has had…blemished by only one mistake. Usually, he gets a call to come back to work at another fund before he ever leaves the base camp."

So…don’t worry about the idiots. As long as the credit boom is still going on…Mr. Devaney will be all right.

But don’t worry, dear reader…it’s only money.

Bill Bonner
The Daily Reckoning
Ouzilly, France
Tuesday, July 31, 2007

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And now…over to Short Fuse, reporting from Los Angeles:

*** Our long-suffering readers may notice that there is something different about today’s issue of the DR. Actually, a few things are different. First, if you are reading this via email, you’ll notice that today’s issue looks a bit fancier. Don’t worry, don’t worry – we haven’t gotten fancier, we just felt that this version of the email (which is technically called html) is a bit easier on the eyes, and more user-friendly.

The next change can be attributed to our readers. Yes, we actually listen when you write in with comments and critiques…and many of you have mentioned the length of The Daily Reckoning. We hear you, loud and clear – that’s why we have decided to remove the guest essay portion of each day’s issue. Taking out the guest essay will cut down your reading time considerably.

Before you start to panic – the Mogambo will still be here every Monday (you know we wouldn’t take that away from you), and Bill’s Friday essays will now be found through The Rude Awakening, and we will provide you with a link to the essay.

The last change that you may have noticed is that you are hearing from me – on a Tuesday, when most of you are used to reading Views from the Fuse in the Weekend Edition. Well, lucky you – now you get me six days a week. I will be covering market news and other interesting goings on in this section everyday. And I will try to keep it as short and sweet as possible, I promise.

So, we hope you enjoy the new and improved DR – and please bear with us as we figure out the glitches in the new system. We aren’t sure what they will be yet, but we are pretty sure there will be some…there always are. And as always, any comments or concerns can be directed to your faithful managing editor at this address:

kincontrera@dailyreckoning.com

Now, onto today’s news…

*** The debt ceiling has been raised 16 times since 1987 – and now Treasury Secretary Henry Paulson is asking Congress to raise it again, ASAP. We are fast approaching the $8.9 trillion cap, and that clearly scares the pants off of Hank.

"The actions that are available to the Treasury Department to take in order to avoid breaching the statutory debt limit would create unnecessary uncertainty for the financial markets and result in costs to the government," Paulson wrote, in a letter to Senate Majority Leader Harry Reid. "These actions should be reserved only for extraordinary circumstances, and should be avoided."

It definitely begs the question: What exactly is the point of having a debt ceiling if we can just raise it whenever things start to get a little tight? It’s like having a 10 o’clock curfew for your son but letting him stay out until midnight every time there’s a "supercool party."

And what, pray tell, is this heightened debt ceiling for, wonders Addison Wiggin in today’s issue of The 5 Min. Forecast.

"A rainy day fund? The war on terror? Entitlement programs? The coming energy crisis? No… Paulson seeks more debt allowance so that the U.S. government can borrow money to pay outstanding bills. The money Congress grants him (which it surely will) has already been spent."

"What an amazing country we live in," Addison continues. "In order to keep up appearances, the man we all ‘trust’ to run the nation’s Treasury would rather sink the nation deeper in debt than dare rattle the world’s cage by questioning the true worth of our Treasury notes, the real purchasing power of our economy and the actual ‘value’ of the dollar."

To read the rest of this story, and for more insights into today’s markets, see The 5 Min. Forecast

*** And some interesting contradictions in the markets today…

While consumer spending is moving slower than molasses – actually, the slowest increase in spending since September 2006 – consumer confidence is at a high not seen since August of 2001.

Falling gas prices are said to have played a part in this optimistic outlook – but how long can gas prices stay low…especially after the price of crude oil hit a new one-year high?

Crude oil rose to above $78 a barrel today, on news that crude inventories fell last week – and more craziness ensues in Nigeria.

The AP reports: "Investors believe Wednesday’s inventory report by the Energy Department’s Energy Information Administration will show that refiners drew down oil inventories as they continued to increase gasoline production last week, analysts said.

"News that a Nigerian construction worker was kidnapped Tuesday added to the bullish tone of a market that seems determined to test last year’s record highs, analysts said."

And whenever the price of oil rises, you know what shows up all over the news: Ethanol.

We hate to be Debbie Downer, but despite what the government touts and the media reports, ethanol is NOT going to break America’s oil addiction, make us less dependent on the Middle East or save the environment. And, unfortunately, investing in ethanol is not going to make you any money.

So – that’s the bad news. The good news is that you can profit from the "new power revolution" in a way that has nothing to do with the ethanol scam.

So…that’s just about it for today. Again, just bear with us as we work out the kinks in the new DR. We promise it will be worth your while.

Until tomorrow,

Short Fuse
The Daily Reckoning
July 31, 2007

Editor’s Note: Kate "Short Fuse" Incontrera is the managing editor of The Daily Reckoning. Each Saturday, she also brings you The Daily Reckoning’s Views From The Fuse, a weekly wrap-up of contrarian insights and ideas.

Kate studied literary theory and writing at Towson University and the University of Cambridge. After receiving her degree in English, Kate joined The Daily Reckoning team in 2004.