Bear Market Reinvents the Question Mark

Today is a holiday in France; it marks the day when the Virgin rose into heaven. As to its veracity, we cannot comment; we weren’t there. But more than 100 million people are getting the day off from work because of it.

Not here at The Daily Reckoning headquarters, of course. We honor no holidays except our own. And today, we have reckoning to do.

Yesterday, the Dow dropped 207 points. Investors are beginning to get nervous. What if the stock market continues to go down? What if it stays down for years? What if more hedge funds go broke? What if the housing market stays like this for years…or worse; what if house prices go down 20% or more? What’s Ben Bernanke going to do about this?

The question mark was invented in a bear market, we conclude. When people are feeling fat and sassy, they have no need for it. It is the old fellow, under pressure, who finds it useful.

“Why should I pay such a high commission?” he asks his broker.

“What if prices don’t come back up?” he asks no one in particular.

“What does this new beau of yours do?” he asks his daughter.

Clients in Goldman’s (NYSE:GS) global equity fund must be asking themselves what is going on, after hearing that the fund lost 30% of its value in the last week. It must be what shareholders of the building stocks are wondering too…and what a lot of homeowners want to know.

A few weeks ago, they had scarcely ever met a question mark. Now they’re finding it essential…taking it wherever they go…and keeping it next to the bedside in case they need it in the middle of the night.

Goldman dropped the fees on its fund to 10% of profits. Still, an investor might want to ask the questions: What if there aren’t any profits? What if there are more losses?

Investors in the giant private equity firm Blackstone (NYSE:BX) are probably asking themselves when the stock, now trading at $26, will get back to where it was when they bought it – $31. And the fellows who run rival takeover firm, KKR (AMS:KPE), are probably asking themselves if they want to bother to go public at all. They already had to amend their offer documents, letting investors know that since the low-hanging fruit had been picked, they would have to skinny up a few trees to get the money they were looking for…and that might mean lower operating margins.

Meanwhile, the dollar has gone up! People are asking themselves about that too. But that’s what happens in a credit crunch. Investors, speculators and householders need dollars to pay their bills. Dollars are what people owe. So dollars is what they must have. When dollars are not so readily forthcoming, they go up in price.

Many analysts believe, too, that the dollar is still a ‘safe haven’ for wealth. After posing nervous interrogatories, an investor is likely to take his money out of risky speculations and move it to dollars. Looking around at the great universe of paper currencies, we see that the Chinese are increasing their money supply (CNY) at an astounding 20% annual rate (according to Goldman). The Indians are adding rupees (INR) at a 24% rate. And the Russkies, (what are they thinking…?) are adding to the world’s supply of rubles (RUB) at a 51% rate! Alongside those numbers, the dollar does look safe. But why the euro – easily as safe as the dollar – should fall against the greenback is another thing that calls for a question mark. The euro has lost 1.5% of its value, compared to dollars, over the last two weeks. Why?

Our guess is still that the dollar is doomed…maybe not in the short-run credit crunch. Definitely in the long run. But when will the long run arrive?

What’s happening? Where will it all lead? We don’t know dear reader. We’ll just sit tight with our gold and wait and see.

So many questions, dear reader…and on a holiday no less!

*** A credit crunch bashes the good with the bad. Our guess: There are probably a few good mortgage companies selling at reasonable prices.

*** Each era has its own delusions…its own magicians and its own mountebanks.

If you had told an investor in the 19th century that he could make a lot of money by applying higher mathematics to market situations, he would have regarded you as a fool. The mathematics of investing was very simple back then. A company either made a profit or it didn’t. You didn’t need fancy arithmetic to figure that out. Besides, investors knew that the secret to making money was not mathematics; it was metallurgy. The whole world was getting hammered out in steel and iron – ships, engines, bridges, railroads…even the wires that brought the latest in telegraphic communications were made of metal.

Up until the 1980s…there was no particular use for mathematicians on Wall Street. The math was basic. Besides, stock prices were quoted in fractions that still had an archaic, pre-digital air about them.

But then came computers…and computer models…and decimals. And then came the mathematicians who knew how to use them. And then came an explosion of new math-based products – whose actual value had to be tracked by complicated computer formula. Billions of dollars in speculative positions were no longer “marked to market.” They were now “marked to model.”

“What are those things really worth?” asked the old coots who still ran Wall Street firms. “What is our real risk?” they wanted to know.

“Don’t worry J.B.,” came the answers. “The geeks who run the models tell me that it would take a 25-sigma event to cause any real problem.”

“What the f…”

“You know, they talk this lingo…25-sigma means 25 standard deviations from the norm…which, as near as I can figure is about as likely as hell freezing over.”


Well, dear reader. Last week, hell froze. The Financial Times reports:

“In a rare unplanned investor call, the bank revealed that a flagship global equity fund had lost over 30 per cent of its value in a week because of problems with its trading strategies created by computer models. In particular, the computers had failed to foresee recent market movements to such a degree that they labeled them a ’25-standard deviation event’ – something that only happens once every 100,000 years or more.

“‘We are seeing things that were 25-standard deviation events, several days in a row,’ said David Viniar, Goldman’s chief financial officer.”

Losses in the Goldman fund could go over $1.5 billion. But heck, everyone makes mistakes. And even a great mathematician such as James Simons, founder of Renaissance Technologies, takes a loss from time to time. Simons used to do math for the Pentagon. Then, he discovered that he could make billions running a math-based hedge fund. But last week, Simons was forced to write a letter to his investors. His fund lost about 9% in the first few days of August…and now Simons says, “we cannot predict the duration of the current environment.”

Ah…question marks. Even the math whizzes find they cannot live without them when the markets turn down. And no matter what kind of math you do, sometimes things take you by surprise. This is the premise of our friend Nassim Nicholas Taleb’s latest best seller, The Black Swan: The Impact of the Highly Improbable. As he told the attendees at the AF Investment Symposium in Vancouver last month, a ‘black swan’ event is an unexpected event that has grave consequences.

Hmmm…sound familiar? The title of Taleb’s speech at the Symposium was “The Scandal of Prediction: How We Can’t Predict and Why We Don’t Know It.”

“We don’t listen to negative advice – what doesn’t work – we listen to what works – but this means we ignore then the ‘silent evidence’ of what doesn’t work – which is often more instructive,” he told the crowd.

“We are unable to look at data without trying to make a causative link – it’s human nature – but it doesn’t serve us…”

You can listen to Taleb’s – and the other presenters – full speeches from the comfort of your own living room.

“Models (ours including) are behaving in the opposite way we would predict and have seen and tested for over very long time periods,” said Lehman Brothers (NYSE:LEH) last week.

As we explained here in The Daily Reckoning, data cannot replace wisdom, and math is a poor substitute for good judgment. The mathematicians claim to be able to calculate Value at Risk, or VAR. But they can’t really calculate risk at all. Instead, they use historical volatility as a proxy. But just because a stock only traded as low as $10 once in the last 10 years does not mean that the real odds that it will trade at $10 again are only 10 x 365. Just let the private equity boys get ahold of it…strip out the best parts of the business…and load the rest up with debt!

*** Oh, by the way, we always take a vacation from the Feast of the Assumption to the beginning of September. We’ll be back when school starts.

*** “How do you deal with such a complicated life?” asked a friend the other day. “You work in one city. You live in another city. You’re always traveling. You have businesses and houses all over the place. Not to be nosey, but isn’t it all a little too much?”

We were asking the same question. In every life, there is a time to expand and a time to contract – just like an economy. In our 40s and early 50s…we added things…places…people…projects. Now, we find that we have more than we can comfortably manage. Mistakes need to be corrected. Fat needs to be trimmed. It is time to focus on the essentials…to figure out what we really want…and how to handle it. Simplify!

That’s what we’ll be thinking about on our vacation.

Bill Bonner
The Daily Reckoning
August 15, 2007


…over to Short Fuse, reporting from Baltimore


Views from the Fuse:

*** With all the craziness in the markets lately, where – if anywhere – is it safe to put your money? In today’s guest essay, Doug Casey looks at just that…

“Everybody’s got an opinion on where the market is going to go. So I’ll give you my opinion briefly,” says he, in today’s piece, entitled, aptly, “Where Should Your Money Be?”

“Okay, so forget about stocks, forget about bonds. What about cash? How about T-Bills? No, because T-bills are denominated in dollars, and the dollar is an ‘IOU nothing’ issued by a corrupt and bankrupt government. It’s a floating abstraction. If you hold dollars today, you’re going to be as dumb as an Argentinean who held pesos ten years ago. And you’re going to have the same fate. So forget about that…”

*** “Producers from CNBC called me at 4am this morning… CNN and FOX News by 7am,” Kevin Kerr told both The Daily Reckoning and The 5 Min. Forecast this morning. “I guess storm season has arrived.”

“Tropical bulletins are popping up all over, from Hawaii to Havana,” reports Kevin. “Tropical storm No. 4 was upgraded to Tropical Storm Dean and officially fills the fourth slot for 2007 as it charges across the Atlantic.”

Dean is currently about halfway between Africa and the Caribbean, and is currently rated a Category 3 hurricane.  Another, much smaller tropical storm – which will be named Erin, provided its winds reach 40 MPH – is expected to touch down in Texas by Wednesday.

“As the storms start rolling in, keep an eye on the orange juice and natural gas market because they are likely to be very active,” advises Kevin. “The natural gas market is prone to shutdowns and possible rig or equipment damage during this time of year, and thus requires more risk management than most.

“If you’re playing natural gas, it’s usually a good idea to lock in profits as they come and only keep part of your position open for big gains.” See: Trader’s Code

Kevin will be appearing on be on CNBC’s Squawk Box tomorrow at 6:20 am (EST) to discuss the storms potential impact.

Also, today, he will be guest hosting with Alexis Glick on Neil Cavuto’s “Your World” and discussing the potential impact on key commodities and the broader economy. Check your local listings.

“India is experiencing its own ‘unprecedented’ bad weather. According to the India disaster agency, this is one of the worst monsoon seasons in the past 100 years.”

You can continue reading this story in today’s issue of The 5 Min. Forecast.

That’s it for today…

Short Fuse
The Daily Reckoning

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.

The Daily Reckoning