Friday, October 10, 2008

Even big guys have to take their losses

"Cut your losses and let your winners run," is a lesson every successful trader learns...the hard way. Trading, you see, is an implicit recognition of superiority- for only a quicker, smarter chap will be able to make money trading. Yet, that basic sense of superiority must be tempered by painful experience. The successful trader needs to grasp that he or she may be smarter than other traders but not the fundamentals themselves.

Fundamentals matter.

Even, eventually, for the biggest players.

Of late, the powers that be have been fighting the tape- trying to keep equity prices up, interest rates down, and precious metals down further. It is a Sisyphusian task.

In the US Bond market, foreign Central Banks, with help from the US Fed, have been trying to keep yields low. Unsurprisingly, at least to those of who for whom fundamentals matter, the credit markets have seized up. Private sector flows into Treasuries, as Brad Setser has long been noting, long ago dried up. The yield is wrong. If one wishes to attract private sector capital back into Treasuries, yields must rise.

Asian Central Banks and Sovereign Wealth Funds continue to manifest the faith evident in the run-up to the last crisis a decade ago- if we stop people from selling, the price won't fall. They, apparently, have yet to accept that prices are set in people's minds, and only manifest in the market. They also, apparently, haven't learned that key trading lesson, the first guy who dumps a declining market wins, even if the trade itself is a loser.

Better to lose a little than lose a lot, which is why cutting one's losses is vital.

But, as I noted above, this view is only learned through bitter experience. One has first to realize that one can lose, that publically perceived reality is not infinitely malleable. Recent market action is teaching the powers that be this bitter lesson.

I've been asked to toss out my 2 cents worth of opinion on possible solutions to the current mess. The following might not be worth 2 cents but here it is.

1) The US needs to accept that in the absence of private sector bond inflows, cutting interest rates only exacerbates pressure on the Fed, and other Central Banks. The US needs capital, and they will now have to actually compete for it, by paying the right price.

2) The Fed has recently thrown in the towel on its multi-year attempt to restrain the growth of high powered money. The Monetary Base is up 19.6% y/y and 17.6% q/q. I believe they should continue this action while rates rise to equilibrium. Once beyond equilibrium, the Fed can tighten as Volcker did in the early 80s.

3) The US needs to quickly shift gears on spending- redirecting military flows to infrastructure flows. The multiplier effects of the two wars have been negative. Oil is more expensive and capital is being consumed. The multiplier effects of improved, far less energy intensive infrastructure would be, in my view, very positive.

4) Fortunately, current conditions are very different from those of the Great Depression. Then the US was a major exporter- capacity was far in excess of domestic demand. Thus the disastrous impact of reduced international trade. A shift back towards current account balance would not involve, as it did in the 30s, massive lay-offs, but rather large scale hirings in, inter alia, manufacturing. As noted above, however, rebuilding infrastructure and bringing manufacturing back home will require capital, for which we will have to compete.

5) The US financial sector needs to be nationalized (the purist in me prefers a clearing of the decks, so to write, but that has a tendency to invite both nasty domestic political changes, and/or foreign invasions) and soon. Portfolios need to be marked to market in order to get capital moving again and this process is likely to be too difficult for current management to do and survive. During this week's Presidential Debate, Warren Buffett's name was suggested as a possible Treasury Secretary. I think, given the current crisis, his distaste for derivatives would be a much needed attitude in that post.

6) Most importantly, the US (and the financial world at large) needs to cut their losses. The experiment in fiat money has run its course, and failed. Gold should be embraced instead of demonized.


STS said...

Dude, I think I understand and agree with most of your policy prescriptions. I'm a little unclear on the 'embrace' gold point, however. How would we manage the money supply under a gold standard? And how would that change the way 'banks' (both regulated and non-regulated) create credit? It seems to me that the credit boom/bust cycle is much the same before and after gold. The difference is mostly that inflation is used as a cushion during the bust phase. And a not particularly soft or supportive cushion at that.