The Big Picture

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• Suppressing Financial Instability Increases Risk of Market Breakdown
• Something Phenomenal Happened
• Succinct summation of week’s events (09/23/11)
• Gold Off $100; Trades Down to $1630
• BN reporting that more Greek bondholders can play
• The Myth Of Cash On The Sidelines
• QOTD: When This Cycle Ends…
• Capturing the Beauty Of The Milky Way at Midnight
• 10 Friday AM Reads
• Fed, Mortgages, Housing

Suppressing Financial Instability Increases Risk of Market Breakdown Posted: 23 Sep 2011 10:00 PM PDT Financial analyst and author Nassim Taleb demonstrated that suppressing market volatility in the short-run leads to much more violent bursts of dislocation and chaos in the long run. Taleb learned many of his ideas from mathematician Benoit Mandelbrot (who discovered fractals). As Scientific American noted in 2008: One of those long-time market watchers is fractal pioneer Benoit Mandelbrot. In 1999, Scientific American​ published an article by Mandelbrot that showed how fractal geometry can model market volatility, while revealing the intrinsic deficiencies of a cornerstone of finance called modern portfolio theory (for which there has been awarded more than one Nobel Prize in Economics). Mandelbrot, 83, contends that portfolio theory, which tries to maximize return for a given level of risk, treats extreme events (like, say, yesterday's market shockers) with "benign neglect: it regards large market shifts as too unlikely to matter or as impossible to take into account." The faulty assumption of modern portfolio theorists, in Mandelbrot's view, is that price changes do not drift far from the mean when observing daily ups and downs—so extreme events are exceedingly rare. "Typhoons, in effect, are defined out of existence," he wrote. Similarly, Graham Giller – from Oxford University in experimental elementary particle physics, then strategy researcher and portfolio manager for Morgan Stanley – writes today: The Greenspan [and Bernanke] era monetary policy has altered the distribution of changes in interest rates in a way that exchanges a reduction in day-to-day 'normal' variability for a considerably higher (perhaps catastrophically higher as we are finding out this week) likelihood of extreme shocks. I first made the attached chart in 2004 after attending a lecture by Benoit Mandelbrot, and reading his "Fractals and Scaling in Finance." *** So a narrative for what the Greenspan era monetary policy has done to the distribution of changes in rates is to exchange a decreased daily variability for a higher (perhaps catastrophically higher as we have found out) likelihood for extreme shocks. [And nothing has changed under Bernanke.] *** The whole enterprise of bond portfolio risk management is intrinsically unreliable. *** It is this constant papering-over of the day-to-day cracks (and business cycle) that is supposedly so beneficial for our society (and central planners) as a whole that creates a building tension as the underlying causes grow larger and larger and are never purged until in one fell swoop, the market mechanism finds a way. And as I noted last year, interest rate derivatives – like portfolio insurance in the 1980s – might also be creating huge risks, while appearing in the short-run to be reducing risks. Of course, Taleb, Mandelbrot and Giller's analysis of volatility means that the Fed and other central planners' attempts to prop up some asset prices or drive some indicators down as a way to reduce volatility could well lead to a more explosive crash of the entire financial system. Suppressing Political Volatility Increases the Risk of a Breakdown in Existing Social Order This principle not only applies to markets and finance, but also to sociology and politics. "Those who make peaceful revolution impossible will make violent revolution inevitable. " - President John F. Kennedy "If you shut up the truth and bury it under the ground, it will but grow, and gather to itself such explosive power that the day it bursts through it will blow up everything in its way." - French author Emile Zola Indeed, Taleb co-wrote an article in May with Mark Blyth – Professor of International Political Economy at Brown University – stating: Why is surprise the permanent condition of the U.S. political and economic elite? In 2007-8, when the global financial system imploded, the cry that no one could have seen this coming was heard everywhere, despite the existence of numerous analyses showing that a crisis was unavoidable. It is no surprise that one hears precisely the same response today regarding the current turmoil in the Middle East. The critical issue in both cases is the artificial suppression of volatility — the ups and downs of life — in the name of stability. It is both misguided and dangerous to push unobserved risks further into the statistical tails of the probability distribution of outcomes and allow these high-impact, low-probability "tail risks" to disappear from policymakers' fields of observation. What the world is witnessing in Tunisia, Egypt, and Libya is simply what happens when highly constrained systems explode. [Well, Al Qaeda also had a role in creating chaos in Libya, that's beyond the scope of this post.] Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to "Black Swans" — that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers. Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems. Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups. And it is the same misperception of the properties of natural systems that led to both the economic crisis of 2007-8 and the current turmoil in the Arab world. The policy implications are identical: to make systems robust, all risks must be visible and out in the open — fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying. So the efforts of governments, powerful corporations and mainstream media all over the world to stifle dissent could backfire … and lead to a wholesale dissolution of the entrenched systems of power.

Something Phenomenal Happened Posted: 23 Sep 2011 04:30 PM PDT Something phenomenal happened during our Austin City Limits Festival live webcast this past weekend. A band blew up right before our eyes DURING the Festival weekend. It happened online. And it further proved that in 2011 Festival webcasts are making a difference for artists. Full disclosure: I produce the live webcasts and the video at the ACL Festival (and Lollapalooza and Coachella). Here’s what happened. In addition to the live webcast of 50 bands, we were asked by YouTube if we could clear at least 4 artist-approved songs for the online Archives by the end of Friday night. If so, they would promote these videos on the YT Home Page on Saturday, and drive traffic to the ACLFestival page. We scrambled and got approved titles from Coldplay, Foster the People, Brandi Carlile, and Smith Westerns. And an emerging band called Cults, who played first-up on Friday at 11:45am, in front of a few hundred on a small stage, just about the lowest slot at the Fest. The YT Home Page promo went up mid-Saturday. By midnight on Saturday 160,000 people has streamed the VOD of Cults buzzed-about song ‘Go Outside.’ At that point Coldplay’s new single Paradise was at 150,000 streams. Foster’s hit also had big numbers. By Sunday the Cults number was 320,000; Coldplay tracking right with them. As of Tuesday evening when I’m writing this, uber-stars Coldplay are at 502,817 streams, and Cults are right there at 502,416. Five Hundred Thousand Streams in 4 days!!! It’s not a dancing cat or a cute baby. It’s a song. I knew Cults had a buzz, but WOW. All these videos and dozens more below: I just like this story. Young band, barely out of the basement, gets blog love, still getting their shit together, hasn’t toured much, record just out. Then HUGE CRAZY numbers of fans find them this week online, and see that they are cool. And this costs the band nothing. The label didn’t do it. The festival promoters (C3 Presents) made this happen (and YouTube, more on them later). Everyone on the band’s team gets jazzed. They sell-out more shows. Get to make more records. Rock ‘n Roll lives to fight another day. And it’s surely not our video genius that’s making this happen. Frankly, our video for Cults is not so damn good. It was Noon (!), first band of the first day, our smallest stage, director hasn’t settled in, doesn’t even know his cameramen’s names yet. It’s 101 degrees in Texas, band is barely awake, crowd is just arriving. We only had 3 cameras working there, so I’m just thrilled we even caught it properly. It’s all live/live, no edits, no remix. But a hit’s a hit! Cults are far from the only ones to benefit from Fest webcasts. At Coachella the indie-band Freelance Whales told me they vaulted into the top Twitter Trends during their webcast performance. Foster the People at Lolla got crazy numbers for their perf video of Pumped Up Kicks. Coldplay has blogged repeatedly about their Festival webcasts, and the traffic has followed. My Morning Jacket’s's online fans came back to the band with tons of love for their Lolla and ACL shows. Just a few examples, but literally every band connects. So what changed in 2011? It’s on YouTube, that’s what. You need a great Festival, committed promoters, and a sponsor who wants to be part of it all. But YouTube brings it to the people globally, and then let’s them know it’s there. At Coachella, we cleared Arcade at 5pm on showday, and Kanye at 8pm on showday, and YouTube still got the word out. They sit in our trucks all weekend, and tweak the user experience non-stop. And get this, they care about the music. I’m telling you, they are passionate. So good for Cults AND Coldplay. And good for another band next time. Source: Bob Lefsetz Hank Neuberger, Springboard Productions www.springboardproductions.net

Succinct summation of week’s events (09/23/11) Posted: 23 Sep 2011 01:00 PM PDT Succinct summation of week’s events: Positives: 1) Following another sharp rally in US Treasuries and the FOMC announcement of buying more MBS, Bankrate.com says the avg 30 yr mortgage rate falls 18 bps on the week to 4.0% but will it matter? Likely only for refi’s 2) Aug Existing Home Sales at 5.03mm annualized were 280k more than expected, in part due to closings that were delayed in prior months 3) Housing start permits rise in both single family and multi, single family we don’t need more, multi we do 4) German ZEW investor confidence in their economy falls to lowest since ’98 but was a bit better than feared. Negatives: 1) Confusion reigns with what happens next for Greece, and thus with the rest of the region 2) Italy gets unexpected credit downgrade from S&P 3) Euro basis swap reverses late last week’s fall after ECB/central bank swap line move 4) Euro zone mfr’g and services composite index falls to lowest since July ’09 5) FOMC continues its almost religious mission of suppressing the cost of money, still hoping for a different result. Albert Einstein is smiling 6) China’s preliminary HSBC mfr’g index fell to 49.4 from 49.9 7) Initial Jobless Claims totaled 423k, 3k more than expected and prior week revised up by 4k 8) MBA said refi’s rose just 2.2% while purchases fell to 7 month low.

Gold Off $100; Trades Down to $1630 Posted: 23 Sep 2011 12:00 PM PDT click charts for updated prices ~~~ > What is up with Spot Gold prices lately? After trading up to $1900 (double top?), its been a painful ride down. Today, it broke through $1700 to the downside, which may flip a few technicians negative. Over the past few months, we have discussed Gold as a trade repeatedly. In the presentation I made at the Agoroa conference in Vancouver, I titled one section “Gold is a Trade, Not a Religion.” We also noted that Diverging ETFs: What Are GLD & SPY Telling Us ? (August 23rd, 2011). The Gold trade may not be over — especially if we eventually see a QE3 — but for now, it looks like it is going to be a painful backing and filling process, as the shiny yellow metal consolidates all of 2011′s gains. In 4 days, Gold has retraced 6 weeks of gains, taking us back to prices last seen in early August. I have heard rumors of Gold being sold to cover margin calls in equities. Serious support exists at 1600, then at the 200 day moving average, around 1525 . . . ~~~ NOTE: Here is what I discussed at Agora: When the long term trend channel has an upside parabolic breakout, you have to peel off 10 or 20%. You can always buy it back cheaper, when the parabola collapses.

BN reporting that more Greek bondholders can play Posted: 23 Sep 2011 10:47 AM PDT Bloomberg news is reporting that Greece wants to expand the size of Greek bondholders that can sell back their bonds back to Greece as originally agreed upon with the July 21st Bailout 2. As part of that agreement, Greece can buy back debt with money issued to it from the EFSF but only certain bondholders were allowed to sell back to them, specifically those taking part in the debt swap. The EU may now allow Greece to accept bonds from a broader group of Greek bondholders at the same time Greece proceeds with the debt exchange plan. The bottom line goal is too further put a dent in their debt load and this should help. While this sounds like there can be more debt reduction than initially thought, which is good, a haircut of 50%+ rather than the 21% in the debt exchange would do so much more dramatically.

The Myth Of Cash On The Sidelines Posted: 23 Sep 2011 08:30 AM PDT On Friday the Federal Reserve released its quarterly Flow of Funds data, current through June 2011. One of the more popular headlines from this data concerns the record amount of "cash on the sidelines". Through Q2 2011, nonfarm nonfinancial corporate businesses held $2.05 trillion in liquid assets on their balance sheets. As the argument goes, this must be a sign of pent-up demand just waiting to be unleashed on the market. The second chart below illustrates why this may not necessarily be the case. Liquid assets held on companies' balance sheets is a nominal number, much like the nominal level of GDP, that rarely decreases. Of course cash on the sidelines is at a record nominal level, it usually is. This series must be compared to other balance sheet items for relevance. The chart below shows liquid assets as a percentage of total nonfarm nonfinancial corporate business assets since 1952. By this measure, the "cash on the sidelines" argument is far less compelling. Even when examined over a shorter time frame, as shown below, the percentage of cash on the sidelines is still within its range of the past 30 years. While liquid assets have certainly increased relative to the rest of corporations' assets since the end of 2008, the idea of record levels of cash just waiting to invest in the markets is not evident when viewed in this manner. Source: Bianco Research, LLC. September 20, 2011

QOTD: When This Cycle Ends… Posted: 23 Sep 2011 07:30 AM PDT You are so CORRECT with this observation, IMHO:  Before this full cycle ends, will the March 2009 lows hold? Ron Griess of The Chart Store fame makes the following observation: “[Its possible that] the current phase swoon ends 1,010 to 1,100, year end stabilization/rally (right shoulder builds) and the final wipeout commences sometime next year. It is amazing how many long-term bottoms are made in years ending in 2.  1932, 1942, 1962, 1982 and 2002 come to mind.” Great stuff, Ron.

Capturing the Beauty Of The Milky Way at Midnight Posted: 23 Sep 2011 07:00 AM PDT Source: Photographer captures beauty of the Milky Way DailyMail, September 21, 2011

10 Friday AM Reads Posted: 23 Sep 2011 06:30 AM PDT Ahhh, not quite so busy today. Here are what I hope to read when I get 3 minutes today: • Why Identifying a Bubble Is So Much Trouble (Bloomberg) • Kass: Low Rates Don’t Hold the Answer (The Street) see also What Really Caused the Eurozone Crisis? (The Street Light) • Global Stocks Drop 20% Into Bear Market as Debt Crisis Outweighs Profits (Bloomberg) see also Global economy alarm bells ring (CNN/Money) • Lowenstein: The War on Insider Trading: Market-Beaters Beware (NYT  Magazine) • Do Regulations Really Kill Jobs Overall? Not So Much (Pro Publica) • Mercedes-Benz Sales Growth Slows in China (WSJ) • Housing Survey: Bye, Bye To The American Dream? (Trulia Insights) see also Housing Slump Hits New Mortgage Loans (WSJ) • A Business Insider retrospective (Macro.org) see alsoBusiness Insider, over-aggregation, and the mad grab for traffic (Reuters) • Can Meg Whitman: Be Hewlett-Packard’s Steve Jobs ? (BusinessWeek) • Parsing Netflix's 'Apology' (NYT) see also The internet is a brutal taskmaster – even for Netflix founder Reed Hastings (Telegraph) What are you reading? >

Fed, Mortgages, Housing Posted: 23 Sep 2011 05:30 AM PDT Fed, Mortgages, Housing September 22, 2011 David Kotok "The Lord giveth and the Lord taketh away."  –Job 1:21 We shall paraphrase.  The Fed giveth and the Congress taketh away. First the Fed. By now, everyone between here and Mars knows about "Operation Twist."  Simply put: the Fed is selling short-term securities and buying longer-term securities.  The overall size of its portfolio remains the same.  Markets reacted with a lowering of longer-term interest rates.  The 10-year benchmark US Treasury note traded to a record low yield; it is currently 1.78%.  The 30-year bond broke below a 3% yield and is currently at 2.89%. Shorter-term rates are unchanged.  Worldwide dollar flows coupled with huge excess dollar liquidity balances combine to keep these rates near zero. The 2-year Treasury note yields 0.19% this morning.  The Fed is committed to maintaining its very low short-term rate strategy for two more years.  BTW, Bernanke's term as Fed Chairman ends in 2013.  Every Republican candidate has indicated he/she would replace him if elected president.  Bernanke has the votes (seven affirmative) to continue his policy; he is now accustomed to three dissenting voting presidents.  The market is used to them, too. The Fed also committed to rolling its mortgage portfolio by reinvesting cash flows into more qualified mortgage paper.  This policy action was a surprise to many observers.  The mortgage paper originates with the federal agencies (GSEs).  It is riskless because of the US government backstop of Fannie Mae, Freddie Mac and FHA.  Residential mortgage rates reacted by falling.  We are about to see the 15-year conforming mortgage interest rate below 3% and the 30-year below 4%.  This policy is designed to help the real estate market stabilize.  Thus, the Fed giveth. Now to the Congress, where the lunatics we elect to represent us taketh away. Congress has been in a fight over funding FEMA, which needs money.  It is dealing with hurricane and flood damage from South Carolina to Vermont.  It also needs to be prepared for the next event.  The post-Katrina FEMA cannot exist as a "pay as you go" and/or "wait until we need you" agency.  It has to be forward-looking so it can react to crisis in a timely way. But Congress is stymied by those who will not fund emergency appropriations without cutting something else.  So FEMA sits in limbo while Washington fiddles, Texas burns, and Vermont tries to dry out.  What has that got to do with housing and the Fed?  Answer: a lot. Here is an excerpt from a research note penned yesterday by Charles Gabriel of Capital Alpha Partners, LLC.  We thank Charles for giving us permission to share this note with readers,  and for providing the links to see the details. Readers: please take a few minutes and examine the information in the links below.  This is huge.  In New Jersey, as an example, every county is negatively impacted by the Congress' inability to reach common ground decisions. "Last Chance Hopes for a Loan Limit Reprieve Are Now Dead – What Does ItMean? "… Separately, Feinstein’s decision to hold back her last-ditch amendment was said to be due to a lack of Republican votes, although as we wrote earlier, the measure would likely have gone nowhere in any event. This means that the higher loan limits can now be considered all but officially dead, unless they are reinstated retroactively later this year (a prospect only in the event of another sharp implosion in the economy). "… perhaps the most worrisome effect could be that in some 620 of 3143 U.S. counties, or 20% of the total, an average drop of as much as 14% in FHA loan rates might ensue, with an even bigger impact (per the National Association of Home Builders) 'because these counties include significant concentrations of population and housing.' Thus, the FHA-related change might impact as much as 59% of all owner-occupied housing in the U.S. [See a useful NAHB study summary here and chart of affected U.S. counties here.]" Many thanks again to Charles Gabriel, his partner Jim Lucier, and their colleagues for superb research. As for our elected Washington lunatics, we fear that Congress may undo all the Fed is trying to do.  It seems to me that the finger-pointing by Congress at the Fed is aimed in the wrong direction.  House Members and Senators of both parties need to look in the mirror. We are headed to Helsinki and Stockholm next week.  Helsinki for brief meetings (one day) and then to Stockholm for the Swedbank annual global economic outlook meeting.  It will be followed by the Global Interdependence Center conference (www.interdependence.org).  European sovereign debt issues and resolution options will be the subject of both the public portion and the private discussion. Some thoughts on stocks before we leave for Stockholm. It looks like markets are going to test the 1100 level of the S&P 500 index.  That was the intraday low reached on August 8 and retested twice in the futures market.  Was it an interim selling climax or was it "the" selling climax?  History suggests it was the final climax, if we are not going into another recession.  If we are heading into recession again, history suggests that the bear market will be longer and the bottom deeper. We are on the "no recession" side.  Slowdown yes, but steep recession, no.  We admit that uncertainty is very high, and all expectations have wide confidence intervals.  We look at the S&P 500 Index dividend yield and see it higher than the riskless 10-year Treasury note yield.  We look at conservatively estimated earnings yields and compute an equity risk premium of 600 to 700 basis points.  That is an extraordinarily high reward for anyone willing to invest in stocks.  History shows it is a bargain.  We will seize it.  Our longer-term target for the S&P is above 2000 by the end of this decade, if not before. Skoal. David Kotok, Chairman and Chief Investment Officer

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