Tuesday, July 27, 2010

Further on the Left Tail Risk....

In addition, to the as yet to be realized jobs being supplanted by technology and the real estate issue.  Remember the baby boomers are going to need nursing homes not vacation and primary homes, can you say glut.  Add a nice top in gold to go along with the previous two and we've got lot's of opportunities for a left tail risk event.... 

Gold Top?
As most people  know, gold has been in a raging bull market for more than 10 years rallying from about $250 per ounce to more than$1,250 per ounce. Many people are now wondering if the world's currencies have any value at all and are flocking to gold as the only hard asset that historically has always had value.
Gold coin purchases are at an all time high. There are people walking up and down city streets and in shopping mall, holding signs saying "We Buy Gold." There are even vending machines where  people can purchase gold bars. Of course, there are the ubiquitous commercials on TV about gold.
Does a contrarian look at all these factors and take the other side? Possibly, but the problem is most of these factors have been present for more than two years and gold has rallied more than $400. Why would gold be any different now?
I believe the psychology of the gold market is in a dangerous place, but manias can go on longer than people think. This happened in the real estate market in 2005 when everyone rushed in. Real estate TV commercials ran nonstop, many were buying second homes as an investment with no down payment, bankers were giving loans to anyone.
It took about three years for it to finally come apart. The gold and real estate markets are not related, but the mass psychology is eerily similar.
Are we finally at that tipping point? I believe we are.
Until two weeks ago, gold had been in a steady uptrend since February.  It was going up because of inflation or deflation; it was going up because Euro weakness or Euro strength or it was going up because of stock market strength or stock market weakness. People on CNBC have even said gold will never go down.
But close inspection of the gold market at this time show many technical difficulties that may bring it down. Below is a candlestick weekly chart of the gold market.

Source: Barcharts.com
Gold set the all time high of $1,264.80 per ounce during the week of 6/21/10, but that week also formed a candle stick called a "hang man". This is when a market breaks off the highs but then runs all the way back up to the previous daily or weekly close. The next bar is critical because it must run back down and close under that previous low.  As you can see, this is exactly what happened.
The chart below also shows some import reversal patterns. This is a daily candlestick of gold. On June 21, gold made an all time high but closed below the previous day's low. This previous day was the all time high. This can bea very bearish sign. Also notice it happened againjust five days later.

Source: Barcharts.com
There have also been some major divergences recently. The Gold Bugs Index bug index (HUI), a basket of un-hedged gold stocks, topped out in March  2008 just as gold did. From there, both markets had severe sell-offs. Since then, gold has come back to make new highs in November 2009, and then another rally to an all-time new high again in June.As you can see, HUI has not confirmed this high, not just once but three times. This triple divergence is also very dangerous.

Source: Barcharts.com

Source: Barcharts.com
The last component I analyze closely is the Commitment of Traders Report (COT).  The rally in gold this year has gone to new highs but buying from managed futures traders (the purple line) has not had the buying enthusiasm that accompanies these type of rallies. The large spec (the green line) also has been a reluctant buyer. The commercial trader (the red line) set an all-time record on the short side in March. This type of selling from commercials does not pinpoint tops, but it does put you on alert for possible market failures.

Source: Barcharts.com
Calling tops in a raging bull market can be very difficult and painful,but with so many yellow flags, there seems to be a great trade from the short side. If gold closes below $1,170 per ounce I think the gold market is in for a large fall.
Bruce Gwyn
Managing Partner
Level III Trading

web: http://www.level3trading.com
email: bgwyn@level3trading.com

Are jobs the left tail risk?

 Left tail risk in my view is likely the rapid displacement of jobs, this will gain momentum remember this is the gift that keeps on giving and the faster technology develops the faster people will be displaced.  Another left tail risk is definitely real estate, real estate appears to moving forward and holding it's own the real test will be the spring of next year to see if it sticks.

Guest Article: Left Tail Risk
by Duncan Frearson, Smith Street Capital , July 22, 2010

Seemingly small initial events have cascaded many times into far from normal outcomes. These can both act in a positive way, such as birth of the Web browser or the discovery of oil, or in a negative way, such as the 1929 panic, by damaging economic conditions severely.

Popularized as “Black Swans” these three sigma events tend to occur slowly at first and then rapidly escalate. In 1929 a bankruptcy of a large conglomerate is said to have begun the great unwinding that led to the initial stock market crash and then the subsequent Great Depression. In early 1997 funding problems at major Thai finance companies and the consequent decision to float the Baht began a run on Asian currencies. In 2007 some initial defaults in the U.S. subprime mortgage market escalated into a nationwide housing collapse and financial panic.

Why does this happen?
Collapses generally involve high degrees of leverage. Large scale leverage can be gained by very loose lending or by the use of derivatives with incredibly low collateral requirements.
Leverage in and of itself is not such a bad thing as it can be used to finance a house, or a car or a new factory for production, but when it becomes concentrated into certain end markets in a large enough way it can have devastating consequences. If this lender or borrower is also connected in some way to another institution that also faces the same type of concentrated exposure, then the pain has been multiplied. Two becomes four which becomes eight which becomes 16, etc.

This happens rapidly. Once a critical mass is reached, the problem becomes somewhat unstoppable under normal conditions. However, if this rapid escalation gets muted by hitting a well capitalized diversified number of lenders only one or two institutions would then be the ultimate victims. One way to mitigate this risk within a closely knit system is to require concentration limits to various borrowers and categories. In the U.S. banking system individual loan limits have been in place for awhile, but no hard limits for lending to entire categories have been put into effect. In our latest bust we saw a chain reaction occur due to a huge build up in exposure to housing both in construction and development lending and in mortgage lending.

Once this trend began to come undone banks found they were all connected in a fairly concentrated way to one another. To make matters worse, a certain segment of their borrowers were the same people involved in constructing the houses.

Source: SNL
The cascade across Asia in 1997 had the same fundamental issues. Concentrated lending in real estate and infrastructure development caused one failure to cascade through the regional lending system, multiplying the initial problem across many players.

In all these instances the banking system itself was unable to stem the cascade and the only solution was large scale involvement from both the central bank and the government. In the case of large foreign debtors the IMF was also called in to provide dollar funding.

Is there a way to reduce this tail risk to the system? It would seem that imposing limits on concentration not just to individuals but also to categories would provide the ideal roadblocks to this type of dangerous cascade.
The question of whether this was tackled in our latest financial reform is certainly a good one.
In 1933 Glass-Steagall approached the problem by limiting the activity of the deposit banks. Investment banks were left to run stock lending activity but margin requirements were put in effect to keep the down payments high.
If some stock market players began to default depositors would not be impacted because the investment banks that tended to borrow widely from the capital markets would spread the pain around. There was a cut-off in place that isolated the risk.

This was eventually overcome by investment bankers using securitization markets to get into the bank lending business through finance companies which caused a boom in lending in housing related markets at the deposit banks.
The two players became connected again and once the investment banks began to get into trouble, the concentration that had built up at the deposit banks in the same market began to cause problems.
All this was accentuated by the build up of credit insurance written against that same lending that was now facing claims and by the off balance sheet lending that created far greater leverage than was immediately apparent.
In today’s environment there has been talk of another cascade from the build up of sovereign debt at some of the less stable nations of the world. Sovereign debt has been used to provide a bridge to allow private market participants to restructure their own finances. We might look to budget deficits as a far from normal condition but this is a different state of affairs as governments will only default when they have foreign debt exposure that can’t be paid back by raising domestic currency.

In the case of Europe the banks have access to dollar swap lines from the Federal Reserve and access to domestic currency has been assured by the ECB. This means that despite challenges in certain European nations there is virtually zero risk of a cascade as principal payments are essentially assured.
There is also talk of another cascade to be set into effect from a further decline in U.S. house prices. I think one of the fundamental changes at present however is that the concentration risk in the U.S. system has been reduced and housing collateral values have been reset at far lower levels.

There has also been a build of protective capital at the large and regional banks capable of preventing the type of cascade we have recently seen. This new capital buffer would require a very large decline in what is arguably a less concentrated book of business in order to cause the same sort of chain reaction we saw in 2008.
Government involvement in the housing market provided an initial boost but as they wind down these programs a subsequent drop off in activity is almost inevitable.

This uncertainty can cause tremendous volatility.and we must be careful about any premature extrapolations.
For example, when the “cash for clunkers” program approached its roll-off date, auto sales rose to over 14 million annualized units and then dropped to around 9 million a month later. Auto sales now stand at 11.3 million units, according to industry data.

The housing market may well see the same sort of volatility in sales activity.
It should also be noted that the sensitivity of consumer discretionary income to declines in interest rates, given the 15% or so of disposable income that is taken up by debt service is especially pronounced and the rise in refinancing activity will not only facilitate the large rollover burden, but will also help keep those teetering on the edge from losing their homes.
There is an increase in the margin of safety in both buying or deciding to remain in one’s home because of the decline in interest rates. The build-up of monetary stock in the economy and the Fed’s communication of an “extended period of low rates” will continue to keep both short and long term interest rates low for the foreseeable future.
Ultimately, the question is how does a manager price this tail risk and is the pricing for this protection reasonable.

We believe the risk of another negative cascade is low.
If this is the case, the premium required for portfolio protection in the next 12 months is not such a great deal. Another option is to hold cash as a protection of principal, but at a 0.32% yield for 12 months, it becomes economically expensive considering the higher yields available in owning high quality equities.

If you believe, like we do, the tail risk is low, then holding high quality equities with stable earnings in a zero growth environment will provide you with a far better yield than holding cash. If the economy eventually grows then this will be icing on the cake.


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