The Inevitable Correction Seems to Have Arrived

This week finds us more than a little chastened by a Market correction that seems to have arrived a bit sooner than I expected. Last week’s Musings ended with: The Market got its badly needed excuse to sell off, ... but long term investors who are attuned to the global economy should not be dismayed. By midday Friday, dismay would be a very apt way to describe my frame of mind. With the Nasdaq having already already melted some 8% over the dozen or so trading days since its January 11 (intraday) peak, it seems more likely than not that a bona fide correction, as opposed to a mere “pullback”, is upon us. This installment of Musings will explore some of the putative reasons why the prevailing bias seems to have inflected in a southerly direction.

The first thing to remember about a Market correction is that it really doesn’t need a reason. Nature’s tendency to impose regression to a mean can and does suffice. Whenever the pullbacks that were experienced along the way since the March 9 seemed like they were about to become the new norm, there were plenty of “reasons” being proffered by the hired guns of Wall Street and their media enablers. We should not be surprised to hear this chorus grow louder in the days ahead. I can remember toward the end of that swoon that ran from mid June until the day Intel’s Q2 results ignited a rally (and set the stage for the sucker’s game of trading ahead of earnings that has failed the not-so-smart-money so spectacularly these past two weeks) hearing a lot about technical breakdown and ahead of the earnings, etc. The same was true during the multi-week pullback that was seemingly precipitated by purportedly disappointing (i.e., they blew away official estimates, but analysts “expected” more, and outlooks fell short of somebody somewhere’s all-but-certainly-unguided expectations) earnings in the latter part of October. My experience has been that the “reasons” for the Market to go up or down are always there and don’t change as much as they seem to. What changes, from day to day and season to season, is what gets focused on, spotlighted if you will, by the seeming keepers of consensus. It’s as if there are a bunch of cue cards that we are all supposed to heed, and the Market shifts direction to the extent that someone somewhere decides which set of cue cards to use. (Ah, the dreaded unseen “they” who are behind the misfortunes of the conspiracy minded. Human nature is such that it is more reasonable to believe that coteries or factions will attempt to rig the system in their favor than to assume that some moral compass or fear of punishment will rule out this possibility. Just because manipulation, or any ad hoc behavior for that matter, cannot be proved or even directly observed does not mean it does not happen, any more than irrefutable assertions, a generation ago, that the Mafia “did not exist” disproved the existence of organized crime families rooted in Sicily.)

This pullback or correction that has overtaken the Market does not need a reason, some fact of life that was not in play the when the trend was the Bull’s friend, but I think a few catalytic factors have entered the mix. Much has been made of financial troubles in Greece. Substantively speaking, this should not be a big deal, as Greece is just not that much of country. Its population is only 11.3MM (up only about 340K in the last decade), which is fewer people than Texas has cows or Mongolia has sheep. Its GDP approximates the market cap of Exxon Mobil. It is less than one third the size of New Mexico and most of that (86%!) water. It is hard to think of what assets it has besides tourist venues, and its leading export seems to be people. Greece has been around longer than just about any people group presently extant, thirty centuries at least, and yet they couldn’t bring themselves to organize into a country until 1830. If the whole country were to take note of Mongolia’s very low people/sheep ratio and move there (a sort of mass "embraceable ewe" hysteria?), would the world economy notice? Hardly. I think what is in play here, besides someone somewhere with influence over what scripts get read or what “research” gets published trying to scare you into doing something stupid, is that players of all stripes are being reminded of a recent traumatic experience. The fear of imminent global collapse, so rampant only a year ago, has died down, but it left painful scars that have not healed. Visions of dominos (metaphor run amok!) jellify the knees of traders and investors. The smart money senses this and piles on, confirming the not-so-smart’s worst fears, and we get a Market correction until the path of least resistance is no longer down.

If there is a true catalyst for this apparent correction, my guess is that is that it revolves around political developments, or perhaps nondevelopment. It is a continuation of what fell into place last March. As Musings noted on March 25: “For weeks on end up until the Market’s first upward surge, we were being treated to volumes of scary-making talk of transforming our experiment in ordered liberty into an amalgamation of Chicago and Berkeley, with a sprinkling of Havana thrown in. Control of both Houses suggested that “get it all in a hurry” was going to be unstoppable. The thing is, it only seemed that way. What occurred to me as that buying stampede wore on was echoed a few days later in the WSJ by Mr. Karl Rove. He noted that every Administration starts with political capital, which they inevitably spend. It’s just a matter of time, and some spend it much more quickly than others. I can remember when Reagan had basically spent his c. 1986. It occurred to me that this time, the collective efforts of this crew had thus far been so amateurish, so evocative of Commencement Day at Clown College and so presumptuous of success as to perhaps set a land speed record for blowing one’s political wad.” It was the realization of this that launched the rally which came to denote 2009. Along the way, in thinking about what might sustain a recovery, it became plausible to suppose that we might be headed for a redux of that Clintonesque triangulation that the Market seemed to applaud fifteen years ago. The notion developed that much the way the Clintons overreached, were rebuked and then changed course in ways that facilitated relatively benign governance (from capital’s point of view, you know, things like welfare reform and NAFTA), the HopeNChange Express was on a collision course with humility and would alter their ways accordingly. This salubrious outcome was expected to be delivered in November. It came early, most recently and vividly in Massachusetts, but the drama has thus far not followed the aforementioned script. We see heightened intransigence where a shade more comity was expected. We get shrill reminders, replayed ad nauseam by the financial media, of the sort of rabid populism that degrades and ultimately destroys any economy it infects. Instead of a Clinton redux, we are left with the unsettling sense that some would move us in the direction of Chavez. (Speaking of that redux, remember that by no means is everyone who is cheering the political incapacitation of this Administration a Republican. We should not be surprised that in the back rooms and soirees were campaign fund raising takes place, it is becoming common knowledge that our Secretary of State and her husband are stepping up their heretofore low-key campaign to return to 1600 Pennsylvania. The slow drip poison accompanying that game is going to make for unsettling developments in the next couple of years.)

What is especially vexing about this downturn, and what likely caused my overly optimistic sense that the rally would stay intact for a while longer, is encapsulated in those words lifted from last week: “attuned to the global economy”. The fundamentals are not great a la what they seemed in 1999 or 2006, but who among us expected anything but a slow recovery? If anything, much of the news is far better than we were expecting even a few months ago, and certainly better than we had any right to expect at the Bottom. No one saw how strongly so much of the global Tech sector would recover. Yet here we are in the wake of the earnings season where monster blowouts by INTC, MSFT, STX and down the line culminated in Tech leading the rout. It could be argued that to the extent “Tech” is synonymous with “risk” and risk aversion just came back into style, this makes sense. This betrays an outdated notion of much of the Tech world. How many countries are better risks, better credits, than Microsoft or Intel? Which would you rather trust with your capital for the next twenty years? No, something else is afoot. What I think has happened is that the Street (those big firms who publish research and invest on their own accounts) recognizes just how great the prospects are for much of the Tech Sector over the next several years, but they didn’t figure it out fast enough to back up the truck and accumulate enough (the trouble with the greed-addled is they have no sense of “enough”.) So we get all this hokey “research” fraught with constructs like “normal peak multiple” and when the mood turns as skittish as it has been these past two weeks the owners at the margin give it the benefit of the doubt. This research is redolent with what seems to be willful ignorance. (Ponder just how much relative weight to accord to each of these terms.) I have a very large bet on certain parts of the Tech Sector (see my List), and either the companies have succeeding in bamboozling me with the steadily strengthening outlook that I have pieced together OR the Street is trying to bamboozle us with its research. The next Musings will address why I am gritting my teeth and riding through this rough patch with an outsized bet (i.e., the four largest positions constitute about a third of my investable net worth) on these Tech stocks.

The Empire Strikes Back (Volcker = Vader?)

Talk about a sudden mood change! This holiday-shortened week started out with all eyes on Massachusetts as referendum on health care reform but ended up being all about the Administration’s proposals to change up the rules for the banking industry. What seemed like applause for the swan song of Government-Issue Health Care quickly gave way to the rumble of investors heading for exits, swept along by their not surprising disdain for any such sudden thickening of atmospheric uncertainty. There has been a lot not to like about the populist trash talk that the Administration has directed at the “evil fat cats, et al” who by the way contributed so much to their political success, but I find it very encouraging that they seem to have tumbled to the understanding that was articulated in Musings few months back (Nov. 11) . That would be that something akin to the Glass Steagall Act, which separated deposit-taking banks from investment banks, needs to be re-imposed if we are going to make any sort of headway in managing down the “too big to fail” problem.

If this week’s reversal dented your net worth and dinged your sense of being on top of the ebbs and flows of Market sentiment, remember that it could be worse. You could be the Attorney General of the Bay State. One suspects that for years to come, any politician who suffers a really bad day can look in the mirror and say, “Well, at least I’m not Marcia Croakley!” Her candidacy was emblematic of corruption, the sort of decay that sets in when a “machine” is imposed and then goes for decades without an effective challenge. How else to explain the fecklessness that denoted both her campaign and career? Like an army that had been at peace for decades and no longer bothered to even drill, the gang that thought they had everything under control was no match for a no-name adversary they could not bring themselves to take seriously until it was too late. It all happened too quickly to know exactly what to make of Mr. Brown. Having been constantly reminded of the huge disparity that often exists between public persona and “what the family sees” (St. Elizabeth Edwards most recently comes to mind), it is quite premature to form much of an opinion about him, other than that he is hard working, a gifted politician and has a fetching family behind him. It struck me as bizarre when on the morning after there was speculation about him running for President, seeing as how six weeks ago almost no one outside of Wrentham, MA knew who he was. Then it occurred to me that “obscure State Senator jumped up to U.S. Senator and then commencing a successful run for the White House a few months later” has already happened. How often do you suppose he voted “Present”? He seems likely to be at least a modest net positive for the World’s Greatest Deliberative Body, but it remains to be seen whether he is even remotely qualified for the job of Chief Executive.

So the Market went from anticipating the death of Health Care-reform-as-an-exercise-in-imposing-Statism to withering under a gamut of uncertainties no one was thinking about during the three day weekend. I am skeptical about both the intentions of the Administration and the government’s collective ability to end up with something that actually does less harm than good, but I do like the essential thrust that recreates a “wall” akin to what Glass-Steagall imposed. That was a suboptimal fix as well, that had to be tweaked along the way, and not every tweak was for the good. We have a pretty good idea of its consequences, intended and otherwise. We also have viscerally memorable experience with the unintended consequences of that “wall” going away. How awful would it be if banks evolved back into boring businesses, like utilities or cereal makers or big drug store chains? Taking deposits and lending against them based on collateral that can be understood by anyone with a rudimentary knowledge of business (i.e., your typical bank examiner) might not be an exciting business, but it can be a not-bad business. Banks that want to offer insured deposits and have access to the Fed window should not be engaging in activities that even the Sage of Omaha finds incomprehensible. Investors seeking safety and relative predictability will migrate in that direction; if other investors want the kind of “excitement” that comes from the creation of “products” akin to alchemy and perpetual motion machines, we can be sure that the investment banks will provide them the opportunity.

What needs to happen is for banks to be given a window of time, five years would probably do it, to wind down or spin out their hedge fund-like activities. I would give them a year to affect either a wind down or a partial spin off, with a provision that their equity interest in such activities is permissible, but will be subjected to escalating “haircuts” re its value within regulatory capital as time goes by. My sense is that to the degree the world needs the kind of speculative activity they have been providing, it will be taken up by hedge funds, whose principals face an altogether more bracing set of risk/reward terms. We will probably end up with a bit less speculative activity, and that will be a good thing even beyond its role in rendering institutions less likely to be “too big to fail”. A moderate amount of speculative activity is a good thing, a lubricant for a vastly complex system that no one could design, but this does not mean that more such “lubricant” is necessarily a good thing. Sometimes, speculation becomes like the tail wagging the dog. It happened leading up to 2007, especially in the commodity markets, and its undue influence on commodity prices has not gone away. The really galling thing is that we all get to pay for it when excess speculation pushes commodity prices to extremes. Speculators don’t “cause” much of anything, and the world is better off with at least a few of them, but there is no doubt that speculation, egged along by perverse incentives (i.e., taxpayer funded backstops to failure) exacerbate things unto wretched excess whenever momentum becomes broadly discernible (like gasoline at $4/gallon).

One obvious roadblock to dialing down what is essentially money center banks impersonating hedge funds is that it will hinder badly needed economic recovery in the New York metroplex. That economy (down for the count, as I recall, in 1991) was given a burst of steroids by all that bonus money sloshing around for everything from shoe shines to summer places. It’s going to be a long slog back any way you slice it. (Insofar as the very idea of money center owes much to a now obsolete need for physical proximity entailed in the exchange of securities, i.e. certificates that got run across town during the day before the trade settled, recovery is not a foreordained outcome.) While the amount of speculative activity, as reckoned in the number of high earning traders, analysts, etc. will find a level in line with the need, the unwinding of the mega-casinos will ripple through a local economy that has already taken a terrible beating. Expect anyone who has a stake in the viability of that local economy to push back against reform harder than most of the rest of us are willing to push for a lasting semi-solution to “too big to fail”. Nonetheless, by acknowledging the root of this problem, that human nature is such that “bank” preceded by “investment” is the very antithesis of the safety and security that word is supposed to connote if its principals do not have copious quantities of the right kind of skin in the game, the Administration has given us the most hopeful signal we have seen in a very long time. The Market got its badly needed excuse to sell off, and rightly fears that there will be collateral damage even if the new regulations move us in a basically right direction (like the last time Mr. Volcker was calling the shots), but long term investors who are attuned to the global economy should not be dismayed.