The Simplest Explanation

The Simplest Explanation? In over 30 years on Wall Street, I cannot remember such a prolonged period of time when the Bulls and Bears were in such agitated disagreement. Zero Hedge has an excellent collection of specific factors suggesting that the economy and the marketsare going to get worse. There is a blunt force of impact to such ZH topics as Quant Divergence, Backup Liquidity Providers, Volatility, CRE, Stress Test Shenanigans, Bailout/Stimulus Alphabet Soup, Administration Thuggery, Breakdown of the Rule of Law, etc. “Why I am Freaking Out” is a good summary of how this affects the regular reader, and Lira correctly argues that much is explained by self-fulfilling prophesies from the Main Stream Media (not to mention CNBC - poster-boy for the Green Shoots and Mustard Seeds advocates), and correctly points out that that is neither good nor bad. “Gonzalo Lira” also very effectively ‘lifts the veil’ on the arguments of the optimists to examine their sorely lacking fundamental underpinnings. But while entertaining, Lira’s arguments have the feel of debating points, and the ‘selffulfilling prophesies’ view of macroeconomics doesn’t fully explain Mr. Market driving into the camp of the optimists. While also a Bear, I have been searching for a more comprehensive explanation, and this exposition is an attempt to connect more of the dots (albeit with the usually disclaimer that such an exposition must skim the wave-tops, and of course, most of the topics covered are outside my sphere of expertise), without concluding that we should all head into the bunker. In other words, can a Bear with conviction still have Hope? Occam’s Razor suggests that we find the simplest explanation, the one with the fewest unsupported assertions. The simplest explanation, it seems clear to me, is that THE BULLS AND BEARS ARE BOTH RIGHT. Certainly this is simpler thanone or the other being right. Of course, another simple explanation is that BOTH ARE WRONG. More about that later. Is it even possible for both to be right? To test this, I break the process into three steps. First by reducing the competing arguments to simple statements (which reduction is necessarily subjective), Second by laying out a conceptual framework for the markets, and Third, by suggesting a set of behavioral rules that – possibly - ties everything together. FIRST. Reducing the arguments sets to a minimum. BEARS: 1. The real values (the new low ones) and credit losses are not properly reflected in the markets 2. The economy has not turned the corner and may be getting worse, and the stimulus plans won’t work

3. Government expansion will lead to higher interest rates, currency deflation and commodity inflation BULLS: 1. The market always anticipates a recovery, there are reserves of liquidity, and credit is flowing 2. The World Economy is fundamentally strong, and the stimulus plans have worked (and indomitable human spirit, etc.) 3. The necessary evil of deficits will be cured by growth and nudging the economy into more productive and efficient directions

SECOND. A conceptual Framework of the Markets. In what might seem like a diversion, let me next try to sort out a rough picture of the market landscape. I have been thinking about this primarily because I get a headache when I can’t organize a problem into easy-to-understand pieces. Although I am comfortable with complex reorganizations of corporate capital structures, the instruments in the structured/derivative world give me a headache every time I try to understand the relationships (if any) between diverse things like SPY, DIA, JPY, USD, EUR, LCDX, IG12, M1, UST30, UST10, VIX, LIBOR, Gold, Oil, etc. So I tried to stuff all financial instrument ‘Primary’ Markets and their derivatives into the smallest number of categories. 1. Commodities (Minerals, Food, Energy) The real answer is Two: Things and a. Cash/Spot Commodities Entities, but the rest of the list is a lot i. Futures easier if the answer is Four: Commodities, ii. Options Real Estate, Corporations and iii. Mutual Funds Governments (list at right). iv. Index Funds v. ETFs The point of the exercise is to observe all vi. Royalty Trusts the derivative instruments that have 2. Real Estate (Resid., Comm. & Indust.) proliferated over the last 30 years, and a. REITS where they fit in (would love sector experts i. Options to expand and fill out the list, especially if ii. Mutual Funds they can supply market sizes). Please iii. Index Funds note that since Government is arguable a b. Mortgages first derivative, Currency Options could be i. MBS/CMBS argued to be third derivatives. Why does ii. Collateralized Debt Obligations this matter? Because all derivatives have (CDO, CLO, CDO^2, etc) one thing in common: their essential iii. Credit Default Swaps purpose is TO CREATE LEVERAGE. iv. Reference Index Derivatives (Markit) Hedging you say? Sure that is the v. Mortgage REITS

marketing pitch, but I have never heard of 3. Corporations (including Financials and a derivative market with only hedgers, Capital Equipment) there are ALWAYS speculators (as there a. Corporate Equities should be), and hence leverage. OK, i. Options perhaps a simple Mutual Fund does not ii. ETFs directly introduce leverage, but in fact the iii. Mutual Funds ‘diversification’ attracts more individual iv. Index Funds investors, and more capital to the markets, v. Royalty Trusts marginally inflating the equity capital base, vi. ETC hence permitting more corporate leverage. b. Corporate Debt And if an innocent index fund indirectly i. Credit Default Swaps introduces leverage to the system, you can ii. Collateralized Debt Obligations just image what iTRAXX or IG12 do. (CDO, CLO, CDO^2, etc) iii. Index Derivatives (Markit) We all know how financial entities were iv. Interest Rate Derivatives forced to deleverage over the last 18 (LIBOR, Prime, etc.) months, and the raging argument over 1. Spreads whether it is complete, or not, or merely 2. Swaps transferred to the balance sheet of the 3. Options Federal Reserve and the Treasury. But 4. Governments the sheer size of the derivative markets a. Debt (incl. State/Municipal) means that even when (or if) the dei. Options leveraging is complete, there is systematic ii. Futures leverage imbedded in all of these financial iii. Money Market Funds instruments. iv. Mutual Funds v. ETFs So What? So if there is really more and vi. Interest Rate Derivatives persistent leverage out there, then our 1. Futures instinct about the correct level of values 2. Options (assets, securities, or derivatives) may be 3. Spreads significantly skewed by our lack of 4. Swaps understanding of the true structure of the b. Currencies markets. i. Options ii. Futures Has anyone tried to add up all of the iii. Mutual Funds known equities (you can get it on iv. ETFs Bloomberg), corporates, mortgages, commodities, currencies and governments, and then tried to correlate that with all of the know owners of financial assets (individuals, pensions, mutual funds, financials and sovereigns)? I can never get close to an answer. And when you get the inevitable delta, is the answer leverage, derivatives, or both? So my conclusion about the markets is that they are significantly more complex than ever before, and while experts can understand each market sector or sub-sector, it is not possible to grasp the ENTIRE market. Certainly not for someone at Treasury or the Fed. But more importantly, even if people had a grasp of the markets when working, certainly nobody could grasp them when major parts are broken. And then introduce changing rules, and the prospect of new changing rules, and we have a problem.

THIRD. Elementary Behavioral Rules Apologies to people who actually know something about this. Just as Lira said, the markets and economies are a mix of Rational and Irrational. Neither is right or wrong, good or bad. Nor can one ascribe short-term or long-term to either. 1. Humans explain their decisions as Rational and explain their detractors as Irrational 2. Human nature expects that over time: a. asset values will rise b. depleting resource prices will increase c. production will become more efficient d. there will be a reversion to the Mean 3. Humans are comforted by: a. known rules b. the ability to predict outcomes 4. Most investing is governed by Fear and Greed, but humans are essentially optimists Unfortunately, humans make a lot of mistakes, so their ability to discern Rational from Irrational is very subjective. They are also often wrong about time series: not only do asset values constantly deteriorate without maintenance, but they frequently become obsolete; while truly depleting resources ought to rise over time, humans are not the best at estimating the extent of the resource, and they are bad at predicting technologies for increasing production, conserving, or replacing the commodities; although it is true that production generally becomes more efficient, humans are usually too optimistic about this. And since they don’t know where the Mean is, anyway, you can never tell when it is reverting (or where to). Regarding rules and outcomes, humans frequently fail to observe that the rules are constantly changing, and are shocked when they notice the changes, and while they joke about the inability to predict outcomes, this is in fact their favorite sport. And because humans also have trouble telling when they are reacting primarily out of Fear, or primarily out of Greed, they are often overreacting. But this environment is different for several reasons: A. There HAVE been a series of shocking events that MUST make it more difficult for people to differentiate Rational/Irrational and Fear/Greed. B. NOBODY’S long term expectations can withstand a DOWN 60%, UP 30% swing. C. The RULES have been changing faster than ever.

D. The structural framework of the markets makes them impossible to understand, with new untested securities that act in non-intuitive ways, and with hidden structural leverage in many layers of the markets. E. Not only can you lose your job for being wrong, but in this environment, you can lose your job for trying to do the right thing

Weaving it all together How can everyone be right? We have extremely diverging opinions, driven by extremely unusual events, in an extremely complex and untested market, with rules changing faster than ever, subjecting humans to the WORST POSSIBLE environment for their REALLY BAD skills of prediction. The only consistent answer would seem to be that each side has been driven by isolatedfact sets to draw extreme conclusions. All (or most) of the facts are correct, and the conclusions must be modulated to become consistent. Real Values. The Bears are right that there are more bad things coming: credit losses, unemployment, demand destruction and earnings disappointments. But the Bears are not suggesting that the Dow will drop to 5,000 and stay there for 10 years. Nor are the Bulls suggesting that the Dow won’t drop (or even drop to 6,500). Shorting the market is too dangerous with all the rules changing. So make selective long investments and accumulate slowly. The Economy. The Bears are right, the stimulus won’t work. However, they are not suggesting that the wheels will fall off again, nor are the Bulls suggesting strong growth starting in August. The answer is that the economy is fundamentally sound to have stood up to the shocks of the last 18 months, and it will recover, but starting in mid2010, and it will be gradual. Deficits and Interest Rates. The Bears are right here too, but are over-stating the case. The Administration will not drive the deficits over a cliff in each of the next ten years. There will be cuts, and there will be taxes. And the economy will grow out of the deficits eventually. And what if the Bears and Bulls are BOTH WRONG? (the second most simple solution). That is really suggesting that we repeat Japan’s bad experiment from the 1990’s to present, or that we need WWIII to pull us out of the Second Great Depression. It really seems hard to imagine, UNLESS, two things happen (both of which are not impossible): A. The RULES keep changing in a volatile fashion B. Capital starts to flee in frustration and fear

However, even the MSM has picked up on the Administration tactics, and Chrysler, GM and Health Care should represent (we hope) a peak in the ability of the new President to make radical changes. How would I handicap it? Both Right

45%

Bears Right 25% Bulls Right

15%

Both Wrong 15%