Interview: Precision Capital Management's Bob English on Market Manipulation

by: Wall St. Cheat Sheet

Conspiracy theories are nearly as old as the first human thought. However, there is a valid demarcation between presenting a collection of complicated facts as opposed to connecting stars from across the Universe.

Bob English and his team at Precision Capital Management recently distributed a buzz-worthy report entitled, “A Grand Unified Theory of Market Manipulation.” With a healthy dose of skepticism and understanding that the “Invisible Hand” is actually semi-transparent, I asked Bob to put his theory on the anvil so we could see which quality sword emerges …

Damien Hoffman: Bob, your team recently released an interesting report entitled, “A Grand Unified Theory of Market Manipulation.” Could you summarize this report for us?

Bob English: There’s an episode of an American sitcom I remember seeing years ago that featured a kid played by Ricky Schroeder and a grandfather played by the inestimable John Houseman — who, interestingly, was a grain speculator until the 1929 crash wiped him out. They decided to corner the baseball card market for Tommy Lasorda cards by buying all they could, then planted rumors that he was a shoo-in for the Baseball Hall of Fame. The scheme worked at first as they were able to sell the cards for high prices that they could set. They owned the supply and created artificial demand. However, in the end, Tommy Lasorda dumped a carton of his own cards on the market, collapsing their prices. As a side point, there never was a good explanation given why Lasorda did this.

Anyway, in the current situation, instead of baseball cards we have US Dollars, and the US government controls the supply. If the government increases supply slowly and encourages demand, the Dollar’s price erodes over time but most people don’t notice. The real threat is a Tommy Lasorda in the form of China or Japan coming in and dumping the cards (i.e. Dollars) onto the market at once. Those Lasordas don’t want to do this, but there is a point that can be reached at which they would — for example, if they saw their investment in US Dollars about to become worthless and thus had little to lose.

At the same time, everyone has a vested interest in a rising stock market. It makes the citizen-investors and Wall Street happy. It also allows the administration to pursue its reform agenda without angry citizen-investors getting in the way. Unfortunately, the government must compete with the stock market for money to fund its debt. The government is in the fortunate position of having the Federal Reserve, which can print money. However, if it prints too much too fast, it also has the effect of dumping Dollars (cards) on the markets. So, there’s a very delicate balancing act going on, with the government trying to keep the stock market going higher while not devaluing the Dollar so quickly that people and other countries become alarmed.

This is quite a bit over-simplified, but necessarily so. And, although we’re talking as if the US government has a single voice, competing interests within the government often align, but sometimes diverge. We believe the Federal Reserve Bank of New York tends to prefer a rising stock market and Bernanke, as Federal Reserve Chairman in Washington, tends to prefer protecting long term interest rates. Because Bernanke is seeking re-nomination to his post next January, he would of course like to have both. His approval ratings have soared with the stock market gains, but they will reverse quickly on another crisis. His job, therefore, depends on a steadily rising stock market without another crisis. And, the greatest threat to financial stability comes from interest rates that get out of control. We’ve only talked about the stock and bond markets here, but the derivatives markets that reflect them are key too.

Damien: What are the important issues for the major players you mentioned insofar as what guides their market actions?

Bob: In the current environment, we need to closely monitor long term Treasury yields and pay attention to money supply and interest rate volatility. According to the Bank for International Settlements, as of December 2008, the notional amounts of interest rate derivatives has exploded to $418.7 trillion, while credit default swaps — the instruments that helped cause last year’s implosion at AIG and other places — were only $57.9 trillion at their peak in December 2007. Interest rate swaps must be dynamically hedged and do not respond well to volatility. Therefore, we view this as a looming problem that could cause the next financial meltdown, with the potential negative shocks far outsizing what happened in 2008. Once long term yields exceed a critical inflection point, they will eventually spiral higher, with the Fed becoming more drastic in its responses and risking a systemic shock to the interest rate derivatives market.

We would estimate this inflection point to be between 5.00 to 5.50% in the 30 year, but in the short term, it looks like the Fed is trying to protect the 4.84% high from June of this year. It was shortly after this level was reached, having taken out the previous June 2008 high, that equities got a sharp correction.

Though the Fed has direct control over the monetary base (MO), it historically has had only indirect control over M2 money supply, which is what is watched for indications of inflation or deflation. With the unprecedented emergency powers it has both usurped and been granted by Congress, we believe the Fed now has much more control over M2 and has contracted it sharply since April.

Whether it is intentional or not can be debated, but there is an important correlation to observe. We researched and now follow the seasonality of M2 by looking at the non-seasonally adjusted figures provided by the Fed. The seasonally adjusted numbers don’t paint a very good picture of what is going on, because it is the seasonality itself that gives clues as to potential market threats. There is an annual contraction of M2 from about the third week of April into the third week of July, and we have found that when this contraction reaches a critical level — as measured by what we call M2 Volatility — there is a high probability of a strong correction in the stock market at some time over the next three months going into the third week of October. For example, S&P 500 corrections have been at minimum -9.09%, on average -16.69%, and at maximum -33.38%. Our model forecasts all nine of the corrections greater than 9% since data began in 1981, with only one false positive in 2006. All the major crashes, including the 1987 crash of -30.01%, followed strong contractions in M2. This year has seen the greatest contraction in M2 in the data set, so we believe this greatly increases the fragility of an already precariously perched stock market.

Damien: So, this means the Fed’s actions in the Treasury markets remains very important. Tell me about the August Treasury auctions and what the average investor should look for.

Bob: In general, the average investor wants to see solid foreign interest in the US Treasury auctions. Even though it competes with money from the stock market, a healthy Treasury market allows the economy to muddle through the deleveraging process rather than see continued wild swings. If the auctions get worse, we could easily see more frantic rallies in equities, but they will eventually be reversed in equally dramatic fashion.

For August, by the time this is published, we will have had the closely watched 10 year and 30 year Treasury auctions, as well as an FOMC Announcement on August 12. These will likely set the tone of the markets for the next six weeks. There will be another large set of auctions at the end of August, but they will need to be evaluated within the context of what happens this week. So, basically, we’re in ‘wait and see’ mode right now.

The key will be the renewal or termination of the quantitative easing (QE) program that began in March of this year and was designed to allow the Fed to repurchase $300 billion in long term Treasurys to support the credit markets. It has helped hold down long term yields, but the de facto monetization has also had the effect of unsustainably ramping the stock market, which is itself destabilizing the Treasury market. What’s troubling and what makes it unsustainable is that the monetization has not worked itself into the broader markets’ money supply, which means that once QE ends (if it ends) without a rise in M2, the fuel for the stock market will have evaporated with nothing to replace it.

Damien: In your report, you say you are leaning toward a failed attempt by the Fed to keep rates low and the market levitating. What does this mean for the US Dollar and Gold?

Bob: Short term, we expect the Fed will do its best to keep long term yields under control. But in the next few years, they’re more than likely to fail. The US Dollar is in secular decline and that will continue.Gold is in a secular bull market, and that will continue. The question is how controlled the movements will be.

The rest of the world is already preparing for a rotation out of the Dollar and into the International Monetary Fund’s Strategic Drawing Rights (SDRs), which are composed of a basket of currencies (including the Dollar). The IMF has already taken the unprecedented step of issuing its own debt based in this new currency. Rotation into SDRs will be a de facto default by the US on its obligations. As to gold, everyone watches the psychologically important 1,000 level. It is heavily defended and we don’t expect a breach until after the next crisis unfolds and the gold selling to meet margin calls abates. But, when it does break through convincingly, it will be the start of a rush into gold like we have not seen for decades, and there is very little overhead resistance.

Who is Reigning Over the Roost?

Damien: “Manipulation” is a dirty word. But against what benchmark do we grade the Fed? If the Fed’s manipulation helped us avert a depression with real-world repercussions like the Great Depression (e.g., bread lines, etc.), did they succeed in keeping the economy and society in positive shape, relatively speaking?

Bob: In light of the fact that we believe the Fed has been the biggest contributor to these crises through artificial manipulation of the money supply and interest rates, we are not quick to compliment. I think the best scenario we can hope for is a lost decade similar to Japan, which by no measure is what we would call success. However, if we avoid further meltdowns, it will be in large part because the Fed has managed a very difficult juggling act between not allowing interest rates or equities volatility to become too great. That will take a lot of luck too.

Damien: Ah … the great “Creator-Destroyer” like in the Hindu religious texts. If the Creator-Destroyer is now back in creation mode, meaning the Fed has prevented a true correction, are we merely kicking the can farther down the road? If so, when do we pay the ultimate tithe to the Destroyer?

Bob: We are indeed kicking the can farther and farther on an uphill road that is getting steeper. We have to keep kicking harder to get the can up the slope and it keeps coming down with increasing speed. One missed kick, and the can ends up at the bottom. We’ll be watching money supply and interest rates for clues on if and when we’ll pay the piper — but it’s difficult to make predictions beyond a few weeks. At a minimum, it will take three years to work through the deleveraging — probably more like seven to ten years. The Fed has to be perfect during this length of time. How likely is that? While we acknowledge we are in a deflationary environment currently, that can change very quickly if and when the Fed starts printing aggressively again.

Damien: Other alleged market manipulators include seemingly bulletproof Goldman Sachs (NYSE:GS). Given that Goldman had only TWO losing trading days last quarter, do you think Goldman has the most brilliant trading desk in the history of the world or a logistical competitive advantage?

Bob: Having and exploiting competitive advantages, logistical or otherwise, is what smart businesses are supposed to do, in our opinion. We develop our own competitive edges. To that end, with the discovery and help of some very bright people in a private trading group to which we belong hosted by the author of the book Value in Time, we have found there are indeed some tradable edges surrounding the permanent open market operations (POMO) of the Federal Reserve Bank of New York. These are the quantitative easing operations whereby the FRNY buys Treasury debt from primary dealers. This infuses them with capital that can be levered and used to push equities through critical resistance areas, paving the way for higher prices. Though the net movement for the S&P 500 in a day may be down or up and mask what we call the POMO effect, there are certain hours within these days that have tradable directional biases. It’s not the holy grail, but a valuable, empowering tool in an increasingly opaque financial world.

As to Goldman, a guaranteed risk-less trade is illegal front-running. If that is what is going on, then it needs to stop If it’s just some bright people with the best computers and algorithms in town, than good luck to them. Goldman can expect increased scrutiny as these profits continue, and it is not immune to market forces. It was the bust of Jay Cook & Co. that precipitated the long depression of 1873, and it could be said that they were as highly connected at the time as Goldman is now. Karl Denninger, Zero Hedge, and others have been relentless in their coverage of high frequency trading, dark pools, etc., and we’re thankful we have them as watchdogs. Unfortunately, as soon as one loophole is closed, another pops up and we are left with over-reaching knee-jerk regulation that was in response to the previous loophole.

Damien: We appreciate Zero Hedge’s watchdog efforts so much that we recently awarded them our inaugural First Amendment Award for Outstanding Journalism in the Best Blog category. In addition to reading reports from Zero Hedge and similar watchdogs, if the Fed has manipulated the markets in the ways your report suggests, what should we do about it as citizens and investors?

Bob: The Fed’s mandate from Congress through the Federal Reserve Act is one of manipulation, so there’s not much that can be done while that mandate exists. Ron Paul is releasing a book soon called End the Fed, and has introduced legislation to audit the Fed’s balance sheet. The Bill has gained a lot of momentum and has a surprisingly high 282 co-sponsors. Unfortunately, we tend to agree with economist Robert Wenzel that, if the audit is conducted, all we’ll end up with is a Federal Reserve that has a different set of warts, and maybe worse ones. The crises have been framed — nearly successfully — as failures of free market economics. Surveying history, we don’t see anything approaching a free market economy in the US since perhaps the Jackson administration. As long as we prop up zombie banks and corporations, precious resources that otherwise could be employed productively will be drained and used unproductively. That is what turns panics and crises into long, drawn out depressions.

This is a very precarious time for investors. To be a successful long term investor in this environment, one needs a solid foundation in economics, the ability to predict which industries and businesses within those industries the government will support with largess, the ability to read the Federal Reserve tea leaves, and to monitor market microstructures that can foretell upcoming crises.

We have seen that in times of crisis, there is no diversification among asset classes as all correlations go to either 1 or -1. We prefer diversification in time frame because, as short term traders, we forecast various scenarios that can unfold over the coming hours, days and weeks, and have the agility to act and react as necessary. It’s an admittedly impossible strategy for a large fund manager that creates its own footprints in the markets, but is a niche to be filled.

For the average investor, the safest long term investments are probably in corporate bonds of commodity-based companies and commodities themselves, such as gold and silver. They will likely not perform greatly in the short term, but we expect them to appreciate in price relative to most currencies over the coming years. Sovereigns of commodity-based currency countries, such as Canada, Australia and New Zealand are also probable good long term bets. US Treasurys are currently safe, but will be devalued long term and have the potential to become unstable and unsafe over the coming years.

In closing, I know we paint a bleak picture here, but we are not pessimists. We have the opportunity to rebuild and allow the markets to allocate resources using people’s creativity and entrepreneurship. There will be more pain over the coming years, but the human spirit will survive. And, there will be some very interesting opportunities and developments in price discovery that have the potential to mitigate the volatility and the boom-bust economy to which we have become accustomed.

Damien: Bob, that is very helpful! Thanks for taking the time to explain your theory and how we can maneuver as citizen-investors. This has been very educational and fascinating.

Bob: Thank you for your insightful questions and we look forward to talking with you again.

This article was originally posted on August 12, 2009