Why I Covered Half My Shorts

I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by any theory of efficient markets.. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy.

- George Soros, Testimony To Congress, 1994, quoted in “George Soros Theory of Reflexivity MIT Speech”, April 26, 1994

It was a period of tremendous experimentation. When you’re faced with a crisis of this magnitude, if you take the view that every measure that we take has to be exactly right, you don’t do anything.

- Frederic Mishkin, Economist, Columbia University, who left the Fed board in August 2008, quoted in “Government’s Trial And Error Helped Stem Financial Panic”, David Wessel, The Wall Street Journal, September 14, 2009, A1

We’re propping up the market with so much liquidity right now that it has no other place to go but up. You can almost throw out the other fundamentals, which tell you the market should be looking overbought. The reality is, the money has to go somewhere.

- Howard Simons, Bianco Research, quoted in The Wall Street Journal Online, September 22

I have been wracking my brain and doing some soul searching over the last couple of weeks trying to figure out what, if anything, I might have gotten wrong or missed. This rally has surprised me in its strength and duration and I’ve been wrong time and again in predicting its imminent demise.

My daily comprehensive surveys of economic and financial reports, print and online media, and blogs, persuaded me that the fundamentals did not support a new bull market. Hence, it had to be a bear market rally that would end at some point, though the exact timing is always elusive.

Within the last week, however, new understandings and integrations have made the powerful character of the rally intelligible and comprehensible to me. To state it succinctly: The barrage of government programs has worked in putting a floor under the economy - for now.

*****

These new insights started last Thursday as I read a shocking front page Wall Street Journal article detailing the governments massive subsidization of the housing and mortgage markets: “No Easy Exit For Government as Housing Market’s Savior”, The Wall Street Journal, September 15, A1. Put together the nationalization of Fannie Mae (FNM) and Freddie Mac (FRE), a 0% Fed Funds rate, Fed purchases of $1.5 trillion in Fannie and Freddie debt and mortgage backed securities, the growth of The Federal Home Administration and Ginnie Mae in guaranteeing mortgages and the $8,000 first time home buyer credit, and it’s no wonder that home prices have stabilized and bottomed. Of course they have! With all this stimulus, the Feds might even be creating a new, artificial, boom.

Remember that it’s been the housing market that has driven the entire bust. Not only has it hurt the wealth of homeowners and cost the income and jobs of many in the real estate business, but it has destroyed the banks. It was the blowup of the financial system as a result of the housing bust that brought down the stock market last year.

But with all the Federal programs and subsidies seeming to have worked in putting a floor under the housing market, many of these problems are alleviated and start to go away. Stable house prices means owners with onerous, adjustable rate mortgages can start to think about refinancing. There are buyers because of all the Federal mortgage programs combined with low prices and the $8,000 first time buyer tax credit. In fact, according to the WSJ piece, the Federal government now provides some form of support to more than 80% of all residential mortgages. This generates activity and jobs in the real estate business.

On the mortgage side, the stabilization of home prices naturally stabilizes the mortgage market. All those mortgages and mortgage backed securities increase in value as the situation of homeowners improves and the value of the underlying collateral stabilizes. Because of the secondary market for mortgages, improved pricing can be marked to bank balance sheets and improves their capital position. That also increases their ability to be active in markets and to lend.

The government bailouts and subsidies have not been limited to the housing market either. They guaranteed the $4 trillion money market market allowing these funds to buy corporate commercial paper with a government back stop. That provided money for corporations to use to fund day to day operations.

The government guaranteed bank debt resulting in $113 billion in issuance in December 2008. Of course buyers were comfortable buying this debt when it was backed by a guarantee from the federal government. All that money repaired bank balance sheets and allowed them to lend and be active in markets.

Let’s not forget about the TARP either. Many banks are paying back or talking about paying back this money. But that’s another $700 billion that was injected into the financial system. That money has go somewhere.

And that’s not an exhaustive account of the government bailouts…..

*****

The next thing to realize is that much of this new money found its way into markets. It has reflated the mortgage, credit and stock markets. And here’s the key point: the rise in these markets not only reflects improvement in the real economy but is actually one of the fundamental drivers of that improvement. Here is where George Soros’s theory of reflexivity comes into play.

Consider just the stock market for now, which is not even the most important market. In the six months since the March low, the value of the US stock market has surged by $5 trillion. The value of global stock markets has increased by $18 trillion (see “Investors Get Back $18.31 Trillion”, BeSpoke Investment Group, September 21). U.S. citizens and corporations are now $5 trillion wealthier than they were 6 months ago. Do you think that makes a difference in how they conduct business, the decisions they make and their credit worthiness to lenders?

Now apply that same logic to the reflation of the housing, mortgage and credit markets. Holders of all these assets are now much wealthier than they were six months ago. Individuals and corporations that were in financial trouble have in many cases been bailed out by the increase in value of their assets.

In sum, all the government programs have succeeded in stabilizing the housing market and reflating securities markets, resulting in a massive, bubble-like, increase in wealth for individuals and corporations across the United States and the entire globe. This increase in personal and corporate balance sheets has gone a long way towards repairing the damage of the bust and has a reflexive impact on the real economy.

*****

There are long term consequences to all this. We got into this mess because of easy money, excessive debt and government subsidization of the housing market. It seems strange on the face of it that more of the same would be the cure. Obviously, it isn’t. It’s analogous to a drug addict in the throes of withdrawal who can’t take it anymore and goes for a big dose. At first, he feels great, he’s back to normal, he’s cured. But, in the end, the ultimate crash is even worse than it would have been.

All this easy money literally papers over problems in the real economy at the long term cost of the soundness of our monetary unit on which the entire global economic system depends. Bernanke’s “whatever it takes” approach has worked for now, but he is gambling with our economic future in an unprecedented way.

*****

As a result of these new insights, I covered half of our short positions, which had grown rather large as the market moved against us, last week. That raised cash in the portfolio and brought our overall positioning closer to flat though we are still net short.

Even with everything I just wrote explaining and justifying the recent stock market rally, the S&P has already rallied more than 60% since early March. Much of this analysis is already discounted in the stock market. So this is no time to completely change course and put everything into stocks. The move could still be close to over or it could have more to go.

I have already determined in my mind at what levels I will cover our remaining short positions and move to the sidelines to wait for a better spot. If the market continues to move up, I will also consider speculating with a small portion of our portfolios. But this is a very speculative market and my main concern at the moment is prudence and capital preservation.

I am still trying to integrate and make sense of this new analysis and its implications for investing our portfolios. I will keep you posted on our journey as always. I am sorry we have not participated in this move to the extent all of you would have liked. But I am optimistic that I am in the process of righting the ship in the bizarre economic and financial circumstances we currently find ourselves in.

Comments

[Roger Knights:]

Your realization that the Fed's + the administration's injections of credit are the "crack of boom," is what cynical old Marc Faber has been saying for a good while. Here's a link to an SA paper today that in turn links to videos of his most recent interview. He's a hoot.
seekingalpha.com/artic...

Sep 23 08:55 AM

[Mudduckk:]

Yep, I'm putting profits into shorts too. This rally is not sustainable, and some ex market factor like H1N1 or is going to prick the bubble. If not that, then 4Q or 1Q '10 earnings reports will take care of it.

Cheers.


On Sep 23 06:12 AM logicalthought wrote:

> Thanks for covering, Greg, now that I'm just starting to put some
> (shorts) on... You seem like a very nice guy, but I've seen your
> columns here for a while, and you seem to have been a near-perfect
> reverse-indicator.

Sep 23 10:08 AM

[David Van K...:]

Duh. You've been short in anticipation of a reversal because you were convinced that this was a bear market rally that would end imminently? And now you've covered SOME of your shorts (after the market's been rallying for 6 months+), because you've finally realized that the government's massive injection of money into every nook and cranny of the economy actually has an effect on the economy? And you just now came to add up and understand all the government's activism in the past couple of weeks after reading a "shocking" article on the front page of the WSJ?

ALL of this information has been publicly and easily available for months. The stock charts (the ones going up) have been available for months. Why do you have any shorts left at all? The time may come for shorting, but it is not now. Anticipatory shorting (or anticipatory buying long, for that matter) is a fool's game. Wait for the turn; play the trend that exists, not the one you expect (or wish for) down the road. This is not a college term paper about where things might go. It is about what's happening right now.

Sep 23 10:28 AM

[JLarkin:]

I liked your article. I guess the Fed and Treasury are big enough to support the economy for a long time. The headwinds I see coming are, due to the fact that consumers really haven't pulled back all that much yet, a steeper drop in consumer spending (PCE) that could overwhelm even the Fed; a vicious cycle of more layoffs due to lack of demand; a commercial real estate crash, which will decimate the regional banks; and corporate and municipal defaults, and deflation. The big "players" will be saved no matter what. How all this affects the stock market or commodities is anyone's guess.

Sep 23 12:55 PM

[chap08:]

Don't get too confident. You are just doing the same as Greg. You are shorting the market on no basis other than "it should go down".

See David Van K's excellent comment above. You are doing what he calls anticipatory shorting. Unless of course you have an indicator which has just turned down. In which case, what is it?


On Sep 23 06:12 AM logicalthought wrote:

> Thanks for covering, Greg, now that I'm just starting to put some
> (shorts) on... You seem like a very nice guy, but I've seen your
> columns here for a while, and you seem to have been a near-perfect
> reverse-indicator.

Sep 23 12:55 PM

[inthemoney:]

> ALL of this information has been publicly and easily available for months. The stock charts (the ones going up) have been available for months. Why do you have any shorts left at all? The time may come for shorting, but it is not now. Anticipatory shorting (or anticipatory buying long, for that matter) is a fool's game. Wait for the turn; play the trend that exists, not the one you expect (or wish for) down the road. This is not a college term paper about where things might go. It is about what's happening right now.

----------------------...

Sometimes trend following strategies work and sometimes they don't. More often than not they don't work ebcause the market is sideways. Lst 6 months the market has been unidirectional, but that is not the norm.

Sep 23 01:48 PM

[thiazole:]

They aren't ever sideways during a recession. We knew about this recession long before the market started falling and we knew that the recession was bottoming out earlier this year (those of us who followed leading indicators and who knew that "green shoots" wasn't blasphemy), so it didn't take much effort to wait for the trends to start and to jump on board. If you know of any recessions where the market was flat, though, please point them out.


On Sep 23 01:48 PM inthemoney wrote:

> > ALL of this information has been publicly and easily available
> for months. The stock charts (the ones going up) have been available
> for months. Why do you have any shorts left at all? The time may
> come for shorting, but it is not now. Anticipatory shorting (or anticipatory
> buying long, for that matter) is a fool's game. Wait for the turn;
> play the trend that exists, not the one you expect (or wish for)
> down the road. This is not a college term paper about where things
> might go. It is about what's happening right now.
>
> ----------------------...
>
> Sometimes trend following strategies work and sometimes they don't.
> More often than not they don't work ebcause the market is sideways.
> Lst 6 months the market has been unidirectional, but that is not
> the norm.

Sep 23 02:53 PM

[Guruprasad V:]

Its great that you've changed your view. If everyone like you does this, I'd be in huge short thru etfs and other instruments. I'm looking forward to see people like change their stance and become bulls.

Sep 23 03:12 PM

[Steve Harris:]

When the last of the bears become bulls... you know the rest.

Sep 23 03:15 PM

[Roger Knights:]

"you seem to have been a near-perfect reverse-indicator."

He seems to have timed the top to the day! S&P down 1% today, after reaching a new high. Maybe it's a key reversal day.

Sep 23 04:22 PM

[thiazole:]

Interestingly, I have an indicator that is signalling a correction starting right now if the market follows through with the end of the day movements that happened today. If it happens, it would likely only be a 10% correction (not enough for me to bother doing anything about it), so you might actually make a little money with your shorts. Normally I'd chide you for shorting a rising market (kind of like trying to catch a falling knife), but as it turns out, you might just get lucky.

On Sep 23 06:12 AM logicalthought wrote:

> Thanks for covering, Greg, now that I'm just starting to put some
> (shorts) on... You seem like a very nice guy, but I've seen your
> columns here for a while, and you seem to have been a near-perfect
> reverse-indicator.

Sep 23 04:25 PM

[phan:]

I agree with much of what you said. However, you're still missing the point.

The market should never have dropped as far as it did. Yes, there were monetary and liquidity problems, but the key fact in the value proposition is that the resources in our economy -- the people, the machines, the property and technologies -- they never went anywhere, and yet the major indices dropped by half in very little time. All of the unemployed people and underutilized physical resources were and are aching for that to change. Going short in such a time isn't just wrong, it's insane. A spring follows every winter, and fertile land once again turns green.

We often see people looking at the P/E of the S&P 500 and saying that the market is fairly valued or overvalued. A better gauge would be price to book value, a more realistic measure of untapped resources. In this market, price to book value is still quite low. I own stock in 3 profitable companies that are actually below their net cash value! That should never happen.

Sep 23 05:11 PM

[logicalthought:]

Chap & Thiazole,

I'm definitely not "too" confident... I put 10% of my account into SDS in the S&P 1040s, and I'll do 10% more around 1100 (if it gets there) and 10% more around 1150 (if it gets there). And to answer your question: Yes, I have "an indicator": it's the fact that even most of the bears have covered their shorts (even if they refuse to go long), coupled with increasingly bullish sentiment and put-call ratios. The only reason I'm not shorter yet is that sentiment isn't yet "outrageously" bullish. However, the reason I'm starting to get short is that at some point the terrible fundamentals will overwhelm everything else. (And I'm certainly not a perma-bear; I'm up around 100% YTD and have compounded gains of 30%/year for the past five years, and still have a couple of substantial non-correlative long positions evn now.)

Thiazole: I'm not looking for just a 10% correction. I'm looking for the S&P to head back into the 600s, if not lower. I think we're going to see a 10x to 12x multiple as soon as people realize that S&P GAAP earnings will be stalled in the $45-$50 range for at least the next three years.


On Sep 23 12:55 PM chap08 wrote:

> Don't get too confident. You are just doing the same as Greg. You
> are shorting the market on no basis other than "it should go down".
>
>
> See David Van K's excellent comment above. You are doing what he
> calls anticipatory shorting. Unless of course you have an indicator
> which has just turned down. In which case, what is it?

Sep 23 06:35 PM

[mna:]

The masses aren't always wrong. Most times you probably should have a better reason to be short than "because the rest isn't", especially when long term forces work against your position.


On Sep 23 06:35 PM logicalthought wrote:

> Chap & Thiazole,
>
> I'm definitely not "too" confident... I put 10% of my account into
> SDS in the S&P 1040s, and I'll do 10% more around 1100 (if it
> gets there) and 10% more around 1150 (if it gets there). And to answer
> your question: Yes, I have "an indicator": it's the fact that even
> most of the bears have covered their shorts (even if they refuse
> to go long), coupled with increasingly bullish sentiment and put-call
> ratios. The only reason I'm not shorter yet is that sentiment isn't
> yet "outrageously" bullish. However, the reason I'm starting to get
> short is that at some point the terrible fundamentals will overwhelm
> everything else. (And I'm certainly not a perma-bear; I'm up around
> 100% YTD and have compounded gains of 30%/year for the past five
> years, and still have a couple of substantial non-correlative long
> positions evn now.)
>
> Thiazole: I'm not looking for just a 10% correction. I'm looking
> for the S&P to head back into the 600s, if not lower. I think
> we're going to see a 10x to 12x multiple as soon as people realize
> that S&P GAAP earnings will be stalled in the $45-$50 range for
> at least the next three years.

Sep 23 07:33 PM

[logicalthought:]

>>especially when long term forces work against your position.<<

You're kidding, right? You think "long-term forces" for this market are BULLISH???


On Sep 23 07:33 PM mna wrote:

> The masses aren't always wrong. Most times you probably should have
> a better reason to be short than "because the rest isn't", especially
> when long term forces work against your position.

Sep 24 08:51 AM

[thiazole:]

You aren't going to get that kind of correction - at least not in nominal terms. The bears have one thing right, and that is the fact that in real dollars, the market will probably be much lower in 5 years than it is today, and it may even be less valuable than the low we saw in March. Hell, after inflation, the market is lower right now than the 2002 bottom. The kind of tame inflation we saw from 2002 to now is nothing like what we will get going forward. Unfortunately for you, that doesn't really provide you much incentive to short the market long term.


On Sep 23 06:35 PM logicalthought wrote:


>
> Thiazole: I'm not looking for just a 10% correction. I'm looking
> for the S&amp;P to head back into the 600s, if not lower. I think
> we're going to see a 10x to 12x multiple as soon as people realize
> that S&amp;P GAAP earnings will be stalled in the $45-$50 range for
> at least the next three years.

Sep 24 12:07 PM

[logicalthought:]

I understand and respect that argument, however, i think we have deflationary problems analogous to what Japan went through, and therefore we'll see much lower stock prices.


On Sep 24 12:07 PM thiazole wrote:

> You aren't going to get that kind of correction - at least not in
> nominal terms. The bears have one thing right, and that is the fact
> that in real dollars, the market will probably be much lower in 5
> years than it is today, and it may even be less valuable than the
> low we saw in March. Hell, after inflation, the market is lower
> right now than the 2002 bottom. The kind of tame inflation we saw
> from 2002 to now is nothing like what we will get going forward.
> Unfortunately for you, that doesn't really provide you much incentive
> to short the market long term.
>

Sep 24 12:30 PM

[thiazole:]

The massive increase in money supply combined with inventories falling 1+% every month for the past year (with no end in sight) = too many dollars chasing too few goods and will cause inflation for sure. I can change my mind on a dime, but I haven't seen any deflationary pressures follow through lately. Yeah, they are out there (and it is why we are currently seeing year over year disinflation), but they seem to be slowly drying up, while the inflationary pressures are gaining momentum. Where we are right now is the polar opposite of where we were in the summer of 2008 - at that point were were seeing significant year over year inflation, but the deflationary pressures (growing inventories, shrinking money supply) were snow balling and the recession was killing the inflationary pressures. Now we deflation/disinflation, but the inventories have been ravaged and the money supply is growing (and don't think that the effects of quantitative easing goes away once the Fed stops buying treasury bonds - it will last until those bonds mature and the treasury buys them back).


On Sep 24 12:30 PM logicalthought wrote:

> I understand and respect that argument, however, i think we have
> deflationary problems analogous to what Japan went through, and therefore
> we'll see much lower stock prices.

Sep 24 03:19 PM

[logicalthought:]

There's plenty of excess manufacturing capacity, should there be a pick-up in demand. Meanwhile, there's a hugely deflationary amount of bad debt out there, which will keep a big damper on the economy and, thus, asset prices.


On Sep 24 03:19 PM thiazole wrote:

> The massive increase in money supply combined with inventories falling
> 1+% every month for the past year (with no end in sight) = too many
> dollars chasing too few goods and will cause inflation for sure.
> I can change my mind on a dime, but I haven't seen any deflationary
> pressures follow through lately. Yeah, they are out there (and it
> is why we are currently seeing year over year disinflation), but
> they seem to be slowly drying up, while the inflationary pressures
> are gaining momentum. Where we are right now is the polar opposite
> of where we were in the summer of 2008 - at that point were were
> seeing significant year over year inflation, but the deflationary
> pressures (growing inventories, shrinking money supply) were snow
> balling and the recession was killing the inflationary pressures.
> Now we deflation/disinflation, but the inventories have been ravaged
> and the money supply is growing (and don't think that the effects
> of quantitative easing goes away once the Fed stops buying treasury
> bonds - it will last until those bonds mature and the treasury buys
> them back).

Sep 24 04:38 PM

[thiazole:]

I think you are discounting just how much inventories are falling and have fallen. You are also assuming banks will lend money for inventory restocking (which it doesn't appear that they are). I don't know how to get the exact number (business, wholesale, manufactuing, etc), but total inventories have fallen by hundreds of billions of dollars (business inventories alone have fallen by nearly $200 billion research.stlouisfed.or... and continues to fall at a rate of around $10 billion a month). You can't just ramp up production and crank out that much excess product overnight - to do it in one quarter, it would take far greater than a 10% INCREASE in GDP - and you still have to increase production by the rate it is falling just to BREAK EVEN. That alone could increase GDP by around 2%.


On Sep 24 04:38 PM logicalthought wrote:

> There's plenty of excess manufacturing capacity, should there be
> a pick-up in demand. Meanwhile, there's a hugely deflationary amount
> of bad debt out there, which will keep a big damper on the economy
> and, thus, asset prices.

Sep 25 12:07 PM