Trader’s Narrative

Since I got my hands on my copy of Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, I’ve been devouring it almost non-stop.

Written by Barry Ritholtz, Director of Equity Research at Fusion IQ, and blogger at The Big Picture, it promised to be a definitive guide to the financial mess - and it didn’t disappoint.

In his inimitable colloquial tone Ritholtz sets out to meticulously explain how the stage was set for the historic unraveling of the global economy in 2008. Although we will no doubt have a plethora of similar books, Ritholtz’s book, for its detailed historical approach and its comprehensiveness will probably end up being the encyclopaedia that future historians and traders come back to.

Filled with charts, diagrams, cartoons and highlighted sections, Bailout Nation grabs hold of your attention and never lets you come up for air until the very end. I found very few errors or bumps along the way. Some sections were a bit repetitive. For example, referring to the case of LTCM, he says:

The collapse of that hedge fund in 1998 and its subsequent Fed-orchestrated rescue plan provided one of the greatest — and most terrible — examples of moral hazard ever known.

Then a few paragraphs later:

Contrary to what Greenspan claimed, the Federal Reserve’s involvement did not create “slight” moral hazard. Rather, the 1998 Fed-orchestrated rescue was moral hazard writ humongous.

Yes, we get it Barry! But because the book is so well written and researched, I’m nitpicking here really.

I truly appreciate that Ritholtz comes across as politically agnostic. He excoriates both the Democrats and the Republicans for reckless policies and decisions that have no logic but foster a culture of entitlement, reduce or entirely eliminate regulation and get private enterprises addicted to public funds.

Most Americans are labouring under the patriotic delusion that they live in a free market society. But for all their pro-capitalistic bravado, America’s history is replete with corporate welfare. Both Democratic and Republican governments have lavished public funds on businesses that would have gone extinct in a real free market. To start at the beginning, Ritholtz highlights the precedent setting bailout of Lockheed Martin in 1971. This was the first time the US government had acted to help out a single corporation. He then proceeds to describe the other bailouts, which by now had become the norm.

Ritholtz spies a 10 step pattern of bailouts:

1. Risk Event
2. Pre-awareness
3. First Reactions
4. Bigger Reactions
5. “Interested Party” Agitation
6. Official Concern
7. Broader Worry, Deepening Panic
8. Major Intervention/Bailout
9. Rationalization & Apologies
10. Expected Results and Unintended Consequences

It isn’t too hard to spot us at stage 9 - with Greenspan’s sheepish “flaw” apology and Geithner’s haphazard attempts to sell everyone on his ill thought out PPIP proposal.

When it comes to casting blame, Ritholtz doesn’t pull any punches. As you can imagine, with a foreword written by Bill Fleckenstein (author of Greenspan’s Bubbles), Ritholtz doesn’t shy away from criticizing the Maestro. In fact, he puts him front and center, as the primary enabler of this convoluted tragedy. But he also defends what he considers to be “misplaced fault” such as naked shorting, mortgage interest deduction, etc. I don’t totally agree with him on naked short selling. The deregulation that he cites elsewhere was also why naked shorting was allowed to take place - at times on a massive scale, with devastating consequences.

Ritholtz also cites a very clever reason for why Wall St. got greedy in the first place and went into overdrive, taking on fatal amounts of risk. I won’t ruin the aha! moment for you but it is signature Ritholtz to be able to pull together very disparate variables and see a pattern emerge.

I’m often asked by friends and family members to explain why Wall Street just imploded. Bailout Nation is an accessible and fun to read book that explains every question they have - and a few they never even thought of asking.

Last Thursday, Barry Ritholtz wrote in The Big Picture about two data points sent in by Doug Kass:

• The cash positions in mutual funds stand at 3.8%, slightly below the 3.9% low established in 1972.

• Margin debt as a percentage of the S&P market cap has climbed to 2.4%, an all-time high. The previous peak? Early 2000, at the height of the Internet bubble.

While Kass is a blisteringly smart guy, his penchant for the bearish side is well known. So to balance things out a bit I’d like to offer a few counter points delivered by Jason Goepfert from SentimenTrader.com

Mutual Fund Cash Positions
Since Goepfert won the 2004 Charles H. Dow award for his paper on mutual fund cash levels, he is a real authority on this topic. To read it, click on the Dow Award folder within the free trading resource box.

According to the paper, we have to normalize the mutual fund cash levels to account for varying interest rates over time. When interest rates are high, mutual fund managers have an incentive to maintain high cash levels because they are compensated for it. So Goepfert models the theoretical cash level for every interest rate point.

However, having normalized cash levels we still find that right now, mutual fund managers are holding about 3.38% less cash than they should be (theoretically for this interest rate level). It may not be that bearish though. For one, if we see a reduction in the Fed rate, it will reset this indicator. Also, a low cash level can be explained by structural changes in the mutual fund industry.

As indexing has grown, it has taken a larger and larger percentage of assets. Since by definition an index can not hold any cash, this can skew the data. But in reality it only reflects a trend towards indexing (and closet indexing).

Another possible explanation is that charters for mutual funds only allow the manager to hold a certain level of cash and in essence, forces them to invest the rest in equities. As well, with the implementation of new technologies, asset managers can now see fund flows in almost real time, allowing them to react quickly to redemptions and not requiring them to have a cash cushion.

To be totally honest though, while valid, these alternative explanations are rather weak. This indicator is quite accurate in the long term and because of that, it does bother me when I see it at such extreme. What Goepfert argues is that it may not be as extreme as it looks.

Margin Debt
When NYSE margin debt overtook the 2000 levels, many bears made a huge deal out of it. However, this data point must not be taken so superficially.

Goepfert points out a little known statistic: apparently the NYSE not only keeps track of how much margin is being used within brokerage accounts but also how much available cash is there. It is important to note that these cash levels exclude the cash generated by short sales - so what is reported is cash that is owned, unrestricted by the account holder.

Interestingly, when we look at cash level, we see that, as a percentage of market capitalization, it is around 16% now. That’s double from 8% at the 2000 bubble top.

The point is that while margin debt relative to market capitalization is high now, investment account holders have in fact much more cash than they did during the top. This represents a huge amount of real buying power that can drive the market much higher as the cash is put to use.

That potential buying power simply was not there seven years ago.

Classic
This is classic Goepfert. He takes what is seemingly obvious, drills to the core, brings data and hard facts to bear and serves up real insight. Most people start out with a conclusion that ‘feels right’ and cling to the factoids that support their position.

I didn’t reproduce the graphs he provides but they are a thing of beauty. To see them, take a 14 day free trial. Trust me, you’ll stick around on day 15.

It doesn’t matter if you’re daytrading or watching the grass grow on your 401k, as long as you’re serious about making money in the market, Jason’s insights are a must.