Trader’s Narrative

The Merril Lynch chief investment strategist, Richard Bernstein, seems to have finally gotten it right. As the saying goes, even a blind squirrel finds a nut eventually.

Almost to the day this time last year, Richard Bernstein flipped from a dyed-in-the-wool bear who had fought the cyclical bull market three years out of four, to a born-again bull.

If we end the year here and now, Bernstein seems to have finally gotten it right. Assuming we coast, the S&P 500 will have gone up by about 5% in 2007.

Here’s the screenshot of the Bloomberg article from Dec 12th 2006:
(click to enlarge)

Interesting article on Goldman Sachs’ “luck” in escaping unscathed from the sub-prime mortgage mess:

Goldman’s good fortune cannot be explained by luck alone. Late last year, as the markets roared along, David A. Viniar, Goldman’s chief financial officer, called a “mortgage risk” meeting in his meticulous 30th-floor office in Lower Manhattan.

At that point, the holdings of Goldman’s mortgage desk were down somewhat, but the notoriously nervous Mr. Viniar was worried about bigger problems. After reviewing the full portfolio with other executives, his message was clear: the bank should reduce its stockpile of mortgages and mortgage-related securities and buy expensive insurance as protection against further losses, a person briefed on the meeting said.

The article fails to mention that Goldman Sachs (GS) is Wall Street. They might as well own it outright. And now they’re making inroads into government where policy and oversight reside. They don’t play the game, they are the game.

But in the end, even if you practically own the place, risk and its management is the real game:

At Goldman, the controller’s office — the group responsible for valuing the firm’s huge positions — has 1,100 people, including 20 Ph.D.’s. If there is a dispute, the controller is always deemed right unless the trading desk can make a convincing case for an alternate valuation. The bank says risk managers swap jobs with traders and bankers over a career and can be paid the same multimillion-dollar salaries as investment bankers.

One of my favourite market axioms is “Discipline over conviction.” There is no point in risking ruin when you don’t have to. Coming back to play another day is a prime victory. Had Niederhoffer hired one or two risk controllers, he wouldn’t have blown up (again).

This graph tells the whole story:

According to the most recent Merril Lynch monthly survey, almost 50% are expecting an increase in inflation next year. Although not the highest this survey has seen, this is a pretty high level of bearishness (for bonds).

I mentioned this little known survey a year ago when inflationary expectations were at another extreme.

Merril Lynch’s monthly survey has provided some great contrarian signals for the bond market. In March 2005 it reached a high of 70% (expecting more inflation in the future). That marked an important top for yields (and bottom for bond prices).

Last summer it again saw 70% expecting higher rates going forward. That was another great contrarian signal. Bonds bottomed and started to climb for the rest of 2006.

Earlier this year few (11%) respondents were expecting an uptick in inflation. Which, surprise, turned out to be a fantastic time to sell bonds (see graph below). Back to the most recent data, eventhough we don’t have a real extreme reading, what you have to consider is that the survey was conducted at the beginning of the month, before 10 year yields jumped to 5.3%. Can you imagine the bearishness if the survey was taken after that carnage?

Of course, I don’t think one can trade based on one single indicator. Especially sentiment. But it is valuable when layered on top of other technical indicators and confirms them. For example, the distance from moving averages.

Given the interplay between the bond market and the stock market, this bodes well for equities going forward. That is, assuming that such sentiment translated to price action and we do get a sharp decline in bond yields (rally in bonds).