GameStop: Wall Street's bloody battle of the shorts

Something is happening on Wall Street that is almost unheard of. A war has broken out between large institutional investors (banks, hedge funds etc.) and small investors. And as of this post, the small investors are crushing the big boys of the financial world. 

Read the story here.

If you don't understand how short selling works, you can read a plain English explanation here. 

Disclaimer: I do not own or speculatively trade any individual stocks or other financial securities which is very risky. Nor do I encourage speculative investing unless you fully understand what you are doing, the risks involved, and are prepared to lose some or all of the money you are playing with. 

Meanwhile on Wall Street

As the nation appears to be collapsing into an economic depression (see previous post) Wall Street has been singing its favorite song. After the initial panic of late February and March, the stock market has been rallying. The S&P 500 has recovered around half of its losses as investors seem determined to ignore the steady stream of bad news. Are they right? How long will this last? Hmm...

Is the stock market rigged?

If you have to ask that question then you need to stay very far away from investment securities until you have done a lot of research.

The Permanent Portfolio And Its Returns

As long time readers of this blog may be aware, I almost never give specific investing advice despite my obvious interest in economics. One of the very few exceptions I have made to that rule is my strong endorsement of the Permanent Portfolio investment strategy devised by the late libertarian economist and two time presidential candidate Harry Browne. This portfolio strategy has two key components. First is an assumption that at all times the economy is experiencing one of four conditions. Those being

• Prosperity
• Deflation
• Inflation
• Tight Money - Recession

The second assumption is that while it may be amusing to prognosticate on future events, in reality the future is unknowable. Which is to say that most people are wrong, most of the time, when predicting the future.  This is especially true when the subject is economics. With these two assumptions accepted, Harry Browne set out to create a permanent portfolio (PP) that would adopt an agnostic approach towards future events and at the same time would function in any of the four economic conditions mentioned above. By "function" I mean that it would first preserve the wealth or capital in the portfolio from any dramatic losses and secondly give a reasonable positive return over time that would keep the investor ahead of inflation.

This portfolio is designed in such a way as to be exceedingly easy to construct while remaining very "low maintenance." Indeed you can build a PP in about 15 minutes using online investing tools or in a short call with your broker. Index funds and or ETFs (exchange traded funds) can be used for most or even all of the PP which has the added advantage of keeping your expenses very low.* Once set up it requires no tinkering or adjusting other than a once or twice a year peak to make sure it has not gotten out of balance.

The PP simply consists of taking four asset classes and putting one quarter of your money in each one. The PP is then left alone unless one or more of the assets rises or falls by 10% of the aggregate value of the portfolio, i.e. becoming 35% or 15% of its total value. Only then would you rebalance the portfolio by selling the assets that have done well and buying up those that have underperformed so that once again you are at 4 x 25%. In normal circumstances rebalancing events are rare, occurring perhaps once every two or three years.

Within the PP each asset class functions independently of the other three and is designed to protect you in one of the four conditions listed above. Specifically...

•  Stocks rise dramatically during periods of prosperity.

• Long Term US Government Bonds rise dramatically during periods of deflation.
• Gold rises dramatically during periods of inflation/currency debasement and also protects you against catastrophic events like war or civil unrest.
• Cash is the only neutral asset and it provides a cushion against periods when central banks tighten the money supply creating a recession and also allows you to handle unexpected emergencies in life without having to sell other assets, possibly at a disadvantageous time.

In each economic scenario one or more of the asset classes is likely to be falling. But the one correlated to that condition will normally rise so violently that it outpaces any losses from the other asset classes. The only exception to this is during periods of a deliberately induced tight money supply created by the central bank. In that scenario there is nowhere to hide other than in cash. But history has shown that such conditions are rare and usually can only last a brief period of time.

Now if you are like me, and in my experience most other people when first reading about the PP, you are probably thinking that this is nuts. That certainly was my initial reaction. In particular the idea of keeping a quarter of ones money in gold, which has no internal rate of return was something I had a really hard time with. But the true test of an investment strategy is to back test it and see how it performed in previous years. The farther back you can go the better. It is however rare for people to be able to back test many strategies going back more than a decade.

Happily that is not the case with the Permanent Portfolio.

Thanks to a gentleman named Craig Rowland who has been something of a one man band trying to keep alive the legacy of the late Harry Browne, we have detailed returns for the PP going all the way back to the early 1970's! During this time frame of four decades we have experienced every one of the four economic conditions mentioned above. We had high inflation in the 1970's, a brief but brutal recession in the early 80's when the FED jacked interest rates to break the runaway inflation, a long period of general prosperity (with a few hiccups) running from roughly the mid 80's through the late 90's and we had the financial crisis of 2008-09 and the years following where for the first time since the Great Depression we have seen the specter of deflation.

In every one of those conditions except the two brief periods of tightened money supply the PP delivered positive returns or basically broke even. In only three years out of forty (1981,1994 and 2008) was there a negative return. In each case the losses were relatively minor and were followed by violent up years. Even in 2008, which was the worst year for the stock market since the early 1930's the PP posted a loss of less than 1%. I have seen some other figures showing a very slight gain. But it's so close either way that I would basically call it break even in a year where the broad stock market was down near 40%.

Further an examination of these returns against each asset class individually and a 50/50 split in stocks and bonds generally delivered very good long term returns with virtually no volatility. Note the chart here. While both a total stock portfolio and a 50/50 split in stocks and bonds delivered statistically near identical returns as the PP over the forty year period (1971-2011), the increased volatility was dramatic. And there were very long periods where both stocks and bonds seriously underperformed. By contrast on the chart the PP is represented by something very close to a straight line, without any of the jagged rises and dips in stocks, bonds and gold on their own.

The compound annual growth rate (CAGR) for the Permanent Portfolio over the last forty years has been an astonishing 9.7% with only three very slight down years.

Does this mean that the PP is indestructible? No. But barring a truly catastrophic event...

 ...it is hard to conceive of what could inflict especially severe losses on a permanent portfolio. And if you can come up with such an event, what sort of portfolio do you see as being safe and that will still cover you just in case the world doesn't end on your schedule?

Nor is this a blanket declaration that there are no other legitimate forms of investing. Anyone who decided to adopt a Jack Bogle type portfolio with a 50/50 split in stocks and bonds using index funds would probably be OK in the long run. As long as you can handle the more dramatic ups and downs and you have a long term investment horizon that's fine. Though I would note that such a portfolio might be especially vulnerable to inflation.

Some people of course are addicted to trying to outsmart the financial markets. In my experience which I believed is backed up by mountains of statistical evidence this is a fools game. Market timing is folly. There is no bell that rings telling you when to buy and that then rings again when it is time to sell. Such systems invariably ignore the joker in the deck, which is simply unexpected events. 9-11, Pearl Harbor, JFK's assassination, 1914, the crashes of '29, '73, '87, '08-09, the abandonment of the gold standard in 71 and so on. You can't predict the future.

Even if you are able to predict the future with some degree of accuracy (and you can't), in order to beat the market over the long term you have to keep climbing a mathematical wall, that gets steeper and taller every year. That wall is called fees, expenses and taxes.

Every trade you make you have to pay someone a fee. If you are selling a security at a profit you are creating a taxable event. If you are using an actively managed mutual fund or hedge fund you are paying fees and expenses to the fund manager. And here is the dirty little secret of Wall Street (at least one of them). Those fees don't just get paid once. The money you hand over in fees and taxes this year, is gone from your portfolio next year as well. And it is gone the year after that and the one after that. In fact it is gone every year for the rest of your investing life, where it might have been making more money for you. And then you have to remember that fees and expenses are paid every time you trade or annually to your fund/portfolio managers. So this just keeps snowballing and compounding. In other words, fees expenses and taxes are a form of negative compound interest on your long term returns.

All of which means that actively managed portfolios are at a huge mathematical disadvantage when trying to beat low cost index funds that just track the broader market and charge you next to nothing. This is especially true if you are reinvesting dividends. It has been repeatedly proven in numerous studies that adjusting for fees and expenses less than 10% of active fund managers (professional Wall Street money men) will beat their respective indices over any given ten year period. Over a twenty year period that figure drops below 1%. And all the while they are underperforming they charge their clients obscene amounts of money for their non-services. If they can't do it, what makes you think you are going to be in that 1%?

Even so the urge to speculate is pretty strong. And Harry Browne even said it was fine as long as you obeyed a couple of basic rules to which I have added two of my own.

• Never speculate with money you can't afford to lose.
• Never dip into your permanent portfolio or designated retirement money to cover losses from speculations that go bad.
• Never speculate in an investment you don't understand.
• Never speculate in any manner that can leave you exposed to losses greater than your original investment. This applies especially to investing on margin.

Harry referred to money you were prepared to gamble with as a variable portfolio as opposed to a permanent portfolio for that part of your wealth or assets you are unable or unwilling to take risks with. Within the limits listed above his attitude was to go for it and have fun if you want to try and beat the market.

This post is by no means an exhaustive discussion of the topic. For further reading or research on this subject I recommend...

• The book Fail Safe Investing by Harry Browne.
• The Crawling Road blog by Craig Rowland, and especially the podcasts he has posted there.
• The Permanent Portfolio discussion forum hosted by Craig Rowland.
• The historic returns of the Permanent Portfolio between 1971 and 2011.
• The permanent portfolio discussion threads on the Boglehead forum here and here.

*I note that Harry Browne generally advised holding at least some of the gold in the form of physical bullion or 1 oz coins. Most supporters of the PP concept agree with this advice although for convenience many people also use a bullion backed ETF.

Citigroup shareholders nix massive CEO bonus

Citigroup (C 0.00%) shareholders dealt a harsh blow to CEO Vikram Pandit on Tuesday, rejecting his $15 million pay package at Citi's annual meeting in Dallas.

The vote is non-binding -- meaning that Citi's board of directors could ignore it -- but it's still a rare slap in the face for the head of a major U.S. company, and the directors say they're going to take another look at pay for Pandit and four other senior executives.

What brought about this unprecedented display of investor rancor? Here, a guide.

Read the rest here.

Financial Markets Recover to Pre-Crash Levels

NEW YORK (Reuters) - The S&P 500 closed above 1,400 for the first time since the 2008 financial crisis on Thursday as stocks resumed the upward climb that has produced a steady stream of gains this year.

The benchmark index is up for six of the past seven sessions and is on target for its best week since early February. Financial stocks <.GSPF>, which have dragged lately, led the day with the S&P sector index up 1.9 percent as another round of better-than-expected economic data bolstered investors' enthusiasm.

"The data is lifting us today, but so is the momentum of the market," said Rex Macey, chief investment officer at Wilmington Trust in Atlanta, Georgia, which manages about $60 billion.

"People are getting more comfortable with the S&P above 1,400 and financials leading, which by itself is indicative of a sigh of relief. The trend is your friend, and lately the trend has been higher."

Though 1,400, which marks the highest level for the index since June 2008, does not have much technical importance, it is viewed as a bullish psychological marker.

Read the rest here.

Economic worries spark steep sell off on Wall Street

NEW YORK — Worries about the state of the economy in the U.S. and around the world slammed stocks on Thursday, driving the Dow briefly down more than 400 points and sending the S&P 500 into correction territory.

Bonds soared as investors sought a safe place to park their money.

The Dow Jones industrials average was down about 3 percent. The broader S&P 500 index was down around 10 percent from its May high. The market's so-called "fear index," the CBOE Volatility Index (VIX), jumped to its highest since March.

"People are throwing in the towel because they can't find relief on any front. There are a lot of worries about the economy," said Milton Ezrati, market strategist at Lord Abbett Co. in Jersey City, New Jersey, which manages $110 billion in assets.

Analysts predicted further losses ahead, given the strong degree of pessimism in the market.

Read the rest here.

Wall Street takes a hit; Gold and Silver plunge

After a powerful first quarter stocks have started the month of May on the downside.  As of this writing the S&P 500 is deep into its third day of negative trading with commodities taking the biggest hit.  Oil is now trading at just over $108 a barrel.  Precious metals have been hammered since posting records all through April, with Gold and especially Silver (which rose more than 20% in April alone) in headlong retreat so far this week.  The sell off in metals was however predicted by more than a few traders who warned that a month of record gains was going to cause some major investors to take profits.  Many analysts also cautioned that silver's near parabolic move to the upside had outpaced market fundamentals and it was due for a correction.

The general pattern for metals, especially gold, for the last decade has been two steps forward - one step back - pause - repeat.  Many believe this is a continuation of that pattern.

CRASH

It's time to call this what it is... a stock market crash. It's occuring in slow motion. But it's a crash all the same.

Did We Just Dodge A Bullet?

I think we did.

Mr. Bernanke and Treasury Secretary Henry M. Paulson Jr. had made an urgent and unusual evening visit to Capitol Hill, and they were gathered around a conference table in the offices of House Speaker Nancy Pelosi.

“When you listened to him describe it you gulped," said Senator Charles E. Schumer, Democrat of New York.

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program “Good Morning America,” the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”

Mr. Schumer added, “History was sort of hanging over it, like this was a moment.”

When Mr. Schumer described the meeting as “somber,” Mr. Dodd cut in. “Somber doesn’t begin to justify the words,” he said. “We have never heard language like this.”

“What you heard last evening,” he added, “is one of those rare moments, certainly rare in my experience here, is Democrats and Republicans deciding we need to work together quickly.”

Although Mr. Schumer, Mr. Dodd and other participants declined to repeat precisely what they were told by Mr. Bernanke and Mr. Paulson, they said the two men described the financial system as effectively bound in a knot that was being pulled tighter and tighter by the day.

Read the rest here.

Large Scale Federal Intervention On the Way?

As I am typing the chairman of the Federal Reserve, the Secretary of the Treasury, and the bi-partisan leadership from both houses of Congress are preparing for an historic (and emergency) meeting in Washington. The meeting appears to be for the purpose of hammering out some sort of plan for a large scale Federal Government intervention aimed at stabilizing the crisis now gripping the nations financial markets.

Details are all but nonexistent at the moment and likely will change during the course of the meeting anyways. But the very general thrust seems to be in favor of creating some sort of Federal Gov't entity that would relieve Wall Street banks of the mountains of bad debt that have accumulated, mostly from sub-prime mortgages. This debt is crushing the banks and depriving them of the ability to issue credit. Which in turn is having wide spread effects on the rest of the economy both here and around the world.

Lets not kid ourselves here. We are in the midst of the most serious financial crisis since at least the crash that precipitated the Great Depression. We can't keep rescuing some banks and letting others succumb (though in truth they deserve to). Twice in the last year the Feds have almost certainly prevented a for real no joke full blown stock market crash. The first time was with their emergency rate cut of .75% and the second was two days ago when the U. S. Government effectively nationalized AIG less than 12 hrs before it would have gone under. In the absense of those interventions I (and most analysts that I have read) believe we would have seen losses of between 1000 and 2000 points on the DOW in a single day.

The danger is not over.

This is where Ben Bernanke and Henry Paulson earn their salaries. We are living in historic times. A hundred years from now economics students will study the Panic of '08. The question is will they study it as an example of how to deal with and tame a panic in the financial markets like J. P. Morgan's intervention that arrested the panic of 1907? Or will they view it the way we look back on the build up that ultimately lead to the crash of 1929?

History is being written even as we all type. I find that a rather humbling thought.

Wall Street Bracing

From today's New York Times

Nation’s Financial Industry Gripped by Fear
Fear and greed are the stuff that Wall Street is made of. But inside the great banking houses, those high temples of capitalism, fear came to the fore this weekend.

As Lehman Brothers, one of oldest names on Wall Street, appeared to unravel on Sunday, anxiety over the bank’s fate — and over what might happen next — gripped the nation’s financial industry. By late afternoon, Merrill Lynch, under mounting pressure, entered into talks to sell itself to Bank of America.

Dinner parties were canceled. Weekend getaways were postponed. All of Wall Street, it seemed, was on high alert.

In skyscrapers across Manhattan, banking executives were holed up inside their headquarters, within cocoons of soft rugs and wood-paneled walls, desperately trying to assess their company’s exposure to the stricken Lehman. It was, by all accounts, a day unlike anything Wall Street had ever seen...

In Frantic Day, Wall Street Banks Teeter

In one of the most extraordinary days in Wall Street’s history, Merrill Lynch is near an 11th-hour deal with Bank of America to avert a deepening financial crisis while another storied securities firm, Lehman Brothers, hurtled toward liquidation, according to people briefed on the deal...

Update at 2200 PDLT: Lehman Bros has filed for bankruptcy protection.

Fasten your seat belts please...

Wall Street October 1929

A wave of selling swept through most of the world's financial markets yesterday while the US markets were closed for the M L King holiday. Today the selling in Asia became something close to an outright panic. As of this writing the European markets after an initial wave of frantic selling have stabilized and seem to be holding their breath, waiting for an indication of what will happen when the US markets open in a couple of hours. Barring an emergency and very deep rate cut by the Federal Reserve be prepared for a blood bath. Dow Futures are down over 500 pts.

The sell off has been triggered by growing fears that the US economy is heading into (or may already be in) a nasty recession. Many foreign banks hold massive amounts of American debt (bonds), some of which are probably going to be bad. There is a growing fear that the U S Government may be limited in it's ability to respond to the growing economic crisis. Heavy debt at all levels of American society from private consumer debt (credit cards & high interest mortgages etc.) to corporate and national government are weighing heavily on the economy now. Ever since George Bush took office the United States has been living on the national credit card, with deep cuts in taxes and large increases in spending to finance a shocking amount of pork and two wars. The result is that the national treasury is depleted and we have been receiving warnings that our our country's bond rating could be reduced from the AAA status it has held since 1917 to AA.

In order to finance the wars and ensure that the wealthy are not inconvenienced by higher taxes the US has been borrowing money at record rates (most of those bonds are held by foreign banks) and we have been printing more money. If you or I decided to print money to solve our financial shortfalls we would go to jail. However the Treasury Department does not operate under the rules the rest of us have to follow.

The only problem with this is that money is not immune to the basic laws of economics. The more you have of something, the less it's worth. Case in point; our money (no longer backed by gold for very good reasons) is today backed by public confidence. For decades the dollar has been the store of value in the international financial markets and the de facto currency of international finance. In short term emergency situations you can (and should ) print more money to help give a boost to the economy or keep the lights on at the government. This is perfectly OK as a temporary measure to meet an immediate and urgent need. It is not an acceptable long term answer to a knee jerk aversion to raising taxes or making politically tough decisions to cut spending. If you print more money for a long period of time you will start to loose the short term advantages and run the risk of your currency loosing its value.

Herein lies the quandary we now find ourselves in. As a general rule of thumb it's a bad idea to raise taxes or deeply cut spending during a recession. These are things you want to do during the good times so your finances are in reasonably good shape for the not so good times when you will need to use the national credit card. Also there are some things which one does not finance (at least entirely) by debt. Wars being chief among them. Since the attacks of Sept 11 2001 we have been financing two wars almost entirely through debt. At no time in the history of this country have we ever had an administration that cut taxes during war time.... until G. W. Bush. Between war spending and out of control pork barrel spending by Congress (one of the few bipartisan undertakings in Washington over the last seven years) our debt has now reached proportions that are alarming to the international financial community. Add to this the recent decline in the value of the dollar and evidence of inflation and you have the makings of a perfect storm.

Here we sit, probably in the early stages of an economic recession and the question looms large. What can the government due to help out? Yes the Fed can cut interest rates and inject currency into the markets to help stabilize things. But this runs the not inconsiderable risk of adding to inflationary pressure and further reducing the value of the dollar. Normally this would be a good time for the government to cut taxes at least short term to promote consumption and investment and increase spending in some areas in order to provide relief to people who will need some help to get through the economic tough times. But the treasury is empty. There is no rainy day fund. That was handed over lock stock and barrel to people making over a million a year in the form of tax cuts for the wealthy. We have been borrowing money hand over fist to buy bullets and body armor for troops in Iraq and Afghanistan. Where are we gong to get the money for emergency economic relief without adding to what is already an ocean of red ink?

There is a limit to how long and how much you can borrow, as any one who has ever had to live in the real world and balance their budgets can attest to, before you go over the proverbial financial cliff. So what will the government do? I am not sure. But I do feel fairly confident that they will do something. This is an election year and the appearance of being unresponsive would be political suicide. The problem is that anything that they do might be very temporary in its benefits and something we are going to pay a steep price for down the road a ways. Cut interest rates and taxes and increase spending. Those are the traditional formulas for dealing with a recession. But they are predicated on your national finances being in sound order going into the crisis. Our's are not.

The bottom line... fasten your seat belts. It's going to be a very bumpy landing.

UPDATE: The Fed authorized an emergency interest rate cut of 3/4 percent.