Monday, October 13, 2008

Beyond Rationality

Perception certainly had a profound effect on reality this week. In fact, the two were so intertwined they were hardly distinguishable. A global liquidation of unprecedented proportions is underway. Last week I wrote that hedge fund liquidation could be occurring because large investors wanted their money back. It turns out that it was worse, large investors needed their money back. This week not only Russian oligarchs were forced to sell to meet margin calls, but corporate executives in our own backyard were forced into margin selling.

Sumner Redstone was forced to sell holdings in both CBS and Viacom to meet loan covenants, John Malone sold stock in Liberty Capital to meet margin calls and the CEO of Chesapeake Energy was forced to sell all of his holdings. But wait, there is more…a director of Coca-Cola Enterprises surrendered 18.6 million shares to JPMorgan and several officers at General Growth Properties were forced to liquidate holdings.

As the uber-wealthy cut back on champagne and caviar lunches, the forced selling turned into a panic. This panic pushed many asset prices beyond what a rational investor would consider value. For example, Continental Airlines (NYSE:CAL) has over $3 billion in cash as of June 30, 2008, but as of Friday had a market cap of $1.25 billion. A rational investor could buy every share of the company, pay herself back with the cash on hand and still have $1.75 billion in the bank.

Of course, in rational times this would spark a nice buyout boom, but these are not rational times. The prevailing perception and reality is that companies need every bit of that cash to fund operations and that by the time any deal closed that cash could be gone.

As the credit markets unfreeze, companies that still have plenty of cash should be the beneficiaries of any rally. However, we have stiff economic headwinds and I can still see no reason to buy US equities. We may have pushed past rationality, but that does not necessary mean the worst is over.

The Rule of 11

So much damage has been done to the economy that the probability of a sustained bull market in US equities is close to zero any time in the near future. However, there are some structural elements to the action in the S&P 500 that suggest Friday has a high probability of being a short term bottom in the market.

The bull market of the last 4 years began on October 10, 2002, including this date there have been 30 major peaks and troughs. These peaks and troughs have tended to occur on or around the 11th of the month. In fact, 53% of the time the market peaked or bottomed within 3 trading days of the 11th, 90% of the time the market peaked or bottomed within 7 days of the 11th. The following table shows the date of every major peak and trough since October 10, 2002 and the amount of trading days since the 11th of the month.

This week is prime time for a market bottom based on the historical pattern. I have been short the S&P 500 since September 4th, 2008. I will be covering at least 1/3 of my position on any meaningful rally this week. If the rally is strong enough I will cover another 1/3 and leave 1/3 to take advantage of any further weakness.

Trading Days from 11th













































3 days


5 days


7 Days


The Kanundrum Model of Markets

The following is a description of the major global financial markets and their current position within the Kanundrum Model of Markets. An explanation of the Kanundrum Model can be found at

US Equities

Current Stage: Belief and Proof – Stage 3

Current Market Condition: Bear

We have seen both the belief and proof that the world is in a tough place manifest itself in the equity markets last week. It is possible that last week was the climax of this stage and we could be entering Complacency – Stage 4.

The key will be the strength and length of any rally. A choppy, low volume rally would suggest the sellers are simply using the rally to get better prices. A high volume, long rally may indicate that this belief and proof stage has also encompassed the Mom and Pop stage.

US Treasuries

Current Stage: Mom and Pop – Stage 5

Current Market Condition: Bull

The market for US treasury securities is less clear to me than other financial markets. My hypothesis is that we are in the final stages of the bull market. The past week saw investors chasing after yields near 0%, which suggests that safety trumped rational thought. Irrational behavior is common at market tops.

The wild card in this scenario is the Federal Reserve; I cannot construct a scenario where the Fed raises interest rates in a slowing economy. Therefore, the only thing that should take rates higher is market demand for better yields. If foreign investors refuse to fund the US deficit at near zero real rates then the market will take rates to an acceptable level.


Current Stage: Disbelief/Confusion – Stage 2

Current Market Condition: Bull

There is a very good possibility that we are at the beginning of a major bull market in gold. There are too many factors to discuss in this short format, so I plan to write more about this in a separate report.

In brief, the global financial panic has resulted in tremendous demand for gold; if the dollar begins to slide the result could be a massive rally in gold.


Current Stage: Disbelief/Confusion – Stage 2

Current Market Condition: Bear

Although the dollar has had a significant rally in the last few months I still consider this a corrective rally in a bear market. Until the fundamental picture for the dollar changes I cannot in good conscience suggest that there is a bull market in the dollar.

Most of the action has been technical and mechanical in nature. The credit crunch caused tremendous demand for dollars to fund dollar denominated liabilities. As banks hoarded cash, those dollars became hard to come by and those in need were forced to pay higher prices for the dollars.


Current Stage: Unclear

Current Market Condition: Unclear

Oil is trading on the perception of a global economic slowdown. This perception is quickly turning into a reality. However, I am still not completely clear or convinced that the bull market in oil has ended or even that a bear market has begun. Until I get some clarity I am staying on the sidelines of this market.

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