The Weekly Blather Dec. 7, 1930

Disclaimer: None of what follows is to be taken as financial advice. Do your own due diligence on all investment decisions! Also, the observations here aren't particularly original at this point, but maybe I can add an angle or two ...

No Journal was published Sunday, Dec. 7, 1930. Since I'm now doing the snarky commentary day by day, I'm going to try some more free format commentary. First, my personal favorite item of the week, from Dec. 6:

Alaska's vast distances can be appreciated by overlaying it on the continental US. If it were placed with the Northern tip touching the US-Canada border west of Lake of the Woods (about halfway across the US), part would reach the East Coast between Georgia and S. Carolina, while another part would cross over Southwest New Mexico into Mexico, and the Westernmost part would enter the Pacific in Southern Calif.

I'm too lazy to verify if that one is true, but it sure is cool. Second, my most interesting items of the week, from Dec. 6, 3, and 2:

Comprehensive total of all loans on securities is available once a quarter; peak was $16.974B on Oct. 4, 1929; this declined to $11.521B on Sept. 24, 1930, and is estimated at $10.5B now. This includes loans by banks to non-brokers and loans to brokers by non-banks. Total bank loans on securities are currently $7.761B, which is actually higher than on Aug. 30, 1929 when the market was close to its peak.

“Due to the lack of demand from brokers and business, banks have been forced to seek employment for their funds in investments.” Many have criticized this heavy buying of investment securities by banks in the past year as risky. Bank defenders point out there's been a large increase in deposits too, so the ratio of investments to deposits is still relatively small.

Fed. Reserve member banks weekly report for Nov. 26: loans on securities down $77M to $7.761B, “all other” loans down $86M to $8.766B. Investments held by banks are up $400M in the past 8 weeks and $1.4B since start of Oct. 1929.

which will provide the basis for some serious blathering. The interesting thing here is the fact that banks remained so exposed to the markets, even after the extensive liquidation that observers thought had taken place at the time. The answer to the following question would no doubt take deep study, but I'll ask it anyway. Note that the bear market at this point is still a fairly run of the mill one, down a bit over 50% from the peak and only down about 35% from where it was in mid-1929, before the final blowout rise from 300 to 380 that summer. Is it coincidental that the bear market doesn't become a true outlier until the big banks start blowing up around this time?

And, to make a feeble attempt at modern-day relevance, might it be possible that the big banks today, being unwilling or unable to find outlets in lending (as credit has again been shrinking as it did then), remain a touch too exposed to the markets? You would certainly hope that the banks, after their death-and-artificial-resuscitation experience last year, would be cutting back seriously on risk. But is this in fact happening, or is a horde of manic traders at banks and the hedge funds they lend to taking one more desperate shot at, in the words of manic trader par excellence James J. Cramer's latest book title, Getting Back to Even?

Unfortunately, it would probably be difficult to answer this question by studying bank financial statements; there are so many innovative ways banks can keep stuff off the balance sheet these days, not to mention the still almost completely uncontrolled and uncounted ability to take on market exposure using derivatives. Might there be some other signs we can look for? Well, one subtle one might be the ginormous trading profits reported by almost every big bank in Q3. But how about a more holistic approach?

Lets look at market movements over the past few months. Stocks - up; Low-quality stocks - up even more; Bonds - up; Low-quality bonds - up even more (amazingly, spreads between corporate bonds and treasuries are back to mid-2007 levels); Commodities - up; Dollar - down; Gold - up; Implied volatility - down (this is a number that correlates with the cost of buying options on stock movements, i.e. buying insurance against stocks going up or down - so this insurance has been getting cheaper).

Now, maybe there's a single rational belief about the economic future that all these market movements, taken together, are expressing. However, all the attempts I've seen are like Silvio Berlucsoni trying to wear a Speedo - no matter how you try to make everything fit, a couple of awkward bits wind up poking out and ruining the picture.

However, what if we switch the question from: “What coherent opinion about the economy are all these different markets expressing?” to: “Given that a large number of traders at banks and the hedge funds they loan to have are trying to get even, what trades with momentum would they pile into?”

Suddenly, a whole bunch of trends start to fit. Stocks? Check. Especially low-quality high-beta tradeable stocks? Check. Bonds? Check. Especially low-quality marked-down bonds that you'd make a killing on if they bounced back? Check. Commodities? Check. Gold? Check. Non-dollar currencies? Check (anti-dollar carry trade). Implied volatility down? Check (as Lowenstein noted in When Genius Failed, there is a class of quantitative traders who seem inexorably drawn to selling volatility).

If this hypothesis is true, a couple of practical consequences follow. First, it suggests that when things do go into reverse, almost everything goes down at once; gold, commodities, non-dollar currencies, bonds, stocks etc. - nothing is a shelter from the storm and the only thing you want to be long is panic. Of course, this result in itself clearly makes the hypothesis impossible as it's ridiculous for all these anti-correlated things to all go down at once; in fact, that would clearly be a thousand-year flood, since it hasn't happened for around a year.

Second, it's probably futile to try and figure out when things go into reverse based on economic predictions, since it depends more on when some significant part of the common liquidity pool feeding everything springs a leak. In fact, I wouldn't be surprised if the rallies continue on bad economic news and reverse when the economic news is looking better. The turn may come when some central banks decide to act, but I think the more likely possibility is that it's triggered by some fairly small looking default ... that causes a scramble to get out of linked assets or derivatives ... that causes a margin call or two ... and we're off to the races again.