US Treasury Bonds Soar on the News of Their Own Downgrade?

Anyone who’s been seriously securities pricing over the last several years has seen a series of bizarre pricing anomalies in securities as markets have gone from boom to bust- back and forth. Taken individually, any of these pricing anomalies as the market moves would be a challenge to Efficient Market Hypothesis (EMH) notion that the current price of a security reflects the most current analysis of information regarding that security. EMH proponents have a hard time explaining the internet bubble, or really any security that seems to defy rational explanation.

Still, people put stock in the pricing mechanism of the marketplace and see some wisdom in it. When gold was languishing in comparison to the US Dollar through the 1980s and 90s, the rational explanation was that people no longer felt it was a safe haven. Now, conspiracy minded Libertarians such as myself felt that there was a greater conspiracy at work on the part of the powers that be to get people to believe in the US Dollar as the ultimate safe haven rather than gold. There are certain strange coincidences, such as the decline of the spot price of gold in the wake of most major political news (such as the start of Desert Storm or 9/11) which would be occasions where you would thing it would go up.
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The Not-So-Efficient Market

There is a theory in stock circles called the “Efficient Market Hypothesis.” It was first proposed by a student of famed mathematician Benoit Mandlebroit (who proposed Chaos Theory) named Eugene Fama. The theory is easy to understand; markets such as the stock market have so many players that it reacts instantaneously to process all known information about a given security. A corollary of this theory is that because all information about the market has already been “priced in”, that it’s impossible to beat the market because any actionable information about a given security is already reflected in its price. This theory was popularized in books such as A Random Walk Down Wall Street. It has been attacked in a number of books including Benoit Madlebroit’s The Misbehavior of Markets as well as my book, What Do You Mean My Money’s Worthless.

I’ve found that some of my biggest investing mistakes are caused by giving any credence to the notion that the market has priced in any information at all. Case in point, for much of this year I was an investor in the Prudent Bear Fund (ticker=BEARX) which is a mutual fund that is short the market, yet, despite many of my predictions of doom and gloom coming true, the stock market continued to hold its value in the face of more and more bad news. Then came October. Paulson and Bush announced that they were going to do a massive bailout of all troubled assets on bank balance sheets after allowing Lehman Brother to fail, and the stock market rallied strongly. 

At that point I lost faith that the stock market was going to decline. It seemed that the Federal Reserve and the US Treasury were simply going to inflate the problem away, and the market was responding in just such a direction. So the logical move to me seemed to be to invest in gold in order to protect from inflation and away from shorting. I figured that, with all the bad news that has come out, if the stock market was going to crash it would have already done so. I closed my short positions just before one of the most violent stock market collapses ever based on the belief that knowledge of the credit freeze and oncoming recession were already “priced into” the market. I’m still up on the year (which few people can say) but I missed out on a great opportunity to profit due to my putting ANY credence in the notion that the market was efficient. 

Now I’m realizing that the key to investing is not to predict the tomorrow’s headlines, but rather to figure out which of yesterday’s headlines will the have staying power to shape market movements in the future. That’s what I’m trying to do today. Call it the “Slow Market Hypothesis”- which significant piece of news will the market take the longest to get through its thick head? A question that is very much on my mind today. 

The headline that’s dominated the last couple of months has been that “Deflation is Coming. Run to Cash!” Call me crazy, but I think that headline’s played out now. The headline of today was that “Dollar slides as Obama vows stimulus.” Gold moved strongly up and Barrick Gold, my personal investment vehicle of choice, closed the day up 8.39%. I think that the headlines going forward are going to become more focused on inflation rather than deflation as markets react to the new ending stream of new dollars being cranked out by the Treasury and the Federal Reserve. Just today, it seems that Congress and Bush are dipping into the bailout goody bag for $15 Billion to loan the auto industry. The hard figures on M2 straight from the Federal Reserve says that our money supply has expanded by 7% over the course of year, which is not nearly as alarming as the “Adjusted Monetary Basis” (a measure which accounts for changes in the reserve requirements as well as changes in foreign exchange market intervention) which the St. Louis Federal Reserve Bank publishes. Here, take a look at it yourself:

That’s a rather astounding rise in the monetary base (1400% annualized), and it’s only going to get worse. The next stimulus package that’s being proposed by Barack Obama is roughly $1 trillion

The rise in the value of the dollar was caused because liquidation was forcing people to sell their assets in order to meet margin calls that were written in terms of US dollars, but that’s going to be a short lived phenomenon. As the full impact of these monetary shenanigans start to sink in, the market will seek a safe haven that isn’t being grossly tampered with, and that’s going to lead them back to gold. That’s my prediction anyway, we’ll see how it turns out.

Seven Days of Loses Makes One Weak

Ouch! The poor Dow Jones Industrial Average has continued it’s rout for the last 7 days. Falling from 10750 to close today at 8579. That’s a decline of roughly 20% in one week. If we go back one full year, the Dow closed at 14164 on 10/9/07. A loss of roughly 40%. Put those two numbers together and we see that the Dow has suffered half of its 40% decline on the year in the past seven trading days.

Gold closed the day at $910. For those of you who have read my book and are interested in the Dow-Gold ratio, gold was priced at $730 an ounce one year ago. It’s $910 today. So the Dow-Gold ratio has fallen from a ratio of requiring 19.4 ounces of gold to buy 1 “share” of the Dow a year ago to only requiring 9.43 today. That’s a decline of roughly 51% in one year. Any way you slice it, stocks have been an absolute bloodbath.

It’s been a good market for us bears, and it will continue to be. I am predicting that the Dow-Gold ratio will continue to fall all the way to a bottom of two or three. That’s another 70%+ loss or so, but I don’t think it will come this year. I think the stock market is do for a snap back. The carnage will take a breather and it will lull in people who feel it’s a good time to buy. People who do so hoping to make a good long term investment are going to be sorely disappointed. You might see some short term gains, but it’s still a long way down. It’s a traders market.

I haven’t seen many stories today discussing these market declines in terms of the Efficient Market Hypothesis (EMH). In years past, whenever you’d see these market declines a Hedge Fund somewhere would suffer some huge loss. Typically the press would ask the manager for a comment and the manager would say something like, “The market activities of the last couple of weeks of market activity are so extraordinary that they were impossible to predict. These types of market only occur once every 1000 years.”

Those statements were based on predicting stock market returns as a normal distribution about a daily average with each day having no influence on the days following it. As we’re seeing, that’s just not the case. The last few days along have seen a string of huge loss after huge loss one right after the other. That’s not bad luck; that’s a bear market.

I have a hairstylist friend who works in a very expensive hair salon. She keeps my book at her station and has noticed a lot of people asking about it lately. It prompted one of her clients revealing that she and her husband had lost the entire $250,000 investment they had made in a hedge fund just a few months prior. Which just goes to show that old story about a fool and his/her money.

Short term corporate bonds are going for unheard of yields.  The search on my Scottrade account is showing annualized yields of 80.9% for National City Corp bonds maturing in April of next year, and that’s but one example. There are plenty others. Those National City Corp bonds have an A3/A- rating, but it seems no one is trusting the rating agencies anymore. And why should they. Washington Mutual bonds were rated as investment grade until just a couple of weeks before they became worthless. With events happening like that, April of next year can seem a long time away indeed. But it does represent a good opportunity for the Michael Millken’s of the world who can sift through the financial statements and sort out the goods bonds from the bad. Then again, with all the accounting shenanigans and off balance sheet Structured Investment Vehicles, who can really tell the junk from the gold anymore. 

That’s the problem with markets that aren’t transparent. No one knows what’s good, so they abandon everything. Until we start to see the yields on these bonds coming down, credit markets will continue to be frozen. That means capital is at a premium and stocks are going to have real trouble doing well. What the next market development is is anybody’s guess.