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    Thoughts from the Frontline

    The QE Sandpile

    May 3, 2013

    Sell in May and go away? What about "risk off?" And ever more QE? Today's letter is a quick note and a reprise of a popular letter from yesteryear (with a bit of new slant), as I am at my conference in Carlsbad.

    But first, I thought I would shoot you a few quick, interesting notes that crossed my desk in the last week. It is almost a ritual for me to mention at this time of year the old investment saw, "Sell in May and go away." It has been surprisingly good advice in most years. My good friend Art Cashin is a curator (and prodigious progenitor) of investment wisdom. He offers these two insights from his research:

    Tomorrow is the beginning of May, so a "Sell in May" review is in order. To avoid reinventing the wheel, let me plagiarize the veteran Jim Brown's synopsis yesterday.

    Sell in May? We are at that time of year when investors have to decide if they want to take profits and move to cash for the summer or risk losing those profits in the next correction. The Stock Trader's Almanac has made the "Sell in May and go away" trade one of the most visible trends in the market. Because the markets normally decline in the summer, they came up with the best six-month trading system. If you had invested $10,000 in the Dow in 1950 and only kept the money in stocks from November through April, you would have had $684,073 as of the end of 2011. If you reversed the strategy and invested for the May-October period, you would have lost $1,024 over the same 61-year period. That is a pretty telling statistic, and the cycle rarely fails to produce.

    And Art followed up the next day with:

    Mark Hulbert suggests it may be a much older multi-national phenomenon. The "sell in May" pattern also exists in other countries besides the US. Ben Jacobsen, a finance professor at Massey University in New Zealand, reached that conclusion after studying all available historical evidence from each of 108 separate stock markets around the world. For example, his statistical tests detected the seasonal pattern in the United Kingdom stock market as far back as 1694.

    Jacobsen, in an interview, emphasized that the Halloween Indicator isn't merely the product of a shameless, after-the-fact data-mining exercise. He said that he found an article as long ago as 1935 – in the Financial Times – in which the "sell in May" pattern is referred to as something that was already well-known and followed.

    Even though the pattern nearly 80 years ago already had a solid historical foundation, Jacobsen notes, since then the difference between the average returns in winter and summer has become even bigger.

    This is a crucial point, he argues, since the all-too-usual tendency is for patterns to begin to evaporate once investors become aware of them and try to exploit them."

    China's PMI came in this week at barely above 50 and has been clearly falling for the last year. Despite what you read, China's economic growth is slowing, which is NOT good for commodity metals and products (different from the "softs" like grains, cattle, etc.). GaveKal argues that the commodity price fall that we have been seeing of late is possibly structural in nature. Yet the bond market rises, gold is rising, stocks are rising. (Clearly, the market did not listen to my friend Nouriel Roubini this morning – Dr. Doom indeed! After his speech, no one at this conference can call me pessimistic. Although he prefers the term realistic.) Seemingly everything is levitating.

    "Where is risk off?" I ask aloud back in the green room as I write this.

    Paul McCulley quips to me, "Never get in a …… contest with a man who buys ink by the barrel." The clear implication is that this levitation is all central bank-induced. The Fed, Japan, and the ECB are all in full gear, and England is only waiting for Mark Carney to arrive from Canada with the North American printing technology employed so well by his friend Ben Bernanke.

    The question I am asking at the conference is, "What will happen when quantitative easing has to end? What does that look like?" I will report next week on what I am learning here, but right now let's return to what has proven to be the most popular piece I have written over the last 13 years. And as you read it, think not just of sand piles but of the analogous pile of electrons of quantitative easing as it mounts up toward criticality.

    Friedrich Nietzsche knew just how the troubling unknown grips our imaginations and compels us to look for answers:

    "To trace something unknown back to something known is alleviating, soothing, gratifying, and gives moreover a feeling of power.  Danger, disquiet, anxiety attend the unknown – the first instinct is to eliminate these distressing states.  First principle: any explanation is better than none…. The cause-creating drive is thus conditioned and excited by the feeling of fear…."  –Friedrich Nietzsche

    "Any explanation is better than none." And the simpler, it seems in the investment game, the better. "The markets went up because oil went down," we are told. Then the next day the opposite relationship occurs. Then there is another reason for the movement of the markets. But we all intuitively know that things are far more complicated than that. As Nietzsche notes, dealing with the unknown can be disturbing, so we look for the simple explanation.

    "Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brain that make us feel good. We literally become addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important to the chemical release. And so we look for reasons.

    That is why some people get so angry when you challenge their beliefs. You are literally taking away the source of their good feeling, like drugs from a junkie or a boyfriend from a teenage girl.

    Thus we may reason that the NASDAQ bubble happened because of Greenspan. Or was a collective mania. Or was due to any number of things – pick your favorite belief. My favorite: just as the proverbial butterfly flapping its wings in the Amazon triggers a storm in Europe, maybe a borrower in Las Vegas triggered the subprime crash.

    Crazy? Maybe not. Today we will look at what complexity theory tells us about the reasons for earthquakes, disasters, and the movements of markets. Then we'll look at how New Zealand, Fed policy, gold, oil, and an investor in St. Louis can all be tied together in a critical state. Of course, how critical and what state are the questions here.

    Ubiquity, Complexity Theory, and Sandpiles

    We are going to start our explorations with excerpts from a very important book by Mark Buchanan, called Ubiquity: Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory and critical states. It is written in a…

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    Robert Braun

    May 5, 2013, 9:53 a.m.

    Cogent and, as usual, very well written: clear, to the point, readable and understandable. However, for some reason you stop before you get to the reason for the instability to exist. That ruler being balanced on a finger top has been placed there by someone: for show, just to have fun or as an experiment or somewhat. What causes the instability of our financial systems? You make the argument that it might be a selfish (and mindless?) endeavor to hedge for risk. And it may be so. But how do all those hedging instruments get born? Who enables that? Or more to the point, who pours those grains of sand on the pile? And why? Is it just for fun? Hardly… This may be of some further interest… I guess…

    stephen myers

    May 4, 2013, 8:14 p.m.

    Long ago, it occurred to me that I tended to read that which re-enforced what I already thought.  That observation helped me justify my preference for fiction; in fiction, the author can create a credible story line that leads to the certain outcome.  It is just not possible to identify, much less control, a story-line “in the real world.”

    May 3, 2013, 9:04 p.m.

    I think some of this also relates to “fractal geometry”. If you are looking for the side where the slide will start one only need peruse the “Banks” but not so much for the reasons you listed. Every other day a story about computers being “hacked” hits the news. Now to my way of thinking banks are a modern “miracle”. I can go anywhere in the world and write a check or use a credit card and that transaction will beat me getting home without any errors. Yet they would have us believe some recalcitrant teenager in his parents’ basement can hack into their systems at will and unfettered. Personally I think this a set up for when the bankers decide that the money in their banks is actually their reserves and not really my hard earned money.What is to stop them from waking one morning and saying your money is gone because some North Korean hacked our computers and your money (which is only ones and zeroes in the computer) has disappeared.What could I say then? The first subtle sign that banks are in trouble is when you try to take out some. Most banks these days put out deposit slips by the handfuls, but withdrawal slips are obtained only after negotiating multiple hoops. Check it out for your self. Next keep a close watch on your stock dividends. I recently had some dividends supposed to come in on good friday. I waited until midnight to call Schwab about my dividends not arriving in my account. They assured me that the money had come in and most assuredly would be there on monday a.m. Monday after close still no dividends, it was wednesday before my dividends arrived. Banks are getting more reticent about withdrawals.

    Matthew Weatherley-white

    May 3, 2013, 8:07 p.m.

    John -

    The “sell in May and go away” calculation was stark enough that I felt compelled to do a back-of-the-napkin gut check. In brief, starting with $10,000 and running a compound return for 61 years to end up with approximately $660k requires a 7% CAGR (give or take a few basis points). The same calculation to generate a $1,000 loss would be about -.2%. This implies that the market has produced about 7% over the past 60 years. Curious, given the myth that the stock market has generated about 10%.

    However, what really sparked my curiosity was the potential impact of short-term capital gains on the trading. Applying a blended historical federal and state short term capital gains rate of 40% (I’m sure that’s light, actually, but this is a napkin calculation, right), and assuming no fancy gain/loss balancing etc., the net result over the same period would be $139,000, or about 4.4% CAGR. A sufficiently big difference to lend credence to the strategy, but a far different result than the one Cashin suggests.

    Unless, of course, he is already taking into account the effect of taxes, which might explain the difference between his imputed 7% return and the mythological 10% that we are all “supposed” to get in the stock market?

    An interesting line of inquiry, no?

    As always, your posts are provocative,

    May 3, 2013, 5:43 p.m.

    “Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words, the more “fingers of instability” that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious “avalanche.”“

    That perfectly describes the current world situation between the West and Islamic societies.  We have fingers of instability growing monthly and yearly.  Since Islam has been at war with the West since the 7th Century, in one form or another, what we are experiencing is simply a continuation of that basic conflict in ideologies.  What will be the grain of sand that will destabilize the whole pile, with its nuclear core?  Not a trivial issue, considering Iran’s current efforts and Pakistan’s current instabilities.  Meanwhile, we are allowing more and more fingers of instability to infiltrate the West.  Sobering.

    Dallas Kennedy

    May 3, 2013, 3:38 p.m.

    As a physicist, I hereby endorse John’s sandpile.

    The thing is, physicists and mathematicians are unconsciously attracted to the problems that can be fully solved: the harmonic oscillator, the two-body gravitational problem, the ideal gas, the complete thermodynamic equilibrium, the Gaussian (bell curve) version of the central limit theorem. Most of the world is not like this.

    The theory for the real-world cases is there, but it’s often too hard to solve or to make easy use of. So we fall back on approximations and, failing good approximations, on simplified models, metaphors, and analogies. There’s always pressure for cookbook solutions, which blinds some to how hard problems like financial markets or climate are.

    OMG Ferguson is remarried to Ali! The rumors were true.

    jack goldman

    May 3, 2013, 1:22 p.m.

    I don’t see complexity. All I see is simplicity. We have silver money circulating freely. US silver coins are 90% silver and sell for twenty times face value. In other words there has been enough counterfeit money printed, enough debt created, to drive the real price of things up 20x. To find the real price without counterfeiting and debt, divide by 20. The Dow is $14,000 in counterfeit money. Divide by 20 and get $700, the REAL price of the Dow in real silver US Treasury money. The Dow was $700 in 1964 and is still $700 in the same exact real money. What is so complex? Counterfeiting money and using debt as money drives the fake price up but the real price never changes. Gasoline was three silver dimes in the 1960’s and is still three silver dimes in 2013. Nothing has changed other then counterfeiting money and using debt as money. When the counterfeiting and debt are withdrawn prices for labor, materials, and producers will drop. The true price of the Dow, in real money, is $700. We live in a luxury, women and minorities, quota, service sector, debt based, government induced, affirmative action, racist, gender biased, command economy.

    Then bankers, brokers, asset owners, and government hope to make all this confusingly complex. It’s all extremely simple to children, families, renters, and employees. The elites are enriching them self with counterfeit money. For how long? No one knows. Stop counterfeiting and prices collapse. Keep counterfeiting and prices go through the roof and we all go to war. These are two bad choices.

    Fraud, counterfeiting, cheating on a spouse, all end badly. When will I get caught and have to pay the price for my cheating and lying? I don’t know. I have to protect myself from liars and cheaters.

    May 3, 2013, 12:42 p.m.

    Taxes are up. Unemployment is down. Profits are up!

    Maybe what we need is more tax increases!