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Generational Dynamics Web Log for 2-Oct-07
Bad news is good news again, as Dow hits a new high

Web Log - October, 2007

Bad news is good news again, as Dow hits a new high

Here's how the pundits explain it.

Monday started off ominously.

UBS AG, the biggest bank in Europe, announced a third-quarter loss, of $700-900 million. Its assets, many of which are tainted with CDOs backed by subprime mortgages, suffered a $3.42 billion reduction in value.

Citigroup, the largest bank in the U.S. by assets, announced a 60% drop in third-quarter earnings, thanks to write-downs for securities backed by subprime mortgages. In addition, Citigroup suffered losses tied to corporate takeovers (leveraged buyouts or LBOs) because of the credit crisis.

This followed the failure, on Friday, of NetBank Inc., based in Alpharetta, Ga. The $2.5 billion thrift had been an online banking pioneer, but was seized by regulators because of significant mortgage-related losses.

Those were ominous warning signs. But no matter. The Dow Industrials skyrocketed by 191 points on Monday, to close at an all time history high, 14,087, eclipsing the 14,000 point high that it reached on July 19.

Here's how CNBC commentator Bob Pisani described the situation as of 1 pm, when the Dow was already at a new intraday high:

"It sounded like bad news from Citigroup and UBS, but the market treated it this morning -- and the comments in the trade press were very clear -- "Get the bad news out now." They took the right approach. ...

Doesn't sound like good news, but the market said, look, they're getting everything out. The losses are very conservative. That is they're taking significant losses. They're trying to anticipate that it may even be worse, and they're trying to move ahead. The market loves that, and you'll notice that the stocks are on the up side here. ...

What seemed like bad news is actually being turned on its head. ... They're getting all the dirty laundry out right now."

And here's what Richard Bove, financial strategist at Punk, Ziegel & Co., said at about 8 am:

"I think it's pretty clear. ... It's because people simply don't believe that there is a crisis of this nature out there.

They believe that the Federal Reserve can solve any problem whatsoever. I mean the Federal Reserve's ability to print money and to throw that money around and solve any crisis that could arise in the financial system is so great that people simply don't believe that this is meaningful."

This has my head spinning. We've moved back into this crazy, bizarre world where up is down and good is bad. If UBS AG had posted a large profit, investors would have been ebullient about the high earnings, and would have pushed the market up to new highs.

But UBS AG posted a big loss, and investors are STILL ebullient. Why? Because UBS is taking significant losses, anticipating that things may even get worse, and they're staying ahead of it. Aaaaahhhhhhhhhhhhh!!!!

In the 1950s, my teachers would tell us about how gullible and clueless the investors were prior to the 1929 crash, and I never understood how it was possible. Now I do. What's going on today is absolutely mind-boggling. The average investor appears to be as dumb as a stump. And to think that they've pushed the stock market bubble up to a new high is almost too incredible to be believed.

Do you want to know how these guys -- these investors and their advisors -- make their decisions, reach their conclusions? Here's an example, by Morgan Stanley's David Miles, in a posting on Morgan Stanley's global economics forum:

"Our main tool for judging medium and longer-term trends in inflation is a five-equation model that allows us to determine the long-run steady state levels for key macroeconomic variables. Part of this model incorporates a Bank of England reaction function such that short-term interest rates are consistent with a path for inflation that stabilises around the target. The other elements in the model reflect wage pressures, consumer spending, unemployment and oil prices – driving factors behind inflation pressures and therefore central to Bank of England interest rate decisions. For the short term (up to one year) central outlook and risk analysis we take into account a wide range of information, including the likely path of utility prices, oil prices, pressures on food prices, house prices and council taxes.

At each stage, we consider risks: in the long run, whether the economy could converge to a different activity level; in the medium term, analysis of shocks that could affect the medium-term path; in the short run, current inflationary pressures that can affect the near-term path. Fortunately, all three approaches currently give a relatively consistent picture."

Can you believe this? He has a "five-equation model" to predict inflation for the next year.

He probably has another "five-equation model" that tells him where the stock market will be next year, and another "five-equation model" that tells him what mood his wife will be in that evening.

I would like to hear from anyone who reads this web site who believes that a "five-equation model" can be used to predict almost anything. Just write to me and let me know.

These guys have no idea what they're talking about. If you listen to the weather forecasts on the radio in the morning, they'll probably be accurate for the entire day. If you listen to stock market forecasts in the morning, there's a good chance they'll be wrong by 11 am.

Even retrospective explanations are bizarre. An evening business report might say, "Stocks went up today on the news that oil prices were falling." Then, the next evening, it'll be, "Stocks went up today as investors were unfazed by rising oil prices."

Before I go on, let me mention that last night when I wrote the article, "IMF questions the globe's continuing financial stability," I made a couple of mistakes in my description of how CDSs and CDOs are created. I thank a couple of sharp-eyed web site readers for correcting me, and the article itself has now been corrected.

However, it really hit me last night how REALLY crazy all this. There's a joke that no one who knew how sausage was made would ever eat sausage.

Well, who the hell would ever buy a CDO? Only a maniac would, especially when you know how they're made. You take high-risk subprime mortgages and merge them into a big blob, break up the big blob into small shares, and the high risk mortgages magically turn into low-risk CDOs. Actually, you still have have some high-risk CDOs left over, and you make another big blob, do the same thing, and magically convert THOSE into low-risk CDOs-squared.

Is anyone really dumb enough to invest in one of those? That's INSANE.

And yet, here we are. Investors, mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth -- they all invested HUGELY in CDOs.

There are 750 TRILLION DOLLARS of these and other credit derivatives in the portfolios of these organizations. And it's all leveraged, based on JUST 10 TRILLION DOLLARS worth of contracts. Man, that's leveraging! And the worldwide annual GDP -- the total sum of all the goods and services produced in the whole world, is ONLY 45 TRILLION DOLLARS.

But that's no problem. All we need is a "five-equation model." It'll tell us that everything is fine. So stop worrying! Be happy!

I never thought that investors would be dumb enough to push the stock market bubble even higher than it was on July 19, but that goes to show how wrong a guy can be. I can hardly wait to see what happens next. (2-Oct-07) Permanent Link
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Generational Dynamics Web Log for 2-Oct-07 Bad news is good news again, as Dow hits a new high

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Generational Dynamics Web Log for 2-Oct-07
Bad news is good news again, as Dow hits a new high