In Search of the Perfect Investment

This has been my worst week in the stockmarket. Three reasons:

+ I lost much money — on paper.

+ I didn’t know why the market turned suddenly down. This was especially irksome.

+ I didn’t know when it would end.

Several “explanations” have floated: First, bond yields have risen. Second, inflation fears. Third, new sentiment: Stocks are “overpriced.” Fourth, we’ve run out cheap money to buy stocks. (See Dick Bove below)

All these four are long-term explanations. Not one of them explain the recent extreme suddenness.

OK, Harry, what’s the best explanation? Cramer had one last night. It seems logical since it fit in with my “Dash for Instant Wealth” theory of yesterday. Here goes:

Hedge funds make their owners rich. For owners to get rich they need huge amounts of other people’s money. To get those monies, they need a great track return. Last year was good, but some hedge funds wanted/needed more.

The safest bet last year was betting against the VIX, which last year was flat — using call options and…

Hedge funds used ETNs like UVXY, VXX, TVIX and SVXY.

As an example, here’s UVXY over the last two years:

Cramer believes they sold call options against against the UVXY — a safe, profitable bet. Until the last few days when this happened:

Suddenly, the call options turned profitable (for the non-hedge fund owners) and the hedge funds who wrote them were on the hook for millions of dollars — which most didn’t have in cash. And since a lot of these trades were done on margin, brokers were getting on the hedge funds’ case to ante up money — i.e. sell other stuff in their portfolios. That led an across-the-board sale of stocks. This makes sense. When I looked at my portfolio yesterday, every one of my stocks were down — bar one, CENT, which had just reported excellent earnings. So, the 1000 point crash yesterday wasn’t earnings based. It was hedge funds selling good stocks to pay for their losses on dumb bets.

It was, Hedge Funds Gone Wild.

Wall Street is a casino. Cramer talked about the Street’s gambling instinct. He spend years working at Goldman Sachs. The people working there would gamble on which raindrops on the window would fall first.

Shows how stupid I am. I’d never heard of the ETFs which Cramer mentioned last night. He called them VIX derivatives:

UVXY — the ProShares Ultra VIX Short Term Futures ETF
VXX — the IPATH S&P 500 VIX Short Term Futures ETN
TVIX — the VelocityShares Daily 2X VIX Short Term
SVXY — the ProShares Short VIX Short Term Futures

What’s all this mean for us lowly unsophisticated investors? First, the market will return to the sanity of stocks whose prices are based on earnings and prospects. And since our portfolio is full of good stocks (see right hand column), I’m convinced we’ll eventually recoup our losses of the last few days.

When will this happen? I’m guessing soon. Some hedge funds will need to close shop. Some already have apparently. Some will soon meet their margin calls by selling everything they need to. The selling pressure on good stocks like Amazon and Netflix will ease. The VIX should drop back. And the UVXY will return to flat — as it did until the last few days. See chart above.

I suspect none of this will bring solace to investors who bought stocks on the naive belief that stock prices reflected corporate earnings and their prospects.  The last few days have been very scary — for them and me.

If all this is correct, then we should start seeing the market begin to climb back, as it’s doing today.

To further illustrate this gruesome story: Imagine you were a hedge fund and you bought oodles of SVXY on margin. You were doing fine for the last two years until this happened:

But some bought SVXY on margin. What nutcase would buy a ProShares Short VIX Short Term Future ETN or ETF (or whatever it is) on margin?

For that you need to delve into the psyche of hedge fund managers. Many of these guys are serious gamblers. Perhaps addicts of the crack/cocaine variety.

I’m not a shrink. But I’ve invested money with hedge funds. Some did well. Some blew up. Overall, I would have been far better off with a Vanguard S&P 500 index fund. Less agita too.

The lesson from all this? If the markets suddenly drop, you to figure why? Is it short-term or fundamental? You need to understand that panic is not a strategy. And you need to keep your eye on this chart:

Meantime, everyone has their theory on what happened. This is one that was published on CNBC.

Dick Bove is not a stock analyst. He doesn’t pick stocks. Some say he can’t. He’s right about the withdrawing of liquidity.  But he’s years too early.  The best part of this bull market is that it’s earnings driven. As example, Nvidia reported great earnings last night and it’s up nicely this morning.

For the next week, don’t buy “cheap” stocks until the hedge funds are finished selling good stocks to pay for their hudge losses. Perhaps another few days. Keep an eye on the VIX. Wait for it to settle down. As I write this — mid morning — markets are down heavy.

Dick Bove’s long-term theory, as reported on CNBC.

Dick Bove argued “A fundamental change is underway in the financial markets, and it will not be pleasant The financial crisis is now over and the aberrational financial values created by the manipulated market are ending. For a decade there has been a great deal of money around at real prices below zero. This era is over.”

That’s the headline. Now for the Bove explanation:

It starts with money and rates.

There is a hot debate among the bulls and the bears as to whether the recent change in equity valuations represents technical market factors that will be quickly reversed or a fundamental change that will take some time to play out.

I am of the view that there is a meaningful fundamental change underway.

t is not economically driven it is financially motivated. Simply stated, in the decade following the financial crisis, money availability was increased through quantitative easing and the cost of these new funds in real terms was negative. The financial crisis is now over and the aberrational financial values created by the manipulated market are ending.

The Federal Reserve has put in place two new policies. The first has lowered the annual growth in the money supply (M2 SA) to 4 percent from what was touching 8 percent, 15 months ago, and over 10 percent, six years ago. The second is progressively increasing the cost of funds. The real cost of money, as measured by comparing the Federal Funds rate to the Consumer Price Index, has been negative 93 percent of the time since 2010.

Restating this point, for a decade there has been a great deal of money around at real prices below zero. This era is over. Anyone who does not understand that this is a significant fundamental change needs to take a thoughtful look at these numbers and think about what they mean.

What make this change more significant is that it is occurring a time when the demand for money is rising. First, the United States government is going to push its $20 trillion debt much higher. Second, the probability of accelerating growth in the economy with moderately higher inflation indicates that the private sector needs more funds. Third, the resumption of economic growth in the Euro zone indicates more money is needed there to maintain forward momentum.

Increased demand for funds at a time when the growth in supply is easing will drive money costs higher and financial values lower. This is about as fundamental as it gets.

But let’s dig deeper. The scoring mechanism in the financial sector is the dollar. If the value of the dollar changes, then the financial assets that it is measuring change. From the trough 10 years ago to the peak at the very end of 2016, the value of the dollar rose by an estimated 41 percent. From the peak in late 2016 to the present it has dropped by 11 percent.

Moreover, while the Treasury Secretary of the United States has indicated that he wants a strong dollar, he has also indicated that the United States would not intervene in currency markets to support the dollar – i.e., he would allow this currency to drop further in value in the short run.

Simply stated, if the scoring system drops in value the items being scored drop in value. A weaker dollar means lower financial assets values. The process is far more complex than being asserted here but the bottom line is that weak dollars buy fewer physical items and financial items must pay higher rates of return to offset the drop in the currency value.

To argue that a shift in money availability; a shift in real interest rates; and a shift in the value of the dollar; have no fundamental impact is simply folly. A folly driven by a lack of understanding concerning how valuation works. The markets are undergoing a far more important change than a technical adjustment.

Be very cautious as to how you invest your money at this time.

Housing in Heaven

A wealthy man died and went to heaven. Saint Peter led him down the streets of gold. They passed mansion after mansion until they came to the very end of the street. Saint Peter stopped the rich man in front of a little shack.”This belongs to you,” said Saint Peter.

“Why do I get this ugly thing when there are so many mansions I could live in?” the man demanded.

“We did the best we could with the money you sent us!” Saint Peter replied.

Harry Newton, who does not crave volatility but prefers sanity and stability. But I’m also wishing for a solid down-the-line backhand, like Federer’s. I wish.