Ignorance is Bliss or From Blissful Ignorance to Obsessive Distrust

Webster’s defines blissful as “happy because unaware” and ignorance as “lack of knowledge – unawareness.”  So is it fair to say that “Ignorance is Bliss” could be thought of “How it is often better not to know about something unpleasant – no matter what the cost.”

On Tuesday I included that Fitch Rating issued a report warning against China’s massive unregulated “shadow banking” sector.  Again from Reuters:

“China has tens of thousands of non-bank lenders that are providing increasing amounts of credit to businesses and government outside the mainstream, regulated banking sector, as situation that is stoking systemic risk, Fitch said.”

Amongst the discussions between global economists and central bankers regarding how the “recovery is on track” or “the banks are again well-capitalized” it has become noticeable that one side still believes that ignorance is bliss and the other has an obsessive distrust bordering on paranoia – of the growing “shadow banking” system that somehow seems to lack any strong understanding.  I’ve seen the word terrified used several times in describing the underlying emotion. 

Take the recent speech by Fed Governor Jeremy Stein and a report released by the Bank of International Settlements (BIS, said to be the central bank of central banks) as examples.  The BIS is an integral player in determining and making palatable bank regulatory practices internationally. 

The BIS report “Asset encumbrance, financial reform and the demand for collateral assets” was prepared by members of the working group chaired by NYFed President William Dudley – yes, the former Chief US Economist for Goldman Sachs and published in May 2013.

Here is a brief synopsis:

The demand for high-quality assets that can be used as collateral will increase due to a number of key regulatory reforms. This comes on top of greater demand for collateral assets through increased reliance by banks on collateralized funding, particularly in Europe. While this can lead to temporary shortages in some countries, concerns about an absolute shortage of high-quality collateral assets appear unjustified, given that the supply of collateral assets has risen significantly since end-2007. In addition, endogenous private sector responses, such as collateral transformation activities, (when banks swap collateral with each other) will help to address supply-demand imbalances if and when they emerge.  

The report identifies implications for markets and policy that result from these developments that warrant monitoring and further analysis. They include:

• Endogenous market responses, while mitigating collateral scarcity, are likely to come at the cost of increased interconnectedness and greater financial system procyclicality. (Meaning – “of or denoting a business or stock whose income, value or earnings fluctuate widely according to variations in the economy of the cycle of the seasons.) and financial system opacity as well as higher operational, funding and rollover risks.
• Greater reliance by banks on collateralized funding can adversely affect the residual claims of unsecured creditors during bank resolution, increase risks to deposit insurance schemes and reduce the effectiveness of policies aimed at bail-in.

Mr. Dudley’s key findings at first glance might not seem alarming, but go back again and be sure to understand all the “bankerese”.  The report was not rosy but somehow its purpose was to ease the terrified bankers wondering who will be left “standing when the music stops in this game of musical chairs.” 

When Warren Buffett declared back in 2002 that derivatives were Financial Weapons of Mass Destruction, most shrugged him off as a fundamentally conservative investor.  After 2008’s meltdown there were some that felt FWMDs were real and needed to be regulated and “cleared” – so along comes the Dodd Frank Act and it’s thousands of pages of legalese included at the behest of Wall Street’s finest. 

What I took away from Mr. Dudley’s findings is that collateral transformation is potentially a very powerful FWMD.  And that the BIS and other regulators are well aware of this and are comfortably (worried?) that they are on the job – unlike the previous crisis that they all seemed to fail to foresee.

Fed Governor Jeremy Stein recently explained the need for “liquidity regulation thusly:

As the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk. That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether. And fire sales and bank failures–and the accompanying contractions in credit availability–can have spillover effects to other financial institutions and to the economy as a whole. Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure. It is this externality that creates a role for policy.

So, it comes back to market failure. It would seem that regulators have never found a market that doesn’t fail at some point, which keeps them in a job – to prevent the next failure or at least explain how the previous one happened.  Aren’t we a society that learns from its mistakes? 

There is a strong link to “shadow banking” presently and well as in the past.  When the regulators became so overly focused on capital adequacy  – liquidity and securitized collateral seemed to just slip away.  The tremendous growth in shadow banking liquidity put the entire financial system at risk should a severe drop in securitized collateral values occur.  Occur it did folks – and collapse we did – many are still fighting and feeling the 2007 housing market drop. 

So again, I restate from yesterday’s article –

So what has everyone on edge in the markets?  It is something I have discussed previously and will continue to discuss.  The Status Quo is changing.  It is shifting away from what has been perceived as “given” for years.  Conventional Wisdom is old, ancient and hazardous to everyone’s financial health.  The corrections that have rumbled across the globe are real.  It may have taken some time for the underlying momentum to change, but change it has.  Perception is NOT always reality!

Real Interest rates in the U.S. are nominal interest rates adjusted for inflation.  So, logic tells us that if interest rates are rising (check out the Treasury Market charts below) and inflation is falling (jury is still out on this one), that is going to cause real interest rates to rise rapidly.  In turn this makes the U.S. dollar more attractive since investors want to have something in their pockets that pays more. 

Take a look at the chart below of the 10-Year TIPS Yield (Courtesy of Business Insider)

Thirty-Year Bond Future (Weekly Chart)

Ten-Year Note Future (Weekly)

Bond markets around the globe are selling off as rising interest rates in the U.S. make U.S. Government debt more palatable for investor.  Yes, this should be interpreted as a sign of good things coming, but it is rattling the nerves of the global markets.  I’ve said it before it doesn’t take much to upset the bond market and if the perception is that there is a strong prospect of the monetary stimulus being pulled back or worse removed from the market by the Federal Reserve.  If the markets believe that the Central Banks around the globe can’t keep control of the long-term interest rates which has been the backbone of the rally that began following the financial crisis of 2008-2009 things might just get a bit uglier.

Wednesday’s sell-off was an across the board affair.  Equities, treasuries, precious metals, and commodities – it was a run to raise cash.  Don’t be fooled into thinking that the money leaving bonds was being put into the stock market or vice versa.  It wasn’t happening that way, at least not yesterday. 

 It is interesting times in which we live and choose to trade.  I have advocated changing strategies as a trader in becoming more of a day trader (no overnight risk) versus carrying positions.  This remains important during times such as these.  When the dust settles it will be important to have the cash to invest for the next move. 

Diversified Trading System

I continue to recommend as the best trading platform available to a broader range of traders from novice to expert.  The Diversified Trading System offers a cost effective product that allows a trader to enter into the “chaos” and trade more effectively.  

Trade Manager from Indicator Warehouse automatically calculates the correct amount of contracts or shares based on your account size or market volatility.  Automated stop-loss management and position sizing eliminates most of the problems most individual traders have.  Day trading and position trading both require (actually demand) good risk management.  Trade Manager does the job across the board and is an essential trading tool that ensures that you take the maximum profit from all your trades. 

A newer member of the money management tools available from Indicator Warehouse is the Profit Finder – System Back Tester.   When implemented it allows the user to:

• Immediately know the impact of parameter changes. 
• Automatically reads all of your DTS entries and exits
• Calculates the profit/loss of each trade
• Performs a wide number of essential intelligence boosting calculations instantly
• Provides solid details about the effectiveness of your trading strategy/ methodology/ indicators

The last two points above are valuable tools to use.  It will show you where some “tweaking” is needed to improve results through the back testing feature. 

My point on money rotation and sector rotation is similar to that on parabolic moves that they happen with frequency within many time frames.  As traders these types of moves can be a bonus for day trading or position trading so again don’t get caught up in the “what’s the catch.”    Realizing a rotation is occurring within a stock you trade or a sector is a great source of stocks to plug into the Diversified Trading System.  Allowing DTS to cleanly and beautifully capture the moves though any or all three DTS trading platforms.  Our goal remains to assist traders to make greater profits during all types of markets.  Sector and money rotation is another tool.

The Diversified Trading System used together with Trade Manager should continue to produce numerous trading signals in the DJIA, YM (mini), S&P 500, ES (mini), RUT, TF (Russell 2000 mini), AAPL, AMZN, GOOG, NFLX, and LNKD, GS, and Tesla Motors (TSLA).    

Here is an updated list of the markets where I have found that DTS (all three birds) are producing numerous signals:

• DJIA future (e-mini available) – Highly recommended
• S&P-500 future (e-mini available) – highly recommended
• Russell 2000 future (e-mini available) – highly recommended
• NASDAQ 100 future (e-mini available) very highly recommended
• US$/Euro futures (e-mini available) – very highly recommended
• GS (Goldman Sachs) – good two way volume –
• AAPL (Apple Computer) – very highly recommended
• GOOG (Google) – very highly recommended
• LNKD (LinkedIn) – solid intraday range
• NFLX (Netflix) – solid intraday range
• TSLA (Tesla Motors) – highly recommended  
• 30-yr Treasury Bond future – did not get quiet – opposite took place
• 10-yr Treasury Note future
• TLT (Treasury Bond Long ETF)
• TBT (Treasury Bond Short ETF)
• Gold (futures and ETF – GLD)
• Silver (futures and ETF – SLV)