It had to happen.

One last comment on Bear Stearns, which I have been concerned with for a long time on this blog.

The Fed had to bail them out. Counter-party risk at that point was freezing a good part of our shiny new (well, post 1973) financial system. If Bear were allowed to drift into bankruptcy, the markets would most likely have panicked. Indeed, I wrote to clients that Sunday (after the deal was announced) that U.S. stocks may trade limit down on Monday assuming the liquidation of massive position and a mad scramble for collateral that may actually be worth 100 cents on the dollar.

Obviously, that scenario did not materialize, due to some very nice work by the Fed, who acted with the speed of a private company, and completely obliterated the authority of the SEC in the process...no mean feat in a large bureaucracy.

Now comes the difficult part. The slippery slope of "bailout" has been greased, and at what point does the Fed say "no mas" to all the needy hands that are suddenly now raised?

The answer to that question is beyond the scope of this blog, as it concerns questions of national policy and questions of governmental power dating back to Mill and Locke.

However, confidence is returning. Again, there will be volatility in the finance sector as the pricing difficulties continue to be cleared, but this last episode has marked a turning point for global liquidity and confidence. A large player was forced to fall on his sword. The real economy is learning to live with a damaged financial economy.

Put another way, the problems that started over a year ago are now abating, and stewards of capital would be well-put to capitalize on these developments. There will be volatility short-term (next 30 days...short-term traders will do well here) but the 1320 S&P level that I spoke about here over a year ago will make a nice beachhead going forward.

On the uselessness of describing "booms and busts"

Quantification is useful, even essential for investing.

However, with computing power so cheap, it is no wonder that arb-type trades and investment strategies CANNOT continue to do well. Profits attract competition, competition squeezes margins...so what is one to do?

Answer: Leverage. Gear up your pairs trades and arb strategies until profits regain expected levels. Regrettably, this process (repeated many, many times by participants) guarantees an entirely different volatility regime. The economist Minksy has been quoted much lately. As the "Minsky moment" is bantered around by everyone seeking some explanation for the events of the past year. But ex-post explanations to me are so unsatisfying, and arguments based on "boom and busts" only tell half the story.

The other half concerns Super Levered Operating Businesses, or "SLOBS".

The SLOB explanation is more ecological and organic. The opportunity cost of firms NOT to invest in SLOBS becomes high. More capital floods into SLOBS. More leverage is required to increase returns. Then, suddenly some heroic participants begin to question the sustainability of the SLOBS profits, and decide to squeeze them into submission.

It has nothing to do with abstract notions of what "should" happen in economic cycles - it has EVERYTHING to do with opportunistic firms sensing a weak hand at the poker table. Booms and busts do not simply "happen". Capital is misallocated by chasing historical returns that can never be sustained in a competitive business environment.

SLOBS become the low hanging fruit of the financial ecosystem - their leverage screams at more nimble and astute firms: "pressure me to de-lever...it will not take much, and once you do, your returns (properly annualized as the gains one receives from shorting these firms comes very, very quickly) will be massive."

So, for me there are no "booms and busts", only opportunistic people and firms taking advantage of herd-following money.

The Great Moderation

With month end being so important on so many levels (Japan year end, expiry, margin requirement changes activating, etc.), and things looking so bleak, I typically recite the mantra "things are never as good nor bad as they really are." Admittedly, the sentence structure of the preceding mantra is atrocious...but the point is that the time to throw caution to the wind draws near. The balance points are beginning to shift to optimism. Fasten your seat belts in the next couple of weeks and well into the 2nd quarter, however.

Here is a wonderful example of why the above mantra holds true - Bernanke's missives from 2004 on how financial engineering and innovation is paving the way for a world where economic cycles are muted and sustainable GDP growth of 4% is a certainty.

http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm

We all know how that rather pollyanish view of the world is turning out. Most of you know I value numeracy when it comes to analysis. However, the power of anecdotal evidence must not be ignored. The same people who declare their home values will appreciate 15% per year until the supernova of our sun also scream bloody murder and the end of the United States when times are not so sanguine.

End Game.

Today's fed action certainly puts things in perspective. When highly volatile markets consider a 75bp reduction in interest a disappointment, then look at the prices of commodities (and perhaps glance at commodity futures prices to garner expected inflation), one has to feel for Ben Shalom Bernanke and his continued employ as a civil servant.

(of course, the cynical part of me realizes that Ben has a massive incentive to rescue wall street firms...future clients, you see.)

So now we are at the end game. The Fed has finally disappointed market expectations (100 bp cut priced in fed funds futures) because the inflationary pressures are so open and obvious that it can no longer keep a straight face when saying things like:

"Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization."

...which, according Bernanke himself, is precisely when the lagged effects of interest rate cuts will be actually be felt.

Again, this is surreal, and central planning posits perfect information and perfect execution on that information. The Fed has neither.

Wonderful...

Again, I will refrain from commenting on an unmentionable formerly great wall street house. Instead, lets think about tomorrow.

Fed action, BS action, and Eurodollar future settlement. This guarantees an interesting day. Let us hope a halt in trading is not the results of the Fed's once-per -century action in rescuing a non-bank institution.

It will be time to go long soon - but there is panic in the streets at the moment.

China

I tend to look for ways to falsify a theory prior prior to taking any action, as the confirmation bias is such a problem.

However, the following story on China is another testament to the "paper dragon" thesis I have maintained on the blog for some time. Its only a matter of time now...and the big boy professionals are only bullish because they have to have someone to sell their financial assets to.

Putting all of one's eggs in a country that has never experienced true "capitalist pig" style chaotic outflows of funds combined with sharply decreasing financial asset prices has never seemed like good a long-term investment thesis to me.

Costly leap - pressure on the factory floor
Rising inflation and wage costs are transforming the Asian giant's
industries and its role as the world's low-cost factory.
John Garnaut reports from Shanghai.
March 15, 2008
http://tinyurl.com/295bg4

The world's second largest sportswear company, adidas, is confronting a new
and unexpected problem. The costs of labour, materials and red tape are
spiralling upwards in its great production heartland in southern China.

It used to be that money made the rules and multinationals such as adidas
could always extract a better deal by threatening to move offshore. The
company runs more than 250 factories here, after all. And each clothing
factory employs 3000 people, on average, while every shoe factory has seven
times that number.

But the Chinese Government is no longer interested. It has recently
abolished export rebates, introduced tougher environmental and labour laws
and increased the minimum wage - squeezing production margins even tighter...

Return and commentary

First order of business is a general Mea Culpa for not posting in some time. The markets wait for no-one and this year has been incredibly interesting thus far as the Fed slouches closer and closer to capitulation.

I will avoid detail today - my missives on Bear Stearns are decidedly un-tasteful given the current straits of that once formidable Wall Street house.

So today I am going to talk about unintended consequences.

The great economist Hayek wrote extensively about this subject and elucidated the (misguided) policy formation process that regulatory agencies and governments utilize.

Instead, I will apply the "law" (I disagree that its a "law" in the scientific sense) of unintended consequences to the current status of the U.S. financial markets.

We are now in the age of financial weaponization. This, added to a completely misguided attempt by the Fed to (defacto) centrally plan the United States economy is actually causing volatility to rise.

This is all such a wonderful example of unintended consequences. Instead of bolstering the U.S. financial system, the actions from the Fed are being met with increasing amounts of frustration and skepticism. I still believe that Bernanke is attempting to counter deflating real estate asset (and financial asset) prices by inflating other asset sectors. The first difficulty with this approach is that inflation is not very discriminatory and goes where it wishes once unleashed.

But it also assumes that the Fed can engineer the consequences of its policy, and somehow knows how to do so. This is at best error and at worst incredibly arrogant.

So the Fed continues to obey its dual mandate of economic growth and guardian against inflation, and the tacit subsidization and blatant bail-outs of financial firms will continue for the time being.

Beyond my doctrinal objections to this chain of, one must take a pragmatic view and determine, within a reasonable degree of error, what causes opportunities may arise from this tumultuous time.