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Don't Confuse Risk Taking With Value


Governments are becoming a larger part of the real economy with their debt creation. Free money means lower returns for everyone.

I haven't had much to say lately. Just more of the same. With money growth my firm estimates at an egregious 14% (compared to a falling GDP now quoted in the 1-2% range, we can safely say that the money is becoming more and more anemic in producing growth), no wonder speculation in stocks and other assets is unabashedly high, along with risk. But I don't confuse risk taking with value and I hope you don't either.

I have suspected for a long time that government "intervention" or "participation" (or whatever you want to call it) in private asset markets is as high as it has ever been. The markets are just not acting "naturally" to me. They seem orchestrated in many ways. Why? With the levels of debt in the system (we have no historical reference), central banks must keep asset prices rising so that the debt doesn't look so bad on balance sheets. To keep the public and corporate sectors borrowing, they have to have rising collateral. Governments are becoming a larger part of the real economy with their debt creation. Free money means lower returns for everyone.

One piece of evidence is something strange going on in option pricing. If governments are buying risky assets like stocks, they wouldn't buy individual stocks, they would buy indexes. Any rally in stock markets would be led by index buying, not from the bottom up where investors buy individual stocks because they see fundamentals improving. Option prices are saying that is exactly what is happening.

My firm measures how stocks correlate with each other by comparing individual option prices of stocks to index option prices. From this analysis my firm backed out an "implied correlation" number. The lowest the number can be is zero (no correlation among stocks) and the highest is one (almost perfect correlation among stocks). Normally correlations fall as stocks rise because healthy rallies are created from the bottom up; normally correlations rise as stocks fall because corrections are caused more by macro events like recessions that affect all stocks. There is also a psychological element: greed is slow and builds over time, but fear is fast and comes quickly in the night. 1998 saw correlations near one.

In November 2006 I saw correlations the lowest ever at 0.2. Complacency was very high as no one was concerned with macro factors. Correlations jumped to 0.65 on Feb. 27 as a quick correction saw a fair amount of index put buying. I have never seen a correction or its corresponding jump in implied volatility and implied correlation abate so quickly. Central banks have indeed done their job in training markets that liquidity will always be supplied when needed (although their ability to do so is exponentially waning).

Recently we are seeing correlations creep up as the market grinds higher. This is quite unusual. Implied correlations are not high at 0.48, but they are high for this low level of implied volatilities for individual stocks. Please refer back to my comments on the New York Fed's poorly thought out analysis of correlation implications between 1998 and now as it pertains to hedge funds.

The reason correlations are creeping up is that the rally is not being led by investors buying individual stocks, it is being led by index buying. I see a large and unnatural buyer (the buyer wants to pay the highest price possible) in indexes every day. I suspect it is the Bank of China buying U.S. stocks with sterilized trade dollars.

Stocks that want to go down because investors deem the fundamentals deteriorating are eventually dragged up with the rest of the market because of the index buying. Index buying infers that participants just want exposure to stocks regardless of fundamentals.

This increases risk. When trade slows down (as it is), there will be less trade dollars to recycle. When debt gets too high there will be less sterilization and lending to buy stocks.
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No positions in stocks mentioned.

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