The Rude Awakening
Laguna Beach, California
Thursday, March 8, 2007 ------------------------- - The rising price of fear,
- Bernanke doubts,
- What goes way up…must crash and burn and plenty
more…
------------------------- Eric Fry, reporting from Laguna beach, California… Normalcy is overrated…and grossly misunderstood. Sure, it's comforting to have a normal blood pressure or a normal cup of tea or a normal night's sleep. But no one ever finds comfort in a normal divorce or a normal root canal or a normal herpes outbreak. Indeed, life's finest moments reside in the realm of the abnormal. Could a memorable kiss ever be a "normal" one? Or could a normal kiss ever be a memorable one? We cherish the sensations and experiences that do not happen every day. We cherish the sensations that are abnormal. Most of us would prefer an afternoon of abnormal sunshine, for example, to a morning of normal brain surgery. Even in finance, we cherish the abnormal. We adore the kinds of markets that produce abnormally high investment returns, like the great bull market of 1982-2000. During this abnormal 18-year time span, the S&P 500 delivered an stounding 18.4% annualized return - or about twice the S&P's long-term average return. By contrast, an abnormally bad stock market can produce abnormally miserable results. During the 10-year span from 1989 to 1999, Japan's Nikkei Index lost half its value. But there's a funny thing about life's abnormalities: They're all perfectly normal. Bull markets and bear markets may seem abnormally good or bad as they are unfolding, but they both contribute to the mosaic we know as "normal." hat's why normal is a dangerous attribute…and never to be trusted. One never knows what face this schizophrenic creature might display. (In fact, we are somewhat concerned that the stock market is about to display a version of normalcy that will please very few investors). Federal Reserve Chairman, Ben Bernanke, recently assured the investing public that the recent market volatility raised no cause for alarm. The markets are working "well," he said, "and they are functioning normally." "On this point, we have no doubt," replied Bill Bonner, editor of the Daily Reckoning. "It is normal for prices to rise to unrealistic levels. It is normal for a correction to follow, when they fall back down to more ordinary heights. It is normal even for asset prices to crash occasionally…after having run up too far too fast. "Our doubts arise when we consider the circumstances," Boner continued. "Mr. Bernanke told investors that his economic forecasts were unchanged. His soothing words and professorial demeanor led them to believe that they had nothing to worry about. But a normal market is like a normal tornado. Both can whip things up and tip over the outhouse. "'Normal' financial markets tolerate fools and knaves for a very long time, but never forever. And the nice thing about \the markets is that the punishments tend to fit the crimes. The greater the deception and scheming…the harder the punishment. The farther out-of-the-ordinary prices go…the more they have to move to get back into the ordinary. The greedier investors become, the more they lose. "If the markets are really functioning as well as Ben Bernanke thinks," Bonner concluded, "they will soon correct the foolish and absurd bubbles blown up by today's excess liquidity…Normally, you'd expect a correction." ---------------------------- Whack-A-Risk
By Eric J. Fry Ever play "Whack-a-Mole?" That's one of the arcade games you usually find in those dreary "game centers" that cater to deafening hordes of young kids. It's one of the games you might find alongside other arcade classics like "Galaga," "Maximum Force" or that dysfunctional crane-in-a-case that always manages to wrap its feeble metal arms around some sort of stuffed animal, but never manages to hang on to it. The objective of "Whack-a-Mole" is simple: To whack a mole. In fact, you're supposed to whack every little robotic mole that pops its head out of the game's playing surface. The more moles you whack, the higher your score. But the moles don't always pop up in the same places, and when they do pop up, they pull back into their holes very quickly. So it's not easy to whack every mole that pops his head up…But that's the object of the game. In the treacherous investment conditions that may lie ahead, investors would do well to treat risks like moles - whack 'em out of the portfolio the moment you see 'em. Some market conditions reward risk-taking, others do not. When in doubt, it's usually best to whack-a-risk. For the better part of the last six years, risk-taking has triumphed over caution. High-risk stocks and bonds of every variety have been trouncing their low-risk counterparts for years. But during the week just passed, risk-taking has met with horrific results, while "caution-taking" has flourished. Seven days do not make a trend, of course, but they might make a trend change. If so, the days of caution-taking have arrived. For six years, junk bonds, emerging market stocks and hard-to-pronounce currencies have delivered superb investment returns. Perhaps a seventh year of strong performance lies just ahead. But we do not like the odds. Caution-taking seems like a better bet. Here's why: 1) Risky assets are no longer cheap. In fact, they have never been more expensive relative to low-risk alternatives. Mean-reversion is a powerful force.
2) Global markets seem acutely vulnerable to a "spontaneous de-leveraging." The robust leverage that has boosted risky assets to such perilous heights could unravel quickly.
3) Investor sentiment remains dangerously complacent and bullish. To begin at the beginning, risky assets have become very richly priced, which means that most of the "juice" is long gone. Little more than pulp remains. 
Junk bonds used to offer a sizeable yield advantage over Treasury bonds. Now they don't. Emerging market stocks used to sell for steep discounts to similar stocks in the mature markets of the U.S. and Europe. Now they don't. The Brazilian stock market, for example, has soared 150% since it garnered a glowing review in the October 11, 2004 edition of the Rude Awakening. (The Caipirinha Connection). Back then, Brazilian stocks sold for about eight times earnings - or about half the S&P 500's PE ratio at the time. Today they sell for about 13 times earnings - or about 75% of the S&P 500's PE. Therefore, in both absolute and relative terms, Brazilian stocks are not the bargain they used to be. 
Meanwhile, Brazilian government bonds have also soared, as investors have embraced the notion that Brazilian assets are not so risky after all. The 10-year dollar-denominated Brazilian government bonds that used to offer twice the yields of comparable Treasurys, now yield only about 30% more. And let's not forget that the Brazilian real - a chronic visitor to currency rehab - has soared 37% since October of 2004. By most measures, therefore, risky assets are as pricey as they've ever been. They might become pricier still, but the potential rewards are not as enticing as they once were. So why place a bet on a dangerous, low-probability outcome? Markets are cyclical - always and forever. As share prices oscillate between lofty valuations and lowly ones, investor perceptions oscillate between greed and fear. When investors are fearful, they demand a large margin of safety from the assets they buy. But when they are fearless, they worry less about safety than an intoxicated teenager. During this particular market cycle, high-risk assets might revert to the mean much more violently than usual. (In fact, they might revert to some value that lies well below the mean). The reason why is leverage…or rather, excessive leverage. Were it not for the leverage that courses through the global financial markets, risky assets would never have achieved their premium prices. The "yen carry trade" is but one very visible example of this leverage at work. The yen carry trade might seem somewhat complicated. But it's not complicated at all. In fact, it's so simple it's almost moronic. "Speculators borrow yen at preposterously low interest rates," explains Bill Bonner, editor of the Daily Reckoning. "They trade the money for other currencies - notably those of English-speaking countries - in order to place the money in higher-yielding investments. They then pocket the difference and think they are geniuses. The game works beautifully. Nothing goes wrong. That is, until something goes wrong. Then, the speculators get spooked and begin to look for the narrow door that leads out of the trading room." But this is all a story for another day…(like tomorrow, for example, when your editors will look under the hood of the yen carry trade and ruminate about the dangers this popular trade may impart to all financial markets. If this subject is not sexy enough for you, maybe we'll feature a couple of gratuitous photos of unrelated subject matter…Check in tomorrow.) The gargantuan derivatives markets also pose a large - albeit incalculable - risk to the financial markets. Wall Street alchemists have converted so many trillions of dollars of leaden assets into fool's gold, that no investor can be entirely sure of who owes what to whom, nor which of the "whoms" will make good on the bets that go awry. In the best of circumstances, unexpected market movements - like a 5% jump in the yen's value - could trigger distressed, large-scale selling in certain asset classes…or throughout the global equity markets. But not too many investors are worried about these sorts of "what ifs." The sharp, swift selloff of the last few days has merely aroused perceptions of risk, without dramatically altering them. And that's not a good thing. In fact, what makes the current market environment so is that it seems to worry almost no one. The CNBC commentators and guest pundits are just as chipper and confident as ever. Such palpable complacency rarely bodes well for the financial markets. Selloffs tend to unfold when investors are feeling supremely confident. It's true that the recent global min-crash produced a visible blip in "fear readings" on most major gauges of investor sentiment. But these blips seem like mere gnats on an elephant compared to prior extreme readings. In other words, investors may be concerned, but they are not even close to being terrified. 
As the chart above illustrates, the VIX Index (a.k.a., "fear gauge") jumped sharply during the recent market carnage - doubling from 10 to 20 in the span of seven trading days. But even at its recent peak of 20, the VIX Index remained well below the highs it reached during the post-9/11 stock market lows and the October 2002 lows. Why should we care about the VIX? Maybe we shouldn't. But the VIX Index does provide a real-time glimpse into the approximate attitudes of investors. This Index measures the implied volatilities of various options on the S&P 500 Index. Because the VIX is based on real-time option prices, it reflects investors' consensus view of future expected stock market volatility. "During periods of financial stress, which are often accompanied by steep market declines," the CBOE Website explains, "option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline." The implied volatilities on options have jumped quite a bit since early last week, but not nearly high enough to suggest that investors have abandoned their optimistic outlooks. Most investors remain confident and complacent…which means only one thing: If you see a risk, whack it! --- The Maniac Trader strikes it rich again --- High-Ho, SILVER! Those who heeded his call banked 400% in just 34 days on this "sterling" options play - one of the 10 Triple Digit winners he picked in 2006… Join the Maniac's rampage and YOU could rake in even more than this - and faster - as the global commodities crunch escalates. Read Here Right Now. ------------------------------------------------ | 
