Black Swan

So, who're you gonna believe, your NYC broker or your lyin' eyes???? Another Reggie Middleton "I told 'ya so" exclusive...

There is a little for everyone in Marc Faber's latest appearance on CNBC. The infamous boomer (and doomer) believes (as we do) that today's downgrades are less significant for stocks (at least until the realization that banks and more importantly insurance companies are about to be cut as well - keep a close eye out on Allianz and Generali (of ASSGEN fame) - it is not incidental that they are abbreviated to A&G, just one letter away from our own AIG) as it is largely priced in but the equity market's rally of the last few weeks (with its lack of breadth and volume) is strongly suggestive of a bear-market rally (as opposed to the decoupling bull market that so many hope for). His view quite simply is that the ECB has undergone a backdoor monetization and without this the EUR would be significantly stronger especially given the huge short-interest (though he sees the trend for EUR is down).  Some highlights include: EUR weakness may help exports but the debt servicing costs of major European firms with huge US denominated debt wil suffer greatly, most European nations should be CCC-rated, nominally European stocks will outperform and holding quality dividend paying companies is preferred, valuation is practically impossible given ZIRP, and finally noting the irony, the worse the global economy gets (and the Chinese economy suffers), the more money printing will occur lifting nominal equity prices while real economies stumble and standards of living drop, so hold gold.

A REAL “black swan event” - an event that deviates by 180 degrees from what is “normally expected” - would be a political debate over root causes and basic principles. The great merit of Ron Paul - and the great service he is giving to his own and every other nation - is the fact that he is doing everything he can to raise the debate to that level. That makes Dr Paul a unique politician, a man who tells people what most of them DON’T want to hear or understand. Or at least they don’t think they want to understand it. Dr Paul’s great and merited attractiveness to a growing number of admirers has a very simple source. He is that rarest of creatures - a FREE man. He is beholden to nobody. He has developed his ideas and his convictions over a long and fruitful life of independent thinking. He does not compromise. He homes in on the fundamental issue and principle of any political issue and serves it up without salt or other “seasoning”. He says what he means and he means what he says. He is the living embodiment of the “dream” that most Americans have long since given up on as they saw it slip further and further beyond their grasp.

If we had to summarize the Status Quo's confidence that no black swans will threaten its control in 2012, we might begin with its faith that the system's self-regulation will resolve all systemic challenges. Just as the Status Quo has placed all its chips on a single bet--that "growth" from debt-based consumption can be resumed with vast public borrowing and saving the predatory financial sector--it also bases its confidence on the system's self-regulation. If the banking sector is riddled with fraud and embezzlement, then some minor tweaking of regulation will solve all issues. If demand for debt has collapsed, then the solution is for the Federal Government to borrow 10% of GDP every year to compensate for the decline of private debt and spending. The faith is that extending and pretending will magically restore the "growth" the Status Quo needs to support its ballooning debt. Extending and pretending offers up the compelling illusion that the system's broken self-regulation is up to the task of fixing systemic problems. In the darkness overhead, we can hear the beating of unseen wings that promise to make a mockery of the Status Quo's supreme Imperial hubris.

In a must read Op-Ed in the WSJ, Mark Spitznagel, founder of "fat tail" focused hedge fund Universa, where Nassim Taleb has been known to dabble on occasion, explains the fundamental flaw with central planning, and specifically why "moral hazard" or the attempt to avoid the destructive part of natural cycles, is the greatest unnatural abomination ever conceived by man. His visual explanation should be sufficient for even such grizzled academics who have no clue how the real world works, as the Chairsatan, to comprehend why what he is doing is an epic abomination of every law of nature: "Suppressing fire, creating the illusion of fire protection, leads to the wrong kind of growth, which then invites greater destruction. About 100 years ago, the U.S. Forest Service took a zero-tolerance approach to forest fires, stamping them out at the first blaze. Fast forward to 1988 when a massive wildfire at Yellowstone National Park wiped out more than 30 times the acreage of any previously recorded fire." Another way of calling this, is what we have been warning about for years: delaying mean reversion does nothing but that. And when the Fed finally fails to offset the inevitable, and it will - it is a 100% certainty - the collapse and destruction will be unprecedented. Ironically, the only way the system could have been saved would be by letting it fail in 2008. Now, we are sorry to say, it is too late.

While everyone's attention was focused intently on peripheral European bond spreads last week and the incessant call for ECB intervention, a dramatic (and contagiously panic-worthy) move occurred in the European Investment Bank (EIB) bonds. For those unfamiliar, the EIB is the EU's IMF-equivalent and is the largest international non-sovereign lender and borrower. Technically, it is defined as "the European Union's long-term lending institution established in 1958 under the Treaty of Rome. It supports the EU’s priority objectives, especially European integration and the development of economically weak regions." 5Y Euro-denominated AAA-rated EIB bond spreads crashed higher, blowing past the 2009 record wides and clearly indicating that European capital flight is in full swing. The IMF-like entity, supported by a small capital base of deposits backed by promises of huge capital injections by sovereign nations (sound familiar?), has massive exposure across Europe (and elsewhere). The massive implicit leverage in the capital structure suggests the need for capital calls (and is Greece, Italy, and Spain likely to do that?) to maintain its AAA-status could be needed - given the MtM losses on its loans at a minimum. Clearly investors think the same this week and are starting to worry about the same self-referencing, self-supporting house-of-cards that caused the EFSF to be written off as potentially unworkable. With EUR20bn to be rolled (and EUR6bn in interest payments) in the next few months, we will get plenty of insight into investor demand for EIB AAA-rated paper and the impact on secondary trading from that supply.

Small reminder of the Black Swan, by www.thetrader.se

China is slowly starting to face the consequences of its actions

Anyone expecting to see an immediate reference to Albert Edwards or Dylan Grice when the name SocGen is mentioned will be disappointed. Below we present a comprehensive outlook report by the firm's Michala Marcussen and her team, which unlike the abovementioned duo of doom, is far more optimistic (not necessarily an outlook we share), although it does provide several unique approaches to evaluating and quantifying future risk. For one, the firm analyzes 6 "anchor themes" which it believes will shape the near and medium term future, namely a "sustainable recovery", "policy asymmetries", a "US mini-v", a "V-shaped recovery for Japan", "German diet for Euro area" and "China bumpy landing." Then it evaluates the impact of each of these across monetary policy, bond yields, currency and risk assets. As we said we disagree with virtually all of the firm's assumptions, but in analyzing the logical consequences of each faulty premise, one can then merely flip the conclusion. Additionally, SocGen also provides a risk map with a black/white swan distribution curve, which identifies the biggest growth outlook downside and upside risks. Bottom line: not a report of the intellectual caliber one would expect from the firm's two core contrarians, but certainly a glimpse into how the traditional bullish groupthink is trying to explain away the current regression to the depressionary mean, and just what outcomes their delusions will have on various market products.

By William Banzai Yeats

I know there is something deep in our psychology to which Black Swan hedges appeal. It seduces me too. A part of brains are wired to fear the unknown, when they part dominates our rational thinking, we process facts in a fearful way. There is another part that embraces complexity, uncertainty, and conflict. This part most people need to nurture. Why? Because fear on an applied level equals conservatism: when one conserves, there is no expansion, no newness. Instead there is theory and dogma and ritual tinged with worry and despair. A trader snorting coke off a luscious Ukrainian tummy needs the opposite. Says the Preacher: “There is a time to embrace, and a time to refrain from embracing.” I think this wise rabbi means this: learn to trust yourself, trust in your ability to rebuild and be awesome. But don’t bet the whole megillah on how big you think your dick is.

While US stock futures continue doing their own thing, primarily on the back of JPMorgan's $20 billion financing for AT&T to buy T-Mobile (gotta love proximity to the discount window and/or excess reserves), with ES surging by 16 points overnight (but not Sprint - sorry guys, you are on your own) after the world apparently did not end, the black swan formation refuses to disperse. Here is the latest news update from Japan, Libya, and Yemen.

Whether related to the broadly escalating violence in the region or not, the latest development out of Israel is sure to bring even more geopolitical tension, especially with Iran adn Syria already on edge following their own violent protests (and arguably looking for a political scapegoat). BBC reports that "Palestinian militants in Gaza have fired dozens of missiles into southern Israel in what appears to be their heaviest such barrage in two years. About 50 mortars were fired - two Israelis were hurt, Israel says." Never one to step away from an escalation, Israel replied in kind: "Israeli tanks later shelled targets in the coastal strip, wounding at least five people, Palestinian officials say." We are confident newsflow out of Israel and Gaza will intensify as the latest and greatest Black Swan out of the middle east is now stretching its wings.

In recent weeks we have been arguing that tail risk remains and is unusually realistic given the potential sources of shocks. We have also found that in many cases clients are reluctant to buy into these fat tail scenarios (actually 'reject' may more accurate than ' are reluctant' ). The argument is basically that they have heard it many times before in the last two years and asset markets have continued to flourish. We would argue that the correct approach is to ask whether the macro risks looking ahead are those that can be dealt with using the policy tools at hand. Consider the obvious potential risks: an oil shock, commodity prices and advancing headline inflation in the context of growing concerns about social and political disruption. We would make the case that the risk is high that if any of these shocks were to move to centre stage, it would be harder for policy makers to deal with them because printing and spending money is not quite the solution to these problems that it was to the financial shock of late 2008 and early 2009...which brings us back to Black Swan fatigue. When we see currency vols so cheap in a world that appears to be so risky and in which policymakers do not hold a terribly strong hand, it makes a strong case for hedging tail risk, even if FX price action is apparently indicating otherwise.

While everyone's strategic focal point still continues to be planted firmly on the black swan even horizon, in essence making the "unexpected" negative event virtually impossible as while nobody knows what will cause the crash, everyone is certain a crash will arrive in some form or another, today John Taylor takes an inverse approach and instead of chasing Black Swans he looks at the possibility of a "White Crow" - or the opposite: a positive outlier event with outsized implications on risk assets. The two main White Crows evaluated by Taylor are i) a conversion of the stock market melt up into a rout up, and ii) a bullish outlook on the EURUSD. The latter is particularly notable as the FX titan has long been known for his extremely bearish outlook on the European currency. Is he throwing in the towel and joining Goldman in the long EURUSD trade? Overall a surprisingly optimistic short-term outlook on the market: "Although our cycles argue there is a reasonable probability of a risk peak in the first half of March, followed by a sharp decline, the cyclical picture before that time is positive for risk. The future outlook might be dark, but the models are positive now. Being open to risky assets is the only way to go." And with $200 billion in additional liquidity in February and March, he just may be right.