Eye On Re-Regulation

O Come, All Ye Faithful

Do you believe in fairies? Say quick that you believe. If you believe, clap your hands!
- James M. Barrie

Page one of the Christmas Eve edition of the Financial Times features a Christmas pilgrim, praying at the Grotto in Bethlehem. The article announces what must surely be considered good local economic news: “An estimated 1.25m tourists are expected to visit Bethlehem by this year’s end – a near doubling on last year’s numbers.” In these trying economic times, there is still someone experiencing year-over-year growth.

The cover of the holiday issue of the Economist features an angel strumming what appears to be a Gibson Les Paul model electric guitar. As the world teeters on the brink of the Great Beyond, Sex and Drugs pale before our yearning for the Life Eternal – though Rock ‘n Roll is holding on.

If you no longer believe in Capitalism after the past year and a half, there are still the comforts of our ministering angels. The principle of No Atheists in Foxholes applies to the walking wounded of the financial world, no less than any other field of battle.

Then there are those of us still working through the unreality of the visible world. Truth is not only stranger than fiction, it also has a warped sense of humor. Al D’Amato – Pothole Al, the man who used to refer to himself proudly as “the poorest man in the Senate” – says Bernie Madoff’s scam appears to have been so broad and complex that it is inconceivable that he could have acted alone. Senator D’Amato – who knows a thing or two about how Wall Street works – said “you would have to believe in the tooth fairy” to believe that Bernard Madoff pulled off this entire elaborate scam without the ongoing involvement of his family.


Speaking of the inadequacy of the regulatory process – we were intrigued by the lead article in the Financial Times of Tuesday, December 23, headlined, “Madoff Investor Warned Its Clients”. Kingate Global Fund Ltd., run by FIM Advisers in London, handed Madoff $2.75 billion, while explicitly warning its investors that their outside manager “could abscond with those assets.” We have not seen the actual documents from which this quote is lifted, so we cannot tell whether this was pointed out to investors as a specified risk, or was merely buried in a litany of boilerplate. Either way, we bet the Fund’s solicitors have already drawn up a brief arguing that Kingsgate Global provided full and fair disclosure. How much more explicit could they have been? the lawyers will ask. Even if it is deemed a technicality, it is a rather large one, against which the courts may be hard pressed to argue, leaving the losers to decry the inadequacy of human justice. “Vengeance is mine, saith the Lord.” Unfortunately, the Lord is no longer taking clients.

In light of the angels around us, let us reflect that ours is a world of Faith, rather than scrutiny. Wall Street is fueled by our propensity to operate on a wing and a prayer, and not on due diligence. The greatest failing of the SEC is that it has never told investors that government regulation of industry does not mean that consumers are safe. We test drive cars before buying. We try on dozens of shoes before settling on a purchase. Yet people wire a hundred thousand dollars to a complete stranger on the strength of a ten-minute telephone conversation. The American public believes fervently in the Angel of Market Success, followed closely by the Tooth Fairy of Regulation. And when the Regulators lost all the teeth they had, we didn’t even find a quarter under the pillow.

So please, if you believe in market forces, don’t bother to clap your hands. Let Tinker Bell die, by all means. And let those who were willing to throw their money at smiling gentlemen in expensive suits finally learn how things work. The nice man in the expensive suit, his job is to throw your money out the window and hope it bounces. The lawyers with their expensive bulging briefcases, their job is to write up contracts with all the pages and pages of small print that will shackle you to your losses. And you? Your job is to read that fine print before you act. All of it.

Christians around the world are celebrating the Birth of the Redeemer. But it is a Lord who redeems only the eternal soul. Those of us fighting the hand-to-hand combat of financial trench warfare know that, come Christmastime, the window for redemptions has long been shut. As Above, so not so very often Here Below.

Of Shoes and Ships and Ceiling Wax

Sometimes a hard look at nonsense yields a surprise.

Page one of the Financial Times of December 23 has a photo of Viktor Bout, alleged Russian arms dealer. (Alleged to be an arms dealer, that is. He really is Russian.) Viktor Bout, described as the Merchant of Death, inexplicably left the safety of Russia, the only country that would never have extradited him to the US, and flew to Bangkok in search of a transaction, leaving behind a wife, a family, and a personal net worth of some six billion dollars.

He is now in a Thai jail fighting extradition to the United States.

What could possibly induce a man in his position to leave the safety of the only haven that will protect him? Even after a Presidential pardon, Marc Rich has barely been seen outside of Switzerland.

We remember the bewildered face of Mikhail Khodorkovsky, multi-billionaire chief of the Russian energy giant Yukos, staring through his glasses and the bars of a prison cell. The interlocking relationship between Russian government corruption and Russian private-sector corruption should not be lost on Western commentators when Putin appears to trash the capitalist values that his own government endorsed. Not every land is America, where capitalists are permitted to be profligate nincompoops, and where the government rushes to their aid when they scrape their knee. There are lands where the government made the transition to a market economy by dishing out favors – creating capitalists by fiat, and for a price. Woe to the capitalist who serves at the pleasure of the government, when he believes his cash puts him beyond the reach of that government.

Our guess is that Viktor Bout incurred the displeasure of the Kremlin and decided that spending his life in an American prison was preferable to having it cut short in a Russian one. Not to mention, in America you get time off for good behavior. Whereas in Russia, as the old joke goes, they shoot all four-legged creatures on sight. But, you ask, surely Viktor Bout is two-legged? Yes. But as everyone knows, they count after the fact.

Russia, down on their luck because of the crash in the price of oil, is trying to create a Gas-PEC – an international consortium of natural gas-producing and exporting nations. Let it not be overlooked that Iran is right at their side. So much for putting a halt to Ahmedinejad’s nuclear wet dream. And that Russia is now strong-arming Ukraine – ditto for the US defensive system in Russia’s vestibule.

But how to pay for all this? Perhaps by nationalizing one of the few remaining highly lucrative businesses left within their borders: arms trafficking.

We wonder who will play Viktor in the movie.

Payment for Order Flow

Woulds’t thou have a serpent sting thee twice?
- Merchant of Venice (Act IV, scene I)

It is a shame we cannot drive using only the rear-view mirror, when in retrospect it is all so very clear. The Financial Times (Wednesday, December 24, page 13) reported on the business that first put Bernard Madoff on the map. In the 1980’s and ‘90’s Bernie was sending checks out every month to brokerage firms who were routing their orders through him. Bernie created what came to be known as the Third Market, at one point draining off some 10% of the total NYSE business.

The article reports that Bernard Madoff, by far the largest practitioner of payment for order flow, was on the commission set up in the 1990’s to look into that practice – the Ruder Committee, led by former SEC Chairman David Ruder.

Madoff typically paid brokerage firms a penny a share for their order flow, then matched orders internally, essentially setting the price on both sides of the trade. He traded his matched executions against the market, often pocketing the lion’s share of the spread on the stocks he bought and sold. One bit the article does not mention is that, as the NYSE’s biggest competitor, Madoff could also influence the market spread, thus paying himself more if he felt he was not getting enough on a trade.

Should we be shocked that Bernard Madoff was named to the panel convened to study his own business?

How do we determine which activities need to be regulated? First the Government asks the people who claim to have been harmed by the activity. Then, to be fair, they hear from those who are about to be regulated. And who knows more about the Third Market than the man who created it? And so Bernie Madoff gained a seat on the Ruder Committee. This is a classic case of Keep Your Enemies Closer – and we don’t mean the Committee keeping an eye on Bernie.

Wall Street has always been the leading indicator for new regulation. It is definitional to its business. Bernie Madoff made his fortune by exploiting an unregulated gap in the market and riding it for as long as he could. It was a gap that even Arthur Levitt failed to plug, and fortunes were made over the years in compensation, from cash payments, to all manner of soft dollars. In common parlance these are called Kickbacks.

Here at Research Edge, our philosophy is driven by our CEO’s dictum that everything important happens at the margins. The fat part of the bell curve poses no threat to the Norm. It is the norm. In the world of Regulation this means that, as laws are passed and rules introduced, the creative minds of Wall Street seek the loopholes. And they find them – because legislators and regulators do not come from the industries they regulate, and so are forever passing laws and making rules to prevent folks doing what they already did. Rules are implemented when, after years of a certain activity going unregulated, it becomes so widespread it is seen as abusive.

We hope the Obama Administration will see the wisdom of bringing real market professionals into the regulatory process, of setting people’s interests against one another as a way of ferreting out the truth of what goes on in the business. For regulation to work it must be forward looking. It is all but pointless to pass laws to prevent the next Madoff scandal. We guarantee that, even now – even as you read these words – somewhere, somebody is working on a multi-billion dollar scam using instruments and strategies and mechanisms none of us has ever heard of. That’s the person we want to catch.

The Random Swim

An article titled “Here Is The Market’s Water Forecast” in the magazine New Scientist (December 13-19, page 10, “) describes a program set up by the Australian Knowledge Exchange. Participants in a virtual marketplace are given a stake of $100,000 play money, and 1000 virtual shares in each of the reservoirs in New South Wales. The stocks pay a monthly dividend tied to the level of water, up to a maximum of $100 for a full dam, and market participants buy and sell one another’s shares, depending on their own analysis of trends in water levels. The government hopes to use the market consensus as a predictor of actual water levels in the drought-endangered country. The theory behind this program is that a market, even a play one, is a better predictor of reality than any academic computer model.

The Australian government plans a proliferation of on-line markets to “help manage other environmental issues such as animal extinctions and brushfires.” These on-line markets are to serve as a touchstone for Australia’s environmental policy.

The Efficient Market Hypothesis, developed as an academic tool by Eugene Fama at the University of Chicago in the 1960’s, was taught to generations of B-Schoolers, thereby becoming gospel from Wall Street to the halls of Congress. The EMH is based on the notion that prices in markets contain all information relative to their instruments. Even now, after EMH theory has been largely nudged aside by new and robust theories, academics agree that significant information content resides structurally in markets. The challenge is to devise mechanisms to mine it usefully.

Enter Nate Silver, (no relation) who gained media stardom by correctly predicting the Obama victory. Silver’s blog,, not only picked Obama as the winner; the statistical analysis was stunningly correct, with a high degree of what quants call “granularity”. This means: he got it right down to the Nth decimal place.

Silver was lauded in the press, garnering such accolades as “Genius of the Year” (blogger Al Giordano), being listed as one of the top “40 under 40” (Crain’s Chicago Business) and featured in the Huffington Post’s list of “Ten Things That managed Not To Suck In 2008”.

Heads up, Team Obama. The greatest benefit of the current global Carbon Emissions Trading programs may be not as an actual control on the level of greenhouse gases, but as a laboratory for studying the phenomenon to create workable policy. It might be more useful to chart the arguments in the next go-round of global environmental negotiations, than to try to actually win them. Robust statistical theories demonstrate that large numbers of people, all busy analyzing the same phenomenon, have great predictive power. It may be more useful to create a bunch of virtual marketplaces than to commission Government studies. Australia thinks so.

Picture an on-line market where people can bet on the level of automobile sales over the next twelve months, the likelihood of war with Iran, the identity of the next Bernard Madoff, or the actual drop-dead date to reverse global warming.

Add to this the stunning productive power of Capitalism – that in short order, people will figure out a way to make these virtual trades pay off in real money. There will be abuses, but not before the predictive power of the market mechanism has become stunningly robust. Anyone have any statistics on the lag between market participants coming up with new money-making concepts, and the upsurge of market abuses to the point where the market loses its predictive power? Looks like there should be a prominent spot on the Obama team for Mr. Silver. Maybe Big Government can actually get something accomplished.

Follow The Money

The Wall Street Journal editorial page (December 23, page A12) was aglow with Capitalist congratulations at the news that Judge Colombo, in Wayne County, Michigan, has thrown out the medical evidence proffered by Dr. Michael Kelly. The Free Press (, November 20, “Wane County Judge’s Ruling Jeopardizes Asbestos Cases”) reports that Dr. Kelly, who received $500 apiece for his expert testimony, has declared 75 patients as suffering from asbestos-related illness. According to the article, “About 1,000 doctors looked at these same 75 plaintiffs and none of them saw what Dr. Kelly saw…” The litany of alleged failures and possible malpractice on the part of Dr. Kelly is succinctly summed up in the Journal’s congratulatory piece.

What this makes us think of is a phenomenon with a similar profile. It struck the attorneys for the asbestos companies as odd that Dr. Kelly’s diagnoses appeared to all follow the same pattern. They looked at the regularity with which Dr. Kelly identified the same maladies, and the high frequency of “hits” – positive diagnoses of asbestos-related illness – versus No’s or Maybe’s. Too good to be true, they thought, and so they investigated.

The charts we have seen depicting Bernard Madoff’s returns to his investors are a market professional’s nightmare. The fact that the line goes up is not the problem. At issue, rather, is the steady, regular slope of the line. Bull market or bear, melt-down or melt-up, Bernard Madoff was returning the same percentage to his investors.

Assuming that he really could beat the market, the only possible explanation was that he was trimming his returns in good times, and husbanding them to pay out in bad times. Or, that he was scalping his good returns and pocketing everything above the rate of return his investors expected.

Or that the whole thing rested on as sound a footing as Judge Colombo found underpinning Dr. Kelly’s expert testimony. It appears the only thing the Doctor may have been “expert” at was bilking insurance companies. Over 2,000 pending asbestos litigation have been called into question.

The corollary to the dictum “Follow the money” – If it goes in a straight line, something is wrong.
Moshe Silver
Director of Compliance
Research Edge LLC

Keith R. McCullough
CEO / Chief Investment Officer

US Market Performance: Week Ended 12/26/08...

Index Performance:

Week Ended 12/26/08:
DJ (0.7%), SP500 (1.7%), Nasdaq (2.2%), Russell2000 (2.0%)

December 08’ To Date:
DJ (3.6%), SP500 (2.6%), Nasdaq (0.40%), Russell2000 +0.80%

Q408’ To Date:
DJ (21.5%), SP500 (25.2%), Nasdaq (26.9%), Russell2000 (29.8%)

2008 Year To Date:
DJ (35.8%), SP500 (40.6%), Nasdaq (42.3%), Russell2000 (37.8%)

Keith R. McCullough
CEO / Chief Investment Officer


McCarran Airport reported that the number of enplaned/deplaned passengers fell 14.7% in November. The decline was the worst since the months following the 9/11/01 terrorist attacks, and the third straight monthly double digit drop. Hopefully, the follow through to Strip revenues will fare better than October when a 12.8% passenger decline translated into 23.2% revenue hit. I believe it will.

My model projects a 12% Strip revenue decline for November assuming normal hold percentages. The decline should be better than the airport data would otherwise suggest for two reasons. First, Strip slot machines held abnormally low in November of 2007. Second, low gas prices probably enticed a higher percentage of drive-in visitors than in recent months, which are obviously not captured by the McCarran data. Nevada gaming revenues should be released in a couple of weeks.

Less bad is hardly a long-term investment thesis and we remain very negative on Las Vegas.

November data was worst since the 9/11 months
I project Strip revenues will fall less than the passenger decline

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Buying Bonds Now? Why We disagree...

Half the story

“For risk averse investors, who can't stomach the ongoing volatility that the bottoming process in equities entails, a broadly spread investment grade bond fund offers upside exposure to an inevitable US recovery with limited downside risk.” Corporate Bonds: Discounting Depression, Dec. 19, 2008

“…we're talking about investment-grade corporate bonds, which are dirt-cheap right now… it's time to pounce.” The Case for Bonds, Fortune Dec. 22, 2008

“The bonds of high-quality firms normally yield one to two points more than the going rate of U.S. Treasuries to compensate you for added risk…. That's just too good to pass up, experts say”. The Bargain Bin, Money Jan. 2009

The pundit patrol has hit upon a new winning formula for ordinary investors: Buy Corporate bonds. The argument that these media anointed “experts” are espousing is that corporate paper is a lot cheaper than equities and will provide a lot more upside during a recovery period. This theory is based on the fact that the yield spread between investment grade paper and treasuries is at the highest level it has been since the depression.

The problem with this logic is that it does not account for the fact that corporate bonds have attractive yields on a RELATIVE basis. If benchmark rates were to rise significantly in the coming 12-36 months (which those of you who were on our call yesterday know that we anticipate) that spread could compress while overall nominal yields increase at a faster pace –leaving confused investors holding corporate bond funds that are down.

Advising retail investors to put on half a relative value spread makes about as much sense as telling them to put on half a merger-arbitrage stock spread, but in the rush for something to sell the talking heads are more than happy to do it.

To illustrate my point I have included two simple charts. The first shows How wide the spread between Corporate yields and treasuries has become on a relative basis, the second provides a longer term view of Fed Funds and CPI –with a focus on the late 70’s “Volker” era when rates rose dramatically as the Federal reserve fought a strong reflationary surge.

It doesn’t take a huge leap of logic to see the potential for reflationary pressure resulting from the current zero rate environment. Corporate bonds may indeed represent a good deal for some investors –but they deserve to see the whole picture instead of the half that the pundits are presenting.

Andrew Barber
Director, Macro

Money-less Center Banks: Charting SPX vs. The New Reality

The New Reality is reflected in both today’s sector level performance, and that which we have seen emerge in the last 3 weeks of trading. The Financials (XLF) continue to underperform, while the Consumer Discretionary stocks continue to outperform. Today the XLF is down -0.40%; the XLY is up +0.45%, providing balance for an SP500 that is +0.25% on the day.

The liquid long American Capitalist is “re-taking” control of his/her country from the levered long bankers. Check out the relative performance chart that is embedded within the story of the XLF underperforming the SP500. The “supermarket” or “money center” banks have been getting hammered.

The New Reality is that the bankers will get paid to service the client before they service their own agenda. Not only will they do this on the client’s terms… but the US government’s! After all, these banks are “money-less” without becoming government supported organizations.

This stock market is no longer trading day to day on a “liquidity crisis.” That has passed, and so has the volatility associated with it. The credibility crisis will remain a structural problem that will rinse itself clean of all that was conflicted about it in the beginning. This Christmas, we should all be thankful for that.

Re-Shorting Japan: Industrial Production & Employment Charts

After seeing the EWJ (Japan etf) rally +17% from its November lows, I am thankful this Christmas for having covered it. Next Christmas, I want to be thankful that I re-shorted this political and economic mess. This morning’s macro economic reports out of Japan are charted below.

Now that the Yen is appreciating alongside a depreciating US Dollar, it’s next to impossible to see how Q1 exports in Japan can turn out to be nothing but terrible. While the Japanese export print of -27% y/y for November was the worst number they have ever reported, there is no economic leadership in this compromised socialist story that gets me anywhere other than back on the short side of my longstanding bearish view of Japan.

There is huge “Trend” line resistance in the EWJ etf up at $9.38. We re-shorted it this morning.

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