Global Macro Notes: “Not Today” (Or, Dancing With The Year 2000)

April 21, 2011

How to describe this market?

Vin Diesel in the new “Fast Five” trailer has as good a line as any:

“Chances are, sooner or later, we’re going to wind up behind bars or buried in a ditch somewhere. But not today…”

On Wednesday the bottom dropped out of the dollar. The VIX (as tracked by VXX) tumbled to brand new lows. “Risk on” surged with a euphoric vengeance, gold cracked $1500, and the spot price of Brent surged (recently above $124 a barrel).

As others have variously noted, crude oil has become “financialized.”

But what happens to real world end users of crude (like China) if or when Brent hits $150 per barrel… $175… $200?

Inflationary pressures in the Middle Kingdom are already reaching extremes. Trucker strikes are being suppressed with violence. The vast majority of Chinese are dirt poor (via George Friedman, “sub-saharan Africa” poor), and spend the lion’s share of their income on food.

Yet the prospect of a dollar meltdown and subsequent food and energy melt-up is of no concern here?

Or how about the euro, now pushing $1.46 as Greece pays loan shark interest rates and Finland threatens to derail the Portugal bailout (and subsequent bailouts to follow). Or the Aussie dollar at a cool $1.07: Can the Australian economy survive “Dutch Disease” — the term that describes severe economic distortion as a result of resource boom?
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Or consider all those E.M. economies faced with the prospect of hiking interest rates… letting the value of their currencies rise significantly… enduring a potentially painful drop in exports to the West… or all of the above. Beyond a certain stress threshold, a diving dollar magnifies the headaches of every mercantilist-minded central banker on the planet.

To wit, how can we expect the $USD to fall ever further — as the financialized price of oil climbs higher in counterpoint — with no serious consequences?

Those who gleefully predict the $USD will plummet to the center of the earth forget that the greenback is still the world’s reserve currency, and thus still a fulcrum of sorts for the global economy. The dollar cannot free-fall without feeding major tectonic pressures, of the sort that eventually shatter the status quo.

For instance: Can you imagine a world where European exporters (PIIGS in particular) are shouldering the weight of a $2 euro… even as China’s inflation rate has gone from “white hot” to “supernova” on the back of $200 Brent… with America facing up to $150 West Texas Intermediate and $6 per gallon gasoline… and the pollyannas yet still rejoicing in the endless bid of a paper asset bull market?

If the answer is “no”, then how much lower, pray tell, do we think the $USD can go before something important snaps? And this is to say nothing of U.S. domestic concerns…

The wonder drug of dollar decline  and QE asset pump is simultaneously a suicide pill, yet investors seem not to care. As we recently wrote in our “Big Short” review, Mr. Market is a cross between Gordon Gekko and Forrest Gump — and now with a touch of Vin Diesel thrown in.

“Not today…”

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For those who want the party to continue on indefinitely, there are plenty of questions to answer, as noted last week in Sizing Up the Bull. But to get a handle on the sentiment currently driving things, our mental rolodex keeps pulling up the year 2000.

An excerpt from a May 22nd, 2000 Wall Street Journal article, How the Soros Funds Lost Game of Chicken Against Tech Stocks, sets the stage:

NEW YORK — For months, through late 1999 and early 2000, the Monday afternoon research meetings at George Soros’s hedge-fund firm centered on a single theme: how to prepare for the inevitable sell-off of technology stocks.

Stanley Druckenmiller, in charge of the celebrated funds, sat at the head of a long table in a room overlooking Central Park. Almost as if reading from a script, he would begin the weekly meetings with a warning that the sell-off could be near and could be brutal. For the next hour, the group would debate what signs to look for, what stocks to sell, how fast to sell them.

“I don’t like this market. I think we should probably lighten up. I don’t want to go out like Steinhardt,” Mr. Druckenmiller said in early March as the market soared, according to people present at the time. He was referring to Michael Steinhardt, who ended an illustrious hedge-fund career in 1995, a year after suffering big losses.

Mr. Soros himself, often traveling abroad, would regularly phone his top lieutenants, warning that tech stocks were a bubble set to burst.

For all this, when the sell-off finally did begin in mid-March, Soros Fund Management wasn’t ready for it. Still loaded with high-tech and biotechnology stocks and still betting against the so-called Old Economy, Soros traders watched in horror when the tech-heavy Nasdaq Composite Index plunged 124 points on March 15 while the once-quiescent Dow Jones Industrial Average leapt 320 points. In just five subsequent days, the Soros firm’s flagship Quantum Fund saw what had been a 2% year-to-date gain turn into an 11% loss.

“Can you believe this? This is what we talked about!” cried a senior trader amid the carnage. Others on the firm’s gloomy trading floor busied themselves calculating how much they had lost by aping Soros investments in their own accounts.

Aside from an April 28 news conference about the firm’s agonies and brief interviews afterward, the secretive Mr. Soros and Mr. Druckenmiller, long his No. 2, have said little about the period leading up to the humbling disclosure of the problems. An account pieced together from interviews with a dozen Soros insiders and managers of other hedge funds — private pools of investment capital — shows two longtime friends and colleagues increasingly at odds until it all became too much.

As the losses piled up, tension inside the firm grew, with Mr. Soros second guessing the traders who had made him billions of dollars in the past decade. Soros executives say they overheard heated arguments, as Mr. Soros pressed Mr. Druckenmiller to bail out of some swooning Internet stocks before they sank even further, while Mr. Druckenmiller insisted that the funds hold on.

During the worst of this period, it happened that the Soros offices were consumed by a powerful burning smell as electrical work on the floor above kept starting small fires and setting off deafening alarms. The smoke and racket and the dizzy headaches they caused seemed “like a divine message,” recalls one Soros executive of the bizarre office scene. “We almost wished it would burn down.”

By the end of April, the Quantum Fund was down 22% since the start of the year, and the smaller Quota Fund was down 32%. Mr. Soros had stated in a 1995 autobiography that he was “up there” with the world’s greatest money managers, but added, “How long I will stay there is another question.” Now came an answer. Both Mr. Druckenmiller and Quota Fund chief Nicholas Roditi resigned. Mr. Soros unveiled a new, lower-risk investing style — completely out of character for him — and conceded that even he found it hard to navigate today’s murky markets.

“Maybe I don’t understand the market,” a reflective Mr. Soros said at the April 28 news conference. “Maybe the music has stopped, but people are still dancing.”

An ironic quote, given the Chuck Prince echo seven years later.

The lesson that we draw from history — particularly the more recent history of the years 2000 and 2007 — is that sometimes Mr. Market acts irrationally in the face of deadly serious risks. When sentiment and status quo have built up enough self-reinforcing power, the “conundrum” of reckless behavior that follows is no conundrum at all.

To close with a favorite from Walter Bagehot, 19th century editor of The Economist:

“At particular times a great deal of stupid people have a great deal of stupid money… At intervals, from causes which are not to be the present purpose, the money of these people — the blind capital, as we call it, of the country — is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone and there is ‘speculation’; it is devoured and there is ‘panic’.”

Let the good times roll,


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11 Responses to Global Macro Notes: “Not Today” (Or, Dancing With The Year 2000)

  1. GoodBread on April 21, 2011 at 11:18 am

    Excellent post. You guys are one of the few voices out there who isn’t looking at the dollar from a completely ideological perspective and actually appreciate the impact of exchange rates on trade imbalances. I felt your analysis on the yen was spot on after the quake and I think you’ll be vindicated, in time, on the dollar and euro as well.

    • Jack Sparrow on April 21, 2011 at 11:37 pm

      Cheers for that — though we aren't looking for vindication per se, just opportunities to make very large sums of money at favorable reward to risk… 🙂

      • GoodBread on April 23, 2011 at 10:34 pm

        Of course, especially since vindication is so difficult to define unless one uses the criteria of investment performance.

        On the below discussion, it seems that the current downtrend applies to a shorter time-frame than the range the dollar has been trading in of late. (Ritholtz just touched on this:

  2. JDI on April 21, 2011 at 10:09 pm

    You're thinking way too much – just follow the price action.

    The world is always coming to an end and yet still here we are?

    Price is everything – the USD will stop falling when it stops falling – until then why try to anticipate something that hasn't happened yet? Too much thinking spoils a good trade.

    • Jack Sparrow on April 21, 2011 at 11:20 pm

      To each his own. Perhaps you're not thinking enough? I don't presume to make that judgment.

      Plus, no one said the world is coming to an end. Did the world come to an end in 2000? No. In fact, the idea that market dislocations bring the world to an end is ridiculous on the face of it, because that would suggest the world "ends" every few years (the rough frequency at which markets have experienced major downside dislocations these past few decades).

      You seem to be projecting your own viewpoints via superficial analysis of what someone else has said, but you haven't closely read. Determining that current conditions are highly shaky on the long side from a reward / risk perspective is a far cry from predicting armageddon.

      As for "the USD will stop falling when it stops falling" — no, really? The potential surprise impact of severe dislocations was one of the points of relating the year 2000 story. The Soros / Druckenmiller team (two traders whom we deeply respect by the way) spent a great amount of time obsessing over when the turn in tech stocks would come, and yet the actual severely damaged them via speed and severity anyway. Saying "oh guys, stop worrying about it, tech stocks will stop rising when they stop rising" would not have been a fantastic help.

      • JDI on April 22, 2011 at 3:08 pm

        The forces, factors, whims, and winds that move markets are myriad, and often inscrutable to the masses.

        All I'm saying is that price action reflects the thoughts, actions, opinions, and bets of thousands of traders – trying to go long the USD before the price actually turns is the old 'catching a falling knife' trade.' There will be lots of blood on the floor. Unless, of course, you use a stop-loss discipline – then you'll only suffer a series of minor paper cuts, which sting nonetheless.

        From my experience the less I think, and the less I try to predict the direction of markets, the better I trade. Of course, this doesn't leave one with much to say, or write about.

        And please don't mention Soros as a 'trader' – when someone can place a bet and then manipulate markets to move in the direction of that bet one is playing on an unfair playing field.

        • Jack Sparrow on April 22, 2011 at 3:31 pm

          As to complex forces and actions, inscrutability etc., on that we completely agree. Prediction and the structuring of high reward to risk bets are two different things.

          Re, going long USD, we are neither long USD nor short any major USD counterpart at this point in time. Picking tops and bottoms out of the blue is a classic "rookie mistake."

          With that said, however, there is a certain self-righteous smugness in assuming no extreme situation ever allows for a favorable contra-trend bet. Reference PTJ for example, who stated flat out that he has made "a lot of money picking tops and bottoms," or the negative carry guys who made triple-digit and even quadruple-digit returns shorting subprime.

          It is one thing to recognize the limits of one's own trading style. It is another thing to blanket assume that such limits apply to all situations and styles. They do not.

          We are not much on prediction either, but we are definitely oriented to scenario building. And we are certainly "thinkers." The ability to work through probability distributions, and allocate capital with attractive reward to risk profiles in the right places as a result of thinking things through, is one of our strong suits.

          Furthermore, as thinkers, it can certainly be said that some of our habits and methods are undesirable for non-thinkers. If our recipes are too complex for you, so be it — it takes all kinds to make a market. And we like our niche: There are plenty of information sources for analyzing markets from a macro perspective with no trading overlay whatsoever ( just to cite an off the cuff example). There are also thousands of sources for the non-thinking mantras, "Keep it simple stupid" and "Just trade the chart." We walk a different path. Before assuming that our strengths, weaknesses and capabilities are the same as yours, it would make sense to consider the implications of that difference.

          Re, Soros, I doubt the playing field could ever have been considered "fair" at any point in time. On a modest scale, large traders do things to tweak or bully the game all the time, no different than large-stacked players will dominate smaller-stacked opponents at the poker table. But this type of action is not the same as exerting any type of formidable or lasting control. Markets are too big for that, even for as connected a player as the palindrome.

  3. JDI on April 22, 2011 at 4:18 pm

    You're absolutely right – it takes all kinds to make a market. And it's important to recognize the limit's of one's trading style.

    If I didn't think your site was a useful source of market information I wouldn't be reading your comments. You do the thinking that I'm incapable of doing!

    I apologize if I came off smug or self-righteous – not what I intended.

    In this game you're utlimately judged wrong or right by the amount of money you make trading the markets – opinions and systems of trading are not worth a dime if they haven't been able to generate permanent profits. I have not yet the right to such a claim – but my list of habitual trading errors has shrunk considerably over the last ten years, and profits have been greater than losses over the last nine months – 2008-2009 was a trading disaster for me because I stepped outside my area of expertise and tried to 'think' my way in and out of the finanical crisis.

    I'm not familiar with your track record or results – where can I find a summary of your trading performance?

    • Jack Sparrow on April 22, 2011 at 4:38 pm

      No harm no foul – apologies likewise if my reply came off as surly. Wholly agree too on performance — though we do not currently publish our managed capital track record to non-accredited public audience.

  4. JDI on April 22, 2011 at 4:19 pm

    The Spanish have a saying: "It is not the same to talk of bulls as to be in the bullring."

    When you throw real money into the markets you step into the bullring every morning of every trading day – not an easy way to make a living. But if you slay enough bulls and can avoid getting gored, the rewards can be magnificent.

    • Jack Sparrow on April 22, 2011 at 4:41 pm

      Absolutely. And speaking of bullrings, as Teddy Roosevelt said (1910):

      "It is not the critic who counts, nor the man who points how the strong man stumbled or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena; whose face is marred by dust and sweat and blood; who strives valiantly…who knows the great enthusiasms, the great devotions, and spends himself in a worthy cause; who, at best, knows the triumph of high achievement; and who, at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who know neither victory nor defeat."

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