Sunday, May 23, 2010

How the Media Lies

The following is a great example of one way in which the media lies.  No, this is not directly related to finance, investing or economics but it is important to recognize these practices whether one is looking to research a stock or understand global politics.

The US mainstream media has been chillingly silent regarding the escalating tensions between North Korea and South Korea. That has begun to change now that it has been confirmed that a torpedo from a North Korean military ship is what caused the sinking of a South Korean military ship.  Unfortunately, our media cannot be trusted to present the facts in an honest fashion when reporting on such subjects.

Here is one example that I stumbled across on Saturday afternoon.  The headline from The Drudge Report, a so called conservative news source, reads NKOREAN LEADER AUTHORIZED ATTACK ON SOUTH:

When I clicked on the link it brought me to The New York Times, a so called liberal news source.  The article in question is titled U.S. Implicates North Korean Leader in Attack.  This does not sound quite as damning as The Drudge Report headline but it sounds quite conclusive, no?  Let's keep in mind that publications like the Times usually have an editor write the headlines and not the actual author of the article.  Now let's read what the article actually states:

A new American intelligence analysis of a deadly torpedo attack on a South Korean warship concludes that Kim Jong-il, the ailing leader of North Korea, must have authorized the torpedo assault, according to senior American officials who cautioned that the assessment was based on their sense of the political dynamics there rather than hard evidence.

“We can’t say it is established fact,” said one senior American official who was involved in the highly classified assessment, based on information collected by many of the country’s 16 intelligence agencies. “But there is very little doubt, based on what we know about the current state of the North Korean leadership and the military.”

So an unnamed American intelligence official believes that the North Korean leader must have called for the attack simply because of his vast understanding of the North Korean leadership.  I have no idea if this unnamed official is right or wrong but what he is stating is clearly different from the Times headline and even more different than what Drudge went with.  This type of reporting, by both major political leanings in this case, needs to stop.  The Korean situation is very serious and deserves to be reported in a serious manner.

Thursday, May 6, 2010

High Frequency Trading Run Amok

So the big news of the day was the huge sell off in US markets.  The final tally was -340 points on the DOW (-3.20%), -37.72 on the S&P500 (-3.24%) and -82.65 on the NASDAQ (-3.44%).  This is a bad day but the intraday lows is what has everyone really talking.  In the span of only a few minutes the market veered completely off the rails, with the DOW dropping nearly 1000 points on the day before recovering most of the losses nearly as fast.

The initial explanation for the plunge was the rumor that a Citi trader fat fingered an order of Proctor and Gamble (PG).  We did not buy this explanation for two reasons.  First, the market was already sliding well in advance of the alleged PG trade.  Second, the volume in Proctor and Gamble stock during the alleged mistaken order was not nearly as great as one would expect given the explanation.  After the market close came official word from Citi that they have no evidence that an erroneous trade was made on their partOur initial take was that the obvious culprit was program trading gone awry, and lo and behold that is now what the NYSE is reporting.

The chart pattern marked out today by all of the indexes is very familiar to anyone who has been watching stocks like Citigroup, Bank of America, AIG and several others intraday over the course of the last few years.  The five stages of such market activity are as follows:
  1. Gradually sliding prices throughout the day
  2. This is followed by a massive waterfall
  3. A V-bottom is created
  4. A large spike right back up is generated
  5. The day ends with a continued rise into the close
Here is a view of today's DOW with these five stages labeled:

This type of market activity is the sure sign of high frequency computer trading run amok and is not something that you will see when human traders participate in an orderly market.

In our minds today's market activity begs two questions.
  1. What kind of dopey artificial markets have we created and why would any sane individual want any part of them?
  2. To this you trust your retirement funds?

Thursday, April 22, 2010

The Great American Squeeze

Even with ongoing sovereign debt crisis affecting countries like Greece and the continued march of bank failures week after week, is it commonly thought that the worst of the financial crisis that began in 2008 is over.  We disagree with this view in that what we are seeing is that the crises has simply morphed from a rapid collapse into a prolonged economic funk.  We are dubbing this new trend The Great American Squeeze and see this eventually leading to an even bigger crisis down the road.

The Great American Squeeze is the phenomenon of constant pressure being applied on regular people from all directions.  These directions take the form of tax increases, inflation, the end of various government stimulus efforts and a reduction in already existing services with the net result being an overall reduction in the quality of life.  The reduction in the quality of life can result in mild setbacks such as eating out less or canceling cable TV to drastic life altering events such as homelessness and hunger.

Elizabeth Warren, whom we are a big fan of, has been talking about the squeeze of middle class Americans for many years.  You can view an excellent speech she gave on the subject here.  She notes that the trend has been going on for over 30 years, so what what we are seeing is not a brand new phenomenon per say but a rapid step up in an existing one.  Nevertheless, because of the rapid advancement in the trend, we think a new term is needed.  Since this trend has been going on for so long, this means that it is even more dangerous than at first glance, since many people were already at the verge of being crushed before the recent difficulties.

Let's start with tax increases.  In 2011, the capital gains tax is set to increase.  Taxes are also being increased on higher end income earners and tax increases are being phased in as part of the recently passed health care bill.  To top it all off, now there is speculation that a Value Added Tax (VAT) could be implemented.

Next up: inflation. Inflation is live and well, despite what some hardcore deflationists would have you believe.  Food prices rose by 2.4% in March, the largest increase in 26 years.  Crude oil is back over $80 per barrel.  The S&P 500 is now up 43% from this time last year.  Need we go on?

Government funded stimulus programs are rapidly being phased out.  The economic stimulus package that was passed last year will see its expenditures peak out in the second quarter of this year.  The home buyer tax credit is set to expire on April 30th.  Finally, perhaps the biggest government stimulus of all, the $1.2 trillion residential mortgage backed security (MBS) program has just ended.  We expect the recent strength in the housing market will end in a relapse of the housing bust of 2007-2009.

When it comes to gradual cuts in services, most of these will affect people at a state and local level so experiences will vary.  One national change that may be implemented though is the end of mail delivery on Saturday.

Less you think that these various data points don't actually trickle down to you and I, here are some recent personal experiences that we have had being caught up in The Great American Squeeze.

Where we live in Hoboken, New Jersey, property taxes have greatly increased in recent years, starting in 2008 with a 47% increase in property taxes.  Since that time there have been additional increases seemingly every few months.  Our landlord has seen the city portion of their property taxes skyrocket in the last two years.  This lead to the owner trying to extract additional rent from us in the middle of a lease to make up for the shortfall.  We of course refused to pay.  Now that the lease is up, the owner is asking for 12% more in rent this year than they asked last year.  We will be moving and there is now a good chance that the owner will have a difficult time finding a new tenant as they have priced themselves out of the market in our opinion.

If that was not enough, NJ Transit has decided to raise their fares by 25% effective May 1st.  Our cost of taking the bus to work will increase by $1 dollar per day.  Meanwhile, the number of bus routes are being reduced.  Less for more?  That did not used to be the American way.

The NJ transit fare increases follow recent increases in the New York City subway fares over the past two years. Upcoming subway service reductions and a fare increase of 7.5% are also planned.  In addition, we have anecdotal evidence that the quality of service has already decreased dramatically from the beginning of the year.

Wrapping It Up

We fear that The Great American Squeeze will be enough to financially knock out a far larger number of people than is commonly understood.  Shielded bureaucrats and political organizations do not seem to understand how close many people are to the edge.  A property tax increase here, a subway fare increase there and soon enough there is a noticeable decrease in the quality of life.  Push the trend far enough and, as the saying goes, at some point you run out of other people's money.  We expect the anecdotal evidence to show up in the economic numbers very soon and much to the surprise of the economists that expect a robust recovery.  This is a long term and likely permanent decrease in the wealth for a large contingent of the country.

Tuesday, March 23, 2010

John Maynard Keynes: A Critique

We have consolidated our six part series on John Maynard Keynes and his most famous work, The General Theory of Employment, Interest and Money into a single document.  In addition, we have added an introduction and conclusion to tie the whole thing together.  We think that this document offers a strong critique of Keynesian economics and if you agree then by all means pass it on.  If the embedded document below does not appear then you can access it here.

Wednesday, March 10, 2010

Pension Funds are in Denial

Two weeks ago we wrote about how Greece and the EU were in denial.  We did not intend to single out Europe and Greece as their problems are equally present in the US and most of its states.  If you are in doubt then simply read the recent New York Times article Public Pension Funds Are Adding Risk to Raise Returns.  Let's take a look at some excerpts:

Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

“In effect, they’re going to Las Vegas,” said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. “Double up to catch up.”

Mr. Rowe has it exactly right.  As anyone who has gone bust either first or second hand, the most common refrain is that the gambler wanted to just win back their losses.

A spokeswoman for the Texas teachers’ fund said plan administrators believed that such alternative investments were the likeliest way to earn 8 percent average annual returns over time.

Because of the bull market from 1982-2000, everyone got this idea in their head that 8%+ annual returns was the norm.  This mentality has still not been destroyed even after ten years of dissapointment.  We obviously have a long way to go.

Boeing and other companies seeking to reduce their investment risk are moving into fixed-income instruments, like bonds — but not just any bonds. They are buying and holding bonds scheduled to pay many years in the future, when their retirees expect their money.

Pension funds went big into tech stocks in the late 90s.  They went big into housing, private equity and hedge funds in the late 00s.  Now they are going heavily into long term bonds.  This, with record low interest rates all around the world and central banks practicing competitive debasement of their currencies.  Sounds about right.

The value of the bonds may fall in the meantime, just like the value of stocks. But declining bond prices are not such a worry, because the companies plan to hold the bonds for the accompanying interest payments that will in turn go to retirees, not sell them in the interim.

That is well and good, but what if the bond issuer defaults?  You can lose money just as quickly in bonds as you can in stocks.

Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

Again, in what universe is 9.5% an expected return for stocks?  Let's pause for a second and use a little logic.  Suppose that GDP, a proxy for the economy as a whole, grows at 5% per year.  Note that this is a very fast growth rate for a mature economy.  Now, let's think about this.  How can stocks, which are priced based off of the earnings power of corporations, which in turn are a subset of the economy, grow faster than the rest of the economy?  Sure, over short periods of time this is possible but mathematically speaking, stocks cannot outperform the economic growth as a whole forever.  If they did, stocks would eventually grow to be larger than the whole economy, which of course is impossible.

The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be. 

Stocks outperformed from 1982-2000.  Therefore, it should hardly be surprising that stocks underperformed from 2000-2010.  In fact, what would be surpring is if stocks stopped underperforming in the next eight years.  This is called mean reversion.

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions. 

But plan officials say they cannot. 

“Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.

We will dub this the Ostrich Investment Plan (OIP).  Head, meet sand.  Like we mentioned with the EU and Greece, these pension fund managers and politicians are in denial.

The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report. 

But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace. 

Colorado looks like they are doomed.  Of course, the game of kick the can will continue as long as possible.

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.

More people in denial.  Colorado cannot afford a 2% increase, let alone 3.5%.

If Colorado could somehow get 9 percent annual returns from its investments, though, its pension shortfall would shrink to a less daunting $15 billion, according to its annual report.

Why not just assume a 30% annual return and claim a surplus?  Problem solved.  I should run for office.

That explains why plan officials are looking everywhere for high-yielding investments.

Yes, the funding shortfalls explain why pension funds are stretching for yield.  Another explanation is that record low interest rates, which are a result of Federal Reserve policies, are forcing these funds to take greater risks.  This is the downside to low interest rates.

Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.

Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.

You just have to laugh at this one.  The gall of these fund managers who think they can goose returns by using swaps, repos, etc. is hilarious.  They don't stand a chance.

Stating the Obvious
All of these wishful projections and financial shenanigans are a waste of time at best.  One or two pensions funds may get lucky and shoot the moon but as a whole, these pension funds cannot possibly outperform the market because they are simply too big.  You cannot outperform the market if you are the market, in other words.  Promises have been made that cannot be kept because there is simply not enough money.  The longer this reality is denied, the harsher the end game will be.

Saturday, March 6, 2010

Keynes: Let's Destroy the Value of your Money

This is part six of our discussion of John Maynard Keynes and his 1936 book The General Theory of Employment, Interest and Money.  So far, we have uncovered some very interesting and often outrageous ideas buried in the famous economist's most well known work.  Here is what we discussed in parts 1-5:
For part six we will discuss how Keynes promoted the destruction of the value of money.  This is commonly referred to by the euphemism inflation but, as we will see, Keynes went even beyond promoting a modest inflation target.  Keynes supported this despite correctly acknowledging that inflation and currency destruction in general hurts the poor disproportionately.

All quotes below can be verified for their accuracy by referencing the full text, which is available online for free here.

Chapter 19, Section II
Except in a socialised community where wage-policy is settled by decree, there is no means of securing uniform wage reductions for every class of labour. The result can only be brought about by a series of gradual, irregular changes, justifiable on no criterion of social justice or economic expediency, and probably completed only after wasteful and disastrous struggles, where those in the weakest bargaining position will suffer relatively to the rest. A change in the quantity of money, on the other hand, is already within the power of most governments by open-market policy or analogous measures. Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter. Moreover, other things being equal, a method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable.

The question here is - what is the best method to lower employee wages?  Keynes argues that it is far better to reduce wages through inflation because it is less understood than a direct reduction in numeric value.  If one's goal is to fool the masses, then quite frankly we agree.

Chapter 19, Section II
In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.

Central bankers like Keynes know that from a psychological standpoint, stealing your money indirectly through inflation is the preferred method.  When someone promotes an inflationary policy, remember that this is what they are advocating - they want to fool you.

Chapter 20, Section III
For a time at least, rising prices may delude entrepreneurs into increasing employment beyond the level which maximises their individual profits measured in terms of the product. For they are so accustomed to regard rising sale-proceeds in terms of money as a signal for expanding production, that they may continue to do so when this policy has in fact ceased to be to their best advantage; i.e. they may underestimate their marginal user cost in the new price environment.

Since that part of his profit which the entrepreneur has to hand on to the rentier is fixed in terms of money, rising prices, even though unaccompanied by any change in output, will re-distribute incomes to the advantage of the entrepreneur and to the disadvantage of the rentier, which may have a reaction on the propensity to consume.

Not only did Keynes hope to fool the masses via inflation, but he hoped to fool entrepreneurs as well!  Fortunately for the entrepreneurs and other generally wealthy people, Keynes correctly recognized that inflation helps the rich at the expense of the poor, as Keynes describes here as well.  Note that fooling entrepreneurs by making them think there is more demand than actually exists, Keynes is promoting the boom and bust cycle that continues to plague our economic system.

Finally, Keynes went one step beyond promoting an inflationary policy.  He also promoted the use of currency with an expiration date, aka "stamped money."

Chapter 23, Section VI
He [Silvio Gesell, 1862-1930] argues that the growth of real capital is held back by the money-rate of interest, and that if this brake were removed the growth of real capital would be, in the modern world, so rapid that a zero money-rate of interest would probably be justified, not indeed forthwith, but within a comparatively short period of time. Thus the prime necessity is to reduce the money-rate of interest, and this, he pointed out, can be effected by causing money to incur carrying-costs just like other stocks of barren goods. This led him to the famous prescription of “stamped” money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher. According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure. According to my theory it should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment. The actual charge suggested by Gesell was 1 per mil. per month, equivalent to 5.4 per cent. per annum. This would be too high in existing conditions, but the correct figure, which would have to be changed from time to time, could only be reached by trial and error.

The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale. But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it, but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes — bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth. As I have mentioned above, there have been times when it was probably the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest; — though under Gesell’s system this possibility would have been eliminated by land nationalisation.

Not only does Keynes and Irving Fisher want to destroy the value of your money but they want to nationalize your land (aka Communism). The bottom line is that Keynes and his followers want to stamp out the free market and steal your land, and thus freedom, because they think they know better than you.  It's all right there in black and white.

Thursday, February 25, 2010

Greece and the EU in Denial

If you are an avid follower of financal news like us then you are no doubt aware of the Greek debt crisis.  In fact, you pretty much cannot avoid it.  We make no predictions on whether Greece will eventually receive a bailout but we are amazed at how quickly the situation has devolved into farce.  For entertainment purposes, let's take a look at some excerpts from recent articles written by the always excellent Ambrose Evans Pritchard:

"If one member of the eurozone were to step out for any reason, this would be a collapse of the entire system," said Carl Heinz Daube, director of the Finanzagentur.  "It is very hard to clarify to a man on the street why one country should step in to help another country," he told the Euromoney bond congress in London. 

So explain it Mr. Daube.  The entire system could certainly collapse if Greece is allowed to fail, but what does that tell you?  If one tiny part of the system can cause the whole thing to collapse, doesn't that imply that the system is terminally designed?  What if the next country that runs into trouble is several times the size of Greece?  It seems that the architects of the EU and Euro should take some responsibility for the current situation, no?

Germany's regulator BaFin fears that the Greek crisis risks setting off "downward spiral" across Southern Europe, posing a system risk to the financial system. It said German banks hold €522bn of state bonds from the region. 

So Greece needs to be bailed out because the German banks were foolish enough to lend them money.  Why should the German people pay for the mistakes made by the banks?  Nobody forced the German banks to throw money at Greece.

Moritz Kaemer, head of Europe ratings at Standard & Poor's, told the forum that "a sovereign default is not going to happen in the euro zone. Greece is still comfortably an investment grade." 

It is good to have such wonderful assurance of calm from the people who missed the housing bubble, the banking crisis and indeed every financial crisis of the last thirty years.  The rating agencies couldn't assess risk if their life depended on it and lucky for them, it doesn't.

Mr Kraemer said it would take Greece 33 years to reduce debt to the already high level of 100pc of GDP even if it manages to consolidate at the rate of the last growth cycle – in boom times that may not be repeated.

So in other words, Greece cannot possibly avoid default if market forces are allowed to work.  What a bunch of nonsensical double-talk when juxtaposed with the earlier statement.

Public and private sector unions joined forces to bring the country to a standstill for 24 hours, halting flights, trains, and shipping, and shutting schools and hospitals.

I am not quite sure what the people of Greece hope to accomplish by destroying their already fragile economy.  Sure, they are angry that their salaries and benefits are being cut but what are they proposing?  They simply don't have the money to pay for their expenses and the world is finally getting tired of accepting their debt.

Theodoros Pangalos, deputy prime minister, said Germany had no right to reproach Greece for anything after it devastated the country under the Nazi occupation, which left 300,000 dead. "They took away the gold that was in the Bank of Greece, and they never gave it back. They shouldn't complain so much about stealing and not being very specific about economic dealings," he told the BBC. 

It is good to see that Greek politicians can be just as big of idiots as American ones.  Clearly events that took place before TV broadcasts began have no relevance today.  Nobody forced the Greeks to join the EU or to adopt the Euro just a decade ago.  If they did not like the terms then they should not have joined.

Twisting the knife further, he said the current crop of EU leaders were of "very poor quality" and had botched this month's crisis summit in Brussels. "The people who are managing the fortunes of Europe were not up to the task," he said. 

Yes, it is the politicians of other countries fault that they cannot bail out your country faster.  Shame on them for letting you get yourselves into this situation.

Portuguese unions have called a general strike for early March. Spanish unions held marches in Madrid and Barcelona on Tuesday over pensions, but turnout was low.

The Portuguese and Spanish are obviously jealous of all of the attention that the Greeks have been getting so they are preparing publicity stunts.  Nice move.

The EU has always found ways to master crises over the last 60 years, and will most likely do so again, but this one feels different to EU veterans.

Sixty years of prosperity is a nice track record but what was it that happened just prior to that period of time?  I seem to remember some minor incidents.

Closing Remarks
What you have here is a total lack of recognition of any sort of responsibility by any party involved.  Nobody in the EU, the banks, the rating agencies, the Greek government or the Greek people want to own up to the fact that they contributed to the current situation.  In short, they are all in denial.  Thus, the situation will continue to get worse until the parties involved stand up and say "I helped get us into this situation and I will stop contributing to it."  Bailout or no bailout, temporary reprieve or not, this story will last as long as the finger pointing continues.

Tuesday, February 16, 2010

What Does One Hundred Trillion Dollars Look Like?

This is a Zimbabwe one hundred trillion dollar bill, which debuted on January 16th, 2009 with a value at the time equivalent to $30.  On April 12th this bill and all other Zimbabwe dollar notes basically became worthless when the Reserve Bank of Zimbabwe legalized the use of foreign currencies.  Maybe Zimbabwe dollars will make a good investment after all, since some individuals are trying to sell these bills as collectables.  We found one site that is asking $20 for each bill.

Thanks to Mike Maroney of for the best freebie of the day at the New York City Traders Expo.

Thursday, February 11, 2010

What's Wrong With Bank Stocks?

Since the middle of October, bank stocks have been trending down and are significantly under performing the general stock market.  Take a look at the following chart.  It compares the Dow (red), S&P 500 (yellow) and NASDAQ (green) with XLF, the Financial Sector Select SPDR (XLF).  XLF is composed of JP Morgan, Wells Fargo, Bank of America and other banking stocks:

As you can see, the divergence has developed since the middle of October, where most bank stocks peaked.  The general markets are comfortably up since that time.

Let's break down XLF by some of its major components.  Here is a comparison of JP Morgan, Citigroup, Bank of America and Wells Fargo.  Citigroup is the lone deviant, having peaked before the others back in August:

This trend is apparent in other financial stocks as well.  Here is a comparison of Goldman Sachs, Morgan Stanley, Credit Suisse and Deutsche Bank, all having peaked out in October as well:

So why is this a big deal?  Well, let's look at the last time that financial stocks started to diverge from the greater stock market.  Here is the first chart again, comparing XLF with the general market indices, but with a time frame from the middle of 2007 until the middle of 2008:

As you can see, the general market was basically flat while the financial stocks were down roughly 30%.  Of course we know what happened just a few months after this - Lehman Brothers went bust, the financial crisis went into full swing and stock markets crashed all around the world.  Are we headed for another financial collapse?  Nobody knows for sure and we do not have quite the divergence that we did back then (yet) but things look ominous.

The market technicals are flashing warning signs.  The economic fundamentals are also flashing warning signs, as the problems in Greece, Dubai, Venezuela and elsewhere continue to spread.  Perhaps contagion will develop into a full blown crisis, similar to what we experienced as collapse spread from mortgage lenders to Bear Stearns to Fannie Mae and Freddie Mac and finally to Lehman, AIG and the whole financial system.  Only time will tell.

Saturday, February 6, 2010

Stock, Gold and the Dollar Market Updates

Friday was a wild day in the markets so it feels like a good time to provide an update.

First up is stocks.  The S&P500 started the week off strong, with up days on Monday and Tuesday.  Wednesday was basically flat followed by a massive sell off on Thursday and a close on the lows for the day. Friday was another massive down day for much of the trading session before a huge rally in the last few hours resulted in a positive close for the day.  Before this massive rebound, we were predicting weekend rumors of a Black Monday style sell off during the next trading session.  Because of the late day rally, however, that possibility looks to be nullified.

Five day view of the S&P500 (click on images for larger views):

In December, we noted that the S&P500 had moved clearly above its 500 day moving average, an important technical level over the past decade.  Since that time, the market has dropped back down and bounced off that line, fell below it, and has now rallied back to the bottom of the line.  If this level starts acting as upward resistance over the next few weeks then stocks could be in big trouble:

The VIX has risen some but is still well within its downtrend.  We will continue to watch this closely, with a breakout being another major negative for stocks:

Next up is gold.  We have been bearish on gold since exiting our profitible position in early December.  We projected a fall in the spot price of gold over the next one to two months to $1000 and $100 on GLD.  Gold fell to around $1050 ($102.28 for GLD) on Friday before rebounding to $1064 ($104.68 on GLD) at the close.  We are still looking for GLD to fall below its 200 day moving average over the next few months, which is just below $100/$1000 an ounce, whereupon we will be large buyers:

We did add a small position in GLD on Friday when it fell below $103.  We entered this position because (1) our dollar index projection had been met (see next section) and (2) we noticed that, while gold and stocks were massively down at the time, most gold mining stocks were up big.  The gold miners typically lead the price action in gold, so we played the divergence.  If the dollar begins to fall while the miners continue climbing then we will hold on to our small position and may even add.

Finally comes the dollar.  Since December we were looking for the dollar to rise into the 80-82 range.  This area was reached on Friday, where the dollar closed at 80.21.  We have no real conviction on the dollar right now, though if it rises to near 82 in the next few weeks we will probably grow bearish:

In summary, stocks are at a very dangerous level but it is a bit premature to call a new bear market.  Gold has fallen far and fast since December and may have bottomed for now but the final bottom of this correction may still be several months away.  The dollar has met our upward target and we have no current projections for this index.

Sunday, January 31, 2010

Keynes on Government Stimulus, Digging Holes

This is part five of our discussion of John Maynard Keynes and his 1936 book The General Theory of Employment, Interest and Money.  So far, we have uncovered some very interesting ideas buried in the famous economist's most well known work.  Here is what we discussed in parts 1-4:
For part five, we thought it was high time to discuss government stimulus.  John Maynard Keynes is often credited with originating the ideas for the various government stimulus efforts that are currently being employed by almost all of the major nations of the world.  But how accurate is this really?  As we will see below, it is quite fascinating to read what Keynes actually said about certain government stimulus efforts.

All quotes below can be verified for their accuracy by referencing the full text, which is available online for free here.

Chapter 22, Section III
The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.

This is the basic game plan employed by Keynesians, or in other words, every central banker.  Booms should not be stifled and busts should be battled with government stimulus.  The opposing view presented by Austrian Economists is that booms lead to busts and thus booms should be prevented from getting out of control in the first place.

Chapter 8, Section IV
In the United States, for example, by 1929 the rapid capital expansion of the previous five years had led cumulatively to the setting up of sinking funds and depreciation allowances, in respect of plant which did not need replacement, on so huge a scale that an enormous volume of entirely new investment was required merely to absorb these financial provisions; and it became almost hopeless to find still more new investment on a sufficient scale to provide for such new saving as a wealthy community in full employment would be disposed to set aside. This factor alone was probably sufficient to cause a slump. And, furthermore, since “financial prudence” of this kind continued to be exercised through the slump by those great corporations which were still in a position to afford it, it offered a serious obstacle to early recovery.

Keynes says that the massive excesses created by the boom were enough to cause an inevitable slump.  This inevitable slump became the great depression.  One would think that it would logically follow that we should try to prevent booms from getting too out of hand (the Austrian argument) but based on the first quote in this article, Keynes clearly did not feel this way.

Chapter 8, Section IV
…in Great Britain at the present time (1935) the substantial amount of house-building and of other new investments since the war [since the end of WWI in 1918] had led to an amount of sinking funds being set up much in excess of any present requirements for expenditure on repairs and renewals, a tendency which has been accentuated, where the investment had been made by local authorities and public boards, by the principals of “sound” finance which often require sinking funds sufficient to write off the initial cost some time before replacement will actually fall due; with the result that even if private individuals were ready to spend the whole of their net incomes it would be a severe task to restore full employment in the face of this heavy volume of statutory provision by public and semi-public authorities, entirely dissociated from any corresponding new investment…Yet is not certain that the Ministry of Health are aware, when they insist on stiff sinking funds by local authorities, how much they may be aggravating the problem of unemployment.

A housing boom that led to a massive bust.  Where have we heard this story before?  Keynes was against the government efforts of his time to spend money to stimulate the housing market.  He said it aggravated unemployment.  Name one central banker who holds this position.

Chapter 10, Section VI
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

To the layman (aka those with common sense) the above argument strikes one as utter insanity.  Thankfully, we have prominent economists such as nobel laureate Paul Krugman who advocates such ideas.  Krugman even featured this passage on a recent blog post.  So rest assured, the above makes total sense.  Forget the fact that Henry Hazlitt debunked this theory in 1946 with his work Economics in One Lesson.  Hazlitt called this the broken window fallacy.

Economics in One Lesson by Henry Hazlitt:
A young hoodlum, say, heaves a brick through the window of a baker’s shop. The shopkeeper runs out furious, but the boy is gone. A crowd gathers, and begins to stare with quiet satisfaction at the gaping hole in the window and the shattered glass over the bread and pies. After a while the crowd feels the need for philosophic reflection. And several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Two hundred and fifty dollars? That will be quite a sun. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $250 more to spend with other merchants, and these in turn will have $250 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be, if the crowd drew it, that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.

Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $250 that he was planning to spend for a new suit. Because he has had to replace the window, he will have to go without the suit (or some equivalent need or luxury). Instead of having a window and $250 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.

The glazier’s gain of business, in short, is merely the tailor’s loss of business. No new “employment” has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.

A very basic economic concept known as opportunity cost describes this as well.  How can this possibly be overlooked by anyone that claims to be economist?

Regardless, people such as Paul Krugman conveniently forget one important aspect of Keynes's argument:

Chapter 16, Section III
“To dig holes in the ground,” paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services.

"Paid for out of savings" is the crux.  A country such as China, with their massive reserves, may actually benefit from government stimulus.  This is only true because the source of the stimulus is savings.  The US has major deficits and thus stimulus efforts are not coming out of savings but out of debt.  This is a big difference and most central bankers are conveniently ignoring this fact.

Thursday, January 28, 2010

Wall Street 2: Is Greed Still Good?

The sequel to the 1987 movie Wall Street, officially titled Wall Street: Money Never Sleeps, is due to hit theatres on April 23rd.  The official trailer was released today so take a look:

The Wikipedia article describes the film's plot as such:

The film is set 23 years after the first film, in June 2008, and Gordon Gekko has just been released from prison. Despite his initial attempts to warn Wall Street of the forthcoming economic downturn and stock market crash, no one believes him due to his reduced standing in the financial world. Gekko decides to re-focus his attention on rebuilding his relationship with his estranged daughter, Winnie. Due to their time apart, and the fact that Winnie blames Gekko for her brother Rudy's suicide, she avoids any contact with him. At the same time, the mentor of young Wall Street trader Jacob unexpectedly dies, and Jacob suspects his hedge fund manager of being involved in the death. Jacob, who is Winnie's fiance, seeks revenge and agrees to Gekko's offer of help, in return for which Jacob agrees to help Gekko with Winnie.

Reasons to be hopeful about the new Wall Street movie:
  • Oliver Stone is back to direct
  • Michael Douglas is back as Gordon Gekko
  • The financial crisis has given the creators ample material to work with
Reasons to be skeptical about the new Wall Street movie:
  • We are trading in Charlie Sheen for Shia LaBeouf? What a downgrade.
  • Gordon Gekko comes back as an old and (most embarrassingly) poor man
  • Long awaited sequels usually suck.  For every Rambo 4 you have ten Indiana Jones and the Kingdom of the Crystal Skulls (and we know who also starred in that)
  • Greed was kind of cool in 1987.  Greed looks a lot less cool in 2010.
  • Seriously, did we mention that Shia LaBeuof is in it? Argh.

Friday, January 22, 2010

The Crude Oil ETFs Stink!

A Norwegian oil rig collapses into the sea, just like the collapse of your oil ETF

In prior posts we have shown how, with commodity based ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes), the performance can vary among the precious metals funds and why the levered and inverse funds suffer huge performance drag.  There seems to be great interest in the various oil based funds so we wanted to examine how their performance compares with the spot price of crude oil itself.

There are five funds available to US investors that are meant to track the price of crude oil:

USO - United States Oil Fund (ETF)
USL - United States 12 Month Oil Fund (ETN)
OIL - iPath Crude Oil (ETN)
DBO - PowerShares DB Crude Oil (ETF)
OLO - PowerShares DB Crude Oil (ETN)

Let's compare the performance of these five funds versus the spot price over varying time periods.  For our historical crude oil price data we used the Cushing, OK WTI Spot Price from the US Energy Information Administration website.  The first row shows the futures price and the next five rows show each fund.  The final column, tracking error, shows the difference between the change in value of the spot price and the change in value of the price of each fund.

Over the last three months, the tracking error for DBO and OLO have been respectable, at less than 2%.  USL is the third best with a tracking error of 2.28%.  USO and OIL both have pretty significant tracking errors for this short of a time span, at 4.6% and 5.02% respectively.

Moving out to a one year time span, our tracking error order stays the same as before, with DBO and OLO having the best performance, followed by USL, USO and OIL.  With that being said, the tracking error for all five funds is just atrocious.

Moving out further to a 1.5 year time span, we have the same performance order as before.  This time, DBO and OLO really separate themselves from the other funds.  USL is a bit farther behind while USO and OIL suffer terrible performance.  We chose this time frame because it matches the inception of OLO.

With our time span stretched back to just under 2 years, we can see that DBO significantly outperforms the other funds.  We chose this time frame because it begins at the inception of USL.  OLO was left off of this list because it does not have performance numbers that stetch back this far.

What do these results tell us?  The tracking error for all five funds is significant and can vary greatly depending on the sampled period.  DBO and OLO are by far the best choices for investors and the only ones we would recommend if one simply has to own an oil ETF or ETN.  USL is a bit worse over all time periods so we see no reason to choose this fund.  USO and OIL have simply horrific tracking errors over all sampled periods and are borderline criminal in our opinion.

To go along with this post, we have updated our Commodity ETFs and ETNs Google Docs Spreadsheet.  This is our list of commodity funds that seek to track the performance of specified commodities. We have excluded 2x and other levered funds because we think they are lousy investments and borderline scams.  Since our last update of this document back in October, we have removed UOY, the MacroShares $100 Oil ETF, because it has been delisted.  We have added OLO, the PowerShares DB Crude Oil ETN, and have also updated the average daily volume information for all funds.

Monday, January 18, 2010

Hugo Chavez: The Mickey Mouse Presidente

 Hugo Chavez: The Mickey Mouse Presidente

As much as we enjoy criticizing the US government and its economic policies, from time to time we do like to remind ourselves how much worse things could be.  Case in point: Venezuela.  Hugo Chavez is doing his best to run that country into the ground and looks to be succeeding.

On January 8th we learned that Venezuela devalued its currency:

The government devalued the bolivar by half on Friday and imposed a 4.3 bolivars per dollar rate, putting an end to the VEF2.15 rate which had been in place since 2005.

The Venezuelan people responded (somewhat) rationally the next day as Nervous Venezuelans buy TVs after devaluation:

Shouting "buy, buy, the world is going to die," Venezuelans went on a frantic shopping spree on Saturday following a sharp currency devaluation that is expected to drive up prices.

"I've been lining up for two hours outside to buy a television and two speakers because by Monday everything is bound to be double the current price," said Miguel Gonzalez, a 56-year-old engineer standing in the tropical sun outside a popular store.

State run television and radio stations avoided using the word "devaluation," preferring the word "adjustment." One pro-Chavez radio station responded to critics of the measure by playing a popular Argentine song called "Imbecile."

Inflation, the highest in the Americas, at 25 percent last year, reached 103 percent in 1996 after a previous president lifted exchange and price controls.  

The title of the article is idiotic.  What the heck would the author do if their money was losing 25%+ of its value per year?  If the author was rational, they would rush to dump cash for goods as soon as possible, just like these people.  Of course, it would probably be smarter to spend money on food (or perhaps a visa to leave the country) than to buy TVs but these are the people that voted for Chavez so what can one expect?

What do I do now?

In response to his people's rush to buy goods, Chavez decided to enforce price controls:

President Hugo Chavez denied that a devaluation of a five-year-old foreign currency peg will lead to a hike in consumer prices and warned that his government will hunt down retailers and companies that raise their prices.

"At this moment there isn't any reason for anyone to increase their prices," Chavez said Sunday during his television show. Shoppers have flooded stores purchasing televisions and home appliances fearing that prices will increase following a devaluation of the bolivar announced by Chavez on Friday.

"I don't understand why people are standing in line. They are victims of terrorist media campaigns creating fear that prices will rise," he said.

Hugo Chavez being undoubtedly baffled by something

What a buffoon. Price controls always lead to shortages.  ALWAYS.  This man is criminally stupid.  The article continues...

Chavez called on the National Guard to help the government fight speculation and price increases, saying without giving details that he wanted it deployed on the streets to hunt down speculators. The government, Chavez said, will "seize any businesses and shops that are participating in speculation."

True to his word, yesterday Venezuela nationalized a French owned retailer:

Venezuela's socialist President Hugo Chavez on Sunday nationalized a chain of supermarkets controlled by France's Casino (CASP.PA) on charges of price gauging after the government devalued the bolivar currency.

"Because of multiple violations of Venezuelan laws the Exito chain will now belong to the republic, there is no way back," Chavez said on his weekly television show.

In his 11 years in office, Chavez has nationalized large swathes of the economy, including major oil projects along with electricity and telecommunications companies.

In what must be merely a coincidence, today came news that a Venezuela natural gas auction closed with no offers.  Imagine the audacity of those greedy capitalists not showing up with their money.  It is as if they think they are above doing business with people who do not respect property rights or contracts.  What a bunch of elitists.

In a truly stunning development for an energy rich country, Venezuela has been hit by power outages:

Venezuela has been hit by unplanned power cuts which the government blames on a drought hitting hydro-electricity.

The government announced this week that the entire country would be affected by energy rationing, with rolling blackouts in different areas on different days.

Yes, it was the damned weather's fault.  Of course, the government could not even enact rolling blackouts without messing that up.  The article continues...

Venezuelan President Hugo Chavez has reversed his decision to ration electricity in Caracas a day after nationwide power cuts were announced.

Mr Chavez said there had been mistakes in introducing rolling blackouts in the capital, and people did not know when their neighbourhoods would be affected.

It's their fault

Meanwhile, we learn that President Chavez has taken time out of his already busy schedule to denounce Playstation games:

Those games they call 'PlayStation' are poison. Some games teach you to kill. They once put my face on a game, 'you've got to find Chavez to kill him'.

Games, said Chavez, "promote the need for cigarettes, drugs and alcohol," adding "That's capitalism, the road to hell."

What is poison is Hugo Chavez's economic policies.  He would do the world and the Venezuelan people a huge favor by stepping down and leaving everyone alone but you know that won't happen.  It is others who are to blame for the problems facing Venezuela and he will do his best to fix things.

Freedom's Vision of Monetary and Political Reform

We are regular readers and commenters on the economics blog Nathan's Economic Edge.  Nathan Martin of the aforementioned blog and Bill Still of The Secret of Oz have joined together to publish a document named Freedom's Vision.  Martin describes Freedom's Vision thusly:

The hope is that [the Freedom's Vision documents] explain the basis for change in the same way that the Federalist Papers did when Hamilton and Madison were exchanging ideas about the Constitution. Thus, we await and welcome your ideas, and even your criticisms.

And with that, we would like provide our thoughts on the proposals outlined therein.

The three key proposals of Freedom's Vision are (1) monetary reform, (2) political reform and (3) a new direction for the future:

1. Monetary Reform – We must replace our unjust, debt-backed money system and cleanse debt and derivatives without creating severe inflation or deflation; without creating a supreme “moral hazard;” and without crashing the entire global economic system in the process.

2. Political Reform – We must exclude large special interests from political decision-making. Removing this influence will accomplish a great deal in ensuring that the quantity of money remains under control and that politicians can go back to working and thinking on behalf of the people, not just in the short term, but also in the long term.

3. Direction for the Future – A change of direction is clearly needed. We are rudderless, and without proper goals to move forward our economy and society will continue to drift. While we feel this is desperately needed, we are focusing on the first two for now. When successful with the other two, the third will follow, but we need to be thinking about direction now!
    Monetary Reform
    The first proposal - monetary reform - is a non-starter.  A radical restructuring of our monetary system is impossible at the moment because of a lack of political will.  Ron Paul is struggling to even get a basic audit of the Federal Reserve, so attempting to replace that institution at this time is just not feasible. Freedom's Vision even admits this...

    One way or another, this over-leveraged system is going to crash and be replaced by something else.

    The current system must be allowed to reach its inevitable conclusion and finish itself off before a replacement can be seriously considered.  What will the end of the current monetary system look like?  Nobody knows but it will not be pretty.  When it does happen, our view is that a temporary stop-gap solution will be needed to calm the waters before a brand new system can be put in place.  Freedom's Vision outlines a transition period between the current monetary system and the proposed one but speaks as if the current monetary system is as it stands today and not after a collapse, which is the only time that the proposal has a realistic chance of being implemented.

    Thus, the proposal needs to outline how to pick up the pieces after a collapse.  The most obvious candidate for this role is one or more gold backed currencies.  For this reason, we feel that gold bugs, hard money advocates and the backers of Freedom's Vision are natural allies, so it is perplexing to us why Martin dismissed the usefulness of gold in his essay The Fallacy of Gold Backed Money.  His points in that essay are well noted but the usefulness of gold as a temporary solution is overlooked.  In the time of panic, people natural grasp for what they have been able to trust in the past.  Gold has a long and storied history of wealth preservation and thus fits this role perfectly.  Bringing gold bugs and hard money advocates into the conversation also increases the potential backers of Freedom's Vision by leaps and bounds.

    Political Reform
    Let's move on to the second proposal - political reform.  We think it is a mistake to list this proposal second in that it is naturally the first step towards getting monetary reform and not the other way around.  There is zero political will to change the monetary system but there is definitely a growing desire among the people for political change.  The public is waiting for a third party that represents both fiscal conservatives that have been betrayed by Republicans and anti war liberals that have been betrayed by the Democrats.  These two groups have more in common than the mashed together Republican base of religious southerns and rich people or the Democratic base of social liberals and poor people.  Think about it.

    Thus, Freedom's Vision can be most effective today by focusing on the creation of a viable third party that represents fiscal conservatives and anti war liberals.  Fiscal conservatives are covered by the monetary proposals but the anti war liberals are left out in the cold by the proposal.  There are notes in the proposal about war in general but Freedom's Vision does not mention either Iraq or Afghanistan once.  This is an oversight both from a politically opportunistic angle and a fiscal conservative one, since the wars are damn expensive.

    A New Direction for the Future
    A new direction for the future is a collection of proposals containing everything from education, energy, science, medicine and space exploration.  These are all nice points of discussion but are frankly not worth talking about when the government is going broke.  The priority is to cut the size of government and any and all new programs should only be considered once current levels of spending are reigned in.

    Final Words
    In conclusion, we feel that Freedom's Vision has some interesting proposals but misses the mark in a few ways.  #1 the focus should be on political reform via the creation of a viable third party.  Monetary reforms can enter the discussion but quite frankly voters have no interest in this subject and gaining their support does not require it anyway.  A better tactic is to gain their approval through issues they already understand, such as government spending and the two wars, and then introduce them to monetary reform once they are already on board.  At that point, monetary reform will be a natural extension of the general platform of the party.

    Once a third party is in place with clout (it does not need to take the presidency or majority of either house) only then will the ball begin to roll.  The monetary reforms are nice to discuss but they are a non-starter until the current system collapses.  Feel free to write proposals and discuss them at length but it is nothing but a hobby for the time being.  Once the system collapses and the aforementioned third party is represented, only then will monetary reform be possible.  This path to successful reform will be unbelievably difficult but it at least has a chance while all other methods seem entirely impossible.

    And with that we leave the reader with the full version of Freedom's Vision embedded below for perusal:

    Saturday, January 9, 2010

    When Stable Value Isn't So Stable

    A lot of uproar was generated last week because of an article posted on Zero Hedge titled This Is The Government: Your Legal Right To Redeem Your Money Market Account Has Been Denied.  The crux of the article is the proposed change to money market rule 2a-7, which specifies that fund managers can suspend redemptions to allow for the orderly liquidation of fund assets.  In other words, if the markets freeze like they did in the fall of 2008, holders of money market funds may not be able to withdrawal their money.

    Who exactly is surprised by this?  The proposed change in law merely reflects the blunt truth that money market funds as a whole can hardly withstand a run on the bank scenario.  Liquidity is an illusion that is swept away during a panic.

    Besides, for those looking for a story with real teeth, I suggest examining the current rules governing stable value funds and what has already happened to those who invested in these funds.  Stable value funds are similar to money market funds but are somewhat less known because they are only available in retirement accounts.  According to the Stable Value Investment Association, stable value funds are defined as follows:

    Stable Value Funds deliver safety and stability by preserving principal and accumulated earnings. They are similar to money market funds but offer considerably higher returns. Their returns make them comparable to intermediate bonds minus the volatility. They are the largest conservative investment in defined contribution retirement plans with over $642 billion in assets

    Tell that to the workers at Chrysler. This story seems to have been buried by the financial crisis of 2008 but it is one of the most important:

    An unnerving new crack emerged in the $520 billion stable-value fund market as an offering for workers at Chrysler LLC dropped 11%, highlighting strains in yet another supposedly safe investment.  The loss at the fund, which is part of the retirement program for white-collar workers at Chrysler, is the latest sign of trouble for these products.

    Stable-value funds, available only in tax-deferred savings plans such as 401(k)s, are designed to provide capital preservation and smooth, positive returns. But Chrysler Stable Value Fund B, offered to certain Chrysler employees and retirees through company savings plans, paid out only 89 cents on the dollar when the fund was liquidated earlier this year. Chrysler declined to say how much money was in the fund.

    "They advertise it as being basically guaranteed. That's why I put money into it," says Johnnie Johnson, a 63-year-old retired Chrysler electrical engineer in Plymouth, Mich. "I'm pretty frustrated with this whole thing." He says he had nearly $80,000, roughly 20% of his total retirement savings, in Chrysler Stable Value Fund B.

    Problems in stable-value funds can become particularly acute when many investors make withdrawals at once, which is what happened in the Chrysler fund this year.

    Employer-initiated events that can cause mass withdrawals, such as a plan termination or the employer's bankruptcy, generally aren't covered by stable-value contracts. Typically, these events are known in advance and the employer and stable-value manager can negotiate coverage that lets investors withdraw their money without taking a loss.

    Investors in Chrysler Stable Value Fund B say there was no sign that the fund was in trouble until they received their distribution checks, which were far smaller than they expected.

    These workers were taken to the cleaners and the best part is that it was all perfectly legal.  Stable value funds are supposedly backed by insurance wrappers that pay out in the event of investment losses but the legal loopholes allow for the screwing of investors, as we saw in this case.  The amount of payout by the wrappers is even under dispute, so in the event of failure investors might not be made whole.

    Going back to the Stable Value Investment Association definition, stable value funds are "similar to money market funds but offer considerably higher returns."  How exactly are these considerably higher returns generated?  In 2008, the average stable value fund returned 4.58 percent, compared with 2.89 percent for money markets.  Risk and return are directly correlated.  If you are garnering higher return, by definition you must be either (1) taking on higher risk or (2) committing fraud.

    Unfortunately, for any specific fund, investors have no way to find out which of these two scenarios apply.  This is because, unlike money market funds or mutual funds, stable value funds are not required to disclose their holdings in any way whatsoever.

    I attempted to contact Prudential about getting either the specific holdings or the market-to-book-value ratio for one of their sizable stable value funds.  Prudential refused to disclose this information and was rudely dismissive of the request.  This despite the Stable Value Investment Association's claim that the market-to-book-value ratio must be disclosed at least once a year by stable value fund managers.  This fund is currently generating a guaranteed 4.59% return per year.

    And what of the insurance companies themselves that wrap these funds?  Who are they and how healthy are they?  Well, by one metric AIG wraps nearly 8% of stable value fund assets, so that should tell you about all you need to know.

    We look at the stable value funds as a potential black swan event that could hit sometime in the next few years.  As the baby boomers retire, funds will be withdrawn from stable value funds.  This will make these funds increasingly fragile going forward, and a general market panic of any kind could produce fund failure.  A couple of high profile fund collapses will generate a "who could have predicted" response from the usual big shots.  With stable value funds currently comprising 36% of all retirement fund assets, this would be no small scale event.  We have no way of knowing what the government's response to the above scenario would be, but after the cold shoulder given to the Chrysler workers, investors should not assume that the government will step in and make these funds whole.  Protect yourselves accordingly.