The More Things Change, The More They Stay the Same

by Rob Kirby, Kirby Analytics. September 12, 2005

I sat with my boss in a sweltering but fashionable downtown eatery in Toronto in mid August 1987 having lunch - with two chaps who were the book runners [traders] for the interest rate swap book of my number one client. This client just happened to be a major bullion bank and at the time the biggest derivatives dealer in the world. One of them was a Polish immigrant, a Ph.D. in mathematics who had been recruited from then DOW 30 constituent Honeywell. While he spoke in slightly broken English, this guy was not only a genius but an accomplished Olympian - as a sailor. These were indeed "heady times." The DOW had just broken the magical 2000 level and 5-year mortgage money was available at approximately 10% in Canada if you were on friendly terms with your local bank manager. In those days 10% money intuitively made most business deals work. Over a nice bottle of wine talk quickly turned to "the markets" - interest rates in particular - and in a larger sense the general equity markets.

It was shortly after the banter turned to the equity markets that our Ph.D. friend, in his broken English informed us, "there are going to be days when the [stock] market [DOW] goes down 4 or 5 hundred points." The other three of us sitting at the table stared at him gawking in disbelief - not sure whether we should laugh or take his words seriously. Given that the largest one day movement in the DOW Jones to that point in time was about 28 points we asked him what his reasoning was for such a bold prediction. His answer was [again in broken English], "the incorrect assumptions in portfolio insurance."

We asked him pointedly just what it was that "was wrong" with the assumptions in portfolio insurance? His reply, "Simple" portfolio insurance constitutes computer generated equity trades. The more the markets move in a given direction, the more the computers will exacerbate the move in the same direction-thus the market will drop 4 or 5 hundred points easily in one day. That produced chuckles and a retort of, "By the same logic it seems the market might equally be susceptible to a 4 or 5 hundred point rise in one day?"

Things Never Crash "Up"

I'll never forget his reply [interrupting and again in broken English], "Empirical observation I have made, things never seem to 'crash' up." We asked him what made him so certain of his convictions regarding the equity markets. His reply, "I've modeled it all in my computer. It is certain to happen given the right conditions." This guy had "modeled" the equity market in a computer program he created in his spare time, for fun, and determined under which circumstances it would catastrophically "fail." He equated this exercise he had undertaken to a car company like FORD testing a new model in a wind tunnel for aerodynamics. This man was a truly brilliant independent thinker.

The folks who "bought in" or were sold on the idea that portfolio insurance was as a panacea or "as good as advertised" in the 1980's did so largely on blind faith. Virtually no one truly understood that its underlying assumptions, so it would seem, virtually guaranteeing its failure when it would be needed most.

It was only two months after those prophetic words were uttered - October, 1987 - that the DOW experienced a 25% single day drop - the biggest in history.

By now you must all be wondering what any of this has to do with the here and now of today. To explain this, I would like to share a thought articulated by GATA's Bill Murphy in this past weekend's Midas commentary. Murphy was quoting the words of the venerable Doug Noland, he of the Credit Bubble Bulletin and PrudentBear.com fame:

"I've never been a big fan of the notion of the "Greenspan Put." I am, however, warming to the notion of a Greenspan Levee. The Greenspan Put conveys that there is a market instrument/mechanism always available to right the markets' wrongs - an exercise of "mopping things up." A Levee, on the other hand, works splendidly until it fails. If the water level is sufficiently high, a breach guarantees a catastrophic outcome (only afterwards will the toxic mop-up commence). The Greenspan Levee brooks the massive and unrelenting inflation of Wall Street finance. Worse yet, we have passed the point where our policymakers will dare scrutinize precarious system dynamics or attendant acute systemic risk."

Murphy goes on to point out that Noland is one of today's financial market's truly brilliant independent thinkers, too. Further highlighting the market's seeming indifference to everything from rising rates to natural catastrophe, in Murphy's own words,

"The PPT [Plunge Protection Team] has supported the US stock market every time some market event should have sent it much lower. Each time the US stock market was about to break down during the last four years, it has mysteriously turned back up late in the day, to save the bacon for the market longs. This peculiar market action, defying all logic, has been articulated in this column on a daily basis as it occurred.
By all accounts Katrina, which hit after almost all US reports revealed an already weakening US economy, is a far worse economic disaster for the US economy than 9/11. Yet, notice the difference in the response of the S&P futures market, a market that was shut down after 9/11."

As I glance at the calendar, I cannot help but notice the timing - the steamy days of August are still clearly visible in the rear view mirror. It will be October - again - soon enough, too. Prophetic words are increasingly being uttered by market mavens such as Noland et al but equity market participants are having none of it - or just don't seem to get it. Then again, the Feds have just started handing out debit cards to the impoverished masses - haven't they? Perhaps my Polish Ph. D. friend was wrong many years ago when he observed that things never crash up? Then again, no one had ever heard of Ben Bernanke or helicopter money back then - had they? Perhaps no one has bothered to mention this to the computer programmers that are responsible for all the program trading on exchanges like the NYSE where in a typical week program trades account for anywhere from 50% to 72% of the daily volume? It seems to me that the more things change, the more they stay the same!

Today's Market

Overseas equity markets got the week off to a roaring start with Japan's Nikkei Index gaining 204 points to close at 12,896. This side of the pond markets were comparatively muted with the DOW closing at 10,682.94 - up 4.38 points, the NASDAQ up 7 to close at 2,183 while the S & P lost 1 - closing at 1,240. Crude oil futures finished the day down .75 per barrel at 63.33 on the NYMEX exchange.

The U.S. dollar had a miraculous reversal of fortunes with the Dollar Index rallying back from overnight lows to close up .81 at 87.70. The YEN finished the day at 110.34, the EURO at .8145, the GBP at .5495, the CAD at 1.1866, the YUAN at 8.0956 and the RUBLE at 28.39.

In the interest rate complex, the benchmark 10-year bond ended the day at 4.18% yield and the 5-year bond ended the day with a yield of 3.98%.

Precious metals finished the day mixed with COMEX gold futures adding .80 to close at 449.80 per ounce while silver futures finished the day down .01 at 7.01 per ounce. The XAU gold bug index finished the day up .08 at 102.68 and the HUI index closed at 220.36 - up .13.

On tap for tomorrow, the Bureau of Labor Statistics [BLS] is due to release August PPI data at 8:30 am. - expected .7% vs. prior 1.0%. Core expected .1% vs. prior .4%. Also at 8:30 am. the Census Bureau is due to release July trade balance statistics, expected -58.1 billion vs. prior 58.8 billion. Then at 2:00 pm the Treasury Dept is due to release their August budget numbers - expected -50.0 billion vs. a prior -41.1 billion.

Wishing you all a pleasant evening and a most prosperous tomorrow!

Rob Kirby

Contact Information

Rob Kirby | Proprietor, Kirby Analytics Newsletter - Proprietary Macroeconomic Research
Toronto, Ontario, Canada | Observations | FSU Editorials | E-mail