A Dash of Insight

Easy Money

Let us suppose a fantasy world in which we could sit down in a game of chance with a select group of opponents.  The other players had the following characteristics:

• They are drawn randomly from the population.  If you think you are smart, they are less smart.
• They have little education in the relevant subject.  You have an advanced degree, and they either did not take or do not remember Course 101.
• The opponents have no theoretical or conceptual model -- and probably do not understand what that means.
• The opponents are willing to make big bets on their opinions.

Please keep the scenario in mind.

Ritholtz Bets on the Masses

Over at The Big Picture Barry Ritholtz offers the rather astounding suggestion that when all of the experts in a field agree, it is time to take the other side.  Here is a key quote:

As someone who has been skeptical about the artificially low inflation and unemployment rates for quite sometime now, the public's reaction makes a whole lot of sense. If we believe the negative sentiment of the American people, then its likely that Inflation has been much more pervasive than reported by either the top line or the core.  And the same thinking likely applies to the low unemployment rate. If we judge by sentiment, perhaps its not as low as advertised. Ignoring widespread distress in the population is a recipe for major electoral changes.

Does this really make sense?  Should an investor take action based upon public perceptions of economic statistics -- throwing out the opinions of experts?

The Public in Action

To consider the wisdom of betting on the public, let us consider their track record.  We'll have more to say about this in future articles, but for now let us go to a source highlighted by Barry, Michael Shermer.  (We could cite our past articles on the blunders by individual investors, but for today, let us stick with Barry.)

In Shermer's book, Why People Believe Weird Things:  Pseudoscience, Superstition, and Other Confusions of Our Time, the author, the editor of Skeptic, (now on our list of featured readings) writes as follows:

If we are living in the Age of Science, then why do so many pseudo-scientific and non-scientific beliefs abound?...New Age ideas and nonsense of all sorts have penetrated every nook and cranny of both popular and high culture.

He goes on to cite a Gallup poll showing that 52% believe in Astrology, 46% in ESP, 19% in witches, 22% that aliens have landed on earth, 41% that humans and dinosaurs lived simultaneously, 65% belief in Noah's flood, and 67% who have had a psychic experience.  42% think they communicate with the dead.

Shall we bet with the public?

Real Life Applications

One application we know about is the world of tournament bridge, where those who have a sound theory and understand odds routinely beat those who do not.  We suppose this is the same in mind sports like chess.

Another application is poker, where the popular conception loses to the expert on a daily basis.  The expert welcomes those with little background or knowledge.

In other casino games, they send a limo for those with a "system."

Is economics different?

What about the Economy?  And the stock market?

How should we interpret economic data?  Shermer has a useful suggestion:

Science is progressive because its paradigms depend upon the cumulative knowledge gained through experimentation, corroboration, and falsification.  

The key point is that real scientists reveal their theories and data, inviting the criticism and tests of others.  Anyone not offering findings for peer review and analysis is suspect.

The pseudo-science of those criticizing economic data relies on sources that have no peer review.  It is something to think about.

Our Take

There are several easy ways of pandering to public perceptions about the economy, government actions, and stocks.

• Those who have no real economic credentials gain from disparaging those who do.

• Those who have never actually developed econometric models -- or any models -- gain from acting as if these models have no value.

• Those who have no government experience gain from simplistic interpretations (That is a model!).

• Those who start with a world view, and then criticize any inconsistent data, can find support for that perception.

The stock market offers the chance for those who can identify the real experts to make easy money.  Most often, this happens when sentiment is at a bullish or bearish extreme, not supported by reality.

One of our missions is to identify such points.  For now, there is a key question:

When experts and the general public disagree, how do you vote -- with your money?

Send the limo.  (More later -- a lot more.)

(Regular readers will note our current model-based bearish stance.  We write both about fundamentals and current prospects.  Often the sentiment diverges from our sense of opportunity. Our trading reflects the differing time frames).

Housing Bill Veto Threat

There is a threat to the housing bill that has been moving through Congress.  It is important, and attracted little market attention today.

Background

The House passed an aggressive version of housing relief, led by House Financial Services Committee Chair, Barney Frank (D MA).  The Senate went through a negotiating process, with Sen. Richard Shelby (R AL) acting as the spear carrier for the Bush Administration.  Shelby succeeded in negotiating a compromise with Sen. Banking Committee Chair, Christopher Dodd.  The compromise bill cleared the committee on a vote of 19-2.

In the normal course of events, the bill would be passed by the Senate, since it has strong bipartisan support.  Many key Republicans represent states hard hit by potential foreclosures.  The next step would be a conference committee to reconcile the differences with the House version.  The plan was to complete legislation for President Bush's signature by July 4th.

Today's Developments

Today's story, breaking from various sources, got little attention during trading.  To the surprise of most (since Shelby had already used the Bush veto to exact various compromises) the Administration announced opposition to the Senate measure.  This bill was more conservative than the Frank version from the House.

Influencing the decision was information suggesting that some key officials, including Senators, received favorable loans from Countrywide.  Some analyses of the legislation suggest that Countrywide will be unduly assisted by the legislation.  There are many articles on this subject, but we recommend the very objective reporting from CQ Politics.

Our Take

At "A Dash" we have emphasized that solutions to the housing problems will not be a single comprehensive solution.  Instead, government works in incremental fashion, addressing one aspect of the problem at a time.  Some of the increments are in place, but this bill is an important addition.

As usual, we urge readers to put aside personal opinions about the  merits of the legislation and consider the market impact.  That is our mission.

This bill would help to stabilize housing demand.  There has been a lot of attention paid to housing supply, but there is also latent demand.  Most observers believe that some buyers are waiting to see stability.  Others need some help in qualifying for loans.  For these reasons, the measure is expected by most to help the housing market in an incremental, but important fashion.

A Presidential veto would be a negative for housing, credit markets, and the stock market in general.  It is possible that a scandal involving leading Senators could either delay the Senate passage, the conference committee action, or passage of the resulting bill.  It might also provide justification for a Presidential veto, especially since the lame duck Bush Administration may not be fully aligned with the GOP election needs.

If the political turmoil derails the legislation, we view this as a serious negative for US stocks.  If the issue is not resolved soon, no action will be taken before the election.

It is a strange fact of our political system that the implications for specific individuals and companies may outweigh a general concern.  One is easy to describe and makes good election fodder.  The other involves a deeper understanding of economic effects, one that eludes the grasp of the average voter.

Important News on the Housing Bill

When something important happens, with potential market effects, we interrupt our normally scheduled programming for an update.

We intend to publish the answers to the economics quiz and to announce the winners.  Meanwhile, potential entrants have another day to win this prestigious contest!

The Housing Compromise

At "A Dash" we have written a series of articles on  housing problems and possible solutions.  Since the government steps have been incremental in nature, the market has not really responded.  At some point, there will be a realization that something important has happened.

Last week we pointed out that investors should be watching Sen. Richard Shelby as the indicator of a real compromise.  A Senate Banking Committee compromise was reached today.  While there are more steps in the legislative process, we see this as the real hurdle.

The Significance

We note with interest the opinion of Nouriel Roubini, an outspoken bear on the housing situation.  In two articles, Roubini discusses the merits of the proposal and responds to critics of his viewpoint.  Here is a key portion of his argument, but readers should consult both articles.

Very few reflected on the substance of this proposal and its strong economic logic that would benefit borrowers, lenders and even the government as the fiscal cost of no action (a systemic banking crisis that would trigger a costly fiscal bailout of banks given deposit insurance) is much higher than the potential modest fiscal cost of this proposal.

Conclusion

This is good news for the housing market, the economy, and the stock market.  We shall delve more deeply into the proposal and the effects in future articles.  We shall also examine the reactions of economists and prominent bloggers.

UPDATE, 5/20/08, 1 PM CDT

The editors at TheStreet.com have kindly moved my article on the Frank/Dodd legislation to the non-subscription portion of the site.  Readers of "A Dash" can check out this article for insights from Doug Kass and Jim Cramer, the description of the remaining steps before it becomes law, and the reasons I believe President Bush will sign the legislation.  The process is going to take another six weeks or so, but it will get more attention before then.

Bailout for Homeowners and Lenders?

Developments in housing remain crucial for the economy and for stocks.  Nearly any account of the housing situation includes reports of the number of foreclosures, the inventory of empty homes, and the potential ARM re-sets that may stimulate even more foreclosure activity.

Any help for distressed homeowners would help to shift the supply curve for homes.  This would suggest more stable prices and a lower inventory overhang.  Some have speculated that demand has been suppressed by the expectation of further price decreases.  If this argument is true, then the foreclosure bill might affect demand as well as supply.

The House has already passed a version of the bill under the leadership of Barney Frank.  The Senate Banking Committee is now considering a similar bill.  The Chairman, Christopher Dodd remains optimistic that a compromise will be reached.

The Administration is using a veto threat to affect the legislation.  Their position is represented in the Senate by Richard Shelby (R- Alabama).  Shelby, a former Democrat who switched parties years ago, is calling for more aggressive regulation of the Government Sponsored Enterprises (GSE'S) in the home financing business.  He is also concerned about bailing out the undeserving with taxpayer dollars.

Those in favor of the proposal think that the cost of the bill, perhaps $2 B or so, is easily justified by the benefit for the housing market and the economy.

Putting aside our own opinions on the legislation, we believe that the market would react positively to something helping out homeowners.  For this reason, it is important to watch the key players, especially Shelby.

Meanwhile, housing remains firmly at the bottom of the sector ratings.

TCA-ETF Update

There has been a lot of movement among the top sectors in the last few weeks.  While energy and natural resources choices remain at or near the top, we now also see some technology.  All of the financial sectors have again fallen out of the "buy" range.

The percentage of ETF's earning a "buy" signal is down to 53%, well off the recent highs.  The overall strength ratings are also not as high as in recent weeks.

Listed below is the weekly update.

Test Your Economics IQ

Stocks can and do stray from valuations suggested by fundamental analysis.  Despite this, it never hurts to understand the economic background.  Understanding the economy helps to gauge earnings forecasts.  This is especially important for stocks with a cyclical character.

Here are some statements about economic data and the market.  For each statement you need merely to decide "true" or "false".  We are not trying to serve up trick questions, but sometimes those citing the information do so in a tricky way.  It is up to you to see through this!

The Quiz

1. Home prices are now deflating at a 32% annual rate, versus 8% six months ago.
2. Inflation, as measured by the CPI, shows housing costs to be increasing according to the "imputed rent" formula.
3. Planned corporate layoffs rose 68% in April to a total of over 90,000.
4. As long as the largest asset on household -- and bank -- balance sheets continues to deflate, the credit and consumption hits will keep coming.
5. The US economy created about 2.5 million new non-farm payroll jobs last month.
6. The TED spread is now at 86 bp's, down from 204 in mid-March.
7. The Baltic Dry Freight Index has plummeted, showing global economic weakness.
8. The Fed has devoted about half of its balance sheet to "unusual" liquidity efforts.
9. The BLS Birth/Death adjustment has reduced past predictive performance, as measured by actual state employment counts when the data became available (months later).
10. Household liquid assets at $21.9 T and net worth at $31 T are about 1% below the all-time records as of the most recent published data.

Answers

Many wise and regular readers of "A Dash" will do well on this quiz.  We will recognize the best scores submitted by email (note the link at the top left).  Please do not show off by making your answers in the comments!

There will be ample time to discuss and disagree when we publish the answers.

Scooped by Muckdog

On our blog agenda there is a discussion of the "alternate data universe."

There is a rich and thriving discussion of economic data among economists -- that would be the "real economists".  We are talking about those who are (preferably) in the academic world or working on Wall Street.

There is another discussion.  It occurs mostly in the cottage industry of those making a business of criticizing the official government data.  As we have noted, government is an easy target.  The only representatives who speak in public are the political actors.  The hard-working, non-partisan, intelligent staffers do not have any access to the media.  That makes organizations like the BLS an easy target.  They are not paid to go on CNBC.

Attacking the non-farm payroll report, GDP, or inflation data is an inviting target for the gonzo-economists, the non-economists, and those with a paid-site business model.

We were looking for a way to describe this "alternate universe" and even had the Twilight Zone in mind, but we were scooped by Muckdog.  (Regular readers of "A Dash" sometimes ask why we recommend Muckdog, with whom we have never spoken, when his source seems to lack the official credentials we admire and is also anonymous.  The answer is simple.  We are not advocates of credentialism.  We do hold anonymous sources to higher standards of helpfulness.  We include them among featured sites when there is a real investment payoff.)  Muckdog gets to the point much better than we would:

From Barry Ritholtz:  GDP Alternate Measure. It's the whole conspiracy theory thing about understating inflation and overstating GDP.  Maybe "alternate universe?"  Sure, but those make for good Twilight Zone and Star Trek episodes, no?  And Barry's always a good read.

The Choice for Investors and Traders

It is pretty simple.  One can go into the Twilight Zone where no official report means anything -- there is always something wrong.  The prime source for this, which we will not link to, is a paid site on a mission.  The serious economists do not cite this source.  The bearish non-economists frequently do so.  The mainstream media, with a couple of exceptions, do not travel this path.  It is a trail which requires certain dubious assumptions:

• "Government" is some unitary actor, like the manager of a business, with a mission of punishing certain people -- mostly senior citizens, in an effort to cut costs and balance the budget.
• The Boskin Commission was some sort of conspiracy with this aim in mind.
• Various Administrations and the Fed have joined forces to foster this approach.

In the beginning government classes students learn that we have a pluralistic society.  Many different interests are represented, and quite effectively.  Senior citizens have a special  pull with Congress, since they represent a powerful voting block.

In fact, the Boskin reforms, discussed in a bipartisan Commission, have been reviewed by economists.  If anything, the adjustments to CPI are still inadequate.  CPI remains overstated.  As we have noted, that is what the Fed believes.

Investors have a simple choice.  They can choose to follow the alternate universe, where  everything has gotten  much worse over many years during a time when wealth increased.  This is an ideological choice, not an investment choice.

Alternatively, investors can accept the debate among real economists, those trying to generate accurate data, and those offering real public policy alternatives about economic issues.

Conclusion

Like the many economic sources available on the Internet, we are not going to engage in a debate on specific calculations.  It is too time-consuming  to fight this battle when the alternative universe has this as a single-minded mission.

A trader or investor who wants to profit is well-advised to deal with the data generally accepted in the economic and investment community.  If no one with real credentials chooses to engage in a discussion of the findings, that is meaningful and should be respected.

An Anecdotal Afterthought

Our mission at "A Dash" is helping investors and traders.  We were in some doubt about whether this was an important issue until we had a recent visit from one of our most intelligent and informed investors.  He asserted that some of these issues were "controversial."

We were surprised.  We suggested an analogy of the debate over cold fusion.  This theory, suggesting a potential for vast energy creation, was almost universally disputed by a broad spectrum of scientists.  Nonetheless, it won popular support, some grant money, and some academic followers.  This was a controversy principally among non-scientists.

There is plenty of room for debate over data and findings.  Unless you are yourself an expert, your mission should be in discovering and following the real experts.

That is what we do at "A Dash."

Fear, Investors, and Marketing

The most powerful selling approaches go with the flow.

Let us compare "selling" investment opinions with the positions of politicians seeking the Presidency.  Both topics hit our sweet spot.  We have also been talking with many individual investors and also many voters.  It is interesting.

The Election

A reader who wants to understand candidate behavior should imagine that he/she was hired as an advisor.  Many voters have strongly-held beliefs, often based on scanty information.  For candidates many issues have a clear choice:  Educate voters to change opinions or go with the flow.

The astute political strategist knows the answer to this one.  It is the easy explanation for the Democratic candidates' positions on NAFTA, capital gains taxation, health policy, payroll taxes, ethanol, and social security.  There is little that a candidate can say to change the viewpoints of voters, especially in the sound-bite era.

The result:  Candidates take positions that will win the day to gain electoral success.  What they actually propose and what they deliver may be quite different.  Readers who are old enough may recall the senior Bush promise to "read my lips, no new taxes."  The reality of governing is quite different from campaigning.

If a Democratic candidate wins the election, we expect the eventual  positions to be more moderate, but that is not that market expectations.

Selling Investment Strategies

We received in our email an appeal from a very famous investment manager.  It was all about fear, the recession, and danger to stock portfolios.  The  oft-quoted manager  had the answer to this -- proven success in the last recession.

This is a message that resonates with the average investor, so it is a good campaign -- not  unlike what  political leaders are doing.

Voters and investors have opinions.  Catering to those opinions is good marketing, regardless of the underlying wisdom.

The email approach described investment returns that were pretty good, although less than we have accomplished.  The proposed strategy is also not much different from what we are doing.  His recession performance in 2000 was not as good as ours.  The sales technique is much better.  The author points to success in the 2000 era and asserts that he will do as well in the coming challenges.

There is no effort to analyze the economy, earnings expectations, or what is already "baked in."  It is just a play on fear.  He is (wisely) going with the flow.  We are (perhaps unwisely) trying to educate investors.  Hmm.

Investor Reaction

Our conversations with individual investors have revealed several significant reactions.

• Some investors bought pre-1847 gold, to be placed with retirement trustees.  They soon learned that they could not sell these positions for anything like the prices they paid.  Big commissions were already deducted.
• Some investors bought variable annuities that guaranteed a rate of return, but with a cap.  The cap was not carefully explained in the expensive and colorful brochure.  These were sold to elderly people, with a high surrender value, and included upfront commissions of 10% or so.  The valuation of the portfolio is done in a way that shows an investment account value quite different from what can actually be withdrawn.  There are assorted provisions allowing investors to withdraw funds on a schedule.  Existing clients are happy with what they see.  None of them understand the function of the cap, how the biggest years are lost in their program, or how the big years contribute to overall returns.
• Most baby-boom investors, looking to retirement, are very heavily in real estate, bonds, and cash.

The Climate of Fear

Many investors took these retirement actions based upon their Internet research.  They are consumers of a climate of fear.  These consumers, encouraged by television advertising to manage their own accounts, read about the "fundamentals" of the economy and the stock market.  They use the same skills that helped them to success in their businesses -- reading, research, and logic.

The problem is that the value of information depends upon the analytic method.

Unless one knows how to interpret data about the economy and forward earnings expectations, the raw data is useless.

A Summary Anecdote

One of our investors, perhaps the wisest man we have ever encountered, likes to make his own calls and argue about ours.  He read a news article about a stock -- something that had been widely known in the market for months -- and wanted to buy it.  When asked whether others might have this same information, and he was a bit chagrined.  He often questions our contrarian picks -- but he stays with us.

The ability to discern what is "in the market" on a specific stock is well beyond what  most investors can do.  They do not think in those terms.  Not at all.  Information alone is not enough.

And by the way -- some of the investors making bad decisions on gold and annuities got their information from big-time Internet blogs with advertising or other ties to these products.

A little knowledge -- too little knowledge -- can be a dangerous thing.

Understanding LIBOR

In the last week there has been a rather big flap about LIBOR rates.  It is a very serious matter.  The Wall Street Journal pointed out a week ago that these rates might be misleading.  There have been various stories following up on this and noting the defects in the method of calculation and the implications for US markets.

We believe that the stories capture neither the significance of the implications, nor all of the possible reasons for the problem.

Four months ago we worked on this issue.  While we urge readers to revisit the entire article, here were some of the key points:

Readers need to know the following:

• Much of the popular discussion of LIBOR moves relates to other currencies, not dollars.
• The relevant discussion of LIBOR rates in US dollars pertains to so-called "eurodollars."  These are dollar deposits held outside the US (not necessarily in Europe).  These deposits are 20%+ of total dollar reserves.
• The rate is determined by a panel of banks trading in eurodollars.  They are big players in this market, but not necessarily US based banks.
• There is only a loose arbitrage between Eurodollar trading and rates in the US.  Many of the banks involved cannot move between the two markets, for example.
• The LIBOR rate most important to the US housing market is the six-month maturity, linked to some ARM's.  This is not the rate that you read about most frequently.
• US investors can trade Eurodollar futures at the CME. Many people do not understand that this is an interest rate instrument with very deep liquidity and a history of over twenty-five years.

The implications for the CME Eurodollar market are just as important as that for various business and mortgage loans.  No pundits seem to have noted this, but you can be sure the Merc traders have.

A Possible Reason

At the time of the original article, we were exploring the idea that US banks had adopted FAS 157, mostly doing so in advance of the deadline of November 15th, 2007.  Meanwhile, international accounting standards differ.

What if banks are concerned about disclosure, more confident in those who have adopted the US accounting  standard?

We tried to generate some exploration of this idea last December, but without much luck.  It is not a topic that hits the "sweet spot" for the leading economists on the web, and emails to specialists did not engage their interest.

Now it may be different.

Felix Salmon raises the question, as follows:

Are European banks significantly riskier than American banks? Looking at RBS's decision to raise $24 billion in new capital, it certainly seems that way: the move will take RBS's tier-one capital from a normal-for-Europe 4.5% up to a normal-for-the-US 6%.

And so it's maybe not surprising that US interbank borrowing rates are lower than European interbank borrowing rates. The spread at the moment is 4bp, which is significant enough, but Carrick Mollenkamp reports that it could widen further, to as much as 10bp, as Libor continues to widen out to reflect reality rather than wishful thinking.

He wonders whether there is a need for an interbank rate based solely upon US banks.

This has very far-reaching implications.  Most importantly, why should various loans in the U.S. which do not involve non-US banks use this rate?  Existing contracts, of course, cannot be changed.

We expect to see much more on this topic.

Housing Problem: What Inning is It?

Are we the only ones getting tired of the "What inning?" question?  When we think baseball, it is better to enjoy the early success of Chicago's two teams, especially the suddenly slick-fielding White Sox.

For several months financial television asked everyone about recession chances.  Prior training or experience not required -- all opinions welcome.

The question du jour is now, "Which inning of the mortgage crisis are we in?"

John Hussman's Answer

The widely-read and respected John Hussman complains as follows:

One of the fascinating aspects of Wall Street is the ability of analysts to provide opinions without the faintest backing from evidence. Among the latest topics of opinion is how far the mortgage crisis has to go. Evidently, the idea is that the recession that these analysts didn't forecast is already over, so it is time to “look across the valley” on the belief that most of the writedowns are behind us.

Hussman's own approach is to take a schedule of resets and integrate the curve to show a cumulative effect.  From this, he concludes that we are still in the early innings, with each inning lasting three months.  The worst is yet to come, etc.  Check out the entire article.

Two Errors

The Hussman analysis makes two serious errors.  First, he uses data from nearly a year ago.  This is assuming that ARM resets are a stationary target.  In fact, many mortgage holders have already refinanced.

This was reflected in a recent AP-AOL survey, the subject of an article we wrote for Real Money (subscription required).  Two survey results were especially relevant to this question:

1. Only 11% of those with mortgages have adjustable rates; 18 months ago, the figure was 22%. This suggests that there has already been a lot of refinancing.
2. Among homeowners with adjustable-rate mortgages, those who are worried about making their payments after an increase is 36%, exactly what it was in the prior survey.

We are hesitant to mix two different methods of measurement and two different time periods, but surely there has been some change since the stale chart cited in the Hussman article.  If he is going to use some fancy analysis to impress and frighten the average reader, at least he could update the data.

The second Hussman error is quite common.  He is focused on the problem while completely ignoring any solutions.  The loosening of restrictions on Fannie and Freddie (including the conforming loan cap and the overall portfolio cap) will help to encourage refinancing that was difficult a few months ago.

Jordan Kahn at In the Money, one of our featured sites, writes as follows:

I think the news from Freddie Mac (FRE) today was pretty significant, although it received little attention.

In the press release, Freddie said it will buy jumbo mortgages in high-cost regions from Wells Fargo (WFC), JPMorgan Chase (JPM), Citigroup (C) and Washington Mutual (WM). The government-sponsored enterprise expects to finance between $10 billion and $15 billion in new jumbo mortgages in 2008.

He points out that the old caps were ridiculous in some areas, a theme we have also argued.  Jordan calls it "big news" which will help us get closer to a bottom in housing.

[Jordan sat in the hot seat today, covering for Doug Kass on his daily investing blog, The Edge.  Doug is doing a lecture at the Harvard Business School!  We hope that the Wharton man gets the appropriate respect from the Harvard crew.  Meanwhile, Jordan did his usual great job as a substitute.]

Conclusion

Ironically, John Hussman did exactly what he accused others of doing.  The evidence he adduces for his answer to the "innings question" is no more plausible than anyone else's.

Our own answer?  We do not know.  Neither does anyone else.  It is going to depend upon the ability of people to refinance, where fixed rates go, how quickly Fannie and Freddie and the FHA provide help, and whether a foreclosure assistance bill passes Congress and gets signed by the President.

We do not know the answers to those questions, but at least we know what to look for.

TCA-ETF Update

As we regularly do on Thursday, we are showing an update on our TCA-ETF sector model rankings.  The overall result for the third cycle, begun on January 25th, is about even, roughly the same as the S&P 500 and a bit ahead of the NASDAQ.  There are two interesting things to observe.

First, the strongest sectors remain the "weak dollar" plays.  Second, the overwhelming majority of sectors are in the "buy" range.

Interested readers can get a report via email on participating in our weekly trading program for individual investors.

Credit Default Indexes: Frankenstein's Monster?

Bloomberg writers Neil Unmack and Sarah Mulholland do a nice survey of viewpoints (Swaps Tied to Losses Became `Frankenstein's Monster') on the problems in relating credit default swaps, indexes and cash markets.

A telling quotation comes from Kevin Gould, the head of data products and analytics at Markit, the source of various indexes.  As expected he provides a defense for the product:

The ABX index has brought greater transparency to the market.  Without it there would have been a number of market participants that would not have been aware of the levels of distress some of their assets were under.

Fair enough.  But Gould also states, (Markit's) "indexes should be used as a tool to gauge the direction of credit markets, not necessarily to value the underlying assets."

Now they tell us!

Many believe that the (very real) credit problems have been exacerbated by faulty government regulation that does exactly what Gould says we should not do.

The Bloomberg Take

Anyone who wants to read all perspectives should check out the entire article.  Mainstream media has given scant attention to this theme.  Meanwhile, this segment captures the spirit of the article:

`Totally Uncorrelated'    

The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz [head of asset backed bond research at Wachovia], almost four times the 13.75 percent rate predicted by Wachovia.    

The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.    

``ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,'' Swiss Re's Aigrain said at the Dubai conference.

Market Breakdown

The difficulty in using these indexes comes from the inability to arbitrage the widely perceived discrepancies.  Brad De Long raises the question of how to make money from this.  We examined the problem a few months ago in this post.

Anyone with a good answer to De Long's question can both make a profit and improve market efficiency.

Thanks to Gary D. Smith for pointing out this story, which seemed to get little attention today.