Mistakes Are the Downfall of Most Traders
by
Van K. Tharp, Ph.D.
In my experience, I find that it is very easy to design a system that will produce great returns (even 100% or more). What?s difficult is actually trading the system and getting those returns. In this article, I?ll show you how easy it is to develop a great system, how mistakes can be your downfall, and how to correct the mistakes you make.
Thinking of Your Results in Terms Risk-to-Reward
One of my fundamentals of trading success is that you must have a predetermined exit point before you enter into a trade. This exit point represents your worst-case risk in that trade. Let?s call risk, R, for short, and look at a few examples.
Suppose you decide to by something at $40 and sell it if it drops 10% to $36. Your risk in this case is $4. If you are buying stock, it means your risk is $4 per share. Now suppose you have $100,000 in equity and want to risk 2% or $2000 in this trade. This means that you can afford to buy 500 shares of stock (i.e., divide your total risk of $2000 by your per-share risk of $4 and you get 500 shares). Notice that you would be buying $20,000 worth of stock, but that your initial risk would only be 10% of that (because of your 10% stop) or $2,000. I?m not recommending any of these numbers (i.e., 10% stops or 2% risk); I am merely using them as examples.
Let?s look at some more examples. Suppose you have a $200,000 portfolio. You want to buy 10 stocks, each with a 1% risk and 10% stops. You can do that and you will be fully invested. Now suppose that you have bought those positions and you get the following rules as shown in Table 1. The table shows the profit and loss on each position and then expresses the result as a multiple of the initial $2000 risk. This is an example of presenting your results as R-multiples.
There are several key things you should look at in this system. First is the expectancy of the system, which is the average R-multiple produced by the system. In this instance, the expectancy is 1.47R. When your sample is large enough, and this means 30 to 100 examples, then your expectancy will also tell you what you can expect to make, on the average, over a large number of trades. Half of your results will be above the expectancy and half of your results will be below the expectancy, but on the average over many trades your results should equal the expectancy.
Table 1: Expressing Your Results as R-multiples
Trade Profit/Loss R-Multiple (1R =$2000)
1 -$1825 (0.91)
2 -$600 (0.30)
3 -$1600 (0.80)
4 -$1400 (0.70)
5 +$12,800 6.40
6 -$1280 (0.64)
7 +$9300 4.65
8 +$2350 1.18
9 -$3600 (1.80)
10 $14,200 7.10
Totals $28,345 14.18
Average $2834.50 1.42
Let?s say that your expectancy over 100 trades is 1.5R and that your system produces about 60 trades per year. Under those conditions, you might expect to make about 90R (i.e., 60 times 1.5R = 90R) per year. And if you risked 1% of your total current equity on each trade, then you could easily make 100% per year.
?But wait,? you say, ?this is really stretching things. For example, 90R is the average return you might get, but half the time the return will be better and half the time the return will be worse.? Well, my response to that statement is that 90R per year is a reasonable result for a good system. In fact, I?ve seen many systems results that are much better than the results in this example. A system that could deliver a return of 100% per year is not that difficult to design.
Remember that we are now thinking in terms of R-multiples. A 10R gain now means that you only have to make 10 times your risk, not 10 times your investment. And since your risk was only 10%, it means that if we double our investment, we have a 10R. And in my experience, it is not that difficult to develop a system that has occasional gains of 10R or more. The big problem is that most people, once they have developed such a system, cannot trade it effectively.
Why Isn't Everyone Making These Returns?
Because people make mistakes. The average person will never achieve anywhere near the expected return from their system because they make mistakes. So what is a mistake? My best definition of a mistake is not following your rules. For people who don?t have any written trading rules, everything they do is a mistake. So let?s look at some common mistakes. These are mistakes that I see professional traders make (not just the average person) all the time.
Not taking a trade that is signaled by your system because you are afraid, not automated, or just are not paying attention.
Taking a trade because of emotions or excitement or just not realizing it.
Keeping a mental stop and then letting the price run right through it.
Trading several systems at the same time with conflicting results and doing it in the same account.
Having position sizing that is too large. (2% is pretty risky, but sometimes people risk 5-10% or more).
These mistakes are very costly. Our preliminary research suggests that an average mistake is worth about 4R. I don?t know if that number will stand up over many, many examples, but that?s my current best guess for the value of a mistake. So what if you make two such mistakes each month? That means you are making 8R worth of mistakes every month. Again, I don?t know how many mistakes the average trader will make, but I do know that the more active you are, the more mistakes you will make.
If your mistakes add up to 8R each month, then you are making 96R worth of mistakes each year. And if we apply it to the original example I gave, in which your system makes 90R per year, you have a net result of negative 6R. Thus, you?ve now turned a winning system into a net losing system by your mistakes. And what usually happens is that you decide that your system is broken and stop trading it. But the system is perfectly fine; it is just your mistakes that are the problem.
Notice that you are making 60 trades each year and about 24 mistakes. In terms of mistakes, we might say that you are 60% efficient. But in terms of results, you are in the hole, so we?d have to call you totally inefficient.
Mistake Examples
One of the keys to correcting mistakes is to recognize them. For example, I sometimes play a marble game at talks. Marbles are pulled out of a bag, each representing a different R-multiple of a trading system. Each marble is replaced after it is pulled. The expectancy of the game is 0.8R and usually we do 30 trades. That means that everyone should be up (on the average) 24R at the end of the game. However, when starting with $100,000, I?ll see a third of the room go bankrupt and another third of the room lose money because of position sizing mistakes. For example, if you risk it all on the first trade and you get a 1R loser, then you are bankrupt. You cannot play any more and have no chance to get the 0.8R expectancy.
But what do most of these people say when they play the game? First, we have the justification response: ?This isn?t like real trading; it?s just a stupid game.? Next, we have the guilt response: ?I was a stupid idiot.? And last, we have the most common response, the blame response: ?I lost money because the marble pull was bad and that guy pulled out a losing marble for me. I?m just unlucky.?
In this instance, most people don?t even recognize their mistakes because they are blaming, justifying, or putting themselves through a guilt trip. Yet the mistake, of course, was that they went bankrupt because they bet too much on the marble pull. And if you don?t recognize your mistake, how can you correct it? You cannot. Instead, you?ll probably repeat it until you give up.
Let?s look at another example that represents real life trading. Let?s look at a fictional trader, Morgan Green. She has a system that produces 100R each year, but makes a lot of mistakes that she doesn?t recognize. Let?s look at a few examples of her mistakes.
She hears a stock recommendation on the television, gets excited about the stock and buys 1000 shares. She loses money. What?s her mistake? In this case, she didn?t follow her system. Instead, she bought impulsively based upon her excitement and her ability to be influenced by outside sources.
Morgan blames the guru on television for the mistake and as a result, doesn?t recognize her own mistake. This is an even bigger mistake and as a result there will always be another analyst on the television that she can blame for his bad recommendations. Here is the key principle: When people don?t recognize their mistakes, they are doomed to repeat them until they recognize them.
Morgan subscribes to several newsletters. She reads each of them and then picks several stocks to buy. She spends $20,000 on these stocks and they all sit in her portfolio and slowly go down. After a year, she is down $2000. And Morgan has missed many good trading opportunities because her account has these losers.
Morgan now cancels all of her newsletters, thinking that none of them are any good because she didn?t make money. But one of them had excellent returns if she?d taken all of the recommendations. However, she only decided to take certain recommendations?the ones that excited her. So then she thought it was the newsletter editor?s fault that she lost money.
Notice all the mistakes she made here.
She only picked stocks because of excitement rather than treating each newsletter as a system and taking every trade.
She blamed the newsletters for the mistake.
She held stocks that were doing nothing, missing many opportunities to buy better stocks because her account was fully invested.
And, she didn?t recognize any of her mistakes, so she can easily repeat them (and likely will).
And here is another common mistake that I see all the time.
Morgan?s system produces eight losses in a row, which is quite common even in a system that makes money 50% of the time. However, Morgan becomes afraid and stops taking trades. When she stops trading, she misses a 25R winner.
Later, Morgan starts to study the market again and she notices the big winner she missed. Her reaction is to say, ?Oh, I?m a stupid idiot. My system signaled that trade, why didn?t I take it?? So Morgan is now getting into self-blame and she?s again missing her key mistake. When you recognize your mistakes, you can take the steps that are necessary to correct them. Calling yourself ?a stupid idiot? does nothing to correct the mistake.
I could go on about the types of mistakes that people make. Perhaps you have recognized yourself in some of the examples. The main point is that people make lots of mistakes, which prevent them from doing well and getting great results from good systems. And this is not just the average trader. We are talking about many professional traders as well.
The Solution: One of the 10 Tasks of Trading
I?ve been modeling successful traders over the last 25 years. And out of that research, I?ve developed the 10 Tasks of Trading, which is a part of the Peak Performance Course. Most of those tasks will help you with correcting mistakes, but one of them in particular, the daily debriefing, is designed to help you fix mistakes.
The daily debriefing requires about five minutes at the end of the trading day. Think about what happened during the day and look at your written trading rules first. Also remember that if you don?t have such rules, then you are not ready to trade and everything you do might be considered a mistake.
The next step is to ask yourself one simple question, ?Did I follow my rules?? If the answer is yes, then simply pat yourself on the back and go home (or if you are home do something else). You are done. And if you lost money and followed your rules, then you might pat yourself on the back twice.
But what if you lost money by not following your rules? What you now do is simply make sure that you don?t do it again. This requires looking for the conditions that produced the mistake, figuring out some solution to make sure you don?t repeat the mistake, and then mentally rehearsing that behavior until it becomes second nature to you.
Repeating the same mistake over and over again is what I call self-sabotage and that?s an entirely different issue. But your job as a disciplined trader is to make sure that you continually correct each mistake so that you NEVER repeat it.
So let?s go over the rehearsal process. What you need to do is discover the conditions that lead to the mistake. Next, you want to anticipate how those conditions might occur again. For example, let?s say the mistake is that you listened to some investment advice on television. How can you prevent that from happening again?
First, the conditions that lead to the mistake were the following:
Watching the financial channel during the day.
Not controlling your mental state so that you were excited by the financial advice you heard.
Preventing the mistake might simply amount to avoiding both of those conditions. First, you could resolve not to watch television while you are trading or at least turn off the sound. Second, think about making a checklist that must be filled in before you purchase anything. The checklist will consist of your buying criteria, which will probably not be met by some guru?s recommendation on the television. And your last resolution is to never again take a trade without filling in the checklist and making sure that all your criteria are met.
Your next step is to rehearse your solution. This makes your actions automatic so that you don?t have to think about it. For example, you could imagine yourself filling out numerous checklists in your mind. You could imagine yourself turning off the television or hearing the words ?STOP? very loudly in your mind if you reach to turn on the television during the day. You must do each of these things a number of times in your head until both of them become automatic for you.
Do a regular daily debriefing and pretty soon you?ll find that your number of mistakes drops dramatically. My guess is that you?ll eliminate most of your mistakes within a few months. But if you stop your daily debriefing, you may find that your mistakes again start to occur. But that?s another example of self-sabotage and that?s another story
Friday, October 31, 2008
Wednesday, October 29, 2008
EVIL WALL STREET EXPORTS
Evil Wall Street Exports Boomed With `Fools' Born to Buy Debt
Oct. 27 (Bloomberg) -- Tom Bosh lowered the telephone receiver into its cradle, making a decision on the way down. ``We're not buying any more,'' he told his traders at Bank of New York Co. ``Nothing.''
It was May 2007, and Bosh, who managed $25 billion from the bank's 13th-floor trading room above Times Square, had just hung up on Ralph Cioffi at Bear Stearns Cos. a dozen blocks away. Bosh had invested $50 million in notes from an issuer Cioffi controlled, and he was ready to pull the plug.
``I had a bad feeling,'' Bosh, 45, recalled. ``Cioffi was just bulldogging everyone. He was saying, `These assets are good, the collateral is paying down, and I know more than you.' That type of attitude.''
Bosh's premonition, a month before two of Cioffi's funds blew up, struck a death knell for structured finance, the system Wall Street banks devised to fuel more than two decades of unprecedented borrowing. The system allowed financial companies to lend beyond their capacity and outside the reach of regulators -- until it crashed this year.
While the collapse was most visible in the stock markets, the cause was the loss of confidence in the world's biggest bond market, structured finance. So far, it has led to the worst financial crisis since the Great Depression, the disappearance or takeover of more than a dozen banks, including three storied Wall Street firms, and almost $3 trillion in government expenditures and guarantees to contain the contagion.
Biggest U.S. Export
The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion.
The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies. Wall Street obliged, with disastrous results: two-thirds of a trillion dollars in bank losses, about 40 percent of them outside the U.S.
``Securitization was based on the premise that a fool was born every minute,'' Joseph Stiglitz, a professor of economics at Columbia University in New York, told a congressional committee on Oct. 21. ``Globalization meant that there was a global landscape on which they could search for those fools -- and they found them everywhere.''
Eager Adopters
European banks, in particular, were eager adopters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros, according to the European Securitization Forum, a trade organization.
Three Icelandic banks borrowed enough to buy $228 billion of assets, most of them securitizations, turning the country's financial system into a hedge fund. All three banks have been nationalized by the government, leading Prime Minister Geir Haarde to advise citizens to switch from finance to fishing.
In Germany, one bank, Landesbank Sachsen Girozentrale, bought $26 billion worth of subprime-backed investments, putting the state of Saxony on the hook for $4.1 billion.
In Japan, Mizuho Financial Group Inc., the nation's third- largest bank, acquired an entire structured-finance team, which proceeded to lose $6 billion issuing mortgage-backed securities.
Shadow Banking
The damage reaches all the way to Australia, where the town council of Wingecarribee, a municipality outside Sydney with a population of 42,000, bought $20 million of securities from Lehman Brothers Holdings Inc. Now, Lehman is in bankruptcy, the town council is in court and the securities are worth about 15 cents on the dollar.
Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade.
Beginning about three years ago, investment banks revved the system's engine to boost earnings. They raised revenue by funding more subprime mortgages and cut costs by relying increasingly on the $4.2 trillion sitting in U.S. money-market funds. As it turned out, those decisions would prove fatal.
`Powerful Technology'
``It's a powerful technology that has been driven beyond the speed limit,'' said Juan Ocampo, a former consultant at New York-based advisory firm McKinsey %26 Co. who wrote a 1988 book popularizing structured finance. ``For the last five years, instead of going 65 mph, they've been gunning it to 140 mph, 150 mph.''
Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost.
During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest.
Off-Balance-Sheet
The word ``securitization'' implies safety. Investors with less appetite for risk buy higher-rated securities and get paid first at lower interest rates. Those with a bigger appetite get paid later and receive more interest.
Securitization's biggest innovation was the use of off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special-purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.
With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.
``The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein %26 Co. analyst and former chief financial officer at Lehman. ``It becomes almost like a fee business because it requires no capital.''
`Capture the Prize'
Like most new products, securitization found a market at home before going abroad. Bankers at Salomon and First Boston Inc. raced from bank to bank to convince issuers it was the wave of the future.
William Haley remembers a 10 a.m. meeting in 1987 at Imperial Thrift %26 Loan Association in Glendale, California. As Haley, at the time a 33-year-old Salomon banker, and his team walked into the conference room to make a pitch, the First Boston team was walking out.
``We exchanged some knowing looks and then tried to beat the pants off them,'' said Haley, who now works at RBS Greenwich Capital Markets Inc., a firm specializing in mortgage-backed securities that is owned by Royal Bank of Scotland Group Plc. ``There was a fierce desire to capture the prize.''
First Boston
First Boston, housed in the same New York office tower as McKinsey, was first out of the gate in March 1985 with a $192 million computer-lease securitization for Sperry Corp., a predecessor of Unisys Corp. The bank then oversaw a series of auto-loan securitizations, including a $4 billion issue by General Motors Acceptance Corp. in October 1986, the biggest corporate debt issue at the time.
Haley's project was a $50 million deal for Banc One Corp. called Certificates for Amortizing Revolving Debts, or CARDs. It was the first credit-card securitization and a blueprint for the $358 billion of such securities now outstanding. The transaction also gave the banks a way to securitize their own assets and get them off their balance sheets, which allowed the money to be lent all over again.
The strategy was detailed in Ocampo's 282-page book ``Securitization of Credit: Inside the New Technology of Finance,'' which he co-wrote with McKinsey consultant James Rosenthal. Ocampo, who received an MBA from Harvard after graduating from the Massachusetts Institute of Technology, and Rosenthal, a Harvard Law School graduate, argued that banks could be more profitable if they used securitization.
McKinsey Book
The authors examined six of the first asset-backed transactions and gave readers a step-by-step guide for how to repeat them. They said that banks that didn't embrace the new technology would be at a disadvantage, and they predicted it would become the dominant form of financing.
``The McKinsey book helped with credibility with issuers,'' said Haley. ``It wasn't that easy in the beginning. Conferences now have thousands of people, but I remember once in Beverly Hills, I gave a speech and there were maybe 25 people in the audience. They were furiously taking notes, however.''
The new technology was spread around the world by the people who worked on the First Boston and Salomon teams. Salomon's group was led by Patricia Jehle, who later founded Bear Stearns's asset-backed unit. Another member, Michael Hutchins, started the first team at a European bank when he went to Zurich-based UBS AG in 1996. A third, Michael Normile, moved to Merrill Lynch %26 Co., where he ran its securities business, then switched to London-based HSBC Holdings Plc in 2004. Haley built similar teams at Lehman, Chase Manhattan Bank and Amsterdam-based ABN Amro Bank NV.
Hard Sell
First Boston's team included Walid Chammah, 54, who went on to head debt and equity capital markets at Morgan Stanley and is now co-president of that firm. Joseph Donovan, the banker responsible for the GMAC relationship, went to Smith Barney in 1995, to Prudential Securities in 1998 and two years later took over the asset-backed group at Credit Suisse First Boston after Zurich-based Credit Suisse bought First Boston.
Donovan remembers traveling to Europe for First Boston in the early 1990s, trying to convince Volkswagen AG in Wolfsburg, Germany, and Renault SA outside Paris of the benefits of securitization. It was a hard sell. Europeans, he said, didn't take out auto loans.
``We tried over and over,'' Donovan recalled. ``We were trying to get more issuers, and there weren't any.''
`50-Year Pedigree'
By the time Donovan went to work for Credit Suisse in 2000, European attitudes had changed. Home-mortgage securitizations were especially appealing, he said, because European banks didn't need a ``50-year pedigree to compete.''
``You don't need a whole equity-research department and relationships with CEOs and CFOs,'' Donovan said. ``You basically needed good computers and distribution. You can always buy a Fannie, Freddie or Ginnie Mae pool. You just go online and buy it. You can't buy a Ford Motor Credit deal, because you have to know people.''
CSFB went from third in underwriting structured finance in 2000, behind Lehman and Salomon Smith Barney, to first in 2001, when it issued $96.3 billion in securities. Its market share increased 50 percent to 12.7 percent. The bank fell to fourth place in 2005, although its volume soared to $144.5 billion.
Exporting Debt
As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf.
``One of the things the United States exported overseas was a debt culture,'' Haley said.
While consumers were snapping up credit cards, Nicholas Sossidis and Stephen Partridge-Hicks at Citibank in London were figuring out a way to sell the new bonds. Their solution: Alpha Finance Corp., the first off-balance-sheet structured investment vehicle, or SIV.
Alpha was created in 1988 as a way for Citibank, and later Citigroup Inc., to vertically integrate its business like an oil company. The raw material was found in a loan, refined into a security, then sold to a SIV at a profit.
Citigroup, formed in a merger of Citicorp and Travelers Group Inc., which owned asset-backed pioneer Salomon, also got a new product to sell: capital notes that boast returns of more than 20 percent a year. Owners of these notes receive all the excess return when borrowers pay their bills on time, though they are the last to be paid when times get hard.
Citi SIVs
In the beginning, SIVs were small and cautious. Alpha was capitalized with $100 million of equity that supported $500 million of commercial paper and medium-term notes. The SIV could hold only debt rated A- or higher and didn't take any currency or interest-rate risk, according to a 1993 Fitch Ratings report.
Alpha was followed by a slew of SIVs with names such as Beta Corp. and Five Finance. By 2007, Citigroup's SIVs had $90 billion of assets, equal to the stock market value of PepsiCo Inc., making up about one-fourth of the entire SIV industry.
In 2003, the bank was sued by creditors of Enron Corp. for its role in setting up entities that enabled the Houston-based company to move assets off the balance sheet for Chief Executive Officer Jeffrey Skilling. Citigroup paid $1.66 billion in March to settle the lawsuit. Skilling, a former McKinsey consultant, was convicted of accounting fraud and is serving a 24-year prison sentence.
Mismatched Funding
Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs. Investors were loath to buy long-term debt of issuers that didn't have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day.
``What happened in 2005 was that because of subprime and some other changes, commercial paper and asset-backed securities offered a bigger spread than anything that had ever been in the market before,'' said Deborah Cunningham, chief investment officer of Federated Investors in Pittsburgh, who oversees $235 billion in commercial paper. ``It was hundreds of basis points, as opposed to 10 or 20 basis points before.''
SIVs, banks and CDOs sold trillions of dollars of asset- backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007.
`Huge Appetite'
Once money-market funds began to be tapped for financing, Ocampo said, ``it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.''
To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months.
Among conservative lenders, that rang an alarm: Bankers are taught to avoid such mismatched funding, in which a lender has to pay back money before the borrower has to pay the principal.
``Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term,'' Bruce Bent, 71, who started the first money-market fund in 1970, said in an interview in July.
Reserve Funds
Bent, chairman of New York-based Reserve Funds, said he didn't buy any asset-backed commercial paper until 2007, when the market froze in the wake of the collapse of the Bear Stearns hedge funds. That's when his Reserve Primary Fund began buying castoffs of asset-backed commercial paper at cut-rate prices from other funds.
Yet asset-backed securities weren't Bent's undoing. His fund also owned $785 million in Lehman debt, bought before the firm filed for bankruptcy Sept. 15. In the two days following the bankruptcy, Reserve clients asked to pull about $40 billion from the $62.5 billion fund, and its net asset value fell to 97 cents. It was the first time that a money fund ``broke the buck,'' or fell below $1, in 14 years. The fund is now being liquidated, and Bent hasn't given an interview since.
Reserve Primary Fund's implosion, and the subsequent seizing up of two Commonfund portfolios used by universities and endowments to hold cash, triggered a panic in U.S. money markets, cutting off this form of credit to industrial companies and banks. No one could be sure whether the banks held securitizations that had dropped in value, making them insolvent. That set off a series of bank takeovers and bailouts around the world, including a $64 billion capital injection by the U.K. government into that nation's financial institutions and 400 billion euros in loan guarantees pledged by Germany.
`Absolute Disaster'
``We've created an absolute disaster,'' said Nouriel Roubini, a New York University professor of economics, who predicted the failure of investment banks in a paper he wrote in February titled ``Twelve Steps to Financial Disaster.'' ``The reputation of the United States as a financial center and a leader has been tarnished significantly.''
Also tarnished, if not blackened, is the securitization business itself. Sales of European asset-backed securities, including bonds for car loans and credit cards, fell by 40 percent to 12.7 billion euros in the second quarter, and CDO sales fell by two-thirds to 10 billion euros. In the U.S., mortgage bonds issued by entities not affiliated with the government plummeted to $10.8 billion in the first half of the year, one-twentieth of the $241 billion sold in the same period in 2007.
Cioffi, Bosh
The authors of the 1988 McKinsey handbook on securitization have moved on. Rosenthal, who declined to be interviewed, became a managing director at Lehman and is now in charge of information technology at Morgan Stanley. Ocampo received a patent for risk-controlled investing and founded an institutional fund-management firm, Trajectory Asset Management. The firm doesn't have any structured-finance obligations.
Bear Stearns's Cioffi, 52, was indicted on charges of misleading investors by assuring them that his hedge funds were healthy when he knew they weren't. Cioffi, who now works out of his home in Tenafly, New Jersey, has pleaded not guilty. He declined to comment.
The Bank of New York's Bosh lost his job when his company was merged with Mellon Corp. in June 2007. He's still looking for work.
``You try to do the right thing,'' Bosh said in an interview this month. ``And this is what happens.''
Oct. 27 (Bloomberg) -- Tom Bosh lowered the telephone receiver into its cradle, making a decision on the way down. ``We're not buying any more,'' he told his traders at Bank of New York Co. ``Nothing.''
It was May 2007, and Bosh, who managed $25 billion from the bank's 13th-floor trading room above Times Square, had just hung up on Ralph Cioffi at Bear Stearns Cos. a dozen blocks away. Bosh had invested $50 million in notes from an issuer Cioffi controlled, and he was ready to pull the plug.
``I had a bad feeling,'' Bosh, 45, recalled. ``Cioffi was just bulldogging everyone. He was saying, `These assets are good, the collateral is paying down, and I know more than you.' That type of attitude.''
Bosh's premonition, a month before two of Cioffi's funds blew up, struck a death knell for structured finance, the system Wall Street banks devised to fuel more than two decades of unprecedented borrowing. The system allowed financial companies to lend beyond their capacity and outside the reach of regulators -- until it crashed this year.
While the collapse was most visible in the stock markets, the cause was the loss of confidence in the world's biggest bond market, structured finance. So far, it has led to the worst financial crisis since the Great Depression, the disappearance or takeover of more than a dozen banks, including three storied Wall Street firms, and almost $3 trillion in government expenditures and guarantees to contain the contagion.
Biggest U.S. Export
The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion.
The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies. Wall Street obliged, with disastrous results: two-thirds of a trillion dollars in bank losses, about 40 percent of them outside the U.S.
``Securitization was based on the premise that a fool was born every minute,'' Joseph Stiglitz, a professor of economics at Columbia University in New York, told a congressional committee on Oct. 21. ``Globalization meant that there was a global landscape on which they could search for those fools -- and they found them everywhere.''
Eager Adopters
European banks, in particular, were eager adopters. Securitizations in Europe increased almost sixfold between 2000 and 2007, from 78 billion euros ($98 billion) to 453 billion euros, according to the European Securitization Forum, a trade organization.
Three Icelandic banks borrowed enough to buy $228 billion of assets, most of them securitizations, turning the country's financial system into a hedge fund. All three banks have been nationalized by the government, leading Prime Minister Geir Haarde to advise citizens to switch from finance to fishing.
In Germany, one bank, Landesbank Sachsen Girozentrale, bought $26 billion worth of subprime-backed investments, putting the state of Saxony on the hook for $4.1 billion.
In Japan, Mizuho Financial Group Inc., the nation's third- largest bank, acquired an entire structured-finance team, which proceeded to lose $6 billion issuing mortgage-backed securities.
Shadow Banking
The damage reaches all the way to Australia, where the town council of Wingecarribee, a municipality outside Sydney with a population of 42,000, bought $20 million of securities from Lehman Brothers Holdings Inc. Now, Lehman is in bankruptcy, the town council is in court and the securities are worth about 15 cents on the dollar.
Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade.
Beginning about three years ago, investment banks revved the system's engine to boost earnings. They raised revenue by funding more subprime mortgages and cut costs by relying increasingly on the $4.2 trillion sitting in U.S. money-market funds. As it turned out, those decisions would prove fatal.
`Powerful Technology'
``It's a powerful technology that has been driven beyond the speed limit,'' said Juan Ocampo, a former consultant at New York-based advisory firm McKinsey %26 Co. who wrote a 1988 book popularizing structured finance. ``For the last five years, instead of going 65 mph, they've been gunning it to 140 mph, 150 mph.''
Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost.
During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest.
Off-Balance-Sheet
The word ``securitization'' implies safety. Investors with less appetite for risk buy higher-rated securities and get paid first at lower interest rates. Those with a bigger appetite get paid later and receive more interest.
Securitization's biggest innovation was the use of off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special-purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.
With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.
``The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein %26 Co. analyst and former chief financial officer at Lehman. ``It becomes almost like a fee business because it requires no capital.''
`Capture the Prize'
Like most new products, securitization found a market at home before going abroad. Bankers at Salomon and First Boston Inc. raced from bank to bank to convince issuers it was the wave of the future.
William Haley remembers a 10 a.m. meeting in 1987 at Imperial Thrift %26 Loan Association in Glendale, California. As Haley, at the time a 33-year-old Salomon banker, and his team walked into the conference room to make a pitch, the First Boston team was walking out.
``We exchanged some knowing looks and then tried to beat the pants off them,'' said Haley, who now works at RBS Greenwich Capital Markets Inc., a firm specializing in mortgage-backed securities that is owned by Royal Bank of Scotland Group Plc. ``There was a fierce desire to capture the prize.''
First Boston
First Boston, housed in the same New York office tower as McKinsey, was first out of the gate in March 1985 with a $192 million computer-lease securitization for Sperry Corp., a predecessor of Unisys Corp. The bank then oversaw a series of auto-loan securitizations, including a $4 billion issue by General Motors Acceptance Corp. in October 1986, the biggest corporate debt issue at the time.
Haley's project was a $50 million deal for Banc One Corp. called Certificates for Amortizing Revolving Debts, or CARDs. It was the first credit-card securitization and a blueprint for the $358 billion of such securities now outstanding. The transaction also gave the banks a way to securitize their own assets and get them off their balance sheets, which allowed the money to be lent all over again.
The strategy was detailed in Ocampo's 282-page book ``Securitization of Credit: Inside the New Technology of Finance,'' which he co-wrote with McKinsey consultant James Rosenthal. Ocampo, who received an MBA from Harvard after graduating from the Massachusetts Institute of Technology, and Rosenthal, a Harvard Law School graduate, argued that banks could be more profitable if they used securitization.
McKinsey Book
The authors examined six of the first asset-backed transactions and gave readers a step-by-step guide for how to repeat them. They said that banks that didn't embrace the new technology would be at a disadvantage, and they predicted it would become the dominant form of financing.
``The McKinsey book helped with credibility with issuers,'' said Haley. ``It wasn't that easy in the beginning. Conferences now have thousands of people, but I remember once in Beverly Hills, I gave a speech and there were maybe 25 people in the audience. They were furiously taking notes, however.''
The new technology was spread around the world by the people who worked on the First Boston and Salomon teams. Salomon's group was led by Patricia Jehle, who later founded Bear Stearns's asset-backed unit. Another member, Michael Hutchins, started the first team at a European bank when he went to Zurich-based UBS AG in 1996. A third, Michael Normile, moved to Merrill Lynch %26 Co., where he ran its securities business, then switched to London-based HSBC Holdings Plc in 2004. Haley built similar teams at Lehman, Chase Manhattan Bank and Amsterdam-based ABN Amro Bank NV.
Hard Sell
First Boston's team included Walid Chammah, 54, who went on to head debt and equity capital markets at Morgan Stanley and is now co-president of that firm. Joseph Donovan, the banker responsible for the GMAC relationship, went to Smith Barney in 1995, to Prudential Securities in 1998 and two years later took over the asset-backed group at Credit Suisse First Boston after Zurich-based Credit Suisse bought First Boston.
Donovan remembers traveling to Europe for First Boston in the early 1990s, trying to convince Volkswagen AG in Wolfsburg, Germany, and Renault SA outside Paris of the benefits of securitization. It was a hard sell. Europeans, he said, didn't take out auto loans.
``We tried over and over,'' Donovan recalled. ``We were trying to get more issuers, and there weren't any.''
`50-Year Pedigree'
By the time Donovan went to work for Credit Suisse in 2000, European attitudes had changed. Home-mortgage securitizations were especially appealing, he said, because European banks didn't need a ``50-year pedigree to compete.''
``You don't need a whole equity-research department and relationships with CEOs and CFOs,'' Donovan said. ``You basically needed good computers and distribution. You can always buy a Fannie, Freddie or Ginnie Mae pool. You just go online and buy it. You can't buy a Ford Motor Credit deal, because you have to know people.''
CSFB went from third in underwriting structured finance in 2000, behind Lehman and Salomon Smith Barney, to first in 2001, when it issued $96.3 billion in securities. Its market share increased 50 percent to 12.7 percent. The bank fell to fourth place in 2005, although its volume soared to $144.5 billion.
Exporting Debt
As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf.
``One of the things the United States exported overseas was a debt culture,'' Haley said.
While consumers were snapping up credit cards, Nicholas Sossidis and Stephen Partridge-Hicks at Citibank in London were figuring out a way to sell the new bonds. Their solution: Alpha Finance Corp., the first off-balance-sheet structured investment vehicle, or SIV.
Alpha was created in 1988 as a way for Citibank, and later Citigroup Inc., to vertically integrate its business like an oil company. The raw material was found in a loan, refined into a security, then sold to a SIV at a profit.
Citigroup, formed in a merger of Citicorp and Travelers Group Inc., which owned asset-backed pioneer Salomon, also got a new product to sell: capital notes that boast returns of more than 20 percent a year. Owners of these notes receive all the excess return when borrowers pay their bills on time, though they are the last to be paid when times get hard.
Citi SIVs
In the beginning, SIVs were small and cautious. Alpha was capitalized with $100 million of equity that supported $500 million of commercial paper and medium-term notes. The SIV could hold only debt rated A- or higher and didn't take any currency or interest-rate risk, according to a 1993 Fitch Ratings report.
Alpha was followed by a slew of SIVs with names such as Beta Corp. and Five Finance. By 2007, Citigroup's SIVs had $90 billion of assets, equal to the stock market value of PepsiCo Inc., making up about one-fourth of the entire SIV industry.
In 2003, the bank was sued by creditors of Enron Corp. for its role in setting up entities that enabled the Houston-based company to move assets off the balance sheet for Chief Executive Officer Jeffrey Skilling. Citigroup paid $1.66 billion in March to settle the lawsuit. Skilling, a former McKinsey consultant, was convicted of accounting fraud and is serving a 24-year prison sentence.
Mismatched Funding
Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs. Investors were loath to buy long-term debt of issuers that didn't have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day.
``What happened in 2005 was that because of subprime and some other changes, commercial paper and asset-backed securities offered a bigger spread than anything that had ever been in the market before,'' said Deborah Cunningham, chief investment officer of Federated Investors in Pittsburgh, who oversees $235 billion in commercial paper. ``It was hundreds of basis points, as opposed to 10 or 20 basis points before.''
SIVs, banks and CDOs sold trillions of dollars of asset- backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007.
`Huge Appetite'
Once money-market funds began to be tapped for financing, Ocampo said, ``it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.''
To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months.
Among conservative lenders, that rang an alarm: Bankers are taught to avoid such mismatched funding, in which a lender has to pay back money before the borrower has to pay the principal.
``Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term,'' Bruce Bent, 71, who started the first money-market fund in 1970, said in an interview in July.
Reserve Funds
Bent, chairman of New York-based Reserve Funds, said he didn't buy any asset-backed commercial paper until 2007, when the market froze in the wake of the collapse of the Bear Stearns hedge funds. That's when his Reserve Primary Fund began buying castoffs of asset-backed commercial paper at cut-rate prices from other funds.
Yet asset-backed securities weren't Bent's undoing. His fund also owned $785 million in Lehman debt, bought before the firm filed for bankruptcy Sept. 15. In the two days following the bankruptcy, Reserve clients asked to pull about $40 billion from the $62.5 billion fund, and its net asset value fell to 97 cents. It was the first time that a money fund ``broke the buck,'' or fell below $1, in 14 years. The fund is now being liquidated, and Bent hasn't given an interview since.
Reserve Primary Fund's implosion, and the subsequent seizing up of two Commonfund portfolios used by universities and endowments to hold cash, triggered a panic in U.S. money markets, cutting off this form of credit to industrial companies and banks. No one could be sure whether the banks held securitizations that had dropped in value, making them insolvent. That set off a series of bank takeovers and bailouts around the world, including a $64 billion capital injection by the U.K. government into that nation's financial institutions and 400 billion euros in loan guarantees pledged by Germany.
`Absolute Disaster'
``We've created an absolute disaster,'' said Nouriel Roubini, a New York University professor of economics, who predicted the failure of investment banks in a paper he wrote in February titled ``Twelve Steps to Financial Disaster.'' ``The reputation of the United States as a financial center and a leader has been tarnished significantly.''
Also tarnished, if not blackened, is the securitization business itself. Sales of European asset-backed securities, including bonds for car loans and credit cards, fell by 40 percent to 12.7 billion euros in the second quarter, and CDO sales fell by two-thirds to 10 billion euros. In the U.S., mortgage bonds issued by entities not affiliated with the government plummeted to $10.8 billion in the first half of the year, one-twentieth of the $241 billion sold in the same period in 2007.
Cioffi, Bosh
The authors of the 1988 McKinsey handbook on securitization have moved on. Rosenthal, who declined to be interviewed, became a managing director at Lehman and is now in charge of information technology at Morgan Stanley. Ocampo received a patent for risk-controlled investing and founded an institutional fund-management firm, Trajectory Asset Management. The firm doesn't have any structured-finance obligations.
Bear Stearns's Cioffi, 52, was indicted on charges of misleading investors by assuring them that his hedge funds were healthy when he knew they weren't. Cioffi, who now works out of his home in Tenafly, New Jersey, has pleaded not guilty. He declined to comment.
The Bank of New York's Bosh lost his job when his company was merged with Mellon Corp. in June 2007. He's still looking for work.
``You try to do the right thing,'' Bosh said in an interview this month. ``And this is what happens.''
Sunday, October 19, 2008
Saturday, October 18, 2008
Friday, October 17, 2008
Thursday, October 16, 2008
RECESSION
Tuesday, October 14, 2008
Monday, October 13, 2008
Friday, October 10, 2008
CRASH
Crash!?
Human nature is a wonderful unfolding drama. In 1929, the time from the last chance to get out to the crash was 55 days. In 1987, 55 days was the Saturday before Black Monday. Now in 2008, the last top was Aug 11 and the first crash was last Monday, Oct 6 - 55 days to the Sunday before. Does it just take about that long for the point of recognition to sink in? Amazing that each time the next trading day after 55 days would be the crash (which can unfold over several days, as in 1929, and 2008).
Who woulda thunk we would relive 1987? I remember being in London, and hearing that the US market was down 200 odd pints, then was coming back; and at the end was down "5 0 8". We thought he meant 5.08. and it had come back. We found out later he meant the incomprehensible drop of 500 points off Dow2200. This would be a 2000 point drop tomorrow. It now seems thinkable. Could it happen?
Look at this chart. Wanna catch the bottom tomorrow? Ever caught a falling knife?
Neely's service has vigorously kept us posted on his thinking, and he has a cell phone alert tomorrow if need be. He put put a crash warning tonight. Obligatory disclaimers: crashes are rare events, impossible to predict, blah blah. The STU merely stated that "third wave declines could go anywhere." Let me make this simple: we already have crashed. Question is how low will it go? Let's explore stopping points below the fold.
Some optimistics on the Street were floating "Dow 8500" as a support level. When the market rose from Mar03 to Jan04, it didn't stop much anywhere, including at 8500, and never got back to that level until now. Hard to see why this is anything but wishful thinking. We hover at that level, albeit futures have already gone below it in the aftermarket (Dow8344). So I guess we shall test 8500 in the first few minutes of trading. Swooosh! On to the next level.
The most logical support level is the triple bottom on Jul02 / Oct02 / Mar03 around DOW7400 and SP777. Intraday, the Dow got down close to 7100. So a range of 7100-7400, or SP 777-800, really is a support level. And a very important one. Prechter first opined that the ~16 year period of correction from 1998/2000 to 2014/2017 would break as a triangle. Neely also shares this view, and I too have been expecting a triangle. The bottom of that triangle would be this 7200 +/- level, and we would expect to hit it three times: in 2002, 2010, and in the final downtick in 2014-17.
If we break it significantly, the triangle is out. Neely thinks we *may* breach it temporarily by as far down as SP650 (an irrational exuberance to the downside) before continuing on the triangle. I had thought we would end above Dow7200, closer to 9500; have a huge Election Rally into May 2009 that could run up as far as SP1325 and Dow14K before the Summer of Disillusionment sets in, and then crumble back down to Dow7200 in 2010. This would constitute wave C of the 14-year ABCDE triangle, and would break as a flat with A = C. While that specific scenario is now out, if we hold above Dow7200, the Election Rally and subsequent end of C in 2010 is still a probable scenario.
But if we break through, the pattern shifts off the triangle to a flat: a three-wave down into Mar03, followed by a three-wave up to Oct07 (it being ok for a B wave of a flat to go to new highs), and now a five-way down to complete the correction. As a flat, C often = A, but we have already had a deeper and faster C than the A. Next most likely is C = 1.6 x A. The A wave fell 4500 Dow points and 750 SP points, not even; the SP had more tech stocks. So perhaps the C wave will even the two indicies out, with the Dow falling 1.6x A and the SP 1x A, pointing to Dow falling 7200 pts (ending at around Dow7200) and the SP dropping 750 pts (ending around 800). Ok, again a confluence around the expected level, not lower.
If we go a lot lower, both the flat and the trinagle would fail, and the pattern would look like a zigzag. Let us hope not! We had a double zig zag from 1966-1982, and we should not have one again under the rule of alternation, at least not if we we count the 66-82 period as 50W2 and our current period as 50W4. We would still have the audacity in the middle of fear and despair to expect a 50W5 robust bull market ahead after the end of 50W4 in 2014-2017. But if this breaks as a zig zag, then we have to reconsider whether Prechter has been right all along to say this is not a mere 14 year correction before another bull run, but a much deeper correction off the whole rise from 1789. Whew! End of the American Century and all that. Let's hope not.
For a variety of reason I expect us to bottom around Dow7200 / SP800. It might be tomorrow, after an historic drop of over 1000 Dow pts, but more likely it is a drama that unfolds over a week or so, touching the eventual bottom several times. Zoran Gayer used to say that in these circumstances expect a triple bottom. And that is what happened in 1987, with the first two happening quickly and the third over the next month or so. Also happened in 2002, with the bottom stretching over 9 months.
At the first bottom expect to see (a) huge volume, at least 3 Bn shares traded that day; (b) a churning just at the bottom, as shares rotate from bears to bulls with no apparent motion; and finally (c) a very sharp and fairly high rally. Much like 1987. And Oct02.
If we crush through Dow7200/SP777, no telling where this stops. On the way up, we had a number of pauses, most notably at Dow3600, where Prechter first thought we would peak (way back in the '80s); Dow4000, where the dot-com fever first broke out in 1995; Dow 5440; and Dow6000 / SP650, numbers bantied about due to Fibonacci relationships.
These are only some of Prechter's many way stations on the way up, but they end around Dow6k, as he stopped calling the top, after having lost credibility for too many Wolf! Wolf! calls. I dare say his credibility is back.
Human nature is a wonderful unfolding drama. In 1929, the time from the last chance to get out to the crash was 55 days. In 1987, 55 days was the Saturday before Black Monday. Now in 2008, the last top was Aug 11 and the first crash was last Monday, Oct 6 - 55 days to the Sunday before. Does it just take about that long for the point of recognition to sink in? Amazing that each time the next trading day after 55 days would be the crash (which can unfold over several days, as in 1929, and 2008).
Who woulda thunk we would relive 1987? I remember being in London, and hearing that the US market was down 200 odd pints, then was coming back; and at the end was down "5 0 8". We thought he meant 5.08. and it had come back. We found out later he meant the incomprehensible drop of 500 points off Dow2200. This would be a 2000 point drop tomorrow. It now seems thinkable. Could it happen?
Look at this chart. Wanna catch the bottom tomorrow? Ever caught a falling knife?
Neely's service has vigorously kept us posted on his thinking, and he has a cell phone alert tomorrow if need be. He put put a crash warning tonight. Obligatory disclaimers: crashes are rare events, impossible to predict, blah blah. The STU merely stated that "third wave declines could go anywhere." Let me make this simple: we already have crashed. Question is how low will it go? Let's explore stopping points below the fold.
Some optimistics on the Street were floating "Dow 8500" as a support level. When the market rose from Mar03 to Jan04, it didn't stop much anywhere, including at 8500, and never got back to that level until now. Hard to see why this is anything but wishful thinking. We hover at that level, albeit futures have already gone below it in the aftermarket (Dow8344). So I guess we shall test 8500 in the first few minutes of trading. Swooosh! On to the next level.
The most logical support level is the triple bottom on Jul02 / Oct02 / Mar03 around DOW7400 and SP777. Intraday, the Dow got down close to 7100. So a range of 7100-7400, or SP 777-800, really is a support level. And a very important one. Prechter first opined that the ~16 year period of correction from 1998/2000 to 2014/2017 would break as a triangle. Neely also shares this view, and I too have been expecting a triangle. The bottom of that triangle would be this 7200 +/- level, and we would expect to hit it three times: in 2002, 2010, and in the final downtick in 2014-17.
If we break it significantly, the triangle is out. Neely thinks we *may* breach it temporarily by as far down as SP650 (an irrational exuberance to the downside) before continuing on the triangle. I had thought we would end above Dow7200, closer to 9500; have a huge Election Rally into May 2009 that could run up as far as SP1325 and Dow14K before the Summer of Disillusionment sets in, and then crumble back down to Dow7200 in 2010. This would constitute wave C of the 14-year ABCDE triangle, and would break as a flat with A = C. While that specific scenario is now out, if we hold above Dow7200, the Election Rally and subsequent end of C in 2010 is still a probable scenario.
But if we break through, the pattern shifts off the triangle to a flat: a three-wave down into Mar03, followed by a three-wave up to Oct07 (it being ok for a B wave of a flat to go to new highs), and now a five-way down to complete the correction. As a flat, C often = A, but we have already had a deeper and faster C than the A. Next most likely is C = 1.6 x A. The A wave fell 4500 Dow points and 750 SP points, not even; the SP had more tech stocks. So perhaps the C wave will even the two indicies out, with the Dow falling 1.6x A and the SP 1x A, pointing to Dow falling 7200 pts (ending at around Dow7200) and the SP dropping 750 pts (ending around 800). Ok, again a confluence around the expected level, not lower.
If we go a lot lower, both the flat and the trinagle would fail, and the pattern would look like a zigzag. Let us hope not! We had a double zig zag from 1966-1982, and we should not have one again under the rule of alternation, at least not if we we count the 66-82 period as 50W2 and our current period as 50W4. We would still have the audacity in the middle of fear and despair to expect a 50W5 robust bull market ahead after the end of 50W4 in 2014-2017. But if this breaks as a zig zag, then we have to reconsider whether Prechter has been right all along to say this is not a mere 14 year correction before another bull run, but a much deeper correction off the whole rise from 1789. Whew! End of the American Century and all that. Let's hope not.
For a variety of reason I expect us to bottom around Dow7200 / SP800. It might be tomorrow, after an historic drop of over 1000 Dow pts, but more likely it is a drama that unfolds over a week or so, touching the eventual bottom several times. Zoran Gayer used to say that in these circumstances expect a triple bottom. And that is what happened in 1987, with the first two happening quickly and the third over the next month or so. Also happened in 2002, with the bottom stretching over 9 months.
At the first bottom expect to see (a) huge volume, at least 3 Bn shares traded that day; (b) a churning just at the bottom, as shares rotate from bears to bulls with no apparent motion; and finally (c) a very sharp and fairly high rally. Much like 1987. And Oct02.
If we crush through Dow7200/SP777, no telling where this stops. On the way up, we had a number of pauses, most notably at Dow3600, where Prechter first thought we would peak (way back in the '80s); Dow4000, where the dot-com fever first broke out in 1995; Dow 5440; and Dow6000 / SP650, numbers bantied about due to Fibonacci relationships.
These are only some of Prechter's many way stations on the way up, but they end around Dow6k, as he stopped calling the top, after having lost credibility for too many Wolf! Wolf! calls. I dare say his credibility is back.
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