|
|
Sky Blue Monthly (May 2000)
All Rights Reserved, 2000
Mervin Yeung
Editor/PublisherHome Page: http://skybluemonthly.freeservers.com/index.htm
E-mail: tinyeung@home.com
May 4, 2000
Important: The structure of Sky Blue Monthly has changed. We launched our e-mail hotline on April 11, 2000. This new e-mail hotline is named Sky Blue Express. To keep up with the latest developments in stock, bond and currency markets, we have to update our analyses as new events unfold; and we use our e-mail hotline (Sky Blue Express) to inform our readers. Therefore, most of our outlooks, forecasts, and analyses are moved from Sky Blue Monthly to Sky Blue Express. Sky Blue Express is written irregularly -- it depends on when and if new economic events occur. To subscribe Sky Blue Express, simply send an e-mail to tinyeung@home.com. Sky Blue Express, like Sky Blue Monthly, is free. We have written 2 papers for Sky Blue Express subscribers: (1) "Economic History According to FFEE" and (2) "The Effects of Excessive Money Creation & Credit Expansion". These 2 papers contain a lot of basic economic concepts that will help you understand both Sky Blue Express and Sky Blue Monthly. From now on, Sky Blue Monthly will become a macro economic e-magazine, instead of a market letter. (We are proud of the accuracy of our previous outlooks (Dec. 1999 to March 2000). For the record, please go to April 2000 Sky Blue Monthly and read the first half of the paper. It lists how we did in our previous forecasts. At least we are happy with our forecasts.)
This issue will investigate why Quantum Fund (managed by George Soros and Stan Druckenmiller) got hit by NASDAQ's dive. We had better introduce the background of current editor of Sky Blue Monthly -- Mervin Yeung. Mervin Yeung graduated from University of Kentucky. He had university degrees in the following majors: Computer Science, Mathematics, Economics, and Mathematical Sciences (all with distinction). He also had successfully completed Series 3 (National Commodity Futures Examination)(USA), Canadian Securities Course, Canadian Options Course, and Canadian Futures Examination. After years of working as an Assistant to the Director of Research and as a Futures Analyst at a $102 million hedge fund in Chicago, he decided to write Sky Blue Monthly and Sky Blue Express. Hence, we know what we are writing when we discuss the topics of "hedge fund" and "decision making process of trading".
Falling Down
Year 2000 has been a very interesting year so far. Not simply because it starts with the number "2". Two of the biggest names in hedge fund business, Robertson's Tiger Fund and Soros' Quantum Fund, hit the wall. According to Bloomberg, Soros, the world's biggest hedge fund manager, saw his Quantum fund plunge 25 percent from March 24 through April because it bet on tech stocks when it shouldn't have; and Robertson's Tiger funds fell 13 percent this year through February after dropping 19 percent last year. Julian Robertson decided to leave hedge fund business and to disband Tiger funds. Soros is still in the business, but the top two managers at Soros Fund Management, a $14 billion hedge fund company, are leaving in the wake of double-digit declining performance this year. The departures of Stan Druckenmiller, portfolio manager of the Quantum Fund, and Nick Roditi, 54, portfolio manager of the Quota Fund, clearly show us that trading is not an easy task, particularly this year.
Since the collapse of communism in Eastern Europe and Former Soviet Union in late 1980's and early 1990's, Soros has been very busy setting up foundations and promoting his "Open Society" idea in those nations. So, Stan Druckenmiller took full charge of running the Fund. Druckenmiller is a gifted fund manager and a brilliant trader. Quantum Fund has performed very well under his management -- e.g. Quantum gained 68.6% in 1992 and 61.5% in 1993. One of the best trades by Druckenmiller was to go short Japanese stock market in late 1989. Japanese stock market bubble burst in 1990 and Druckenmiller was right on the money. Why did Druckenmiller go short? According to Druckenmiller himself, Japanese Government Bond (JGB) was falling apart and Nikkei bubble was still expanding and rising in late 1989. As we know, falling bond prices mean higher long-term nominal interest rates. Rising interest rates are deadly to equity bubble and Druckenmiller knew it. Thus, one of these 2 charts (JGB & Nikkei) must be wrong. Druckenmiller believed that it was Nikkei and he was right. (Just take a look on how Japanese stock market collapsed vertically in 1990 and you will realize how much money Druckenmiller made for himself, Soros and their clients. Certainly, at the other side of the coin, how much money did those bulls (so called "investors") lose in that fiasco?!)
Fast forward to 1999. US T-Bond price movements in 1999 were pretty much a re-run of JGB price movements in 1989. The correlation between 1989 Japanese Government Bond price movements and 1999 US T-Bond price movements was shockingly high. We wrote an analysis (Carry Trade & Its Consequence) on this topic on Dec. 2, 1999 and it is available at: http://skybluemonthly.freeservers.com/thoughts/thcarry.htm. Re-run, replay, whatever… Re-runs were supposed to be very boring. But, US stock market indices, particularly NASDAQ (which contains a lot of technological and internet stocks), were rocketing upward while US T-Bond was falling apart in late 1999. Remember something exciting happened in Japan 10 years ago? Kevin Klombies did a very detailed study on this subject, with all sort of charts. This study compared US T-Bond market in 1999 with JGB market in 1989. The similarity was striking. US Treasury Department probably also realized that. Hence, Treasury Secretary Lawrence Summers announced on Jan. 13, 2000 that the U.S. Treasury Department this year would launch its first-ever cash buyback of government debt and it planned to snap up as much as $30 billion in high-yielding securities by using budget surplus. T-Bond bounced back as a result. The fundamentals for US T-Bond market were deteriorating but they were stopped at the edge of the cliff. (If you want to read Kevin Klombies' study, please e-mail him at: krk@krk-imra.com. The study is his so we do not put it at our website. Remember to ask Kevin Klombies for Dec. 2, 1999 Issue of IMRA. He will e-mail you that issue free because it was an old issue. It is in Acrobat Reader (*.pdf) format, by the way. We suggest you to ask him for that study because it is very important to understand what was (and is) facing us. Without that study, you will find it harder to understand this issue of Sky Blue Monthly.)
Due to US Treasury Department's T-Bond buyback, T-Bond bounced back and this gave Druckenmiller false sense of security. Normally, Druckenmiller would have dumped his NASDAQ stocks if T-Bond had fallen apart in the first few months of 2000. T-Bond would have fallen apart if there had not been T-Bond buyback by US Treasury. Normally, the best indicators are price actions because price is simply the reflection of the vote in market place. People make their buying or selling decisions on their outlook of the commodity or the security. Every trader is voting. Market price is the final vote of all these buying and selling, the interaction of supply and demand. (We always respect market price under this normal condition.) T-Bond price movements are definitely very useful. We are sure that Druckenmiller looked at T-Bond price movements when he decided to hold on to his NASDAQ stocks. Unfortunately for him, T-Bond price movements and level have been affected by US Treasury's buyback scheme. Hence, what he was looking at didn't reflect the vote in market place so the price didn't provide useful information, or worse, it may provide misleading information (imaginary signal). If there had not been T-Bond buyback, he would have got out of those NASDAQ stocks and then he would have sold short those stupid things. Sadly, he was tricked by the imaginary signal and was burnt. What would have been Druckenmiller's best trade (like his short Nikkei trade more than 10 years ago) turned into an absolute fiasco. (We hope this issue of Sky Blue Monthly helps you understand the decision making process inside a hedge fund. Not many people have the opportunity to work there and to learn there. Making the right decision is extremely important. A bad decision cost Druckenmiller and his clients a few billion dollars. If one day you become a hedge fund manager, remember this!)
George Soros and Stan Druckenmiller are rich and famous by utilizing the concept of "Reflexivity" to make money. We used the same concept to analyze US Treasury's T-Bond buyback in Feb. 00 Sky Blue Monthly. We are confident that Soros and Druckenmiller do not believe in New Era. But, they believe in "Reflexivity" and they tried to ride on a stock market bubble. Why they expected that T-Bond buyback scheme would bloat the bubble was not a mystery despite that the planned $30 billion T-Bond buyback is really a tiny number because there is about $3.3 trillion in publicly traded government debt and the total federal debt is about $5.7 trillion. Let us duplicate our previous analysis on T-Bond buyback and then we will explain the details.
We wrote this on Feb. 1, 2000: "As we have discussed in Jan. 00 Sky Blue Monthly, increase in money supply will cause (1) Consumer Price Index inflation (CPI inflation); (2) asset inflation; or (3) capital outflow in form of carry trade. Case (2) is exactly what is happening in the USA. In the last quarter of 1998 and the last quarter of 1999, M3 Growth Rate skyrocketed. CPI inflation remained calm and stock market, particularly NASDAQ, blasted off. This showed most newly created money and newly created credit went directly into the financial market, not the retail market. If the Fed continues to ignore M3 Growth Rate, and if M3 Growth Rate continues to remain at such high level, US stock market will most likely be on the march upward again. However, T-Bond market will be under pressure if M3 Growth Rate remains high. If T-Bond sinks, stock market will get hammered. This means the party is over. Governments and central banks are the true friends of the current bull stock market. Therefore, the Treasury Department's "T-Bond Buyback Scheme" was born. This cash-for-debt buyback of government securities is possible only when the government is running a budget surplus. In order to have a budget surplus, the government has to (a) raise tax rate; (b) cut government spending; and/or (c) collect lots of taxes in a strong economy. Case (a) won't happen due to the opposition of Republicans. Case (b) won't happen due to the opposition of Democrats. This leaves case (c). If an economy is booming, business earnings are high and the tax revenue to the government will increase even if the tax rate is the same. In order to have a strong economy, we have to have a soaring stock market and hence the "wealth effect" will lift our economy. To help the stock market blast off, the cost of money has to be cheap and the liquidity has to flood the market. This was the reason that the Fed was not unhappy even when M3 was skyrocketing. Then again, the Fed's job is to keep CPI inflation from rising. Thus, we are not accusing the Fed for not doing its job. The Fed's job is not to pop a financial bubble.
"Have you got the idea? The relationship described above is a dynamic relation: the cost of money is artificially lowered to provide liquidity to drive the stock market upward. The bull market creates "wealth effect" and consumers spend wildly. Hence, the economy is strong and the tax collected by the government soars. The government will have a budget surplus. Then, the Treasury Department uses the surplus to buyback T-Bond. (If the Treasury Department had not bought back T-Bond, T-Bond would have dived due to the fear of high M3 Growth Rate. The stock market would have been smashed because of the falling bond market. ) Due to US Treasury's buyback, T-Bond will rise. As a result, the Fed doesn't have to do anything on the high M3 Growth Rate. M3 Growth Rate can go even higher because bond market has been taken care of. The stock market continues to march upward. The "wealth effect" from this bull market helps US economy and a strong US economy results in even larger tax revenue. The budget surplus will be even higher. US Treasury can use this even larger surplus to buy back even more T-Bond. T-Bond will rise further. This "benign cycle" goes on and on. If you don't know the real meaning of the word "utopia", this is it! "
George Soros used the word "Reflexivity" and we use the term "Dynamic". They mean the same thing. Soros and Druckenmiller apparently believed that the "benign cycle" described above would go on and on. Fortunately for us, our conclusion in Feb. 00 Sky Blue Monthly was that $30 billion buyback of government securities by US Treasury was not enough to get the "benign cycle" going. (Let us quote our actual wordings in the conclusion of Feb. 00 Sky Blue Monthly on Feb. 1, 2000: "If US Treasury's buyback induces the "benign cycle", US stock bubble can expand on an immense scale. (We believe this scenario is unlikely mainly because $30 billion buyback is simply not enough.) Therefore, we remain bearish on US stock market and US T-Bond market, although we are not as bearish as we were due to US Treasury's buyback scheme.") Soros and Druckenmiller are extremely bright traders but no one can be right all the time in this risky market.
If a "benign cycle" is able to go on and on, the bubble will expand. And some may ask if this means New Era. Definitely not. Mainly because a bubble induces mal-investments (quality) and over-investments (quantity) in the affected economy. Accumulation of mal-investments (quality) and over-investments (quantity) in a liquidity driven economy is the reason that an economic bubble will eventually collapse. Before this final "bust", however, an economic bubble will expand during the "boom" period because mal-investments and over-investments are very strong stimulants to the economy. Central bank can delay the burst of an economic bubble by injecting liquidity into the financial system through repetitive money creation and credit expansion. However, this liquidity injection will cause the economic bubble to expand even further because this new liquidity induces even more mal-investments and over-investments. Besides, this injection will result in "Withdrawal" and "Dependence" in the long run. Withdrawal refers to the fact that after a liquidity injection has been taken for a while, negative economic symptoms can occur in the economy when the liquidity injection is stopped or its level is reduced. Left untreated, withdrawal symptoms will be fatal to the bubble. It is important to note that the symptoms of withdrawal can be quickly reduced or eliminated by taking another dose of the "drug". Therefore, withdrawal symptoms play a crucial role in the development of "liquidity dependence" of a bubble economy because the economy must continue taking the "drug" (getting a "fix") to avoid the withdrawal symptoms. Dependence occurs when the economy (a bubble economy, that is) must take the "drug" (liquidity injection) to avoid withdrawal symptoms. Thus, if and when the liquidity injection is stopped, the economic bubble will collapse. (In short, an economic bubble either expands or collapses.)
Let us remind our readers that our forecasts of stock, bond and currency markets have been moved to Sky Blue Express (our e-mail hotline). Sky Blue Monthly is now a macro economic e-magazine. We hope our readers can utilize Sky Blue Monthly and learn how to analyze. Current US stock market is an old-fashioned liquidity driven bubble, not a New Era. US stock market is now going through the withdrawal symptoms, but don't write it off. Another shot of the "drug" can make this bubble even bigger. However, as we pointed out again and again, any financial or economic bubble will collapse eventually.
June 2000 issue of Sky Blue Monthly will be available by June 14, 2000.
This newsletter is for general information only and does not constitute an offer to sell, nor is a solicitation to buy securities and/or derivatives. The information is believed to be true and accurate at the time of writing and the Publisher of Sky Blue Monthly is not responsible for any actions taken as a result of reading this newsletter. No portion may be reproduced in whole or in part without the consent of the Publisher.
If you have comments or suggestions, email me at tinyeung@home.com
