Black Swan Capital

Tuesday 5 June 5:00 a.m. EDT May 2007

Key News

  •      [The British Retail  Consortium says like-for-like sales in May rose by 1.8%]( compared with May  2006, which was the slowest rate of growth since November. (BBC)
  •      [Ritchie  Capital Management Ltd. is preparing to seek bankruptcy protection]( for  life-insurance holdings in its flagship hedge fund, a month after blaming its  co-investor for more than $700 million in losses.  (Bloomberg)
  •      Key  Reports Due (WSJ):[B]  [/B]

7:45a.m. ICSC Chain Store Sales. Previous: Unch.
8:55a.m. Redbook Retail Sales Index. Previous: +2.2%.
10:00a.m. May ISM Non-Manufacturing Business Index. Previous: 56.0.
5:00p.m. ABC/Wash Post Consumer Confidence. Previous: -14.

Steve Leuthold interviewed in Barron?s 4 June 07:

We’re approaching the 10th anniversary of the big Asian financial crisis. Any thoughts about whether we are going to find ourselves in a similar situation?

"It is possible. We still have 8% in foreign markets, and it’s all in emerging markets. That had been as high as 15% a couple of years ago, then we moved it to about 6% and since the first of the year we’ve been slightly increasing it. Our biggest single position is 2% in China. I ask myself every day if this parabolic advance in the Chinese market is the end of the road.

“Right now, we don’t think so, but maybe as we get closer to the 2008 summer Olympics, the market will begin to discount a correction. We just did a study on stock multiples of companies with more than $1 billion in market value in China and the average is 32 or 33 times earnings, whereas in Japan they were 42 to 43 times earnings at the 1989 peak. But I don’t think there is any way that China is going to quit investing in dollar-denominated securities, though they could allocate more to euro- or even yen-denominated securities or maybe other currencies in the Middle East. But unless the U.S. is stupid enough to raise a major threat of restricting or taxing imports, which it looks like some politicians would like to do, there will be peace until after the Olympics, and we are not likely to see some type of a trade war.”

FX Trading - We?re betting on Minsky!

"The global derivatives market grew by 25,935% since 1987 to US$415 trillion last year. Globalization is not just about outsourcing production operations to countries with lower labor costs, but also involves greater financial openness. In the last two decades, the world economy has indeed experienced a wave of financial integration, leading to lower home bias and the emergence of innovative instruments. For example, according to the Bank for International Settlements, the outstanding notional amount of exchange-traded and over-the-counter derivatives contracts increased from US$1.6 trillion in 1987 to US$5.7 trillion in 1990 and then surged to US$71.9 trillion by the end of the decade. That may look like an astonishing growth, but it is nothing compared to what has happened in the years of abundant liquidity. The latest survey shows that the global derivatives market grew at an annual rate of 68.5% to US$297.7 trillion in 2005 and US$415.2 trillion at the end of last year. In other words, the global pool of structured financial products ballooned from 8.7% of global GDP in 1987 to 246.1% in 2000 and then to 789.2% last year," writes Serhan Cevik, of Morgan Stanley.

Potent punchbowls fuel wild parties.

“Positive feedback develops, as new investment leads to increases in income that stimulate further investment and further income increases. At this stage we may well get what [Hyman] Minsky calls ‘euphoria.? Speculation for price increases is added to the investment for production and sale,” writes Charles Kindlebeger, in his classic, “Manias, Panics, and Crashes.”

Of course the usually driver is money and credit. The global punchbowl of $415.2 trillion in derivatives dwarfs anything our speculative brethren before us could have ever imagined.

Would it be fair to say we have entered the “euphoria” or “overtrading” stage of the Minsky model? Here is the basic pattern laid out by Mr. Minsky so we can all follow along:

² Displacement - New profit opportunities i.e. commodities, emerging markets, new era stuff, etc. (read China and real estate)

² Overtrading/Monetary Expansion?Pure speculation driven by too much credit and overestimation of profits leading to euphoria (read Private Equity Masters of the Universe and hedge funds; but none of us are innocent as we stretch for yields and rush headlong into all markets emerging.)

² Revulsion/Discredit?Fall in the price of the primary object of speculation (displacement stuff) as the players begin to recognize it is “over priced.” Liquidation ensues. Sometimes liquidation is orderly?but usually it manifests in panic form when the money expansion behind it is unusually large. Lenders stop lending in order to salvage some of the collateral initially supporting the credit expansion. This can be swift, as lenders at this stage realize the collateral, they thought they had, was bid up by the very money they lent.

If we were to venture a guess, we?d say we are somewhere in the later stage of Overtrading/Monetary Expansion. Unfortunately, we are just not sure how long this stage lasts. It reminds us of the Nasdaq in 1999. Many knew it would end badly, but no one seemed to know when it would end. And some very smart people such as George Soros and Julian Roberts new it too, but capitulated near the end. That should be a lesson to all of us mere mortals about just how powerful this stage can be.

Watching the lack of impact from the sell off in China over the past couple of sessions (though it was higher this morning) is yet another signal from the market that this thing isn?t over?yet. But, if I remember correctly, that “little” problem emanating from Thailand back in July 1997 didn?t get much attention then either. Sure, things are different. Emerging markets are in much better financial shape than they were. They are creditors instead of borrowers, derivatives risk is parceled out and spread more evenly, Private Equity is squeezing inefficiencies, and oh yeah, there really is a Tooth Fairy!

It?s the stuff that gives weight to a phrase we seem to fall victim too in every investment cycle: Things are different this time! Our bets are on Minsky.

Jack Crooks
Black Swan Capital