For those that don’t understand, in the early 2000s, many large banks and financial institutions took on extreme amounts of risk and leverage in an effort to boost profits and in some cases “hedge”.  As we all know now, companies were levered 30:1, 40:1, or even higher.  When these bets, excuse me, investments, went against the company that took them on, the slightest decline on the trade could wipe out their entire investment because of the leverage.  And, that’s exactly what happened.  Unfortunately, the loss wasn’t limited exclusively to the individual company.  There was counter party risk (other entities involved).  But ultimately, the American taxpayer took on the risk.  Many institutions were either bailed out by our tax dollars or mergers were financed through our tax dollars.  The reason given for these bailouts was the institutions that made these investments were “too big to fail.”  If they failed, the whole system would crumble.  And sadly, it’s true.  In many cases, these companies didn’t do anything illegal.  They simply played the system the way it was set up.  We, the American taxpayer, were held hostage.

Regulation was introduced to prevent these types of events from happening in the future, including the Dodd-Frank Bill, stress tests, etc.  I’m all for regulation when it’s reasonable and doesn’t involve too much bureaucracy (I hear you chuckling).  I don’t think the regulation should stymie risk taking or hedging.  If there wasn’t risk taking, there would only be one side of the trade and markets wouldn’t function, businesses wouldn’t get funded, and the economy would instantly go into a recession.  In addition, investors wouldn’t get paid any premium for investments.  Regulation is needed, but unfortunately with each bill that’s passed to regulate and help prevent financial meltdown, there seems to be more complication and pork that adds to the problem.

To me, the real issue is simply the leverage.  It’s one thing to borrow money.  I’ve never had a problem when it comes to debt or leverage, if it’s manageable.  But, we’ve seen with many people in our country that leverage can kill you.  This was obvious during the recent housing crisis.  There’s a difference between manageable debt for strategic purposes and excessive debt that’s relied upon or can wipe out an individual.  But, it’s not just with individuals, it’s with publicly traded companies.   When a rogue trader or CEO makes bets that he personally doesn’t have to pay for or be held accountable for (assuming nothing illegal was done), the system has a problem.  Therefore, leverage that companies use has to be limited.  Otherwise, our entire financial system will always be at risk.  I think Milton Friedman said it best in 2004 when he said, “There are four ways in which you can spend money. You can spend your own money on yourself.  When you do that, why then you really watch out what you’re doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present, but I’m very careful about the cost. Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch! Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government. And that’s close to 40% of our national income.”  Milton Friedman – Fox News interview (May 2004). Unfortunately, it’s not just our government that spends other people’s money without regard to quantity or quality, many companies seem to follow this same principle.

The recent JP Morgan “trade” that was meant to be a hedge has reminded investors around the world that all the recent regulation instituted since 2008 still has not prevented these types of occurrences.  In fact, with all the extra red tape and pork, it’s hard to tell what it really accomplished.  Again, I’m not in favor of extra regulation.  I’m in favor of reasonable and targeted regulation while still allowing companies and investors to take on risk.  I don’t have the answer of what is “too big to fail” or if the phrase should even exist.  But, I do know that the current system still isn’t working.

In 2011, the same issues that plagued the market a year before reared their ugly head again.  Only this time, there was a U.S. debt downgrade and other issues added to the mix.  This time, the S&P 500 suffered a 21% decline over a 5-month period, and the brunt of this decline occurred in only 12 trading days.  Once again, just like in 2010, the stock market recovered much of the losses by the end of the year.

The first quarter of 2012 was very strong for equities as many believed that the economy was straonger than many economists had first estimated.  However, in the last few weeks, Greece, Spain & Portugal are back in the mix as a problem (as if they really every went away).  In addition, the U.S. economy is beginning to reveal it’s true self, which is mediocre at best.  This has caused a 5.5% correction so far in equities.

CLICK PICTURE TO ENLARGE

As you can see from the chart above, this year is shaping up very similarly to the prior two.  The difference this time is the fact that the U.S. is in a presidential election year and that can cause different moves than the traditional seasonal volatility (i.e. sell in May and go away).

Below is a picture of the volatility index going back three years.  You can see the volatility that picked up just as the time the market began to fall.  It’s now beginning to creep back up.  That’s something to keep an eye on.  As I’ve mentioned in prior blog posts, volatility could stay low for some time similar to the 2003-2006 time frame.  However, that was a time where the economy was recovering and much more stable than the one we’re experiencing in 2012.

 CLICK PICTURE TO ENLARGE

After hours today, we find out that JP Morgan has some very large trading losses that they will have to mark down.  This will not only impact the financial stocks, but the entire market.  This begins to remind folks of 2007 and 2008 and when people think about that time frame, they sell stocks.

Therefore, caution is warranted.  Lower beta stocks, short-term trades, income producing assets, cash, and flexibility are the name of the game.  Stay on the lookout for long-term indicators to turn negative before going into bunker mode though.

This post published at www.karleggerss.com

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