Monday, September 22, 2008

On the Markets, US Dollar, and Inflation

I hadn't planned on prognosticating on the financial markets here, in my journal. These are unusual times, however, and I have been entertaining unusual thoughts lately. But first a little about where I'm coming from..

Background: Trading Activity

I play mostly individual stocks, and luckily (for me, that is) I have been on the right side of the recent market action. I've been in the market for over 20 years now. I first started as a broker on wall street where I became good at selling mortgage backed instruments (CMOs) and such derivatives as "residuals". Actually, no. I wasn't good at selling them; I was good at explaining how the pricing model was supposed to work. I made okay money, but a year or so after the crash of '87 (my best trading day ever), my interest wandered back to painting and I left the business shortly thereafter. I was young, and had yet to try many other things. Through it all, though, I've always had skin in the market.

Over time, I have developed some trading/investing habits. I summarize them below.
  • Whatever the overall strategy, it has to be simple to execute. This means, for instance, that I wont consider a trading strategy that involves anything more than a few trades a day.
  • I generally prefer to be market neutral: that is, I like to hedge my long positions with short positions in other stocks.
  • I like to maintain anywhere from 6 to 9 positions at any one given point in time. This policy does a few things for me. One, it helps me focus on what I believe are the best opportunities by narrowing down on a few. Two, it makes following the news that I have exposure to easier. Three, it makes trading the positions easier. (Trading 20 different stocks is considerably more challenging than trading 3.)
  • I prefer to speculate on medium term trends: 6 months to 2 years out. I will not enter a position for which I have no medium term prognosis.
  • I trade around core positions. I do this in an attempt to increase profits while minimizing my average downside exposure over time.
  • I accept that to win you must also prepare to lose.
  • The only number on the screen that matters is the one on the corner: your account's value.
  • I begin everyday with one mantra: "I don't know anything; I'm just a speculator in search of an edge."
Inflation or Deflation?

What's the nasty end game? That's what everyone is quietly wondering.

Will the dollar plummet, as in the unraveling of an elaborate confidence scheme to which foreign traders of goods and capital are just waking up to? Or will the dollar plummet as the treasury prints more money to stave off a financial crisis which itself was a product of another credit bubble? Or does the master plan (the one nobody knows about but which is written in stone) involve cheating our creditors by wiping off the real value of all this toxic debt with an inexorably steady dose of inflation?

Or is deflation in the cards? The US government does not print money; it doesn't have to. The world's creditors run to the protection of the one "true" thing they still believe in, the US dollar. Economic activity contracts in the developing world and takes the emerging economies down with it. Unemployment rises, interest rates fall, and the treasury finds yet more willing foreign buyers for Treasury debt. And the currency confidence scheme of international trade and national current account deficits continues.

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world..
-W.B. Yeats

The future, it seems, can have both outcomes in the cards. For now, while fear is in charge and world markets price in economic contraction, deflation is the theme of the day. As a horrible as it might get, we will eventually meet our demons, and fear will first be replaced with ambivalence, before greed's comeuppance. Somewhere along that path, I expect inflation to rear its nasty head. I hope it doesn't, but a dollar is an IOU, and that's what happens to IOUs issued by borrowers who can't balance their books.