Disciplined Investing

Another low volume rally on bad news today, and this means that the last two weeks have seen me giving up about half my gains for the year, which is a bit of a bummer. I could make arguments that this is a BS rally or that markets are irrational, but if you're a trader/investor, irrationality is something you're attempting to exploit. That's the point.

Most of my trading is reactionary based on pre-determined rules. If the market does X, I buy Y. If Y does Z, I either sell or hold based on a pre-determined set of rules. This system had me losing money from S&P 760 to 666, but then allowed me to make a lot of money (by my standards, at least) on the first few stages of the rally up until about S&P 800. Since then, I've grown bearish, and been smacked upside the head for my troubles.

I don't use tight stops on many of my trades. Instead, I use other forms of risk management, such as a paired trade. For example, I went long Chinalco (ACH) at around 11. This stock has gone as high as 21, and has hovered in the high teens generally. Since then, I've added a short Baidu (BIDU) at 180 to hedge the downside risk. This has kind of exploded against me, as BIDU is around 225. Now, I think most investment professionals would have sold by now. I remain bearish on BIDU and long-term bullish on Chinalco. Gun to head, I think BIDU falls below 100 by January 2011, and that Chinalco will fall below 10. But I don't know for certain what either will do. So I'm comfortable owning Chinalco, which has a Price-to-Sales ratio of 1, while shorting BIDU, which has a price-to-sales ratio of over 15, even though the trade is going against me bit right now.

Could this decision cost me all my gains in Chinalco? It most certainly could. But a more likely scenario is that this rally peters out, BIDU hits a brick wall, I sell BIDU way lower, use it to buy more Chinalco and eventually the big bad Chinese aluminum company rakes it in big time. This is a happy scenario for me, but I think it is likely enough. And if I'm wrong, I'll probably only give back the gains I already made.

Sounds like a decent risk/reward to me. In a world where I'm not using stops (at least on this trade -- I use them on others all the time), this is just one example where disciplined trading can be different from setting tight stops.

Now, if my entire P&L for the year starts to run away from me, then I will re-evaluate and get smaller. But we're not there yet...

The big move

Just a note I haven't heard anyone mention yet.

As of today, the Russell 2000 is up more than 40% from the March 9 bottom.

Now that, my friends, is a rally.

Disclosure: Short positions in both TWM and IWM.

Bernanke's Silent Power Grab

Ben Bernanke seems so harmless. With his dull, professorial demeanor, I suspect most people view him, insofar as they have any opinion about him whatsoever, as kind of a math-professor-in-chief. The Congress are too stupid to handle any serious financial issues, so we leave those kinds of problems to the math-professor-in-chief. He's nice and apolitical by nature. He doesn't want power. He just wants to do math.

But today there emerged reports that the math-professor-in-chief might be getting a little uppity. He allegedly threatened to go all pulp fiction on one of the world's biggest banking CEOs if he didn't play ball and buy Merrill Lynch without disclosing to his shareholders the risks and the government guarantees. That's a likely violation of securities law, at the behest of the Federal Reserve chairman. Will it even make the evening news? Has Susan Boyle put out an album yet?

After 9/11, George Bush & co. began to implement new policies that didn't resonate too well with civil liberties fans, but he justified them because, "we're at war." This was true, but unfortunately, a war with terror is a war we will likely fight for the rest of my lifetime, and I'd prefer to maintain some civil liberties during my life. Since the fall of 2007, Bernanke has enacted a series of extreme measures, blown up the Fed's balance sheet, and usurped more control for himself than any previous fed chairman had ever before. Some of these measures have been warranted. Had the fed not arrested the flow of money out of money market funds last September, we could have had Armageddon. I applaud him for his calm under those conditions. But this economic war could last a long time, too, and we have to always think about the balance for "emergency action" and personal freedom. Bernanke's actions with BofA, if true, certainly cross that line.

Power goes to people's heads, and Ben Bernanke, for all this avuncular calm, is no different. He is a zealot, no different from Ghandi, Hitler, Stalin, or Caesar. Where he fits on the scale of moral propriety is for others to decide. But we should all be aware that his influence is growing, and he is willing, and increasingly more able, to do "whatever it takes" to accomplish his goals.

Why stability won't breed stability for this economy

Many folks more intelligent than I have commented that markets appear to be stabilizing. This statement is fatally overbroad, of course, and so it leads to lots of great debates.



Some things have gotten better, some are stabilizing, and some are getting much worse. For example of something getting better, look at the credit markets. One could make a very convincing argument that the worst in the credit markets is behind us. It's doubtful that the TED spread is going back to four, and the A2/P2 spread damned well nearly seems reasonable.

Some things are stabilizing. For example, home sales are stabilizing. They're stabilizing at 50-year lows, but they're stabilizing nonetheless.

Then there are certain things that are getting worse. Commercial real estate is blowing up and unemployment is still growing, albeit at what might be a slightly decelerating rate. But if you don't have a job and can't find one, it's hard to find solace in a decelerating rate of unemployment growth.

The big question is what to make of it all. My opinion is strongly contrary to what appears to be popular consensus now, which is that the slowing down of deterioration is an encouraging sign. In most economies that would be true. But this economy needs more than stability. Our highly levered, highly indebted society needs much more than stability to dig itself out of this mess. The West needs growth and plenty of it, or the entire system is going down, in some ugly form or another. Pensions have been designed on the expectation of 8% annualized growth, and they're not getting it. State budgets rely and significant annual growth, and they're getting the opposite. Banking structures also require growth in housing, car loan, and credit card receipts, and they're not getting any of it.

The US economy is a bicycle that needs to accelerate faster for eternity to stay on its wheels. That's an absurd analogy for an absurd situation. And neither is sustainable.