Market dislocations (aka crashes) are among those things that are not well defined and difficult to understand, especially for those who have never experienced them directly. But like true love, you know it when it happens and don't tend to forget it.
Simply put, a market dislocation is when a sustained bubble (eg. Ponzi scheme) begins to wobble and fall apart, and the realization comes generally that it is collapsing, with all participants remaining invested heading for the exits in a mass panic. It can be in real estate, financial assets, shares in a venture or cash flows from a project, stamps, matches, and even tulip bulbs.
These patterns of collapse tend to have a common framework. The challenge is separating a market dislocation from an ordinary correction. In our work, we have arrived at some hallmarks that characterize a market dislocation, which as you know is always a low probability event.
The setup for a market dislocation begins with a sustained increase in price (the Ramp) to a significant new high (the Top) over a period of time which is multiples of the subsequent decline. US equity markets saw such a top late last year in October. From there the first assault in confidence occurs as profit taking, creating a decline more significant than the declines serving as corrections up to the Top. It is usually an initial decline of ten percent or greater. Often we get an uncharacteristic decline
The rally back from this first low not exceed the Top (obviously) and is referred to as the Second High (with the TOP being the first or highest high). It can be equal to the TOP.
The next low must set a lower low, ruling out a double bottom. It is preferable but not necessary that the Lows be noticeably lower than the Highs. The lower the lows, the more likely that the dislocation will mark the start of a bear market rather than just a market clearing event like the Crash of 1987.
It is not uncommon to reach this point, and the vast majority of times will merely be an A-B-C correction. The next step is a critical differentiator, the Failed Rally. If there is a bounce of 2 to 5 percent that fails to gain momentum, and drops back to a lower low, and fails to rally again from there, it sets up a higher than normal probability of a market dislocation which we define for our purposes as a market decline of 30 percent or greater within a one year period.
If you have been paying attention, you may have 
noticed that we never spoke about timeframes. How many days from the first Top to the first low, and then to the second high, and so forth? We have this information in our database, but we do not use it in generating the CrashTrak model per se. We consider market time to be highly relative and variable. What it may have taken a day to be communicated to the broader market participants in 1929 may have taken only an hour in 1987, and only minutes or even seconds in 2008. So we have seen a significant increase in the reaction time of markets which would almost certainly affect timeframes.
Second, and mostly overlooked, the responses of market regulators and the financial authority have increased in power and sophistication, and in some ways remarkably so. This is not your grandfather's Fed or market anymore. They are smarter and more capable of distorting and forestalling events. We believe that they cannot stop a primary trend, but they can delay or defer it, and sometimes significantly so.
Lastly, we are seeking to apply this model to a wider variety of market dislocations. Everyone knows about 1929 and 1987, but what about 1932, 1937, and a slow grind like 1973-74? We don't think ignoring the time periods is all that revolutionary, especially if you consider the long standing use of Point and Figure charts, which are also based on patterns of price action. Still, we have to admit we do keep an eye of sorts on the dates, and map out what we call windows of opportunity. We're in one now, and will be so until about mid-February.
Even in its most high probability moments relatively speaking, a market dislocation is still a very low probability event. We want to make this very clear.
Let's see what happens.
27 January 2008
Crash: the Rally that Fails as Hallmark of Major Market Dislocations
25 January 2008
Société Générale - The Lone Trader Theory
After a rogue trader cost the French bank €5 billion (equivalent 7.1 billion americanos), many are left to wonder about the lucrative but risky equity-derivatives trade. One of the biggest frauds in financial-services history apparently was carried out by a 31-year-old trader in Société Générale's Paris headquarters, whom multiple news sources have identified as Jerome Kerviel. The trader "had taken massive fraudulent directional positions"—bets on future movements of European stock indexes—without his supervisors' knowledge, the bank said. Because he had previously worked in the trading unit's back office, he had "in-depth knowledge of the control procedures" and evaded them by creating fictitious transactions to conceal his activity.
The fraud was discovered Jan. 20, a Sunday, which meant Société Générale had to start unwinding the positions Jan. 21 just as global equity markets were tanking on fears of a U.S. recession. "It was the worst possible time," says Janine Dow, senior director for financial institutions at the Fitch (LBCP.PA) ratings agency in Paris. SocGen, which also announced a nearly $3 billion 2007 loss related to U.S. mortgage-market woes, has had to seek a $5.5 billion capital increase and could even become takeover prey.Previously, Double-Digit Growth
While those facts seem fairly straightforward, a host of troubling questions still need to be answered: How could SocGen, which ironically was just named Equity Derivatives House of the Year by the financial risk-management magazine Risk, have failed to detect unauthorized
trading that it acknowledges took place over a period of several months? Do banks need to tighten the controls put in place after rogue trader Nick Leeson brought down Barings Bank in 1995? Or is the red-hot business of equities-derivatives trading just too tricky to control?SocGen's equities-derivatives business, the biggest at any institution in the world, has posted double-digit growth the past eight years and until now has been hugely profitable. Fitch estimates the business generated about $1.7 billion in profits during 2006, or about 20% of the bank's net earnings. Backed by elaborate algorithmic models, trading instruments with exotic names such as Himalaya and Altiplano have generated an average 40% return on equity for the bank, more than twice the rate for its retail banking business.
Yet SocGen's derivatives operation is relatively small, with fewer than 2,500 employees including about 300 traders and roughly 750 middle- and back-office employees, according to a 2006 investors' presentation by the bank. The rogue trader apparently spent several years in a back-office job before realizing a long-held dream of moving to trading.
An Inevitable Scandal?
Maintaining strict separation between inherently risky trading activities and careful back-office controls is a key tenet of banking regulation, says Axel Pierron, a Paris-based consultant with Celent, a financial-services advisory group specializing in information technology. But, Pierron says, "In derivatives trading, there's not as strong a separation between trading and back office as in other parts of the bank." Letting employees move from the back office to the trading floor is uncommon but generally not prohibited by banking regulations or banks' own rules, Pierron and other banking specialists say.
Some risk-management experts contend that such a scandal was inevitable, given the global boom in trading exotic securities. "This stuff happens more than people may like to admit," says Chris Whalen, director of consulting group Institutional Risk Analytics. Banks increasingly are moving away from traditional banking into riskier trading activities, he says. SocGen's problem 
was "a rogue business model, it's not a rogue trader."
Yet others point out that SocGen's risk-management practices were some of the best in the industry. "The control procedures that SocGen had in place are much better than those at Barings," says Richard Portes, a professor at the London Business School. "Every bank will be reevaluating their procedures, but it's not clear if there are ways to improve them. There hasn't been a broad failure of risk management across the board, just one guy who knew how to beat the system."
Although SocGen is the global equity derivatives leader, other banks are heavily involved in the business, including the global No. 2 player, crosstown rival BNP Paribas (BNPP.PA), German giant Deutsche Bank (DB), and New York-based Goldman Sachs (GS). The French banks got a huge head start in equity derivatives because of sophisticated mathematical models developed at French universities. Now, the math for SocGen is looking ugly indeed.
Next Week: The CFTC and SEC: Making Société Générale Look Like NASA
Hat tip for the original story to BusinessWeek: Société Générale's Fraud: What Now?
Hat tip for 'creative' input to: rasputin, meg-abear, sean_of_the_zurich_gnomes, rodd saito, and denverdave.
24 January 2008
High Priests of Finance Review Société Générale Markets Fraud
January 24, 2008
Société Générale hit by €5bn trading fraud
The French bank disclosed today that a rogue trader had defrauded it of almost €5 billion, prompting it to seek emergency funding
Patrick Hosking, Banking and Finance Editor
The French bank Société Générale stunned financial markets today by revealing that it had been the victim of one of the largest frauds by a rogue trader — losing four times as much as Nick Leeson, the man who sank Barings.
The second-biggest French bank said that it had lost €4.9 billion (£3.7 billion) as a result of the rogue trades by a Paris-based trader who concealed his positions through "a scheme of elaborate fictitious transactions".
SocGen was forced today into an emergency €5.5 billion capital-raising to shore up its ravaged balance sheet.
It said that it was in the process of dismissing the unnamed trader, who had "confessed to the fraud".
Daniel Bouton, SocGen's chairman said today that "four or five" of his managers and supervisors had resigned and a legal investigation was now taking place.
An offer from Mr Bouton to resign was rejected by the board.
Mr Bouton apologised to shareholders and said, “This was a lone man who built a concealed enterprise within the company, using the tools of Societe Generale, and who had the intelligence to escape all control procedures."
The fraud appears to be one of the biggest in history, dwarfing the £827 million lost by Mr Leeson, whose rogue trading led to the collapse of Barings in 1995.The trader had been with the bank for about six years and was a relatively junior employee. According to Mr Bouton, he was paid less than €100,000 including bonus, a small wage for anyone in investment banking.
"He was trading relatively small positions," said Mr Bouton. "He was at the lower end of the scale."
SocGen said the rogue trades - effectively huge bets on European stock markets going up - were placed in 2007 and 2008 but hidden from managers. They were first discovered on Friday evening after a "fishy" trade made in December was investigated.
The bank took the first three days of this week desperately attempting to unwind the positions in what proved to be hostile conditions as markets plunged. If they had gone up, the positions might have made gains for the bank, Mr Bouton said.
As it was, they turned into "gigantic and collossal" losses.
Analysts said SocGen's unwinding of the massive rogue positions on Monday would have contributed to the violent slump in share prices and may therefore have played a part in the shock decision by the US Federal Reserve to slash American interest rates.
"There's a very strong link between the equity futures market and the cash equities market," said one equity strategist at a major bank. "It may have influenced Fed thinking."
The trader managed to conceal his positions through his knowledge of the administrative side of the bank, "the middle office", where he worked for three years until 2005.
The bank said: "Aided by his in-depth knowledge of the control procedures resulting from his former employment in the middle office, he managed to conceal these positions through a scheme of elaborate fictitious transactions."
SocGen described the fraud today as "exceptional in its size and nature".
