The January Stock Market Indicator

"As January goes, so goes the year."

The January Barometer basically says that as goes the S&P 500 in January, so goes the market for the year. “A down January means a down year” would seem to be the obvious reading for 2008. Credit Yale Hirsch, editor of the Stock Trader’s Almanac, for devising the January Barometer in 1972. According to the Hirsch research, January’s trend matches the trend for the year about nine times out of 10. If you toss out a few close calls, when the market was up or down less than 5 percent for the year, the January Barometer still works three out of four times, the Stock Trader’s Almanac reports. Since 1950, the S&P 500 has posted a gain for the year 91% of the time that the index experienced a positive January. For those "cautious" investors who desire an even larger sampling, since 1926, that percentage [a positive January foreshadowing a positive full year] falls to 80%, although that’s still a pretty telling predictor of future market activity.

Strictly market lore like other purely coincident indicators, like winning football teams, magazine covers, and women's hemlines? Not so, according to peer-reviewed statistical research.

"...We systematically examine the predictive power of January returns over the period 1940–2003 and find that January returns have predictive power for market returns over the next 11 months of the year. The effect persists after controlling for macroeconomic/business cycle variables that have been shown to predict stock returns, the Presidential Cycle in returns, and investor sentiment, and it persists among both large and small capitalization stocks and among both value and growth stocks. In addition, we find that January has predictive power for two of the three premiums in the Fama–French [1993. Journal of Financial Economics 33, 3–50] three-factor model of asset pricing."

The Other January Effect, Journal of Financial Economics, Volume 82, Issue 2, November 2006, Pages 315-341

Do Central Bankers Dream of Endogenous Sheeple?

While your blogger is mending from a rather bad cold compliments of his brood of young dependents, they being the reason for working and worrying as hard as we sometimes do, we are pleased to present an extended excerpt from a favorite publication targeted at the Central Banking crowd, appropriately named Central Bank News.

Central bankers seem to be an affable group of fellows. Clubbable, as the British might say. A bit on the reserved side, their cocktail parties must seem like Economic Department soirées, without the occasional pleasant-on-the-eyes graduate assistant. Efficient, bureaucratic types such as T. S. Eliot must surely have had in mind when writing The Lovesong of J. Alfred Prufrock.

"...I am not Prince Hamlet, nor was meant to be;
Am an attendant lord, one that will do
To swell a progress, start a scene or two,
Advise the prince; no doubt, an easy tool,
Deferential, glad to be of use,
Politic, cautious, and meticulous;
Full of high sentence, but a bit obtuse;
At times, indeed, almost ridiculous--
Almost, at times, the Fool."

The stuff of good bureaucrats and effective military staff, with a touch of the common mailman. Excepting embellishment that indolent recuperation has allowed, this is verbatim, as those-who-know have written it. You can't, and really do not need to, make this stuff up.

Central Banking Publications
29 January 2008

"We are not panicking, are we?" ask the central bankers. (They don't KNOW yet? - Jesse)

Ben Bernanke has come in for a lot of stick for allegedly panicking in the face of stock market collapses but other central bankers are not acquitting themselves very well either.

Many of them were on duty – but off the record – at Davos last week. Messrs Trichet of the ECB, Geithner of the New York Fed, Carney of the Bank of Canada, Knight of the BIS and a gaggle of others. All stressed the extreme gravity of the situation. But they seemed completely at a loss when it came to policy responses. (Let's see, shall we prevaricate and cut rates, or jawbone and cut rates? - Jesse)

It must be better to cut rates decisively now, said one, even if we have to raise them again later. The costs of precipitating a banking collapse are so horrendous they far outweigh the risks of a little increase in moral hazard and the risk of stimulating inflation. Others nodded sagely. (Collapse? OMG, the Wall Street bonus money was at risk! - Jesse)

The old system that they thought they understood and to a degree managed has gone, said another. “Everything is on the table”; “the extent of this crisis is very far-reaching”. They welcomed initially the repricing of risk but this has gone far beyond that with the losses of the monoline insurers put at up to $150bn. (Everything? - Jesse)

Faced with what threatens to become not just a credit crunch but the biggest banking crisis in a generation, all they have are their poor little interest rate tools. They are all one-club golfers, after all. No wonder there is a new mood of humility about. (Bet me - Jesse)

Bernanke under fire

When at its emergency video conference convened by Ben Bernanke at 6 pm on Monday 21 January, the Federal Open Market Committee decided to lower rates by 75 basis points to 3.5%, the biggest single cut since 1982, it took the decision “in view of a weakening of the economic outlook and increasing downside risks to growth.”

Ed Yardeni, a well-known Fed watcher, says the FOMC statement should have read: “The Fed chairman panicked on Monday… He convinced all of us to vote for the rate cut except cranky old Bill Poole.”

Accusations of panic came from George Soros, the FT, The Economist and many other quarters. And far from cheering markets, only a few days later the Fed came under pressure to cut again by at least another 50 basis points at its regular meeting. What is going on? (Neo-Keynesians are such rate cut sluts - Jesse)

The first big cut came at the end of a day which saw shares in Asia and Europe plunge as investors dismissed President Bush’s plans for a fiscal boost, unveiled on Friday, 18 January, as largely irrelevant. After the overnight losses on Asian exchanges, European bourses followed suit. On January 21, The FTSE 100 lost 5.5% to 5,578, its biggest drop since the World Trade Centre attacks. the DAX was down 7.2% to 6,790 whilet the CAC 40 tumbled by 6.83% to 4,744.

The Fed top brass – people like Don Kohn and Tim Geithner – knew full well that they would be accused of a knee-jerk reaction to the markets, validating the growing view that Bernanke was following Greenspan in holding monetary policy in thrall to a Wall Street standard. But they were driven to act by fear of a cumulative and rapid collapse. ("Uh, can we have a heads-up for the next imminent collapse? - Jesse)

Yet it later transpired that the global stock market rout of 21 January may well have been triggered, not by fears of a US downturn as by the actions of one bank – Société Générale of France – as it frantically sold shares to unwind positions entered into by its rogue trader Jerome Kerviel in the course of accumulating losses initially put at €4.8bn ($7bn). (Le cover story? - Jesse)

Informed of this belatedly by the Banque de France, the Fed somewhat lamely insisted that they would have done the same if they had known at the time. (Yeah, and next time we'll tell mom. - Jesse)

What price central bank cooperation?

Central bankers were just breathing a collective sigh of relief that over Christmas and the New Year the collective action to relieve market tensions announced on 12 December had actually succeeded. Then they were hit by a new phase of the crisis – the sudden deterioration in the economic outlook for the United States, the stock market collapse, the SocGen affair, the monoline insurance crisis and widening losses at leading banks. ((But meanwhile the Fed was telling US 'all is well?' - Jesse)

Christian Noyer, the governor of the Banque de France, might say he is “not at all worried” about Société Générale, despite it falling victim to the biggest fraud in banking history. (Its only money. Yours! - Jesse)

But when the French central bank admitted that it had known about the fraud since the weekend (19-20 January), there were raised eyebrows in other central banks. Why weren’t we told?

Noyer’s late call to the Fed – and to how own government

On Monday 28 January Christian Noyer admitted that he was informed of the crisis on Sunday 20 January but delayed informing his government until the following Wednesday because he wanted to avoid the danger of leaks as the bank sold the position on the market. (Cherchez le Goldman Sachs. - Jesse)

Moreover, he insisted that SocGen’s actions in selling its positions had no influence on the Federal Reserve’s decision: “I consider that this affair has nothing to do with the monetary policy of the Fed,” he said. “It was a striking action but one that they took based on their judgment of the economic situation in the United States and so has nothing to do with European markets.” (Psych! - Jesse)

“The Fed does not decide its monetary policy actions, particularly not its exceptional ones, because of the situation on European markets in one day. That’s nonsense.” Thus central banks have started the year on the back foot, increasing moral hazard and giving a public demonstration of how not to cooperate. (Life imitates high school. - Jesse)

Sarkozy/Lagrande to lead calls for tighter regulation

When in doubt, call for more regulation. Inevitably, continental central bankers and politicians have seized on the banking crisis to call for more regulation. Noyer has already highlighted three areas in which the regulation of rating agencies needs to improve in the wake of the credit crunch: the degree of transparency in rating methods and the overall role of rating agencies in the securitisation process; whether to change the metric used for rating bonds and structured products and introducing a specific rating for liquidity risk. (Non-competitive! We risk losing important financial business to better organized crime - Jesse)

But regulation of ratings agencies and hedge funds are seen as yesterday’s agenda. Newsmakers expects France to use its presidency of the EU in the second half of this year to press hard for much greater harmonisation of financial regulation in the EU, including London…” (les renegade roast-boeufs, les vaches folles. LOL - Jesse)

Sovereign wealth funds hit back

Heads of the top sovereign wealth funds from the Gulf states, Russia and other emerging markets were in fighting mood in Davos.

Leading the calls for tighter regulation and codes of conduct was Larry Summers, the former US treasury secretary. What would happen in a 1992-type situation, he asked, if SWFs were involved in speculating against a currency as George Soros speculated successfully against the pound? It would create intolerable diplomatic tensions. We need ex ante assurance that this type of situation will not happen. That is why we need a code of conduct. (The IMF and World Bank have exclusive franchises for that - Jesse)

Not so, retorted the funds. We have always been and remain responsible investors. We do not need any of your codes of conduct imposed on us.

On the contrary, it is up to you in the heartland of your famous capitalist system to get your act together. You have lectured us for decades on the need for tighter bank regulation, anti-money-laundering rules and so on and now you are in a bigger mess than we ever got ourselves into. It is your banks who are coming cap in hand to us because they made such a mess of their business under your much-touted regulatory regimes. Get your own houses in order…. (After all we have stolen from you, and this is the thanks we get? - Jesse)

It is the revenge of the emerging markets."

Daily coverage of general central banking developments is available to subscribers through our website: Central Bank News

In Luke 16:19-31, when the beggar Lazarus dies he went to Heaven, while the rich man, Dives, went to Hell. Dives wanted to warn his brothers and asked Abraham if Lazarus could be sent back to tell them. Abraham refused. "If they hear not Moses and the prophets, neither will they be persuaded, though one rose from the dead."

What more can we say? Sleep well.

Crash: the Rally that Fails as Hallmark of Major Market Dislocations

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.

Société Générale - The Lone Trader Theory

After a rogue trader cost the French bank €5 billion, many are left to wonder about the lucrative but risky equity-derivatives business. Is this all a clever cover story for 'les SIVs de merde,' or did a lone bank trader, not even a central banker, wielding his Mannlicher-Carcano trading platform, almost take out the entire world's financial system without a proper bonus, a golden parachute, or even a corner office?

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.

High Priests of Finance Review Société Générale Markets Fraud

From Times Online
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".

The Mother of All Bull Markets

An absolutely amazing chart, if you think about it, and its implications. Recall that as the price goes up, the yield comes down.

Yes, there is a double entendre in that title.

US recession, Fed Funds Cut to 2.25%

NEW YORK, Jan 22 (Reuters) - UBS now sees the United States in a recession in the first half of 2008, as the persistent housing slump and financial market woes have spread into the broader economy, the investment bank said on Tuesday.

UBS also revised its forecast on how far the Federal Reserve would slash the key federal funds target rate to 2.25 percent later this year in a bid to revive growth.

U.S. gross domestic product is expected to contract 1.0 percent in the first quarter and 1.5 percent in the second quarter before growth in the second half of the year, UBS said in a research note on Tuesday.

Meanwhile, UBS said the Fed would lower the fed funds target to 2.25 percent before the end of the third quarter, compared with its earlier forecast of 3.25 percent.

The bank said in a research note that it does not expect the U.S. central bank to opt for an intermeeting rate cut "without a crash in the equities market."

(Does the recent inter-meeting rate cut and crash in progress count, or should we be looking for another one later on? J.)

Economic Recession Unlikely

Economic Recession Unlikely: Congressional Budget Office
Wed Jan 23, 2008 9:24am EST

WASHINGTON (Reuters) - The current U.S. economic slowdown will not turn into a recession and the economy will likely rebound next year as housing and financial market turmoil fades, the Congressional Budget Office forecast on Wednesday.

"Although recent data suggest that the probability of a recession in 2008 has increased, CBO does not expect the slowdown in economic growth to be large enough to register as a recession," the nonpartisan congressional budget analyst said in a new forecast.

"CBO expects the economy to rebound after 2008, as the negative effects of the turmoil in the housing and financial markets fade," the budget and economic report to Congress said.

Saving Private Greed

Fed Emergency Rate Cut of 75 Basis Points
First emergency rate cut since the 9/11 terror attacks.

WASHINGTON (Reuters) - The Federal Reserve on Tuesday slashed a key interest rate by a hefty three-quarters of a percentage point, the biggest cut in more than 23 years, after a two-day global stocks rout sparked by fears of a U.S. recession.

The move, a rare one made between the U.S. central bank's regularly scheduled meetings, took the federal funds rate governing overnight lending between banks down to 3.5 percent, its lowest level since September 2005. The Fed also lowered the discount rate it charges on direct loans to banks to 4 percent.

"The Fed is very, very, very worried," said John Tierney, an analyst at Deutsche Bank in New York.

The Fed's bold bid failed to instill confidence in shaken financial markets as U.S. stocks, playing catch-up with sell-offs around the world, fell sharply at the open. The Dow Jones industrial average (.DJI) was down about 1.1 percent in late morning.

Prices for U.S. government bonds slipped, while the dollar fell sharply against the euro.

"The committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth," the Fed said, referring to its policy-setting Federal Open Market Committee.

"While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households," it said.