Jun 08/15 – The Market Gods are a cruel sadistic bunch

2015-06-08 9am EDT  |  #bonds #Chanos #employment #Fed #Kynikos #Triple Crown

Friday’s US employment release pushed the Federal Reserve one step closer towards the first rate hike in over a decade. The change in non-farm payrolls came in at 280k versus an expected 226k. More importantly, the average hourly earnings nudged up to 2.3%. All in, it was a solid report with almost all aspects heading in the right direction. Tim Duy’s Fed Watch blog had a great summary of the different employment indicators that Yellen keeps an eye on to judge the state of the labour market.

The market’s response to the strong employment report was to push short term yields up to the highest level in over a month:

Although the Fed will be loath to raise rates at the coming June FOMC meeting, this report increases the odds they hike in September. I have long said the Fed will give the market plenty of clearly telegraphed signals about the timing of the first rate hike, so if they are set to raise rates, a June signal for a September hike makes a lot of sense.

It should be interesting to see if the FOMC committee is serious about tightening policy based on an improving employment conditions even though inflation is running below target. Every previous tightening cycle has started with inflation at least at the Fed’s target rate (if not above), so this would be a ground breaking rate hike if it were to occur.

I don’t know what the Fed will do, and I doubt anyone else does either. My suspicion is the FOMC committee members barely know themselves.

It is becoming increasingly more difficult for the Fed to justify their ZIRP (zero interest rate policy). Look at those employment charts at the top of the post – the economic crisis has long past. Yet inflation is stubbornly low. The Fed is not achieving their target inflation rate and hiking rates will not help that situation.

We know Yellen would most likely delay hikes until both inflation and employment were running hot, but although she is the Federal Reserve Chairwoman, the decision is still made by committee. There are plenty of other committee members who believe that monetary policy operates with a long lag, and that the time for the emergency ZIRP is long past.

It is ironic that the employment report was so solid. This makes last week’s plea from IMF’s Christine Lagarde for the US to hold off raising rates all the less likely. It is like the Market Gods purposely responded to her unusual demand with an economic report that makes that course of action the most problematic. The Market Gods can often be a cruel sadistic bunch. It’s like after seeing Christine’s comments, they got together and said to themselves, “how can we make this as awkward as possible for everyone? I know – let’s make the employment strong enough to make it difficult for the Fed to not raise rates.”

Market Gods in action

Don’t believe me about the Market Gods’ cruel nature? How about this week-end’s Triple Crown horse race?

Bloomberg writer David Papadopoulos wrote a terrific piece titled the “The Breathtaking Foolishness of Triple Crown Bettors”.

When the great Spectacular Bid entered the starting gate for the 1979 Belmont Stakes, the gambling public was convinced he'd romp to victory and become horseracing's 12th Triple Crown winner.

This horse couldn't lose. No way.

The jubilant crowd bet him down to odds of 1-to-5 that day, and in so doing, effectively assigned him a stunning 66 percent chance of winning (after factoring in the track's cut). He would finish a well-beaten third. Two years later, Belmont bettors liked Pleasant Colony's chances of pulling off the feat too: 47 percent. Funny Cide was given a 43 percent shot in 2003. Smarty Jones the following year: 64 percent. Big Brown? Oh he was going to be an easy winner as well — 65 percent.

When all of the failed Triple Crown bids during this 37-year drought are examined together — 12 of them to be exact — the magnitude of the gambling public's foolishness is breathtaking. Add up the percentages and they show that, in the crowd's estimate, the probability that at least one of those 12 horses would win the Belmont was 99.97 percent. Or expressed differently, the chances that none of them would pull it off were just 0.03 percent. That's 1 in 3,333.

So either we've witnessed one of the greatest series of random outcomes in the history of sporting events or the crowd is really stupid when it comes to wagering on the Belmont Stakes.

I'll sign up for the second of those two theories. Caught up in the hype and emotion of the moment, gamblers wildly overbet their hero. As they do, they disregard all the challenges that the horse has to overcome: a marathon distance (1 1/2 miles) that he has never tried before and never will again; a grueling Triple Crown campaign of three races in just five weeks; and a field of fresh and rested rivals at Belmont.

This article was a terrific piece that did an excellent job of showing the market’s glaring mis-pricing of this horse race. Every bit was bang on correct. David’s conclusion made perfect sense:

But before you plunk down $1,000 to win on Pharoah at odds of about 1-to-2, remember that the math is working against you. Remember that you're buying an overvalued asset.

Rather than bet on our hero at that price, I'll be putting down a few bucks on one or two of his rivals. Colts like Materiality, Frosted and Mubtaahij all loom as upset threats (more on them and the rest of the would-be spoilers on Friday).

If the big horse is wildly overvalued in the race, then these others will be undervalued. That's how parimutuel wagering works. Don't be sucked in by Triple Crown mania. Use it to your advantage instead.

And of course, just when a pricing inconsistency is noticed, the Market Gods decide it is time to send everybody back the other way. For the first time in 37 years, there was a Triple Crown winner this week-end.

Next year, David’s article will be replaced with all sorts of accounts of the glory of having a winning ticket of a Triple Crown winner. Rest assured, there will be no articles talking about the inconsistencies of betting on the potential Triple Crown winner. The Market Gods never make it that easy…

Stupid fiduciary of the day award

Last week, I came across this funny report about the Philadelphia Pension Board’s recent investment decision. From Bloomberg:

Philadelphia's pension board voted to pull its money from Jim Chanos's Kynikos Associates after losses in April that prompted a finance director to ask "what went wrong."

The board voted unanimously to pull the pension's $25 million investment in the Kynikos Opportunity Fund after the fund lost about 4.7 percent in April, according to the minutes of a pension board meeting. Kynikos lost money betting on declines in China and shorting companies it viewed as having accounting problems or financial distress, the minutes show.

Kynikos Associates is a money management firm specializing in short selling. Chanos is the first one to warn they will have losses as equities rally. The fact that the Philadelphia Pension Board is pulling money from Kynikos should send a chill deep into the bones of every long term equity bull out there. This is the sort of stuff you see at market tops. The board will probably be having a meeting in a couple of years to discuss why they were over exposed to equities. How could their long managers not protect them against the decline? What went wrong? Well, I can tell them right now what went wrong. They are boneheads.

Thanks for reading,

Kevin Muir

the MacroTourist