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Mayday and Black Swans

Bob Moriarty
May 8, 2009

One of the more successful trading theories for the general stock market is to sell in May and go away under the theory that stockbrokers start taking vacation in May and June. I suspect that will be a very profitable move this year.

Investors need knowledge to trade at a profit. In essence the most money goes to those with the most complete knowledge. In two areas today investors need more complete knowledge and I don't think they have it.

Few people actually understand what a "Black Swan" is. You need to because we have a flock of them on the horizon. The term comes from Nassim Nicholas Taleb and was first defined in The Black Swan: The Impact of the Highly Improbable.

A black swan as defined by Wikipedia is a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations.

The best example I can possibly come up with would be the latest Swine Flu panic. Three weeks ago it didn't exist. Two weeks ago it burst into existence and had the world in a panic for a week before someone realized we always have a flu bug floating around and flu sometimes kills. The Swine Flu was a Black Swan event. Unpredictable, rare and large impact on society.

Of much more consequence would be the dangers from derivatives. I've talked about derivatives for years and I suspect most people still don't understand them or the danger they pose to the world economy. I want to show in simple terms the dangers. A new BIS number on OTC derivatives is due in a couple of weeks. I think derivatives are still growing like a cancer totally out of control.

Derivatives are, first and foremost, financial instruments that derive their value from other instruments. A contract of 100 ounces of gold is not a derivative yet an option on that contract of gold is. A Credit Default Swap is a derivative where you make a bet on the likelihood of bonds defaulting from a company. You can make bets on fixed rate mortgages compared to variable rate mortgages or wager on currency swaps.

I need to make two very important points. One is the danger simply from the size of the market and the other is the danger from the nature of the bet.

Let's pretend you are rich and you shoot craps. You go to Las Vegas to the biggest casino there with your wad of money. You go to the manager and ask him if you can bet all your money on a roll of the dice. You will roll until you either make your point and win or crap out and lose. You put your life savings on the line, a million dollars and pick up the dice.

With a million dollars you have two options, you can either win your bet or lose your bet. Those are the two options.

Another bettor with deeper pockets might go into the casino and make the same bet with a billion dollars. And you either make your point and win or crap out and lose, same two options.

But what if someone really rich walked in with a trillion dollars and wanted to make the same bet. I can assure the casino will be thrilled to take the bet. The person picks up the dice and rolls them with a trillion dollars on the line.

What's the only one thing that can happen?

Right. The shooter has to lose. There is no casino in Vegas or anywhere else that can cover a trillion dollar bet if they lose.

Like AIG, they are happy to make the wager, knowing they can't pay off. The size of the bet has introduced an entirely new concept. That of counterparty risk. So when you KNOW the market is going to crash and gold rocket, you might put half your money on S&P puts and the other half into GLD, the Gold ETF.

What if you are dead right, the S&P drops 50% overnight because the US defaults on their $65 trillion in debt and gold goes up 50% in a day. How much money do you make? The answer may surprise you.

You have to take counterparty risk into account. While the S&P futures are derivatives and are entirely fictional, the ETF is supposed to be backed by gold. But what is the chance of your counterparty defaulting. In a 50% move in either gold or the S&P, the counterparty risk goes through the roof. It's the black swans of all black swans and cannot be bet on.

I can't find a good number for the value of all the assets in the world but it's probably something like $150 trillion dollars. With $684 trillion in derivatives, it's entirely possible, indeed probable that more money has been lost than exists in assets in the world.

There is another issue to derivatives that I have never seen discussed by anyone. When you make an investment, that investment affects the likelyhood of the event transpiring. That's sort of a convoluted way of saying something quite important.

Here's an analogy. Let's say you own a horse-racing track and you want to improve your profits. You hire a bright young MBA spark right out of Business School. He looks over your operation and says you are using horse and buggy thinking as it were.

You need more bets for the punters. Let's say you introduce a new bet entirely. A bet on the 3rd horse in the 4th race getting shot just before crossing the finish line.

As a serious guy with lots of experience in horse racing you tell the bright young spark that it's an insane bet that no one would make because it's never happened before. He smiles and tells you that if you make the payoff high enough, the chumps will bet on anything.

So you make the payoff a million to one. A week later the MBA smiles as he shows you the latest numbers. There is a billion dollars bet on the 3rd horse in the 4th race getting shot just before crossing the finish line. You just hauled in $1000 for doing nothing at all. It's found money.

You have another race and this time you get a trillion dollars bet on the 3rd horse in the 4th race getting shot just as he crosses the finish line. You smile in glee as you rake in a cool million bucks for doing nothing.

This is getting interesting; with the next race you go up to 100 trillion dollars in bets on the 3rd horse in the 4th race getting blown away just as he crosses the finish line. You are mentally counting the 100 million you stand to clear just as the race finishes.

Guess what happens? Some fool pulls out a .45 and blasts the horse and now you are bankrupt. Of course, it never occurred to anyone that if you could bet on a negative event transpiring, the bet itself increases the odds of the event happening. With Credit Default Swaps, you can bet on Lehman Brothers going bankrupt at the same time as you pull out your .45 and make it so.

If the BIS announces an increase in OTC Derivatives in a couple of weeks, a total financial collapse is guaranteed. Even the person who came up with the concept of CDSs recently announced that the instruments should be hung, drawn and quartered immediately, or words to that effect. CDSs are the spawn of the devil.

The US dollar, bonds and the general stock market are about to crash. Sell in May and go away. There is a fair chance the senior gold stocks and senior silver stocks will trace the DOW and S&P. Juniors are still historically cheap but if you have big profits in any stocks, think about taking some money off the table.

Bob Moriarty
President: 321gold

321gold Ltd