The Insightful Trader

Archive for March, 2010

Higher Move in Interest Rates Not Necessarily Bad for Market

by on Mar.29, 2010, under Market Commentary

The stock market, as we all know, has made one of its quickest and largest recoveries ever in history, over the past year. This move has been aided in great part, by an abundance of cheap money. Since the Fed and the Treasury have turned on the spigots, standing in front of this uptrend in hopes of a reversal back to newer and lower lows, has been an exercise in futility.

As we close in on the important 62% Fib level on the S&P, as well as several key resistance areas on the DJI, we are starting to see signs that the market has become over bought in the near term from a technical perspective. After a brief respite from it’s climb in January, the market has resumed it’s recovery with a vengeance, now having gone nearly 30 days without even a 1% pullback, much less a more serious correction. And it has done this with declining volume throughout the entire move up for the past year. So caution has become the new watchword as traders and investors wait for the so-far, never coming pullback.

The end result is you have three groups of participants in the game now: those who bought into the move in the early phase and are extremely happy, those who have missed a large part of the move up are but are now eagerly awaiting a pullback so that they can get into the game and thirdly, those who think the whole move up is simply a correction in a major new downtrend and can’t wait to pounce once selling begins, hopefully soon, since some are probably already underwater on short positions. Of these three groups, 2 of the 3 are eagerly looking for topping signs or if not finding many lately, reasons why it should be topping soon.

One of the more prevalent reasons I’ve heard lately, besides certain overbought indicators, has been the recent climb in interest rates to a small degree and the expected greater increase as governments all over the world, but especially ours, have a lot of refinancing to do, as well as plenty of new, in our case. So the pervasive argument is that as rates move higher, this will make stocks less attractive. There is no doubt  that we could be close to breaking a 20-30 year general down trend in interest rates, but I think a look at the charts below may surprise you.

US Treasury 20 Year

Click Here for a larger image

As you can see in the chart above I’ve highlighted the areas where the 20 year rates were moving up. You can also see the SPX in the top of the chart and it’s performance while rates were moving up. I can see no correlation in the past 20 years that rising rates had a negative effect on the market. Now obviously at some point, if we reached rates like in the late 70s and early 80s with rates above 10%, then it may become a different story.

Below we have similar results looking at yields on the 10yr notes.

US Treasury 10 year

Click Here for larger image

The net result that  is that those thinking a move up in rates will be  the trigger for a pullback they’ve been looking for may be disappointed. We may certainly get a correction soon, but I don’t believe it will be because of interest rates. Now there are always those that may argue that traditionally when rates move up it’s because the economy is growing.  Therefore it’s normal that the market moves up then also but that this time it’s for a different reason that rates are moving up, more supply than demand. I think we’ll know soon enough.

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NY Times blogger William Cohan Hearts Poor, Abused Goldman Sachs

by on Mar.07, 2010, under Editorials

In a story that smells awfully like a press agent’s plant, New York Times blogger William Cohan apparently decided it’s time to rehabilitate Robert Freeman. Once the partner in charge of Goldman Sachs’s (GS) risk arbitrage department, Freeman pleaded guilty to one count of mail fraud (the case was actually about insider trading) and served four months’ jail time in 1990.

Cohan tries to prove that Freeman was the victim of a prosecutorial “witch hunt.” Is he also trying to say that public opinion is also tarring GS unfairly now? Hard to say, but why else would anyone bring up Freeman of all people, twenty years after the fact?

No one doubts that Rudolph Giuliani, then a crusading US Attorney, played hardball and made some crucial errors in going after white collar crime on Wall Street. Nevertheless, Freeman admitted to breaking the law on insider trading, and the case seemed pretty clear.

Therefore I don’t see how Cohan can call Freeman’s prosecution a “witch hunt.” The more accurate metaphor would be a “fishing expedition” that expanded perhaps too far afield from its central targets: uber risk arbitrageur Ivan Boesky and Michael Milken, the wildly successful junk bond promoter at Drexel Burnham Lambert. Freeman proved to be unlucky but not exactly innocent. A guilty bystander, as it were.

Here are the facts that matter, whether Cohan likes it or not:

As Cohan states, risk arbs in those days did a great deal of research on the phone, trying to ascertain the latest news, the small details, the so called “color” of the deal related stocks they were trading. New color could cause a significant move in the stock, and sometimes provided clues that researchers could assemble into a mosaic of intelligence on whether deals would close.  On the other hand, arbs could take things only so far: SEC rule 10b-5, forbids trading on “material, non public information.”

In the case that ended his GS career, Freeman bought shares of Beatrice Foods, which Kohlberg, Kravis, Roberts (KKR) was in process of taking private in 1986. After Freeman bought, rumors leaked that the deal was not working out. So Freeman did his job and hit the phones to learn what he could. He spoke with Bernard “Bunny” Lasker, a former NYSE chairman, who suspected the rumors were true. Freeman cut his stake in Beatrice. Then Freeman talked to Marty Siegel, an investment banker who represented KKR. (Siegel eventually went to jail for selling inside information to Boesky.)

Siegel confirmed that the Beatrice deal was in trouble, with the now classic line, “Your Bunny has a good nose.” At which point, Freeman sold his Beatrice call options (and some more of his stock, too depending on which account you read), in clear violation of the law. When KKR announced it was reducing the cash portion of its offer for Beatrice, the share price fell. Freeman may have had reason to fear for the option position: if the calls were short dated and near or out of the money, they might have gone worthless on the news.

Wall Street firms have elaborate controls to prevent trading on inside information when they have it. I suspect GS procedure would have required Freeman to tell the firm’s lawyers about his chat with Siegel, at which point GS would likely have considered itself to be “restricted” in its trading of Beatrice shares until the information became public. (If any readers worked at GS then you are welcome to weigh in about this.)

Furthermore, key court precedents established that trading on inside information is forbidden when that information was obtained in a “breach of duty.” That’s common knowledge among Wall Street professionals.  In this case, Siegel, a banker who represented KKR, betrayed KKR’s confidence by passing privileged information to Freeman. As clear a case of a breach as you can find. And yes, Cohan omits this issue from his article.

What Freeman did was illegal and really, really stupid. Yet notwithstanding all this, Cohan says that Freeman deserves a presidential pardon. Yeah, right.

One of Cohan’s whoppers – and this one destroys the credibility of his whole article – has to do with his treatment of Marty Siegel – and by extension, Giuliani. Cohan insinuates that Siegel was an entirely unreliable witness and that Giuliani went out and arrested all the subjects of his insider trading investigations, including Freeman, based on Siegel’s say-so, without corroboration.  Was Giuliani really that foolish? Well, no, not really.

Along with Drexel banker Dennis Levine, Siegel turned state’s evidence on Ivan Boesky, who was certainly dirty. Boesky in turn helped finger Milken (a prosecution that leaves me uncomfortable to this day) and many others. The Boesky and Milken cases were among the biggest white collar prosecutions of the decade, front page news that went far beyond the world of finance. After winning these cases Giuliani ran for Mayor of New York and won. Incredibly, Cohan omitted any mention of Boesky or Milken.

In other words, Cohan failed to tell his readers that Siegel had hit pure gold for Giuliani. Giuliani had every reason to take Siegel seriously.

Having said that, Cohan correctly judged that Giuliani overreached. Giuliani blundered badly by failing to corroborate Siegel’s assertions sufficiently before arresting Tim Tabor and Richard Wigton, both of Kidder Peabody, and then Freeman. Neither Tabor nor Wigton went to trial – the cases fell apart before that – but neither man worked on Wall Street again. Giuliani had ruined them.

So Cohan may well be right when he says that  Giuliani did everything he could to nail Freeman once the Tabor and Wigton cases proved weak. A contemporaneous Times editorial concurred, saying that Freeman was “abused.” But odious as these facts are, they don’t erase what Freeman did.

Cohan also tries to dance around Freeman’s guilt by saying that Freeman got caught only because his subordinate was given immunity in exchange for testifying against Freeman. But that’s standard procedure in any investigation: prosecutors threaten little fish with stiff sentences to get evidence against big fish. More cogently Cohan notes that several other allegations against Freeman proved false. Which may be why even the judge who sentenced Freeman termed him, “basically decent.”

Here’s an intriguing nugget Cohan noted but didn’t pursue. Apparently Freeman’s position limit was $50 million. Yes, quaint as it looks now GS partners really cared about sums that size back then, especially when all of them were potentially liable for the firm’s mistakes. Yet Freeman risked $66 million on Beatrice including his stock and options positions. Did Freeman’s partners know of the limit violation before the investigation?

If not, one could understand how Freeman might have been driven to sell Beatrice options before the bad news hit the wires: fear that his partners would see that Freeman’s excessive risk taking brought with it excessive losses, which is exactly what position limits are designed to prevent. Or maybe Freeman got prior permission to exceed the limit, but wanted to avoid embarrassment when his big bet went bad. Either way, the risk of an insider trading scandal was greater than that of a trading loss, but even very smart traders make mistakes under pressure.

GS lawyers defended Freeman, but then, according to Cohan, Freeman copped his plea to avoid further anguish for his family when Giuliani threatened to bring racketeering charges. So Freeman served only four months; Judge Pierre Leval suspended the rest of the one year sentence and fine him $1 million. The Times actually approved of that sentence when it came down, saying that Freeman deserved “a taste of prison” but also citing Giuliani’s “outrageous tactics.” My sentiments exactly, but that was back in the day when the Times was more able to call things as it saw them.

As for Goldman, it came up smelling like a rose. Giuliani never brought charges against the firm, and so it was spared the fate Giuliani had visited on Drexel Burnham. But in hindsight it would likely not have gone any other way.

GS management committee member Robert Rubin, also Freeman’s boss and mentor, moved up to vice chairman in 1987 during the Freeman investigation (in 1990 he became the firm’s co-head) and Rubin never paid for any of the things that went wrong on his watch. These would include the insider trading at GS, the financial deregulation Rubin championed as Treasury Secretary,  and the de facto bankruptcy at Citigroup (C) where Rubin was vice chairman. Just a thought.

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