Dr. Michael Burry saw the mortgage crisis coming from miles away. He was featured in Michael Lewis’ “The Big Short”, along with others who also saw the debacle coming. This year, Dr. Burry was keynote speaker at the 2012 UCLA Dept of Economics Commencement. It’s a speech well worth listening to. Dr. Burry is quite pessimistic about the future of U.S. as the debt-to-GDP ratio rises to levels higher than that of Greece. And the problems are no longer in the future, he says, but they have already begun to manifest themselves throughout society.

Perhaps most shocking to some (unless you’ve already gotten used to the TSA groping children)… he describes what happened to him after he wrote a New York Times op-ed criticizing the actions of the government and the Federal Reserve ( I Saw the Crisis Coming. Why Didn’t the Fed? – NY Times ). Within weeks all 6 of his funds were audited, he was compelled to provide Congress with every email he wrote since 2003, and the FBI showed up at his door. He wasted thousands of hours and over $1 million in legal/audit fees defending himself against a frivolous witch hunt against someone with clout who dared stand up and say “I saw it, why didn’t you?”

While not one bankster has ended up in jail, banks have collectively been given $$ TRILLIONS more of our money. And instead of consulting with truly smart and insightful people like Burry (instead of the crooked bankers themselves) as to how such events can be avoided in the future, our government offensively attacks those who predicted the crisis well in advance.  Instead of seeing people like Burry as able to offer true wisdom and insight, they treat him as if he had somehow played a part in masterminding all the pervasive and massively over-leveraged mortgage fraud that went on.

Another great quote from his speech: “As it turns out, information is not perfect, volatility does not define risk, markets are not efficient, the individual is adaptable.”

As a final note, here’s another great bit of Burry’s insights I’ve kept on hand since reading “The Big Short“:

‘ In Dr. Mike Burry’s first year in business, he grappled briefly with the social dimension of running money. “Generally you don’t raise any money unless you have a good meeting with people,” he said, “and generally I don’t want to be around people. And people who are with me generally figure that out.” He went to a conference thrown by Bank of America to introduce new fund managers to wealthy investors, and those who attended figured that out. He gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions. “By and large,” he later put it, “the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below-average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents presents opportunity, not risk, and that the dollar is still worth a dollar.” He was greeted by silence and ate lunch alone. He sat at one of the big round tables just watching the people at the other tables happily jabber away. ‘

In late 2011, once the market bounced off its early October lows, there was increasing chatter over how it’s probably too early for a real full-blown European debt crisis at that point in time, and how the “powers that be” would likely run the market higher into the new year.  But, the real “tell” would be how the markets behaved come the new year, and that’s when all hell would likely break loose all over again.  I too began to think that while the rest of 2011 may lead to a good bounce in the markets, early 2012 could bring back some real turmoil.

Then a thought struck me.  Between all the blog posts, newspapers, and television media pundits calling for a “let’s see how January goes” moment – hey, even I myself was thinking the same thing…  What if, with all of us worrying over that same possibility, January turned out just fine – a perfect “non-event”?  And heck, even Ben Bernanke was probably worried about the new year, and we all know what that leads to: more cheap money and credit would likely be dumped right back into the markets at the first hint of trouble.

So as 2011 came to a close, while I did sell a few positions just in case, I decided to leave most of my longer-term positions as is.  And, while hindsight is always 20/20, that did turn out to be a great decision.  Of course, we never know for sure, and that’s why traders and investors must consistently practice sound risk management.  One must always protect against the times we miss.  And it not only serves to protect and preserve your bankroll, but it also helps provide the clarity and peace of mind necessary – an edge in itself – to properly consider and evaluate the information available to you. Worrying if your over-leveraged position might blow up in your face is not going to help you make a smart decision.

Traders and investors alike must always be open to taking every piece of relevant information into consideration, including our own preconceived notions and biases.  As Ray Dalio of Bridgewater Associates once said “I constantly want to know what I don’t know.  I want to know when I am wrong.  And it helps when someone points it out.”  While it certainly helps if someone else points it out, we can also objectively look at our own thought process, feelings, and emotions and consider how they too may be wrong or dangerously biased.  This in itself becomes part of a valid trading edge.  Everything counts, and we are often our own worst enemy in most endeavors we pursue.  As in playing chess or poker, those players who patiently take a step back in order to “see the bigger picture” and contemplate the best moves will, in the long-run, always triumph over those less savvy players just itching to make a move.

We should always ask ourselves what do other traders think they know.  What are they worried about or afraid of and to what extent?  Am I starting to feel worried or nervous myself, and are these thoughts rational and based on sound reasoning?  There was a great line in the movie Margin Call when CEO Tuld (played by Jeremy Irons) says “It’s not panicking if you’re the first one out the door.”  Granted, no one (and no firm) should ever be leveraged to that extent in the first place, but from his “clear” perspective the mortgage game was up.  And you certainly don’t want to be the one panicking out at the bottom of a move, with or without margin calls over your head.

Am I afraid that if don’t buy some stock tanking like a “falling knife” right now, I’ll miss the huge bounce coming right around the corner?  Is it possible many other traders are thinking the same way?  The reality is that it’s rarely “too late” to get a better price when buying into a crashing stock.  When the price action settles down, stabilizes, and starts to rebound, the stock will probably still be priced below your initial entry.  Sometimes our own feelings can give us strong clues as to what the “crowd” is thinking as well.  There was no need to predict ahead of time that October 4^th, 2011 would be the low of the last crisis and panic.  However, through awareness of our own feelings, astute observation into the collective thoughts of others, and by watching the price action in relation to the current headlines, we are continually provided with clues as to what is more likely to happen next.  For example, each time new headlines appeared about Greece and its debt problems, the chatter they generated seemed to lead to increasingly complacent market action and behavior.  There would be short-lived dips that would quickly recover, as if no one really cared any more.

And more recently, how has the market reacted as we’re hitting new multi-year highs?  Ironically, the VIX (fear) index (and even more so, the publicly traded VXX index based on the VIX futures) has been acting more fearful of a potential coming crash the higher the market goes.  Markets don’t generally crash right after making new highs, unless they’ve just gone through a high-volume blow-off top.  I recently read a study analyzing future market behavior when there are strong upward moves in both the VIX/VXX and the overall market in the same day.  The study showed that it has lead to even stronger upward price action in the near future.  And so far in 2012, that’s exactly how things have played out in the market.  But human behavior is not rational, and memory of the recent volatile past is still imprinted in traders’ minds.  So with each new high in the market, traders buy the VIX products expecting a crash that never materializes, and are then hit over the head with some of the highest levels of contango (the huge cost of rolling over current futures and options contracts to the next month) the VIX market has ever experienced.  And of course, traders are also greeted with another leg up in the market as well.  Never has it been easier for me to explain or visualize the term “climbing a wall of worry”.

In reality, it is the unexpected shocks that lead to the most “real” fear.  Especially where credit and leverage is concerned, it is these quick shocks that are most likely to catch firms (such as MF Global) unprepared and caught with their pants down.  But the more time that goes by with an event in the forefront, the longer the world has to deal with it, adjust by preparing for the worst, and “get used to” the new norm.  Just remember back to the Japanese nuclear crisis, the BP oil spill, or even more recently, the fears over a massively understated Greek CDS credit event once the ISDA declared the Greek bond “re-pricing” a credit event.  Banks, governments, and central banks have now had upwards of eight months to deal with the possibility of messy CDS defaults.  While there were some pundits calling for the possibility of three trillion dollars worth of losses versus the three or so billion claimed, it was likely that “the powers that be” had all the time they needed to deal with these issues.  And, believe it or not, the ISDA CDS auction also came to pass without incident.  That’s not to say there aren’t plenty of roaches crawling around everywhere.  But just as Countrywide Financial and Morgan Stanley were rolled into Bank of America to perhaps conceal a much worst debacle in the sub-prime mortgage market, the “powers that be” have likely had enough time to take similar measures to deal with any more potential blow-ups in the Greek bond market (well, at least for the time being).

In conclusion, always consider all the information available to you, be aware of what you don’t know, and consider where you might be flat-out wrong.  Seek to develop the focus and patience to position yourself in the best possible way, as opposed to merely trying to capture the next small wiggle.  Instead of missing out or being incorrectly positioned, you may provide yourself a much better chance to capture a nice chunk of the real move about to appear just around the bend.

(Robert Sinn) “When the economic data and financial markets soften the Fed strikes a more dovish tone, and as we saw yesterday when things improve the Fed Chairman does not mention the idea of additional stimulus and acknowledges the potential for a short term spike in inflation due to higher gasoline prices.”

Bernanke says, “Since these projections were made, gasoline prices have moved up, primarily reflecting higher global oil prices – a development that is likely to push up inflation temporarily while reducing consumers’ purchasing power.” And despite the fact that Bernanke didn’t mention “quantitative” once — here or anywhere else in his testimony — the media was quick to hype the Fed’s mere acknowledgement of “potential inflation” as a change in stance.

Full Story: Bernanke’s Poker Game (RobertSinn)

However, the majority of the mass media conveniently overlooked the real story of the day…

(WSJ) “The European Central Bank handed out €529.5 billion ($712.81 billion) in cheap, three-year loans to 800 lenders, the central bank’s latest effort to arrest a financial crisis now entering its third year.

Wednesday’s loans were on top of the €489.2 billion of similar loans the ECB dispensed to 523 banks in late December. The ECB’s goal is to help struggling banks pay off maturing debts and to coax them to lend to strained governments and customers. The takeup of this week’s loans was roughly consistent with what bankers, investors and analysts had expected.”

Full Story: ECB Gives Banks Big Dollop of Cash (WSJ)

WOW! So the same day Bernanke is noticing some possible inflation, most news sources completely overlooked one of the greatest liquidity injections ever on the very same day… And in hyping up the wrong story to “help” cover it all up, the media also gave these same banks the opportunity to park their free cash right back into the stock markets at a short-lived “NO QE3″ discount.

(Jim Sinclair) “Because of the volatility you experienced in gold today, and the absolute fact that it was an MSM cover operation of today’s covert operation, which was one of the largest injections of QE liquidity into the Euro banking system ever, you must know the facts.”

“If, in fact, what Bernanke attempted to tell the investment world today, that QE may not be necessary because of a modest improvement in the statistics of unemployment, if that was truly to be believed, then the stock market should have been off 800 points while gold was gold was down $100.  Because the same thing moving the stock market is what’s moving the metals and that is pure liquidity.”

Full Story: Today was a Cover-Up By the Fed & Mainstream Media (JimSinclair)

So for those of you worried about an end to quantitative easing, alleviate your fears. QE and cheap easy money for the well-connected kleptocrats is alive and well and not likely to end all that soon…

(GlobeInvestor) “ETNs expose investors to the risk of losing all or most of their principal. That’s because ETNs are set up as unsecured, long-term debt obligations of the issuer, Ms. Pelant explains. ETF investors don’t face the same default risk because ETFs own a pro rata stake in a basket of stocks, bonds, or derivatives held by a custodian in trust and legally separate from the issuer, she says.”

“When Morgan Stanley’s viability came under question in September , its family of Market Vectors ETNs sold off dramatically. ‘The Market Vectors Remnimbi/USD ETN (CNY) plunged more than 25 per cent versus a 1-per-cent drop in a comparable ETF,’ observes Greg Newton, a veteran financial journalist who writes the NakedShorts blog.”

However, if the ETFs don’t actually hold the securities that make up the fund, and instead use synthetics or swaps rather than physicals, investors may also be exposed to much more credit and counter-party risk than they realize. And as Jeffrey Gundlach discussed at the recent DoubleLine Luncheon at the New York Yacht Club, “Never, ever take counterparty risk. It is the one risk you are almost never rewarded for taking. Unless you are running $800 billion dollars, there is no need to use swaps, synthetics or baskets – trade cash markets and avoid any trades that require a counterparty.”

(HistorySquared) “In light of the counter party risks inherent in ETFs, especially those that use synthetic swaps rather than the physicals, there might be an inexpensive way to express a bearish view on some of the European banks.

For example, in 2008 Lehman Brothers had several failed ETNs. ‘The three ETNs were Opta Lehman Commodity, Agriculture and Private Equity. In September 2008, these ETNs halted trading when Lehman Brothers failed. Currently, the final results are being sorted out, but it appears that Lehman ETN holders will receive 2 cents on the dollar from their original investment.’ ”

These are some clever lower-risk trading ideas for expressing a bearish view on the future solvency of a particular counterparty:

“Perhaps there are some far OTM options on some of the Socgen ETFs that are worth a look . Or a less risky trade could be long an ETF with physicals underlying the ETF that is issued by a more secure bank, and short the highly correlated Socgen ETFs. A potentially catastrophic event could be triggered by Deutsche Banks popular x-trackers.”

Full Story: ETFs as Tail Risk Trades (HistorySquared)

(Bloomberg) “ETFs that use swaps to clone stock, bond or currency returns have been criticized by regulators and firms including Fidelity Investors, which say clients risk losing money should the banks writing the derivatives become insolvent. Outflows from Lyxor are another blow to Societe Generale, France’s second-largest bank, whose shares have tumbled this year as the escalating sovereign-debt crisis squeezes lenders’ funding.

‘It’s an issue of counterparty risk related to the financial health of the backing bank,’ said Jose Garcia Zarate, an ETF analyst at Morningstar Inc. in London. ‘Fears over synthetic replication have been building up, and at the same time, fears of banks’ peripheral-debt exposure have grown. Put those two together: bingo!’ ” — Swap ETFs, Lyxor Have Record Outflows (Bloomberg)

(TheHippo) “The reality of the matter and one that I have believed in is that during crisis there is NO SAFE HAVEN! It is a figment of your imagination and the collective mind of the market. As a friend of the family who was a trader said, ‘when markets drop the correlation becomes 1′. What he was saying is that when a crisis occurs there is no safe haven and there is no place to hide.”

“So then the question becomes what does one do? Outside of the obvious, which is short the market. Go back and look at the charts and look at what happened EACH AND EVERY TIME. The market went back up. This should not be a surprise to you, and should be rather obvious. Yet nobody during those times says, ‘buy equities, bonds, though they did say buy gold’. All you hear are about Safe Haven plays (which don’t work) and how you need to step back and wait.”

“I am a numbers guy. I focus on the statistics and let it define my plays. So when you see these charts a dropped market is a screaming buy! It does not matter what, but everything is a screaming buy. So why don’t people buy? .. Easy answer it’s about the psychology. Buying in times of market turmoil is very very difficult. I have read this Contrarian book that said people would rather be wrong with the crowd than be right in the individual.”

Full Story: Understanding Safe Haven Plays and Market Turmoil $AGG, $PCY, $GLD, $BTI (Haah-TheHippo)

In times of turmoil, your only real safe haven is holding straight CASH in your home currency. Your greatest defense against future crisis and turmoil is proper position sizing (keep your positions small and manageable), stay clear of leverage (especially overnight), and always keep a chunk of cash on hand to take advantage of any great opportunities that may arise. From the article, $PCY (PowerShares Emerging Mkts Sovereign Debt ETF) looked mighty interesting around those October 2008 lows. Historically speaking, many great fortunes have been some of the greatest fortunes made have been in times of crisis. Find opportunity when others panic, and keep your position size small and manageable so that you can always consider adding a bit more if the opportunity becomes even juicier.

Very nice interactive visual guide by NYTimes charting the web of debt exposure among sagging economies, and showing how much each European country owes and to whom.

(NYTimes) “Arrows show imbalances of debt exposure between borrowers in one country and banks in another; arrows point from debtors to their bank creditors.  Arrow widths are proportional to the balance of money owed.  For example, French borrowers owe Italian banks $50.6B; Italian borrowers ower French banks $416.4B.  The difference – their imbalance – shows France’s banking system more exposed to Italian debtors by about $365.8B.”

Full Interactive Chart: It’s All Connected: An Overview of the Euro Crisis (NYTimes)

Back in February 2009, with the markets plunging relentlessly day after day, after day…  I still recall how many traders were waiting in anticipation for some sort of crazy, panicky, high volume day to mark a capitulation bottom.  This latest market downswing took the DOW down nearly 30% in just over two months from 9,088 to a low of 6,470 on March 6^th, 2009.

Many traders whose market analysis and insights I respect seemed to be waiting for some massive “fireworks”-type event that would all but shout “THE LOW IS HERE”;   a sign that all the weak hands have most likely thrown in the towel, and that it was now time to BUY BUY BUY hand over fist.

Of course, Mr. Market will never make it quite that easy, even for its smartest participants to figure out what its current “jig” will be.  The DOW closed below 6,700 for several days before breaking out higher and closing above 6,900 on March 10^th, 2009 on a bit higher average volume.  It also marked the first day since this leg of selling began in early February that the DOW was able to close above its downward-sloping trend-line.  However, that super-charged high volume capitulation day we were all looking for and expecting to occur never materialized.  While in September and October 2008 the VIX volatility index hit highs just over 80, in February and March 2009 the VIX topped out in the low 50’s.  This peak was 35% lower than its earlier spikes, even though the market was now trading at lower price levels.

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