A few thoughts and links for 7.29.10

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A few thoughts and links for 7.29.10

On 07.29.10, In Business and Entrepreneurship, Economics, Investing, Pairs trades, Short positions, by David Pinsen

A few thoughts and links, but first, if you haven’t had a chance to vote for the Portfolio Armor iPhone app in the Thomson Reuters StreetApps Challenge, please take a few seconds to do so here. Thanks a lot.

– Batesian Mimicry Explanation of Business Cycles. Fascinating post by Eric Falkenstein. Worth reading in full, but here’s the heart of it:

My argument is that business cycles are best understood though the framework of Batesian mimicry, an endogenous mechanism for booms and busts thru a misallocation in the horizontal structure of production. In ecosystems, Batesian mimicry is typified by a situation where a harmless species (the mimic) evolves to imitate the warning signals of a harmful species (the model) directed at a common predator (the dupe). For example, venomous coral snakes have red, yellow, and black bands, while the non-venomous scarlet king snake has the same colors in a different order.

[...]

In an expansion investors are constantly looking for better places to invest their capital, while entrepreneurs are always overconfident, hoping to get capital to fund their restless ambition. Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic investors seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign, such as naïve hope that they will learn what works once they get their funding, or sincere delusion that the characteristics are the essence of the seemingly promising activity. The mimicking entrepreneurs are a consequence of investing based on insufficient information that is thought sufficient, but they make things worse because they misallocate resources that eventually, painfully, must be reallocated.

Once the number of mimics is sufficiently high, their valueless enterprises become too conspicuous and they no longer pass off as legitimate investments. Failures caused by insufficient cash create a tipping point, notifying investors that some of their material assumptions were vastly incorrect. Areas that for decades were very productive, are found to contain exceptional levels of fraud, or operate with no conceivable expectation of a profit. Everyone outside the industry with excessive mimics marvels at how such people—investors, entrepreneurs, and their middlemen–could be so short-sighted, but the key is that the mimics and duped investors chose those business models that seemed most solid based on objective, identifiable characteristics that were, historically, correlated with success. An econometric analysis would have found these ventures a good bet, which is why investors did not thoroughly vet their business models (banks, up through 2007, were one of the best performing industries since industry data has been available in the US, and performed well in the 2001 recession).

– John Hussman’s latest. Late to this. Hussman still sees stocks as overvalued, but thinks technicals may continue to prop the market up in the short-term. He reiterates his view that we’re heading for a double dip recession, based in part on ECRI data. And, Dr. Hussman endorses NJ Congressman Scott Garrett:

Having discussed economic policy before with Congressman Garrett, it’s clear that he has a strong understanding of the economic challenges we are facing. As a political independent, I rarely inject electoral politics into these weekly comments, but I have no stronger endorsement for the coming election cycle.

– A few items from Short Screen this week: I got blown out of the short side of my short TRGL / long EGY pairs trade yesterday, for an 18.2% loss on the short side (was using a 20% trailing stop). Tightened up my stop on EGY. I picked up a few puts in AIB in lieu of shorting it, on its post-stress test bounce Monday. As I mentioned on the message boards,

Among the European banks that passed the stress test, AIB had one of the weakest sets of results (http://www.screencast…. ). And bear in mind that these stress tests didn’t test for the effects of a sovereign default ( http://www.bloomberg.c… ).

I picked up a few puts on another (domestic) bank today as well, CPF. This bank was rated “outstanding” by the FDIC for its CRA compliance and has a zero star rating from Bauer Financial.