The Plunge Protection Team
A Hedge Fund's Secret Wish
Randomness and Responsibility
By John Mauldin
April 4, 2003 weekly e-mail
I have had so many letters of late asking me what I think of and/or know
about the existent of the so-called Plunge Protection Team, that mysterious
group of government officials who secretly prop up the stock market when it
drops too much, that I am going to jump in where wiser minds would just
leave the subject alone. It will offer a good opportunity for you to
understand concepts of arbitrage and how the markets really work. Plus, if
you can prove me wrong, I will show you how to get a quick $100,000.
Following the stock market crash in 1987, the government created something
called the President's Working Group on Financial Markets. The group, which
includes the Treasury secretary, Federal Reserve chairman, chairman of the
Securities and Exchange Commission and chairman of the Commodity Futures
Trading Commission, was formed to ensure the smooth operation of financial
markets.
Citing a Washington Post article, Carol Baum recently wrote about a 1997
article: "The Working Group's main goal, officials say, would be to keep
the markets operating in the event of a sudden, stomach-churning plunge in
stock prices -- and to prevent a panicky run on banks, brokerage firms and
mutual funds..."
"The thrust of the article is official's efforts to avert a liquidity
crisis, which is exactly what the Fed did when it flooded the banking
system with reserves following the 508-point plunge in the Dow Jones
Industrial Average on Oct. 19, 1987. How an effort to ensure adequate
access to credit to prevent a domino effect in the event of market meltdown
morphed into a cabal to prop up the stock market is anybody's guess. For a
window into the depths of the conspiracy theory, type "plunge protection
team" into Google and see what comes up."
Every time the market drops and then "mysteriously" rallies, knowing
individuals look at each other and nod, seeing the handiwork of the PPT
(plunge protection team).
Let's say it straight out. The plunge protection team does not exist. It is
an urban myth. Let me step by step prove it does not exist, and see if we
can learn something in the process.
Supposedly the PPT manipulates the market by buying S&P 500 and DOW and
NASDAQ futures when the market is dropping. Somehow, this supposedly forces
the market back up. The problem is that buying futures cannot drive the
stock market, which is obvious to real traders.
I talked with a few good friends about this article prior to writing it, to
get some background and ideas. Art Cashin, of CNBC fame, and one of the
real veterans of the markets, who ahs seen it all, wrote me the following
very clear thoughts:
"Suppose you have a lot of cash and would like to buy the S&P Index. In
the old days (circa 1980), you had two choices. You could buy each of the
stocks in the S&P according to its weighting. Then you would own a
"basket" of the 500 stocks. Or you could buy an S&P futures contract on
the S&P. Which should you choose?
"If you bought the 'basket' of stocks, you would get whatever aggregate
price improvement (or loss) that occurred while you owned the basket. In
addition, you would get any dividends paid. A slight negative would be
that it required 500 transactions (1 for each stock) and thus 500
commissions.
"If you bought the "futures," it would give you similar price action since
it would mirror the ups and downs of the basket and the index. A negative
would be that you would not get the dividends. Positives would be a single
transaction with more favorable margin requirements.
"By constructing a formula of the variables - total dividends, time left to
expiration and interest rates, etc. - you can determine if one of these
choices is cheaper than the other. This is called arbitrage.
"An old example of arbitrage was gold. If gold was selling at $300 in Paris
and $350 in London, one Rothschild might send in a pigeon to another
Rothschild suggesting A buy in Paris while B sold in London allowing the
firm to pocket the $50 (less transportation and currency conversion).
"The futures/basket formula gives you equilibrium or Fair Value. If stocks
(the basket) go up faster than the futures, you might sell the expensive
stocks and buy the cheaper futures. If the futures ran faster then you
would, do the opposite. This is called index arbitrage or sometimes
program trading....
"Anyway, the arbitrage between baskets and futures is now much bigger
thanks to the addition of Exchange Traded Funds (ETF's). So now you can
"arb" the basket against the futures or the S&P Index (ETF) (or any combo
thereof). It is a huge market."
* Trading desks do arbitrage program trading for a fraction of a percent on
a trade. Any attempt by the Fed to manipulate the market would just make a
lot of money for hedge funds and trading desks.
* The amounts of money required to attempt such a manipulation would be
huge. We are talking tens of billions of dollars if there was a true
collapse going on. The collective size of the trading community in the
world (hedge funds and "prop" desks - a prop desk is a proprietary desk for
an investment bank or broker-dealer) is in the multiple hundreds of
billions. It would require the willingness to lose billions of dollars
every time you took the plunge, so to speak.
* If the Fed or Treasury or some slush fund did buy stocks, it would inject
liquidity or more total money into the financial system or money supply.
Since the Fed openly manipulates the money supply every day in transactions
that everyone can see, in order for the Fed to hide the activity of the
PPT, they would have to take out liquidity by selling treasury notes.
Otherwise, the numbers at the end of the day or week would not add up, and
someone would notice. But if they were taking out liquidity and the money
supply did not go down, then someone would know something was up. You can't
hide these numbers, unless you can get a lot of clerks at the Fed and
elsewhere to agree to lie.
* You could not keep something of this size secret. Period. The orders
would have to be entered somewhere. The theory is that Goldman Sachs or
Citibank (or pick a firm) is part of this conspiracy. That means that
multiple traders and officers would have to be in the know. You cannot mask
trades of that size because it would essentially be the largest hedge fund
in the world. Someone would spill the beans. Can you imagine the signing
bonus from a book publisher if you could prove the existence of the PPT?
I hereby offer a $100,000 advance against 50% of the royalties to anyone
who can "show me the trades." Give me names and dates. I will write the
book, and we both become famous.
Further, can you imagine what political hay the opposition political party
would make of the proven existence of a PPT? Do you think that the Dems
wouldn't love to embarrass Bush with "proof" of his manipulation of the
market? Can you imagine Newt Gingrich or Tom DeLay (Republicans) not
beating up Clinton and Robert Rubin for crimes against the market and for
losing billions of dollars of tax-payer money?
If the President's Working Group was really the PPT, do you think every
former SEC and CFTC Commissioner (and there are maybe a dozen) would all
keep silent after they are out? Do you think their wives (or husbands)
would not tell all in a divorce hearing? Do you really think that if Harvey
Pitt would have allowed George W. to fire him if he could blow the whistle?
A Hedge Fund's Secret Wish
* I don't doubt there are all sorts of secrets that officials in our
government keep from us, and that all sorts of untoward things are done
every day in the government, that if we found out we would be shocked.
But if the PPT existed, it would be just too big to keep secret. If it were
small enough to be secret, it could have no effect upon the market. I don't
doubt for a second that if the Fed decided to buy stocks and was willing to
risk losing hundreds of billions, they could move the stock market up for a
period of time. But then what do they do? They own a bunch of stocks. Could
they ever sell without causing a crash?
Furthermore, if there is a PPT, they are the most incompetent team in the
world because the markets have indeed plunged. I can guarantee you this: it
is every hedge fund's most fervent wish that there was a plunge protection
team, because it would be a license to print money trading against them.
Imagine, having someone on the market with an unlimited bank account whose
objective was to lose money? Could it get any better?
Some would argue that the PPT does not lose money - that they are so good
they buy the stocks and wait until the market goes back up before they
sell. If there were individuals who had such god-like insight into the
future direction of the market, they would be running their own funds,
making tens of millions in annual fees, far more than they would make as a
bureaucrat. Further, as the bear market has moved the market down, the
losses would be in the hundreds of billions by now. That much loss cannot
be hidden, even if you have a printing press.
* If you believe in the PPT, it probably would do no good to mention that
the rules under which the Fed operates makes it illegal for them to
participate in such an operation, since you would assume they would not
follow their own rules.
Let's look at the Crash of 1987. At the end of the day, there was a huge
amount of futures buying, which some say is evidence of the Fed or other
group stepping in and stopping the bleeding. What really happened is that
the futures got so out of whack with the physicals that it was an obvious
arbitrage position, and Paul Tudor Jones, one of the largest and certainly
one of the more highly respected traders stepped in and began to cover his
huge short position. Jones was a legend. Once the word hit he was covering,
the crowd stormed in. No conspiracy. No hidden machinations. Just some
traders taking monster profits.
And that often is what you see when there are large and strange moves. Just
traders taking profit, either on the long side or short side. It is what
Chris Fuligni calls his TFTF trade: Too Far Too Fast. When the market moves
too much in one direction, traders take profits.
In my opinion, and as I have made the case for several years, this market
is too high compared to historical trends of value. In my opinion, it has
much further to go on the downside. But secular bear markets do not go
straight down to "fair value." It takes years of going down, with large
rallies back up and then more down before the bottom is finally reached. At
every step, there are advisors and investors who decide that "now" is a
good time to invest. There is no mass consensus.
Remember, over half the years within a secular bear market cycle are up
years, and most of those are up by 20% or more. As the fairly bearish Dan
Denning wrote in Strategic Investment today: "...confidence can be a heady
thing. If Hussein ends up dead and Osama bin Laden is captured, look for
10,000 on the Dow in short order. Euphoria is a powerful emotion."
Those who feel the market is over-valued have ample justifications. You can
go to Standard and Poor's website and look at their valuations. If you take
pro forma earnings (that is Earnings Before Interest and Hype) the current
P/E ratio is 18, which is high, but certainly within historical norms. But
if you look at actual "as reported" earnings, the P/E ratio jumps to 30.29.
That is in nose-bleed territory to the historical average of 15.
If you look at core earnings, the number is over 35. Core earnings subtract
options expense and pension fund overstatements. The new accounting
standards will probably mandate firms to start subtracting these items, so
the core earnings P/E ratio is a number that is increasingly going to be
seen by the investor.
Not fair, say the bulls. To get true historical comparisons, you have to
compare apples to apples. The new standards distort the actual
profitability of a company, and give us no fair historical comparison.
To that, I politely say bunk. Pre-1990, pension benefits did not have
nearly the impact that it does today, as there was not that much over-
funding and estimates of future earnings were far more conservative. It is
only in the decade of financial engineering, where a CEO could create a 10%
rise in his company earnings just by changing the assumptions of his
company pension fund that these elusive pension fund earnings started to
show up in the books in a significant way.
Of course, that helped the CEO's personal options, which again the company
did not have to expense. Options were not a big deal prior to 1980 and not
all that significant even until 1990.
Accounting standards always tighten up in bear markets. Investors become
more conservative. They are not willing to project earnings growth far into
the future. That is why the market drops.
If you go to Decisionpoint.com, you can see in one of the many hundreds of
charts available that if the P/E ratio for the S&P 500 were 15, about
average for the last century, the market would be at 420 today. As markets
have always over-corrected, generally to below single digit P/E ratios, if
it went to 10, the S&P 500 would be at 280, down 68% from here. That is
pretty ugly.
I believe we are going to single digit ratios. I also believe it will take
a decade or more. In that time, earnings will grow, and probably double or
more without having to be too optimistic. What happens in secular bears is
that earnings grow and P/E ratios drop. But it does not happen all at once.
It takes time.
We can be thankful for that, because if the markets were to drop 68% today,
we would be facing a depression as severe as our grandparents faced. It
would be ugly, ugly, ugly. Thus, in a kind of perverted logic, we should be
grateful for market cheerleaders, as they prop up the economy and stave off
a disaster scenario. But as individuals, we don't have to listen to them.
The point is that there are those who see the market as under-valued. When
it does not go up they blame hedge funds, short sellers and wicked analysts
for their losses. There are those who see the market as over-priced and
want the market to conform to their worldview, and they see rallies as
evidence of the Plunge Protection Team. The world is not as it should be,
and there must be some secret reason. That is especially true if they are
short and the market goes up.
The real reason is what Richard Russell says over and over, "The market is
the market. It just is." In a real sense, this is more scary than the
possible existence of a plunge protection team. It means we are subject to
the vagaries of a market which is out of anyone's ability to control. I bet
there have been a few times you wish someone could have made the market go
back up. In a world where anything can happen, risk control is everything.
It would be nice to know that I could count on some secret group to protect
my funds, but it doesn't exist. I am responsible for my own risk protection
and personal portfolio.
Randomness and Responsibility
Thus, we return to Art Cashin's final bit of wisdom: "People can't stand
two things - randomness and responsibility. On the first point we again
cite Voltaire: "If God did not exist, it would be necessary to invent him."
The premise is obvious and a truism - life must have order. The class
needs rules and a teacher. An occasional accident is acceptable, though
maybe not understandable. The logical (for many of us) existence of a
deity transmutes in the secular world into - someone is in charge. (The
government, the moneyed interests, some religious or ethnic group, etc.)
"Now factor in the inability to accept responsibility.
"If my horse doesn't win - the race was fixed - the horse was doped. The
variations are myriad. It can never be my fault or my miscalculation.
That could mean I was careless, or confused or hasty or maybe even wrong.
The latter is unacceptable so it must be someone else.
"Thus conspiracy theorists and the plunge protection theme. In four
decades, I've heard hundreds of theories. The collapse of the Hunt
Brothers' silver bubble was roundly blamed on a government conspiracy. As
time went on it was obvious there was no conspiracy - not there or in
hundreds of other cases. But....when your perfect game is ruined in the
final frame (bowling) or the final inning (baseball) - dashed hopes demand
a villain - an evil deus ex machina. They stole it from me, I tell ya!!"
