Kass: Market Turmoil Will Be a Constant

This blog post originally appeared on RealMoney Silver on Aug. 30 at 7:47 a.m. EDT.

If you've liked the recent up-and-down market, you're gonna love what's coming up -- this volatility is going to be with us for awhile.

Wednesday's wild market swing underscores the volatile scenario I have envisioned and continue to anticipate, and even if an imminent cut in the fed funds rate is upon us, it will not cure the systemic risks associated with too much debt, irresponsible ratings agencies, too little regulation in the derivative markets, hedge fund marking to model (not to market) and too much optimism regarding corporate profits.

I expect the wind-down of excessive credit creation to dominate the investment scene over the balance of the year, contributing to continued volatility and to trendless and lumpy market conditions. (On CNBC on Wednesday, Vanguard's John Bogle called it "unprecedented" in the 50 years he has been in the investment business.)

This backdrop provides the basis for my belief that investors should keep below-average trading/investing positions in order to take advantage of Mr. Market's volatility. Buying strength and selling weakness will be a recipe for investment disaster.

There is no quick and easy fix to the credit problems facing our financial system. There will be more financial failures and hedge fund meltdowns. Importantly, disintermediation in the hedge fund industry has just started and is likely to weigh on the supply and demand for equities.

The market will continue in turmoil and, similar to this week, experience more moves than a shortstop batting .110. Only the most facile traders should be playing on this field.

Yesterday, my tone was a tad more optimistic, suggesting that the Fed was beginning to understand the severity of the domestic and non-export economy's plight (especially in housing). But recognition is only the first step; it is not a cure-all.

Meanwhile, some of the market optimism following Sen. Charles Schumer's (D., N.Y.) release of Fed Chief Ben Bernanke's letter is disappearing as an article by The Wall Street Journal's Greg Ip throws market participants off the scent of a speedy rate cut and serves to put pressure on S&P futures. (Editor's note: A subscription to The Wall Street Journal may be required to view article in its entirely.)

This year, I have written about a number of dirty little secrets in ratings agencies and in the hedge fund world that have been the root cause of today's volatility and which have led (in part) to the chaos in credit.

Back in a February 2007, in a column titled "Ratings Are Subprime's Dirty Secret," I wrote:

The little-known secret in the subprime market is that the ratings agencies have been lax in their downgrades of subprime paper. The recalcitrant agencies -- Moody's, Fitch and Standard & Poor's -- have quietly abetted (blessed) the mushrooming of very aggressive subprime lending that has allowed the Wall Street firms selling these mortgage products to prosper. ... Credit is about to be less plentiful.

Four months later, in June 2007, I played the blame game and anticipated the next shoe to drop -- namely, "the downside of the leveraged and carried trade" -- in a column titled "Hedge Funds' Dirty Little Debt Secret":

The culprits and sinners of this cycle are plentiful. They include a too-easy Federal Reserve, loosely regulated and heedless housing lenders, avaricious home speculators, funds of funds that encouraged hedge fund investors to leverage, greedy hedge fund investors -- you would have thought that they learned from the demise of John Meriwether's Long Term Capital Management -- irresponsible ratings agencies that were reluctant or ill-equipped to downgrade credits, brokerages that packaged these complicated products and, of course, hedge fund managers who have the temptation of large compensation incentives to take undue risk. (They participate in at least 20% of the fund's profitability.)

I ended the column in the following manner:

The lessons to be learned from this crisis are that market values matter for leveraged portfolios; models sometimes misbehave and must be stress-tested and combined with judgment; liquidity itself is a risk factor; and financial institutions should aggregate exposures to common risk factors. And portfolios should be marked to market.

The subprime mess was indeed the eye of the financial hurricane that we are in today.

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