Wednesday, June 29, 2011

Why we GIVE each big bank $12 billion per year

I've been reading quite a lot about the various political battles over efforts to regulate the banking industry, derivatives in particular. This afternoon, quite by coincidence, I noticed on a colleagues' disordered desk a copy of a speech given last year by Andrew Haldane, Executive Director for Financial Stability of the Bank of England. It's message should be a matter of urgent public debate in the US, and elsewhere. Yet I haven't heard Haldane's arguments mentioned anywhere in the US media.

Banks, he argues, are polluters, and they need to be controlled as such. Let me run through several points in a little more detail. First think of the car industry, where producers and users together pollute. Haldane:
"Exhaust fumes are a noxious by-product. Motoring benefits those producing and consuming car travel services – the private benefits of motoring. But it also endangers innocent bystanders within the wider community – the social costs of exhaust pollution."
He then goes on to make the point that we now face much the same situation with bankers, in part due to the proliferation of instruments which have made it possible for banks to spread risks far and wide and make profits events as they amplify system wide risks. The banking industry is also a polluter:
"Systemic risk is a noxious by-product. Banking benefits those producing and consuming financial services – the private benefits for bank employees, depositors, borrowers and investors. But it also risks endangering innocent bystanders within the wider economy – the social costs to the general public from banking crises."
What is to be done about polluters? Back in the 1970s, in the face of the rising air pollution, policy makers, guided by economists, worked out ways to solve the problem through regulations and, where necessary, outright prohibitions of some practices. That's where we are now with the banks. The regulations under consideration recognize the social costs of systemic risk and try sensibly to find a redress. The bankers response has of course been to whine and scream.

The first practical step in addressing a pollution problem is to estimate how much pollution there is. How much do we pay to guarantee bank solvency during these not-too-infrequent systemic crises? Haldane points out that if you count only the monetary amount transferred to banks by governments, the cost of the recent crisis is fairly large -- about $100 billion in the US. But this is probably an extreme lower bound to the true collective cost. As Haldane remarks,
"...these direct fiscal costs are almost certainly an underestimate of the damage to the wider economy which has resulted from the crisis – the true social costs of crisis. World output in 2009 is expected to have been around 6.5% lower than its counterfactual path in the absence of crisis. In the UK, the equivalent output loss is around 10%. In money terms, that translates into output losses of $4 trillion [for the US] and £140 billion [for the UK] respectively."
Now, I'm not one to take GDP loss arguments too seriously. It's not a very good measure of human well being, or even of the narrow economic well being of a nation (in particular, it tells us nothing at all about how much of the store of natural resources may have been eaten up in achieving that GDP). However, the scale alone in this case suggests that the cost of the crisis -- and other crises, which seem to strike more and more frequently with modern financial engineering and its global reach -- are immensely high.

But here is where Haldane's view becomes REALLY interesting -- and goes beyond anything you're likely to see in the popular media (especially in the US).

Lots of people recklessly borrowed in the run up to the crisis; it wasn't only the fault of the recklessly loaning banks. So, how much of the systemic costs associated with financial crises really is due to the banks? One place to look, Haldane suggests, is the valuations given to banks by the ratings agencies, many of which take explicit note of the fact that governments give a subsidy to banks in the form of implicit or explicit safegaurds to their stability. Some give banks two different ratings, one "with government support" and one "without." Haldane goes through a simple calculation based on these ratings, and estimates the effective subsidy to many big banks is on the scale of billions. The data suggests it has been increasing for the past 50 years. The "too big to fail" problem shows up in the data as well -- the average ratings difference for large banks is much bigger than it is for small banks. As Haldane sums up:
For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year...  the large banks account for over 90% of the total implied subsidy. On these metrics, the too-big-to-fail problem results in a real and on-going cost to the taxpayer and a real and on-going windfall for the banks."
Haldane's speech -- as far as I'm aware -- is unique among high-level banking figures in taking seriously the public costs entailed by banking practices. Imagine where the US might be today if we'd taken that $60 billion per year and, over the past decade, invested it in infastructure, education and scientific research.

In the rest of his speech, Haldane explores what might be done to end or control this pollution, through taxes or by making some banking practices illegal. This too is illuminating, although what emerges is the view that finding a solution itself isn't so hard. What is hard is gathering the political will to take steps in the face of banking opposition. Publicizing how much they pollute, and how much we pay to let them do it, is perhaps a first step.

Monday, June 27, 2011

Analysis of the stock market rally of 28th June.

Today the markets rallied and closed solidly in green. However I have few concern regarding the coming uptrend so eagerly awaited by the bullish small speculators.

  • The VXO is in 20s. All past major corrections have ended with VXO in the range of 28+.
  • If  we look at the weekly chart of SPX and put a 75 simple moving average, we shall see that from 2004, all corrections have ended near or below 75 SMA on a weekly chart. By that reckoning, we still have a fair way to go.
  • The money flow was very negative.The Block Traders sold in the strength in the last hour. If past is any indicator, normally the next day is a huge gap down day.
  • The CBOE market data shows that the retail investors have turned bullish.
So I am not holding my breath for a stock rally yet.

I think what I think.

A new week. But the old Greek drama continues. The market has been selling off for eight weeks now. So where do we stand. I am thinking that:
      ·         Although S&P 500 has sold off 7.5% from the June 1st, the fear factor is not high enough to call a bottom. In that logic, I am thinking that we shall see continuation of the sales.
  •        It is possible that we shall see a breach of the 200DMA and then the panic factor comes in play. 
  •    It is possible that by Wednesday, 29th June 2011, we shall see a huge sell off coinciding with the Greek vote. 
  • Because of the uncertainty regarding the Greece situation, the Euro has been selling off. Along with Euro other risk assets like Gold , Silver, Oil etc are also soft.
  • All these commodities along with the stock markets will possibly reach bottom by Wednesday when the market will realize that the Greek vote is inconsequential.
  • We would possibly see a summer rally, in opposite thinking of end of Fed induced liquidity, when retail investors might think of leaving the market.

So I am thinking and  I am marking Wednesday, 29th June as the date of reckoning.

But if the VXO does not reach high 20s by then, I would still think that the sell is not over yet. In short term stock markets are ruled by greed and fear. As of now, there is very little fear. the retail investors have turned bullish as evident from the put/call ratio.Unless we see fear and panic, there is no point going long. So if 29th June gets pushed to 5th July, so be it. I would rather wait.

Sunday, June 26, 2011

Who needs a crash diet?

When you see this picture, you can figure out that it is a picture from Greek Parliament.
Who do you think needs an austerity measure?  To me the answer is obvious. The rich and powerful of Greece, the fat cats, who have sucked the country dry, needs to be put on a strict diet of olive and water for the rest of their life.

Saturday, June 25, 2011

Paying money to lose money in Stock Market

Losing money in stock market is a no brainer. After all these days it looks more like a giant casino and you don’t even have to leave home to gamble. It is rigged and the house always wins. But the dumbest way to lose is to follow the market gurus like Charles Nenner, Prechter of Elliot Wave, and many other forecasters of their ilk.

Before you say that I have no idea about what I am saying, I want to say loud and clear that yes I do have the idea.  Because I have been dumb enough to learn it 1st hand.

When you are new in the game of investment, you want to try out everything and find out what works. I was no exception. In-spite of having a professional degree in Finance & Accounting, in-spite of working at the highest level of corporate management, there is still that desire to be on the correct side of the market without efforts . It is the same reason people go to faith healers who tell them that cancer can be cured with their magic touch or villagers go to fortune tellers and palmist who then predict the future and give them the way out.  I suppose I was na├»ve and stupid to put my belief on these people instead of doing more rational and analytical thinking and research. At some level professional education is no match to the primal insecurity of human being which has created a class of people called god-man.

Let me share my own experience so that those who are reading this, be forewarned.

Prechter of Elliot wave is a very good salesman. He prays on the fear of the people and is always predicting a doom. Now a broken clock is also right twice a day. Because the memory of 2008 crash is so fresh in the minds of the people, people are fearful of another looming disaster and the economic news has not made things easy either. The whole of 2009 and 2010 Prechter and his company went on to predict a crash, month after month, he went on TV predicting Dow at 1000 and all sorts of doomsday scenarios. And every month, the goal posts would be moved. In between there were few corrections in the stock market and he got further boost from those corrections.

Stock markets corrections are a natural phenomenon and are necessary. But he would come and say “I told you so” and a big one is coming. People like me, who invested on the short side of the market, based on his advice, lost money head over heels. We missed out on the great Bull Run and it did not do us any good. Prechter‘s favorite saying was that he called the 2008 bottom correctly and predicted the start of the new bull market. Again, it was one of those fluke things, when lots of people were calling the bottom, like they are doing now. No way Elliot Wave did predict the bottom or call out the new bull market. Because the Elliot wave theory is basically charting the history after the events have taken place. There are many interpretations of the so called wave, major, minor, still born, unborn and every one of the wave experts have their own theory. The internet is flooded with them. The long and short of it, after losing money by following this gentleman, I quit and went for another clairvoyant.
And there was Charles Nenner, the cycle forecaster. His reputation ran ahead of him. Ex-Goldman Sachs and the man who had called the top sometimes in the past. I should have known better.  It is alleged that GS and other primary dealers have 1st hand knowledge of the market movement and possibly a hotline or two with Fed. Otherwise how come they have only one losing trading day in the entire quarter and sometime they never have a losing trading day in the whole quarter at all. It defies the law of probability and the chances of that happening to you and me are one in a billion. That someone has access to that hotline and made a correct call in the past is no wonder. May be he was set up by them to make that call. Who knows?

 But then when I started reading Nenner, I found that it is an exercise in double talk and confusion. For e.g. “The cycle bottoms next week but it can come earlier”, what do you make of such statement? Once again, the blame is put on the reader because of the wrong interpretation. Personally I have never made money following Nenner; in fact I lost money whenever I acted upon his advice. My bad luck! Nenner’s newsletter is like the astrology columns in the news papers. Vague, general and applies to some people at some time but is never accurate.

I challenge both these gentlemen to publish their short term market call (things that will happen in the next 15 days), in clear, unambiguous language and we shall monitor their call for a year. I am ready to stand corrected but till they take up this challenge, I will be a skeptic.

Today, after many years of trial and error, I have found that we can also make the market call, as well, if not better than Nenner or Prechter. Now I study many things like sentiments, demography, money flow in the market, many other technical indicators and try to think like a criminal to beat the criminals in their own game. And I think I am successful. I am winning consistently and if you read my blog, you will see that I am getting good at calling the turns.

Tons of free stuff is available on the net, so we don’t need to pay money to lose money.

Standard Chartered Bank report indicates that "Gold Top" is coming.

No, they did not say that in their report. In fact the report of Standard Chartered Bank is just the opposite. They are calling for US$ 5000/oz gold very soon. And the arguments are same that has been used over and over again during the last 10 years of gold Bull Run.

Before, we go over their argument for $5000/oz gold, let me clarify few things. I have deep suspicion about any recommendation from the big banks which comes out for the benefit of their clients and other investing population. Remember Goldman and other similar banks? It is alleged that (If I don’t use the A word, I might hear from their Lawyers), they packaged all the shitty deals and crappie products into AAA products and unloaded on their unsuspecting clients.  Didn’t Senator Carl Levin say the same thing in his report that Goldman Sachs Group Inc. (GS) “clearly misled their clients and misled the Congress,”? Yes, of course GS has refuted what Senator has said but Justice Dept. may be considering taking action based on that report. In light of that, if I continue to have deep suspicion on the recommendation of these Big Banks, may be that is healthy skepticism after all. Normally, when they say buy, I sell and when they sell, I buy. So far it has served me and my clients well.

So when Stan. Chart Bank comes out with a report based on old hashed reasoning; my conspiracy theory antenna goes up and starts giving alarm signal. May be the top is near, 3 months at the most.
Let us look at their reasoning:
We believe that these factors – limited gold production, buying by central banks and increasing demand from India and China – can potentially drive the gold price to US$5,000/oz, as highlighted in our commodity team’s earlier report." 
Now, Indians have been purchasing gold for ages infinite. How come, pray, gold went into a bear market for over 20 years? Let us look at the long term chart of gold.

As you can see for yourself gold reached the top in the year 1980 with a parabolic move, and then came crashing down. From 1980 till 2001, for 20 long years, gold was in a bear market. Investors, who listened to the same logic in 1980 and purchased gold at the top had to wait 20 years to see any traction in price. In the mean time gold reached near $ 200/oz.  On an inflation adjusted basis, if gold has to match its peak price reached in 1980, it should be over $2500/oz now. So even at today’s price, Investors of Gold in 1980 have actually lost money.

Were not the Indians buying gold for those 20 years? Did the production of gold increased during those years and have now fallen dramatically? Were not there any war or inflation scare during those periods?  And regarding the purchase by central banks, the 2nd largest holder of gold is not any central bank but the GLD fund. Central banks buy gold along with other foreign currencies and it is always within a certain percentage of their total holding. In the year 2010, as per Wikipedia, ( ) China had only 1.7% of their reserve in gold. It is the developed world, North America and Europe, who have the largest gold reserve as a percentage of their forex reserve.  And we shall not see any dramatic change in the holding percentages anytime soon. So the logic given by Stan. Chart does not sound very convincing.
Standard Charted Bank knows all these and yet they come out with a report based on fairy tale.  Let us see when the gold price started rising.

We see the rise in gold prices from the year 2001. Do you remember what happened during that time? The Tech. Bubble burst. Allan Greenspan, in his infinite wisdom, started flooding the market with liquidity. Most of the liquidity went to create another bubble, i.e. Housing bubble, but some part of that money flowed in commodity sector, not because of increase of demand from India and China, but because of the speculators had a free run. By the way, biggest commodity desk and speculative section is usually found in the confines of the big banks. In the year 2008, when the housing bubble burst, helicopter Ben, started throwing more money, more liquidity in the market. The Stock market and commodity became the next bubble. Actually Ben wanted just to inflate the share market, to create a wealth effect, but he has no control where the money ends up. So Oil went up from $35 to over $ 100 and gold and silver went for a parabolic rise. Don’t we hear the same logic about oil? Production is limited. India and China consuming more and more oil etc, when we all know that $40 out of every barrel price is for the speculators.

Let us look at the US Dollar index:

This is a 30 year monthly chart.  In March 2008, UD$ index reached its lowest level of 71. And gold reached $ 1000 for the 1st time. Thereafter when the dollar index jumped up, gold fell. If gold is to reach $ 5000 in the foreseeable future, the dollar index has to fall to the level of below 20. Can you imagine such a situation? If that was to happen, US dollar would have lost its world reserve status, there would be riot on the streets of USA, Gas would be $ 20 per gallon, and food prices would be beyond the reach of common people.
If and when gold reaches $ 5000/oz, we are better off buying guns and ammunition and fill up the basement with dry foods. Because then there will be civil war folks. Then we will not need gold.
Standard Chartered Bank knows that as well. They know that such a situation is not likely to happen. Still they come out with such a report. Only reason I can think of is that, they want to unload their gold position.
gold do well before the crisis not during the crisis. If there is a credit event, another recession, war , balance sheet contraction or whatever the theory the gold bugs are propagating, gold is sure to go down along with other asset class.

Personally, I think, Gold will reach a temporary bottom by end of June 2011, and then it will go up for another two, max three months and reach a top price of $1650/oz. That is when I would want to get out of gold.   

Friday, June 24, 2011

Are we there yet!

For days I have been writing that the sell off is not over yet because the fear factor is not high enough.

The stock market is ruled by greed and fear. Unless we see high fear, verging panic, we cannot call a bottom. How many investors purchased the 200 DMA? It seems quite a lot. It goes to prove that one should not buy based on TA, however TA is very useful while selling. All the TA indicators have been screaming oversold, buy and what not and yet the fear factor was absent.
This is the only chart one need to know. The Eur/Usd.

Remember that the stock markets are price driven not news driven. News follow the price. The 24/7 financial TV and channels have to report something to stay alive and seem relevant. So they spin any news according to the price action of that day and time. If the prices are moving higher, they paint the news rosy and if it is going down, the sound bites are gloomy. But no matter whatever the MSM ( Main Stream media) say, it is almost always irrelevant and on the borderline of being false news. One should see the latest of Jon Stewart on Fox news.

Moreover, we always find that the big movers and shakers (some hot shot hedge fund manager or bond king ) comes and gives their opinion regarding the future of the market. Or Gsucks give advice to its clients which are made public. 9 out of 10 times, we can be sure that they have an agenda. They want to sell high and buy low and they will say the exact opposite of what they are actually doing. A healthy distrust of these people or recommendations are essential for survival in the jungle of the stock markets.

A case of point was the last hour rally in the stock markets yesterday,23rd June 2011. Basically the market rallied on headline and without reading or understanding the full context. As if Greece has really been fixed! Like some one yelling fire and people rushing out in panic. In this case it was greed. The retail investors wanted to catch some early windfall and the news barons, who are billionaires, added some more to their wealth. Today morning all that gain was given up.

I still think we need to sell some more, go down below the 200DMA and have a panic situation. Only then we can call a bottom. But in this manipulated market, one can never be sure. 

PIMCO questions US financial focus

It's quite something when the managing director of PIMCO comes our and announces that the US has gone too far in seeking "wealth creation via financial assets," rather than boring things like science and manufacturing. Sean Paul Kelley at The Agonist points to this, which is worth a read.

Thursday, June 23, 2011

(Corrupt) Lawmakers challenge derivatives rules

I'm not the least bit surprised by this story detailing the push back by well funded (by whom, do you think?) US senators and representatives against proposed rules to reign in derivatives. Here's some choice material:
The lawmakers, Republicans and Democrats alike, argue that some proposed rules could force Wall Street’s derivatives business overseas. They also say that regulators are ignoring a crucial exemption to the rules spelled out in the Dodd-Frank financial regulatory law.

The law excused airlines, oil companies and other nonfinancial firms known as end-users from new restrictions, including a rule that derivatives must be cleared and traded on regulated exchanges. The firms use derivatives to hedge against unforeseen market changes, say a rise in fuel costs or interest rates, rather than to speculate.

“We are concerned that recent rule proposals may undermine these exemptions, substantially increasing the cost of hedging for end-users, and needlessly tying up capital that would otherwise be used to create jobs and grow the economy,” Senator Debbie Stabenow, Democrat of Michigan and chairwoman of the Senate Agriculture Committee, and Representative Frank D. Lucas, her Republican counterpart in the House, said in a letter this week to regulators.
I particularly like the phrase "airlines, oil companies and other nonfinancial firms known as end-users" identifying those who have restrictions. Does anyone doubt that lawyers and accountants at Goldman Sachs, JP Morgan and virtually every other big bank are working overtime right now deciding how they can turn the bank, or some subsidiary in the Cayman Islands, into an airline, oil company or other nonfinancial firm? I would bet they're just looking for a new pathway through which to route all their high risk stuff - and they've counseled the lawmakers on how they can best carve out some useful routes.

The other thing that is simply precious is this (the likes of which we've heard many times already, of course):
The lawmakers, Republicans and Democrats alike, argue that some proposed rules could force Wall Street’s derivatives business overseas.
The proper response would be not worry, but GOOD, PLEASE HURRY UP! Let them take their financial engineering business overseas and blow up someone else's economy.

P.S. Here's a random string of letters and digits: W8ENHMJ8MBKD. Ponder it if you like, but I don't see that it holds any particular meaning or interest. I have to tuck it into one of my blog posts somewhere to get listed on Technorati.

How they cook a lobster.

The Asians (Thailand, Korea) do it the conventional way. They throw the thing in hot boiling water.

In Latin America, they hammer it over the head and then cook it anyway they like it.

In Europe, they put Greece in a pot of cold water and then slowly turn up the heat!

Talk about the humane way of doing things without cruelty.

One would think that the colour of the skin of the lobster has everything got to do with the way of cooking.
When the economic crisis hit Asia in the 80s, these countries did not get pampered with all the Keynesian stimulus stuff, they did not get endless bounty of love to prop up their banks or any such sop. But ahh, there you have it. The banks in Asia did not owe money to the Banks in France. So the benevolent Europeans had nothing to lose if these countries went under. The currencies of the Asian tigers collapsed, businesses closed down and there were untold human miseries all around. Where was the humanitarian concern of IMF at that time? In fact IMF forced these Asian countries to do a cleansing without any social safety net at all. Why then the double standard now when their own European countries are facing the default.That's called new age of colonialism.

In fact if Greece were to default, it would not be the end of the world. Like the Asian countries, Greeks would get up, dust up and fix their economy in a way to become competitive once again. Greeks gave the world democracy but unfortunately today that is a society in decay. Tax avoidance is rampant, in fact at the highest level in Europe, the rich and powerful are in collusion with their political class and have already sent their money out of Greece. It is the bottom 90% who are being asked to join the belt tightening program. But they have got used to the easy life for last so many years and they will not accept anything less. In fact, instead of being thankful to the Germans for the good money that the Germans have thrown after bad money, they are now calling them Nazis. The ungrateful b******s. Not my word. The German press is saying it. The Greek society is blaming everyone else for their plight except themselves.
Anyway, the Lobster got to get cooked. The world will not end. At the most, the hierocracy and double standard of the Europeans will get cleansed along with some ill gotten wealth of the bankers. The growth will resume only after the mess has been cleared off.

The ticking CDS time-bomb

The looming mess in Europe, linked to financial distress in Greece, looks like a perfect if rather frightening illustration of the malign consequences of over-dense banking interdependence on global financial stability. In this case -- as with the crisis of 2007-2008 -- the root cause of the trouble is CDSs and other derivatives. No one in Europe is quite sure how many reckless gambles banks have made over Greek debt and potential default, and the European Central Bank appears to be deadly afraid that such gambles have the potential to bring down the entire financial house of cards.

What's happened to the CDS market over the past decade? It's exploded. Amazingly, the value of outstanding CDS linked to debt in Greece, Italy, Spain and Portugal has doubled in the past three years -- since 2008!! The New York Times today discusses what can only be described as a ridiculous situation -- Europe pushed to the brink of a financial disaster by the actions of a small number of people gambling with other peoples' money in the dark, and doing so in the direct aftermath of the greatest financial crisis since the Great Depression:
The uncertainty, financial analysts say, has led European officials to push for a “voluntary” Greek bond financing solution that may sidestep a default, rather than the forced deals of other eras. “There’s not any clarity here because people don’t know,” said Christopher Whalen, editor of The Institutional Risk Analyst. “This is why the Europeans came up with this ridiculous deal, because they don’t know what’s out there. They are afraid of a default. The industry is still refusing to provide the disclosure needed to understand this. They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”
 Wonderful. We've known about this danger for at least several years and have done nothing about it. But in fact, we've actually known about such danger for far longer, and have only taken steps to make our problems worse. A couple of years ago CBS aired an examination of the CDS market, and it is still worth watching. One interesting comment from the program:
It would have been illegal [selling CDSs of any kind] during most of the 20th century under the gaming laws, but in 2000, Congress gave Wall Street an exemption and it has turned out to be a very bad idea.

Wednesday, June 22, 2011

Dirty little derivatives secrets...

The first dirty little secret of the derivatives industry -- probably not so secret to those in the financial industry, but unknown to most others who still think financial markets in some approximation are fair and efficient -- is that some of the big banks control the market and expressly inhibit competition to protect their profits. I just stumbled across this still highly relevant exposition by the New York Times of efforts to place derivatives trading within properly defined clearinghouses, and the banks' countervailing efforts to gain control over those clearing houses so as to block competition.

The banks (invoking some questionable claims of economic theory) like to argue that derivatives make markets more efficient because they make them more "complete." As Eugen Fama puts it: "Theoretically, derivatives increase the range of bets people can make, and this should help to wipe out potential inefficiencies." Available information, the idea goes, should flow more readily into the market. But the truth seems to be that derivatives make banks more profitable at everyone's collective expense, and not only because they make markets more unstable (see more on this below). From the New York Times article:
Two years ago, Kenneth C. Griffin, owner of the giant hedge fund Citadel Group, which is based in Chicago, proposed open pricing for commonly traded derivatives, by quoting their prices electronically. Citadel oversees $11 billion in assets, so saving even a few percentage points in costs on each trade could add up to tens or even hundreds of millions of dollars a year.

But Mr. Griffin’s proposal for an electronic exchange quickly ran into opposition, and what happened is a window into how banks have fiercely fought competition and open pricing.

To get a transparent exchange going, Citadel offered the use of its technological prowess for a joint venture with the Chicago Mercantile Exchange, which is best-known as a trading outpost for contracts on commodities like coffee and cotton. The goal was to set up a clearinghouse as well as an electronic trading system that would display prices for credit default swaps.

Big banks that handle most derivatives trades, including Citadel’s, didn’t like Citadel’s idea. Electronic trading might connect customers directly with each other, cutting out the banks as middlemen.

The article goes on to describe a host of maneuvers that Goldman Sachs, JP Morgan and other big banks used to block this idea, or at least to make sure they'd be locked into the gears of such an electronic exchange. Eventually the whole idea fell apart to the banks' relief. Guess who's paying the price?
Mr. Griffin said last week that customers have so far paid the price for not yet having electronic trading. He puts the toll, by a rough estimate, in the tens of billions of dollars, saying that electronic trading would remove much of this “economic rent the dealers enjoy from a market that is so opaque.”

"It’s a stunning amount of money,” Mr. Griffin said. “The key players today in the derivatives market are very apprehensive about whether or not they will be winners or losers as we move towards more transparent, fairer markets, and since they’re not sure if they’ll be winners or losers, their basic instinct is to resist change.”
But there's another dirty little secret about the derivatives industry, and this goes back to the question of whether these instruments really do have benefits, by making markets more efficient, perhaps, or if instead they might make them more unstable and prone to collapse. Warren Buffet was certainly clear in his opinion, expressed in his newsletter (excerpts here) to Berkshire Hathaway shareholders back in 2002: "I view derivatives as time bombs, both for the parties that deal in them and the economic system." But the disconcerting truth about derivatives emerges in more certain terms from new, fundamental analyses of how precisely they can stir up natural market instabilities.

I'm thinking primarily of two bits of research -- one very recent and the other a few years old -- both of which should be known by anyone interested in the impact that derivatives have on markets. Derivatives can obviously let people hedge risks -- locking in affordable fuel for the winter months in advance, for example. But they're used for risk taking as much as hedging, and can easily create collective market instability. These two studies show -- from within the framework of economic theory itself -- that adding derivatives to markets in pursuit of the nirvana of market completeness should indeed make those market less stable, not more.

I'm currently working on a post (it's taking a little time) that will explore these works in more detail. I hope to get this up very shortly. Meanwhile, these two examples of science on the topic might be something to keep in mind as the banks try hard to confuse the issue and obscure what ought to be the real aim of financial reform -- to return he markets to their proper role as semi-stable systems providing funds for creative and valuable enterprise. Markets should be a public good, not a rigged casino, benefiting the few, and guaranteed by the public.

Monday, June 20, 2011

It is still " Sell the Rally".

Today was a double POMO day. Approx. US$ 10 Billion was pumped in the market but all S&P 500 has to show is only a rise of less than 7 handles. Not impressive at all.  One more thing to look for, S&P up for 3 days in a row but volume down 2 days in a row.  This is called price volume negative divergence and is normally a short sell set up.

I am not buying in the rally yet  for two reasons.  For one, I expect a lower low than the March low and second, the fear factor (VOX) has not yet reached the high 20s where we can see some panic. In fact at 3 pm, the put call ratio was .88. Means there are more calls than puts and people have reached the conclusion that the bottom is in.

I keep talking of the fear factor because stock market is ruled by greed and fear. Not by news, not by economics. In the past with SPX pullback of 10% or so, the VOX was on an average in the range of 28 +. By that reckoning, we have still some more way to go.

Stock market corrections are like quick sand. They advance two steps lower and rebound one step back, so that the fear factor does not build up too quickly. These countertrend rallies keep everyone interested and invested till such time the capital is gone.

Buying stocks in the face of fear and selling it in the face of greed is the only way to make money in stock market. I am not convinced that I am seeing that fear yet.

Sunday, June 19, 2011

I love " Love Stories"!

I love this story which came out just 2hours ago.
A German compromise plan to resolve a dispute with the European Central Bank over the Greek rescue that was reported by Der Spiegel magazine is no longer on the table, a government source said Sunday………. But a German official, who spoke on condition of anonymity, said that while "several options" were being debated to involve private creditors in an Athens rescue, the reported proposal was "no longer on the agenda".
The source added that the initial plan had differed from the reported proposal in "key aspects".
German officials say they seek a plan with as few "unwanted side effects" as possible. ”.

So already the “Non-Default” event of last Friday and the perfect family reunion photo-op of Mom and Pop shaking hands has been washed down the drain. Anyway the Bond Market has already called the bluff and the brief EUR rally might come to an end sooner than expected.

 I have a feeling, those who are looking for a rally on Monday, 20th June, might be in for some disappointment.

 I love this cartoon and could not resist copying it here. Courtesy

Whom they are trying to fool?

The pompous jacka*s duo Trichet and Sarkozy keep telling everyone who care to listen that there will be no haircut in Greek bailout. Everything will be voluntary and a Greek default is out of the question. They passionately defend everything that is European and throw hissy fit if anyone dares to say the inevitable.
One starts to wonder is it pure stupidity that these men cannot see the obvious? Or is there something else.
For an answer, let us look at the following chart.

Now we know!

The fact is, Trichet is a Frenchman and along with Sarkozy,  all he wants, is to keep the French banks out of the harm’s way, as long as possible. They know that they are just buying time and in the mean time, take money out of Germans and other still solvent European countries. They are doing the bidding of their masters after all.

Good to have such lap dogs!

The Grand Inquisitors of Rational Expectations

In this short snippet (two minutes and 23 seconds) of an interview, John Kay sums up quite succinctly the situation facing Rational Expectations theorists in the light of what has happened in the past several years. Reality just isn't respecting their (allegedly) beautiful mathematical theories.

In Bertold Brecht's play The Life of Galileo, Kay notes, there's a moment when the Grand Inquisitors of the Church refuse to look through Galileo's telescope. Why? Because the Catholic church had essentially deduced the motion of the planets from a set of axioms. They refused to look, as Kay puts it,
......on the grounds that the Church has decreed that we he sees cannot be there. This makes me think of the way some of the economists who believe in Rational Expectations have reacted to events of the past few years. [They're like the inquisitors with Galileo]. ...they refuse to look through the telescope because they know on a priori grounds that what he saw wasn't actually there.

In search of a bottom!

The stock markets have been selling off for the last 6 weeks and have barely had a green close this week.
Lots of people including many subscription based newsletters have been advising their readers to look at the long side of the trade again.
Some are saying the VIX has gone out of the BB and come back and that’s a sure sign of market rally. Some are looking at the high put/call ratio. Many are looking at chart patterns and technical Analysis to find the coming trend.

In my long association with the Stock Market, I have come to few conclusions and I base my trades on that. I do not believe that TA gives you any clue of the future. It just represents history.  I would be better off reading tea leaves. I also do not do day trading. Because I think it is like sitting on a rocking chair. It keeps you occupied but doesn’t take you anywhere. Moreover, when you are always looking at one minute or five minute charts, you tend to miss the big moves.

For a longer range trade I still depend on old fashioned fundamental analysis. But for trading purpose, I would rather look at market psychology. The stock markets represent the animal instinct and primal gambling nature of human being. Did you ever notice that there are more men than women in the field of speculation? That’s because men take more risks. Women make better investment decision although we men think we know better!

Stock markets are governed by greed and fear. And the pendulum swings between the two extremes. My measure of fear factor in the US Stock Markets is still VOX. Not VIX. VOX measures at the money options where as VIX measures out of the money options. VOX measures only the top 100 S&P companies which are more liquid and highly traded. In all similar selloffs / corrections where S&P has corrected between 5% to 10%, bottom has come when VOX has reached the level of 30%. Today it is still in the range of early 20s, which shows that while some fear is still there, panic has not yet set in.

And unless we see the panic, we would not see the bottom of this correction.
That is my humble view but market knows best and I can be very well wrong if we start a rally on Monday. After all it’s a double POMO day.
For me, I would still sell the bounce.

Saturday, June 18, 2011

Millisecond mayhem

The terrifying Flash Crash of 6 May 2010 has long dropped out of the news. The news cycle more of less ended with the release of the SEC's final report on the event in October of last year which concluded that...well... the event got kicked off by a big trade in E-Mini Futures by Waddell and Reed and played out in two subsequent liquidity crises exacerbated -- and crammed into a very short time-sale -- by high-frequency traders. In essence, the report concluded that A happened, then B happened, which caused C to happen, etc., and we had this Flash Crash. What it didn't explore is WHY this kind of this was possible, WHY the markets as currently configured should be prone to such instabilities, or WHY we should have any confidence similar things won't happen again.

I'm not sure what triggered my interest, but I had a quick look today to see if any similar events have taken place more recently. Back in November of last year the New York Times reported on about a dozen episodes it called "mini flash crashes" in which individual stocks plunged in value over a few seconds, before then recovering. In one episode, for example, stock for Progress Energy -- a company with 11,000 employees -- dropped 90% in a few seconds.  These mini whirlwinds are continuing to strike fear into the market today.

For example, this page at Nanex (a company that runs and tracks a whole-market datafeed) lists a number of particularly volatile events over previous months, events in which single stocks lost 5%, 17%, 95% over a second or five seconds before then recovering. According to Nanex, events of this kind are now simply endemic to the market -- the 6 May 2010 events simply seems larger than similar events taking place all the time:
The most recent data available are for the first month and three days of 2011. In that period, stocks showed perplexing moves in 139 cases, rising or falling about 1% or more in less than a second, only to recover, says Nanex. There were 1,818 such occurrences in 2010 and 2,715 in 2009, Nanex says.
 A few specific examples as reported on in this USA Today article:
•Jazz Pharmaceuticals' stock opened at $33.59 on April 27, fell to $23.50 for an instant, then recovered to close at $32.93. "There was no circuit break," says Joe Saluzzi, trader at Themis Trading, because Jazz did not qualify for rules the exchanges put in place after the flash crash for select stocks following extreme moves.

•RLJ Lodging Trust was an initial public offering on May 11. It opened at $17.25 its first day, then a number of trades at $0.0001 took place in less than a second before the stock recovered. The trades were later canceled, but it's an example of exactly what is not supposed to happen anymore, Hunsader says.

•Enstar, an insurer, fell from roughly $100 a share to $0 a share, then back to $100 in just a few seconds on May 13.

•Ten exchange traded funds offered by FocusShares short-circuited on March 31. One, the Focus Morningstar Health Care Index, opened at $25.32, fell to 6 cents, then recovered, says Richard Keary of Global ETF Advisors. The trades were canceled. "No one knows how frequently this is happening," he says.

•Health care firms Pfizer and Abbott Labs experienced the opposite of a flash crash on May 2 in after-hours trading. Abbott shares jumped from $50 to more than $250, and Pfizer shot from $27.60 to $88.71, both in less than a second, Nanex says. The trades were canceled.
 Apparently, according to the Financial Times, something similar happened just over a week ago, on 9 June, in natural gas futures.

I haven't seen anyone who has explained these events in some clear and natural way. I still see a lot of hand waving and vague talk about computer errors and fat fingers. But it seems unlikely these tiny explosions in the market are all driven by accidents. Much more likely it seems to me is that these events are somehow akin to those dust devils you see if driving through a desert -- completely natural if rather violent little storms whipped up by ordinary processes. The question is what are those processes? Also -- how dangerous are they?

The best hint at an explanation I've seen comes from this analysis by Michael Kearns of the University of Pennsylvania and colleagues. Their idea was to study the dynamics of the limit order mechanism which lies at the mechanical center of today's equity markets, and to see if it is perhaps prone to natural instabilities -- positive feed backs that would make it likely for whirlwind like movements in prices to take place quite frequently. In other words, are markets prone to the Butterfly Effect? Their abstract gives a pretty clear description of their study and results:
We study the stability properties of the dynamics of the standard continuous limit-order mechanism that is used in modern equity markets. We ask whether such mechanisms are susceptible to "Butterfly Effects" -- the infliction of large changes on common measures of market activity by only small perturbations of the order sequence. We show that the answer depends strongly on whether the market consists of "absolute" traders (who determine their prices independent of the current order book state) or "relative" traders (who determine their prices relative to the current bid and ask). We prove that while the absolute trader model enjoys provably strong stability properties, the relative trader model is vulnerable to great instability. Our theoretical results are supported by large-scale experiments using limit order data from INET, a large electronic exchange for NASDAQ stocks.
The "absolute" traders in this setting act more like fundamentalists who look to external information to make their trades, rather than the current state of the market. The "relative" traders are more akin, at least in spirit, to momentum traders -- they're responding to what just happened in the market a split second ago and changing their strategies on the fly. Without any question, there are indeed many high-frequency traders who are "relative" traders -- probably most. So mini-flash crashes -- perhaps -- are merely a sign of natural instability and chaos in the micro dynamics of the market.

Friday, June 17, 2011

Bond Market has called the bluff of Europe.

This morning we work up with the wonderful news that Greece has been saved. Mom and Pop have made up and have given a nice photo-op. The “non default, default”  event was conjured up by the Politicians of Europe in the style of Prof. Dumbledore.  For a brief few hours we were transported to Hogwarts, the mystical and magical land. And then, poof! The magic went out of the window. The Bond Market called the bluff, lie and farce of the European politicians.
Let’s start with Greece.
Two year yield was near 30%. Not a sign of confidence, eh?

May be Ireland was doing better?
But last we saw, it was over 11%

We would probably have better luck with Portugal.
But no such luck, the rate was nearing 11%.

How about Spain?

Hmmmm, getting near 6%. What the bond market is seeing that we are missing?

But nothing to worry. Core Europe is fine.
Really?  Let’s look at Italy.

But if it is so fine, how come the rate there is near 5%.

The pompous fool of Trichet and Sarkozy is giving media show and gaining some more time for the Banks of their country, France. I don’t think they really care about Greece or united Europe or Euro, I think they are concerned with their jombi banks which are definitely going to go bust along with Greece. By the way, banks in France will be affected more badly than the banks in Germany when the time comes.
I also think, Merkel agreed to go along with Sarkozy for now because Germany have set September as their date of reckoning and the banks in Germany need some more time to withstand the catastrophic effect of the Greece default.
But the Bond Market and the Stock Markets called their bluff. The S&P 500, which went up 10 handles in the morning with the news of the “Non Default”, gave up almost all its gain for the day and at some point, was on the verge of going negative. Only some last minute monkey job saved the day for option expiry. The investing community knows a default when they see one.
I hate to say, “I told you so”, but I did tell you in the morning don’t believe this rally. It was running on empty.

Real steps on banking reform?

Don't want to get too wildly optimistic. When it comes to banking regulations, disappointment always lies just around the corner and everything important happens behind the scenes. But a couple things today give me some cautious hope that regulators interpreting the new Basel III banking rules may actually take some real steps to curb systemic risks -- they may even take the structure of banking network interactions into account.

First, Simon Johnson gives an excellent summary of recent developments in the US where banking lobbyists seem to have been caught flat-footed by recent steps taken by Federal Reserve governor Dan Tarullo. I hope this isn't just wishful thinking.

The banks are apparently pushing four key arguments to explain why it's a really horrific idea to make the banking system more stable, and why, especially, the world will probably end quite soon in a spectacular fiery cataclysm of the biggest and most well-connected banks are required to keep an additional few percentage points of capital. Johnson dissects these arguments quite effectively and suggests, encouragingly, that regulators at the Fed, charged with interpreting Basel III, aren't convinced either.

Elsewhere, this Bloomberg article suggests -- and this really surprises me -- that the measures under consideration would...
.. subject banks to a sliding scale depending on their size and links to other lenders.
Now this is an interesting development. Someone somewhere seems to be paying at least a little attention to what we're learning about banking networks, and how some risks are tied more directly to network linkages, rather than to the health of banks considered individually. The density of network linkages itself matters.

Research I've written about here suggests that there's essentially no way to safeguard a banking system unless we monitor the actual network of links connecting banks. It's certainly an encouraging step that someone is thinking about this and trying to find ways to bring density of linkages into the regulatory equation. I hope they're pondering the figure below from this study which shows how (in a model) the overall probability of a banking failure (the red line) at first falls with increasing diversification and linking between different banks, but then abruptly begins rising when the density gets too high.

The implication is that there's likely to be a sweet spot in network density (labeled in the figure as diversification, this being the number of links a bank has to other banks) from which we should not stray too far, whether the big banks like it or not.

A Stock Market rally is coming today.

So Greece has been saved while we were sleeping!
Germany and France apparently agrees on the common ground and there will now be another bailout package of $ 150 billion. No haircut for senior / private investors. And so the S&P futures are already up 12.5 points one hour before the open. A rally is coming today. Isn’t that a perfect world!
I have already said in my blog that we should expect the Stock Markets to go up on Thursday and Friday. How did I know? Did I have a dream or vision? No, but I am getting a feeling of the pattern of the manipulation in my head.
But I said that the low is not in yet and don’t believe in any bull$hit rally. There was not enough panic in the market for the market to go up. There was no gut wrenching despair and talk of share market crash. Everybody was expecting a bounce and bounce we are getting. Now everyone cannot be correct at the same time. To quote from one of my favorurite blogger Rohan from Australia:                                                                   ” if everyone has the same opinion, and has entered into the same trade in anticipation of that opinion playing out, then no-one is left to ‘buy’ or ‘sell’ to deliver the outcome that is the expected by the consensus opinion.”.
I think the stock markets will go up substantially today, not because the problems of the world have been kicked down for few months, but because the manipulators have to kill maximum number of puts and calls and so they have to pop the market today. Today might be a perfect opportunity to close all the longs and go on the short side of the market. 
I am expecting a lower low in the coming week.

Thursday, June 16, 2011

Till “Debt” do us part.

The Stock markets in USA, reached their bottom only two years ago.  It was June 2009 when S&P 500 reached a low of 666, Dow reached a low of 6470. Two years hence S&P reached a high of 1370, Dow reached a high of 13870. They doubled!
So the factors which caused the stock markets to collapse in the 1st place have all been sorted out, correct? Otherwise how come such a parabolic gravity defying moves?  But then we are shocked to see that unemployment is still above 9%. We are shocked. Even after spending over US $ 2 trillion, what we have to show for? Only the wealth effect in the stock market and commodity speculation. Sad but true. So what is driving the stock markets? For answer let us look at the following picture.

It is the huge amount of leverage built up on margin , helped by QE1 and QE2 , that has encouraged the investors, speculators and yield hungry pension funds to pile on to the long side based on the mantra  “ don’t fight the Fed”.  Margin levels are almost at the same level where they were in 2008.
But debt on debt does not help growth of GDP. If you have read the excellent book, “This time is different” by Reinhart & Rogoff, you know that after the debt has reached a certain percentage of GDP, it actually reduces growth and leads to default. Reinhart & Rogoff have given numerous examples from the last 700 years of various countries, where Countries have defaulted because they took on excessive debt. And we see that happening in Greece, Ireland, and Portugal and in so many other places. Japan has become a country in perpetual deflation for the last 3 decades and most likely the same situation awaits us here. The similarities between USA and Japan are too much to ignore, but that is a discussion topic for another day.
When the going was good, Greenspan was giving away free money and creating another bubble, all these banks and speculators have borrowed and invested, rather speculated on various assets, whose value today is less than half of what it was initially. Thus there is debt destruction or balance sheet contraction. Even the two trillion US Dollar that helicopter Ben has pumped in the system in the last 2 years, have not been able to increase the money  supply in the system because the banks are busy repairing their balance sheet to the extent they can. They are now holding approx. US Dollar 1.5 trillion in their cash reserve and hoping that when the sushi hits the fan now, they would be able to survive.
The problem facing us is not inflation, in spite of the money pumping because everywhere the value is getting destroyed, be it home equity for the individuals or loan portfolio of the banks. The powers that be have tried to fight this with more debt and it is failing. And they know that they are facing the demons of deflation.
Now we go back to the chart at the top. When deflation finally hits the shore, when the contagion from Europe catches up with USA and the dominos fall, the margins will be called 1st and this time there will not be anyone to re-inflate it again. According to Russell Napier, the S&P 500 will reach 400 at the end of the true bear market. If such a situation should arise, all the castles of sands will be washed out to sea because:  the final bear market stage "is caused by distress selling of sound securities, regardless of their value, by those who must find cash market for at least a portion of their assets."

Low is not in yet.

I have mentioned in my morning post that today would most like be a green day. So it was. And I expect a big jump tomorrow and possibly on next Monday as well. But do not read much into these counter trend rallies because the next week may not be pretty. The low is not in yet.

Profit from the "End Game".

Yesterday, one of the protesters in Greece was carrying a placard with a sign that their Prime Minister, George Papandreou was "Goldman Sach’s employee of the month". Now that’s a good insult. If the Greeks can get it, understand it that they have been screwed tight by the Banksters, why can’t the Americans, Irish and people in similar situation?
I have mentioned before, that it is a question of when not if Greece will default. Nobody can survive with 160% debt to GDP, when the economy is shrinking and you don’t have the control of money in your own hand. One way to default would have been to devalue the old Greek currency, but that option is not available today.
Today the question is, is the end is now or will they be able to kick down the can for some more time. Knowing the politicians, they will try to kick the can to infinity and the effort is on in earnest.

Reuters, reports, Germany now "wants the deadline for a second Greek rescue package to be pushed back to September, reflecting the problems Europe is having hammering out the details, EU and banking sources said on Thursday."
One EU source told Reuters that German Chancellor Angela Merkel and Finance Minister Wolfgang Schaeuble favored a delay.

"The argument goes: We don't know what to do, let's buy more time," the source said, adding that Berlin had its customary backing from the likes of the Netherlands, Finland and Slovakia.

A high level German banking source also told Reuters Berlin was targeting September as the point at which all the problems could be solved

The euro reached 1.4080 by 8.30 AM but is now rallying back above 1.4141. The US Dollar index which was above 76 in early morning has now come down to 75.74. All these are happening in the last one hour, indicating that the end has been pushed down for some other day. Reading between the German official statements, they are saying that their Banks will be ready to absorb the shock of the Greek Default by September. I think Germans are now ready for the default eventuality, they always were and being methodical and systematic people as they are, they have now fixed a date and time for the inevitable.
Meanwhile, jobless claim has come out and it is below expectation. Something to spin around for a higher stock price in the US Markets. Yesterday was a major distribution day (NYSE down Volume: NYSE up Volume >= 9) and the day after a major distribution day is usually a green day. Unless something happens that is beyond the control of the manipulators. And going by the Option Pain results, they will try to push the markets up today and tomorrow.
But the selling is not over yet and will not be over till next week at the earliest. They want to create panic and are almost there. Yesterday Barron’s screamed about “Bull Run” being over. Times had an article about weak economy. NY Times ran something similar. So one last time they want to buy cheap and by September will sell it back high. If we can ignore the talking heads of the televisions and MSM, if we can do just the opposite of the recommendations of the likes of Cramer, we should be OK. It is not difficult to see through their broader plan; the immediate timing may vary a bit. In the end, we might be able to profit from that end game.

Complexity economics

Complexity is one of the hottest concepts currently nipping at the fringes of economic research. But what is it? Richard Holt, David Colander and Barkley Rosser last year write a nice essay on the concept which makes some excellent points, and they're certainly optimistic about the prospects for a sea change in the way economic theory is done:
The neoclassical era in economics has ended and has been replaced by an unnamed era. We believe what best characterizes the new era is its acceptance that the economy is complex, and thus that it might be called “the complexity era.”
Indeed, something like this seems to be emerging. I've been writing about complexity science and its applications in physics, biology and economics for a decade, and the ideas are certainly far more fashionable now than they were before.

But again -- what is complexity? One key point that Holt and colleagues make is that complexity science recognizes and accepts that many systems in nature cannot be captured in simple and timeless equations with elegant analytical solutions. That may have been true with quantum electrodynamics and general relativity, but it's decidedly not true for most messy real world systems -- and this goes for physics just as much as it does for economics. Indeed, I think it is fair to say that much of the original impetus behind complexity science came out of physics in the 1970s and 80s as the field turned toward the study of collective organization in disordered systems -- spin glasses and glassy materials, granular matter, the dynamics of fracture and so on. There are lots of equations and models used in the physics of such systems, but no one has the intention or hope of discovering the final theory that would wrap up everything in a tidy formula or set of axioms.

Most of the world isn't like that. Rather, understanding means creating and using a proliferation of models, every one of which is partial and approximate and incomplete, which together help to illuminate key relationships -- especially relationships between the properties of things at a lower level (atoms, molecules, automobiles or people) and those at a higher level (crystal structures, traffic jams or aggregate economic outcomes).

Holt and colleagues spend quite some time discussing definitions of complexity, a task that I'm not sure is really worth the effort. But they do arrive at a useful distinction between three broad views -- a general view, a dynamic view, and a computational view. The second of these seems most interesting and directly related to emerging research focusing on instabilities and rich dynamics in economic systems. As stated by Rosser, a system is "dynamically complex" if...
it endogenously (i.e. on its own, and not because of external interference) does not tend asymptotically to a fixed point, a limit cycle, or an explosion.
In other words, a dynamically complex system never settles down into one equilibrium state, but has rich internal dynamics which persist. I'm not sure this definition covers all the bases, but it comes close and certainly strikes in the right direction.

Holt, Colander and Rosser go on to outline a number of areas where the complexity viewpoint is currently altering the landscape of economic research. I wouldn't quibble with the list: evolutionary game theory is bringing institutions more deeply into economic analysis, ecological economics is actually bringing the consideration of biology into economics (imagine that!), behavioural economics is taking account of how real people behave (again, what a thought!), agent-based models are providing a powerful alternative to analytical models, and so on.

This is all insightful, but I think perhaps one point could be more strongly emphasized -- the absolute need to recognize that what happens at higher macro-levels in a system often depends in a highly non-intuitive way on what happens at the micro-level. One of the principle barriers to progress in economics and finance, in my opinion, has been the the systematic effort by theorists over decades to avoid facing up to this micro-to-macro problem, typically through various analytical tricks. The most powerful trick -- a pair of tricks, really -- is to assume 1) that individuals are rational (hence making the study of human behaviour a problem not of psychology but of pure mathematics) and 2) assuming (in what is called the representative agent method) that the the behaviour of collective groups, indeed entire markets and economies, can be calculated as the simple sum of the rational actions of the people making it up.

The effect of this latter trick is actually quite amazing -- it eliminates from the problem, by definition, all of the interesting interactions and feed backs between people which make economies and markets rich and their dynamics surprising. Having done this, economics becomes a mathematical task of exploring the nature of rational behaviour -- it essentially places the root of complex collective economic outcomes inside the logical mind of the individual.

To put it most simply, this way of thinking tends to attribute outcomes in collective systems directly to properties of parts at the individual level, which is a terrific mistake. This might sometimes be the case. But we know from lots of examples in physics, biology and computer science that very simple things, in interaction, can give rise to astonishing complexity in a collective group. We should expect the same in social science: many surprising and non-intuitive phenomena at the collective level may reflect nothing tricky at all in the behaviour of individuals, but only the tendency for rich structures and dynamics to emerge in collective systems, created by myriad pathways of interaction among the system's parts.

Taking this point seriously is what I think most of complexity science -- as applied to social systems -- is about. It's certainly central to everything I write about under the phrase the "physics of finance." I take physics in the broad sense as the study of how organization and order and form well up in collective systems. It so happened that physics started out on this project in the context of physical stuff, electrons, atoms, molecules and so on, but that's merely a historical accident. The insights and methods physics has developed aren't bound by the nature of the particular things being discussed, and this project of understanding the emergence of collective order and organisation goes well beyond the traditional subject matter of physics.

Holt, Colander and Rosser make one other interesting point, about the resistance of macro-economists in general to the new ways of thinking:
Interestingly, these cutting edge changes in micro theory toward inductive analysis and a complexity approach have not occurred in macroeconomics. In fact, the evolution of macroeconomic thinking in the United States has gone the other way. By that, we mean that there has been a movement away from a rough and ready macro theory that characterized the macroeconomics of the 1960s toward a theoretically analytic macro theory based on abstract, representative agent models that rely heavily on the assumptions of equilibrium. This macro work goes under the name new Classical, Real Business cycle, and the dynamic stochastic general equilibrium (DSGE) theory, and has become the mainstream in the U.S.
This is quite depressing, of course, but if most of what Holt and colleagues write in their essay is true, it cannot possibly stay this way for long. Economics as a whole is changing very rapidly and macro can't remain as it is indefinitely. Indeed, there are already a number of researchers aiming to build up macro-economic models "from the bottom up" -- see this short essay by Paul De Grauwe, for example. All this spells certain near-term doom for the Rational Expectations crowd, and that doom can't come a moment too soon.

Wednesday, June 15, 2011

A Good Shake

I have been watching the live streaming and reading news all day about the 3rd general strike in Greece. Now it is 4 pm my time and it is night out there in Athens. Thousands of people, estimated to be around 40000+ , have blocked the Greek Parliament. Police have fired teargas towards the crowd who are slowly becoming unruly.
We are seeing it in a country which is supposed to be part of the developed world, not a third world country. The anger of the population is so immense that one can almost touch it. The same anger is growing in the youth of Spain, people in Ireland are getting restive. And I wonder, whether we shall see that kind of anger in USA.
Iceland was smart. They gave the middle finger to the European bankers and now they are on the path to recovery. Everywhere else in the developed world, the bankers have passed on all the losses to the population and now it is the bottom 90% who are asked to sacrifice, the social safety net programs are being dismantled or reduced, Public utilities are being sold off to private entities and the politicians are trying to reduce the tax rate on the rich. This is not "Democracy", this is "Oligarchy". And this is also the recipe for disaster. Social unrest will definitely follow in a big way and the capital market will be destroyed. Democracy and capitalism as we know today will not be the same. But that is another day.
As we talk, S&P 500 is sitting just above the 200 DMA. Last time it was below 200 DMA was in Sept 2010. Today S&P 500 fell over 22 points or 1.73%. All the gains of yesterday were given back and some more. This is exactly what I said yesterday, that do not believe in this bull$hit rally.  Where it will go from here, nobody can say. But we can make an educated guess, based on so many other parameters, some fundamental, some technical and some based on the observation of the market manipulation.
I think the market will close green tomorrow as they will try to kill as many puts as possible. Because CBOE equity only put call ratio now reflect more put buying by the retail investors. The short term average of the ratio now stand at 0.76 (from 0.64 last week), which is highest since last summer’s correction.
However the week after Triple witching week is usually bad. Dow has declined 19 of the past 21 years in the week after.  I therefore do not think that a low has been set in. While VIX has touched the top of the Bollinger band, it has not yet jumped through it. I think, sometime in the next 10 days, there will be one night when the Futures, as well as the entire world is in deep red, and if you are long, (purchased the f**king dip) you will find it very hard to sleep and market keeps selling off until you feel pain in the stomach, don’t hit the sell button yet because most likely the bottom is in then.  
From the top of 1370, we should expect a 10% selloff as a normal correction and therefore we have to close well below the March low. I would think the range is somewhere between 1230 to 1240 when we can call a bottom. By then gold, silver, oil and every other risk trade would have got a good shake out. 

And I plan to go long thereafter.  

Slippery bankers slither through the constraints...

A couple months ago I wrote this short article in New Scientist magazine (it seems freely available without subscription). It pointed out a troubling fact about recent measures proposed to stop bankers (and CEOs and hedge fund managers, etc.) from taking excessive risks which bring them big personal profits in the short run while saddling their firms (and taxpayers) with losses in the long run. The problem, as economists Peyton Young and Dean Foster have pointed out, is that none of these schemes will actually work. If executives keep tight control on details about how they are running their firms and how they are investing, they can always game the system by making it look outwardly to others that they're not taking excessive risks. There's no way to control it without much greater transparency so shareholders or investors can see clearly what strategies executives are using.

Here's the gist of the article:
You might think that smarter rules could get around the problem. Delay the bonuses for five years, perhaps, or put in clauses allowing the investor to claw back pay if it proves undeserved. But it won't work. Economists Dean Foster of the University of Pennsylvania in Philadelphia and Peyton Young of the University of Oxford have now extended Lo's argument, showing that the problem is simply unsolvable as long as investors cannot see the strategies used by managers (Quarterly Journal of Economics, vol 125, p 1435).

As they point out, delaying bonuses for a few years may deter some people as the risky strategies could explode before the period is up. But a manager willing to live with the uncertainty can still profit enormously if they don't. On average, managers playing the game still profit from excess risk while sticking the firm with the losses.

So-called claw back provisions, in the news as politicians ponder how to fix the system, will also fail. While sufficiently strong provisions would make it unprofitable for managers to game the system, Young and Foster show that such provisions would also deter honest managers who actually do possess superior management skills. Claw back provisions simply end up driving out the better managers that incentives were meant to attract in the first place.
This work by Young and Foster is among the more profound things I've read on the matter of pay for performance and the problems it has created. You would think it would be front and center in the political process of coming up with new rules, but in fact it seems to get almost no attention whatsoever. From this article in today's Financial Times, it seems that bankers have quite predictably made some quick adjustments in the way they get paid, conforming to the letter of new rules, without actually changing anything:
Bank chiefs' average pay in the US and Europe leapt 36 per cent last year to $9.7m, according to data compiled for the Financial Times, despite variable performance across the sector....

Regulators have declined to impose caps on bank pay, instead introducing changes they believe will limit incentives to take excessive risks. That has led many banks to increase fixed salaries, reduce employees’ reliance on annual bonuses and defer cash and stock awards over several years.

“The real story around pay is the progress on ensuring bonuses are deferred, paid in shares and subject to clawback and performance targets, rather than the headline figure,” said Angela Knight, British Bankers’ Association chief executive.
 It's just too bad that we already know it won't work.