Sunday, July 31, 2011

Dark Clouds Over The American Dream.

For over 200 years, America has been the place which draws the best and the brightest from all over the world. It is the place where dreams come true.  

In his definition of the American Dream, James Truslow Adams said in 1931, "life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement" regardless of social class or circumstances of birth. 

Let me quote from Wikipedia: “The idea of the American Dream is rooted in the United States Declaration of Independence which proclaims that "all men are created equal" and that they are "endowed by their Creator with certain inalienable Rights" including "Life, Liberty and the pursuit of Happiness." “

Such noble words!  “Life, Liberty and Happiness”. Is there anything else in life? Yet, we now find that our dreams for a better life, a better future for the next generations are being increasingly threatened.  The middle class, which forms the back bone of the American Society, is being squeezed like never before. Somewhere along the line, the dream has been robbed by the Grinch. The Grinch exists on both sides of the aisle. Today the top 0.01% of the population control over 70% of the wealth.

 The last ten years have been exceptionally bad. We waged wars which were not needed, gave money to the super rich under political patronage, and even when the Oligarchy bought the country down to the ground with its financial frauds, we socialized the losses while privatizing the profits.
Three years after the financial tsunami, not a single person has been punished. Those responsible for the messes are bigger than before. They wrote a 2000 page law which promised much, but delivered little. One year after the Dodd-Frank Act, we still have no consumer protection as promised and only a handful watered down laws have been written so far which are totally ineffective.  We put lipstick on the pig and made it beautiful. Grinch has really robbed our dream.
The giant Ponzi scheme that is being played on us is now reaching its end game. The illusion of prosperity cannot be carried on much more. The growth built up on borrowed money is collapsing like a house of cards. Look at the dark clouds on the horizon.

•           The socialist economies of the Europe has almost but collapsed. The unemployment is Spain is almost 40%.
•           Growth is negative in Italy, Greece, Ireland, Portugal, Spain, UK.
•           Banks in Italy, Spain as well as France are dead men walking. With the slightest weakness in the global financial system, banks in these countries will be denied further liquidity, so necessary to keep them alive.
•           Japan has been in depression for decades now with little sign of any life in the economy and with a debt to GDP ratio of over 200%.
•           GDP growth is now officially 1.3% in the USA and 0.3% in Canada.
•           Much closer to the shore, shipping container traffic is slowing, rather, decreasing alarmingly.
•           The growth in China since 2008 is purely construction driven, with very little domestic consumption growth. This is another Ponzi scheme that is about to collapse soon, bringing the commodity sector down with it.
•           The ports in China, the export powerhouse of the world, are seeing their total numbers falling dramatically.
•           There is no job growth in the USA nor there any real income growth for the last decade. The consumer spending which constitute 70% of the economy is unsustainable when the QE is taken out of the system.
•           The major shock is going to come from the Balance Sheet Contraction at a global level. Here in the USA, just the residential housing sector has lost well over $ seven trillion value from its peak. Add to that useless MBS that the financial institutions hold, trillions of dollars of derivatives based on such valueless properties, and we just sitting on a ticking time bomb.
•           The frauds in the financial sector continue and more than ever, Government is now a part of that fraud, aimed to keep the status-quo going.
•           Since 2008, over $ two trillion has been pumped in the system, to give the wealth effect based on the misguided trickle-down theory. All it has done is to increase the debt to more dangerous level, where the law of diminishing return is now in play. It has merely helped keep the big banks alive yet reducing the market value of assets in their books. If the banks follow the proper accounting principles, and start marking their assets to the market, instead of fantasy, each one of them will be bankrupt. Yet, today they are pillars of our financial system.
•           We have not touched the Geo-political tensions that are smoldering in different parts of the world. Bombing of Iran by Israel is a real possibility. The unrest in MENA region is going on and Syria is about to explode soon. China is having serious tension with its neighbor in the south sea region. In South East Asia, Pakistan is an unstable country with nuclear capability and the fountain head of global terrorism. Pakistan with its proxy Muslim fundamentalist military dictatorship is hell bent on destroying secular democratic India. India and China are having issues with water. Drinking water is going to be a major flash point and potential conflict point in the future.

These  list can go on and on. But there is no way the western civilization can continue to enjoy the lifestyle of the last 40 years. The payback time is here and now.

The debt drama is just a diversion from the real challenges. I never doubted for a second that America will raise its debt ceiling. Each politician owes his/her position to some special interest groups. Do you ever think GS or JPM would allow the USA to default now? After-all even the most power-full politician in Washington has just one head on shoulder. This drama was just to scare the general population to sell cheap. The next chapter will be euphoria. The Boyzs who control the markets, know that the end is near. They now need to make one last effort to suck as much money out of the ordinary Americans and their retirement funds and savings.

It is a monkey business alright. If SPX can fall 50 points in three days, it can also go up 100 points in six days. Do not be surprised to see the markets making new highs in August. But that will not be the beginning of a new bull market. Rather, it will be the beginning of the end. Hope you have not sold out in this panic. Sell when the market is experiencing an out of the body high and be prepared for the next storm. It is coming. 
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Friday, July 29, 2011

Market Analysis and Outlook, July 29.

We need to re-visit my yesterday’s post to make a sense of what happened today.  Among many other things, I made the following points:

·         I think we are still in a Bull market, although it is coming to an end. 
·         Tomorrow the QE2 GDP will come out and it may miss expectations. Coupled with uncertainty, this may trigger the SPX to dip below 1300 level.

And this is what exactly happened today.

I am not so much worried about the debt drama as the falling GDP, in-spite of the huge Government stimulus that has gone in the economy so far. The growth engine is coming to a stall and smart money knows it. They also know that the situation in Europe is still worse. That is why US T.Bonds are in such high demand even when AAA rating may be in question.  SPX came down hard, touched the 200DMA and bounced and that says a lot.

The market action today is signaling that a bottom is in or will be in soon. See the hammers in the Index.
All selling in the past have bottomed when such candle patterns have emerged.

SPX went down up-to 1282 level and bounced back. Couple of times, even came in green.

And VIX went through the sky again. That is three days in a row VIX has closed beyond BB. The fear factor is now in high 20s and I have written repeatedly in the past that for the selling to complete, fear factor has to be in high 20s. We got that today.

VIX also has a spinning top today. ” After a long decline or long black candlestick, a spinning top indicates weakness among the bears and a potential change or interruption in trend.”( Stockcharts).

Once again, I think a bottom was in today.                                                                 

But here is the paradox. On one hand a bottom is in and on the other hand the economy is stalling. Will we not sell now? Isn’t it time for another bear market to start?

I have been repeatedly saying that the world is not going to end on 2nd August. Although the US economy is almost at stall speed, it has not yet reversed. So we will muddle through, if there are no other external shocks. Even if the unemployment is at 10%, it is still better than Europe or Japan. The US Banks, in a bad shape as they are, still are in a better shape than their European counterparts.  And there are plenty of cash on the sideline. The market will not go down unless it has soaked all the cash up.

So I expect the stock market to rocket upward as soon as the drama in Congress is resolved. We will be greedy when others are fearful and fearful when others are greedy. It is easy to understand the fear, but difficult to understand and control the greed. In a few weeks, when the market is going up again, we will forget this crisis and MSM will present all the good and beautiful stories. We will think that the good time is not going to end. 

That is when we will turn bears, not today. 

Democracy Crisis

I've long felt that while we need a better science of markets and economics in general, one that embraces ideas from other areas of modern science and brings economics up to date, this will never be enough. The recent crisis wasn't just a puzzling episode, a strange and unpredictable financial hurricane; it emerged directly out of the deep influence of financial industry money on governance. There's no solution to financial stability without good governance.

It's a depressing read, but this long essay by Numerian paints a rather bleak -- and all too realistic -- picture of US democracy. Plus some perspective on the debt-ceiling crisis (which I don't pretend to understand in any detail):
"Financial Armageddon may not ensue from this downgrade – the market may just have to get used to the benchmark “risk free rate” being less than stellar, because there is no alternative in market size and liquidity to US Treasuries. Still, it will be a landmark event – an exclamation point to the closing out of the American Century."  (h/t The Agonist)

Leverage Control -- A Subtle Story

I mentioned recently some work (in progress) by Stefan Thurner and colleagues exploring how leverage influences stability (price volatility) in a competitive, speculative market. Thurner spoke about this at a meeting on Tipping Points in Durham, UK. What I find most appealing about this work is that is explores this question with a model that is rich enough to exhibit many of the basic features we see in speculative markets -- competition between hedge funds and other investment firms to attract investors' funds, the use of leverage to amplify potential gains, the monitoring of leverage by banks who lend to the investment firms, occasional abrupt crashes and bankruptcies, etc.

Is it a perfect model? Of course not, there is no such thing; models are tools for thinking. But it is arguably better than anything else we currently have for running "policy experiments" to test what might happen in such a market if regulators take this or that step -- establishing tight limits to allowed leverage, for example. 

Stefan kindly sent me the slides from his talk, a few of which I'd like to mention here. As I said, this is work in progress, so these are preliminary results. They're interesting because they suggest that avoiding dangerous market instability through leverage limits comes with costs, and that our intuition isn't at all a reliable guide -- we need these kinds of models in which we can discover surprising outcomes (before we discover them in reality).

I won't give a detailed description of the model; it can be found in an early draft of the paper available here. Thurner and colleagues have been working to improve the model over several years, and it now reproduces a number of realistic market behaviors quite naturally. Thurner summarized these as follows:

In other words, the hedge funds act to eliminate mis-pricings (taking volatility out of the market), and profit by doing so. Funds have to be aggressive to survive in the face of stuff competition, but suffer if they get too large. Risks shorten the lifetime of a fund. Overall, the models also reproduces the right statistical fluctuations in the market.
As I discussed in my earlier post in this work, competition between hedge funds leads naturally to increasing leverage and drives the market to have a fat-tailed distribution of returns; it becomes subject (like real market) to large price fluctuations as a matter of course driven by its own internal dynamics (no external impacts required). In this condition, the market is highly prone to catastrophic crashes triggered by nothing by small price fluctuations linked to noise traders (unsophisticated investors buying and selling more or less at random). The figure below shows a typical example, plotting the wealth of various funds versus time, with a dramatic crash that affects all funds at once (different colors for different funds):

Now, a natural question is -- could these kinds of events be avoided with proper regulations? One idea would be to restrict the amount of leverage allowed with the aim of keeping the market returns in a mode Gaussian regime, i.e. eliminating fat tails. People could probably argue for decades about whether this would work or not without coming to an answer; this model makes it possible to do an experiment to find out, which is what Thurner and colleagues have done.

Two figures (below) show some of the results, and require some explanation. The different colors correspond to different possible regulatory regimes, and show how behavior changes with maximum allowed hedge fund leverage : BLUE (no other regulations), PALE GREEN (regulations akin to Basel I and II, in which banks loaning to hedge funds are restricted by capital requirements) and RED (a situation in which banks monitor hedge funds and reduce a hedge fund's allowed leverage below the maximum when the volatility in its assets grows; a kind of adaptive leverage control). 

First, consider a figure showing how how the action of hedge funds, and their use of volatility, actually benefits the market -- making it more efficient (in one sense). 
The figure shows the mean square price volatility versus allowed leverage. Increasing leverage lets the hedge funds pounce on opportunities more aggressively and wipe out mis-pricings more effectively. Die hard free market people should love this as it shows that the effect is strongest in the absence of any regulation. The regulated markets require higher leverage to get the same reduction in volatility.

But this isn't the whole story. Now consider another figure for the probability (per unit time) of a failure of one of the hedge funds:
Here the pure free market solution isn't so good, as this probability rises rapidly with increasing leverage. There is a relatively low value of leverage (around 5 in the model's units) where the market benefits of leverage have already been realized, and more leverage only leads to more failures (because it takes the market into the regime of fat-tailed returns; this can happen even if the mean square volatility remains small).
The regulated markets in this case perform marginally better -- the regulations reduce the number of failures, and the cost for this is marginally increased volatility.

A surprising outcome is that these same regulations, in the regime of very high leverage, actually do worse than no regulations at all -- they lead to higher market volatility AND more failures as well, a truly perverse regime.

All in all, then, this model offers a sobering perspective on how regulators might go about trying to avoid crashes linked to fat tails by limiting leverage. Some limitation clearly seems to be good. But too much can be bad, especially when coupled with other market regulations. You can't test out one idea in isolation, because they interact in surprising ways.
I'll probably have some further comments on this in the near future. It's a work in progress, as is my understanding of it -- and of what it means for the bigger picture.