Sunday, March 31, 2013

Shifting Of Tectonic Plates

The earth is made up of moving tectonic plates and yet we don't ever feel them moving, except when it is too late. That's when we have tsunami or earthquake and have death or destruction upon us.

Believe it or not, the tectonic plates of our finance world are moving and moving fast. Today the central bankers of the world led by Bernanke of the Fed are giving the last moment gift to the top 1% of the oligarchy. Because very soon another tsunami or earth quake will visit us soon which will make 2008-9 look like a movie trailer.

I am not a fan of Prechter or ZH and I do not like to continue spawning storing of imminent collapse. I have been long till January and have been on the sideline since. But we have not shorted the market despite various indicators saying top. Nor did I buy the theory of collapse of the world till now.

However, I see that we are reaching an important infliction point. My favourite route remains SPX reaching an important top in April, followed by a deep correction in summer. That should be followed by another sharp rally in Q3/Q4 before the onset of a deep bear market.  The exact timing of going long or short will vary and will be available to subscribers. These are general market direction but we use many parameters and price points to decide when to go long or short. The guiding principle is that the only way of wining is not losing.

For the month of Feb/March, many have paid subscription only to hear me say : wait , don't short, need confirmation of this or that before taking any action. There were no instant gratification because we are not looking to score on every 10 point turn. Rather the focus is on weekly or monthly trend and not get distracted by the news. If that is your focus as well, you are welcome to join the gang of subscribers. But if short term trading is your focus, I am not the right guy.

Hope you had a great Easter weekend and all ready for the month of April. It is going to be exciting in fits and starts and most likely will demonstrate the formation of an important top. But we are not going to front run and will wait for confirmation before taking any action.

Wish you all best of luck in your trading / investing.

Saturday, March 30, 2013

The Next Step in Europe's Implosion

Rome wasn't built in a day and the Eurozone will not collapse in a day.  But, the Eurozone will collapse.  It's just a matter of time.

Consider the stronger countries in the Eurozone -- Germany and France.  Both economies are now contracting.   Meanwhile their debt levels, acknowledged and unacknowledged, have exploded to new levels.   Both countries are now in the situation that faced Greece four years ago.  So, how is their future going to be any different that what is now taking place in Cyprus, Greece, Spain and Italy?

The ECB ministers are a group of political hacks who know little or nothing about economics (something they share with the Obama advising team).   Their idea of improving the economic plight of the Eurozone is to increase the level of debt, continue to implicitly guarantee profligate spending and bureaucratic regulations, and plunge the Eurozone into the economic dark ages.

GDP is falling, debt is rising, unemployment is rising, and recriminations are flying.  The Eurozone is coming apart at the seams.   Civil society has broken down in Greece and is in the process of breaking down in parts of Spain and Italy.  Cyprus is entering a dark period.  Nothing good lies ahead for the Eurozone.

So, what happens next?

Deposits will begin to seep out of the Eurozone -- most notably from Spanish and Italian banks -- but from other Eurozone countries as well.  After all, the ECB bureaucracy has changed the rules.  Deposits are now legitimate targets for the bureaucrats.  It wasn't the ECB that decided not to confiscate insured depositors in Cyprus, it was the Cypriot parliament who refused to ratify the ECB and IMF policy of confiscating insured depositors.  The confiscation of government insured deposits is now a legitimate policy weapon in the Eurozone, overturning a long past history of FDIC-like guarantees in the Eurozone.  Nothing is sacred to the bureaucrats.

The genie cannot be put back in the bottle.  The European banking sector cannot recover from this bureaucratic policy blunder.  Deposits in the Eurozone can never be considered secure, even in circumstances where the bank that houses them is secure.  The government can confiscate deposits wherever they may be.  This is now a legitimate Eurozone policy weapon.  It is also an IMF (read USA) policy tool as well.  Even US FDIC-guaranteed deposits may be fair game to the bureaucrats when US debt woes become a front page crisis.  An eventuality that must come in time.

Tuesday, March 26, 2013

Great, free alternative to Google Reader: The Old Reader

Needed to find a new RSS reader in the wake of Google's recent decision to kill off Google Reader, which takes effect on July 1. I'm guessing some of you are still hunting for an ideal replacement too.

After some initial reading and experimentation, I've decided to go with The Old Reader, the best free alternative styled after, wait for it... the old Google Reader. You can see a screenshot of the reader (and my newly imported RSS subscriptions) below. 

Since the Old Reader development team (a small, volunteer crew) was caught off guard by Google's announcement and the influx of new users, there was a queue for new users importing feeds into TOR (see: "How to export your Google Reader feeds"). 

If you want to import your feeds into The Old Reader, you'll probably be placed in the queue but it shouldn't take more than a week or so. In the meantime, you might want to try some of the other Google Reader alternatives for Mac, PC, and mobile users. 

Personally, I found patience to be a virtue here, even though I was just experimenting with the import of a small RSS list (I'm sure I could've just as easily added my RSS subscriptions manually). I really like the simple, clean layout and interface of The Old Reader - it's my favorite of the lot.

Hope this RSS solution helps you out, and don't forget to subscribe to our feed to keep up with the latest.

Same Old, Same Old.

It has been a while I did a post here.
Fact of the matter is, while I am super busy and all the sabaticals that I took last year is now catching up with me, there is nothing much to do but wait patiently.
Yesterday the markets had a bearish reversal day. And today it is pumping up. All to convince the sheeples that the only way to get rich is TBFD.
So what yesterday's selling was all about? Did you say Cyprus?  Oh yes. The Euro politicians have shown that in case of emergency, they will put their hands where ever they can. Earlier they would socialize the loss and privatize the profits. Now they would rob the common men to save the Banksters. Great news now that we know that no body's money is safe.
And what is today's ramp all about. It seems because home prices are now at the highest level since 2008? So the problem of Euro Zone has been solved and we have the collective memory of a gold fish.
But none of these news drive the market. Rather they drive the retail investor sentimement. And speaking of that the powers that be (TBTF Banksters) know how to manipulate that retail sentiment. Over the last few months, the bottom level is being convinced that we are at the beginning of a new bull market. Only then the retail will buy stocks and they normally buy at the peak.
However, I think we will continue to see this rollar coaster ride for the major part of April before any decent correction. So my advice to the subscribers have been to stay on the sideline and avoid all kinds of temptations. It is still not the time to short yet.
We may get occational day or two when we will have 1% sell off but again we will see markets being pumped up on low volume. Doing anything in such sitiation is bad for our financial health.
I know it is damn difficult to remain patient for month after month and do nothinig when the entire 24/7 news media is trumpeting how we are missing on the golden opportunity of getting rich and retire quickly. But that is their agenda. Our goal is to protect our savings and investments.
Just remember, what goes up, comes down. And Wall St. is not above the laws of gravity.

Saturday, March 23, 2013

Little Cyprus

So how big is Cyprus?  800,000 people with a GDP of about 18 billion Euros -- less than 10 percent of the size and wealth of the State of Virginia.  So, how can Cyprus rock the Eurozone?

Easy.  Let politics substitute for economics and anything can happen.

The grand Euro scheme of bailing out country after country is rapidly running up against reality. The sacrifices that the bailers require are politically unacceptable to the bailees.

Austerity traded for more debt -- this is the bailout scheme devised by politicians.  This scheme is an effort to change reality and it won't work.

The reality is that Cyprus banking is history.  Who, in his right mind, would willingly leave their money in a Cypriot bank after the events of the past week?  It doesn't really matter what solution is imposed, the Cypriot financial community will not recover.

Meanwhile, institutions with deposits in Italian and Spanish banks now face a new reality, hitherto not contemplated.  The European Central Bank and the IMF have this week endorsed a new policy tool for dealing with debtor nations -- confiscation of bank deposits.  Who would have thought?  But now the thinking begins.   Should I or shouldn't I move my cash deposits from Italian and Spanish banks for the safer confines of London or New York or Geneva or Singapore?  No doubt such thoughts are now extant in the minds of all institutional investors across the globe.

When economics no longer guides economies and the politicians take over, this is the outcome -- collapsing GDP, rising debt levels, and growing political anarchy.   We are just at the early stages of the coming demise of Europe.

Thursday, March 21, 2013

Fun debt graphs

I was having a bit of fun making graphs for a talk. Are we all fine and debt is no longer a problem? I went back for a closer look at the CBO's long term budget outlook and The budget and economic outlook 2013 to 2023. All numbers from these sources.

 Above, I plot the CBO's long term outlook, in the alternative fiscal scenario (i.e. the one that is even faintly plausible).  As you can see, though they think the deficit gets better for a bit, then the entitlements disaster is still with us.

Of course, this will not happen, the only question is what adjusts.  If bond markets get a whiff that we actually will try these paths, we have a crisis on our hands.

So what can adjust? Revenue is historically about 20% of GDP no matter what tax rates are.  Doubling Federal revenue, while of course states, cities and counties keep taxing us, seems like an unlikely prospect. I'm all for cutting spending, but really, cutting spending in half, and by more than 20 percentage points of GDP? Well, it's in the Ryan budget, but it's a lot. So, what else can we do?

Answer: Growth. Tax revenue equals tax rate times income, and income equals todays income times growth. Greater growth makes all the difference.

To illustrate this point, I made a simple calculation. Suppose growth is 1% and then 2% greater than the CBO projects. What effect does that have? To keep it very simple, I assume that spending stays the same, and revenue stays the same fraction of GDP. Thus, I just divide spending/GDP by a 1% and then 2% growth rate (e^(0.01 t)) and we have the new spending as a fraction of the larger GDP.

This is pretty amazing, no? If we just had two percentage points GDP growth greater than the CBO's forecast (which is a bit above 2% in the out years) the whole budget would be solved without fixing anything.

This thought sent me back to look at the CBO's economic assumptions,

Uh-oh. The CBO thinks we are going to quickly enter a period of 4% growth, go back to trend, and then start growing smartly. Tax revenue = tax rate x income, that's a lot of revenue.  The CBO, the Fed, and everyone else (me too for a few years) has been forecasting this bounce back growth just around the corner for a while now. What if it doesn't happen, and 1.5% growth without catching up to trend is the new normal?

To keep it simple, I redid the above chart now just assuming 1% and 2% less growth than the CBO.

Is that Greece, or Cyprus?

So, the real budget news that could matter has little to do with tax rates or spending. What matters most of all is whether we break out of this sclerotic growth trap.

I found this graph pretty chilling as well: 

Really, what chance do you think there is that defense, nondefense discretionary and other mandatory spending will decrease form 4% of GDP to 2.5-3% of GDP in 10 years?

The net interest line is interesting. That's a huge rise. Why? Here are the other economic assumptions

You see the strong GDP growth, 4% for several years, in the top left panel. Inflation, bottom left, apparently has nothing to do with deficits, the Phillips Curve is alive and well.

But, the CBO is projecting interest rates to rise sharply in 2016, back to a low-normal 4% 3 month and 5% 5 year rate. This causes the $850 billion a year in interest costs highlighted in the previous graph, about the same numbers I was bandying about in "Monetary Policy with Large Debts" when worrying whether the Fed could actually do that to deficits.

From the deficit view, a Japanese lost decade of low interest rates would keep this from happening (or postpone it). Of course any financial event leading to higher interest rates would increase these interest payments a lot. 

Tuesday, March 19, 2013

Insights from hedge fund legend, Julian Robertson

While looking through some archived interviews at Financial Sense, I found this 2004 interview on hedge fund legend, Julian Robertson with author Daniel Strachman

Although Strachman's book on Julian Robertson was not terribly well received (see reader reviews), this interview does offer some worthwhile anecdotes and insights on one of the hedge fund industry's great investors. Let me share a few with you here.

1. Hedge funds began as an alternative investment vehicle for high-net worth individuals. Later, they came to fill the void of liquidity in the marketplace left by the trading operations of once-private firms such as Goldman Sachs, J. Aron, Lehman Bros., JP Morgan, etc.    

2. The strength of Tiger Management was in its highly focused research efforts (pre-web) and Robertson's willingness to follow his conviction on a trade or investment. 

Julian was unmoved by price movements that went against his positions if he had conviction in a trade and the fundamental story. This worked in his favor at times (copper in the mid-'90s) but proved to be a disadvantage at other times (shorting tech stocks during the earlier part of the bubble - though he refrained from shorting them again in '99).

3. Robertson is very competitive and also able to delegate research and decisions to his team, utilizing their expertise in order to get the best investment results. He is a Graham and Dodd investor, but he also found great success by applying aspects of this investing philosophy beyond the world of stocks (in currencies, commodities, etc.).

4. Julian met hedge fund pioneer, Alfred Winslow Jones and from Jones he learned lessons on business organization and the advantages of delegating research work. He also learned that the hedge fund structure could be very profitable and he brought his investing talents to bear in this format.    

5. Among the factors that led to Tiger Fund's demise in 2000: Robertson's decision to avoid participating in the bubble led to a decline in AUM. Also, younger managers who had helped build Tiger (the "Tiger cubs") went off to start their own hedge funds and were gradually replaced by Wall St. veterans. Younger and hungrier workers who had been the lifeblood of the firm left, taking their performance abilities with them.

6. When asked what he most admires about Julian Robertson, Strachman relates the story of their first meeting, which "deeply affected" him. He was nervous about the meeting, but was struck by Robertson's ability to make people feel welcome and valued, "a great skill". Julian is incredibly driven to win, but he also knows there is "no I in team" and he leverages the strengths of those around him.

In addition to Strachman's book, Sebastian Mallaby's book on hedge funds also carries some background on Julian Robertson and Tiger Fund, as well as other industry pioneers.

You can check out our related posts to hear more from Julian Robertson, including his thoughts on the increasingly competitive environment for hedge funds. 

You'll also learn more about hedge fund pioneer Alfred Winslow Jones, who was mentioned in Strachman's interview.

Related posts

1. Julian Robertson interview with

2. Julian Robertson interview with CNBC.

3. Julian Robertson on hedge fund strategy and competition (Bloomberg).

4. A.W. Jones and the history of hedge funds.

Monday, March 18, 2013

Growth in the UK?

I thought European "austerity," meaning mostly large increases in marginal tax rates on anyone daring  to work, save, invest, start a company or hire people, while spending stays north of 50% of GDP, was a pretty bad idea.

So I was glad to read the tiltle, when a friend sent me a link to the Telegraph, announcing Osborne to unleash raft of policies to kick-start growth. Great, I thought, after trying everything else, the British will finally try the one thing that will work.

The byline was only a bit disappointing
The Government is to reveal a series of major new measures to boost national and regional growth ahead of the Budget to show its “pro-business” strategy is working
Pro-business is usually a code word for protection and subsidy. But there are plenty of worse code words.

And then it all falls apart
The measures will include:

• Billions of pounds of central government funding directed at boosting regional growth and a backing for Michael Heseltine’s plans for new local spending powers;

• The planning go-ahead for the Hinkley Point C nuclear power station;

• Support for housebuilders and for first-time buyers trying to get mortgages;

• A push on major infrastructure projects, including the Merseyside Gateway and the “super-sewer” in London, and more government guarantees for such projects;

... The Bank of England could also be given a broader mandate to support growth.

...billions of pounds of central government funds should be made directly available to the regions and cities such as Birmingham...

Lord Heseltine’s report made far-reaching recommendations for stimulating economic growth. The Government will unveil plans enabling Local Enterprise Partnerships and businesses to bid regionally for money that is now allocated centrally.
It's not all bad. Allowing a nuclear power plant to operate is nice, and some plans to lower corporate taxes a bit. But the blossoming of free enterprise in the land of Adam Smith, alas, this is not. Keynes still rules.  

The fair price of catfish in Vietnam

Source: Wikipedia
Another fish story.  In recent news, our Federal Government is now taking on the "fair price" of catfish in Vietnam, and imposing large "anti-dumping" tariffs. Can the price of tea in China be far away?

Lovers of free markets and free trade, this is for you. Fry it with a little hot sauce.

Who gets hurt here? US catfish consumers. Who is that? Hint: catfish isn't on the menu in fancy Washington DC restaurants, or even at Spiaggia here in Chicago.

Well, I'm glad we can come to bipartisan agreement -- Republican Congressemen and Senators, and the Administration's trade apparatus -- to take money out of the pockets of relatively poor catfish consumers.

I'm interested in the language and rhetoric that we use to describe economic policy.  I highlighted some particularly interesting words and phrases (all emphasis mine.) 

Press release from Senator Jeff Sessions:
Commerce Department Will Enforce “Fair Value” Pricing, Protect Alabama Catfish Industry Following Letter Organized By Sessions Thursday, March 14, 2013

WASHINGTON—U.S. Sen. Jeff Sessions (R-AL) commented on a decision today from the Commerce Department regarding the need to protect Alabama’s catfish industry from unfairly priced Vietnamese imports and non-market economies. Sessions organized a bipartisan letter to the Commerce Department to urge them to take action.

“Domestic production and fair value pricing are essential aspects of a sound economy. [JC: "fair value pricing?"] I am very encouraged by the findings of the Commerce Department’s 8th Administrative Review. This decision is a step in the right direction to protect US workers and our catfish industry in Alabama. [JC: What happened to the US catfish consumer?] The dramatic catfish production decrease over the last decade can be directly attributed to unfairly priced imports, leaving our local catfish farms at risk. The Commerce Department’s decision to use Indonesia as a surrogate country for Vietnam helps correct unfair competition and ensures that jobs and industry in our state are protected. [JC: well, there you have it. The goverment's job is to "protect industry."]  By enforcing our nation’s trade laws, and fostering an environment that requires healthy competition, I am confident that our local catfish farms will again be a market leader.”

BACKGROUND: On February 7, Sessions organized a letter signed by Senate colleagues, Richard Shelby, Thad Cochran, Roger Wicker, Mark Pryor, John Boozman, David Vitter, and Mary Landrieu regarding the 8th Administrative review, from the Department of Commerce, determining “fair value” pricing for Vietnamese producers’ frozen fish fillets. The Department of Commerce uses surrogate countries to determine the fair value of products for non-market economies. In previous reviews, the Department of Commerce has used Bangladeshi data to set the market price for the Vietnamese producers’ fish fillets despite industry proposals for a surrogate nation with higher quality data available, such as the Philippines or Indonesia. The Bangladeshi prices range from $0.29/lb-$0.43/lb whereas the U.S. price is about $0.80/lb. The lower rates have had significant negative effects on the US market and this continued approach would bolster the volume of Vietnamese frozen fish fillets to the detriment of the United States industry.

Today, the Department of Commerce announced that Indonesia would be used as a surrogate country for Vietnam to best calculate the price per pound of frozen fish fillets. This decision helps ensure that Vietnamese production will be subjected to appropriate and reasonable standards and that domestic catfish producers will not be victims of unfair pricing.
Congressman Rick Crawford:
Washington, Mar 14 -

Today, Congressman Rick Crawford (R-AR) welcomed news for the U.S. Catfish industry after the Commerce Department issued their final results of the 8th Administrative Review of the antidumping duty order on Certain Catfish Filets from Vietnam. The results indicate that Vietnamese catfish will face fair antidumping duties when imported into the domestic U.S. market.  For years, the Commerce Department has been unfairly assigning a near-zero antidumping duty on Vietnamese Catfish, which has led to unfair competition, and a flood of Vietnamese imports. Since 2008, Vietnamese imports of catfish fillets have tripled, and have taken nearly 80 percent of the domestic market. The Department decided to switch from a Bangladeshi surrogate value to Indonesian price index for calculation of antidumping duties...

Crawford issued the following statement after hearing the welcome news:

“For too long, the Arkansas catfish industry has faced unfair competition from non-market economies, such as Vietnam. I am pleased to hear that the Commerce Department heeded my call to assign a fairer price calculation to the value of Vietnamese Catfish. This is a win for the U.S. Catfish industry and the Delta region in the First District of Arkansas. [JC: and noticeably not a win for US catfish consumers] I am confident that the Commerce Department’s decision to fairly enforce our trade laws is a great first step towards a U.S. catfish industry recovery that will create jobs and grow the Delta economy.”
Maybe we should feel a bit sorry for Sessions and Crawford. At least other senators get to lobby for real money, like bank bailouts.

The Department of Commerce memo is worth reading too. Sometimes it's worth seeing just what goes in to our Federal sausage
The product covered by the order is frozen fish fillets, including regular, shank, and strip fillets and portions thereof, whether or not breaded or marinated, of the species Pangasius Bocourti , Pangasius Hypophthalmus (also known as Pangasius Pangasius ), and Pangasius Micronemus .
Frozen fish fillets are lengthwise cuts of whole fish. The fillet products covered by the scope include boneless fillets with the be lly flap intact (“regular” fillets ), boneless fillets with the belly flap removed (“shank” fillets), boneless shank fillet s cut into strips (“fille t strips/finger”), which include fillets cut into strips, chunks, bl ocks, skewers, or any other shape. Specifically excluded from the scope are frozen whole fish (whether or not dressed), frozen steaks, and frozen belly-flap nuggets. Frozen whole dressed fish are beheaded, skinned, and eviscerated. Steaks are bone-in, cr oss-section cuts of dressed fis h. Nuggets are the belly-flaps. The subject merchandise will be hereinafter referr ed to as frozen “basa” and “tra” fillets, which are the Vietnamese common names for these species of fish.
It goes on like this for 54 mind-numbing pages. A random excerpt
Bangladesh is a significant producer of identical merchandise pangasius hypophthalmus
...The production experiences of pangasius producers in Bangladesh replicates those of the Vietnamese respondents in that produce pangasius through commercial pond-based aquaculture. This directly implies that the cost of production, related expenses, and revenues for pangasius farmers in Vietnam and Bangladesh are very similar.

In Indonesia, only 70 percent of the 2011 pangasius production is from ponds, and the record is unclear as to what proportion of the Indonesian pond based aquaculture production is accounted for commercial-based pond aquaculture as opposed to homestead-based pond aquaculture.
The life of a planner is a hard one.

I do feel for the producers. I hope someone knowledgeable will write in, answering the question: what else can you do with a catfish farm? Is it possible to change from catfish to, say, genetically engineered salmon? Trout? Caviar sturgeons? Usually when low-price low-quality competitors appear (and frozen catfish from Vietnam is clearly that), the answer for a domestic producer (if Congress doesn't protect it) is to change to high-value skill-intensive products. 

Capital not a lost cause?

Admati and Hellwig (my review here) (and fellow travelers) may be having some effect! From today's WSJ "Heard on the Street":
There is growing talk among regulators, for example, of forcing banks to issue a minimum amount of long-term debt, cap the size of their short-term liabilities or restrict activities that can be conducted within regulated bank subsidiaries.

At the same time, regulators seem to be focusing more on the need to pre-emptively address potential systemic risks.

Any such moves could further constrain banks' ability to juice returns through leverage while also limiting lucrative activities that fall outside a traditional lending function. That could subdue earnings growth already hampered by the superlow interest-rate environment.

The danger isn't lost on banks themselves. A number of banking groups recently joined together in a public attempt to rebut notions of a big-bank borrowing subsidy.”
OK, 3 out of 4 ain't bad. Admati and Hellwig (and I) take a dim view of asset risk regulation and the chance that regulators have any hope of seeing bubbles emerge. But more capital, and more people understanding that leverage and TBTF is a subsidy to banks, so banks are forced to fight about it... that's progress.

Saturday, March 16, 2013

Quo Vadis SPX?

Some say SPX is headed for the moon. Well, that was bit of an exaggeration, but surely we hear talk of SPX 2000. Personally, I think a long term top can be found around 1600. The question that I ask, whether that long term top is now or still few months down the line.

While many are pointing to various extreme reading of various indicators, I do not see any sign of correction yet. Only once so far the sell signal was triggered but that did not match with my other indicators and I decided not to short even when the sell signal was on. On hindsight, it was a good decision because had we been short, it would have caused us emotional pain and in some cases, the short positions have been puked already resulting in actual loss.

While I am advising subscribers not to short and stay on the sideline, for some of you who are short already, I would say that bear the pain if you do not want to book the loss. Nothing goes up for ever and this moon rocket is also subject to the law of gravity. Ben and other powers that be think that stock market is equal to economy and a higher stock market means a strong economy. So the never ending money printing and inflating the balloon goes on. We have seen this many times in the past.

And we know how it all ends. This time is never different. Only we do not want to front run and get run over.

So far the bubble has been formed in Equities and we have not yet seen the rise is other asset prices like Oil or PM sector. Before the bubble burst, we will see all these asset classes rise again. Oil should take out its all time high and gold should make a new high. Question is when. For now, the BOYZ are working on a simple plan. That is to get the retail and lagging fund managers move in to equities. It works on the simple hope that some else will buy the stocks at a higher price at a later date. If you don't believe, just look at the chart of Apple few months back. When Apple crossed $ 700, they were  talking about Apple $1000 and folks who bought Apple at $ 700, were hoping to flip it around soon. Same story now with something else.

Dow ended in red this Friday after 10 consecutive weekly gains and 8 new all time highs in a row. And SPX is trying to make its all time high. I think it is so damn risky to go long here but also not the right time to short. Not yet. There are other fish to fry in commodities and there is less risk there.

The blog posts have been irregular and my apologies for the tardiness. I intent to post at least two/three times a week but time is difficult to come by. In any case, I did not have much to say since my last post except repeating that:

Cash is King.

Have a great weekend folks. 

Friday, March 15, 2013

Ben Franklin on the Pursuit of Happiness

Ben Franklin explains that our Constitution describes our right, as citizens, to pursue happiness and property. However, it can not grant us that happiness. We must earn it for ourselves. 

A free society should strive for equality of opportunity, where all men ("persons") are equal in the eyes of the law. We cannot, and should not, promote or promise a utopian vision of equal outcomes for all. 

We are all individuals of differing abilities and makeup. Every one of us has a unique drive, personality, and outlook on life. Can we therefore expect everyone to outperform and achieve a certain prescribed level of happiness, wealth, and personal fulfillment? 

In our recent interview with "Trader Vic" Sperandeo, Victor pointed out that some of his friends were happy driving a bus while others were driven to work 70-80 hours a week on Wall Street in an effort to get rich. In real life, people are driven by different desires and passions. While some would label their difference in situation an "inequality", our society acknowledges their right to pursue happiness and a living in the manner of their choice. 

As for the end result, as old Ben says, we have to catch it for ourselves. 

Related posts

1. Lessons from Benjamin Franklin.

2. Marc Faber's advice to young people and the meaning of success.

Thursday, March 14, 2013

GMO Salmon

This weekend's New York Times brought the interesting story of AquaBounty's genetically modified salmon, which are genetically engineered to grow twice as fast as normal Salmon. A few choice bits:
"In 1993, the company approached the Food and Drug Administration about selling a genetically modified salmon that grew faster than normal fish. In 1995, AquaBounty formally applied for approval. Last month, more than 17 years later, the public comment period...was finally supposed to conclude. But the F.D.A. has extended the deadline...

Appropriately, it has been subjected to rigorous reviews... scientists, including the F.D.A.’s experts, have concluded that the fish is just as safe to eat as conventional salmon and that, raised in isolated tanks, it poses little risk to wild populations.
Why the delay?

... some suspect that political considerations have played a role in drawing the approval process out to tortuous lengths. Many of the members of Congress who oppose the modified fish represent states with strong salmon industries. And some nonprofit groups seem to be opposing the modified salmon reflexively, as part of an agenda to oppose all animal biotechnology, regardless of its safety or potential benefits.

Even the White House might be playing politics with the salmon. “The delay, sources within the government say, came after meetings with the White House, which was debating the political implications of approving the GM salmon, a move likely to infuriate a portion of its base.”
anti-biotech groups, which traffic in scare tactics rather than science...
This story brings three thoughts to mind.

1. So who is "anti-science?" I can't resist. There were a lot of potshots at Republicans for being anti-science, some well-deserved. But "science" is abundantly clear here. "Science" is indeed wrong at times, but if we want policy based on "science," the safety of GMO foods is about as good as it gets. There's plenty of magical thinking on both left and right, it turns out.

2.  $10,000 dollars invested in the stock market in 1993 is worth $50,000 today ($31,477 after inflation)  yes, even after the crash. It was already worth $37,600 ($32,700 after inflation) in 1999.  Remember, AcquaBounty hasn't sold a single fish. The cost of 20 years delay is enormous, amounting to a huge tax disincentive.

3. We need growth. Where does growth come from? Modern growth theory is abundantly clear. New ideas, new processes, new businesses that raise productivity. Like a new idea that lets us double the growth rate of farmed salmon. And, yes, lower profits of current salmon fishermen, much to the relief of wild salmon.

GMO foods are, potentially, a huge game changer. Once every 50 years or so, we bump up against a Malthusian limit, and a new idea frees us again. Fixing airborne nitrogen. Green revolution. Now, GMO foods. GMO plants are being bred to use less fertilizer and insecticide, i.e. to be better for the environment, as well as to cure vitamin A deficiency, produce less waste, and so on. No, dear Greenpeace, organic farming is not the answer, unless we use a lot more land for agriculture, starve out half the people, or believe in magic.  (It's too bad organizations like this suffer such mission creep. I would happily support their efforts on behalf of endangered species.)

Or maybe not. The lesson of industrial policy is that academic bloggers are just as bad as government bureaucrats in finding the next game changer. But there are hundreds of similar game-changers underway. Read any popular science magazine. Will we let the winners bear fruit?

Why do countries and civilizations fail? When interests vested in the status quo or magical thinking stop that process.  A long decay precedes the crises. I am reminded of the famous failures, such as the Chinese Emperor's ban on long-range shipping, at a time when Chinese ships were way better than Portugese.

Update: A very nice article by Henry Miller on GM foods, titled "Anti-Genetic Engineering Activism: Why the Bastards Never Quit." Henry is obviously much more knowledgeable than I am.

Taxation of capital and labor

"Redistributing from Capital to Workers: An Impossibility Theorem" is a fine post by Garrett Jones on Econlog, explaining the theorem that the optimal tax on capital is zero. It's the best blog-post length, evenhanded, accessible summary I've seen. It includes all sorts of links where you can see arguments in detail, an unusually scholarly approach for a blog post.

His one-sentence summary
 Under standard, pretty flexible assumptions, it's impossible to tax capitalists, give the money to workers, and raise the total long-run income of workers. Not, hard, not inefficient, not socially wasteful, not immoral: Impossible.

Saturday, March 9, 2013

Everything Must Be Great

DOW made new high!. Yeeeee.
Now everything in the world must be al-right and every American is now rich. The retirement accounts are filled to the brim and no body cares what the crooks do.
But I feel little sad for ZH and Prechter. These guys are running out of ideas about what to write about the imminent collapse of USA. Not only the collapse (which was just round the corner) never materialised, even a 10% decent correction is also not on horizon. Only last October they were saying that QE4 has failed to do its magic and QE is dead. So far I have not seen anything anywhere saying sorry, we were wrong.

Anyway, now that Indices have or are in the process of making new high, where in the sentiment cycle are we?
I personally think we are in the Euphoria stage. The retail is just now getting excited about the rally while the TA guys have given up.

Our collective memory is short. Otherwise, we would have simply looked at what happened during the same period of last year.
This is a daily chart of SPX from December end of 2011. Does the up move of 2012 looks similar? If they look like ducks, walk like ducks and quack like ducks, then most likely they are ducks. And most likely this years pattern is just a repeat of last year. And by that token, the bears should remain in hibernation till the better part of March. 

We went out of all long positions by end of Jan. with SPX around 1510. So far we have given up about 30 points rally but we have no emotional roller coaster ride. We are what is called reluctant bear, sitting on the sideline. Just waiting for the move to exhaust itself. We have avoided all temptations to short because our model did not give us the go ahead signal. And we are not looking for the end of the world, not yet.

Coming back to the market, the shearing is not yet complete. 
I think the BOYZ will spend another couple of weeks to corral most of the sheeples. Retail almost always buys at the top and why it would be any exception this time? And for those TA enthusiasts looking for all sorts of elusive Da Vinci Code for the Top and shorting relentlessly, only to lose the underpants, I have news for you. The Fed is buying Bonds almost every day for the month of March! (POMO Days are here again).

I am not for a moment saying that buy buy buy. On the contrary, I think if we are long, its better to take chips off the table and raise cash. We have gone off gold and silver sometimes back and are waiting for the cycles to bottom. But I am not shorting anything yet. Subscribers will get email when the signal comes and they know the levels to watch for.

So far the market is moving as per my base line projection for 2013. If ZH and Prechter can continue till 2014, they might have some chance of gloating. But that's a long shot. We will take one month at a time and put forward our steps very carefully. From now till next few years, before I make any investment or trading decision, I will be asking myself: how much will I lose, if I am wrong, instead of thinking how much will I make. 

Its a jungle out there. So don't front run and trade safe.
Have a great weekend folks.

Friday, March 8, 2013

Crunch time

David Greenalw, Jim Hamilton, Peter Hooper and Rick Mishkin have a nice op-ed in the Wall Street Journal summarizing their recent paper, Crunch Time: Fiscal Crises and the Role of Monetary Policy, (The link goes to from Jim's website there is also an executive summary.)

David, Jim, Peter and Rick are after the same question in my last WSJ oped and Blog post: Suppose the Fed wants to raise interest rates with a huge debt outstanding. With, say, $18 trillion outstanding, raising interest rates to 5% means raising the deficit by $900 billion a year. That's real fiscal resources. In a present value sense, monetary tightening costs someone $900 billion a year of taxes.  There is no chance that current tax revenues can go up that much, or current spending can go down that much. So, raising interest rates to 5% with a lot of debt outstanding means we will borrow it, the debt will grow $900 billion a year faster, and the larger taxes /lower spending will come someday in the far off future.

Or maybe not. David,  Jim, Peter and Rick delve in to the "tipping point" I alluded to.
Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders about fiscal sustainability lead to higher government bond rates, which in turn make debt problems more severe.

Southern Europe was basically on a similar death spiral until the ECB stepped in and said it would print euros to buy up any debt as needed. The big contribution of the paper: facts.
Using statistical methods, case studies and a wealth of recent data on fiscal crises, we have found that countries with gross debt above 80% of GDP and persistent current-account deficits—as is currently the case in the United States—face sharply increasing risk of escalating interest payments on their debt. This means even higher budget deficits and debt levels and could lead to a fiscal crunch—a point where government bond rates shoot up and a funding crisis ensues.
The vitally important point: it's nonlinear. Evidence from times and countries with lower debts does not apply.

When the Fed raised real rates in the late 1970s, Federal debt was “only” 32% of GDP. Interest payments did swell, from 1.5% to 3% of GDP, accounting for more than half of the Reagan deficits. And long-term real interest rates were high for a decade, usually interpreted as the market's worry that we would go back to inflation, which is the same thing as saying that the government might not have the stomach to pay off all this debt. But strong growth and tax reform led the US to large primary surpluses, and we paid off that extra debt.

We go in to this one with over 100% debt to GDP ratio, and much weaker growth prospects. The experience of how "easy" tightening was in the early 1980s should not lull us in to a sense of security.

They made a small, but I think crucial omission:
With sufficient political will, the U.S. government can avoid fiscal dominance and achieve long-run budget sustainability by gradually reining in spending on entitlement programs such as Medicare, Medicaid and Social Security, while increasing tax revenue by broadening the base.
Quiz question: What's missing here?

Growth. Tax revenue = tax rate x income. You can broaden the base as much as you want, without economic growth the long-term US budget is a disaster. And the current alarming projections assume that we will, someday, return to strong growth. All the reining in, soaking the rich, and base broadening in the world will not save us without growth. We prescribe "structural reform" for Greece. Why not for the US? 

Note to graduate students. The theory here is actually less well worked out than you think. Suppose the Fed follows a Taylor rule, hoping to control inflation by raising interest rates when inflation breaks out. But suppose there is a Laffer limit on taxes, total tax revenue is less than T. In this paper and my own speculations there is a conjecture that inflation can get out of control, and a sense of multiple run-prone equilibria, and a sense that current debt/GDP is an important state variable. It needs better working out.

Wednesday, March 6, 2013

You Want To Know What Is Risk?

What is risk?
Risk is the amount of money you will lose if you are wrong.
To know how ordinary investors chase beta and lose money, you must read the following:
How to lose money
It is said the bulls make money, bears make money, pigs get slaughtered.

Comic of the day

Greg Mankiw posted this lovely "comic of the day." He called it "not completely fair." I'm not sure what he meant.

Perhaps it's in need of a better caption. To be fair to Keynesian economics, perhaps the caption should continue,

"When you're done, another half a box will magically appear on the wall." 

Maybe this is a good time for a cartoon caption contest!

Tuesday, March 5, 2013

Schwartz's Quandary

Today's NYTimes features an interesting article by Nelson D. Schwartz headlined "Recovery in US is Lifting Profits, But Not Adding Jobs."  Surprise, Surprise!

The main tool for solving unemployment by the White House is to figure ways to make employees more expensive.  Businesses aren't dumb.  If you make a factor of production much more expensive, businesses will use less of it.  Machines aren't more expensive; outsourcing is not more expensive, but hiring American workers is much, much more expensive thanks to Obamacare and numerous "worker protection" rules, laws and regulations.

So, what to do?  Obama now suggests raising the minimum wage from $ 7.25 to $ 9.00 -- almost a 25 percent hike in the minimum wage.  That is in keeping with the philosophy of making employees more expensive.

The war on workers and the war on the middle class by this White House continues unabated.  Schwartz is puzzled by the "golden age for corporate profits" unaccompanied by meaningful increase in the demand for workers.  But why is there any surprise.  This is the predictable result of White House economic policy.

Monday, March 4, 2013

Market Wizard, Vic Sperandeo interview: gold, inflation, and trading the QE wave

Trader, author, and Market Wizard, Victor Sperandeo joins us for an exclusive interview in our first Finance Trends podcast. To say we caught a lucky break with our first guest is a bit of an understatement. 

Victor is a highly regarded veteran trader who has been involved with the markets since his first job as a Wall Street quote boy back in 1966. When he began his independent trading career in 1971, his primary goal was to make money consistently, month after month, year after year. 

After 40+ years of consistent profitability, I'd say he's met that goal. 

Over the course of his career, Vic has traded independently, managed hedge funds and CTAs (commodity trading advisors), and ran portfolios for George Soros and Leon Cooperman. He has also written three books on trading, including, Trader Vic: Methods of a Wall Street Master, a personal favorite which interlaced Vic's trading insights with sections on Austrian economics and personal psychology!

In this rare, hour-long interview you'll hear "Trader Vic" discuss his recent editorial on Paul Krugman (a "political hack") and our debt problems, the Fed's quantitative easing program and prospects for future inflation, his outlook on gold prices, Austrian economics and economic and personal freedom (or lack thereof), as well as his insights on successful trading and the importance of trading psychology. 

Plus, you'll hear about the upcoming Trader Master Class with Vic in New York City (more info below).

Some highlights and quotes from our interview with Vic Sperandeo

On gold prices: "What gold doesn't like is higher didn't do well from 1982 to 1999. Gold likes chaos and it likes inflation. With every central bank in the world inflating, long-term, gold is a buy. Short-term, there is someone putting pressure on the gold market. I believe it's the Fed or banks working through the Fed to keep gold prices down and to make money-printing policies more acceptable."

The effects of Quantitative Easing: "QEs have not worked to the degree that most people have assumed they would because nobody is spending the money. Money velocity (the turnover of money in the system) hasn't sped up to a degree that would create runaway inflation... and banks aren't making loans of any consequence. What it's doing [with the mix of current, offsetting fiscal policies] is slowing the economy and distorting the markets as people are putting their money in stocks, thinking that this is good for corporate profits."

Vic's insights on trading and the need for emotional discipline: "Sometimes the smartest people and those who have biases, like yours truly, can cost themselves money. You try to eliminate your biases. In my case, I'm biased against believing in the Fed and in Ben Bernanke knowing what he is doing. But that doesn't subtract from trading - if you're trading you really don't care what Bernanke knows or doesn't know [set aside your biases]." 

Investing vs. trading in 2013: "We're not in a real good investment environment here. We're in a very good trading environment and a great liquidity environment. If you're a trader, you should be doing well following the uptrend in stocks because of QE. If you're taking bigger positions and you're betting on longer-term growth, there's where the differences lie and you have to be very careful. Trends and the technicals trump the fundamentals here [in a Fed-driven market]." 

How crucial is psychology in trading and in life?: "The fact is you can train a number of people to do the same thing and you get different results. Why is that? The difference is emotions - it's psychology. The problem is not in the knowledge, it's in the execution. Very few people can discipline themselves to execute the knowledge. It takes emotional discipline." 

Victor Sperandeo will be sharing his global macro outlook and his trading techniques with a select group of participants in an upcoming (March 22nd) Trader Master Class in New York City. You can learn more and sign up (class size is tightly limited) at the link above. 

I hope you enjoyed listening to this interview half as much as I enjoyed doing it. If you'd like to help us spread this discussion to more listeners, please share and retweet this post with your friends and readers by choosing from the ShareThis buttons below (email is included). Thank you for reading and come back often

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Related posts

1. Inner Voice of Trading: a lesson on ego and risk.

2. Nassim Taleb and Stan Druckenmiller on coming crisis (Bloomberg interviews)

3. Lessons from Hedge Fund Market Wizards: Steve Clark (full post series).

Sunday, March 3, 2013

Monetary policy with large debts

This is a Wall Street Journal Op-Ed, March 4 2013. They titled it "Treasury needs a better long game," but the most important question is whether the Fed can keep any independence, if 5% interest rates will cause $900 billion interest costs. There is a pdf version of the oped on my webpage. 

Sooner or later, the Federal Reserve will want to raise interest rates. Maybe next year. Maybe when unemployment declines below 6.5%. Maybe when inflation creeps up to 3%. But it will happen.

Can the Fed tighten without shedding much of the record $3 trillion of Treasury bonds and mortgage-backed securities on its balance sheet, and soaking up $2 trillion of excess reserves? Yes. The Fed can easily raise short-term interest rates by changing the rate it pays banks on reserves and the discount rate at which it lends.

But this comforting thought leaves out a vital consideration: Monetary policy depends on fiscal policy in an era of large debts and deficits. Suppose that the Fed raises interest rates to 5% over the next few years. This is a reversion to normal, not a big tightening. Yet with $18 trillion of debt outstanding, the federal government will have to pay $900 billion more in annual interest.

Will Congress and the public really agree to spend $900 billion a year for monetary tightening? Or will Congress simply command the Fed to keep down interest payments, as it did after World War II, reasoning that "Fed independence" isn't worth that huge sum of money?

This additional expenditure would double the deficit, which tempts a tipping point. Bond markets can accept fairly big temporary deficits without charging higher interest rates—buyers understand that bigger deficits for a few years can be made up by slightly larger tax revenues or spending cuts over decades to follow. But once markets sense that deficits may be unsustainable, and that bond buyers may face default, restructuring or inflation, they will demand still-higher interest rates. Higher rates mean higher deficits—leading to a fiscal death spiral.

Many economists think the tipping point starts when total government debt (federal, state and local) exceeds 90% of GDP. We are past that value, with large state and local debts, continuing sclerotic growth and a looming entitlements crisis to boot. This, not the "balance sheet" or other monetary or institutional constraints, will be the Fed's quandary—can the monetary authority really dare to risk a fiscal crisis?

The obvious answer is to fix the long-run deficit problem, with the reform of runaway spending, entitlement programs and a pro-growth tax policy. So far that is not happening.

Still, the Fed and the Treasury can buy a lot of time by lengthening the maturity of U.S. debt. Suppose all U.S. debt were converted to 30-year bonds. Then, if interest rates rose, Treasury would pay no more on its outstanding debt for 30 years. And if the country couldn't solve its fiscal problems by that time, it would deserve a Greek crisis.

Maturity structure of US debt.
Alas, the maturity structure of U.S. debt is quite short. I estimate that our government rolls over 40% of its debt every year, and 65% within three years. (I account for Federal Reserve holdings, coupon payments and use market values.) Thus the fiscal impact of higher interest rates will come quickly.

Mr. and Mrs. Smith shopping for a mortgage understand this trade-off. Mr. Smith: "Let's get the adjustable rate, we only have to pay 1%." Mrs. Smith: "No, honey, that is just the teaser rate. If we get the 30-year fixed at 3%, then we won't get kicked out of the house if rates go up."

Amazingly, nobody in the federal government is thinking about this trade-off. Instead, each agency thinks only for itself.

The Fed is still buying long-term bonds in an effort to temporarily drive down long-term interest rates by a few basis points. It has concluded it can survive the loss in mark-to-market value of its bond portfolio that higher interest rates will imply, when they come, by suspending its customary interest-rebate payments to the Treasury. If the Treasury was counting on that roughly $80 billion per year, that is Treasury's problem. If higher rates cost the Treasury $900 billion a year, that is Congress's problem.

The Treasury's Bureau of Public Debt controls the maturity of federal debt issues. It has been gently borrowing longer in response to low long-term rates, but not enough to substantially alter the government's interest-rate risk. The bureau also views its job narrowly—which is to finance whatever deficits Congress determines, not to take actions that mitigate future deficits. Congress and the administration are busy with other matters.

Ironically, the Fed's buying and the Treasury bureau's selling have neatly offset, leaving very little change in the maturity structure of debt in private hands.

What to do? First, the Treasury and Fed need a new "accord" to decide who is in charge of interest-rate risk, most likely the Treasury, and then grant it clear legal authority to manage that risk. The Fed should then swap its portfolio of long-term bonds for a portfolio of short-term Treasuries and forswear meddling in the maturity structure again.

Second, the Treasury should seize its once-in-a lifetime opportunity to go long. Thirty-year interest rates are at 2.8%, a 60-year low. Many corporations and homeowners are borrowing long to lock in low funding costs. So should the Treasury.

You may complain that if the Treasury borrows long, then long-term rates will rise. If so, it is better that everyone knows that now. It means that markets aren't really willing to buy long-term government debt, that the 2.8% yield is only a fiction of the Fed's current buying, and that it won't last long anyway. Better fix the fiscal hole, fast.

[WSJ cut: Moreover, if buying and selling a lot of bonds is a problem, the Treasury should engage in an aggressive swap program. In a swap, the Treasury pays a counterparty a fixed rate (say, 2.8%) and receives floating rates, with no bond changing hands. The First Bank of Podunk uses swaps to manage interest rate risk, when it doesn’t want to buy and sell assets. So can the Treasury.

You may complain about counterparty risk. But swaps are collateralized, so each counterparty does not lose if the other one defaults. And if the thousands of pages of Dodd-Frank regulation, and the army of stress testers can’t ensure that too-big-to-fail banks properly manage simple interest rate risk, then we really should have a law-book bonfire. ]

You also may argue that 2.8% long term-debt is more expensive than 0.16% one-year debt. There are two fallacies here. First, the 2.8% long-term yield reflects an expectation that short rates will rise in the future, so the expected cost over 30 years, as well as the true annual cost, are much closer to the same. Second, to the extent that long-term bonds really do pay more interest over their life span, this is the premium for insurance. Sure, running a restaurant is cheaper if you don't pay fire insurance. Until there is a fire.

A much longer maturity structure for government debt will buy a lot of insurance at a very low premium. It will buy the Fed control over monetary policy and preserve its independence. If Fed officials realized the risks, they would be screaming for longer maturities now.

But we don't have long to act. All forecasts say long-term rates will rise soon. As the car dealer says, this is a great deal, but only for today.

Notes: See this earlier blog post or pdf essay for more. I hope to sell WSJ on the second part, keeping the balance sheet big and Treasury floating-rate debt, sometime soon.

If you think I'm pessimistic or making up numbers, here are the CBO's baseline budget projections 

By 2023, the CBO thinks interest payments on the debt will be $857 billion, essentially the entire deficit!  The CBO assumes (see p. 67 here) that interest rates start rising in 2016 and in 2018 stop at 4% one year and 5.2% ten year rates. What if the Fed really wants to tighten?

Moreover, the cheery forecast of return to a balanced primary budget relies on an assumption of spectacular growth (p. 68) -- 3 years of 4% growth bringing us back to "potential" (see p.36) -- in-your-dreams tax revenues, and the rosy-scenario "baseline" expenditure cuts. What if the primary deficit is also $900 billion dollars?     

Three Cheers for Christina Romer

It has been somewhat of a puzzle that Obama's economists haven't rebelled at his Administration's assault on the US economy.   Economics is, after all, economics.  Finally!

In today's NYTimes, Christina Romer, former head of Obama's Council of Economic Advisors, questions the necessity of the minimum wage.  She not only wonders openly about increasing the minimum wage, but questions the very idea of minimum wage legislation.

Romer is right that the minimum wage is not the way to go.  While she doesn't go far enough to oppose the minimum wage outright, it is hard to see her op-ed piece as anything but a plea for sanity and clear opposition to Obama's recent call for a minimum wage increse.

Saturday, March 2, 2013

Nassim Taleb, Stan Druckenmiller talk crisis on Bloomberg TV

Our future may be a bit more fragile than "Anti-fragile", if the latest warnings from Nassim Taleb and Stanley Druckenmiller prove correct. 

The pair recently sat down with Bloomberg TV to voice their concerns over America's social and economic strains. Taleb believes we are still loaded down with the unsafe systemic risks and toxic leaders of our recent past. Druckemiller sees a crisis "worse than 2008" ahead. 

We have their full interviews for you here, so let's jump right in. 

Nassim Taleb feels we are at a point where we have not learned or benefited from the mistakes of our recent financial crisis. This has made our society more susceptible to fragility and will deepen the effects of future crises.

Moral hazard has increased as bankers have paid themselves larger bonuses with our (taxpayers') money. Quantitative easing has lifted asset prices. Median incomes, and the average person's standard of living, have been dropping while the top tier of society ("the 1 percent of the 1 percent") has been absorbing the lion's share of recent economic growth.

As Taleb puts it, we are now paying for the bad debts and disastrous trades made by irresponsible, bailed-out parties in the last cycle. We have transferred private problems and failures into public problems by transforming private debt into public debt. 

In order to improve our situation and ensure future prosperity, we need to face our mistakes and make our regulations and tax codes less complex. Complex regulations are a boon to lawyers and big businesses who game the laws to their benefit. To quote Taleb, we need "sound, minimal regulations and more skin in the game (personal liability) for those who make mistakes.".  

Recently retired from running public money, star hedge fund manager, Stanley Druckenmiller has stepped back into the spotlight to warn of a looming entitlement spending crisis in the USA. 

"Every once in a while, the world of investing and what's going on in the country will intersect". 

Druckenmiller recounts his conversations with US officials about previous storms on the financial horizon. Based on his past experiences, he figured it was better to keep quiet and manage his investors' money than get caught up in public debates over politically sensitive issues, like the fallout from the 2000s housing bubble. 

He now feels he needs to speak out to warn citizens about a coming bust of America's demographic bubble. Druckenmiller notes that in 2030, the average population of the USA will be older than the average Floridian is now. "I don't know about the timing of when markets will respond to this, but I know it will happen based on the fundamentals.". 

Stan also offers his thoughts on the valuation of the equity markets, bonds, risk assets and zero rates, and competitive currency devaluations. "Every single major country is now running stimulative monetary policies, basically modeled after the Fed.". 

One great piece of investing advice from Stanley Druckenmiller (and a recurring theme in this interview): "You've got to think in an open minded fashion and look out into the future to judge companies [and stock prices]. Try and imagine the world 18-24 months from now and not the way it is today. Then think about where securities prices will be to reflect that view".

Related posts:

1. Victor Sperandeo exclusive interview: gold, inflation, and trading the QE wave

2. Nassim Taleb on Antifragile at Google.

3. Jim Rogers on Street Smarts and outsized returns.

Friday, March 1, 2013

The banker's new clothes -- review

I wrote a review of Anat Admati and Martin Hellwig's nice new book, "The banker's new clothes" for the March 2 2103 Wall Street Journal.

Bottom line: Banks should issue a lot more equity, a lot less debt, especially short term debt, and a heck of a lot less nonsense.

I admire Anat and Martin. The rest of us read the gobbledygook in the newspapers, chuckle at the faculty lunch -- "Ha ha, xyz is CEO of a huge bank and has never heard of Modigliani-Miller! Ha Ha -- pdq is a senior regulator, and doesn't know the difference between capital and reserves!" -- and then we go about our business. Anat and Martin have admirably taken the bull by the horns. They write opeds, they go to interminable banking policy conferences, they fight it out with bigwig bankers, regulators, and their consultant economists, and endure their scorn. This nice book summarizes their arguments very clearly (without the foaming at the mouth ranting and raving that I would have had a hard time avoiding in their place!)

(Links: This review at the Wall Street Journal (html), in a pdf from my webpage. Admati and Hellwig have a book website with lots of extra material and response to critics.)

Enough preamble. The review: 

Four and a half years ago, the large commercial banks nearly failed, inaugurating our great recession. They were saved by the Troubled Asset Relief Program, Federal Reserve lending and other government support. If you think all that was bad, imagine the ATMs going dark. What has been done to avoid a repetition of these events? Sadly, and despite all the noise you hear about bank regulation, not much.

The central problem, at the core of Anat Admati and Martin Hellwig's "The Bankers' New Clothes," is capital.

In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock, its "capital." So if only 4% of the bank's loans fail, the shareholders are wiped out, and the bank cannot pay its debts. Worse, if there is a rumor that some loans are in trouble, creditors may "run," each trying to get his money out first, and force a needless bankruptcy. Think of Jimmy Stewart in "It's a Wonderful Life."

When banks are on the brink, all sorts of other pathologies emerge. Bankers and their regulators may try to keep zombie loans on the books, hoping things will turn around. Or bankers may bet the farm on very risky loans that either save the bank or impose larger losses on creditors and the government. Ms. Admati and Mr. Hellwig explain all this nicely in their first few chapters.

The solution seems pretty obvious, no? Banks should fund their investments by selling a heck of a lot more stock and borrowing a heck of a lot less, especially in the form of run-prone short-term debt, as most other companies do.

Far more value was lost in the 2000 tech bust, for instance, than in the subprime mortgages that sparked the 2008 crisis, but the tech bust did not cause a financial crisis. Why? Tech companies were funded by stocks, not short-term debt. Worried shareholders can drive down the price of a stock, but they have no right to demand that the company redeem shares at yesterday's price, so they can't drive the company to bankruptcy in a run. Depositors and other short-term creditors have a fixed-value, first-come-first-serve promise from a bank—they can run.

More capital and less debt would stabilize the financial system in many ways. If a bank wants to rebuild its ratio of capital to assets from 1% to 2% by selling assets, it has to sell half of its assets. Doing so can spark a fire sale, especially if all the other banks are doing the same thing. If the same bank wants to rebuild capital from 49% to 50% of assets, it only has to sell 2% of its assets. That bank will also have a far easier time issuing more stock, rather than selling assets, which is a better way to build equity in the first place.

The U.S. government has instead addressed the risks of banking crises by guaranteeing bank debt. Guaranteeing debts creates perverse incentives, so our government tries to regulate the banks from taking excessive risks: "OK, cousin Louie, I'll cosign the loan for your Las Vegas trip, but no poker this time, and be in bed by 10."

Ms. Admati and Mr. Hellwig show how this approach has failed, repeatedly, over the course of many years—in the 1984 Continental Illinois rescue; in the Latin American debt crisis and savings-and-loan crisis in the 1980s; in the Asian-currency crisis and the collapse of Long-Term Capital Management in the 1990s; and in the recent financial crisis. Each time, our government bailed out more and more creditors in a wider array of institutions. Each time, our government wrote reams of new rules that banks quickly got around.

Now pretty much all of the big banks' debt is guaranteed, explicitly or implicitly through the widely held expectation that a big bank's creditors will be bailed out. But our regulators promise that next time, trust them, they really will spot trouble ahead and do something to stop it—even though our massive bank-regulation machinery failed to notice that subprime mortgages might be a bit risky in 2006 and even though, as Ms. Admati and Mr. Hellwig note, Europe's regulators still consider Greek government bonds to be risk-free assets.

Most basically, Ms. Admati and Mr. Hellwig point out that current regulation is focused on a bank's assets: the loans, securities and other investments that bring money in (and sometimes don't). They want us to focus instead on the bank's liabilities: the ways banks get money and the promises banks make to depositors and investors. Bank assets are not particularly risky or illiquid. Apple's profits from selling iPhones or a mutual fund's portfolio of stocks are far riskier than any bank's portfolio of loans and mortgage-backed securities, or even their much-disparaged trading books. Bank liabilities—too much debt and too much short-term debt—are the central problem that causes financial crises.

What about those "tough" new capital regulations that you keep reading about? They are not nearly as tough as you think. At best, the new Basel III international bank regulation agreement calls for a 7% ratio of capital to assets by a leisurely 2019 deadline. But that is the ratio of capital to "risk-weighted" assets. Risk-weighting is a complex system in which some assets count less against capital requirements than others. A dollar of mortgage assets might count as 50 cents, but it might count as 10 cents or less if it is a complex mortgage-backed security, and zero if it is government debt. When Ms. Admati and Mr. Hellwig unravel those "risk weights," we're still talking about 2% to 3% actual capital.

Foreseeing the usual risk-weighting games, Basel III requires a backstop 3% ratio of equity to all assets. "If this number looks outrageously low," Ms. Admati and Mr. Hellwig write, "it is because the number is outrageously low." Indeed.

This simple truth has been met by howls of protest and layers of obfuscation and derision by bankers, their consultants and many of their regulators. "Oh, you just don't understand the complexities of banking" is the basic attitude. "Go away and let the experts fix this." Well, Ms. Admati and Mr. Hellwig, top-notch academic financial economists, do understand the complexities of banking, and they helpfully slice through the bankers' self-serving nonsense. Demolishing these fallacies is the central point of "The Bankers' New Clothes."

No, they write, it was not always thus. In the 19th century, banks funded themselves with 40% to 50% capital. Depositors wouldn't lend to banks unless the banks had a lot of skin in the game. Without a government debt guarantee—and, early on, without limited liability—shareholders wanted less risk as well.

"Capital" is not "reserves," and requiring more capital does not reduce funds available for lending. Capital is a source of money, not a use of money. When, as Ms. Admati and Mr. Hellwig gleefully note, the British Bankers' Association complained in 2010 about regulations that would require banks to "hold"—the wrong verb—"an extra $600 billion of capital that might otherwise have been deployed as loans to businesses or households," it made an argument both "nonsensical and false," contradicting basic facts of a bank balance sheet. Requiring more capital does not require banks to raise one cent more money in order to make a loan. For every extra dollar of stock the bank must issue, it need borrow one dollar less.

Capital is not an inherently more expensive source of funds than debt. Banks have to promise stockholders high returns only because bank stock is risky. If banks issued much more stock, the authors patiently explain, banks' stock would be much less risky and their cost of capital lower. "Stocks" with bond-like risk need pay only bond-like returns. Investors who desire higher risk and returns can do their own leveraging—without government guarantees, thank you very much—to buy such stocks.

Nothing inherent in banking requires banks to borrow money rather than issue equity. Banks could also raise capital by retaining earnings and forgoing dividends, just as Microsoft MSFT +0.54% did for years. Every dividend drains capital from banks and removes a layer of protection between us taxpayers and the next bailout. Ms. Admati and Mr. Hellwig are at their best in decrying U.S. regulators' decision to let banks pay dividends in 2007-08—amounting to half the TARP bailouts—and to let big banks begin paying out dividends again in 2011.

Why do banks and protective regulators howl so loudly at these simple suggestions? As Ms. Admati and Mr. Hellwig detail in their chapter "Sweet Subsidies," it's because bank debt is highly subsidized, and leverage increases the value of the subsidies to management and shareholders. To borrow without the government guarantees and expected bailouts, a bank with 3% capital would have to offer very high interest rates—rates that would make equity look cheap. Equity is expensive to banks only because it dilutes the subsidies they get from the government. That's exactly why increasing bank equity would be cheap for taxpayers and the economy, to say nothing of removing the costs of occasional crises.

And, in an all-too-short chapter on "The Politics of Banking," they show us how politicians and regulators like the cozy cronyism of the current system. Banks are, of course, "where the money is," and governments around the world use regulation to direct funds to politically favored businesses, to preferred industries, to homeowners and to the government itself. Politicians want to subsidize and protect their piggy bank. Regulators commonly become sympathetic to the interests of the industry they regulate, which advances their careers in government or back in industry. Last week's news coverage of Treasury Secretary Jack Lew's interesting career is only the most recent reminder.

Part of me wishes that Ms. Admati and Mr. Hellwig had been more specific in their criticisms: naming more names and quoting more nonsense, writing a gripping exposé dripping with their justified outrage. But their restraint is wise: Too much exposé would detract from the clarity of their ideas. So readers will have to recognize the arguments and add their own outrage.

Ms. Admati and Mr. Hellwig do not offer a detailed regulatory plan. They don't even advocate a precise number for bank capital, beyond a parenthetical suggestion that banks could get to 20% or 30% quickly by cutting dividend payments. (I would go further: Their ideas justify 50% or even 100%: When you swipe your ATM card, you could just sell $50 of bank stock.)

But this apparent omission, too, is a strength. A long, detailed regulatory proposal would simply distract us from the clear, central argument of "The Bankers' New Clothes": More capital and less debt, especially short-term debt, equals fewer crises, and common contrary arguments are nonsense. More capital would be far more effective at preventing crises than the tens of thousands of pages of Dodd-Frank regulations and its army of regulators, burrowed deep in the financial system, on a hopeless quest to keep highly leveraged and subsidized too-big-to-fail banks from taking too much risk. Once the rest of us accept this central idea, the details fill in naturally.

 How much capital should banks issue? Enough so that it doesn't matter! Enough so that we never, ever hear again the cry that "banks need to be recapitalized" (at taxpayer expense)!

(Update in response to a lot of comments. C'mon, this is a review of a book about banks. It's not my place here to expand the discussion to GSEs' CRA, the run on repo and broker dealers, money market funds etc. On the ATM card that sells bank stock: That card can also sell a share of your S&P500 index. And if you want stable value accounts, money market funds that hold only short term treasuries can provide all the fixed-value assets we could possibly want.)