A good oped in Bloomberg's "Business Class" series tackles money market funds. (I signed it along with the rest of the Squam Lake group, but I can't take credit for much of the writing.)
There was a run in money market funds. We have to do something about this.
Money market funds are a bank. Their liabilities are fixed value, first-come first-serve, just like deposits. Their assets are longer term, and less liquid. This fact puts them at risk for a run. The essence of stopping future financial crises is stopping runs.
One way to stop a run is for the government guarantee all the liabilities. That stops the run, but gives horrible incentives to the fund managers, so now you need regulation. This is what we did with banks and what the industry seems to want for money market funds. Watch for what you ask for, you just might get it.
The Squam Lake group, and others thinking about these issues, note two other eminently sensible possibilities.
First, money market funds can trade at net asset value, just like equity mutual funds or exchange traded funds. (The small difference between those doesn't matter here.) Now there is much less incentive to run. The situation that happened with the Reserve Fund in the financial crisis, that everyone sees net asset value less than a dollar per share and knows it's time to run, cannot happen.
This seems like the simplest fix. In the modern world, liquidity need not mean fixed value.
Alas, as the more knowledgeable Squam members informed me, this conceptually simple resolution to the problem causes accounting and tax problems. Money funds are used as money. If I have to pay you $1,000, it's easy to say "sell 1,000 shares and send the proceeds." It's much harder, technically, to say "sell $1,000 worth of shares and send the proceeds."
The tax issue is that if every transaction takes place at a different market value, then you have to track capital gains and losses on a huge number of transactions.
Say I, well, for a few hundred billion dollars we can surely fix these accounting and tax law problems (like get rid of capital gains tax!). Why accept that one bad regulation must beget another? But critics are right that this does spread the difficulty of making a change.
Second, money market funds can include capital just as banks do. If there is an equity tranche holding even a few percent of value, then money funds can promise $1 per share and always have net asset value above that. Banks have equity tranches. So can money funds. If we're going to maintain $1 per share, this seems like a no brainer, and basically what the Oped calls for. The objections, like most objections to higher capital for banks, basically don't understand the Modigliani Miller theorem.
That said, money market funds are a lot simpler than banks, and fixing the regulatory system is a bit less crucial in my view.
The chance of a systemic run is lower for money market funds. The danger in a systemic run is that bank A is found to be insolvent; people don't know what bank B's assets are, so they run just to be sure. That's not what happened at the Reserve Fund: People knew it held a lot of Lehman paper, and knew it was insolvent. People can see what assets the other money market funds had, and quickly verify if the did or did not hold Lehman paper.
The transparency of money market funds -- the fact that we know the net asset values pretty well and the composition of assets -- makes the chances of a "multiple equilibrium" run or a "systemic" run a lot less than that of banks.
Still, there is no reason to put up with runs at all, or to provide a blanket government guarantee, when fairly simple changes to the contracts can fix the problems.
Facilitating NAV trading or an equity buffer is important for another reason -- to expand money market funds and let them take on more risk.
The SEC has already started the "regulate" part of the traditional model by forcing money market funds to shorten the maturity of their assets. Great, but as forcing institutions to buy "AAA" debt subsidized the artificial creation of "AAA" assets, forcing funds to hold "short term" debt subsidizes creation of short-term liabilities. And short term debt anywhere is the poison in the well that causes crises. It encourages banks and other issuers to finance themselves with a lot of short-term debt, exactly the opposite of what we want.
You can move risk around, you can't eliminate it. Keeping the risk in the fairly transparent money market funds with a solid equity tranche rather than in the bowels of horribly complex too big to fail banks seems like a good idea.
Thursday, April 19, 2012
Why Is This a Conundrum?
A conundrum is something that is surprising and unusual and difficult to explain. Sometimes a conundrum is described as a "riddle." Today's conundrum, according to the media, is the "jobless recovery." Really?
Is it truly difficult to find the reasons why employers have scant interest in adding to their work force? The only folks that find that this is a "conundrum" are folks that are not employers. American employers know perfectly well why hiring new employees is of little interest and could pose a major threat to their company's financial security.
The future of the US is to use labor from outside the country. Why? Is it because wages are low? If that were the case the US would have always "imported" it's labor through outsourcing. Why is "outsourcing" a modern phenomenon? Is this really a conundrum, as the media is fond of asserting? Or, is it simply the logical and predictable outcome of the dramatically increased labor costs imposed by various levels of government on employers that have the temerity to have a work force?
A machine can't sue you. An employee in China or India can't sue you if they don't work for you, but work instead for your subcontractor. You don't have to provide various benefits to an employee in Vietnam or Poland who is providing labor services to a company that provides you with a product. So, why should American companies have any "local" employees at all. That is probably the real "conundrum."
It is not a surprise that we have a jobless recovery. The real surprise would be if American employers got enthusiastic about hiring American workers. Based upon current government policies and existing law, that's not likely to happen.
Is it truly difficult to find the reasons why employers have scant interest in adding to their work force? The only folks that find that this is a "conundrum" are folks that are not employers. American employers know perfectly well why hiring new employees is of little interest and could pose a major threat to their company's financial security.
The future of the US is to use labor from outside the country. Why? Is it because wages are low? If that were the case the US would have always "imported" it's labor through outsourcing. Why is "outsourcing" a modern phenomenon? Is this really a conundrum, as the media is fond of asserting? Or, is it simply the logical and predictable outcome of the dramatically increased labor costs imposed by various levels of government on employers that have the temerity to have a work force?
A machine can't sue you. An employee in China or India can't sue you if they don't work for you, but work instead for your subcontractor. You don't have to provide various benefits to an employee in Vietnam or Poland who is providing labor services to a company that provides you with a product. So, why should American companies have any "local" employees at all. That is probably the real "conundrum."
It is not a surprise that we have a jobless recovery. The real surprise would be if American employers got enthusiastic about hiring American workers. Based upon current government policies and existing law, that's not likely to happen.
Wednesday, April 18, 2012
If Things Are So Bad In Europe, Why Euro is Still Above Parity?
Things are not so good across the pond. ECB is unable to make the PIIGS pretty even with 1 Trillion Euro lipstick. (LTRO). Spain bailout is not a matter of if but when. Italy has just announced that their target for reaching budget target will be postponed by one more year. Given all that bad news, why is Euro still above parity? Why the commercials are long Euro week after week for last so many months as you can see in the COT report. What do they know that we are missing?
ZH and all the proponents of doom and gloom are predicting the imminent end of the world and urging us to load up on gold, gun and canned food. But Gold is refusing to go up, Campbell shares are down in the dumps and only gun sales are up. What gives?
I think the answer can be found in the following graph.
It shows the liquidity pumped in by all the central banks around the world. And Obama will do anything to get re-elected. If he can make a side deal with the Russians regarding missile defense, do you think he would feel shy of pumping the market?
One might ask, if so much money is being pumped in the system, why we do not see much of inflation, leave alone hyper inflation? There are two reasons. First, inflation is rampant in BRIC countries. It is officially around 10% in India and 9% in China. Actually it is much more. Secondly, In developed countries like USA, it is hidden from direct public eye. If you are doing your groceries, you definitely feel the pinch and see either prices of milk,bread and other essentials are going up every year or package sizes are reduced by the companies who charge the same price as before. It is just because the way they calculate CPI in USA that they are able to show inflation below 2%.
But most importantly, there is a huge erosion of asset values which is kind of deflationary. So basically what we have in USA is stagflation. How does that affect the stock prices? In the long run, not the way Bernanke wants them. But that is another story.
I have been writing not to short the market yet, although the upward momentum is almost over. Because we might go in sideways for some time before any correction and even then the correction may not be very deep.
That’s it for today. Trade safe and do not front run. Remember we do not always have to be in the market.
Thank you for reading http://bbfinance.blogspot.ca/.
Why Jobs are Few and Far Between?
Americans are generous people. They believe in helping others. The Americans for Disability Act, passed by overwhelming bi-partisan Republican and Democratic support, championed both by then Senate Majority Leader Robert Dole and then President Bill Clinton, must have seemed like a good idea at the time. Why not help people with disabilities? Isn't that the right thing to do?
Most Americans would answer the above question in the affirmative. Why not?
But, the reality is the ADA, as the act is known, has a definition of disability that the vast majority of Americans would never agree with. For just one example, chronic alcoholism is a "disabililty" under the ADA. If an employer refuses to hire someone because they are obviously inebriated in the interview and they confess to a severe drinking problem during the job interview, then that employer can be prosecuted under the ADA. Is that what a bi-partisan group of Democrats and Republicans thought they were singing up for? Funny! Neither Bob Dole nor President Clinton brought up the plight of alcoholics as reasons for their support of the ADA when they spoke eloquently for the Disabilities Act.
In the modern University, professors are required to "accomodate" students with disabilities. You might think that would mean students with speech impairments or other physical disabilities. Nope, such accomodations to students with physical disabilities are rare. The vast majority of the "accomodations" in the classroom are for students with "learning disabilities." Such learning disabilities often give such students three to four times as much time to take an examination as the time provided for students without such disabilities. One wonders what future careers this time of "accomodation" is preparing the student for? What are these "learning disabilities?" That's a pretty murky topic. "Inability to focus or concentrate" for lengthy periods of time is one such disability. Did the sponsors of ADA envision this application of the notion of a "protected disability?"
No wonder employers shy away from hiring employees when lawsuits can quickly emerge if a potential job candidate shows up drunk for the interview. Worse, the target of the lawsuit is the potential employer! There are so many reasons not to hire anyone and to economize on the work force. This is just one of many.
Outsourcing looks very attractive when you stop to think that employers in other countries don't face these kinds of lawsuits from the mere act of attempting to give someone a job. America has put itself in a position where offering a job is, more often than not, a prelude to a civil suit or a violation of the criminal code. So, why bother? Employees are toxic and best avoided. That's the message from the US government.
Most Americans would answer the above question in the affirmative. Why not?
But, the reality is the ADA, as the act is known, has a definition of disability that the vast majority of Americans would never agree with. For just one example, chronic alcoholism is a "disabililty" under the ADA. If an employer refuses to hire someone because they are obviously inebriated in the interview and they confess to a severe drinking problem during the job interview, then that employer can be prosecuted under the ADA. Is that what a bi-partisan group of Democrats and Republicans thought they were singing up for? Funny! Neither Bob Dole nor President Clinton brought up the plight of alcoholics as reasons for their support of the ADA when they spoke eloquently for the Disabilities Act.
In the modern University, professors are required to "accomodate" students with disabilities. You might think that would mean students with speech impairments or other physical disabilities. Nope, such accomodations to students with physical disabilities are rare. The vast majority of the "accomodations" in the classroom are for students with "learning disabilities." Such learning disabilities often give such students three to four times as much time to take an examination as the time provided for students without such disabilities. One wonders what future careers this time of "accomodation" is preparing the student for? What are these "learning disabilities?" That's a pretty murky topic. "Inability to focus or concentrate" for lengthy periods of time is one such disability. Did the sponsors of ADA envision this application of the notion of a "protected disability?"
No wonder employers shy away from hiring employees when lawsuits can quickly emerge if a potential job candidate shows up drunk for the interview. Worse, the target of the lawsuit is the potential employer! There are so many reasons not to hire anyone and to economize on the work force. This is just one of many.
Outsourcing looks very attractive when you stop to think that employers in other countries don't face these kinds of lawsuits from the mere act of attempting to give someone a job. America has put itself in a position where offering a job is, more often than not, a prelude to a civil suit or a violation of the criminal code. So, why bother? Employees are toxic and best avoided. That's the message from the US government.
Tuesday, April 17, 2012
Top Is Near.
I apologies for my long absence. It has been extremely busy at work with extended hours. It never seems to finish. This is more so as we are shifting the entire client portfolio to a defensive position.
Anyway, nothing much has changed since last Thursday. One big up day followed by a big down day followed by a still bigger up day. The trends following models are giving whipsaw after whipsaw. If you remember my last post, I said, it is time to sell in to strength and remain in cash. It is not yet time to short. And I still stand by that comment.
Just a look at the daily chart of SPX should convince you that we are in a topping process.
It seems that the DMI is about to have a cross over. I keep writing that we will re-test the high and only when we fail, we can be sure of trend reversal. McClellan Oscillator is still negative, even after the huge gain today.
It still has some more room to run which might take SPX near the earlier high.
As per my cycle analysis, the top is around April Op-Ex. It is not an exact science and it may move around a day here and there but I would not be in any long position after Friday, April 20th. It is either SPX 1450 or April 20th, whichever comes 1st. The earning season has been good so far and that it’s keeping the hope alive but hope is not a good trading strategy. So we might see a last minute surge before the curtain falls.
How far we will fall in correction is not yet sure. But most likely, May will not be very kind to the bulls. It is important to remember the time frames. In a longer time frame, we are in an uptrend but in a shorter time frame, we will see corrections. That correction will be a buying opportunity but we need to know when the correction is over when it is time to buy again. As of now, it is time to sit on the sideline.
Thank you for all your kind emails and comments. I will try my best to be regular.
Monday, April 16, 2012
Price and volatility in the great crash
I made the following cool graph last week. (Well, I think it's cool):
The black line is the VIX volatility index. You can think of it as a market forecast of volatility over the next month. It starts at about 25, reflecting a 25% per year standard deviation of stock returns. In the financial crisis, it shoots up to 80%. Yes, 80% annualized standard deviation. Then it tails back again with another jump in early 2010. (The VIX tracks realized volatility almost perfectly in this episode, so it's not about volatility risk premiums.)
The blue line is the cumulated return on the Fama-French total stock market index. (Data from Ken French's website.) If you had a dollar in the market in January 2008, it shows you the percent gain or loss through time. (The level of the S&P500 shows almost exactly the same pattern.) That's also pretty dramatic: you lose half your money by March 2009, before the market recovers.
The negative correlation between these two lines is striking. Yes, we've known for a long time that lower prices are associated with higher volatility, but it's not often that you see such a striking correlation.
What do we make of it? It seems to revive the idea that mean returns and volatility are related. If volatility goes up, then mean returns must go up too, so that the average investor keeps holding the market portfolio. The only way for mean returns to go up is for the price to decline. You can almost blame the fall in prices on the rise in volatility.
The challenge is to get the numbers to add up. The standard portfolio allocation rule says
Variance is volatility squared, so if volatility goes from 20 to 80, the denominator rises by a factor of 80^2/20^2= 16! If you have all your money in stocks, share = 1, we need the mean also to rise by a factor of 16; say from 6% to nearly 100%. Did participants expect the entire 50% stock market decline to be reversed in 6 months? I've written about time-varying expected returns, but even for me a market risk premium of +100% seems like a lot.
I think the answer is, this is the wrong equation. It's time to get serious about Merton portfolio theory for long-lived investors. The real (Merton) portfolio theory adds to the last equation
So, something about this term must be screaming "get in" to counteract the last equation's advice to "get out." Why do people care about volatility risk? ("aversion") Why does this term vary strongly over time?
Something in this event seems to be crying to explain "state variable risk" in an intuitive way, but doing so is just out of my reach. (I've been puzzling about this for a while, see p. 1082 of "Discount Rates". )
Of course, volatility is not the ultimate "state variable," and understanding the movement of stock prices will eventually means we need to dig deeper to underlying events.
Context: I was discussing two nice papers at the NBER asset pricing meetings: "Volatility, the Macroeconomy and Asset Prices, by Ravi Bansal, Dana Kiku, Ivan Shaliastovich, and Amir Yaron, and "An Intertemporal CAPM with Stochastic Volatility" by John Y. Campbell, Stefano Giglio, Christopher Polk, and Robert Turley. Both papers explore time-varying volatility and attempt to answer this puzzle. (Google for latest versions of the papers.)
Cambpbell et. al. also argue that the value effect (higher returns for value stocks than growth stocks) is explained by value stock's tendency to move with changes in volatility. That's why I included the value stock cumulative return in the graph.
Update
Pedro Santa-Clara sent this graph:
It shows a nice correlation between the VIX and the earnings/price ratio. In turn, the earnings/price ratio is one of the best return forecsaters. So, conditional mean and conditional variance of returns do move together.
That's nice, as it sometimes seems that volatility and mean return wander off in different directions, in response to different state variables, and at different frequencies. A united view of the two moments is essential.
But don't get too exited. The graph certainly does not document a constant Sharpe ratio, or even a constant mean to variance ratio. The earnings yield corresponds roughly 1 to 1 ("roughly" means between 1 to 1 and 1 to 3) with one-year expected returns, so you're seeing expected returns vary roughly from 4 to 7 percent. The VIX is moving orders of maginitude more. So one-year Sharpe ratios and mean/variance ratios are still moving a lot over time! But perhaps we can coalesce the state variables somewhat, and find common factors in conditional mean and variance.
The black line is the VIX volatility index. You can think of it as a market forecast of volatility over the next month. It starts at about 25, reflecting a 25% per year standard deviation of stock returns. In the financial crisis, it shoots up to 80%. Yes, 80% annualized standard deviation. Then it tails back again with another jump in early 2010. (The VIX tracks realized volatility almost perfectly in this episode, so it's not about volatility risk premiums.)
The blue line is the cumulated return on the Fama-French total stock market index. (Data from Ken French's website.) If you had a dollar in the market in January 2008, it shows you the percent gain or loss through time. (The level of the S&P500 shows almost exactly the same pattern.) That's also pretty dramatic: you lose half your money by March 2009, before the market recovers.
The negative correlation between these two lines is striking. Yes, we've known for a long time that lower prices are associated with higher volatility, but it's not often that you see such a striking correlation.
What do we make of it? It seems to revive the idea that mean returns and volatility are related. If volatility goes up, then mean returns must go up too, so that the average investor keeps holding the market portfolio. The only way for mean returns to go up is for the price to decline. You can almost blame the fall in prices on the rise in volatility.
The challenge is to get the numbers to add up. The standard portfolio allocation rule says
share in risky assets = 1/(risk aversion) x mean return / variance of return
Variance is volatility squared, so if volatility goes from 20 to 80, the denominator rises by a factor of 80^2/20^2= 16! If you have all your money in stocks, share = 1, we need the mean also to rise by a factor of 16; say from 6% to nearly 100%. Did participants expect the entire 50% stock market decline to be reversed in 6 months? I've written about time-varying expected returns, but even for me a market risk premium of +100% seems like a lot.
I think the answer is, this is the wrong equation. It's time to get serious about Merton portfolio theory for long-lived investors. The real (Merton) portfolio theory adds to the last equation
... + (aversion to volatility risk) x (covariance of return with changes in volatility)
So, something about this term must be screaming "get in" to counteract the last equation's advice to "get out." Why do people care about volatility risk? ("aversion") Why does this term vary strongly over time?
Something in this event seems to be crying to explain "state variable risk" in an intuitive way, but doing so is just out of my reach. (I've been puzzling about this for a while, see p. 1082 of "Discount Rates". )
Of course, volatility is not the ultimate "state variable," and understanding the movement of stock prices will eventually means we need to dig deeper to underlying events.
Context: I was discussing two nice papers at the NBER asset pricing meetings: "Volatility, the Macroeconomy and Asset Prices, by Ravi Bansal, Dana Kiku, Ivan Shaliastovich, and Amir Yaron, and "An Intertemporal CAPM with Stochastic Volatility" by John Y. Campbell, Stefano Giglio, Christopher Polk, and Robert Turley. Both papers explore time-varying volatility and attempt to answer this puzzle. (Google for latest versions of the papers.)
Cambpbell et. al. also argue that the value effect (higher returns for value stocks than growth stocks) is explained by value stock's tendency to move with changes in volatility. That's why I included the value stock cumulative return in the graph.
Update
Pedro Santa-Clara sent this graph:
That's nice, as it sometimes seems that volatility and mean return wander off in different directions, in response to different state variables, and at different frequencies. A united view of the two moments is essential.
But don't get too exited. The graph certainly does not document a constant Sharpe ratio, or even a constant mean to variance ratio. The earnings yield corresponds roughly 1 to 1 ("roughly" means between 1 to 1 and 1 to 3) with one-year expected returns, so you're seeing expected returns vary roughly from 4 to 7 percent. The VIX is moving orders of maginitude more. So one-year Sharpe ratios and mean/variance ratios are still moving a lot over time! But perhaps we can coalesce the state variables somewhat, and find common factors in conditional mean and variance.
Bernard Baruch: private speculator & public life
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| Bernard Baruch with Winston Churchill (left) and Dwight Eisenhower (right) in 1953 (via loc.gov). |
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