Oh Caaanada... parity with USD at last!

Ooooh yeah, 1 Canadian dollar now buys more than 1 USD--so much for making fun of Canadians!

Canada kicks ass... especially their currency--oh what fun it is to have a budget surplus and a currency so correlated with basic materials, natural resources, and mining.

Just look at the appreciation! This is awesome for anyone that has a lot of their investments/holdings in Canadian dollars. (i.e. my Roth IRA... weeee!)

This will hurt Canadian exports to the U.S. though--paper and forestry products, gas, and any other manufactured products whose cost curve is based on the loonie. But that's a story for another time... I just wanted to express my excitement at this monumental event! Let's see if it lasts (and with the way the U.S. has been handling fiscal and monetary policies, and with inflationary pressures in basic materials, it should!)

I was too lazy to write this so someone else did it for me

Fears of dollar collapse as Saudis take frightBy Ambrose Evans-Pritchard, International Business Editor
Last Updated: 8:39am BST 20/09/2007

Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East.

China threatens 'nuclear option' of dollar sales
Ben Bernanke has placed the dollar in a dangerous situation, say analysts
"This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

"Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.

As a close ally of the US, Riyadh has so far tried to stick to the peg, but the link is now destabilising its own economy.

The Fed's dramatic half point cut to 4.75pc yesterday has already caused a plunge in the world dollar index to a fifteen year low, touching with weakest level ever against the mighty euro at just under $1.40.

There is now a growing danger that global investors will start to shun the US bond markets. The latest US government data on foreign holdings released this week show a collapse in purchases of US bonds from $97bn to just $19bn in July, with outright net sales of US Treasuries.

The danger is that this could now accelerate as the yield gap between the United States and the rest of the world narrows rapidly, leaving America starved of foreign capital flows needed to cover its current account deficit - expected to reach $850bn this year, or 6.5pc of GDP.

Mr Redeker said foreign investors have been gradually pulling out of the long-term US debt markets, leaving the dollar dependent on short-term funding. Foreigners have funded 25pc to 30pc of America's credit and short-term paper markets over the last two years.

"They were willing to provide the money when rates were paying nicely, but why bear the risk in these dramatically changed circumstances? We think that a fall in dollar to $1.50 against the euro is not out of the question at all by the first quarter of 2008," he said.

"This is nothing like the situation in 1998 when the crisis was in Asia, but the US was booming. This time the US itself is the problem," he said.

Mr Redeker said the biggest danger for the dollar is that falling US rates will at some point trigger a reversal yen "carry trade", causing massive flows from the US back to Japan.

Jim Rogers, the commodity king and former partner of George Soros, said the Federal Reserve was playing with fire by cutting rates so aggressively at a time when the dollar was already under pressure.

The risk is that flight from US bonds could push up the long-term yields that form the base price of credit for most mortgages, the driving the property market into even deeper crisis.

"If Ben Bernanke starts running those printing presses even faster than he's already doing, we are going to have a serious recession. The dollar's going to collapse, the bond market's going to collapse. There's going to be a lot of problems," he said.

The Federal Reserve, however, clearly calculates the risk of a sudden downturn is now so great that the it outweighs dangers of a dollar slide.

Former Fed chief Alan Greenspan said this week that house prices may fall by "double digits" as the subprime crisis bites harder, prompting households to cut back sharply on spending.

For Saudi Arabia, the dollar peg has clearly become a liability. Inflation has risen to 4pc and the M3 broad money supply is surging at 22pc.

The pressures are even worse in other parts of the Gulf. The United Arab Emirates now faces inflation of 9.3pc, a 20-year high. In Qatar it has reached 13pc.

Kuwait became the first of the oil sheikhdoms to break its dollar peg in May, a move that has begun to rein in rampant money supply growth.

Bearish Gibberish (still in the works)

Alright! Some free time off work! Whew… time to let some stuff off my chest! I was gonna write a week ago… but you know what they say: the hardest part is getting started. Aint that the truth!

Well I feel vindicated… all my previous babbling of a possible doom that I dare not predict the timing of… but still…

First of all… more currently… what? What’s all this talk about current market situations reflecting a “classic bank run”—long term assets’ inability to meet short-term liquidity needs? If only it were that easy! What about the actual quality in these long term assets? If they were actually sound investments it would be easy to restore confidence… but the fact of the matter is that nobody knows where these assets are anymore, or who the guarantors are, and what they should be priced at. All this talk about the markets gaining confidence again due to renewed liquidity injections... by the Fed, by Bank of America… ho ho ho… with all that bad debt underwritten in the past few years, do markets really think that everything can be solved by banks making a little bit of market here, and asset managers writing down just a couple billion there? The potential amount of bad money created by bad debt multiplied by bad leverage over the past couple of years is laughable! (laughable because there’s not much else to do) And for those still holding on to a glimmer of hope that not 100% of the securitized/packaged/voodooed debt will default and thus sound assets will prop up the desire and liquidity to own these things once they are cheap enough… hold fast hope, cuz it doesn’t really take a genius to figure out that some residual quality will still be worth something—but it is the sheer sell down resulting from not knowing where that residual quality is that will give us, hopefully, a great secular bear market where bitter people like me can pick up assets for cheap. Woohoo! (I really should hide my enthusiasm on wanting the markets to tank… badly tank… tanking to the historical bear markets of 15-20% earnings yield businesses… and stay there for three years to give enough time to load up the value truck HA HA HA!)

And with that, I’d like to rant some more about current developments and outlooks of the financial markets of our times

--

The Contagion

You hear people talking about a financial contagion… what is it? Two contagions actually: greed and fear! That’s what it is… and its roots are in the emotions, pure and simple. Money really is just a reflection of thoughts and processes that’s, after all, only in our heads. So this contagion is more like a parasite that’s been stuck in the butt of mankind for eons—an extension of a gamut of complicated biological responses to adverse stimulation, the most basic reactions to pleasure and pain. And the two reflexively work off of one another to create a complicated web of cause and effect events that the many see as isolated and linear when they are anything but.

I think it’s funny when talking heads on CNBC start speaking about the contagion like it just crept up on us, as if it were a silent killer or a disease—none thinks about the possibility that these sort of things are unavoidable, that there is a world after the contagion has done what it is supposed to do, and that the losses suffered by the greater many will also create opportunities for a braver few. In a way, the masses will sway as they’ve always swayed—with the crowd and thus the reason for the term masses.

The great greed/fear contagion of the late 1990s to early 2000s taught us a lesson that we’re quick to forget. Of course, the greed contagions of today came in the form of cheap money and cheap loans for businesses/consumers alike wanting to make wealth out of thin air (inelastic goods speculation—say—land/houses, assets, derivatives on assets, transactional profit from writing derivatives on assets). And the fear contagion will come from not knowing the unknown… and what’s the unknown? You guessed it… complicated structured products on structured products on structured products that nobody knows how to price without a mega computer calculating a billion probability trees (and even then, it’s just a computer model… can you really trust a—computer ROBOT? *shifty eyes*) I want to show you pictures, but alas, I choose words as my medium like a true babbler! Any investment newsletter writer can bore you with charts of consumer savings (or lack thereof), house prices, subprime originations, CDO originations, aggregate money supply, inflation, risk/return spreads, implied volatility, asset wealth to income ratio (and what happens when asset wealth dissipates in a down market)… but I challenge YOU! Reader, to seek these things out yourself! The truth—or the absence of such in this random world of ours—will set you free but you must seek on your own! That, and... I’m too lazy/time constrained to copy and paste all that info. But if I was retired with a billion dollars maybe. HAHA.

And its funny to think that markets will quite possibly see two consecutive downturns in just a single decade when modern finance theory, structured products and derivatives is supposed to have made the markets permanently safer and risk premiums and earnings yield on equity investments permanently lower is… well… ironic. And what a dropkick in the face for those who think human nature and markets on an aggregate level can be tamed! Managed maybe, but tamed? Baloney! Financial contagions after a prolonged period of excess good times are very much a part of nature as—get ready for some obnoxious metaphors—(1) forest fires when too many trees are preserved in the wildlife regions of Midwestern U.S. (2) earthquakes when a period of long calm create unseen but pent up friction and pressure in the geology (3) wars after long periods of peace where populations grow to the point where resources (where productivity of use does not increase) are fought over between groups (4) any smarty-pants critical state ubiquity theory applicable. New financial innovations only give a sense of abolishing the inevitable, the inevitable of eternal recurrence (any Nietzsche fans out there?)…regression to the norm, and a whole lot of curve hugging volatility in between.

Where is the Excess Liquidity?

So back to the part where claims were being made… saying, modern financial theory and financial innovations are making markets permanently safer and liquidity readily available where necessary. In monetarist-speak, that just means: too much money is chasing too few assets, and excess leverage and velocity in the money system has been tinkering with otherwise rational risk perception! I’ve always liked them monetarists.

Economics 101 will tell you that money is created mostly from the lending system. Where banks have a certain amount of reserve from deposits, and can lend out money with that so long as there’s no “run”, and the lent out money in turn becomes deposits and reserves at another financial institution which lends out a portion of that money and the process continues.

Finance 103 will tell you that now a days, that the process of money creation can be expedited through creating avenues where banks can lend where none existed. Derivatives, asset backed securitization, receivables financing, to name a few—all to serve the purpose of driving the cost of debt lower by guaranteeing the lender that there is “something” that backs up the value of the loan just in case of borrower default. Today these things are so complicated (but if you have an hour or two on your hands you can still figure them out pretty easily…) that it’s beyond the purpose of this ramble to go into them in too much detail. All you need to know is they are based on probability theory. Every single last one of these quant valuation metrics… all probability and no pragmatism!

The lower the interest rate goes and the more financial innovations out there, the “looser” the money supply. So excess liquidity isn’t rocket science… it’s just extra money! (with or without extra value to back it up) Ever wish to yourself: man I wish I could have all the money I ever need? Well, excess liquidity is what happens when just that happens! Just on an aggregate level s’all.

But leverage works both ways. Money creation also leads to money destruction when no value is behind the paper. We learn that very early on… Finance/Econ 101! Excess liquidity can turn into excess contraction in the blink of an eye, and it can all start with writing-off of certain assets, and margin calls from brokers ect, and perfectly good assets can get sold, and perfectly bad assets will have no market and no pricing—and BAM! You get a nice big drop (which I’m still waiting patiently for but cannot help but get giddy trying to hurry it on)

Just call excess liquidity what you will… stupid money! That’s what it really is. And you know it when there’s a plethora of jobs in the finance field! The Chinese have a funny people’s anecdote. It talks about work habits in Japan, China, and America as compared to rowing crews in a race. The Chinese have everyone rowing, but nobody shouting out “1! 2! 1! 2!” To keep the rhythm, since there’s so many workers and no real leaders the boat doesn’t go anywhere. The Japanese have one guy shouting and everyone else rowing so they ultimately win. And the Americans—funny big nosed pink skinned people—everyone on the boat is a supervisor/investor, and no rowers to boss around! But you can always hear them talking loudly about where to invest and how to find the best rowers HAHA! Well that’s exactly what happens in an environment of excess money—Just look at what goes into earnings of the S&P! If you saw a big chunk generated by the finance industry, then that’s just what’s happening! (Consumer spending related sectors is the other major portion, which requires blabbling about later on)

Ponzi Finance

The term “ponzi finance” was coined by a famed 20-th century economist Hyman Minsky. You might have heard of talking-heads mention the words “Minsky moment” every once in a while—and poor Hyman Minsky died without ever knowing that his works would be famous… anyway. The ponzi finance he’s talking about is the excesses that financial worlds tend to turn into whenever a prolonged period of stability and prosperity takes shape. In a conservative period, we’d start out with “hedge finance”, which means debt is borrowed only when interest and principal obligations can be repaid in every period. Then we get a little crazy and start “speculative finance”, where debt must constantly be rolled over and refinanced and income only pays at best the interest portion of debt. Lenders usually are reluctant, but since the firm generates such a “stable and predictable stream of cash flows”, I guess they really don’t care so long as someone else could refinance this firm later in the future. “Ponzi finance” is the kraziest, with a K… and that’s when income flows of a firm or in aggregate will not cover even interest cost, and a firm must constantly be creative in order to convince lenders to keep throwing money. In modern times, Ponzi finance can be thought of as many things… and mainly cuz lenders these days don’t really give a hoot about borrower income not being able to cover interest, since they can just readily sell it to someone else through securitization and necromancy… and let me tell ya, ponzi finance is only possible when there is an excess supply of ready liquidity to chase returns.

When you think about it, the financial community really doesn’t create value—finance measures risk and return, allocates value accordingly, but doesn’t actually do the work needed to create the value, that’s the job of entrepreneurs, executive managers, politicians (NOT! I just put that there to see if you’re still paying attention. HAHA) So when there is an excess supply of “financing” available and quite a few entrepreneurs and sound companies, they’re all going to chase it like no tomorrow, and its supply/demand really—quite elementary no?

Back to Ponzi financing… so every once in a while, you will have pseudo-entrepreneurs come out during these times, and promise a certain rate of return that sounds just spectacular and makes you giddy—let’s say, subprime mortgage originators and private equity extra-extra-premium LBOs. The underlying business/asset? Pure crap. But do investors pay attention in a time of ponzi finance, that though the asset itself is worth nothing, the interest payments it seems to promise, and the potential that the investor themselves can package these loans up and sell them to someone else before anybody knows anything is wrong, now grasshopper, that is what we call a MORAL HAZARD—musical chairs, hot hands should stay in elementary schools, and that’s when society should have outgrown these ideas that you can crowd out someone else before you yourself gets hurt!

The subprime and dubious LBOs are underwritten to the public, and the bankers knew exactly what was being sold/invented/brewed-in-the-witches-pot, but they don’t care—they have the transaction fees in hand… a nice stream of income on the backs of other people’s ignorance. Arguably, an ignorance created by buying off the rating agencies (not blatantly, of course, but where do you think ratings agencies get their “revenue growth”?)

But can you really blame financiers for this… or the pseudo-entrepreneurs? In a world where money is awash, what do you do to make money unless you get creative? During excess liquidity periods—I just want to sleep all day long and complain about how nothing is cheap… cuz that’s how I roll. And people would say to me “Ming, you’re old school, think about all the productivity gains and the future”, and I reply “What… I don’t get it”. I do get it! I just don’t even wanna explain myself to someone stricken by the greed contagion, cuz there is no explaining it without getting severely rebuked by rhetorical acrobatics that only sound smart when loud and angry (and I’m a lover, not a fighter!)

Stat-arb Fund Blowups

The only hedge funds that makes headlines these days are the ones that have blown up (except Citadel, who makes headlines by buying up something that blew up), and the strategies that were employed by these funds are none other than, you know it! Statistical arbitrage funds! Whose quantitative valuation models (which all it is, is factors based on financial models, correlation, beta, momentum, ect. and a truck load of probability trees) feeds orders into a computerized trading model.

I don’t claim enough brilliance to already know what these models are (and frankly I don’t really care to know since they sure proved their worth! HAHA!), but ever since the beginning of my short and humble career as a money-shuffler I’ve been suspicious of these quantitative trading models—or just trading based on beta, correlation, and treating tickers not as underlying businesses, but as stochastic movements that somehow can quantified in math. Of course, there is a WHOLE LOT of merit to this method of making money, and I’m sure those that understand it fully could lead very fulfilling P&L books in their careers, however, there’s gotta be safer ways to make money. HAHA! It’s sort of ironic if you think about it. The more “hedged” and “neutral” you are, the less safe in a panic! And you can bet it’s the panics that make or break money managers! As can be seen in the fall of LTCM. Contrast that to the success of the likes of Warren Buffet to keep their principal even in times of turmoil. Well, it’s really not that hard—keep cash! And/or keep companies with at least >12% stable cash yield! And no leverage voodoo!

Cuz the fact of the matter is, it doesn’t matter if you make 10% gains every year for the past 10 years on 10x leverage, if you lose 61.5% on the 11^th year, you will lose ALL your gains… but investors and prime brokers probably won’t wait around until that happens, anything that gets close to 20% will get you a margin call or a redemption, which forces you to sell good quality assets at bargain prices to meet withdraws—and set off a chain reaction of losses and margin calls, and that’s what happened to some of these funds, and if you lose more than 61.5%? Tough! LTCM style… but to be fair, LTCM was levered some 100x? That’s just insane… So we have all these LTCM copycats who aren’t as hardcore as LTCM, but nevertheless suffer because of indiscretion and assuming markets are efficient/rational all the time.

To put it on a more extreme example suppose you make 10% every year for ONE HUNDRED YEARS (as in, your best and brightest son from your third mistress took over the business after you died), Oh man, you’re a genius, you’ve multiplied the equity portion of investors’ money by a factor of 13780.6x, anyone that invested just 72.57 bux in your fund would have become a millionaire after 100 years (or their children… this is before inflation which makes returns actually worse). And suppose they had their families stay with your son for money management, but suppose your son got a little carried away, and instead of having leverage 5x, with 1/3 in cash as a buffer, he carried leverage to 25x, and invested all the cash reserves in market neutral strategies? And when a market sell-off came to be, none of the brilliantly structured derivatives would trade, so he’s forced to sell off high quality assets for cheap to meet margin calls. And when that wasn’t enough because you’re levered TWENTY-FIVE TIMES, The entire equity portion of the fund gets wiped out on asset write-downs when finally a market is made on the brilliantly structured derivatives, except they only now sell for 18 cents on the dollar! The billions you’ve created over your career was destroyed instantly by your third mistresses’ son. Aint that a drag! HAHA! (but I guess you don’t care since you were dead by the time this happened! HAHA)—

Of course, people don’t have an extreme time-horizon like the one mentioned above, most people just want to make money as quickly as possible, and run for the hills (who doesn’t?) And that can be seen with returns chasing in many instances over the past five years or so even after the LTCM debacle, people still look at markets as if it were alchemy, with a way to make money any time all the time, when in fact it takes much more (or less, depends on how you look at it) than probability models to correctly price something. And in five short years for many of these funds, look what happened?

Some people will tell you that these irrational events occur 1/1000000^th of the time, but that’s where the hubris of science gets it wrong. Statistic lies, and often, because of the dangerous assumption that probability models reflect real life. When’s the last time anyone actually questioned the normal/log-normal curves? The only curves I care about in life are my beautiful girlfriend’s! HAHA! In all seriousness now… it actually seems that ten standard deviation events actually occur with a three standard deviation frequency. Ever read “The Masque of the Red Death” by Poe? It’s kinda like that! You can’t ever prevent that one guy that nobody paid attention to, and disaster strikes at your party more often than you can imagine!

Something Bearish This Way Comes

I give up, I can’t hide my giddiness… I don’t know why I get so worked up thinking about a huge crash—and you might ask “Ming… people are going to lose their jobs, their families are going to lose jobs, and you might not see stock market gains for ages! How is this in any way good for you?” To that, I say… I dunno! Haha, I can’t explain it. It’s not schadenfreude, if you think it is. I get very miserable reading articles about people losing their homes, and anecdotes on families shoved with mortgage papers in fine print that they could not understand but trusted their mortgage brokers to take care of them (you’d sooner trust a drug dealer!), and its heartbreaking to have to hear about people losing their jobs, and prospects of a worse time to come makes people scared, and how helplessness might be the best way to describe the state of mind in many people. And maybe it’s the little bit of sympathy left in me… or pity, whatever it is, but pity sure never helps anybody! People are hurt, but the reason why they are hurt in the first place was because of all the things I’ve been blabbing about! Speculative excess! And perhaps, one could unclog the pipes of hindsight, and ask just what it is that brought about people’s ability to purchase their homes in the first place, and what industry hath god wrought—mortgage brokers and real estate agents out to make a quick underwriting buck. I wouldn’t say the homeowners deserved it, or that all this unemployment now serves the mortgage industry right… ok ok who am I kidding… that’s exactly what I’m saying! Homeowners heard and trusted what they wanted to believe in, being able to afford a home on measly income and somehow the rest will take care of itself. Mortgagers wanted to believe that homeowners could repay the bill eventually, and that they were doing a service by giving people a home to live in (and if you could do that and write the loan to someone else, and forget that you were cheating both your clients and investors with the help of your bankers… then blessed are those who can forget).

The drawbacks of such thinking? Well, where do I start? It goes back to the problem of money creation, asset inflation, and a speculative spiral driven upwards. If you could write mortgages, sell these mortgages, use the proceeds to buy land/build houses, and write more mortgages to sell, and all the meanwhile (1) house prices go up and homeowners are eager speculators themselves (2) financial institutions love you because you give them bundled assets to sell (3) ratings agencies love financial institutions because they give them bundled products to rate (4) investment managers love these products because its free alpha, and eats these and pretty much everything else they can use leverage on (5) banks love investment managers for outperforming and give them more leverage for cheap, they also notice the general rise in the wider financial markets and starts providing financing for cheap to anyone that comes to them with a model to make money (6) everyone feels an asset inflation bliss, and assume eternally low volatility and default rates in pricing models.

Of course, that was yesterday… and it wouldn’t be strange then to walk down the street and see people happy, and all the wall street people bustling trying to make deals happen, especially since WACC is so low (because default premiums are gone, and the more debt you have, the lower your cost of acquisition, and the bigger/badder deals you can get), and business school students applying for jobs in real estate, private equity, and M&A banking, thinking “damn look at these fat bonuses”. Now people are starting to worry about the prospects of such futures. And the last panic of July 2007 sure was a really big rock tossed in the middle of lake placid, with a big splash—traders and fund managers everywhere shell shocked at just how close we all got to a complete financial meltdown. But now that the ripples have faded a bit, with the fed injecting that much needed liquidity, and confidence being restored in markets as some M&A deals continue to get announced… people might come out of their hiding holes… but they’ll probably be quick to go back in sirs! Cuz the show isn’t over yet!

Optimism remains, as it always has and always will be, and thoughts of utopia will never escape the human mind so long as it benefits rational self-interest—hope, my dear friends, that the fed will lower rates and bail out the indiscretion of financial markets… and we can blame others for such mistakes—after all, it’s not us that wrote the mortgages, it’s not us that caused the excess liquidity… or is it? The lines get blurry from here—after all, the Fed bailed out financial markets pretty hard the last time stock markets came crashing down, that gave an environment of easy money which could be argued to have caused the bubbles of today. And the rampant currency problems that we are already beginning to experience, (too many US dollars! And the foreigners are beginning to see!) and the fact that if it weren’t for the Chinese disinflation, we’d see some serious price increases in every day things. But that’s a story for another time!

Anyway, this optimism should prove short lived, and if history is any guide (and it usually is, except in the case of risk in quantitative models… HAHA) And although macroeconomic forecasting is a fool’s game, one can see the doubts and the moods manifest themselves… and whenever mood manifests themselves, there’s usually a great show. Just like how you wouldn’t see a movie that has no mood… you wouldn’t want financial market participants to be solid and sure all the time either (cuz then prices don’t vary, and people don’t panic sell!) I used to say “what’s inevitable is not always imminent”, but now, it sure is starting to get just a little bit more imminent every day—which is cool! Since everything seems to be falling into place… and what the bulls called “normal” we bears called “excess”, so now… we sure hope that the great normalization will kick in soon enough! And we just might start to see things cheap again.

The Boy Who Cried “Ease”! Inflation and Currency

But all this talk about this possible ease by the fed to bail the financial markets out is making everyone giddy with greedy eyes again. “Renewed liquidity will save us”, “Bernanke is watching the markets closely and will help us all in the end”, and my favorite “if I was the Fed, I’d sure lower them in light of what’s happening” (thank heavens you’re not! HAHA) The possibility of an ease is there, of course… any time a financial system is on the brink of collapse, the central bank must do its job and provide enough liquidity and money to at least support pricing/market making. But before we all get giddy and say “everything’s fine! Bernanke and the rest of the gang will be sure to fix this mess and we’ll be back on our feet again”, let’s take a closer look at what’s implied in loose monetary policy and bailouts of speculative excess from here on.

It’s hard being a central banker. No, it really is. Many people in the finance field don’t give these guys enough credit… and many talk with conviction and foresight as if they could do the jobs themselves… “oh look at this chart, oh look at this statistic, it only makes sense if the Fed does this”, and many would put good money on directional bets of where they think fed will take interest rates in the next meeting (my heart aches just thinking about it… I’m like Mr. Crabs from Spongebob Squarepants, why do you have to throw away a perfectly innocent little dollar?) And it’s always been my conviction that sometimes—actually, most of the time, the more you know about something, the more you think you know about it—and the more you think you know, the more you actually don’t know. All the data lying in front of you, and piece them together in some form or fashion and you can usually get something that makes sense in an abstract world but not at all in the real world. But I digress… the point is, Fed-watching is a whole lot like bird-watching… one should do it for vicarious intellectual fun, not for hairy chested, ego-on-the-line, table pounding. After all, you can’t influence how the birds will fly, and you can’t influence the way the Fed will act. But most people don’t prescribe to that philosophy, and being a central banker is tough because of just that—a whole lot of pressure from the outside people that think they know what they are talking about. It takes Bernanke a whole lot to sit there in a committee hearing, and get questions like “why do you want the value of the American people’s homes to go down?” while being shown a chart of the drastic drop in home prices (if you know what I’m talking about, then you must be an avid watcher of C-SPAN! Get a life! No… I’m just kidding, kudos to you for actually seeking the epistemology behind market noise!). Let the birds fly, I say! They know what they should do better than you!

At this point, a whole lot of people are reaching the consensus that the Fed will ease in the next meeting, and they are clamoring for it as if it is a necessity rather than a grace. Future markets, after all, are already pricing that possibility fully in the S&P futures markets. Most are foaming at the mouth at every “hurt growth”, “losses exceed the most pessimistic of forecasts”, “financial stress beyond mortgage market”, and of course “will act as needed to stem impact of market turmoil” as signs of an impending decision to lower rates. After all, if the Fed isn’t going to rescue the markets, who will? Like a knight in shining armor fighting back the dragon of bankruptcy; wielding the shield of monetary policy to block out the fires of financial meltdown… bad metaphor? You betcha! HAHA. But alas, I choose a bad metaphor for a reason, for an unrealistic literal outlook deserves nothing more! As if the Fed could stop impending disaster single-handedly! And once the crisis is over everyone can enjoy excess liquidity and stable yields again—with princesses, kings, and investment bankers and all… happily ever after? How nice… but of course, there’s always phrases like “Fed responsibility is not to protect investors” that people like to ignore… if the knight in shining armor does not fight the dragon, who will?

It wouldn’t be a stretch to say that the Fed has accommodated the markets quite a bit over the past decade or so… and has literally been the white knight that bailed out many instances of speculation gone wrong. With buying LTCM, and the tremendous easing after the tech bubble burst and September 11, all to create the liquidity necessary to prop up markets. For all those who don’t know… liquidity in this case means nationalizing bankrupt financiers, and dropping interest rates so low that people can’t help but borrow their hearts out to invest in asset markets (houses being the vehicle of choice). This has in turn rescued us from what could have potentially been an even worse bursting of the stock market bubble six-seven years back… and bulls cheered the quick recovery as sheet genius on part of Alan Greenspan, and bears jeered the bail out and mega-easing as a sign of an impending politicization of the central bank—and precedents that would bring about the doom of capitalism. Whatever one wants to believe, the reality of the situation is that the central bank is indeed political in nature, and to think that the bank can act independent of the representations of the American people is pish-posh! It just so happened that at the time, the majority of the American people actually participated in the asset markets as investors, so the central bank really could not sit back and watch the show while people were losing their retirement and life savings. Not to mention… in 1998, LTCM was a couple hundred billion dollars in the financial system, and that wasn’t exactly small change—and for that money to suddenly disappear overnight because of margin calls would have caused such a de-leverage effect that the we would have surely seen something worse.

So it’s a matter of how badly things get this time around (and from the looks of it, it could get pretty darn bad), and we bears can clamor all we want: “just let it be Bernanke!”, “the speculators deserve their pain!” The reality of the situation is that a melt-down is really no good for a well-functioning society—especially when people’s hard earned homes are involved—and the fact that it wouldn’t only be the speculators and the loud-mouthed bulls that would suffer from an impending financial doom (since leverage is everywhere!), we think twice about wasting time and wishing for impending doom… The media is already full of stories of poor American 40-50 somethings that have just bought their house, but now cannot meet interest payments because of blah blah blah, it would be unpatriotic now to not do something about a possible crash. “The Fed would only be doing their job if they bailed the markets out again—its only right because America needs help.”

So all this bearish talk about “artificial money” and “excessively low interest rates” being morally wrong and anti-capitalistic—don’t be surprised if it comes back again!

Oh, and keep in mind that a measely 25 bps or 50 bps ease will not change anything—if the Fed eases, it will have to be a consecutive ease like the one Greenspan undertook in the first few years of the millennium to bring sexy back to the markets!

Short-term monetary policy is nothing that one can predict. And I wanna make it clear that there is no way to call what the Fed will do in their next meeting September. But one thing is clear, whether they ease or raise, in the long-run, any decision would have its long-lasting effects in inflation and the integrity of the American dollar. While an ease might give financial markets crying “gimme a hit!” the much needed narcotic in a time of withdraw symptoms, and might even bring back a nice renewed rally—it’ll come at the expense of those that do not participate in capital investments. That’s another reason why being the Fed is hard… do you throw the bunny at the hyenas, or do you throw the bunny at the wolves? Either way, the bunny is dead… but you have to pick how it dies. So put on the gloves: currency or economy? Inflation or unemployment?

Yes… and all that money that’s being spent over there in the wars on terrorism, and all the currency account deficits that we’ve been running—that’s gonna come back to us one of these days. When China stops exporting disinflation as their currency strengthens and as European consumption and their own consumption strengthens, and when these foreigners no longer trust investments in America, we will see a flood of U.S. dollar selling, and we will have inflation-o-rama! That’s my story and I’m stickin’ to it! And if the Fed starts a series of interest rate eases, then they should know that would only exacerbate the consequences of the inevitable: dollar selling, import inflation, excess money supply. But does that mean they will choose to protect the integrity of the dollar and prevent inflation at the expense of short-term agony? Hard to say! Again, do you heed to the hyenas, or do you heed to the wolves?

And like a boy that cried “ease!”, one day the wolves (metaphorically, inflation) will actually come out—and by that time, the central bankers would not come and save the boy (the days of Paul Volcker returns), and the wolves will have their day, with a boy that has been grotesquely fattened by the rice-bowl of planned capitalism and artificial disinflation for way too long! Look at him run, with all that jiggly fat! That looks almost as bad as me when I run! HAHA!

Consumerism and Its Discontents

Economic Data as a Lagging Indicator

Macroeconomic Forecasting: A Fool’s Game

Zen and the Art of Value Investing

Of Bulls and Matadors, and Why A Bear Market Would Completely Kick Ass

The Inevitable is Imminent! (hopefully)

*Die Walküre – Richard Wagner plays*

So the house of cards (dubious debt) is finally getting ready to crumble as expected. Quants and leveraged financiers can't expect to make all the money all the time :) The show’s not over yet folks! Let’s hope the Fed doesn’t ruin our fun with a bailout :D I want cheap assets!

$ amt of ARM resets—in billions USD:

Macro-view funnies

HAHAHA
ahhh... the vagaries of macroeconomic prediction

hedgefolios.com: You know you are a Permabull when……

· each time the market declines you declare it a “healthy pullback”

· sideways moves are actually just the market “taking a breather” or a “pause”

· missing earnings estimates is ok as long as management confirms next quarter’s guidance

· bad guidance is ok as long as last quarter’s earnings beat estimates

· you criticize any analyst that downgrades your stock from “Strong Buy” to “Buy”

· you applaud poor economic results as good for the market because this time they will cause the Fed to stop raising rates

· any negative market commentary is evidence of a huge “wall of worry” that the market needs to go higher

· you plead that a 10% decline is a “great buying opportunity”

· you blame any market decline on short sellers who just don’t understand

· oil declines to $60 and you expect that will cause the market to head higher

· oil increases towards $70 and you point out how the market has been able to absorb higher oil prices

· you quote the cliches “history repeats itself” for positive things and “it’s different this time” for negative ones

· an inverted yield curve doesn’t concern you at all…

---

bigpicture.typepad.com: You Know You are a Permabear When…

· Each time the market rallies, you declare it an “unhealthy sign of speculative excess”

· The great majority of chart patterns always appear to be either rallies in a bear market or an imminent major top.

· CNBC asks you to appear as balance to the optimistic Bull guests.

· Good economic results are bad for the market – it will cause the Fed to keep raising rates; bad economic results are bad for the market -- its proof of the coming recession;

· You worship at the alter of the holy trinity: Roach, Fleckenstein and Kass;

· Sideways moves are actually just “setting up the market for the next down leg”

· You still rail against Nixon for taking the US off the gold standard;

· Your colleagues think you should become a fixed income portfolio manager.

· All the anecdotal evidence you see reveals excessive bullishness;

· You have trouble sleeping when you take a long trade.

· You refer to the 1987 crash, and the NASDAQ collapse of 2000, as "the good 'ole days." Bonus factoid: The LTCM debacle actually made you money.

· You have a ready "tulip-bulb" joke to use at all times.

· On days when gold prices drop, it's due to a government conspiracy;

· When gold prices rise, it's because central banks have finally lost control of manipulating the gold market. Either that, or the masses have finally figured out their fiat currency is just paper.

· If gold drops again the next day, see #1.

· The move from Dow 7,000 to Dow 11,000 has “just been short covering”

· When companies make quarterly earnings estimates, its bad because a) its already built it, and b) its evidence of earnings management. Missing earnings, on the other hand, is bad, because, well, its bad.

· Your website links to Marc Faber (The Gloom, Boom & Doom Report), Grant's Interest Rate Observer, and the Ludwig von Mises Institute.

· You criticize any analyst that upgrades a stock from “Strong Sell” to “Sell”

· The Yield Curve Inversion is a sure sign of the coming recession; As the inversion flattens, however, you note out how negative higher 10 Year Yields are for stocks;

· Positive market commentary is evidence of “complacency” and proof that the market must go lower;

· Any 10% rise in an stock is a “great shorting opportunity;”

· You blame market rallies on ignorant bulls “who just don’t understand;”

· The market is trading at 5 times earnings with a 5% yield -- and you are calling for the “next leg down”

· Strong economic data is proof that the BLS/BEA is politically fixed -- weak economic data shows how much the economy is slowing;

· You short anything that is in your parents' retirement portfolio – and are determined to outperform.

· You insist that Robert Prechter is just misunderstood

Science rules

Finally, biology and engineering combine to make... biological robots!
http://www.reuters.com/article/topNews/idUSN2832706120070628?feedType=RSS

Economic Epiphany in an Easy to Read Chart

This chart is from a really cool book called Ahead of the Curve written by Joseph H. Ellis on the vagaries of economic prediction (no oxymoron intended). The book is very well written... brilliant even. One of the coolest concepts in there is something called asymmetrical circular causality. But he can explain that better than I can. Check it out!

Okay, well, if you're too lazy to check it out here's a good summary, written by the author:

* Personal income - largely wages and salaries - is the primary driver of consumer spending, by far the largest sector in the economy. Credit and borrowing play a role, but if we can identify the most important indicators of spending power through wages, we have a shot at forecasting consumer spending.

* Uptrends and downtrends in consumer spending drive advances and declines in manufacturing and services.

* In turn, the capital spending sector of the economy, which includes companies' spending on plants and equipment, follows, like clockwork, the trend set by production and services, and consumer spending before them.

* These three sectors of economic activity - consumer spending, industrial production and services, and capital spending - represent the core of corporate profits produced in the United States, so the dependence of corporate profits on consumer spending is also clear.

* The stock market, which advances and declines as a sensitive predictive mechanism reflecting corporate profits, is therefore also tied closely to consumer spending at the front end of the cycle. This makes it easier to understand the sequencing of the stock market in this chain of cyclical events, with major stock market advances and declines tending to occur at similar points in successive cycles.

* Because business hire or fire workers based on the respective rise or fall of sales and profits, employment - jobs - follows rather than leads the economy. Mastering this fact is one of the core hurdles in overcoming emotional but erroneous reactions to economic news.

"In other words, consumer spending is dominant in the economy as a whole to such an extent that it is, by itself, the sector that cyclically determines the direction of the overall economy. This being the case, carefully monitoring overall consumer spending - or, even more significantly, forecasting the direction of consumer demand - is the key that unlocks effective forecasting for most other developments and sectors in the economy."

Financial and Economic Cycles: A Short Story

A lighthearted note today... speculating on a hypothetical situation in a hypothetical world... where asset prices are going up-up and the perceived risks are going down down since its beginning. Let's call this hypothetical world: Omicron Ceti III (OC for short--star trek nerds will appreciate this), where a certain two groups of people interact in an imaginary economy, and establish economic exchange involving money. There were two clans in this world: The Klings and the Fergies.

The Klings were a nomadic hunter-warrior tribe before coming to OC. Honorable, proud, and sticklers for tradition, they are a hardworking people who have left their birthplace due to climatic changes and other acts of nature which forced them to find new sources of subsistence. The Klings were a very numerous people as women bore many children and men were prolific fathers. This eventually put strains on the environment when all their game were extinct. They had to move somewhere as many people were starving and had no food to eat.

The Fergies were in early stages of establishing agricultural surplus and an elementary economy before their coming to the OC. They have pride in their abilities to think beyond what's given in nature, and were superior to the Klings in education, intellect, and organization. They were also very resource minded and frugal, mainly because they were greedy. They established a very sophisticated system of social organization, and did not breed much and deliberately controlled breeding with complex systems of religion that promoted chasity. They wanted to conserve nutrients in their farmland and be frugal with what they know to be limited economic resources. They lived a rich life with a high standard of living per capita. Unfortunately, their military strengths were no match for a neighboring clan who has decided to invade them, and thus their trek to OC to find a new place where they can be left alone.

When the Klings and the Fergies met up in OC when both tried to settle in the land, the two chieftains who led the people at the time agreed to establish a democracy of equals, with the rule of law and property. The Klings were very impressed with Fergian knowledge of agriculture and political economy, and the Fergies needed badly the Kling dedication and experience with the "grunt work" and not to mention war-like activities to acquire and defend territory. Thus, generations have passed, and eventually both the Klings and the Fergies settled down and both called OC home. But of course, due to the Fergies previous intellect and experience with economic activities, and also due to their shrewdness and greed, they soon acquired significantly more wealth than the Klings. After a period of two generations, the Fergies were only 5% of the population, but controlled most of OC's vast amount of wealth and property. By then the economy has gotten relatively advanced. Not only were there a basic food and services industry that the people originally needed to survive, but tastes for consumer discretionary, finance, real estate, luxury goods, and the likes have also popped up on the backs of high population growth and a healthy labor market. Of course, it was mostly Fergies who had the bulk of the wealth to enjoy these amenities. Naturally, the Klings were unhappy with this, as their people were working very hard, but none could ever make as much as the Fergies. As the economy developed, up went the prices of assets such as land, shelter, and raw materials used to create the goods and services, and this meant it was very difficult for Klings to get in on the action with seemingly very meager wages. One day, a whole lot of Klings gathered and signed an official petition for a fairer distribution of wealth, and they protested and complained during a democratic council that the Fergies were guilty of manipulation and conspiracy to undermine the Kling people. This was the first time that the two groups of population had such problems since their founding.

Sensing danger of popular unrest, the democratic council tried very hard to figure out a solution. Around the same time, a secret committee of business and financial industry titans of the Fergie race convened in a secret meeting to try and figure out what to do to keep the Klings happy. The Fergies knew that the Klings were generally a proud and stubborn bunch who could in no way compare to the Fergie intellect and instinct for wealth accumulation, but they also did not think that this was a crime. These Fergies didn't look down upon the Klings, for they also needed the vast number of labor resources that the Klings provide for their civilization. They also realize that a Kling could kick a Fergie's butt any day in a physical match, which makes them dangerous if the Klings ever became politicized. The Fergie committee thought long and hard about what to do, and how to make the Klings feel richer without having to give up their own property and wealth that they've worked so long and hard to accumulate. But they just couldn’t figure it out, would they really have to give away their hard earned money and property in order to keep the social fabric from tearing apart?

Just then, a deus ex machina came and saved the day. A peaceful people known as the Chins sailed to OC from afar, with a caravan full of goods. They were very interested in opening up trade with OC, and the best part of it is that all they asked for in return for the ship full of goods were common shiny pebbles that were plenty to be found on a beach nearby. Apparently, where the Chins came from, these pebbles are very valuable.

The Fergies quickly capitalized on this opportunity and called in an emergency session with the democratic council on the island. The Fergies promised to fix the problem of income inequality by changing the money supply from the current rare gemstones to pebbles, and make available many assets in due time that Klings could purchase with these pebbles. The community built a 10 ft, heavily guarded wall outside of the beach, and established the first central bank in the OC. Of course, none of the Klings were smart enough to figure out what was going on, and the Fergies funneled enough pebbles into the pockets of Kling politicians to keep them happy enough to allow the Fergies to be the ones that controlled this seemingly endless beach full of pebble money. When the bank opened, all was welcomed to exchange their gemstones for these pebbles at a set rate of 50 pebbles per gemstone. The population quickly did so.

Trade with the Chins quickly heated up, and a vast surplus of goods and services were soon imported from the distant homelands of the Chins. A complex system of banking and finance sprang up as a result, where paper representing ownership of pebbles soon began circulating in the two-world economy. The Chins soon also incorporated bank-notes from the Fergies as a part of their currency back home, though they’ve always kept it tucked away as the Fergies didn’t export what they didn’t already have back home. The only thing that the Chins ever really wanted from the OC were the seemingly ubiquitous shiny pebbles and notes representing claims to these pebbles.

Soon, the food of goods from the Chins created a disinflationary effect on the economy of the OC, and the Klings, whereas before they could not afford the luxuries that the Fergies have enjoyed, quickly snatched up goods at cheap prices. The opening to foreign trade had allowed Fergie business owners to shift their production to low-cost foreign countries, outsourcing jobs once held by Klings. There were some complaints regarding job-loss, but in general, society in a very content state-of-being, everyone could purchase price-deflated consumer goods for cheap, and no one was hungry.

Of course, the Fergies who have outsourced labor overseas to the land of the Chins quickly found themselves able to earn very handsome margins on the products they shipped back home. Branded goods and services soon appeared, and an entire fashion and glamour industry sprang up on the backs of high selling prices. Voluptuous females, Kling and Fergie, paraded the catwalks and appeared in newly printed media advertising the new crowning consumerism, and urging the nouveau riche to splurge pebbles on luxury goods made widely available and affordable.

This worked pretty well for a while. The Klings were happy consumers, and could purchase more than they ever thought imaginable. And due to the flexibility of the Fergie dominated central bank, which has increasingly injected more and more pebbles and claims to pebbles into the money supply to pay for goods imported from the Chins, the Klings were able to enjoy very beneficial financing terms. They soon bought their own homes with very little down payment and mortgage debt with very little money down, low interest rates, and a terms of twenty-plus years. Despite the fact that more and more jobs were being shifted to the land of the Chins, in aggregate this was no problem because enough jobs were being created in the real estate, finance, and consumer retail industries in the OC to off-set job losses in hard-asset businesses. Nobody really worried about “real wages”, because inflation didn’t exist in this world of endless cheap Chin goods. Of course, all this prosperity have kick-started asset prices even more, and prices in the local stock exchange—once very illiquid and with only Fergie participation—has become very trendy among the new middle class Klings. Everyone was happy to see their home prices appreciate, and everyone was ecstatic when the value of their portfolios went up steadily day by day. This has created even more confidence in consumer spending, and the Klings were enjoying the seemingly unlimited wealth that the new banking/financial system created. Meanwhile, behind the scenes, the Fergie central bankers and central bank chairman Ulan Bluespan made sure that the system created enough pebbles and pebble denominated debt to sustain this asset inflation and the consumption binge.

And meanwhile, the Chins were increasingly worried that the pebbles and notes claiming pebbles would soon depreciate in value. After all, their economy is now flooded with pebbles, and they have been recently suffering a serious bout of deflation with more and more manufacturing capacity coming online with the easy pebbles available. However, the seemingly insatiable demand of the OCs were simply too profitable to ignore (at least in terms of what they thought was profit… more and more pebbles and pebbles denominated notes). Plus, the OCs were seen by the Chins as an economically and politically superior group of people. The Fergies, on the backs of a prosperous economy, had encouraged out-of-work young Klings to join in a new military expansion program—in the name of all that is good and just: freedom, liberty, and the pursuit of happyness. Over time, this military expansion program had lead to overseas expeditions known as freedom fights, and this showed off the OC economic and military might to the rest of the world, which significantly helped in the credit ratings of the OC central bank in the eyes of Chins and an increasing number of other societies.

All this has served to greatly increase the Klings satisfaction with the Fergie banking administration. Although the Fergies did not necessarily create real income equality, there was a standard-of-living equality that greatly satisfied the large Kling population, whom can now be largely considered “middle class”. At the same time, however, nominal income disparity widened further, as the original many Fergie asset owners, and a few Nouveau riche Klings accumulated an ever-increasing share of society’s wealth, so much that they had no idea what to do with it except to invest further into more assets and/or use them to flip stocks.

Abstract artists, once considered economically despicable in both the proud warrior-like Kling species and the practical Fergie race were soon making a good living tapping paint on a canvas and making random stories of feelings and heartbreaks. A canvas with three red dots were fetching on the market for as high as five hundred million pebbles. This mirrored the increases in securities markets and maybe even more.

However, the Fergies soon realized that this economic miracle would not be forever, and they soon started thinking about the downside to all this. The more they thought, the more they began to hedge themselves. The consumption binge and the seemingly endless asset inflation would grind to a halt if any trouble with the belief in the value of the pebble would come into question… but so long as the Chins and other nations impressed with the OC’s economic and military might were willing to take these pebbles and finance whatever account deficits and a growing national debt, and keep these in their foreign reserves and treat them as legal tender for possible future purchases, then the OC would be fine, and this binge would continue on and on. But all good things must end, and the fact remains that these pebbles were once just pebbles on a beach, and they hold no real value what-so-ever, and that sooner or later, there would be doubts to the real value of the OC pebble, and what goods and services that it might bring to the holder. The Fergies know this, and they are devising methods to try and shift the risk away from themselves.

Finally, the greediest among the Fergies would devise a method to enrich themselves one last time and still guarantee they would still come out alright. So, with a natural instinct for profit, and ever at a loss in finding ways to make money and keep money to themselves, the Fergies have devised very intricate financial innovations. The first of these innovations was asset securitization. The Fergies geniously devised a plan to extend even more credit to households that were not living the OC dream yet (they call this subprime pebble loans), and packaging these loans into fixed income securities called Mortgage Backed Securities. They also extended numerous loans to new start-up companies created by young, educated, and optimistic Kling entrepreneurs, and packaged the cash-flows to those and sold them off as Asset Backed Securities and Collateralized Debt Obligations. The Fergies loaned to whoever they could, and transferred the risk of default and asset depreciation to the investing public (whom by now are in a frenzy of asset purchases and speculation), and pocketed billions of pebbles worth of transaction fees and brokerage fees. Second, they began marketing various derivative instruments and packaged fixed income instruments to foreigners—in particular, the Chins, who were not as sophisticated as the Fergies in coming up with financial innovations, but were nevertheless eager to invest due to the strength of the OC pebble on the international currency exchanges. Third, the Fergies began to encourage leveraged products, as diminishing investment returns and low risk-return spreads plagued the rabidly greedy investors. This leverage allowed Fergies to pocket even more fees as they package ever increasing debt and sell them off to the public. As long as asset prices appreciated more than the interest on any of these loans that the Fergies made, then the investors were golden. Fourth, the Fergies began to create even more fervor among markets by organizing Private Equity funds, where they garner billions and billions of pebbles from investors, and take public assets private on the bank of billions of dollars in bank loans often at 20 – 30% premiums, and then IPOing these private equity funds back to the public at and even more mark-up.

Among all the frenzy in the markets, and everyone buying into the belief that the new financial innovations that the Fergies devised making investments permanently safer and more liquid, asset prices kept going up for a while. The Fergies have long gotten out of the game, while the Klings keep flipping and the Chins keep hoarding assets.

One day, out of the blue, the Chins decided that they now had enough pebbles and pebbles denominated debt to last them ad infinitum, so they started buying OC hard assets themselves (much like the Japanese did during their market bubble). The Klings also started selling these assets, and pretty soon, there was a rush of Klings wanting to sell and pocket their gains. Asset prices went down a bit, and margins on loans were called, and securitized products began losing some of their collateral. In other words, minor events and tremors in the system, and the subsequent asset price declines soon triggered several critical states in the economy. Those that had houses on subprime pebble loans began receiving rates that were beyond their payment capability, and they defaulted. Loans made on the backs of company products and equity securities were increasingly being called in. Klings and Foreigners across the board began losing money, and buying interest was taken out of the system by quite a bit.

And the Fergies central bank, in attempt to fix the problem, pondered two possible scenarios: lower borrowing costs, which will inject excess liquidity even more and support asset prices, but nevertheless will induce foreigners to sell pebbles, and will probably resulted in a run by the Chins on the existing pebble currency, where inflation hidden in years of disinflationary consumer products will finally kick in. Or, do nothing, which will create total illiquidity, where asset prices continue to tumble and across the board losses will occur with much of the value of pebble denominated assets wiped out—not to mention all the derivative products that were written to the public. Either way, however, the Fergies come out fine, due to their shrewd transfer of risk to the public, and their ability to buy back cheap assets when the markets tank.

Fergies 1, the rest 0. By now, the gems that were originally the money supply replaced by pebbles are now worth 600 pebbles per 1 gem. And the economy of OC is being plagued with an extended period of stagflation.

What will the Fergies think up next?

Complex Theory and Power Laws, With Philosophical/Economic Implications

An artist's depiction of fractals in complexity/chaos theory

These are concepts set out to replace linear causality. Instead of event A causing a response called event B, events A, B, C, D and so on act as either points, planes, or spatial objects, with or without mutual exclusivity, push and pull in tandem or in flux or with mutual influence but not to the full extent, either cause some other group of events to occur, cancel themselves out, or somewhere in between.

I suppose that's where things get complicated (thus, complex theory, what a cool name), but it is certainly a concept more befitting of economics than linear algebra--and not just economics either, but maybe existence itself too. Of course that's beyond what I'm trying to do in a blog entry. But what's amazing about complex theory is its scope of application, in back-testing of what's happend in the past, in understanding how we got to where we are now, and in setting a framework for any sort of art in predicting the future. After all, to make an example of a commonly known process: evolution, the beginnings of life were once considered humble and quite easy to understand. Now, to define life itself as an academic pursuit would take years of not decades of categorical work. As the theory goes, single celled organisms divided itself and combined with other organisms to form living beings planet earth is teemed with today. First with simple structures and organelles to sustain itself and reproduce--a cell wall to house cytoplasm, a nucleus to shelter chromosome, mitochondria to generate energy, and some endoplasmic reticulum to distribute resources. Then on to sexual reproduction and combination with the genetic codes of other cells to create intergenerational adaptation and evolution through the shared replication of superior genes. Then, as cells moved beyond being isolated phenomenons, vessels of massive size are created to house groups of cells who have found ways to co-exist under mutually beneficial arrangements--we can think of these as plants and animals at any given stage of evolutionary complexity. Some remain very simple as rudimentary genomes find no reason to evolve beyond what is necessary to survive in a simple, unchanging environment--phytoplankton, algae, and various other microorganisms. Some, in order to exploit changing circumstances and power over other organisms evolved into a complex entanglement of organs and biological fluids working together for the goal of common survival and reproduction. And some of these organisms even evolved an executive cell group created solely for the purpose of intellectual thought called the brain. And it didn't end there. Intellectual thought (at least only in humans on this planet) quickly became a means for what was once cellular organisms to go beyond biological fluids and structures, to create social interaction, common history, civilization as we know it recorded in the form of knowledge--the rise and fall of empires, the evolution of media and the press, religion, economics, politics, and most recently the creation of the most complex web of virtual ideas known as software. And who knows what the future holds. But what's clear to scientists and philosophers is that each stage of evolution and change can be traced and graphed as according to a secret order, and the magnitude and timing of each tipping point or critical state could be related back to a statistical power law. Changes of a certain magnitude will happen less likely the bigger these changes themselves are. The frequency of such revolutions in biology, science, knowledge, ways of thought will happen statistically less—as according to a power law, with some physicists and scientists pointing to a factor of four times as likely or not as likely. But these critical states of change happen in natural phenomena, and it gets quicker and more complicated with every branch of development expanding ever rapidly. It took longer for single-celled organisms to go from asexual reproduction to sexual reproduction, than for a moth to develop chameleon-like skin as according to their environment to avoid predators (a process that takes only a couple of generations, each lasting a couple of years). By the same token it took much longer for man to develop and pass on agriculture and basic technologies to the next generation, than for modern innovation to take a foothold in everyday life (remember the most daunting advancements in technology and social organization came about in the 19th and 20th century). This example of evolution, and the frequency of critical turning points in its progress (the second derivative), is just one of what modern intellectuals can attribute to complex theory and power laws--which, as the trend of our scientific times has determined, the origins of virtually everything on this planet, hardware and software, can be ascribed.

As any model goes, it serves very well as a framework for organizing and back-testing data collected on historical data and developments. Simple and seemingly linear progressions would start very easy, but accelerate into multifaceted networks of causality weighing on one another and create systems of stable equilibrium that expand infinitely. This is mathematically beautiful (I personally think so). You could look at the development of anything with a new perspective, from evolution as we've just mentioned, to the development of our current government (from townhouse meetings to national democracy to national committees and agencies to bureaucratic glut), the great monotheistic religions (from simple beginnings of monotheism to Judaism to the crucifixion of Christ and the spread of 'the word' by Paul to the arrival of Mohamed and the thereafter split between Sunni and Shia to the splits in Christendom of Eastern Orthodoxy, Catholicism, Coptic Christianity, Protestants, Evangelicals, and the arrival of Islamic fundamentalism), to why one should do well early on in school (from As in math, science, and english, to an A in subjects derived from these subjects, history and economics for example, and then knowledge of each subject in detail, which is virtually every subject from the beginning ones, and the detrimental effects of having to catch up if full understanding of simple origins of such knowledge is not achieved) to categories in science, politics, economics, philosophy, you name it. And all knowledge and existence could be related to a tree, with which metaphorical branches spawn even more branches, and it doesn’t stop. Sometimes branches get old and die, in existence and in knowledge, and when branches wither and fall from the tree the other branches fall with it—like an act of god or maybe the inability for the environment to support certain phenomena or without the environment going head-to-head against its very existence. And thus a web is disturbed. The example would be like a tiny moth going extinct due to an external factor such as human intervention to control their population, leading to certain smaller birds of prey unable to feed their young, leading to tree-dwelling mammals unable to find birds eggs as a source of food, and larger predators unable to secure a steady supply of these mammals as prey, and extinction occurs at the top of the food chain more often than the bottom, ect. Sometimes branches continue their upward and outward growth, far outpacing what its original host had intended, due to its prolific potential as a basis to develop offspring—knowledge, for one, has several of these: monotheism, mathematics, literature and philosophy, or even the more modern ones such as the Einstein’s theory of relativity, Darwin’s theory, game theory, critical state ubiquity (the most recent). Sometime knowledge could be destroyed or rarified in human knowledge, and rendered antiquated and useless—such as geocentric theory, medieval treatment of lunacy through exorcism, Zoroastrianism, countless languages from extinct tribes of people, and the list goes on.

To put it in a nut-shell, "complex theory" serves to describe an underlying order to what seems to be the complete chaos of modern day life, by first ascribing the origins of any categorical phenomenon under consideration and then, with a model--either scientific or philosophical, slowly branching out these origins and fitting more modern manifestations under these models, and be able to explain their evolution or destruction and the prospects of the “branch” going forward. The "power law" describes the speed and the frequency at which the branching out occurs—for example, outlining the occurrence of earthquakes and its statistical frequencies according to their magnitude—the famous Gutenberg-Richter theorem, or the accumulation of wealth being defined as being a certain power of more or less frequency as the amount of wealth increases or decreases by a certain factor in the individuals of a population, or just the normal curve under any statistical study delineating the expected normal occurrences spread across standard deviations—with events getting rarer as sigma grows.

Anyway, that was quite a bit of description, but hopefully one can see the implications that these theories can have on economic development, whether macro or micro, and the relevant policy or investment decisions might be derived from understanding such models. But, as any model, it's very good for hindsight. We should keep in mind the adage "Models do not provide answers, they only serve to detail questions". So what would this theory tell us in the world of finance and economics? Could we use something like this to learn more about how the world of practical matters such as money, employment, social security, empire building, etc.

Let’s leave that for another time.

Just another suggestion, pick up these books, they are insane and make you go "holy shit this kicks ass" with every page:

Ubiquity - Mark Buchanan, Deep Simplicity - John Gribbins, The Selfish Gene - Richard Dawkins

They may mention finance/economics only seldomly, but the concepts and simple truths delineated in the pages is something that everyone in perhaps every profession would benefit to know.

Fortune Favors the Bold?

These spreads are pitiful (yields of riskier credit securities compared to treasuries)...


In a nutshell, this chart shows how much investors of debt securities demand back in terms of yield. This chart relates a nice picture back to us regarding the general sentiments regarding risk, and how much return should compensate for that risk. The relationship of credit-spreads between what is considered "risky" and "riskless" shows very well the risk-reward expectations of the investing public. Basically the yellow and the red line compare how much "extra" return is expected when investing in securities other than the completely riskless U.S. treasuries market (the bonds issued by the U.S. government). Why does this picture scare me?

1.) People are no longer afraid of credit risk, expecting a measly 1% spread for barely investment grade securities and a little under 2% for emerging market sovereigns (usually considered pretty risky, but given the fact that "emerging market" has become a buzzword for growth and riches now-a-days, nobody really thinks about default or non-payment). With the easy availability of credit default swaps (derivative instruments that allow an investor to completely diversify out of default risk--provided the counter-party does not double-default... but who knows?) brunting the bulk of the uncertainties with investing in instruments of dubious integrity.

2.) To get the return required for yield hungry U.S. investors, institutions and money managers (alright alright, mostly hedge funds...dammit) have been using substantially higher leverage to capture ever decreasing returns. If you think credit spreads are bad, you should see how much people are willing to pay for equities these days (15-20x earnings on normalized businesses not unusual!) But yeah, here's a picture of how much hedge funds are levered. Prime brokers (firms who execute trades, lend money, and provide various other financial and administrative services to investment funds) have been literally giving money away since late 2003. Who can blame them? Money grew on trees as we were coming out of the tech bubble, all that extra cash needed to go somewhere, the new wonder-kids of finance at hedge funds are 'good' at making money all of a sudden because everything is going up, and the fees on these borrowings are not half bad.

3.) The justification for this complete negligence of investment sense is the circular argument that derivatives and credit default swaps has permanently made financial markets safer and more liquid, when the wide availability of these derivatives were a product of a secular bull-market driven by the wide availability of money supply in the first place. A paradox of the chicken and the egg is here. When I think about it, it makes my head hurt, because... first of all... would derivatives and credit default swaps be so easy to finance if it weren't for the fact that volatility was low and asset prices were perceived as sound? Second of all... would asset prices be sound and leverage/money be so easily dished out if it weren't for the fact that derivatives and credit default swaps has created "permanently" less risk and much more trading and liquidity? So, look at the two charts below... is it the chicken or the egg?




If I'm brilliant enough to call what's supposed to happen next as a result of this non-sense, I would be making millions of dollars right about now (if not billions)... I don't claim I know what's going on, but I do know that somebody has to be getting the short end of the deal. When there's a winner that has diversified away all his/her default risk and volatility risk, somebody else is taking it on--even if that somebody else has diversified that risk away themselves, then that somebody else's somebody else will be the one brunting the blow. Even if it comes full circle, somebody will probably have to default if things get bad enough.

I just wanna see what happens in a bear market, when liquidity suddenly dries up and trading grinds to a slow. When everyone wants to sell, you can bet this scenario of permanently lower volatility/risk/returns, higher leverage, and the happy-go-lucky world of record-high dow closings and never-ending LBO/M&As will be less enthusiastic.

Fortune doesn't favor the bold these days, it favors everybody. Virgil wouldn't be quite as poignant on courage if he saw what's happening today. Bankers winning on fees and investment funds winning on returns forever and ever seems like a utopia, but utopias are never quite so economically viable--for an extended period of time anyway.

How Loose Monetary Conditions (not economic) Affect Stock Market Returns, and Why I'm Still A Bear

Before I begin a long-winded thought jot-down that was long before due regarding my views on the economic and investment outlook that I personally hold regarding the future, I'd like to say right now that I am not assigning any time-line to when I think my views would come to pass. Any economic view on the market, despite the potential inevitability that views suggest, are by no means ever imminent--as the market is still after-all a voting machine that is run by human psychology rather than the fundamental truths that might be of consequence. I've been bearish on the state of the U.S. economy and stock market for a while now, but that doesn't necessarily mean I want the stock market to fall, and for people to lose their jobs, or for America to lose its economic supremacy in time. What I am is worried, and I worry because I need to know where money can be made in the finance world if making money was the cause of a lot of fundamental disequilibriums in the first place. The problem of excess liquidity (I'm probably one of very few on the street that think excess liquidity is a problem rather than a solution)  have weighed heavily on real returns, and the illusion of capital gains are paid on the backs of an unending quest to build capacity in Asia and the ebullient view of a neverending consumer binge that drives what it means to be American today. Nevermind the fact that the performance of the S&P has been caused mainly by the rise of financial stocks and consumer stocks, and nevermind the reason that much of the core growth in corporate earnings actually came from abroad in the form of a weakened dollar. The question that must be addressed is how America's chronic deficit spending, and the economic liberalization of the previous Greenspan regime effected our futures as investors and every day citizens going forward. And why we should be worried about a potential pitfall in investing in America if things go unaddressed. Difficulties in curbing inflation (i.e. things getting more expensive and our retirements getting more difficult) will be the challenge of the Fed and central bankers around the world as they try and figure out how this financial frenzy of today will affect money supply and velocity, where people give three cheers for M&A activity that make little to no sense simply because it drives stock returns, and where the wealthy simply give money away to anybody with a business plan for a (fill in the blank) fund. One can cite countless deals that have happend over the last few years done by private equity or investor consortiums that have investment yields thinner than Victoria's Secret models, and how if wealthy people really wanted to throw away money they might as well throw away money at kids starving around the world rather than down a black hole of greed and expectations comforted only by the scant hope that maybe someone else will buy the investment at a higher price (because, there's enough liquidity, duh).

Before anything, here's a very interesting piece courtesy of Marc Faber of the GBD Report and John Paul Koning of Pollitt & Co in Toronto:

The Zimbabwe Stock Exchange is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they've already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicice. Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability.

As for capital improvements, there is little incentive on the part of companies to invest their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe's policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.

Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions and not changes in GDP. New money gets spent or invested. In Zimbabwe's case, because there are no alternatives, it is stocks that are benefiting.

This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock marekts over the preceding twenty-five yeras has been created by a vastly increasing money supply, and how much is due to actual wealth creation. Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.

This example really hit me, it describes a whole lot of what's going on around the markets in a more extreme manner. The emphasis in bold is mine, and what it's suggesting hints at how any investment return--viewed in absense of a perspective on the general monetary conditions of an economy--is at best illusory and at worst stupid. One might view the 12,000% returns in Zimbabwe industrials as very attractive, but in light of the horrible inflation and the lack of general investment options to preserve capital enough for a meal the next day is scary. Of course, the current inflation in the United States might be viewed as benign in comparison to much of the developing world (some 2.0%+ annualized), and compared to the 20%+ returns in the S&P500 over the last year or so this is a very good deal for anyone that has gotten into the markets, for their wealth in real dollar terms have increased by quite a bit.

But what does it really mean to hold wealth? What is money? To the average joe, the more money the better, and the more things money can buy, the merrier, if only everybody in the world could have money then every problem we have would go away. This is a fantasy not far off from what perhaps 95% of the population would agree with. However, for economists and interested investors, this is far from true. Economics 101 would tell you that if everyone in the world could make fast money, and build wealth in nominal dollars, and have a fatter bank account that grows day by day for some reason or another--with the awesome money their mutual fund managers and their mutual fund manager's fund managers makes--then there would be a case of increasing prices so that everybody loses purchasing value year after year and no "real" wealth is built at all. Certeris Paribus, $100 dollars that used to buy a coffee machine will now only buy a pack of coffee machine filters. Of course, the real world isn't ceteris paribus, but enough empirical evidence has already given us signs of danger that the next recessionary pressure we feel will surely be stagflationary, in consequence to lagging consumer spending, job loss, much higher commodity and raw material prices, and a weakening dollar. So we must ask ourselves is inflation truly under control? Prices in the United States have stayed stable, but any traveler can tell you that staying in other places around the world (developing economies excluded) have become much more expensive. Americans, as usual, are pretty complacent spending their evenings at home and not thinking outside of their own continents--but people really should be more concerned about the falling value of the U.S. dollar, and what implications on inflation it actually has at home.

While stock prices and house prices (until recently) have continued their upward climb slowly but confidently, driven primarily by the reflexive success of financial and consumer markets on the back of increasing asset prices that becomes its own grandpa, the rest of the world seems to have begun a bleek view on the fate of American status and the strength of the American Dollar (once pinnacled as the currency of dicipline and value preservation). A comparative glance at several currencies considered relatively "hard" against the dollar--meaning more fiscal dicipline and less monetary expansion--can tell you something about "true" inflation, in terms of how much it actually costs an American to live in the world (as opposed to his couch in surburbia).

How much Euros to buy one dollar



How much British Pounds to buy one dollar



How much Swiss Francs to buy one dollar


How much Austrailian Dollars to buy One Dollar



How much Korean Wons to buy One Dollar



For any of these foreigners to have invested in American assets in the last five years would have been difficult due to the falling to flattish real returns they would have earned on average (say in the S&P or treasury markets). The story of real inflation for Americans haven't hit home quite yet due to the still relatively cheap goods and cheap capital that is available in China and Japan, respectively. In China, manufacturing capacity and saturation have literally reached its limits, and the endless supply of labor have since cooled the price of consumed goods in America while under normal circumstances Americans would have certainly felt heat. But the China problem (the one that US politicians and economists keep talking about) might have found a solution yet--a gradual appreciation of its currency to reflect global norms and correct trade deficits.

The biggest draw back in the case of China is that, although "lowering our deficits to China" and "help save our jobs" sounds good to Americans now, the actual consequences will be dire in the form of much higher prices. China has acted as a cooling engine in world inflationary pressures in consumer goods (a cost that has arguably been passed on to increases in raw materials, energy, food and commodity prices that they are continuing to drive up), and this has enabled many societies around the world to live with relative comfort and still be frugal. Now I say Americans will feel heat, because while China has enabled a much cheaper manufacturing environment and thus cheaper goods to be enjoyed by everyone, Americans have been overspending even in light of this. A quick glance at the household savings rate and the household debt level (manifested primarily in credit cards, auto-payments, and mortgages) in Amerca will tell you the story:






But in light of these increasing pressures in actual finances of the consumer, it's still "okay" to buy the new playstation and the wii because the stock market or the value of the house is going to pay for it. The stock market, specifically, has continued its run over the last two years, and is coming closer to the levels reached in the Tech Bubble--only this time around, it's the consumer-spending-on-frothy-assets-and-financial-stocks-on-M&A Bubble as a result of easy credit expansion and the exponential growth in derivatives that "hedge-out" risk (provided that nobody defaults). A self-reinforcing phenomenon occurs here with two factors: (1) consumer spending and financial returns based on rising asset values (2) rising asset values based on increased consumer spending and financial returns.

Nominal S&P returns in the last 5 years


Nominal S&P returns in the last decade (tech bubble included in 2000)


Again, I repeat, foreigners (who fundamentally would view the dollar as an important consideration in investment decision making, and those more keen to inflationary pressure and American froth than we Americans) have seen little appreciation in the value of their investments if one were to adjust market returns in terms of their currency (look at the charts of dollar value of other currencies above). This tells a true story about the "real" wealth actually being built in the United States.

And the bit going around the market talking about how a "weak" dollar will help the American economy is declaring ignorance of the painful short-term effect of a continuing weak dollar. Namely, a slow-down in consumer spending, and a flatting and falling asset market that Americans pride itself on. Longer-term, the macroeconomy will adjust, and maybe we can see the United States actually making something "tangible" again in the future instead of just shuffling money and intellectual property, but nobody can predict when this long-run is. The case in point is that inflation in Ameica will hit sooner or later, and the factors have already been set in motion: (1) calls for a weaker Chinese Yuan that will increase consumer prices across the board (2) falling real estate prices and defaulting mortgages hurting consumer spending and financial returns over the next year or two (3) drying liquidity as capital loses value in the form of less trading, less M&A, and unwinding of the Yen carry-trade (4) yields too low to chase--which eventually but surely must happen unless the entire investment community collectively lose their minds.

All the money that's been spent in the Iraq War and the war against terrorism, and all of the money funneled into foreign central banks (such as China's and Japan's) will also play a role in increasing the money supply in the US. Although the velocity of these "eurodollars" are not enough to create rampant inflation in their current idle state, it would be interesting to see if any of them would make their way back into the states eventually as the dollar continues to weaken and money floods back to buy American goods. We would all be much poorer when that happens if we don't invest appropriately...

Whatever lessons this situation could tell us paints a picture of much uncertainty in the future. Stock prices will not increase forever, and macroeconomic conditions, although benign currently, are starting to slow. Making "real" money is difficult, but money in large doses as according to hedge funds and private equity funds still is performance since inflation doesn't hit that hard in its current manifestation. The investment outlook of any prudent investor should be one of caution as we move forward. Nobody can predict the timing of the unwinding of this seemingly stable disequilibrium (if it even unwinds in our career), but an investor can always protect against these events by going into foreign markets, and investing in sound businesses uncorrelated with the market at large that are cheap (something that calls for much more qualitative research in the microeconomic perspective). Just don't buy into the easy solution of investing in whatever grows that will most likely continue to grow so long as the economy is doing well and excess liquidity never stops.

w00t, that sure was long-winded. Probably would have tons of grammatical mistakes and concept left out if i were to go back to read it too... but that's my two cents, for whatever its worth (which will probably turn into one cent sooner than we think)