Shock and awe

It appears that contemporary monetary policy is conducted to appease the markets. This is not too bad as markets set the price of money and any artificial deviation from it by monetary prescriptions do not help. However, most policy makers do not believe that. Many believe that the Fed has infinite power to set the course of the economy by finely tuning fed funds rate and other open market operations. In the past two decades, the expectations of what can be accomplished by monetary policy have grown. The rock star status of Fed governors who used language that nobody understood increased the mystery of monetary policy. “Shocking the market” was a phenomena invented by the previous regime and it was apparently a way to shake everybody to “good behavior.” People with convictions in the “knowledge of many” dominating the “wisdom of few” will always question policies that shock and awe. Contemporary policies appear less “shocking” although there have been some attempts early. Now it seems to have settled to “reflecting” what the markets already know. Such a policy will be far more effective than sudden bursts of monetary shock that we got used to previously. Uncertainty always has a price. Introducing uncertainty into markets through policy is costly for the economy.

Energy policy options - Doing everything is neither good nor practical

Economic and energy policy issues have become so complex that politicians find it difficult to understand them, let alone make the right prescriptions. A high degree of technical understanding of the issues is necessary before policy can be made. The current policy making bodies are not structured to accomplish this. Ad-hoc policy making has been prevalent primarily because of lack of technical and holistic understanding.

Take energy policy for example. The standard answer for most politicians is that “we need to invest in everything – off shore drilling, solar, wind, nuclear, tidal, bio fuels – everything.” On the surface, this appears to be a reasonable approach. However, if we are faced with a problem and there are 7 possible ways to solve it, one of the solutions is likely dominant - It is unlikely that all 7 solutions are equally good. The counter argument is that since we do not know which one will work, we can reduce the risk of not finding the solution by following all possible avenues. This may be a rational thought in an environment where the resources are limitless. That is to say, if we have enough money and people to pursue everything, that may be a good approach. However, this is not the case and it is important that politicians and policymakers understand the concept of prioritization that managers of private enterprises routinely engage in (as they have no ability to tax people or print money).

To prioritize, politicians and policymakers have to fully understand the technical aspects of all solutions. These are complex technologies with significant R&D risk. The cost and time lines of R&D show significant uncertainty and the outcomes cannot be precisely predicted. Further, the economics of these solutions need to consider all aspects – R&D, production, logistics and maintenance – before they can be prioritized. Economics, Science and Engineering need to come together. Stump speeches in the political trails and in the congress may sound great but they will not solve problems. Decision makers have to engage experts and in lot of the cases delegate decision making (and policy) to them. This may sound undemocratic but the alternative – policy making by those who both do not understand the alternatives and have vested interests in bringing investment to their constituencies – is much worse.

The brightest of them all

Before the financial chaos started, many believed that certain financial firms contained most of the world’s intellectual capital. Many aspiring commoners from around the world held them in the highest esteem. Recent events seem to have taken some of the shine off the mystique of these firms, not to mention some of them vanished from the face of the earth.

In retrospect, one has to ask whether the presumption of immeasurable capability in such small spaces was correct. Suppose the institution has an ordinary investment idea that is expected to return, say a paltry 3% per year. If it is allowed to leverage that idea 40 times, it could create mesmerizing (expected) returns exceeding 100%. If the original 3% happened, it would imply that the leveraged position will return over 100%. If a casual observer just looked at the end return and marveled at the immense capability of those who “manufactured” it, she will be considering only one side of the story. As a senior executive of one of these financial institutions recently remarked, “people are learning that there are two sides to leverage.”

Ah, yes. If the return is -3% (just a minor bump), the institution will lose all of the original investment (100% loss) and may go bankrupt, unless, of course the Government (and the tax payers) steps in to save it. Is the ability to leverage part of the “capability” that existed in these firms? Or more importantly, was leverage the only “capability?” In this case, an average Joe can create (expected) returns in that range also, if he is given an “exception” to leverage to such high levels. Perhaps the regulators should give everybody an “exception” to leverage to 40 times. This way, we can “spread the capability” around.

Chartists rule again: Time for Government to step in

Technical analysis, a form of financial alchemy, is on the rise again. Heads, shoulders and “tradable bottoms” are back in full force. Pundits seem to have given up on “fundamentals” and are slowly succumbing to the power of the charts. One positive side of this is the development of new display devices that show many technical metrics in the same chart. We are entering the era of multidimensional technical analysis that makes the traditional chartists look like babies with crayons.

The question though is whether the technical analysts and chartists are eating the lunch of everybody else. It is difficult to get reliable data on this but my guess is that the chartist who won today may lose tomorrow. If so, are the technical analysts any better than the fundamental analysts? Does analysis really matter, if in either variety, one has only a 50% probability of success?

If the technical and fundamental analyses do not provide additional information, such activity destroys productivity and the people who engage in them add no value to the economy. Do we really need a large number of financial analysts rating stocks, given their poor record? Do we need rating agencies at all, given their dismal history? Do we need financial TV with hundreds of forecasters, given their inability to forecast?

Now that we have ushered in an era of the government deciding on many aspects of the economy, perhaps this is another opportunity for a regulatory change. Perhaps it is time to ban all financial forecasting (given the lack of reliability) and deploy the excess resources in productivity adding aspects of the economy, such as farming. If this can be done, we can bring the economy back to growth a lot faster than otherwise.

Predictions with power and magic

The number of experts who are able to predict the stock market’s every move has been puzzling. I have been watching the business news TV with great interest in a desperate attempt to learn how the experts are able to predict market moves. There appears to be some common themes in these predictions. For example consider the following predictions:

“Market volatility will continue”
“Market is in a bottoming process”
“Buy. Markets will go up sometime in the future”
“Sell. Markets may go down in the future”
“Just hold your stocks. In the long run markets will go up”
“Markets look forward 6 months and so if you know what will happen in 6 months you know what markets will do today”
“I am bullish in short term, bearish in the short to intermediate term and bullish in the intermediate to long term”
“You should always be in the market. When it goes up, it goes up very fast”

All of these predictions may sound intelligent and may be delivered after significant analysis (we can’t be sure). However, if you study them, you can see that these statements could be made by anybody (not just the experts) and if delivered with confidence on TV, these may sound good. But not much analysis is needed to make these predictions and there is no information in such predictions. The other way to make a “name” in market predictions is to take a side. For example, one could say something like “in 6 months, S&P will go up.” In this case, one can go back on TV if the predictions come true (there is a slightly higher than 50% probability for this) and if it does not come true, drop out of view for a few months and go back to make another prediction.

Another way to predict the markets is by the “bracketing technique.” A senior executive from one of the investment banks has been delivering it perfectly. When S&P was at 1400, she predicted it will be between 1350 and 1450, 12 months out. At 1300, she felt that it will be between 1250 and 1350 and at 1200, you guessed it, the forecast for 12 month price was between 1150 and 1250. To her credit, she has not made any predictions after S&P dipped below 900, all in less than 6 months.

The other way of doing this is to make a large number of predictions (as seen in after market shows on business TV) so that the complete set of predictions will be difficult to keep track of by the observers. For example, if one makes up predictions on 50 stocks and down predictions on another 50, 50% of the predictions will likely be correct. One trick to reinforce one’s infallibility is to analyze the predictions afterward. For example, one could highlight the 20 of the 50 predictions that were correct and then pick 5 out of the 50 incorrect picks and say something like – “I really went wrong on these 5.” Most people who listen to such an analysis may conclude that the forecaster is not only a good person but also a great fortune teller.

Forecasting of prices in commodity markets are done by those with a strategy. It is magic.

The new type of insider information

I am always a believer that if there is no insider activity, market prices are generally efficient for commodities including stocks and bonds. Over the years, we have had number of crooks who did not play the game according to the set rules and traded on proprietary information. I am hoping that most have been found and sent to enjoy accommodations in federal penitentiaries.

Recent events also reveal another type of insider information that some may have taken advantage of. The recent financial meltdown can be traced back to a few “rule changes” by the government and regulators with little understanding of all the associated effects. These include the creation of Freddie and Fannie with “implicit guarantee of the federal government,” the lowering of credit standards to “increase home ownership” and the exception granted to five investment banks to leverage over 3 times normal. In all these cases, you have the government and the regulator writing a put option, allowing the recipient to put the “asset” (home, balance sheet etc.) to the government when things do not go well. In the case of investment banks, they are bold enough to even change the rules of the “put option” when they were forced to exercise them. Instead of putting the asset to the government and wiping out all equity, they want the government to “save” them. Some say it is not a "bail out" of the banks - rather it is a "bail out" of us, the tax payers, who may lose our jobs and may not be able to get credit to run our homes and businesses (because banks are refusing to lend...)

Creating such an asymmetric payoff will always result in an incentive to take excessive risks as one can take part in the profits and not worry about the losses (as the government and tax payers will take care of it.) Creation of such rule changes (altering the characteristics of the free market system), has enormous impacts on prices and anybody who has preferential access to such information has to be considered an insider. So, in addition to the regular search for insider activity in companies, SEC has to also focus on insider activity everywhere else, especially if the government will be routinely engaged in “rule changing” in the future.

Mistaking luck for skill

The markets for commodities - stocks, oil, grains - reflect the information known to millions of participants across the world. These are standardized instruments - one share of IBM, one barrel of Texas light sweet crude and one bushel of wheat - all will have the same price (each) anywhere in the world (adjusted for transportation costs). To make a transaction happen, there has to be a willing buyer and a willing seller. The price of IBM share is at $85 because the buyers and sellers have independently and mutually settled on that price. Both the buyers and sellers know that the economy is stalling, Obama is leading in the polls, the winter is approaching, Christmas shopping will be tepid, employment is tanking, companies are pulling back on capital expenditures, the ice caps are melting.... and all the information you and I know. The price of $85 reflects all of this information. It is, however, surprising that there are many people out there - in the print, on TV and in stock markets who believe that the price is going up (or down) and they may point to information already known to the world as if the entire world is stupid enough not to take that into consideration.

Suppose you think that the IBM price is going up next week and bought a large number of calls on IBM, there is over 50% chance that you will be right and make bunch of money. If you do, will you attribute that to luck or skill? Most seem to want to attribute it to skill. The problem is that if it was luck, there is a possibility that it does not show up in the next trade. Every year, there is a list of mutual fund managers who “outperformed” the market. However, the year after, we get another crop of mutual fund managers, who “outperformed. Alpha (risk adjusted excess returns) is notoriously inconsistent – proof that “outperformance” is largely driven by luck than skill.

Lack of fundamental valuation: A cause for bubble formation and subsequent crash

It is clear that we have entered an unusual economic regime that amplifies the effects of good management on companies, both financial and real. We got here primarily due to bad decision making in all types of companies. In the financial world, securities transactions happened without a fundamental understanding of what they are worth. As we learned from the tech bubble, when fundamental valuation is not present and current price is largely based on yesterday’s transaction (a proxy), bubbles tend to form. Such bubbles can persist and accelerate to some critical level followed by a bust and crash. This understanding from history did not seem to have done any good to the titans of Wall Street – who further exasperated the problem by leveraging the transactions they did not understand. The SEC granted an exception to certain financial companies (for unknown reasons) in 2004 to lever up to levels 2.5 times normal and they immediately obliged by buying securities they did not understand using massive amounts of borrowed money. Complex securities are not a problem – transacting in them without understanding their value is certainly a problem. Many of these securities derive their value from an underlying asset – such as a real estate property and they have options like characteristics. There are many levels of these securities, some deriving their value from pools of other securities. They are complex but they all have some fundamental value that can be derived using established economic principles. Firms that transacted in them without knowing what they are worth were wasting their own money or the money of their clients. By levering up their mistakes they put the entire economy at risk and now they need to be “bailed out.”