Sunday, May 23, 2010

How the Media Lies

The following is a great example of one way in which the media lies.  No, this is not directly related to finance, investing or economics but it is important to recognize these practices whether one is looking to research a stock or understand global politics.

The US mainstream media has been chillingly silent regarding the escalating tensions between North Korea and South Korea. That has begun to change now that it has been confirmed that a torpedo from a North Korean military ship is what caused the sinking of a South Korean military ship.  Unfortunately, our media cannot be trusted to present the facts in an honest fashion when reporting on such subjects.

Here is one example that I stumbled across on Saturday afternoon.  The headline from The Drudge Report, a so called conservative news source, reads NKOREAN LEADER AUTHORIZED ATTACK ON SOUTH:

When I clicked on the link it brought me to The New York Times, a so called liberal news source.  The article in question is titled U.S. Implicates North Korean Leader in Attack.  This does not sound quite as damning as The Drudge Report headline but it sounds quite conclusive, no?  Let's keep in mind that publications like the Times usually have an editor write the headlines and not the actual author of the article.  Now let's read what the article actually states:

A new American intelligence analysis of a deadly torpedo attack on a South Korean warship concludes that Kim Jong-il, the ailing leader of North Korea, must have authorized the torpedo assault, according to senior American officials who cautioned that the assessment was based on their sense of the political dynamics there rather than hard evidence.

“We can’t say it is established fact,” said one senior American official who was involved in the highly classified assessment, based on information collected by many of the country’s 16 intelligence agencies. “But there is very little doubt, based on what we know about the current state of the North Korean leadership and the military.”

So an unnamed American intelligence official believes that the North Korean leader must have called for the attack simply because of his vast understanding of the North Korean leadership.  I have no idea if this unnamed official is right or wrong but what he is stating is clearly different from the Times headline and even more different than what Drudge went with.  This type of reporting, by both major political leanings in this case, needs to stop.  The Korean situation is very serious and deserves to be reported in a serious manner.

Thursday, May 6, 2010

High Frequency Trading Run Amok

So the big news of the day was the huge sell off in US markets.  The final tally was -340 points on the DOW (-3.20%), -37.72 on the S&P500 (-3.24%) and -82.65 on the NASDAQ (-3.44%).  This is a bad day but the intraday lows is what has everyone really talking.  In the span of only a few minutes the market veered completely off the rails, with the DOW dropping nearly 1000 points on the day before recovering most of the losses nearly as fast.

The initial explanation for the plunge was the rumor that a Citi trader fat fingered an order of Proctor and Gamble (PG).  We did not buy this explanation for two reasons.  First, the market was already sliding well in advance of the alleged PG trade.  Second, the volume in Proctor and Gamble stock during the alleged mistaken order was not nearly as great as one would expect given the explanation.  After the market close came official word from Citi that they have no evidence that an erroneous trade was made on their partOur initial take was that the obvious culprit was program trading gone awry, and lo and behold that is now what the NYSE is reporting.

The chart pattern marked out today by all of the indexes is very familiar to anyone who has been watching stocks like Citigroup, Bank of America, AIG and several others intraday over the course of the last few years.  The five stages of such market activity are as follows:
  1. Gradually sliding prices throughout the day
  2. This is followed by a massive waterfall
  3. A V-bottom is created
  4. A large spike right back up is generated
  5. The day ends with a continued rise into the close
Here is a view of today's DOW with these five stages labeled:

This type of market activity is the sure sign of high frequency computer trading run amok and is not something that you will see when human traders participate in an orderly market.

In our minds today's market activity begs two questions.
  1. What kind of dopey artificial markets have we created and why would any sane individual want any part of them?
  2. To this you trust your retirement funds?

Thursday, April 22, 2010

The Great American Squeeze

Even with ongoing sovereign debt crisis affecting countries like Greece and the continued march of bank failures week after week, is it commonly thought that the worst of the financial crisis that began in 2008 is over.  We disagree with this view in that what we are seeing is that the crises has simply morphed from a rapid collapse into a prolonged economic funk.  We are dubbing this new trend The Great American Squeeze and see this eventually leading to an even bigger crisis down the road.

The Great American Squeeze is the phenomenon of constant pressure being applied on regular people from all directions.  These directions take the form of tax increases, inflation, the end of various government stimulus efforts and a reduction in already existing services with the net result being an overall reduction in the quality of life.  The reduction in the quality of life can result in mild setbacks such as eating out less or canceling cable TV to drastic life altering events such as homelessness and hunger.

Elizabeth Warren, whom we are a big fan of, has been talking about the squeeze of middle class Americans for many years.  You can view an excellent speech she gave on the subject here.  She notes that the trend has been going on for over 30 years, so what what we are seeing is not a brand new phenomenon per say but a rapid step up in an existing one.  Nevertheless, because of the rapid advancement in the trend, we think a new term is needed.  Since this trend has been going on for so long, this means that it is even more dangerous than at first glance, since many people were already at the verge of being crushed before the recent difficulties.

Let's start with tax increases.  In 2011, the capital gains tax is set to increase.  Taxes are also being increased on higher end income earners and tax increases are being phased in as part of the recently passed health care bill.  To top it all off, now there is speculation that a Value Added Tax (VAT) could be implemented.

Next up: inflation. Inflation is live and well, despite what some hardcore deflationists would have you believe.  Food prices rose by 2.4% in March, the largest increase in 26 years.  Crude oil is back over $80 per barrel.  The S&P 500 is now up 43% from this time last year.  Need we go on?

Government funded stimulus programs are rapidly being phased out.  The economic stimulus package that was passed last year will see its expenditures peak out in the second quarter of this year.  The home buyer tax credit is set to expire on April 30th.  Finally, perhaps the biggest government stimulus of all, the $1.2 trillion residential mortgage backed security (MBS) program has just ended.  We expect the recent strength in the housing market will end in a relapse of the housing bust of 2007-2009.

When it comes to gradual cuts in services, most of these will affect people at a state and local level so experiences will vary.  One national change that may be implemented though is the end of mail delivery on Saturday.

Less you think that these various data points don't actually trickle down to you and I, here are some recent personal experiences that we have had being caught up in The Great American Squeeze.

Where we live in Hoboken, New Jersey, property taxes have greatly increased in recent years, starting in 2008 with a 47% increase in property taxes.  Since that time there have been additional increases seemingly every few months.  Our landlord has seen the city portion of their property taxes skyrocket in the last two years.  This lead to the owner trying to extract additional rent from us in the middle of a lease to make up for the shortfall.  We of course refused to pay.  Now that the lease is up, the owner is asking for 12% more in rent this year than they asked last year.  We will be moving and there is now a good chance that the owner will have a difficult time finding a new tenant as they have priced themselves out of the market in our opinion.

If that was not enough, NJ Transit has decided to raise their fares by 25% effective May 1st.  Our cost of taking the bus to work will increase by $1 dollar per day.  Meanwhile, the number of bus routes are being reduced.  Less for more?  That did not used to be the American way.

The NJ transit fare increases follow recent increases in the New York City subway fares over the past two years. Upcoming subway service reductions and a fare increase of 7.5% are also planned.  In addition, we have anecdotal evidence that the quality of service has already decreased dramatically from the beginning of the year.

Wrapping It Up

We fear that The Great American Squeeze will be enough to financially knock out a far larger number of people than is commonly understood.  Shielded bureaucrats and political organizations do not seem to understand how close many people are to the edge.  A property tax increase here, a subway fare increase there and soon enough there is a noticeable decrease in the quality of life.  Push the trend far enough and, as the saying goes, at some point you run out of other people's money.  We expect the anecdotal evidence to show up in the economic numbers very soon and much to the surprise of the economists that expect a robust recovery.  This is a long term and likely permanent decrease in the wealth for a large contingent of the country.

Tuesday, March 23, 2010

John Maynard Keynes: A Critique

We have consolidated our six part series on John Maynard Keynes and his most famous work, The General Theory of Employment, Interest and Money into a single document.  In addition, we have added an introduction and conclusion to tie the whole thing together.  We think that this document offers a strong critique of Keynesian economics and if you agree then by all means pass it on.  If the embedded document below does not appear then you can access it here.

Wednesday, March 10, 2010

Pension Funds are in Denial

Two weeks ago we wrote about how Greece and the EU were in denial.  We did not intend to single out Europe and Greece as their problems are equally present in the US and most of its states.  If you are in doubt then simply read the recent New York Times article Public Pension Funds Are Adding Risk to Raise Returns.  Let's take a look at some excerpts:

Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

“In effect, they’re going to Las Vegas,” said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. “Double up to catch up.”

Mr. Rowe has it exactly right.  As anyone who has gone bust either first or second hand, the most common refrain is that the gambler wanted to just win back their losses.

A spokeswoman for the Texas teachers’ fund said plan administrators believed that such alternative investments were the likeliest way to earn 8 percent average annual returns over time.

Because of the bull market from 1982-2000, everyone got this idea in their head that 8%+ annual returns was the norm.  This mentality has still not been destroyed even after ten years of dissapointment.  We obviously have a long way to go.

Boeing and other companies seeking to reduce their investment risk are moving into fixed-income instruments, like bonds — but not just any bonds. They are buying and holding bonds scheduled to pay many years in the future, when their retirees expect their money.

Pension funds went big into tech stocks in the late 90s.  They went big into housing, private equity and hedge funds in the late 00s.  Now they are going heavily into long term bonds.  This, with record low interest rates all around the world and central banks practicing competitive debasement of their currencies.  Sounds about right.

The value of the bonds may fall in the meantime, just like the value of stocks. But declining bond prices are not such a worry, because the companies plan to hold the bonds for the accompanying interest payments that will in turn go to retirees, not sell them in the interim.

That is well and good, but what if the bond issuer defaults?  You can lose money just as quickly in bonds as you can in stocks.

Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

Again, in what universe is 9.5% an expected return for stocks?  Let's pause for a second and use a little logic.  Suppose that GDP, a proxy for the economy as a whole, grows at 5% per year.  Note that this is a very fast growth rate for a mature economy.  Now, let's think about this.  How can stocks, which are priced based off of the earnings power of corporations, which in turn are a subset of the economy, grow faster than the rest of the economy?  Sure, over short periods of time this is possible but mathematically speaking, stocks cannot outperform the economic growth as a whole forever.  If they did, stocks would eventually grow to be larger than the whole economy, which of course is impossible.

The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be. 

Stocks outperformed from 1982-2000.  Therefore, it should hardly be surprising that stocks underperformed from 2000-2010.  In fact, what would be surpring is if stocks stopped underperforming in the next eight years.  This is called mean reversion.

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions. 

But plan officials say they cannot. 

“Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.

We will dub this the Ostrich Investment Plan (OIP).  Head, meet sand.  Like we mentioned with the EU and Greece, these pension fund managers and politicians are in denial.

The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report. 

But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace. 

Colorado looks like they are doomed.  Of course, the game of kick the can will continue as long as possible.

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.

More people in denial.  Colorado cannot afford a 2% increase, let alone 3.5%.

If Colorado could somehow get 9 percent annual returns from its investments, though, its pension shortfall would shrink to a less daunting $15 billion, according to its annual report.

Why not just assume a 30% annual return and claim a surplus?  Problem solved.  I should run for office.

That explains why plan officials are looking everywhere for high-yielding investments.

Yes, the funding shortfalls explain why pension funds are stretching for yield.  Another explanation is that record low interest rates, which are a result of Federal Reserve policies, are forcing these funds to take greater risks.  This is the downside to low interest rates.

Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.

Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.

You just have to laugh at this one.  The gall of these fund managers who think they can goose returns by using swaps, repos, etc. is hilarious.  They don't stand a chance.

Stating the Obvious
All of these wishful projections and financial shenanigans are a waste of time at best.  One or two pensions funds may get lucky and shoot the moon but as a whole, these pension funds cannot possibly outperform the market because they are simply too big.  You cannot outperform the market if you are the market, in other words.  Promises have been made that cannot be kept because there is simply not enough money.  The longer this reality is denied, the harsher the end game will be.

Saturday, March 6, 2010

Keynes: Let's Destroy the Value of your Money

This is part six of our discussion of John Maynard Keynes and his 1936 book The General Theory of Employment, Interest and Money.  So far, we have uncovered some very interesting and often outrageous ideas buried in the famous economist's most well known work.  Here is what we discussed in parts 1-5:
For part six we will discuss how Keynes promoted the destruction of the value of money.  This is commonly referred to by the euphemism inflation but, as we will see, Keynes went even beyond promoting a modest inflation target.  Keynes supported this despite correctly acknowledging that inflation and currency destruction in general hurts the poor disproportionately.

All quotes below can be verified for their accuracy by referencing the full text, which is available online for free here.

Chapter 19, Section II
Except in a socialised community where wage-policy is settled by decree, there is no means of securing uniform wage reductions for every class of labour. The result can only be brought about by a series of gradual, irregular changes, justifiable on no criterion of social justice or economic expediency, and probably completed only after wasteful and disastrous struggles, where those in the weakest bargaining position will suffer relatively to the rest. A change in the quantity of money, on the other hand, is already within the power of most governments by open-market policy or analogous measures. Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter. Moreover, other things being equal, a method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable.

The question here is - what is the best method to lower employee wages?  Keynes argues that it is far better to reduce wages through inflation because it is less understood than a direct reduction in numeric value.  If one's goal is to fool the masses, then quite frankly we agree.

Chapter 19, Section II
In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.

Central bankers like Keynes know that from a psychological standpoint, stealing your money indirectly through inflation is the preferred method.  When someone promotes an inflationary policy, remember that this is what they are advocating - they want to fool you.

Chapter 20, Section III
For a time at least, rising prices may delude entrepreneurs into increasing employment beyond the level which maximises their individual profits measured in terms of the product. For they are so accustomed to regard rising sale-proceeds in terms of money as a signal for expanding production, that they may continue to do so when this policy has in fact ceased to be to their best advantage; i.e. they may underestimate their marginal user cost in the new price environment.

Since that part of his profit which the entrepreneur has to hand on to the rentier is fixed in terms of money, rising prices, even though unaccompanied by any change in output, will re-distribute incomes to the advantage of the entrepreneur and to the disadvantage of the rentier, which may have a reaction on the propensity to consume.

Not only did Keynes hope to fool the masses via inflation, but he hoped to fool entrepreneurs as well!  Fortunately for the entrepreneurs and other generally wealthy people, Keynes correctly recognized that inflation helps the rich at the expense of the poor, as Keynes describes here as well.  Note that fooling entrepreneurs by making them think there is more demand than actually exists, Keynes is promoting the boom and bust cycle that continues to plague our economic system.

Finally, Keynes went one step beyond promoting an inflationary policy.  He also promoted the use of currency with an expiration date, aka "stamped money."

Chapter 23, Section VI
He [Silvio Gesell, 1862-1930] argues that the growth of real capital is held back by the money-rate of interest, and that if this brake were removed the growth of real capital would be, in the modern world, so rapid that a zero money-rate of interest would probably be justified, not indeed forthwith, but within a comparatively short period of time. Thus the prime necessity is to reduce the money-rate of interest, and this, he pointed out, can be effected by causing money to incur carrying-costs just like other stocks of barren goods. This led him to the famous prescription of “stamped” money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher. According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure. According to my theory it should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment. The actual charge suggested by Gesell was 1 per mil. per month, equivalent to 5.4 per cent. per annum. This would be too high in existing conditions, but the correct figure, which would have to be changed from time to time, could only be reached by trial and error.

The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale. But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it, but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes — bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth. As I have mentioned above, there have been times when it was probably the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest; — though under Gesell’s system this possibility would have been eliminated by land nationalisation.

Not only does Keynes and Irving Fisher want to destroy the value of your money but they want to nationalize your land (aka Communism). The bottom line is that Keynes and his followers want to stamp out the free market and steal your land, and thus freedom, because they think they know better than you.  It's all right there in black and white.

Thursday, February 25, 2010

Greece and the EU in Denial

If you are an avid follower of financal news like us then you are no doubt aware of the Greek debt crisis.  In fact, you pretty much cannot avoid it.  We make no predictions on whether Greece will eventually receive a bailout but we are amazed at how quickly the situation has devolved into farce.  For entertainment purposes, let's take a look at some excerpts from recent articles written by the always excellent Ambrose Evans Pritchard:

"If one member of the eurozone were to step out for any reason, this would be a collapse of the entire system," said Carl Heinz Daube, director of the Finanzagentur.  "It is very hard to clarify to a man on the street why one country should step in to help another country," he told the Euromoney bond congress in London. 

So explain it Mr. Daube.  The entire system could certainly collapse if Greece is allowed to fail, but what does that tell you?  If one tiny part of the system can cause the whole thing to collapse, doesn't that imply that the system is terminally designed?  What if the next country that runs into trouble is several times the size of Greece?  It seems that the architects of the EU and Euro should take some responsibility for the current situation, no?

Germany's regulator BaFin fears that the Greek crisis risks setting off "downward spiral" across Southern Europe, posing a system risk to the financial system. It said German banks hold €522bn of state bonds from the region. 

So Greece needs to be bailed out because the German banks were foolish enough to lend them money.  Why should the German people pay for the mistakes made by the banks?  Nobody forced the German banks to throw money at Greece.

Moritz Kaemer, head of Europe ratings at Standard & Poor's, told the forum that "a sovereign default is not going to happen in the euro zone. Greece is still comfortably an investment grade." 

It is good to have such wonderful assurance of calm from the people who missed the housing bubble, the banking crisis and indeed every financial crisis of the last thirty years.  The rating agencies couldn't assess risk if their life depended on it and lucky for them, it doesn't.

Mr Kraemer said it would take Greece 33 years to reduce debt to the already high level of 100pc of GDP even if it manages to consolidate at the rate of the last growth cycle – in boom times that may not be repeated.

So in other words, Greece cannot possibly avoid default if market forces are allowed to work.  What a bunch of nonsensical double-talk when juxtaposed with the earlier statement.

Public and private sector unions joined forces to bring the country to a standstill for 24 hours, halting flights, trains, and shipping, and shutting schools and hospitals.

I am not quite sure what the people of Greece hope to accomplish by destroying their already fragile economy.  Sure, they are angry that their salaries and benefits are being cut but what are they proposing?  They simply don't have the money to pay for their expenses and the world is finally getting tired of accepting their debt.

Theodoros Pangalos, deputy prime minister, said Germany had no right to reproach Greece for anything after it devastated the country under the Nazi occupation, which left 300,000 dead. "They took away the gold that was in the Bank of Greece, and they never gave it back. They shouldn't complain so much about stealing and not being very specific about economic dealings," he told the BBC. 

It is good to see that Greek politicians can be just as big of idiots as American ones.  Clearly events that took place before TV broadcasts began have no relevance today.  Nobody forced the Greeks to join the EU or to adopt the Euro just a decade ago.  If they did not like the terms then they should not have joined.

Twisting the knife further, he said the current crop of EU leaders were of "very poor quality" and had botched this month's crisis summit in Brussels. "The people who are managing the fortunes of Europe were not up to the task," he said. 

Yes, it is the politicians of other countries fault that they cannot bail out your country faster.  Shame on them for letting you get yourselves into this situation.

Portuguese unions have called a general strike for early March. Spanish unions held marches in Madrid and Barcelona on Tuesday over pensions, but turnout was low.

The Portuguese and Spanish are obviously jealous of all of the attention that the Greeks have been getting so they are preparing publicity stunts.  Nice move.

The EU has always found ways to master crises over the last 60 years, and will most likely do so again, but this one feels different to EU veterans.

Sixty years of prosperity is a nice track record but what was it that happened just prior to that period of time?  I seem to remember some minor incidents.

Closing Remarks
What you have here is a total lack of recognition of any sort of responsibility by any party involved.  Nobody in the EU, the banks, the rating agencies, the Greek government or the Greek people want to own up to the fact that they contributed to the current situation.  In short, they are all in denial.  Thus, the situation will continue to get worse until the parties involved stand up and say "I helped get us into this situation and I will stop contributing to it."  Bailout or no bailout, temporary reprieve or not, this story will last as long as the finger pointing continues.

Tuesday, February 16, 2010

What Does One Hundred Trillion Dollars Look Like?

This is a Zimbabwe one hundred trillion dollar bill, which debuted on January 16th, 2009 with a value at the time equivalent to $30.  On April 12th this bill and all other Zimbabwe dollar notes basically became worthless when the Reserve Bank of Zimbabwe legalized the use of foreign currencies.  Maybe Zimbabwe dollars will make a good investment after all, since some individuals are trying to sell these bills as collectables.  We found one site that is asking $20 for each bill.

Thanks to Mike Maroney of for the best freebie of the day at the New York City Traders Expo.