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Archive for the ‘The Big Picture’ Category

If It’s Too Good to Be True…

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I wish I could say that it’s stunning how many victims have emerged in the Bernie Madoff Ponzi Scheme that resulted in the evaporation of more than $50 billion in assets. I wish I could say that it’s stunning who those victims are, among them some of the world’s largest banks, including RBS, HSBC, Natixis and BNP-Paribas, and some famous “small” investors, including the owners of the Mets, Dolphins and Eagles.

Alas. The only part of this that is stunning is that so many seemingly intelligent people allowed themselves to be drug into this pyramid fraud. The problem is that people believe in the concept of long-term profits that exceed the market return. It’s possible to outrun the market for a while, as I have done for the past few years holding a stake in Apple, but the extra risk inherent in a technology company, as well as a lack of diversification, that brought outsized returns in years past has served to erase those profits in a matter of months recently.

The same holds true- eventually- for everyone. No mutual fund, no individual investor, no algorithm, has ever successfully beat the average market return over a long-run timeframe. This isn’t meant to be a blog specifically about the finance industry or even the stock market, but rather economics in general. The fact that the market cannot be beat in the long-run is an economic absolute, not a financial absolute.

The reason is because it’s impossible for any algorithm or investor to account for the precise demands of every market consumer in the world, every potential news story or natural disaster, every political election, etc. Markets in general are priced, at least in theory, on every piece of data in the world (or at least every piece possibly relevant in the slightest to market values). This is the meaning of an “efficient” market. And where markets are even just generally efficient, not perfectly so, achieving an outsize profit in the long-run is unfeasible.

Those that were sucked into this scheme allowed themselves to be fooled by the trappings of finance. Financial wizards have concocted a variety of complicated instruments and investment schemes meant to perfectly shield from risk, provide excess returns consistently, or otherwise “break the rules”. We see their handiwork on display right now in the utter destruction of some of Wall Street’s oldest names. This particular story is no different and brings to mind an old adage: pigs get fat, hogs get slaughtered.

Even though Mr. Madoff was reporting returns well above those of the market year after year, without disclosing any type of pricing model or particular insight that could lead to exploiting market inefficiencies to such success, some of the world’s most respected banks apparently did not think to ask how this was possible. They were willing to believe, in effect, that two equaled five, and not just once, but on a continuous basis. Shame on them. Individual investors are more likely to get cheated into such a scheme because they don’t necessarily have the requisite knowledge to know that even the best investor couldn’t achieve these gains continuously. The financial institutions, though, should have known better.

This will eventually become the overriding narrative of this market tumult: the people in charge have no idea what they’re doing. To return to an economic description, one might say that 10% of the market is a reasonable portion to dedicate to those financial middle-men that handle all other transactions in the economy. Yet nearly 20% of the economy, when seen in terms of the S&P 500, was dedicated to the financial sector as recently as last year. Does anyone reasonably believe that one in five dollars should be allocated to transaction costs in our grand technological age? Even the federal government would be impressed by this level of bloat and inefficiency.

Welcome the current market convulsions. What we are witnessing is the grand economic reallocation of a full 10% (or more!) of our economy away from poor decisions to better avenues. It is clear that many of the people currently in charge of billions of dollars of other people’s money should not have that responsibility. Market forces will, we must hope, see to their demise.

This is why opposing government bailouts is important. This meddling in the market serves to reward those that have made poor decisions. As for saving those that were hurt by frauds perpetrated by men like Madoff, this too would be a mistake. The investors here are as guilty as Mr. Madoff. They participated in a willing suspension of disbelief in order to bring home profits that they knew had little to no grounding in reality.

The automakers (or more succinctly, the UAW) are facing their own reckoning. I believe that they will emerge stronger and more competitive in the end, or they will face ruin. GM will be drug by the government or by the market to friendlier waters. Ford has already properly vectored itself for success. Chrysler will die.

As I have said before, we face a unique opportunity here. The market will decide where all of this newly-freed capital will go, unless we intervene. I don’t support doing so, but the political realities seem to make this all but inevitable. If that is the case, we should do our best to be the market’s intercessor and be active in promoting those policies that will make us all more prosperous in the end.

Written by caseyayers

15 December, 2008 at 11:02 am

Of Pianos and Cars

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A great column has been published today over at Mises worth reading. As a musician myself, the subject certainly struck a chord (ha). The author looks at the rise and fall of piano production in the United States and how it compares to Detroit’s situation today. Certainly an interesting and valid analogy, proving that no particular product or good is exempt from the laws of the free market. I stand by my previous statements that providing a bridge loan to GM and Ford is a more palatable situation than printing money to cover losses on absurd, synthetic financial instruments, but Mr. Tucker does us the good deed of reminding us that less-bad is not the correct option in the long run. Excerpt and link to the full article follow below:

With the growth of this manufacturing came an explosion of shops that served the piano market all up and down the industry. Piano tuning was a big-time profession. Retail shops with pianos opened everywhere, and the sheet-music business exploded with them. Ever notice how in big cities the music stores are typically family owned and established 40, 50, and even 100 years ago? This is a surviving remnant of our industrial past.

All of this changed again in 1930, which was the last great year of the American piano. Sales fell and continued to fall when times were tough. The companies that were beloved by all Americans fell on hard times and began to go belly up one by one. After World War II the trend continued, as ever more pianos began to be made overseas.

In 1960, we began to see the first major international challenge to what was left of the US market position. Japan was already manufacturing half as many pianos as the United States. By 1970, a revolution occurred as Japan’s production outstripped the United States, and it has been straight down ever sense. By 1980, Japan made twice as many as the United States. Then production shifted to Korea. Today China is the center of world piano production. You probably see them in your local hotel bar.

Click to Continue Reading “The End of the US Piano Industry”

Written by caseyayers

10 December, 2008 at 12:06 pm

Re-Writing the Rules

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From today’s Politico Arena question: “The economy: How big a stimulus? How wide a rescue?”

It depends on what indicators take priority. If the goal is to make stock market values rise quickly, then an immediate reduction of the capital gains tax to 0% would do wonders to bring buyers back into the market. However, because these would be speculators looking to take advantage of a limited-time tax break, this could simply be another shot in the arm that leads to an even deeper hangover recession a few years down the line.

If instead we agree that we’re in the midst of a broad reallocation of resources across the board (which is a recession’s part to play in free markets), then we can choose two routes. Either we allow the recession to take its course, lasting longer than we would probably like but resulting in a more efficient economy in the long run, or we make decisions at the governmental level about what priorities America most values. For example, how important is General Motors to this country? If we as a people decide that it is worth saving due to national pride or some other metric, then that is well within our reach.

Map of the US Interstate System

The key is that whatever decisions are made, they should be made with a larger sense of strategy. It’s maybe a bit distasteful but okay in the long run to run up a deficit in the present if it leads to strong returns in the future. Some people call this overspending; others call it speculative investment. It seems clear that government interventionism is here to stay for now. So be it: put the unemployed to work on green energy projects and on building this country’s infrastructure for the 21st century. Imagine what this country would be like had similar expenditures not been made the 1940s and 1950s. We can use this as an opportunity to set the ground rules for future economic growth.

Written by caseyayers

7 November, 2008 at 2:42 pm

He Has Them Where He Wants Them

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John McCain wasn’t kidding when he made that statement. The reality is that his campaign faces such certain doom that it would seem Obama has already been the president for several months. McCain is a specialist in rising like a phoenix at the least likely (and last possible) moment, and this is the perfect opportunity for his greatest performance. The elements are in place for such a stunning reversal of fortune to occur. This isn’t to say that it’s likely, just that it’s possible, which is in and of itself a feat given how far the conventional wisdom has gone to write him off at this point.

Two things must happen for McCain to pull out a squeaker. First, note that a stunning fourteen percent of voters remain persuadable at this late hour, only four days until the general election. You have to love the incredulosity of the Associated Press report that claims, “a stubborn wedge of people…somehow, are still making up their minds about who should be president.” After all, what could keep them away from Obama? It all comes down to money. When the economy looks a little bad, I believe that voters tend toward a more liberal philosophy to “fix it”. Yet when faced with a market selloff like the one hopefully just behind us, more of an every-man-for-himself mindset begins to set in. Given this newfound personal insulationism in the face of dwindling retirement accounts, voters are becoming more wary of what they perceive as the Obama threat of raising taxes. They feel they simply can’t afford to give up one more dime. The Obama campaign’s fuzziness on the high-end number for their redistributive tax credit doesn’t help because it leaves the middle-class receptive to McCain’s argument that their tax hikes will creep down the line, leaving tax credits only for those that barely pay taxes to begin with.

Secondly, the almost absolute assumption of Barack Obama’s inauguration on January 20, 2009 could potentially depress turnout on election day. Even though excitement seems high for the Obama ticket, if too many of his supporters figure that he will win by such a landslide that their vote is not required, we may see a stunning reversal from arguably accurate poll numbers to actual numbers at the poll. That, however, assumes strong turnout for McCain, which is a problem. But if enough undecideds swing toward the more conservative choice and enough Obama supporters simiply write off victory as inarguable, John McCain may yet find a way to pull off what would be, perhaps, the greatest upset in the history of the presidency.

Written by caseyayers

31 October, 2008 at 10:16 am

Why Oil Is Tanking

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It’s all about what I call Illusory Perceived Demand. At least that’s what the run-up was all about. The reality is that oil is much closer to its true price. Part of the reason that it has fallen is also attributable to the dollar, which has been remarkably strong given the Treasury’s efforts to completely discredit it as a legitimate currency as of late. But we’ll talk about the incredible inflationary cycle that we’re about to undergo another time.

For now, let’s focus on oil, which was fallen as of today to under $70/barrel, from a high of around $150 as recently as this summer. In the past month alone, the value of crude has fallen by more than thirty percent. So why is oil falling so quickly?

It’s easy to blame the Hedgies, day-traders and speculators, and to say that because they have now been forced out of the market, prices are swiftly falling back to “real” values. But speculators did not cause this, or at least not the type of speculator you have in mind. Rather, actual consumers of oil, the type that purchase these contracts on futures markets, drove up the prices in a bit of a panic. Speculation-in-earnest, not greedy speculation, is the issue here.

The mentality on the futures market has been, until recently, that a massive, amorphous being called CHINA would absorb each and every drop of oil in the world unless Western companies could thwart them by consistently raising the stakes. Because “China” would pay almost anything to continue its stunning growth trend fueled largely by oil, American companies perceived that there was a massive and unquenchable demand afoot that forced them to pay ever-higher premiums to receive the oil they needed to operate. So they accepted rapidly rising oil prices as a geopolitical absolute, and continued to suck down as much of the stuff as they could possibly afford (to the economics student, right up to where marginal cost equals marginal revenue, most especially in the airline industry).

But the reality that is now prevailing in the commodities market is that China is not, indeed, insatiable. Furthermore, their economic system, although difficult for many to understand, doesn’t result in an unlimited supply of wealth with which to buy energy. Further still, their growth is not a phenomenon that will continue to gain speed no matter what. Just as America and Europe are undergoing a recessionary period at this point thanks to the recent liquidity crisis, China is facing a rocky road. Perhaps China is even worse off than America, for instance, since China is so dependent upon Western consumption to maintain its level of growth.

So the boggart has been put back in the armoire, and appropriately so: by enough people standing up to declare the current situation to be ridiculous. The market is soaked in oil, with new production coming out of every spigot at this point. Even the largest nightmares are eventually wiped away as the rational thinkers in the market begin to wake up and question exactly what makes oil almost thrice as valuable as it was just a couple years ago. China is, in fact, a normal player on the world stage, following the same rules of consumption that the rest of us follow. And oil is not in such dire low supply as to be gone within a decade. Even worse for the naysayers, watching oil prices fly so high resulted in many new fields and techniques being discussed anew for where additional oil may reside but be too expensive presently to drill out.

This isn’t to say “Drill Here Drill Now” is the end-all solution to long-term energy needs for this country or the world. Gas will not be, though, obsolete by this time next year. The decision to move to new sources of energy en masse will be made either politically, where citizens decide that they prefer short-term economic inefficiencies for purposes of national security or environmental wellfare, or it will be made economically, when oil supplies truly are outstripped by demand in the long-run.

Unfortunately, the huge run-up and present crash of oil prices is not that dissimilar from the scenario we’ll see when all of this unabsorbed liquidity catches up with the markets. The idea that credit is unavailable is almost absurd. Rather, bankers are claiming that the liquidity flowing out of the fire hydrants is poisoned. When the market quits thrashing about in hysterics and sets to the task of absorbing these funds, they will find money laying about in true excess. This will lead to massive inflation, unless the Fed can perfectly thread a needle that’s almost impossible to read. But we’ll cover that later.

Written by caseyayers

22 October, 2008 at 3:38 pm

Stop the Bailout Train

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In response to today’s Politico Arena question, “Does McCain’s ‘Homeowner Resurgence Plan’ announced at the debate make sense?” (Text of plan from the campaign’s website can be found here.)

The problem with the McCain campaign’s proposal is that it favors certain types of investment (namely, housing and real estate) and does so with taxpayer money. What compensation is to be given to those that own Apple or Google stock, with both companies’ market capitalization nearly sliced in half in the past year? Will there be a bailout for stock market investors that were “misled” into buying at prices that make the investment seem unpalatable today?

Government assistance in guaranteeing low interest rates is still an affront to the free market, but a more necessary and less harmful one. It is true that many homeowners were misled into accepting deceptive mortgage terms, and many families may be willing to continue to pay down the original principal of the loan if their payments at the very least do not go up from here.

Free market adjustment of mortgage values should be encouraged, too. Homeowners have every right to simply walk away from the mortgage they signed. The banks that hold these loans will often be very willing to rewrite mortgages to lower values on their own accord, rather than assume the responsibility of the property and be left with a house they may not resell for a long time.

Involving the federal government in yet another facet of a problem that, at its origin, is the result of artificially low interest rates will only serve to increase the national debt, lower the dollar’s prestige, and accelerate the rate of inflation, only further penalizing those that continue to pay their mortgages or invested in assets other than real estate.

Written by caseyayers

9 October, 2008 at 8:08 am

The Pie is Bigger Than it Looks

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So how do runs on the bank work, anyway? To understand how bank runs create a self-fulfilling prophecy, it’s important to understand how banks keep and loan money.

Banks don’t keep all of their deposits on tap. Rather, only a portion of these are kept around at any time. Under normal circumstances, this is fine, because it’s very unlikely that everyone will suddenly ask for their money at the same time. Therefore, just keeping a small percentage on hand is enough for the daily traffic at any branch. Why don’t they keep all of the money on tap at any particular moment? That question strikes to the heart of how banks stay in business at all.

Keeping just a portion of the money on hand, a practice known as having a fractional reserve system, means that the bank can use most of their funds to make loans to other people, to businesses, and to other banks. This also leads to an expansion of money behind the scenes. The Federal Reserve sets the reserve requirement; we’ll say it’s 10% for this example:

You deposit $1,000 at your bank. The bank is required to keep $100 of that on hand as its reserve, but is free to loan out the other $900. So they do: your bank also issues credit cards, and I walk into Home Depot with their card to purchase a washer and drier that cost $1,400 together. I put $900 on my card, which means that Home Depot will receive this money. However, the store offers a special no-interest deal for the remaining $500. They can afford to lend this credit, ironically, in part because of the other $900 that I just gave them. Home Depot only uses part of that money, though, and also takes out a loan at a favorable rate to help cover the financing. They do this by drawing on someone else’s savings.

Confused yet? That’s what makes the current situation difficult to understand: everybody owes everybody else somehow, and it all started with just a few green pictures of Ben Franklin.

An economist would tell you that a 10% reserve requirement on $1,000 means there’s actually $10,000 out there. The math is simple: either divide $1,000 by 10%, or carry it out all the way. Everyone has to hold onto 10%, meaning $1,000 creates a new loan of $900, and then another of $810, and then another of $729, and so on until the difference is negligible. But this isn’t really how it works. As in the example, sometimes money “sticks” before it has reached its terminal point. Home Depot pockets the majority of the cash from that $900 I put on my credit card. When that happened, the possibility of that money being loaned out again quickly to somebody else decreases significantly.

So that’s the first cause of the current “liquidity” crunch: money gets stuck along the way. In a period of uncertainty like today, this money leaves the economy and goes underneath a mattress somewhere. But this money has been taken out of the system somewhere halfway through. The real trouble starts when the money is taken out from the origin point: your checking or savings account.

Bank runs happen because people are afraid that they won’t be able to get their money back. This could be due to fears over national security, the global economy, or just poor management of a local bank. In any case, a mad rush of withdrawals can quickly wipe out a bank’s “current liquidity”, otherwise known as the 10% they kept on hand from your savings and those of everyone else. And when this happens, the bank quickly becomes broke. They have to tap into money they’d otherwise use to make loans in order to meet withdrawal requests and, piece by piece, have to take apart all of the different, longer-term instruments like bonds or mortgages that they owned as they keep running out of cash.

Welcome to the current situation. The reason why so many mortgages, and we’ll talk about how they’re wrapped up in packages some other time, appear to be worthless now is because a couple banks that were particularly reckless had to dump out of them for pennies on the dollar just so that they could have a little more cash on hand. The mark-to-market rules I keep harping on means that other banks have to pretend like their securities are just as worthless as those sold at firesale, making it appear like they took huge losses when in fact they have plenty of cash left.

The prophecy is fulfilled when people become worried about these banks’ health and withdraw all of their money. Since our economy is based on a monetary system that boils down to little more than keeping tabs on a scoreboard, when the lifeblood of the system is taken out the whole thing breaks quickly. That’s what we’re seeing now.

Written by caseyayers

2 October, 2008 at 7:47 pm