Monday, May 22, 2006

Signs of the Economic Apocalypse, 5-22-06

From Signs of the Times 5-22-06:

Gold closed at 659.00 dollars an ounce on Friday, down 8.6% from $716.00 at the end of the previous week. The dollar closed at 0.7827 euros Friday, up 1.2% from 0.7737. The euro closed, then, at 1.2777 dollars compared to 1.2926 at the previous week’s close. Gold in euros, then, would be 515.77 euros an ounce, down 7.4% from 553.92 for the week. Oil closed at 68.36 dollars a barrel Friday, down 5.4% from $72.04 the previous Friday. Oil in euros would be 53.50 euros a barrel, down 4.2% from 55.73 for the week. The gold/oil ratio closed at 9.64 barrels of oil per ounce of gold on Friday, down 3.9% from 9.94 at the end of the week before. In the U.S. stock market, the Dow closed at 11,144.06 on Friday, down 2.1 % from 11,380.99 for the week. The NASDAQ closed at 2,193.88 Friday, down 2.3% from 2,243.78 at the end of the previous week. In U.S. interest rates the yield on the ten-year U.S. Treasury note closed at 5.06%, down 13 basis points from 5.19 for the week.

Last week saw a pullback in commodity prices with gold dropping 8.6% and oil dropping 5.4%. In another reversal of recent trends, the dollar gained ground after some down weeks. While such reversals might seem like good signs for the world economy, the increasing volatility of markets in recent weeks is not a good sign at all.
A turbulent week on global financial markets

Nick Beams19 May 2006

A correction or the start of something much bigger? That is the question hanging over financial markets following a major sell-off in currency, commodity and equity markets over the past few days.

In New York the Dow Jones industrial average fell a further 77 points on Thursday, following a 200-point drop the previous day. The high-tech Nasdaq index fell by 0.7 percent for its eighth straight daily decline—the longest losing streak since 1994. The S&P 500 index has fallen by 4.8 percent since May 10, when the Federal Reserve Board increase its benchmark interest rate to 5 percent. This is the biggest fall over a seven-day period since March 2003.

The immediate cause of the sell-off in equity markets is the fear that interest rates will continue to rise. Announcing its latest rise, the Fed’s open market committee indicated that future increases may “yet be needed to address inflation risks”. These fears were compounded by the announcement of a higher than expected inflation rate of 0.6 percent for April.

But it is not only the Fed’s plans on interest rates causing concern. Across the world, central banks have been tightening rates. The Bank of Japan has ended its policy of ultra-liquidity introduced to combat deflation and could soon move back to a more normal interest rate regime, while the European Central Bank has indicated that it favours further rate increases. The Japanese move is particularly significant because Tokyo has been the source of cheap funds for so-called “carry trades” in which borrowed yen are used for more profitable investments in the rest of the world.

Whatever the developments over the next few days, there is a perception that the situation has turned. According to David Bowers, chief global investment strategist at Merrill Lynch in London: “The prospect that central banks will have to actually cool things off is a very frightening prospect. There is a macroeconomic vulnerability for stocks here that there has not been before.”

Little more than a week ago, the Dow Jones index was heading for an all-time high of 12,000. But now the atmosphere has changed. As a comment in the Financial Times noted: “There’s a new term stalking the markets, one that hasn’t really been voiced for a while—volatility. Global concerns about the outlook for inflation and growth, and fears of a collapse in the dollar, have been pushing up price volatility for stocks, bonds, currencies and commodities.”

This represented a departure from the steady comfortable markets of recent years that were marked by general confidence, allowing investors to take on greater risks for higher returns.

While fears of interest rate rises may have provided the initial impetus for this week’s large movements, the underlying causes lie in the unprecedented imbalances in the global economy. World economic growth, and especially the China boom, has become increasingly dependent on the increased indebtedness of the United States, where the balance of payments deficit is now around 7 percent of gross domestic product. At the same time, the transfer of the balance of payments surpluses from China and East Asia into the US financial system has kept interest rates at historically low levels, ensuring that consumer spending can continue to be funded through debt.

Besides funding consumption spending, record low interest rates have also led to the creation of a series of financial bubbles—in stocks, housing, “emerging market” equities, and, most recently, industrial commodities.

Between March 1 and May 11 alone, the price of copper rose by 80 percent, gold 40 percent, zinc 75 percent, nickel 45 percent, aluminium 38 percent and tin 20 percent.

Analysing the longer-term trends in a comment published on Monday, Morgan Stanley chief economist Stephen Roach noted that over the past four years the prices of industrial commodities have risen by 53 percent, faster than has occurred in any of the four previous phases of global expansion. In real terms the increase is 42 percent, nearly double the 23 percent increase in the two commodity booms of the 1970s.

The increase is clearly not the result of rapid economic expansion. The average growth of world gross domestic product in the period 2002-2006 is likely to be 4.2 percent, compared to 4.4 percent in the four previous expansions.

Roach pointed out that while there is nothing exceptional about current rates of growth when compared to earlier periods of expansion, “the current surge in commodity prices has been off the charts when compared with those of the past”.

“In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history.”

In other words, a large part of the rise in commodity prices is a financial bubble, in which an increase in prices induced by speculative inflow of funds leads to a further inflow, followed by another round of price increases.

Everything goes well, so long as the inflow of money continues and prices keep rising. But once the situation turns, the gains on the upswing turn into massive losses.

That turning point may have been reached if a report on Thursday’s trade by Telegraph journalist Ambrose Evans-Pritchard is anything to go by. “The risk of defaults” he wrote, “was hanging over the London Metal Exchange last night after a clutch of clients failed to meet margin calls on losing copper trades, leaving brokers struggling frantically to match their books.” According to one “market source” cited in the article: “The hedge books of the banks are seriously underwater on copper, but apart from that there are now brokers in trouble because clients can’t meet the margin payments.”

Much of the speculation in equity, commodity and currency markets is the result of the activities of hedge funds, which shift enormous amounts of money in the daily search for profits. It is estimated that somewhere between $800 billion and $1 trillion is invested in hedge funds.

This is five times the amount invested in September-October 1998 at the time of the financial crisis set off by the collapse of the Long Term Capital Management hedge fund, which had to be bailed out to the tune of more than $3 billion.

Today there are between 7,000 and 9,000 hedge funds in the US and they are estimated to account for as much as 20 percent of all US stock trading. In a speech last Tuesday, Federal Reserve Board chairman Ben Bernanke warned that financial authorities had to stay attuned to the potential risks.

“Authorities should and will try to ensure that the lapses in risk management of 1998 do not happen again,” he said. But with increased turbulence in all markets, that may be easier said than done.

For a contrary view on hedge funds the neoliberal James Surowiecki published a piece last week in The New Yorker arguing that hedge funds contribute to stability in the markets.
In the past five years, hedge funds have become a new power on Wall Street; the number of funds has doubled, to more than eight thousand, and the assets they control have tripled, to more than a trillion dollars. In the process, they’ve also become a favorite scapegoat for bad financial news, blamed for everything from inflating the housing bubble and demolishing stock prices to jacking up the price of oil. A German politician has called hedge funds “locusts” of the global economy, while William Donaldson, the former head of the S.E.C., has warned that “disaster” looms if hedge funds aren’t regulated. The title of a recent column made the point nicely: “Instruments of Satan.”

That’s not quite what Alfred Winslow Jones had in mind when he started the first hedge fund, in 1949. Looking to make money in both up and down markets, Jones adopted a strategy of buying some stocks and selling others short. Because, at the time, mutual funds were legally barred from selling stocks short, Jones avoided government regulations by restricting participation in the fund to a small number of wealthy investors. In the half century since, hedge funds have moved a long way beyond Jones’s simple “long-short” approach, and they now pursue a dizzying array of investment tactics in nearly every market in the world. But they have retained a few of the original characteristics: they’re free to invest in whatever assets they want; they can buy those assets with borrowed money, using leverage to improve their returns; they generally have long “lock-up” periods for their investors’ money; and, if they are successful, the people responsible earn vast fortune.

Aside from the part about vast fortunes, that doesn’t sound especially demonic. But hedge funds are easy to hate. They’re secretive, rarely making public disclosures about their investments or their performance, and so are fertile terrain for fraud and incompetence. Last year, investors in a fund called the Bayou Group found out that its managers had been lying about its performance for years, having blown all the money on bad investments. Hedge funds often trade in markets—and with investment strategies—that few investors understand. Many critics suspect hedge funds of hunting in packs: conspiring to bring down ailing companies or currencies, or artificially inflating the price of commodities. Worst of all, the funds’ reliance on leverage increases the scale of disaster when things go wrong. In 1998, the collapse of Long-Term Capital Management, a giant hedge fund that had made huge leveraged bets on currencies and government bonds, exacerbated a global financial crisis.

Yet hedge funds have been far more of a boon to financial markets than a bane. Markets work best when investors are drawing on diverse sources of information and relying on many different kinds of tools to figure out what’s going to happen next. The sheer variety of investing strategies that hedge funds use—in contrast to mutual funds, whose managers mostly just buy stocks and bonds—enhances the diversity of markets. In the U.S. stock market, hedge funds’ willingness to sell stocks short also makes the market smarter and more efficient.

Paradoxically, some of the characteristics of hedge funds that make them seem frightening also make them valuable. Secrecy, for instance, makes it harder for hedge-fund managers to imitate what their peers are doing, a common flaw among mutual-fund managers. And, because investors in hedge funds typically have to give notice of a month or more before withdrawing their money, managers are freer to pursue contrarian trading strategies that may work only over the long term. That doesn’t mean that hedge funds are immune to trends: a year ago, a number of big hedge funds suffered major losses from a bad bet on G.M.’s stocks and bonds. But a series of academic studies has found scant evidence of the pack mentality that hedge funds are often accused of. A recent paper by the economists Burton Malkiel and Atanu Saha, for instance, showed that the range of performance among hedge-fund managers was much wider than among mutual-fund managers, which suggests that they’re operating more independently.

Hedge funds are speculators, and we think of speculators as contributing to volatile markets and wild price spikes. But a recent study of eleven commodities markets found that when speculators made up forty per cent or more of the market, prices were roughly half as volatile as they were in markets where speculative trading was less prevalent. Similarly, a study published by the Federal Reserve Bank of Cleveland says that hedge funds tend “to reduce, not increase, the volatility of price,” something that the authors attribute to the funds’ willingness to go against the prevailing wisdom. It’s probably no accident that in the past three years, as hedge funds have made an increasingly large percentage of stock-market trades, market indexes have become far less volatile.

Perhaps hedge funds can provide stability for a while, but they buy that short-term stability at the cost of increased long-term instability. Maybe we are reaching the end of the period in which hedge funds and derivatives provide stability to markets. Hedge funds by definition need for some investments to go up while others go down. What if a point is reached where all assets point downward and no one is willing to go long? The crash will then be much worse than if there had been no hedge funds.

Here, the Financial Times put the blame for the recent drop in worldwide stock markets on hedge funds:

Market confidence gives way
Chris Hughes
Fri May 19, 1:20 PM ET

Investors said it could not last. They were right. The confidence that has propelled stock markets for three years gave way this week to fear.

Stock markets have ended the week approximately 4 per cent lower than where they began. The FTSE-100 is off 4.3 per cent at 5657.4 and the FTSE-All Share is down 4.6 per cent at 2884.1.

The visible explanation for the turn was a higher-than-expected US core inflation data on Wednesday, which prompted fears of rising interest rates and weaker global economic growth. In response, the FTSE-100 suffered its biggest daily fall in three years, while European bourses ended the day roughly 3 per cent lower.

But one piece of ugly economic data cannot fully explain either the initial rout or the market's gyrations for the rest of the week. The US inflation figure was, after all, just 0.1 percentage point higher than forecast.

The reality is that investors have had their fingers apprehensively poised on the "sell" button for several months, amid increasing doubts that the bull run in equities could last any longer.

"When markets have moved a long way in a short period of time, it doesn't take much to get people to sell," says Andrew Milligan, head of global strategy at Standard Life.

Hedge funds were feeling especially nervous. They counter their long positions in equities with some offsetting short positions. But the bull market had persuaded many to shift the balance increasingly towards long positions.

These were concentrated in a handful of sectors - mining, energy and stock exchanges - and were leveraged, or financed with debt. Moreover, these positions were duplicated across the industry. That was a risky cocktail.

Worries about the US economy were a natural catalyst to turn sentiment. A weakening dollar raises the spectre of higher import prices, and, in turn, higher US interest rates and bond yields.

Fears that higher interest rates could choke economic growth helped drive down commodity prices after their spectacular rise of recent weeks. Copper, for example, fell more than 7 per cent this week.

On top of the impact on global growth, higher interest rates would threaten the wave of debt-funded merger activity - especially by private equity houses - that has been a dominant driver of equity returns this year.

Xstrata's announcement late on Tuesday of a jumbo share placing may have also created some indigestion, given so many investors were long of the mining sector.

In taking profits, investors targeted the stocks that had given them the best returns. Mining and energy groups took the brunt of the pain. The continental stock exchanges were another obvious target. Hedge funds exacerbated the falls, as they sought to reduce their leveraged exposure to these sectors.

"When there's been one way of making money, you keep riding it. When there's a bit of nervousness, everyone heads for the exits," says Stuart Fowler, head of UK equities at Axa Investment Managers.

"I haven't the faintest idea what the real trigger was," adds hedge fund manager. "Fear has become more pervasive. When one person sells at the margins, it becomes self-perpetuating."

So why did the wider market fall too? One answer is heavy selling by investment banks of their proprietary equity positions to cover their exposure to derivative contracts written with hedge funds. A quick way for hedge funds to reduce their long exposure is to sell futures on an index. That forces the counterparty, typically an investment bank, to sell the underlying stocks.

But investment banks also had to sell equities to cover their exposure to so-called variance swaps written with hedge funds. These are derivative contracts enabling hedge funds to bet on rising volatility in the markets.

The Enron trial went to the jury last week. Enron is as emblematic of the present era of capitalism as the Titanic was of another. Here is an interesting take on Enron by Adam Ierymenko from the point of view of evolutionary biology. In it we can see how the process of ponerization, facilitated by corporate capitalism, leads to implosion. When the pathocrats take over completely there is no creativity left to exploit. Thieves can only steal things created by others. The system then falls in on itself:

I just watched a documentary entitled Enron: The Smartest Guys in the Room. This documentary was fascinating, especially from an evolutionary point of view. It provides a great cautionary tale illustrating at least one of the reasons why compulsory eugenics doesn't work.

One of my favorite papers in evolutionary biology, which I have mentioned here before, is this:

Muir, W.M., and D.L. Liggett, 1995a. Group selection for adaptation to multiple-hen cages: selection program and responses. Poultry Sci. 74: s1:101

It outlines the group selection effects observed when trying to breed chickens for increased egg production in multiple-hen cage environments. In short, selecting individual chickens for increased productivity in a group environment didn't select for increased productivity. Instead, it selected for mean chickens. The result was an overall reduction in productivity. Only by selecting at the group level was productivity increased.

This is a great experiment because it illustrates why evolutionary theory cannot be reduced to the phrase "survival of the fittest." That phrase isn't technically wrong, but it neglects so much that it might as well be. "Survival of the fittest" is either meaningless or misleading. It's like saying that mountain climbing is just "walking upward" while neglecting to discuss proper supplies, fitness training, establishment of base camps, selecting the proper climbing group, atmospheric oxygen considerations, and... the fact that you don't always walk upward. Sometimes you have to walk sideways, or downward, to get to the top.

So how does this chicken paper relate to Enron? Well, it turns out that Enron sorta reproduced this experiment through their corporate human resources policies. (Are you shuddering yet?)

Apparently one of the Enron CEOs was a big fan of Richard Dawkins' book The Selfish Gene. He took Dawkins' (in my opinion) overly reductionistic view of evolution and proceeded to even further reduce it in his own mind to social Darwinism of the knuckle-dragging "survival of the fittest" (grunt, grunt) variety. Enron's HR policy included an iterative performance evaluation and firing step reminiscient of a reality TV show like Survivor or The Weakest Link. Basically, they would evaluate the traders and most other employees based on performance metrics and then fire the lowest 10-15% of the company population.

Think chickens and trading floors folks. Enron was a trading, brokering, and investment company. (Go ahead, shudder some more.)

Everyone knows that there are many things you can do in any corporate environment to give the appearance and impression of being productive. Enron's corporate environment was particularly conductive to this: it's principal business was energy trading, and it had large densely populated trading floors peopled by high-powered traders that would sit and play the markets all day. There were, I'm sure, many things that a trader could do to up his performance numbers, either by cheating or by gaming the system. This gaming of the system probably included gaming his fellow traders, many of whom were close enough to rub elbows with.

So Enron was applying selection at the individual level according to metrics like individual trading performance to a group system whose performance was, like the henhouses, an emergent property of group dynamics as well as a result of individual fitness. The result was more or less the same. Instead of increasing overall productivity, they got mean chickens and actual productivity declined. They were selecting for traits like aggressiveness, sociopathic tendencies, and dishonesty.

After a couple rounds of this selection experiment, these mean chickens could be heard on recorded intra-office phone communications laughing about "those poor grandmothers" they were ripping off via market scams. They changed the company motto internally from "Enron: Ask Why?" to "Enron: Ask Why, Asshole."

Of course, everyone knows the rest of the story. While these mean chickens weren't terribly productive (the company was losing money hand over fist), they managed to peck their trading consoles so as to give the impression of increasing productivity. This worked, for a while. Then this whole monument to Darwinian fundamentalism collapsed rather spectacularly…

Here we see, perhaps, a way out of the rotten economic system we are in. An economics for what Lobaczewski, the inventor of the term ‘ponerology’, calls ‘normal people,’ those with a conscience who would like to work for the benefit of all, might select based on different factors than self-serving aggressiveness. From one of the comments on the above essay on Enron and chickens:

Seems like the best way to select for the right traits is not to select an individual based on that individual's traits. Behavior is group-oriented and emergent, so you must "break the barrier" between individuals in order to gain the correct metric.

Do not select a chicken based on how well that chicken lays.

Select for the chickens around whom all the other chickens lay more.

Select Chicken A based on the behaviors of all chickens not-A.

If you're selecting for group traits and emergent behavior, that's all you can do. That one thing alone would select for all the traits you want, and select against the meanness and sociopathy that surface when you select Chicken A based on Chicken A's performance.

Another commentator followed with this:

I think you capture the important point of observing the benefits of the surrounding chickens, but you cannot so easily discount the individual either. Chicken A itself is integral to the system.

For example: If you were indeed to "Select Chicken A based on the behaviors of all chickens not-A" then you might have the opposite effect of what happened in the paper cited. All the chickens would be passive and could theoretically not care if they get food or not. Thus producing less eggs.

I think the whole point behind Adam's post is that the dynamics of the system can't be broken down into a simple answer that can accordingly be maximized/taken advantage of.

Maybe this is why the universe seems to require a balance between service to self and service to others. In sports this effect is well known. In basketball, for example, much is made of players who make their teammates better. They usually do this with a combination of setting a good example through their own play (they are usually the best players on their teams) and by “keeping their teammates involved,” usually by distributing scoring opportunities to others thereby sacrificing, to a certain extent but not completely, their own scoring. This “external consideration,” to use a term coined by Gurdjieff, represents the opposite of the Enron ethic. It requires an active empathy, an understanding of, and the coordination of, the legitimate needs of others, something that parasitic pathocrats cannot fathom.


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