Lack of Trust

The fabric of any society lies in trust. In our personal lives, we trust our family our close friends and our life partner. Society and civilization grew as an extension of this trust. In modern day, we trust our government, our firms and institutions to uphold their responsibilities and trust. The origin of finance lies in trust too and credit is a measure of this trust. 

Financial transactions are a set of promises. Money is an agreement that a piece of paper can be exchanged for goods or services. Financial framework began with small loans within families and trusted friends. As the circle of borrowers and lenders grew, the complexity of financial transactions increased; promises became harder to enforce. The modern financial structure became so complex and interconnected that businesses had to trust each other for the engine to run smoothly. Men and society in general, driven by greed, lost corporate and personal ethics. Trust was lost, credit bubble burst and the engine has stopped running. The fed can try to expand balance sheet, buy agency or corporate debt might even buy long dated treasury; but none of these will promote easing of credit. 

I would like highlight few instances of lack of trust that reinstates my point. First in my article written in November '08, I had indicated that the first bailout package would neither be enough nor be properly used. Out of the first $350 bln, $18.5 bln was used to pay wall street bonuses. So the poor taxpayer who has seen his net wealth reduce by 50% has paid out even more money to the greedy, corrupt and rouge bankers and traders. Second, can I trust the rating agencies, research analysts and regulators? When State Street posted unanticipated record losses last weeek, 9 analysts had a buy and 8 were on hold. Kudos to your hard work and million dollar pay. Regulators were on top of their game that we have witnessed countless of ponzi schemes and fraud accounting. Rating agencies downgrade Greece and South Korea who are in downturn, but hey we in the US are still AAA despite nightmarish CA deficits and total external debt. 

In terms of market, I ask the same questions. Can I trust the profitability, capital structure and the sustainability of corporations in US? Can I trust that the policy-makers understand the complexity and depth of the problem that their bailout packages can revive the system with no medium/ long term fiscal problems? If you have the answers for these you know the state of S&P, dollar and interest rates. 

Trust is an acceptance of other's value and ethics. In the modern world , man and hence society has lost corporate and personal morality. Most people ask me what will turn this crisis around and I wonder maybe when society adheres to Goethe's words

"As soon as you learn to trust yourself, you will know how to live."

Survival of the Unfit

It is not the strongest of the species nor the most intelligent, but the one that's most adaptable to change that survives - Charles Darwin

The 19th century naturalist's statement doesn't apply only to evolution but also to any form of competition. I extend this to corporations and to individual's life in general. Firms that can adapt themselves to evolving global economic scenario and can restructure their business models, will not only be the ones to survive but also generate sustainable risk adjusted returns. 

In this context the bailouts by US government is irrational. One cannot get out of recession by pumping money into every unfit corporation. If its that simple, every society across history would have printed away to prosperity. US government crystalizes the essence of american consumerism - "Borrow money that we don't have to spend on things we don't need". They are expanding the liabilities on their balance sheet, against assets they don't have; to bailout unfit corporations the economy and society don't need. Irving Fisher and notable economists would argue that quantitative easing and bailouts prevent a rise in deflation, a catalyst in the great depression of 1930s. But by solving one problem they create another one. Ultimately it is the US government bond holder who will feel the pinch, either through rates or through fx or both. Pimco in their recent investment outlook have also substantiated this viewpoint. 

Warren Buffet's adage that when the tide runs out we know who has been swimming naked has never been more true. Madoff's ponzi scandal is an instance in point. Trading and investing is a zero-sum game; somebody wins and somebody has to lose. The ponzi scheme also substantiates my point in the previous article on how regulations and growth in society are orthogonal.  The question I ask myself is what has happened to corporate ethics and righteousness. In the light of Enron scandal, corporations seems to have learned what could be done but not what should not be done. Its ironic that the Indian software firm that was involved in fraudulent accounting was named Satyam, which stands for truth in Sanskrit. I believe there are more rats under the carpet and I hope the regulators become more watchful. I would like to highlight two particular cases that caught my eye. 

Firstly, the accuracy of the important economic data is under the microscope. The revisions to previous non-farm payrolls numbers have been massive in the last few months. The original release of true numbers would have caused massive disruptions as the market would have realized the depth of the problem. Are the government and policy makers tweaking the numbers to portray a diluted picture of the problem? Many would recollect Bill Gross questioning the validity of the CPI numbers in the summer of 08. Secondly, the nature of profitability of some hedge funds raises my eyebrow. Renaissance's flagship medallion fund open only to employees returned 58% while the funds open to investors are down 20%. I don't need a Kalman filtered momentum based diffusion model to tell me that it smells fishy. In my opinion when market turned rough in 2008, all in-the-money trades were classified under medallion while the rest were borne by investors. I might be wrong on both of these cases, but only time will tell.

In 1968 Sevan Schreiber in his book "The American Challenge" foresaw massive increase in productivity that by 2000, society will be working 7 hours a day, 4 days a week with 13 weeks of paid vacation. What went wrong? If anything the current generation is working longer hours than its predecessors ever did. The challenge for mankind is to get this process of increasing productivity restarted. Its tough, long drawn and requires reshaping the mentality of society. You can leverage up in housing or in credit, but as long as technology and productivity doesn't improve the real growth in economy, there will be bubbles. 

Why too many bubbles

Post written on November 11, 2008

The question I have been pondering for a while now is why did we witness 3 bubbles in the last decade. First the tech bubble of late 1990s, followed by the housing bubble and the current credit bubble. A common thread connecting the three apart from excessive leverage and greed, is the lack of value creation. Through out history society has evolved through science, innovation and technology. James Watt invented the steam engine that mobilized transportation and powered the industrial revolution. Global economy benefited as a result. All through the 20th century great inventions fueled the global economy. Inventions like telephone, airplanes, television and automobiles brought the world closer and gave rise to new sectors in economy; creating jobs, increasing productivity and bolstering society. 

Unfortunately cutting edge inventions have not come through the last 30 years with the exception of internet. Education has not kept pace with growth in technology and science; and society tends to identify more with Britney Spears than with Thomas Alva Edison. But money needs to be invested somewhere and investors see mirages (illusionary value). Spotting of water leads to booms, when identified as mirage leads to busts. The amplitude get magnified by excessive leverage.  To further fuel this problem lawmakers who neither understand the problem nor are prompt in addressing issues. Regulations tend to come orthogonal to booms are busts. They are loose when there is a bull market and become over-regulated when there is a bear market. A framework thats meant to fail efficiently. 

Speaking of efficiency, the efficient market theory that we all learnt in school has two critical assumptions; rational expectation of human behavior and de-correlation of major events. Nash states equilibrium is achieved when people do what's best for themselves "in the interest of common good". Human mind fails to apply the latter clause. Had politicians and policy makers followed these principle, the world wouldn't have witnessed many catastrophic events. Failure of Lehman is an instance in point. Even if the holes to plug in the economy were identified, it will not get smoothly and quickly. My concern is that the $850 bln bailout package will not only be inadequate but also will not be wisely spent. 

What we need is a globally coordinated set of monetary and fiscal policies to address the issue. This is a global problem not just an American or European one. In market, look for increased failures in retail and consumer discretionary sector, followed by entertainment and broadcasting companies. Look for even worse labour market numbers and unemployment rate to edge towards double digits by mid 2009. This necessarily does not imply a downward spiral in stock prices. To break the 850 support on S&P, market needs increased failures and contracting financial sector. But in the long term unless sustainable value is created, there will be more bubbles.