equities

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Are Markets Informationally Efficient?

A key assumption in many mainstream macroeconomic models (both formal and informal) is the Efficient Market Hypothesis. Very simply, this is the belief that markets are informationally efficient — that they reflect information with little (or no) delay, leaving few (or no) arbitrage opportunities.

So the real question here is what information do markets (and by markets, I mean free markets where market participants are free to pay and receive any negotiated value for an asset) really reflect? When we see the price of an asset or asset class fluctuating, what does this movement signify? Is it fluctuation in the fundamental value of the asset? Is it just a fluctuation in the market’s perception of an asset? Is it some combination of these two factors? Or is it just random noise? Fundamentally, markets are composed of a series of transactions, each between a bidder and a seller. Each transaction in itself reflects a discrete set of information — specifically, what the bidder and the seller are willing to pay for, and take for that specific asset. This in turn is typically (although not always!) influenced by a some or all of the following: what others are willing to pay and accept for an asset presently, the use-value of an asset, notions of fundamental value (price-over-earnings, stock-to-flow, EBITDA, cashflow, etc), notions of momentum and what others may be willing to pay and accept for an asset in the future (trendlines, gut feelings, “hot stock tips”, etc).

An intriguing addendum to this is that the automation of trading (high-frequency trading) has created bidders and sellers who are acting on the instructions of algorithms. As these instructions are programmed by humans — usually automating some form of technical analysis — the only real difference is that of (extreme) speed. The beliefs reflected in high-frequency trading reflect the underlying algorithmic instructions programmed by the humans who created the algorithm.

Ultimately, whenever we purchase an asset for the purpose of speculation or investment (and even use-value — prices can change, and the price we paid last week or last year could end up looking very expensive, or very cheap) we are taking a guess as to whether the current bid or sell value is worth it. Each agent makes their guess based on a different set of data and expectations. What the prices in markets signify is the operation of this mechanism — different agents evaluating information and making guesses about the future.

Let’s consider the example of Bitcoin, the price of which is currently soaring. Some choose to buy Bitcoins based on momentum, or their liking of the cryptography, or Bitcoin’s inherent deflationary bias or some other positive belief. This is a speculation that the price may continue to climb. Some may choose to buy bitcoins based on their use-value, as an anonymous, decentralised currency that can be used to buy a wide array of things. Holders of Bitcoins may be motivated to sell by the fact that the price has risen since they bought or mined their coins, or by the belief that bitcoin is “in a bubble”, or some other negative belief.

What the market reflects is the net weight of different opinions and resultant human actions. If those who are motivated to buy outweigh those who are motivated to sell, the price  rises and vice versa. This means that the beliefs of big players in a particular market can have strange and disproportionate effects. Consider the effect of the Hunt Brothers’ attempts to coin the silver market in 1980. The price of silver rose from $11 an ounce in September 1979 to almost $50 an ounce in January 1980, as the Hunt Brothers bought more and more. The market was very efficient at reflecting the fact that the Hunt brothers were willing to buy more than the market could supply at lower prices. And once the Hunt Brothers faced margin calls, the market quickly adjusted to reflect the fact that they were now selling instead of buying, and prices fell.

That’s what (transparent) markets are guaranteed to reflect — bidders and sellers, supply and demand. This information is still useful to firms trying to gauge what, and how much to produce.  Everything else — the information that bidders and sellers are acting upon — is not necessarily reflected in market activity. Very often, bidders and sellers are brought to the market by new information regarding a large number of things — price changes, earnings, business decisions, technologies and inventions, macroeconomic data, etc — but there is no systematic or reliable way to predict what humans will respond to, or how they will respond. Human psychology and human action in this sense is totally unstable and nonlinear — consider the recent contrast in market reaction to earnings data from Apple and Google. This instability is an alternative explanation for why consistently beating the market is indeed very difficult, as the Efficient Market Hypothesis implies.

And prices do not even reflect an aggregation of sentiment toward an asset or asset class — they only reflect the sentiment of those who are involved in the market, in proportion to their level of buying and selling activity. This means that the opinions of big players who buy or sell a lot, are reflected many times more than those of small players who buy or sell a little. And irrationality can create a feedback loop — if stock prices are rising, and macroeconomic fundamentals are weak, many market participants may initially be sceptical. Yet as more participants pile into the stock market purely for reasons of sustained upward momentum, more and more participants may begin to suspend their disbelief, if only to not miss out on a profit opportunity. This is one mechanism (of infinitely many) through which price bubbles can form.

Yet accurately reflecting supply and demand is not the same thing as informational efficiency. Empirical data show that arbitrage opportunities are widely exploitable and exploited even in modern markets. One of the largest forms of high frequency trading is of course statistical arbitrage. This reality should probably be a final nail in the coffin of the idea that markets reflect anything more than the actions of bidders and sellers. Unfortunately, very many models rest on the assumption of informational efficiency in markets, meaning that this approach is very unlikely to die out any time soon.

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The New European Serfdom

So let’s assume Greece is going to leave the Eurozone and suffer the consequences of default, exit, capital controls, a deposit freeze, the drachmatization of euro claims, and depreciation.

It’s going to be a painful time for the Greek people. But what about for Greece’s highly-leveraged creditors, who must now bite the bullet of a disorderly default? Surely the ramifications of a Greek exit will be worse for the international financial system?

J.P. Morgan — fresh from putting an LTCM alumnus in charge of a $70 trillion derivatives book (good luck with that) — is upping the fear about Europe and its impact on global finance:

The main direct losses correspond to the €240bn of Greek debt in official hands (EU/IMF), to €130bn of Eurosystem’s exposure to Greece via TARGET2 and a potential loss of around €25bn for European banks. This is the cross-border claims (i.e. not matched by local liabilities) that European banks (mostly French) have on Greece’s public and non-bank private sector. These immediate losses add up to €400bn. This is a big amount but let’s assume that, as several people suggested this week, these immediate/direct losses are manageable. What are the indirect consequences of a Greek exit for the rest?

The wildcard is obviously contagion to Spain or Italy? Could a Greek exit create a capital and deposit flight from Spain and Italy which becomes difficult to contain? It is admittedly true that European policymakers have tried over the past year to convince markets that Greece is a special case and its problems are rather unique. We see little evidence that their efforts have paid off.

The steady selling of Spanish and Italian government bonds by non-domestic investors over the past nine months (€200bn for Italy and €80bn for Spain) suggests that markets see Greece more as a precedent for other peripherals rather than a special case. And it is not only the €800bn of Italian and Spanish government bonds still held by non-domestic investors that are likely at risk. It is also the €500bn of Italian and Spanish bank and corporate bonds and the €300bn of quoted Italian and Spanish shares held by nonresidents. And the numbers balloon if one starts looking beyond portfolio/quoted assets. Of course, the €1.4tr of Italian and €1.6tr of Spanish bank domestic deposits is the elephant in the room which a Greek exit and the introduction of capital controls by Greece has the potential to destabilize.

A multi-trillion € shock — far bigger than the fallout from Lehman — has the potential to trigger a default cascade wherein busted leveraged Greek creditors themselves end up in a fire sale to raise collateral as they struggle to maintain cash flow, and face the prospect of downgrades and margin calls and may themselves default on their obligations, setting off a cascade of illiquidity and default. Very simply, such an event has the potential to dwarf 2008 and 1929, and possibly even bring the entire global financial system to a juddering halt (just as Paulson fear-mongered in 2008).

Which is why I am certain that it will not be allowed to happen, and that J.P. Morgan’s histrionics are just a ponying up toward the next round of crony-“capitalist” bailouts. Here’s the status quo today:

Greece no longer wants to play along with the game?

Okay, fine — cut them out of the equation. In the interests of “long-term financial stability”, let’s stop pretending that we are bailing out Greece and just hand the cash over to the banks.

Schäuble and Merkel might have demanded tough fiscal action from European governments, but they have never questioned the precept that creditors must get their pound of flesh. Merkel has insisted that authorities show that Europe is a “safe place to invest” by avoiding haircuts.

Here’s my expected new normal in Europe:

After all — if the establishment is to be believed — it’s in the interests of “long-term financial stability” that creditors who stupidly bought unrepayable debt don’t get a big haircut like they would in a free market.  And it’s in the interests of “long-term financial stability” that bad companies who made bad decisions don’t go out of business like they would in a free market, but instead become suckling zombies attached to the taxpayer teat. And apparently it is also in the interests of “long-term financial stability” that a broken market and broken system doesn’t liquidate, so that people learn their lesson. Apparently our “long-term financial stability” depends on producing even greater moral hazard by handing more money out to the negligent.

The only real question (beyond whether or not the European public’s patience with shooting off money to banks will snap, as has happened in Greece) is whether or not it will just be the IMF and the EU institutions, or whether Bernanke at the Fed will get involved beyond the inevitable QE3 (please do it Bernanke! I have some crummy equities I want to offload to a greater fool!).

As I asked last month:

Have the 2008 bailouts cemented a new feudal aristocracy of bankers, financiers and too-big-to-fail zombies, alongside a serf class that exists to fund the excesses of the financial and corporate elite?

And will the inevitable 2012-13 bailouts of European finance cement this aristocracy even deeper and wider?

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Treasuries Still Not Cracking

Tyler Durden pointed out yesterday that just three weeks after Goldman made the case for equities relative to bonds, the muppets who had listened to their advice were getting skewered:

I wrote a while back that (unlike some others) I didn’t believe it was likely that  this was going to be a cataclysmic rate spike. Readers who want to detect one need to watch whether sovereign creditors especially Russia and China are selling, and at what pace — the faster the liquidation, the more rates may spike.

Of course, I am still convinced that the real fragility to America’s economy isn’t actually a rate spike or inflation.The Fed has a very good handle on both of these things (but not, perhaps on unwanted side effects. They can effectively do QE without really inflating the currency much; simply shoot the money to primary dealers for treasuries.

When volatility is artificially suppressed, there are always unwanted side effects. And that — the unwanted side effects, not the widely-reported fears of inflation and rate spikes — I believe, is the true danger.

One unwanted side effect could be provoking a damaging trade war with China, from which the West imports so much. That is my pet theory, and one I’ve devoted a few thousand words to over the last few months. But the trouble with side-effects is that it is very hard to tell what the weakest link (i.e. the point that will break) in a volatility-suppressed system is. Tyler Durden reports that systemic financial fragility (as measured by CDS) is at a recent-high, too:

Believers in technical analysis (I am very sceptical) are pointing to a head-and-shoulders top in the “recovery” (to go with the bigger head and shoulders top that is very much one of the stories of the last ten years):

I don’t know when the black swans will come home to roost and the strange creature that we call the present global economic order will go ka-put. I don’t even know if they ever will! But I see the fragilities caused by central planners suppressing the system’s natural volatility.

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Get Bullish, Muppets!

Sounds like Goldman has some equities (AAPL?) to dump on its muppet clients.

From Business Insider:

Goldman portfolio strategists Peter Oppenheimer and Matthieu Walterspiler are out with a doozy of report, basically presenting a big bullish case for stocks, relative to bonds.

From Goldman:

In 1956, George Ross Goobey, the general manager of the Imperial Tobacco pension fund in the UK made a controversial speech to the Association of Superannuation and Pension Funds (ASPF) arguing the merits of investing in equities to generate inflation linked growth for pension funds.  He became famous for allocating the entirety of the funds investments to equities, a move that is often associated with the start of the so-called ‘cult of the equity’.

Prior to this, equities were largely seen as volatile assets that achieved lower risk adjusted returns than government bonds and, consequently, required a higher yield. As more institutions warmed to the idea of shifting funds into equities, partly as a hedge against inflation, the yield on equities declined and the so-called ‘reverse yield gap’ was born. This refers to the fall in dividend yields to below government bond yields; a pattern that has continued, in most developed economies, until recently.

In his speech to the ASPF, Ross Goobey talked about the long-run historical evidence that the ex-post equity risk premium was positive and that investors ignored this at their own peril.

The long-run performance of equities was much greater than for bonds having adjusted for inflation. As he said: ‘I know that people will say: ‘Well, things are never going to be the same again’, but … it has happened again, and again. I say to you that my views are that it is still going to happen yet again even though it may not be the steep rises which we have had in the past.’ Over the 50 years that followed Mr. Ross Goobey’s pitch, his predictions proved very successful. The annualized real return to US equities (as a proxy)  between 1956 and 2000 were 7.4%.

But things have changed since the start of this century and the collapse of equity markets following the bursting of the technology bubble. In this post bubble world valuations fell from unrealistically high levels. But the decline of equity markets continued well after most equity markets returned to more ‘normal’ valuations. The onset of the credit crunch, and the deleveraging of balance sheets in many developed economies that followed this have punctured the confidence that once surrounded equities, and the pre-1960s skepticism about equity returns has returned. Dividend yields are once again above bond yields and both historical, and expected future returns have collapsed.

That’s right muppets, time to get bullish and hoover up all the equities we want to offload! This is a once in a generation opportunity to own equities!

Or not. Let’s just say that prices aren’t exactly being supported by a surge in manufacturing:

That’s right: manufacturing is just about where it was at the turn of the millennium, and unsurprisingly so is the S&P.

However there is a sliver of a superficial hint that the muppet masters may be right.

Here’s the S&P500 priced in gold:


Looks cheap next to where we were ten years ago. But in the long run I don’t really think where we were ten years ago tells us much about the fundamentals; it tells us more about Greenspan’s propensity to grease markets with shitloads of liquidity and watch stocks soar. The deeper I dig into the data, the more I tend to conclude that we really need to throw all recent historical trends out of the window.

Here’s a choice data set:


Does that look like a normal recovery? It looks like a complete paradigm shift to me. I’ve already covered my underlying reasons for believing that we live in unprecedented times. But this chart from Zero Hedge speaks as much as anything else:


So, if you have money to burn and a gullible nature go ahead and throw your money at the muppet masters. In the long run, equities and other productive assets have proven themselves superior to any other asset class, because they tend to produce a tangible return.

But right now? The real problem is that the global economic system is a mesh of interconnected fragility where one failed party can take the entire system down. Well run companies can be dragged down by badly-run counter-parties, and badly run companies can just be bailed out, totally obliterating the market mechanism. This is not an environment conducive to organic growth. It’s a cancerous environment, juiced up on (priced in) central bank interventions. It is the very definition of iatrogenesis: when “medicine” causes deeper and worse sickness.

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Is it Always a Good Time to Own Gold?

Is it always a good time to own gold?

Absolutely not. A portfolio in the S&P 500 or Treasuries in 1973 has returned a much higher rate than gold bought that year — even if gold raced ahead up ’til 1980, and is racing ahead again now. We know that throughout history gold has sustained its purchasing power, and fiat currency has lost its purchasing power. But we also know that stocks have grown their purchasing power.

But gold continues to rise — so what makes gold different right now? Well, from a technical perspective, America and the West are in a secular bear market:

But a technical perspective doesn’t really give enough political and economic background to explain why we are where we are.

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