It seems as if “Macro” forces are dominating movements in the financial markets these days. The latest call to attention of this fact is the article by Tom Lauricella and Gregory Zuckerman on the front page of the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704190704575489743387052652.html?mod=wsjproe_hps_TopLeftWhatsNews). The “big” picture appears to be driving things and not the performance of individual investment opportunities.
Specific attention is given to a statistic called “correlation” which measures “the tendency of investments to move together in a consistent way.”
The article reports that in the 2000-2006 period the correlation of stocks in the Standard & Poor’s 500 Index was 27%, on average. However, during the events that led up to the Iraq war, correlations were near 60%. At the height of the financial crisis, October 2008 to February 2009, correlations were around 80%. They were around 80% during the sovereign debt dislocations in Europe earlier this year. In mid-August correlations dropped to 74% and now reside in the 65%-70% range.
When the prices of many or most stocks move together, individual stock picking is not the optimal investment strategy. This is why many investors have been moving to mutual funds that focus more on “macro” issues rather than on individual companies.
One of the most interesting statements in the article was this: “Prior to the financial crisis, such high correlation levels were seen previously only during the Great Depression, according to data compiled by market-strategy firm Empirical Research Partners.”
I pick up on this statement because of my belief that we are going through a tremendous period of transition. The world is changing. And, it is changing in ways that we don’t fully comprehend. As a consequence, individual “bets” are extremely risky, much more risky than “bets” that tend to aggregate outcomes.
The period of the Great Depression represented another period of major transition. During the Great Recession of the 2000s people were constantly referring back to the 1930s for “lessons learned” with respect to monetary and fiscal policies that could be applied to the current situation so as to avoid falling into as deep a hole as occurred at the earlier time.
However, the major lesson we may have to learn from the era of the Great Depression is that economies have to go through transition periods as they move from one kind of societal structure to another. In many ways, the American economy, and much of the rest of the developed world, still operated on an agricultural foundation in the 1920s. Yes, the industrial base was developing, labor unions were coming into existence, and cities were coming to dominate the rural areas but, in many ways, agriculture still dominated economic policy making.
The government in the United States supported and subsidized the agriculture sector in a way that was unsustainable relative to the emerging industrial cities. When this unsustainable effort collapsed, the economy fell apart and the 1930s through the 1940s saw America restructure from a rural society to one where prosperity resided in the cities and suburbs.
During this transition, it was not easy to pick out winning investments because no one really knew what the future was going to look like. Thus, the correlations of stock prices were high because success depended more upon how the whole economy re-structured and, consequently, how the whole economy recovered.
I believe that there are strong parallels in this respect between the current situation and that which existed in the 1930s.
Whereas America supported the farms and farmers in an earlier age because farming was “the American Way,” in the post-World War II period America supported owning a home in or near cities because it was believed that owning a home was, more or less, the right of all Americans.
Now, something else is happening. The industrial base in the United States is deteriorating, capacity utilization is around 75%, underemployment of individuals of working age is around 25%, and income inequality has become quite large. Labor unions are becoming like the dinosaurs, their species is dying. Center cities do not seem to be the wave of the future as they once were seen. And, home ownership for everyone may not fit into the future of society.
The United States government supported and subsidized the housing industry for fifty years, putting GIs into homes after World War II, financing the suburbs, rehabbing the cities, and so forth. Well, the bubble burst, just like it did for the agricultural sector.
What’s next?
That’s the interesting thing about transitions…you never know exactly where they are going to end up.
There are lots of changes taking place. Before the 1930s, the Industrial Age began: the late 19th century was just the spectacular beginning although agricultural still dominated the scene. The late 20th century saw the beginnings of an Information Age even as the cities and industrial concerns remained in the headlines.
What will an Information Age look like? That is still up to the science fiction writers.
What I am sure of is that information will continue to spread and cause changes worldwide that we cannot even imagine at this point in time. Information markets are going to become ubiquitous and innovation with respect to “Information Goods” is going to extend far beyond the field of finance.
But, there are other changes taking place that are going to “rock” the world. One of these is the political makeup of the world. There is the rise of China and the other BRIC nations. Power collected in the G-7 has been transferred to the G-20. The IMF is changing and will have to change a lot more, moving from European and American dominance to include greater roles for South America and Africa. These changes are going to have massive impacts on the way things are going to get done.
Furthermore, the emerging markets seem to be the place to invest these days. The economies of the United States and western Europe are the sluggards as they go through their needed transitions. These emerging nations are now dealing with one another because the allocation of commodities in the world is crucial for the continued progress of these areas. All these movements are “macro” in nature.
As the transition takes place, the “old” is not going to work in the way it used to. Stock investing will be different, at least for a while. The “old” political philosophies are not going to be very effective as we are finding out in the United States and in western Europe. But, this is a part of the whole process. We must adjust and find out what works and what doesn’t work.
Those that try to force things back into the “old” boxes are not going to survive!
Showing posts with label subprime mortgages. Show all posts
Showing posts with label subprime mortgages. Show all posts
Friday, September 24, 2010
Monday, April 26, 2010
E-Mails, Investment Banking, and the Rating Agencies
Thank goodness for emails! Now we know what was really going on at Goldman Sachs and Moody’s and Standard & Poor’s. How about Congress including in their bill on financial reform the requirement that all financial institutions and rating agencies and all other organizations having to do with finance (say the Federal Reserve and the Treasury and Fannie Mae and Freddie Mac…and Congress…and the White House) release all of their e-mails a week after they were written.
This would really provide the financial markets with transparency!
The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.
Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” (http://www.ft.com/cms/s/0/a9da1aa4-508b-11df-bc86-00144feab49a.html). Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”
But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.
The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (http://online.wsj.com/article/SB20001424052748703441404575206400921118356.html#mod=todays_us_money_and_investing.)
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)
This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”
To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!
Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”
And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”
“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.
But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.
And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”
She concludes: “what is needed is systemic reform that removes conflicts of interest.”
This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.
The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.
As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.
So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”
But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”
And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.
Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.
I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”
Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.
This would really provide the financial markets with transparency!
The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.
Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” (http://www.ft.com/cms/s/0/a9da1aa4-508b-11df-bc86-00144feab49a.html). Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”
But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.
The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (http://online.wsj.com/article/SB20001424052748703441404575206400921118356.html#mod=todays_us_money_and_investing.)
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)
This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”
To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!
Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”
And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”
“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.
But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.
And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”
She concludes: “what is needed is systemic reform that removes conflicts of interest.”
This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.
The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.
As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.
So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”
But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”
And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.
Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.
I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”
Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.
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