Monthly Archives: July 2015

Systemic Risk

From Jared Dillian:

The reality is that when you have someone in a privileged position where they can see order flow and position themselves accordingly, they will surely take advantage of it—human or computer. For a number of reasons, I’d rather have the computers.

Except for this: the problem with the current system where a few large firms, electronic trading firms, act as liquidity providers is that they actually centralize, rather than decentralize, risk.

They take small risk (a bunch of little orders) and turn it into big, concentrated risk. Now, electronic trading firms are not in the business of taking big risk—they are in and out of it very quickly, so it’s unlikely that they’d willingly strap on a big position. But a few years back, Knight Capital had a catastrophic trading error that resulted in them having to be bailed out by a group of independent investors.

What if that happens again—even bigger?

It’s actually a general principle that things work better when you break them down as small as possible. This is the principle the United States is founded on—that states and municipalities retain political control.

Problem is, we’ve been concentrating risk everywhere since the financial crisis. I don’t care who you think was responsible for the crisis, the net result of our interventions is that the banks that were too big to fail in the first place are now even bigger. I don’t think that’s progress. I don’t think it’s progress that if anything goes wrong, we put it on the government’s balance sheet.

If I were in a position of authority in the government, I’d spend my time looking for ways to break down risk to the smallest unit possible.

But that’s not what we’re doing. We’re going around looking at things like mutual-fund companies and calling them SIFIs (Systemically Important Financial Institutions) and then regulating them, which will only make them more systemically important. Dumb, right?

What are the chances that we are going to have another big crisis as a result of this? 100%.

It’s not just anti-capitalist, that is, cronyism, to set up certain companies to be SIFI, but it’s also a path to more, not less, pain.

Add this together with previous posts on market drops and debt, and market price momentum, and an argument can be made for a economic perfect storm.

 

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Price Momentum

This is why momentum investing works.  And it is self reinforcing.  From Tom Brakke:

Machines ~ While there are quantitative strategies of all kinds, many are driven by what’s worked and what’s working.  The absolute price levels of the market or of a security are of little concern; it is their movements that matter.  And, yes, the machines might even trigger actions themselves with some “momentum ignition” if that has proven to be successful in the past.

Momentum players ~ Wherever the spark of momentum comes from, there are large numbers of momentum traders/investors in the market.  As confirmed by academic analyses and supported by sociological observations, price momentum is a powerful force and it drives behavior by lay and professional players alike.  Some forthrightly state momentum as their strategy, while others practice it under cover of a more marketable philosophy.

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Stock market crashes and Debt

From the Economist:

WHEN Chinese shares plunged earlier this month, the government tried frantically to limit the damage. It pumped cash into the market, capped short-selling and ordered share buy-backs. Although China was unusually heavy-handed, it was hardly the first country to try to bolster stock prices for fear of the economic harm a crash could bring. Alan Greenspan, as chairman of the Federal Reserve, famously created the “Greenspan put” by giving investors the impression he would cut interest rates to stop stockmarket routs.

The underlying rationale for these interventions is an idea that until recently received surprisingly little scrutiny—namely, that stockmarket busts are very damaging for the economy. The link seems clear enough in the case of the crash of 1929, which led in short order to the Depression. But it is also easy to point to contrary examples. The bursting of America’s dotcom bubble in 2000 wiped out $5 trillion in market value, equivalent to half of GDP. Yet it was followed by a shallow recession.

Not all bubbles, it would appear, are equally bad. According to two new papers*, the crucial variable that separates relatively harmless frenzies from disastrous ones is debt. In many cases, though certainly not all, stockmarket manias fall into the less worrying category.

This makes tons of sense.  What is worrying now?  We know the stock market is toppy, bubbly, frothy, overvalued, overbought, whatever you want to call it.  Henry Blodget may not be a market participant, or respected, but he has compiled some very good research showing how overvalued the US market currently is, via David Stockman.

What about current debt levels in the US?  Here’s inflation adjusted total debt and consumer debt.  Looks like we have recovered from the last debt bubble, by any measure:

fredgraph debt

 

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GE goes into battery storage

This hurt Tesla’s stock price.  Did people think no one else would enter the market?  Although it’s tough to compete with a company that has a direct line to the president, and pays negative taxes.  From Reuters:

General Electric Co (GE.N) wants to be a “sizable” player in the market for systems that store energy to manage power volatility, a sector the company expects to quadruple to $6 billion by 2020, the head of GE’s energy storage business told Reuters.

Demand for industrial battery systems is being driven by increasing reliance on intermittent energy sources such as wind and solar power and the potential to add energy to the grid quickly when power needs spike.

This need has attracted a wide range of companies, including Elon Musk’s Tesla Motors Inc (TSLA.O), which said in April it plans to package batteries for use for utilities as well as homes and businesses.

“We believe in the space and its ability to grow,” Jeff Wyatt, GE’s general manager for energy storage, said in a recent interview. “We think we can be a sizable player within it, and that’s really what we’re intending to do.”

GE over the past year has overhauled its approach to the energy storage market, as it saw weaker demand for the battery it developed.

Now Fairfield, Connecticut-based GE is repositioning itself as a one-stop shop for power producers seeking to install energy storage systems, offering inverters, control systems, software as well as financing options.

Earlier this year, it scaled back production of its own Durathon industrial batteries, reducing its manufacturing workforce from 200 to 50 at the Schenectady, New York plant where the battery is made. The company is focused on improving Durathon’s longevity, including managing its chemical degradation.

As part of its new energy storage package, GE is offering customers the option to install lithium-ion batteries made by other companies.

 

This is great news.  GE would not get into a business that doesn’t have a BIG future.

 

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US Home Ownership Rate 2015Q2

From Doug Short.  I’m not sure of the entire meaning of this, but I think it speaks to income inequality as well as wealth inequality.  As a data point, not as a value judgment.

Home-Ownership-Rate

 

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Henry Blodget on Equities

From David Stockman, Henry Blodget talks the current overvaluation of the stock market, with awesome references to Shiller, Doug Short, and Hussman.  But the part that is really valuable is his current asset allocation:

In February, I changed the “dividend reinvestment” policy on my S&P 500 fund. (I’m an indexer — I think stock-picking is generally a lousy strategy for individuals.) Specifically, I stopped reinvesting dividends.

I’m a long-term investor, so I don’t really care what stocks do next. This dividend change was a bet that, at some point in the future, I will be able to reinvest the cash from these dividends in stocks at lower prices than today. If stock prices never fall below today’s level, this will cost me money. It will also make me feel dumb for (sort of) trying to time the market.

But at some point you’ve got to put some money behind what your analysis is telling you.

What my analysis is telling me is:

1) stocks are extremely expensive and will eventually revert toward historical means, probably via a sharp correction of 30% to 50%

2) long-term stock returns from today’s level will be about 2% per year — nothing to write home about

So if I think there’s risk of a crash, why don’t I just sell everything? For the reasons outlined below. Again, I don’t care if the stocks I own tank, as long as they don’t tank permanently. A crash will just give me a chance to buy more at lower prices.

Why I think long-term stock returns will be lousy from here

I have no idea what the market will do over the near term. But there are two reasons I think long-term stock performance will be lousy:

  • Stocks are very expensive on almost all historically predictive measures
  • The Fed is tightening (or will be soon)

Below, I’ll discuss those concerns one at a time.

Before I do, though, a quick note: Sometimes people are confused by me still owning stocks while getting increasingly worried about a sharp price decline. So here’s why I don’t sell:

  1. I’m a long-term investor (horizon of 10-plus years);
  2. I’m a taxable investor, which means that if I sell now, I have to pay taxes on gains;
  3. I don’t know for sure what the market will do (no one knows for sure, and the bulls might be right);
  4. I think timing the market is a dumb strategy;
  5. I’m mentally prepared for a sharp decline (I won’t get spooked into selling if stocks crash — on the contrary, I’ll buy more);
  6. I think stocks will eventually recover from a crash; and
  7. There’s nothing else that looks cheap to invest in (every other major asset class is also priced so high that they’ll all most likely deliver lousy returns)

Yes, if stocks drop 50%, and then we enter a Japan-like scenario in which they continue to drop for two decades, I’ll feel like an idiot (and poor). But otherwise, I’m OK with sharp price declines. I’m a long-term bull on capitalism and the USA. And crashes create the opportunity to buy stocks with much higher likely future returns.

 

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Improve Your Life

From Eric Barker, another great post:  (even if it has a clickbait title)

The Lazy Way To An Awesome Life: 3 Secrets Backed By Research

Nicholas Christakis, MD, PhD, MPH, is a professor at Yale University and directs the Human Nature Lab there. He is the author (with James Fowler) of Connected: The Surprising Power of Our Social Networks and How They Shape Our Lives. (Here’s his TED talk.)

Tons of research (and common sense) shows that the people around you influence your behavior. In fact, they influence it a lot more than you might think and probably more than you’re comfortable with admitting.

But here’s the really crazy part: not only do your friends affect your behavior, so do their friends. And their friends’ friends. Here’s Nicholas:

Across many different kinds of behavior: voting, cooperation, smoking, weight loss and weight gain, happiness, cooperative behavior, public health behaviors, we and others have been able to show that people are very meaningfully affected by the behaviors of other people to whom they’re connected. And here’s the kicker: they are also affected by the behaviors of people to whom they’re not directly connected. When your friend’s friends quit smoking or your friend’s friends friend become nicer and more cooperative, this ripples through the network and affects you. Similarly, when you make a positive change in your life, when you start running for example, or you participate in our democracy and you vote, it ripples outward from you and can affect dozens, hundreds, perhaps even thousands of other people.
So if you spend time with different people, could you become a different person?

Want the laziest way to improve your life? The prescription is simple…

1) Hang Around The People You Want To Be

The Longevity Project, which studied over 1000 people from youth to death had this to say:

The groups you associate with often determine the type of person you become. For people who want improved health, association with other healthy people is usually the strongest and most direct path of change.
In Charles Duhigg’s excellent book The Power of Habit: Why We Do What We Do in Life and Business:

In a 1994 Harvard study that examined people who had radically changed their lives, for instance, researchers found that some people had remade their habits after a personal tragedy… Just as frequently, however, there was no tragedy that preceded people’s transformations. Rather, they changed because they were embedded in social groups that made change easier… When people join groups where change seems possible, the potential for that change to occur becomes more real.
Many researchers I have spoken to, from Duke’s Dan Ariely to Cornell’s Brian Wansink, have emphasized context as the most powerful (and most ignored) catalyst for changing your life.

But what if you’re not even trying to make big changes in your life? What if you just want to be treated well? Turns out altruism and jerk-itude also move through networks. Here’s Nicholas:

We’ve shown that altruistic behavior ripples through networks and so does meanness. Networks will magnify whatever they are seeded with. They will magnify Ebola and fascism and unhappiness and violence, but also they will magnify love and altruism and happiness and information.
And the workplace isn’t much different. Behavior is contagious there, too.

Via The 100 Simple Secrets of Successful People:

Psychologists have observed that bad habits can spread through an office like a contagious disease. Employees tend to mirror the bad behaviors of their co-workers, with factors as diverse as low morale, poor working habits, and theft from the employer all rising based on the negative behavior of peers. – Greene 1999
When I spoke to Stanford GSB professor Bob Sutton, he told me his #1 piece of advice to students was this:

When you take a job take a long look at the people you’re going to be working with — because the odds are you’re going to become like them, they are not going to become like you.
(For more on how to get people to like you, from an FBI behavior expert, click here.)

So the people around you can unconsciously affect your behavior in many ways — positive and negative. Let’s focus on one thing we’re all interested in: happiness. Because this is where it gets really interesting…

2) Making Friends = Making Happiness

Would an extra $10,000 dollars a year make you happier? I’ll assume you’re nodding. Research shows 10K only provides a 2% increased chance of happiness.

Meanwhile, being surrounded by happy friends make you 15% more likely to be happy.

Even if a friend of a friend of a friend becomes happier, that means a 6% chance you will become happier.

So the happiness of people you have never met — and may never meet — is three times as powerful as money.

Via Connected: The Surprising Power of Our Social Networks and How They Shape Our Lives:

An extra $5,000 in 1984 dollars (which corresponds to about $10,000 in 2009 dollars) was associated with only a 2 percent increased chance of a person being happy. So, having happy friends and relatives appears to be a more effective predictor of happiness than earning more money. And the amazing thing is that even people who are three degrees removed from you, whom you may have never met, can have a stronger impact on your personal happiness than a wad of hundreds in your pocket.
A happy friend increases the likelihood of you being happy by 9%. An unhappy friend means a 7% decrease.

You don’t need a degree in accounting to figure out what that means: overall, more friends = more happiness.

Spending time making friends has a higher happiness ROI than time spent making money. So next time you meet up with a happy pal, ask them to bring a friend. Even a lazy person can manage that.

Via Connected: The Surprising Power of Our Social Networks and How They Shape Our Lives:

We found that each happy friend a person has increases that person’s probability of being happy by about 9 percent. Each unhappy friend decreases it by 7 percent. So if you were simply playing the averages, and you didn’t know anything about the emotional state of a new person you just met, you would probably want to be friends with her. She might make you unhappy, but there is a better chance she will make you happy. This helps to explain why past researchers have found an association between happiness and the number of friends and family.
Here’s the really interesting part: you can totally rig the system. It’s the scientific version of karma.

With the effect spanning three degrees, there’s a good chance making a small effort to make friends happier will flow back to you.

Nicholas found that if a friend became happy in the past six months there’s a 45% chance your happiness will increase.

(For more on what you can learn from the happiest people in the world, click here.)

So, lazy bones, are you willing to send a couple emails or texts to dramatically increase your happiness? Here’s how.

3) Introduce Friends To Friends

Unsurprisingly, people at the periphery of a network have fewer friends and are more likely to be lonely.

And yes, that loneliness can flow back three degrees to you. (And no, you can’t easily track these people down and kick them out of your network.) Know what you can do? Introduce your friends to each other.

Again, happy friends means a 9% gain, unhappy friend means a 7% loss. All other things being equal, I’ll take those odds in Vegas any day. This strengthens the network, and increases everyone’s chance of staying happy.

Via Connected: The Surprising Power of Our Social Networks and How They Shape Our Lives:

At the periphery, people have fewer friends; this makes them lonely, but this also tends to drive them to cut the few ties that they have left. But before they do, they may infect their friends with the same feeling of loneliness, starting the cycle anew. These reinforcing effects mean that our social fabric can fray at the edges, like a strand of yarn that comes loose from the sleeve of a sweater. If we are concerned about combating the feeling of loneliness in our society, we should aggressively target the people at the periphery with interventions to repair their social networks. By helping them, we can create a protective barrier against loneliness that will keep the whole network from unraveling.
(To learn the 4 most common relationship problems — and how to fix them, click here.)

So a few tiny efforts can yield massive positive change in your life. Let’s round up the details and learn two other fascinating tidbits that can change the way you see the world — and make that world a better place.

Sum Up

Here’s what we can learn from Nicholas:

  • Hang out with the people you want to be: Behaviors spread like a virus. Make sure it’s one you want to be infected with.
  • Make more friends. Time spent making friends has a higher happiness ROI than time spent making money.
  • Introduce friends to friends. Friends becoming happy increases your chance of happiness by 45%. Keeping the network happy protects you against unhappiness.

Other research Nicholas did turned up something truly heartwarming: friends are family. Quite literally. Here’s Nicholas:

We looked at the genetic similarity between friends and we found that on a very deep level you resemble your friends genetically. What this means is that, basically, your friends are kin that you choose. What we found in one of our papers was that, roughly speaking, your friends are something like your fourth cousin.
And one last thing: keep in mind that Nicholas’ research also gives you great power. And, as all good Spider-Man fans know, with “great power comes great responsibility.” Here’s Nicholas:

It’s very important for people to understand that when they make a positive change in their lives it doesn’t just affect them. It affects everyone they know and many of the people that those people know and many of the people that those people in turn know. If you make a positive change in your life it actually ripples through the social fabric and comes to benefit many other people. This recognition that we are all connected and that in our connectedness we affect each other’s lives I think is a very fundamental and moving observation of our humanity.
When you make a positive change in your life, it affects the people around you and ripples out to others.

So you can be lazy and see benefits by surrounding yourself with great people — but you can also choose to make strides in your life, even small ones, and contagiously pass those benefits to those you care about.

Making yourself a better person isn’t a gift you only give to yourself. It’s a gift you give to the world.

Spread the happiness virus! Share this with friends (and friends of friends, and friends of… you get it.)

The part in there about choosing your work wisely really cannot be overstated.

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