Rogue Traders, Rogue Central Bankers and now – Rogue Algorithms

 

By Bob Hoye

 

SIGNS OF THE TIMES:

"GM Ramps Up Risky Subprime Auto Loans to Drive sales"

– Investors.com, July 27

Electrifying concept!

 

INTERESTING NUMBERS:

 

In 1962, 6 percent of Americans were on welfare. Now it is 35 percent, or more than 100 million people. Many of whom vote. Some 9 million are receiving federal disability payments, which is up from 5 million in 2001.

 

"An Intriguing Idea to Encourage Bank Lending"

– Wall Street Journal, July 30

 

This was an idea promoted by Prof. Alan Blinder at Princeton. An ardent interventionist, he was instrumental in the "Cash for Clunkers" fiasco of summer, 2009. This is minor compared to the late 1980s when he was one of the top-selling authors of economics text books.

 

As socialism/communism was being marked "failure" by Eastern Europeans his1988 textbook asked "The real question is not whether we want elements of socialism or planning to abridge our personal freedoms, but by how much?".

 

This is from a Special Discussion of September 1, 1991 and it is attached.

 

The main story from Blinder's notion is that banks are not lending enough – according to those who have personal ideas about controlling the lives of other people.

 

"$100 Million! The Most Expensive Apartment in the Country Hits the Market"

"The super luxury market has been red-hot in the last few months."

– New York Daily News, July 30

 

*   *   *   *   *

 

PERSPECTIVE

 

Out here in Vancouver – the home of the old and notorious Vancouver Stock Exchange – we have directly watched and took advantage of High Frequency Trading. One of our favourite exploration companies closed Tuesday at 2.13.  Opening at 2.12 yesterday, it ticked up to 2.14 and plunged to 1.81 in the first ninety seconds (repeat seconds) of trade. That was on 1,000 individual trades amounting to a little over 100,000 shares. Recent daily volume on NY has been around 40,000 shares on 25 trades.

 

At day's end, the volume was 6.5 million on NY and Toronto, with over 40,000 trades. Wild! The high was 2.16 and the close was 1.90.

 

No matter how reckless the promoters were back in the day, nothing close to this week's absurdity could ever have happened. It had to be written up in these pages.

Of course, this was part of the Knight Capital trading disaster and Forbes at 1:44 NY time wrote "Bears Claw Into Knight Capital after Bizarro Trades".

 

The inmates have really taken over the institution and it will be interesting to see what they can do next.

 

The other excitement for the day started at 2 PM when the DX jumped from 82.7 to 83.1 in less than an hour. Our first thought was that perhaps Bernanke had missed the big Fed pronouncements, but sadly he made them. We have yet to figure out what he said.

 

CREDIT MARKETS

 

Other than disruptions from disastrous news from Europe, U.S. credit markets remain complacent to enthusiastic. Actually the action in corporates (LQD) has been outstanding – outstanding enough to register technical readings only found at important tops. Our price target has been the 122 level and today it's reached 121.

 

Close enough to say it is time to start taking money off the gambling table that the bond markets have become.

 

The technical peak in corporates follows the "Eiffel Tower" peak on long-dated treasuries.  Up one side and eventually down the other.

 

It seems that the reach for yield is throwing cash and caution out the window. This shows in emerging market bond funds. Part of the buy recommendation is that such countries have a growing middle class with funds to invest. JP Morgan's emerging bond fund ETF is one example and is yielding around 4.5%. The EMB chart (follows) is becoming overbought. Also, important highs have shown a common pattern as the RSI sets a negative divergence.

 

With Wall Street back to "bundling" sup-prime stuff, it is worth reviewing a reliable indicator of the transition from good times to the opposite. The sub-prime mortgage bond we monitor (AAA.6-2) gave us confirmation of the pending high for stocks and commodities in the spring. It is working on a similar top right now and with today's recklessness higher prices have been accomplished. The chart follows.

 

After some relief, Spanish bonds are again increasing in yield. The break to new highs will be devastating to financial markets and to the central banking crowd. The latter have been working very hard to prevent or limit bad things.

 

One of the features of a great post-bubble contraction is that the recession starts with the first crash. Recessions are severe and recoveries are weak and in our example the first business cycle out the crash is ending.

 

Earnings and tax receipts so essential to servicing debt are again diminishing.

 

KNIGHT CAPITAL FIASCO

 

The company is probably seriously impaired and while the cause of their disaster may be unique.  Although small, we should view it as a possible insolvency. Within a likely peak in speculative urges this is could be a classic warning.

 

Recent stock action is interesting. On July 18 KCG plunged from 11.75 to 10.25 as trading volume jumped from a typical 1 million to over 4 million shares.

 

At 2.70 the action has taken out the low of 3.47 set in 2002.

 

CURRENCIES

 

Today's swing in the DX from 82.1 (four-week low) to 83.5 is impressive and working an outside reversal – to the upside. This is appropriate for another crisis, and Levente notes that the ECB was "fooling" around in foreign exchange markets overnight.

 

Last Thursday's ChartWorks noted that technically the dollar was poised for further weakness. This is still in the chart and the jump in the DX seems mainly due to Spain and KCG.

 

 BOB HOYE,   INSTITUTIONAL ADVISORS

E-MAIL  bhoye.institutionaladvisors@telus.net

WEBSITE:   www.institutionaladvisors.com

 

 

 

Sub-Prime Mortgage Bond AAA.06-2

 

  

 

Emerging Markets Bond Fund

 

 

  • Make note that when priced with dividends the 50-week moving average (109.99 has been a good support.

 

BOB HOYE

PUBLISHED BY INSTITUTIONAL ADVISORS

SPECIAL DISCUSSION

MAINSTREAM ECONOMICS & POLITICAL CHANGE

(First published September 1, 1991)

 

There is a political cycle associated with the price cycle.  During the long period of rising prices, the political direction of society is towards the collective, each country, in its own way and to its own degree.  As prices stop rising, the political tone begins to change from collective initiative back to individual initiative.  Other descriptive terms would include left to right, Liberal to Conservation, Stalinist to Perestroika, and Democrat to Republican.

 

The irony in the recent conclusion that Communism has failed is that Lenin concluded as much in 1921 when, after 3 years of crashing failure, Communism as a system was abandoned for Socialism and, ultimately, a police state.  Beyond this, Lenin's change in 1921 was from left to right following 25 years of rising global prices and increasingly collective forces.

 

In the United States, as prices rose to 1920, politics went generally to the left as progressivism flourished and, within that, there was a seething radical movement in universities, press, and trade unions.  John Moody, eminently a market observer, wrote in 1928 about the previous political era:  "A large part of the period was checkered with radical antitrust legislation; socialistic ideas were rampant in all directions.  It was a period of the 'trustbuster', the muckraker, and the 'undesirable citizen'".

He continued by noting some of the changes since then.  "Our own experiment in government operation of the railways had gone far to blight the growing propaganda in favour of public ownership and operation.  No longer were the people agitated by the pre-war political issues of tariff, antimonopoly, and 'trustbusting'; labor was no longer aggressively urging socialistic legislation; the League of Nations issue and 'Wilson Policies' had been pushed aside by the return of the Republicans in 1920." .

 

We have documented similar political change at each of the ends of rising price periods in modern history.   For example, the 1560 financial crisis was associated with the end of the tyrannical, authoritarian, and Catholic party, as represented by "Bloody" Mary.  With Elizabeth, the party was Protestant, less authoritarian and more freedom was a very popular concept.

 

As mainstream economists through most of this century have used government to implement a lot of notions that can best be described as financial adventurism, they have maintained a high regard for central planning.   Political and economic conditions are quickly changing everywhere except Academe.

 

This is made evident in an essay by Tom Bethell in the October 13, 1989 edition of the National Review, which follows:

 

Socialism by the Textbook

 

"Our best-selling economics textbooks still treat socialism as the ideal system, Communism as its imperfect-but-ever-improving embodiment."

 

For decades, the best-selling economics textbook was Nobel Price-winner Paul A. Samuelson's Economics, now in its 13th edition and co-authored by William D. Nordhaus of Yale.  In all editions it has sold over three million copies.  Perhaps more than any other book, Samuelson's has promoted the Keynesian view that there is an abstract entity called "the economy", which will provide people with jobs if it is fine-tuned, its pump primed, and the "aggregate demand" flowing through its metaphorical pipes suitably controlled by wise economists in Washington, D.C.  In his 1955 edition Samuelson wrote that the private economy is "like a machine without an effective steering wheel".  The steering was to be done by economists – with mathematical minds and compassionate hearts.

 

Most observers now pretty much concede that socialism as an economic system is a failure.  Even most U.S. journalists have thrown in the towel.  Nice in theory, they say, but somehow it just doesn't deliver the goods.  "Communism", said 60 Minutes commentator Andy Rooney recently, "is fundamentally a more uplifting idea than capitalism".  It's "only real weakness seems to be that it doesn't work".  Western holdouts for the triumph of socialism now also have to contend with all manner of renegade Soviet economists.  Some preach private property!  Even Mikhail Gorbachev said recently that people in the Soviet Union "forgot how to work because they got used to being paid often just for coming to work."  (U.S. economists have not yet dared put their finger on that crucial defect of Communism.)

 

So, what do our leading textbook authors have to say on the subject?

 

Campbell McConnell is a genial 61-year-old professor of economics at the University of Nebraska and the best-selling economics-textbook writer for at least the last decade.  According to one source, his 1987 edition sold 200,000 copies in its first year of publication, probably netting McConnell $1 million in royalties and one-third of the new-book market in that year.

As with Samuelson, the Keynesian hydraulic metaphor remains enshrined by McConnell, but he is regarded as "middle of the road" ideologically, with a devout following in the professoriate.  McConnell is "the successor to Samuelson", but better disposed toward the market.  Nonetheless, he politely but firmly resisted my suggestion that a 968-page book on economics principles should have more than one paragraph on private property.

 

In his 1987 edition, McConnell says:  "Despite the gargantuan character of the coordination problem, Soviet central planning has worked, and historically has functioned reasonably well."  This was toned down from the 1981 edition, in which central planning had worked "remarkably well".  He notes (1987) that "the real standard of living of the average Soviet citizen is roughly one-third that of an American counterpart", down from one-half in the 1981 edition, in which it was also reported that labor-union strikes "simply do not occur".  In 1987 that was amended to "do occur with some frequency".

 

McConnell reported in 1981 that "authoritative estimates put the Soviet GNP at slightly more than one-half that of the United States".  By 1987 this had risen, surprisingly to "about 60 percent".  He told me that in his 1990 edition, "I use 50 percent, but that may be on the low side."  (He seemed to worry that I might accuse him of being too hard on Communism.)

Gorbachev recently put out figures claiming the Soviet economy is no more than 27 percent of ours.

 

It has long been an article of faith among mainstream economists that socialism and central planning yield high rates of economic growth.  This faith was reflected in Paul Samuelson's text, which in successive editions showed a Soviet GNP growth path rising more steeply from a lower base than its U.S. equivalent, projected to overtake our GNP about twenty years in the future.  With each new Samuelson edition, the date of intersection was suitably advanced.  But when 1980 arrived, the long-promised cross-over seemed no nearer at hand.

 

In their 1989 edition Samuelson & Nordhaus asked how "the economic performance of the world's largest command economy" compares with that of the mixed economies.  Samuelson & Nordhaus now write, "Soviet economic growth since the 1920s has indeed been impressive.  Measured Soviet real GNP has grown more rapidly over the long run than have most of the major market economies."  But recently things have been slowing down.  "By some analysts' reckoning, indeed, the U.S. growth has outstripped Soviet growth in the last decade."  Indeed.

 

Where does the Soviet economy stand today?  "Soviet GNP was about 57 percent of American GNP in 1987", Samuelson & Nordhaus claim – about double Gorbachev's figure.  But in 1967 Samuelson estimated Soviet GNP at "about one-half" ours.  This confusingly suggests that, while we have "outstripped" them, they have nonetheless narrowed the gap.

 

And what of "the scourges of capitalism, unemployment and inflation?  The answer appears to be that there is effectively none of either in the USSR."  So how do all of these elements add up?  "The Soviet model has surely demonstrated that a command economy is capable of mobilizing resources for rapid growth.  But it has done so in an atmosphere of great human sacrifice – even loss of life – and political repression."  Is this "worth the economic gains"?  (Gains?)  "This is one of the most profound dilemmas of human society", Samuelson & Nordhaus lamely conclude.

 

The question of choosing among economic systems is of "vital concern", the Princeton professors Baumol and Blinder remind us in their fourth edition (1988), "and it remains an issue today."

 

There follows a section comparing "The Market of the Plan?  The Scoreboard".  Growth depends on investment, the authors conventionally but misleadingly remind us, and "planned economics have more direct control over their growth rates than do unplanned ones because the state can determine the volume of investment."    States can engineer "very high growth rates – an option they have often exercised."  But this can be at the expense of consumption, personal freedome, even human life.  It seems that high growth can be achieved without planning, "though planned systems may have an easier time of it."  And among less-developed countries "the goal of rapid development is typically of paramount importance." 

 

"The real question", then, "is not whether we want elements of socialism or planning to abridge our personal freedoms, but by how much."  Thus the latest word from Princeton.

 

Our next witness is Bradley R. Schiller, a professor of economics at the American University in Washington, D.C., and the author of The Economy Today, which has sold well lately.

 

"Which is Better?" he asks at the end of his chapter on "Socialist Planning".  "What we end up with is a mixed bag of wins and losses.  The Soviet and Chinese economies rank higher in terms of economic growth, the distribution of income and economic stability".  In the Soviet Union, he writes, "income disparities are much smaller than in the United States, and wealth is, of course, not concentrated in the hands of a private minority."  Looking at income equality, then, "the socialist countries come out ahead."  As for stability, in socialist economies unemployment "never occurs", which is, 'far superior to the situation in capitalist market economies, in which fluctuations in aggregate demand lead to insecurity, poverty, low output, and potential alienation".  (Schiller overlooks the problem that Gorbachev identified:  the socialist guarantee of employment means that people forget how to work.)

 

You only have to set foot outside the Moscow or Leningrad airport to know that the experts have been misled. "In Moscow, there's no sign of an economy", Paul Craig Roberts told me the other day.  A professor of political economy at the Center for Strategic and International Studies, he addressed a Moscow conference in June, the session chaired by Gorbachev's chief economic advisor.  "We came to the conclusion that only full-fledged private property would work", Robert said later.  He is a longtime student of the Soviet economy.  "If their economy is half ours, there's no sign of it, unless it's hidden in the military", Roberts said.  "No road, no cars, nothing to eat, houses fall down.  If you can't get soap, what kind of an economy is that?"  The Soviet economy may be no more than 10  percent of ours, he said.

 

"Their perceived success is due to western professors' hatred of the market", said Roberts, who is one of the few to assert boldly that ideology lurks beneath the misleading statistics.

 

 

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