Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

26 January 2014

Market Manipulation in the Third Millennium


[For brief comment on the State of the Union Speech and the Republican response, click here.]

The mini-crash
The usual suspects
What’s left
How easy it is

The mini-crash

Equity markets tanked Friday. Worldwide. Millions lost money. I was among them.

What caused the mini-crash? It’s hard to say.

All the fundamental indicators seemed up. Just a few days earlier, the IMF had raised its economic forecast for the whole world together, and for nearly all advanced economies that matter. For some time, the auto industry—including our own once-beleaguered and government-rescued one—has been predicting steadily increasing sales, soon to surpass pre-Crash levels.

Exxon Mobil and First Solar are trading at low price-earnings multiples. At Friday’s close, their P/Es were 12.4 and less than 10.3, respectively.

These are energy companies, with real businesses and real profits. Energy is not an Internet fad. It’s a necessity.

Earlier this year, Warren Buffet had placed his bet on Exxon Mobil, to the tune of $ 3.4 billion, as revealed last November. He’s hardly a day trader. Have people lost their faith in the Sage of Omaha?

Except in Greece and Italy, and some struggling “emerging” markets, interest rates remain near historic lows. Despite the Fed’s “tapering,” they will remain so at least for the rest of this year.

Are investors rushing back into bonds, knowing that interest rates will inevitably rise and principal evaporate? Not hardly. (El-Erian’s departure from PIMCO, over the laments of his co-chief Gross, tells you all you need to know about that.)

Unemployment is down. Economic forecasts are up. China is deflating its credit and real-property bubbles gradually, under an authoritarian government run by some of the smartest leaders in the world.

Even politics appears to be cooperating, for a change. Iran is winding down its nuclear enrichment under an interim international agreement. Providence, in the form of volcanic activity, is building a new island for Japan, suggesting that maybe giving up 69 years of peace and going to war with China over what Japan calls the Senkaku Islands may not be necessary, let alone advisable. The lion, in the form of Assad, is sitting down with the lamb, in the form of some rebels, although early breakthroughs in the talks are not expected.

So why the gloom? The reason that most commentators give is company profits. On a year-to-year basis, they are down.

Of course they are down. For the last four years, since the trough in 2009, they have been rising from historic lows not seen since the early 1930s. So, on a year-to-year basis, they have been anomalously high.

Year-to-year comparisons can’t stay inflated forever. Markets have to adjust to “normal” yearly increases in a slowly but solidly growing economy. Investors didn’t know this, when it’s been coming for half a decade?

So Friday’s mini-crash is not easy to explain, except as a mini-stampede. What might have caused it? Read on.

The usual suspects

Only three possible causes make any sense at all. The first is Yankee politics. We still have some rogues like Ted Cruz, whose minds (if you can call them that) turn to extortion and revenge. There is still low-level murmuring among the GOP’s big extremist wing about using the statutory debt limit to extort political concessions.

That could happen even earlier than February 7. It would have the usual, entirely predictable, negative economic effects. Maybe investors trust the GOP to stay stupid.

That could be, but it doesn’t seem likely. Stolid, Johnny-One-Note (“lower-taxes-more-jobs”) Boehner is not known for his emotional effusiveness. When he screamed “Are you kidding me!?” recently, he said all you need to know about what the GOP’s leadership and business wing thinks about shutting down the government and dancing with default. Maybe the rank and file will get the message soon.

The party is still divided, if not schizophrenic. Its full reform is still years away. But the writing is on the wall. The message is especially clear for folks like Christie and McDonnell. In the long run, extortion doesn’t pay, whether of innocent commuters or hawkers of nutritional supplements seeking political influence and free publicity.

So fear of the GOP once again shooting the economy, or holding it hostage to get its own way, is probably overblown.

The second possibility is legitimate profit taking. Equity markets, and even bond markets, have generated enormous profits during the last few years, at least for investors able to see the signals through the noise. Maybe a whole lot of people decided to take their profits and cash out, all at the same time.

That’s possible. But where would/did they all put their money? In their mattresses? In money-market funds paying fractional-percent interest? In gold, which is down and probably going lower, as people begin to understand that its intrinsic, industrial value is nowhere near its market value, so it differs little from paper investments?

With bonds down and likely to go lower, there are not many other places to park money besides equities. No real-estate bubble appears to be forming, at least not so soon after the big one burst in 2008. Besides the perpetual one in London, the closest thing to a real-estate bubble is now deflating in China.

What’s left

Once you eliminate all the usual suspects, you have to consider the less likely, even the improbable. And so we come to market manipulation.

It’s hard even to discuss the subject rationally here in Yankeeland. Despite the Crash and its self-evident lessons, most of us remain in thrall to a form of politico-economic religion, which I call free-market fundamentalism. (You might also call it Taliban economics.)

Ask the average Yankee investor, and he will tell you the “Invisible Hand” governs market values. As the very name suggests, it’s an ineluctable, irresistible force, against which resistance is futile, especially in the form of regulation. Even prayer won’t do much about it.

But as I have outlined more than once (see 1 and 2), this worldview is utter nonsense as applied to our finance sector. It may have some validity as applied to apps in Apple’s closed garden, of which there are millions and thousands of vendors.

But finance is controlled by around 250 leaders worldwide. They all work in, for or with the world’s biggest banks. All you have to do to see that banks don’t work by “normal” market rules (or the normal rules of capitalism ) is to know that Jamie Dimon just got a 74% raise for presiding over a year when his firm’s profits dropped 16% and it paid over $ 15 billion in settlements and fines.

When you can’t understand something, an old Latin phrase is often helpful. Cui bono? Who benefits?

That question helps us understand the Roman priests who kept the Vestal Virgins. It worked for the Catholic Clergy that ran Western society during the first half of the last millennium. And it works for the international bankers, brokers and traders who now control most of the global economy at the dawn of our Third Millennium.

As any physicist or engineer knows, big crashes produce reverberations. Things oscillate for a while. But friction and inertia eventually damp down repercussions. Wide fluctuations subside, and things return more or less to normal.

That’s about where we are in the aftermath of the Crash of 2008. The reverberations are dying down, along with unemployment, financial insecurity and China’s incipient real-property and credit bubbles—the last ones on the immediate horizon right now.

By all that is normal and holy, the VIX should be subsiding, too. But it’s not. Why?

Because we have a huge “industry,” employing millions of people, whose profits, livelihood and vast employment depends on it staying high. Some of still them tell you to “buy and hold.” But in fact that’s the last thing they want you to do.

If investors buy and hold, commissions plummet. If investors waited to sell for the months and years that it takes real business to show solid signs of success or failure, all the automatic electronic trading algorithms would be useless. If everyone on the planet invested like Warren Buffet, the vast majority of bankers, brokers and traders would be out of jobs. Heaven forfend!

How easy it is

That, of course, can’t happen in a global economy where bankers call the shots. The VIX is Wall Street’s earnings index. So naturally it must stay high.

Bankers make money on the way down, by selling short. They make money in a bull market, on the way up. They make money every which way, through puts, calls, straddles, hedges and buying and selling derivatives. The one thing they can’t stand is placidity. So they follow my grandfather’s old political joke: “Down with what’s up! Up with what’s down! And fluctuate the middle!”

Think I’m joking or insane? Think again. Just days before the recent mini-crash, Barry Ritholtz (a financial columnist in Bloomberg.com) published a sawtooth graph showing time intervals between 10% or greater market corrections. The gist of the graph and its accompanying text was that we are overdue.

The post was utter nonsense in two ways. First, without some theory as to what causes a correction, the graph has absolutely no statistical validity. It’s like betting that the next coin toss will come up tails because a few previous tosses came up heads.

If you doubt this, just read Nate Silver’s excellent recent book, which tries repeatedly to explain this fundamental point for people not fluent in statistics or math. He makes the point with examples from fields as varied as weather, climate, poker and baseball.

But the second point is even more compelling. Ritholtz’ sawtooth graph was and is misleading. It is so misleading that it suggests malice.

The graph depicts each 10% or greater correction as a sawtooth, that is, a plot falling from some presumed market level to zero, or nearby. Thus it made each correction plotted look worse—much worse—than the Crashes of 1929 and 2008, despite the fact that each correction was, in reality and by selection, only 10% or greater.

To someone like me, with math in my blood, the graph and its interpretation were inherently absurd. To more credulous people, maybe not so much.

If you wanted to start a fear stampede, you could hardly do a better job than that misleading sawtooth graph. And you could hardly do a better job than publish it less than five years after the greatest Crash since the Great Depression, when stocks actually did dive some 35%, not just 10%. The disclaimer in the piece itself, which read as if drafted by a lawyer, suggested that Ritholtz and/or the folks at Bloomberg.com saw that risk clearly and didn’t want to be liable for it.

And what better place to start a fear stampede than on Bloomberg.com? Now that the Wall Street Journal, the New York Times, and the Washington Post are all on a subscription basis, Bloomberg.com is the only widely read national financial print medium that’s entirely free.

That point is hard to overemphasize. Mike Boomberg is no longer mayor. So he’s now free to devote all his considerable brains, energy and fortune to making Bloomberg.com a news source to be reckoned with. Since he now has the biggest and best-known free, national print news source on the Internet, he’s well on his way. And you can tell from the increase in content and gross format changes since the end of Mike’s mayoral term that he’s serious about doing just that.

Most people are not likely to subscribe to more than one on-line newspaper. So just as English is everybody’s favorite second language, Bloomberg.com will likely become everybody’s favorite online newspaper, just because it’s not bad and free. And as a deep, deep pocket, Bloomberg has the wherewithal to keep it free.

Mike didn’t get to be a billionaire and a successful mayor of New York City by being stupid. The question is whether he’s willing to let his creation be used for market manipulation.

More fundamentally, the question is whether we as a society want to let bankers and pundits manipulate us for their own purposes in the Third Millennium, just as priests did for centuries in the Second.

We have a First Amendment, which authors of market manipulation will rely on. But we also have laws against fraud, deliberate market manipulation and insider trading. There’s a tension there.

How we balance those two values will determine our global economic health for decades and maybe centuries to come. It will tell whether we have truly free markets or a finance sector controlled by the machinations of self-interested insiders, with the aid of complicit media. So far, there’s little evidence that the insiders are losing their battle to keep the VIX high and their employment opportunities and profits plentiful.

I would give a lot to know whether Ritholtz sold short, or otherwise bet on the downside, before publishing that grossly misleading sawtooth graph (just three days before Friday’s mini-crash). But if human nature is any guide, I think I know the answer.

Should such behavior be criminal? Maybe not. But should we find some other way to discourage and control it? Probably yes. Otherwise, what good is central banking and all our regulatory precautions, when self-interested fools with a pen can start a stampede that keeps their profits high, traders fully employed, our bankers fat, and stock prices with very little correlation to company values or industry prospects?

Footnote: Funny how Boeher keeps repeating this falsehood as if it were Biblical Truth. There’s no definitive study showing that raising taxes cuts even private-sector jobs. There’s just a lot of economic controversy about special conditions and circumstances in the few credible studies that exist.

But no one denies that cutting taxes can cut government jobs, because taxes pay for them. In fact, that’s exactly what the Tea-Party-promoted austerity policy and the Sequester produced, especially at the state level: a loss of government jobs.

When people lose jobs, they have less money to spend on goods and services. That’s true even if they used to work for government. But Boehner and the Tea Party never lament this obvious hit to our economy. They don’t claim to be economic experts, just true believers.

The Sorry State of our Union

I don’t know about you, but the President’s State of the Union speech and its aftermath depressed me deeply.

It wasn’t the speech itself. PBS’ commentators described it lukewarmly as “workmanlike” and “timid.”

But that wasn’t my thought at all. I liked the President’s specific proposals on broadening early childhood education, making college more accessible, fixing and improving our infrastructure, converting to natural gas as a bridge fuel, continuing subsidies for renewable energy (our energy start-up technologies), raising the minimum wage, giving ordinary workers incentive to save for retirement, tax free, through “My-RA” accounts, and giving women equal pay for equal work (at last). I liked his reminding us, gently but firmly, that he has wound down two totally gratuitous and horribly expensive wars (in both money and wasted lives) that his predecessor foisted on us and then kept off our balance sheet.

Throughout the speech, I was thinking how godawful it is that our politics and our nation have marginalized this brilliantly competent man who now sits in our White House.

In both form and substance, the President’s speech was exactly what you would expect of realistic and compassionate leader who can think. Every paragraph began with a fact, usually a statistic. These were not throw-off “gotchas” or “talking points.” They were relevant, important, specific facts, which any competent leader or informed voter would want to know in addressing the problem or opportunity under discussion.

Then, in each paragraph, the speech went on propose a specific change or policy. In several cases, it chided Congress for doing nothing, and then promised executive action to do what can be done.

As I listened to the speech, my mind drifted to the pols of my youth. They were serious, well-educated and well-informed men. (Nearly all pols were men in those days.) They could think. When they spoke, they made sense. Specific sense. They were not big on abstract castles in the air. They were practical leaders.

This pattern continued throughout the President’s speech. But there was more. Lots more. In speaking of minimum wages, health care, and our troops’ horrendous sacrifice in two wars (to which most of us paid no attention at all), he was both emotional and lyrical.

He combined genuine information, succinct statement of a problem, and the proposal of specific solutions with extraordinary understanding of emotional impacts on real people, which no sentient human could mistake.

Seldom have I seen a single speaker weave such a rational, practical and beautiful fabric. And seldom have I seen both his audience and PBS’s commentators so unmoved.

But that was only half the reason for my depression. The other half was the utterly vapid response given by the Republican designee—one Representative Cathy McMorris Rodgers of Washington State.

While the President’s speech was full of facts and specifics, Rodgers’s speech was completely devoid of them. David Brooks’ old phrase, “a relentless march of vapid abstractions” came to mind. So did my high-school cheerleader, but only briefly. I’m sure that most cheerleaders in my high school could have penned a better speech as a routine homework assignment. So could any marketer in a small business with more that 30 employees.

I hoped that the substanceless cheerleading would eventually fade into a little substance. I hoped in vain. With every fiber of my being screaming “turn off the TV and end the nausea,” I listened through the whole ten minutes.

Not once did I hear a single fact or specific proposal. Not once did I hear even a good turn of phrase. The relentless march of cliches numbed me to my soul. I kept wondering how any sentient creature could really believe the absurd fantasy that downsizing government would instantly solve all our problems.

When the empty speech and my agony finally ended, depression overwhelmed me. This, I thought, is the highest ranking female Republican member of the House. This, apparently, is what our GOP thinks of women: creatures dominated by vague emotions, unable even to recognize a fact, let alone connect it to consequences or policies.

At the dawn of the twenty-first century, this is the best one of our two great political parties can come up with to reply to the speech of a brilliant President whom it has stymied now for five years.

I have trouble believing that Rodgers is a moron. No one who has achieved her office could be. More likely, she thinks her constituents are morons, or the people who wrote her speech for her think women are morons. Even more likely, Republican men like them that way. God help us all.

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