Wednesday, February 29, 2012

Maybe the Retail Investor is Retiring

A persistent trend for the past three years is that retail investors have been bailing out of the stock market. Even now, with the market reaching new post-2008 highs, individual investors continue their exodus. Stock market pundits scold shrilly, pointing out that these wusses have missed out on the big rally of the past six months. The same wusses are deemed to be short-sighted for piling into bond funds at a time of historically low interest rates following a 30-year bond market rally. The pundits pronounce retail investors foolish, or worse.

But stock market pundits often get it wrong. Very few of them predicted the 2008 crash. Most don't have investment records that beat the S&P 500. Retail investors may in fact be acting very rationally. The oldest Baby Boomers are reaching retirement age--i.e., 65. It's accepted wisdom that investors should ease out of stocks as they get older, and shift into bonds to stabilize their portfolios. This portfolio shift was recommended long before the 2008 crash, and nothing that's happened since then has made it seem less than wise.

The volatility in the stock market, resulting from its domination by short term, big money, usually computerized traders, would like nothing better than plenty of retail participation. That would give the smart money more sheep to shear. But having been just recently shorn, Boomers and other investors may be less willing to buy into the hype. Prices of risk assets have painfully proven to be ephemeral. Real estate, on the whole, is still falling. Stocks are bipolar. Just because the Dow tops 13,000 doesn't mean its worth 13,000 or anything near that, not unless you plan to sell tomorrow. Retail investors--or at least the Boomers among them--may be gradually retiring. And this trend could continue for a generation.

Thursday, February 23, 2012

The Greek Debt Crisis: Another Failure of Derivatives

Once again, derivatives have failed. This time, it's in the Greek sovereign debt crisis. Greece and many EU member nations are dead set on making private holders of Greek bonds take losses in the range of 70% of the face value of the bonds. Not only that, but the EU wants to structure the hit to private bondholders in such a way that it doesn't trigger the requirement for credit default swaps (which are insurance on the bonds) to pay injured bond holders. The legalities involved become rather labyrinthine at the margin. Suffice it to say that the entire bucket of yogurt may well end up in court, where attorneys charging very reasonable fees will secure the funds needed for their children's college tuition.

Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.

An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.

In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.

Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.

Monday, February 20, 2012

Distribution of Income and Wealth is the Issue

As much as many politicians--mostly on the right--try to deny it, today's politics are all about the distribution of wealth and income. Democrats, with President Obama at the forefront, have made financial inequality a crucial element of their 2012 platform. Republicans argue against new taxes, and for the long term reduction of taxes and the shrinkage of the federal deficit. That, too, affects the distribution of financial resources, mostly in directions unfavorable to middle class and modest income households. Long term cuts, to be effective, would have to come to a large degree from Medicare and Medicaid, which verge on insolvency in the relatively near future. Social Security benefits may well shrink over time, although the cuts aren't likely to be apocalyptic. The 1% won't have to trim their sails much if the Republicans have their way. Most of the rest of us will notice the increased costs we would bear.

The Euro crisis is all about the distribution of economic resources. As a whole, Europe has more than enough money to resolve the sovereign debt crisis. But a lot of the money that would have to be paid out to bond vigilantes would come from the good burghers of northern Europe, and they have no appetite to cover chits signed by spendthrift members of the EU. Reality is the Europe isn't a whole, and its continental wealth isn't available to cover the debts of profligate nations. The thrifty don't want to distribute their wealth to the prodigal.

In China and India, even as substantial middle classes emerge with the turn toward capitalism, hundreds of millions remain mired in poverty. The governments of both nations, in different ways, grapple with difficult problems of distributing the fruits of growth. China also confronts a demographic problem far worse than America's; its principal solution to date has been to slash the safety net once provided by the iron rice bowl. Both nations equivocate when asked to commit large sums to bailing out Europe. How can they explain to their citizens why they should save much wealthier Europeans from themselves?

In times of brisk economic growth, the expanding size of the pie makes sharing easier. Stagnation, however, brings out harpies. Increasing growth is the obvious solution. But that, for sure, falls into the category of more easily said than done (for elaboration on this point, call Ben Bernanke, Fed Chairman and Tim Geithner, Treasury Secretary).

Since the times when humans clung together in small groups of hunter-gatherers, distributional questions have existed. Hunting is a hit or miss process (pun intended), and the lucky hunter bringing down a deer would expect to share it with the entire group, just as the next day, another lucky hunter would share.

In a modern free enterprise system, protection of private property rights is important to provide incentives to work, save and invest. But market forces, alone, do not always produce distributions of financial rewards that comport with societal needs and norms. The demands of market-based economies altered social structures. Extended families disappeared as children reaching adulthood move hundreds and even thousands of miles away to find suitable jobs. Family-based safety nets evaporated as families splintered. But market forces make no provision for those injured on the job, the sick, the disabled, the laid-off or other unfortunates; and most certainly not for the elderly who no longer wish to or can work. Government programs were necessary to fill the gap.

There are no easy answers to distributional questions. But it's important to debate and decide them, because they are among the most crucial issues of the day. Trying to silence President Obama by accusing him of class warfare is tantamount to avoiding the central point in today's political dialogue. Whichever side you take on the question of the size of federal deficits, or the allocation of tax burdens, you're talking about the distribution of financial resources. A nation that faces up to the responsibility of dealing with this problem has a chance to reach the accommodations that lead to social harmony. A nation that ducks the issue and indulges in political mudslinging will face a grim future.

Thursday, February 16, 2012

Rising Oil Prices: Has the Fed Been Too Clever By Half?

In eviscerating interest rates and quantitatively tranquillizing (we're way past easing), the Fed has sought to push investors into risk assets. Investors have responded. Stocks have risen sharply over the past six months. More disturbingly, oil and gasoline prices have bounced up, too.

The standard explanation for rising oil prices--demand from emerging markets like China and India--seems less plausible now that these economies are slowing down. The threat of Iran going off the deep end points toward higher prices. But Saudi Arabia's expressed intention to keep prices stable can't be taken lightly either.

However, the flood of liquidity that has come out of the Fed surely is a factor in rising petroleum prices, as all this cash has to find a home somewhere in the financial system. Rising oil prices create jobs in some parts of the country, but discourage consumers in all parts. While oil consumption won't fall much in the short term (because demand for gasoline is relatively inelastic, as economists would put it), consumption of clothes, food, vacations, and other things will suffer as gas bills snarf up the monthly budget. Recently improving economic statistics may reverse their trend.

The distribution of income enters the picture. Owners and sellers of risk assets benefit handsomely from the Fed's easing, while consumers (most of whom are middle class and hold little or no risk assets) are shortchanged. This matters in America, where consumption is 70% of the economy. One can see why QE 1, 2 and perhaps soon to be announced 3 haven't and won't boost economic growth that much. With the QEs, the Fed giveth, and it taketh away. The net gain to the economy is unclear.

Tuesday, February 7, 2012

Is the Fed Banking on a Crisis?

Scary things can happen when a central bank prepares for a crisis and it doesn't occur. In the late 1990s, there was a great deal of handwringing over the so-called Y2K problem. Numerous computer programs written in the 1960s and 1970s didn't originally accommodate dates in the twenty-first century, evidently because no one thought they would be in use for that long. But they were, and vast armies of computer programmers were deployed to modify programs written in ancient, almost forgotten computer tongues like Fortran and Cobol.

The Fed, alarmed at the possibility that bank and other computer systems might abruptly fail at 12:00 am, January 1, 2000, flooded the financial system with liquidity during 1999, to combat the risk of a credit crunch at the outset of the new century. This liquidity had to go somewhere, and a lot went into stocks. In the last quarter of 1999 and the first quarter of 2000, the S&P 500 rose about 12-13% (or 24-26% on an annualized basis), and the Nasdaq rose by two-thirds (or about 135% on an annualized basis). We know what happened next--the tech bubble burst and stocks have never, on an inflation adjusted basis, returned to their March and April 2000 heights.

There was no Y2K crisis, as it turned out. The armies of programmers carried the day, and the world rolled right into the twenty-first century as if there had been nothing to worry about.

But the Fed's flood of liquidity set the stage for the crisis that actually occurred: the collapse of the tech stock bubble. Although tech stocks were bubbling anyway, the Fed made things worse by lowering the price of cash, thereby effectively escalating the price of stocks. The Fed's bargain basement sale on liquidity in 1999 was to the stock market bubble like gasoline poured on a prairie fire.

Since last fall, the Fed has been sending double and even triple trailer trucks filled with liquidity from its loading dock 24/7. It's ruthlessly stamped out any positive interest rates on the short end of the yield curve, and thoroughly cowed the long end. Its apparent rationales for such actions include preparation for crises such as the sovereign debt mess across the pond, Iran's nuclear ambitions, and so on. Not surprisingly, stocks have risen over the past six months. Liquidity has to go somewhere. In late 1999 and early 2000, it went into stocks. During the past six months, we seem to see something similar.

If there really is a crisis today--like a credit crunch in Europe from Greece's default (the Greek default has effectively occurred; all that's happening now is the negotiation of the exact amounts of the losses to be borne by taxpayers, bondholders, etc.), a war between Israel, Iran and who knows who else, or the real estate bubble in China pops--the Fed will probably look wise and prudent for having engineered the biggest liquidity dump in central banking history.

But if the Europeans somehow muddle through (the stock market's current assumption), Iranian nuclear ambitions are somehow constrained without use of force (the stock market's current assumption) and the Chinese government manages a soft landing (the stock market's current assumption), then what will happen with stocks? Since late last summer, the DJIA has risen about 18% (or 36% on an annualized basis). The economy has been improving, but hardly enough to account for this kind of upswing.

Price inflation has been comparatively low (although more of a problem for those with modest incomes than the top 20%). But asset inflation is alive, well and snarling. If we avoid a major crisis this year, stocks may well soar. And perhaps soar some more. But then what? We have an all too recent and vivid history of government engineered asset bubbles ending badly. Whether you think history repeats itself or only rhymes, things are starting to look disturbingly familiar.