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Is Time On Our Side?

A week away, and nothing has really changed. The 10y yield is still around 3.84%. Stocks are still going up (although the Dow broke 11,000! Yay! By the way, when did anyone start caring about 11,000?). Greece is still in trouble, and there is still a rescue package for them. Really, this time. No, seriously. This time they mean it.

An important part of trading is figuring out whether time is on your side, or working against you. Right now, if you are a bond bull then time is against you. Every week brings billions in further supply. Every week that the data doesn’t start to roll over decreases the chances that we will have a double-dip recession and increases the chances that banks may begin to divest Treasuries in favor of making loans. Every week gets us closer to the day when the Fed hikes rates modestly, and the bond market overreacts. Every week brings us nearer to the day when some central banks start pulling back on liquidity, hurting all asset markets (and with some chance of a discontinuity in some of them).

To be sure, I don’t think that we need a strong economic recovery to produce higher interest rates. The monetary pressures on the global economy are all towards higher inflation, and those pressures will produce inflation at some interval. Right now, monetarists are selling bonds to Keynesians. All that economic strength (or just a pause in the sequential blow-ups) would do is cause those Keynesians to turn around and sell the bonds to…whom?

The market looks somewhat confused – except for equities, of course, where investors are often wrong but never in doubt. The zero-coupon inflation curve has a peculiar shape in that the curve of 1-year inflation forwards (1year inflation, 1 year forward; 1 year inflation, 2 years forward, etc) is upward sloping until 1-year inflation, 7 years forward. At that point, the curve projects 3.15% every year from the 8th year onward. Almost exactly (see chart below).

This is a rather peculiar shape.

I am not correcting here for convexity, but there isn’t broad agreement on which way that should bend the curve, anyway. I can’t decide if this illustrates that the market is pessimistic, that the Fed is going to let inflation slip up that high, or optimistic that the Fed won’t let inflation get  out of hand. I rather suspect that investors aren’t sure either.


There are lots of reasons to be skeptical of the linear stock-market rally, but low volume isn’t one of them. An article I saw last week, during my vacation, (here) suggested that the rally has weak underpinnings because of the low volume. This is one of those times when the “art” of technical analysis is supposed to trump whatever science its practitioners claim for it. Volumes are lower, and will stay lower I suspect, because high-speed trading and market-making is being actively discouraged by regulators and the Administration generally. Most of the volume that we see these days – and one reason that volume has been losing its value as an indicator anyway – is scalping. If you lift the high-speed trader who in turn tightens the bid or lifts the better offer, double the volume trades although liquidity was only demanded once. This exaggerates the volume statistics. Moreover, the very low cost of trading, as reflected in tight bid-offer spreads, leads to more trading since it lowers the cost of hedging and makes more-frequent hedging more feasible. As bid-offer spreads widen, because of building momentum for the “Volcker Rule,” then volumes will naturally decline as a symptom of the lower liquidity. These are not per se bearish developments. Although I have argued that lower liquidity implies lower stock prices over time, by itself this is no reason to become bearish if you weren’t already.


I tend to use vacations to catch up on reading, as much as I can with two young children. And wow, did I read a great book last week. Richard Bookstaber wrote a book in 2007 called A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, and it has been on my shelf since then. Bookstaber is well-positioned to write a book on this topic, as he worked at some very sexy firms (Solly, e.g.) at a very high level of risk management. Much of the book details his personal observations and his sometimes very different slant on what caused certain crises. For example, in discussing the 1987 stock market crash, he discusses the delicate interaction between a specialist lowering prices to seek liquidity and an investor’s decision to buy cheaply…or do nothing, because the price has fallen too far. And he makes a compelling case that the Crash was essentially a queuing problem:

The specialists at the NYSE tried to elicit more buyers by dropping the price, but there was a limit to how much more buying interest they could attract. No matter how quickly the price was dropped, the decision making by the equity investors took time; unlike the twitch-quick futures pit traders, they made portfolio adjustments only after reasoned consideration. With their limited capital, the specialists were not willing to wait for the process to unfold, and their increasingly aggressive offers ended up backfiring. Prices dropped so violently that many potential buyers started to wonder what was happening and backed off completely. (page 20)

Bookstaber also has a number of observations about liquidity providers and the importance of liquidity providers that are very poignant today, as the Administration considers rules designed to make “proprietary trading” (also known as providing liquidity by substituting time for price) more difficult.

Liquidity providers provide a valuable economic function. Their business is to keep capital readily available for investment and to apply their expertise in risk management and market judgment. They look for instances of a differential between price and value, and as they trade to exploit that differential, they provide liquidity to the market. in short, they take risk, use their talents, and absorb the opportunity cost of maintaining ready capital. For this, they receive an economic return.(page 214)

In a very interesting analogy, Bookstaber argues that liquidity provision not only has direct economic value (look, he says, at the difference in price between two instruments that differ only in liquidity, like on- and off-the-run bonds, and you can see there is an economic consequence to illiquidity) but also a social value: “It provides economic freedom. It allows wealth to be accessed and used to take new opportunities.”  And to demonstrate this, he reaches back to medieval England where there was no liquidity for wealth (because land could not be transferred).

Now, this book was written before the latest crisis, and as such it is well worth reading in light of what has happened and some of the knee-jerk responses that are resulting. In fact, he predicts some of those responses (although he figured they’d come after hedge funds, and instead they came after Wall Streeters themselves), but argues very persuasively for the importance of the economic function that these weasels provide. “But blaming hedge funds is a bit like The Simpsons episode in which a meteorite hits Springfield and the townspeople gather, shouting, ‘Let’s burn down the observatory so this never happens again!'”

In a nutshell, he argues that crises – such as the one that was about to happen when the book was published – stem from a combination of two factors: market complexity and tight coupling. Market complexity, which increases with more regulation rather than decreases, means that not only are there known unknowns, but there are unknown unknowns and, moreover, the market’s response to these unknown unknowns, when they happen, is not necessarily linear. And tight coupling means that there is no release valve; things happen too fast to figure out what to do next. In talking about crises, he draws an analogy to other disasters, like Chernobyl and the ValueJet crash in Florida a few years ago. It makes for compelling reading. I wholeheartedly recommend this pre-crisis book to anyone who is trying hard to understand the crisis in retrospect, and who thinks they know how to fix the problems at hand.


There is no important data out tomorrow: Trade Balance for Feb, Import Price Indices; Chairman Bernanke speaks in the evening on financial literacy, which is probably not market-moving anyway, but Richmond Fed President Lacker is going to be talking about the economic outlook. These speeches seem to move the market less than they once did, since we all figure that the Fed will tell us well in advance before they do anything, but there really isn’t much else on the docket. On Wednesday, we will get CPI…but I’ll talk about that tomorrow.

Categories: Book Review
  1. Mike
    April 12, 2010 at 5:22 pm

    Mike, I’m not sure why you continue to harp on the ‘skepticality’ of the bull equity market. Valuations are still around 30% off their peaks while growth in corporate profits (at least in US corporates) maintained a phenomenal rate through the teeth of this ‘great’ recession (quotations because if you actually look at the data, this will turn out historically to be a relatively minor recession, at least in terms of GDP destruction). US companies slashed hard and fast to maintain margins, and it’s paying off. Equity valuations are not a proxy for GDP or unemployment, they are a reflection of the ability to generate earnings growth. Of course, there are some unsettled arguments over whether the mass unemployment casualties will ultimately impact those margins in the future (can’t have you’re cake and eat it too? Or destroy the village in order to save it?), but right now I don’t see any great qualms with the equity valuations and I think you might not be seeing the forest through the trees here.

    I don’t have any great insights on the value of liquidity provision from proprietary trading, other than to say that you know and I know that ‘liquidity provision’ comes from an excess of leverage, and that a few proprietary traders at banks on the street don’t do jack to move that needle. The amount of leverage in the system has been destroyed (particularly the shadow banking system), and that’s phenomenally more important than whether the street is allowed to proprietary trade. Hedge funds aren’t (and were never) as leveraged as the street was under the shadow banking regime. These regulatory movements are akin to a doctor treating emphysema by removing the appendix. Totally unrelated, but it sounds like you tried to do something.

  2. April 12, 2010 at 6:37 pm

    Hmmm, well considering that valuations at the peak were about 2x fair, 30% off the peak doesn’t seem to me like it provides a reasonable margin of safety. Real returns over the next decade will likely be under 2%. I’m not smart enough to pick the next 30% wiggle, but I do know that historically, equity investors at these valuations have never been rewarded for the volatility. Ever. Maybe they will be this time. I won’t bet on that nag to win, though.

    I will go further, and I will make this prediction again in one of the comments I write in the next week or so. If the Volcker rule passes, we will have a 40% or greater decline in equities within 5 years. I disagree that liquidity provision comes from an excess of leverage, unless you are claiming that leverage was too high in the early 70s when we had a liquidity crash as well as in the mid-80s and the 2000s. Liquidity and leverage are probably inversely related: more leverage implies less liquidity, at least crisis liquidity.

    The Volcker Rule will undo everything that the move to deregulate in the last couple of decades did…and that means wider spreads, less liquidity, and lower valuation multiples. It is probably less dangerous than the health care debacle only because it is easier to repeal.

  1. May 7, 2010 at 4:51 pm

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