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Necessary Finger Crossing

Housekeeping note: in case you missed it, here is a link to Tuesday’s article, which was not picked up through all of the “usual” syndication channels. Note that, in addition to doggerel, it contains an announcement regarding the free ‘office hours’ I am making available to readers who wish to sign up. (On the basis of the first “round,” I’ve decided to lengthen the sessions to 20 minutes but only offer three of them per week, but this may evolve further as I learn more.)


When we look back on this period of financial history, I wonder if it will not be called the “era of unintended consequences.” I can think of lots more names for the era, some of them unprintable, but this one certainly applies.

I tend to think of unregulated markets as chaotic, but fundamentally structured. They tend to be efficient, although research has demonstrated that even completely free markets can produce bubbles and negative bubbles. But I really do believe in something like Adam Smith’s ‘invisible hand,’ that leads the baker to make just enough bread without being told how many loaves to make. A farmer’s market or third-world bazaar, although seemingly chaotic, still often manages to arrange itself so that most purveyors of similar goods end up in one general area. However, when someone intervenes to organize the chaos, there is often an unintended consequence. A recent example is the Fed’s low-rate policy in the mid-2000s, which was meant to respond to the equity bubble burst and the recession of the early 2000s; it also helped produce the housing bubble. Certainly, the housing bubble was not intended by the Fed, but it clearly followed partly from the easy money policies. As another example, Cyprus needed a bailout partly because their banks had been involved in helping Greece by buying Greek debt. Surely countless other examples suggest themselves.

Another example came to my attention today. As part of a presentation I am giving in a week and a half, I will be talking about the “portfolio balance channel” and how it is pushing investors to take more risk than they should, based on the absolute return expectations, because of the configuration of relative return expectations. (I wrote about this in “A Relatively Good Deal Doesn’t Mean It’s A Good Deal”, back in January). But a friend pointed out that it isn’t merely retail and professional investors who are being forced to take risky assets at bad prices because the safe assets have even worse prices: central banks are as well, according to this article in the Financial Times, entitled “Central banks move into riskier assets.” Who knew?

Central bankers are not supposed to really care about portfolio returns. They’re supposed to care mainly about return of capital rather than return on capital. That’s theory, but the reality is that central bankers want to be heroes just like anyone else, and their jobs are definitely made politically easier if they are revenue generators and not cost-centers. And that in turn made me think of the article in this month’s Financial Analysts Journal by Robert C. Merton et. al., in which they argue that “monetary and fiscal policies designed to deal with things like stimulus or consumption demand can actually have unintended consequences of some magnitude for financial stability and markets.” More interestingly, they graphically illustrate how much more connected financial institutions are now than they were prior to 2008.

And one important unintended consequence of the Fed’s efforts on the portfolio balance channel is that the connectedness is increasing, and the nonlinear exposures of central banks are increasing as well. That, in turn, suggests that rather than being meaningfully safer than we were five years ago, we may well be less safe. You could already make such an argument by pointing out that sovereign states have less room to fiscally ease in response to crisis, but add to that the fact that central banks themselves could be caught up in a crisis and be losing capital at just the moment when it is most needed. Of course, at some level a central bank that has control over its own currency – unlike those in, say, Portugal or Italy – can always print a solution. The increasing risk posture of central banks, I believe, increases the possibility of a blatant printing outcome (as opposed to the circumspect printing currently being pursued) in response to a renewed crisis.

Never before have so many fingers been crossed for the global economy. And never before has it been so necessary to cross our fingers!

  1. J Nash
    April 11, 2013 at 6:44 pm

    Mike big fan yours office hrs after 415 close would help me I work in index options. QE has distorted markets for a long time last rate change 2008 now spx is on runaway train everyday. Volatility is super cheap and any bad news is just opportunity to sell vol before we start to rally. US stock market appears to be place to money to work and the fed is happy more fund managers are going to jump in to justify 2/20 fees and push it even higher.

    • April 12, 2013 at 7:34 am

      I have changed the sessions previously scheduled for 1-2:30 on April 25 to be 3:30-5 on April 24th (Wednesday). See if one of those works for you!

  2. HP Bunker
    April 11, 2013 at 7:28 pm

    Meanwhile, Cramer says “this rally is real”, and Goldman released a statement today saying all assets, everywhere look cheap on an absolute basis. This really is a crazy world, and the current state of affairs is worthy of one of those “unprintable” decriptions you mentioned…

    • April 11, 2013 at 10:19 pm

      Are you making up that Goldman statement? That’s a crazy statement. In pretty much any time period. But certainly after 100%+ rallies in a lot of assets, it’s hard to really make that case….

  3. HP Bunker
    April 12, 2013 at 12:03 am

    I may have exagerrated somewhat. What Goldman actually said is that all equities, everywhere look cheap on an absolute basis. They were less sanguine on bonds. Quotes include:

    “We forecast strong returns, mainly driven by earnings growth, in all four regions we consider. We expect the best annualized total return in Asia ex-Japan (21%), followed by Europe (19%), Japan (15%), and finally the US (9%). These returns fall between the 50th and the 87th percentile of the distribution of US historical returns.”

    And: “With a 2015 horizon all regions look attractive on an absolute basis.”

    The annualized total return predictions are out to the end of 2015. There is the caveat that I haven’t been able to source this to any site other than zerohedge:


    • April 12, 2013 at 6:14 am



  4. HP Bunker
    April 12, 2013 at 12:11 am

    As an aside (and something that may be worthy of an article in itself), it would be helpful if the financial services industry could unite around a standard meaning of “PE ratio”. The zerohedge piece includes a chart of market predictions (presumably sourced from Goldman) in which the 2013 PE for the S & P is given as 14. With SPY currently trading at a trailing PE of 16.6, I can only assume that 14 is based on “forward looking operating earnings” or something to that effect.

    In general, more bullish predictions tend to rely on that methodology, despite the silliness of dismissing “one time charges” for the entire US equity market year after year and anticipating a mid teens explosion in S & P earnings in Q2 and Q3 of 2013.

    • April 12, 2013 at 6:21 am

      Yes, several years ago – in the mid-2000s, I can’t remember the exact year – Bloomberg abruptly started to report the S&P’s P/E with the denominator being the sum of all POSITIVE earnings. Since that is obvious nonsense, I called up and asked why they did that. I pressed really hard, since it makes absolutely no sense to ignore not just one-time charges, but any negative earnings at all. I was told that some of their “big customers” had made the request so they changed it. Those big customers, of course, were the ones who made money hawking stocks. It was one of the most intellectually-dishonest things I’d ever seen from Bloomberg. Or anywhere.

  5. Eric
    April 12, 2013 at 10:30 am

    So today retail sales crap the bed, and retails stocks are flat to up. But commodities are getting taken out and beaten with the ugly stick. And my mining shares? ouch. Commodities are saying major recession and stocks are saying “what, me worry?”. At least I sold my bitcoins near the top. 🙂

    (I keep having to remind myself that even though, in 20/20 hindsight, I “should” have backed up the truck and bought the hell out of those, in reality even the tiny number i bought for “fun” was probably foolish.)

    • April 12, 2013 at 10:43 am

      I looked at mining bitcoins but couldn’t figure it out. 🙂


      • Eric
        April 12, 2013 at 10:51 am

        🙂 They sell dedicated machines now. You just plug them into the internet and they start mining using internal chips whose instruction set is tailor made for mining bitcoins. But the big money was just buying and holding. I bought a small handful for about $4 each, and watched in amazement as they climbed up in the double digits, then triple digits, then up to $265. If I had had my whole portfolio in bitcoins (and I hadn’t died of a coronary over the last week) then commodities wouldn’t be going down this week because I would have been moving the market. 🙂

  6. Lee
    April 12, 2013 at 10:33 am

    Adam Smith also feared monopoly power and so was also for some intervention.

    • April 12, 2013 at 10:49 am

      …as was one of my old professors, Walter Adams. Although the real problem with monopoly is (a) the use of market power to gain monopoly unfairly, as opposed to through “superior skill, foresight, and industry”; and (b) the rise of monopolies becauseof intervention, rather than despite it. And I think it made more sense to fear monopolies in Smith’s time, when markets were far more local. Consider Kodak, which is a classic example of a company that had a monopoly position by virtue of “superior skill, foresight, and industry,” and is now trading at 0.28/share. With global markets and rapidly-developing technologies, it is really hard for a company to maintain a monopoly position without government sanction/interference. Which is one reason I will not buy Google. (And see also the article I wrote a while back that mentioned the paper Rob Arnott wrote on the performance of market leaders).


  7. Jim H.
    April 14, 2013 at 9:49 am

    With the S&P having broken out above its Oct 2008 high last week, J. Nash’s characterization of the SPX as a ‘runaway train’ rings true.

    Creating serial bubbles is the only operative economic model now. Today’s speculative circus rhymes with the late Nineties — back-to-back global crises; super-easy money in response.

    Attractive absolute returns are nowhere to be found. But with unlimited free money, there’s no reason why the S&P can’t be driven to 2000, or 3000, or any number one pleases. Instead of Y2K, now it’s SPX2K, so Bernanke not only can depart on a high note next January, but also be replaced by someone who’ll make Ben (in retrospect) look like a crabby-visaged, hair-shirt disciple of Andrew Mellon.

    As Saddam Hussein used to say … ‘Anything is possible now, my brothers!’

    • April 14, 2013 at 7:04 pm

      Yes, kinda scary that both equities AND housing are now rallying. On the one hand, there could be a huge additional rally yet to come – and how can you play that, or NOT play it?? On the other hand, the comeuppance at the end would be epic.

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