If the Wyckoff accumulation model holds and we are indeed in the latter stages of Phase C, we are headed to 800 very soon, followed by a massive bounce past 1000. It will be interesting to see how accurate a predictor this Wyckoff model proves to be...
Friday, January 30, 2009
If the Wyckoff accumulation model holds and we are indeed in the latter stages of Phase C, we are headed to 800 very soon, followed by a massive bounce past 1000. It will be interesting to see how accurate a predictor this Wyckoff model proves to be...
Thursday, January 29, 2009
UPDATE: it's nearly 11:00 ET on Friday, January 30, and with the SPX down to 832, it's clear this channel isn't holding. Back to 800 we go?
Sunday, January 25, 2009
Gold is going up because of general fear and an almost religious form of mass delusion. Inflation isn't here and won't be back this year, but if you want an inflation hedge, oil or natural gas are priced awfully cheap right now and there are lots of ETFs available to play that angle with less downside risk. Fine, say another group of gold bugs, but gold is also a deflation hedge, and we're seeing deflation now. So you should buy gold to protect against deflation. This was certainly true during the last century as the gold standard for various currencies distorted markets in ways that forced its price artificially higher, but I have yet to hear a solid argument that still holds today that doesn't at its heart depend on the perpetuation of the gold religion.
Like any religious movment, as you begin to ask more questions of different community members you are quickly faced with the quandry of falsifiability. This is what divides religion from science, and why the gold bugs are nearer the former than the latter. There is no theoretical evidence of any type that would falsify the gold bug belief in the accumulation and purchase of gold, be it deflation or inflation, a return to a normal business cycle or descent into anarchy. If your investment thesis isn't theoretically falsifiable in the face of any class of conflicting evidence, then you are investing via mass delusion. In the history of such episodes, it is rare to find a true believer who has successfully avoided the catastrophic end. But there are always a few fortunate ones who accidently exited near the top with some fantastic gains.
When will the gold bubble pop? My guess: as soon as the irrational fears gripping the financial system subside and most Americans come to see the timid return of inflation as the welcome early signal for recovery. The day and month nobody knows, but there's a decent chance it happens this year, and when it does, I'm planning to ride the GLL money train all the way to the bottom the same way others rode FAZ and SKF earlier this year to the recent bottoms in financial stocks. I predict we'll see an unexpected and sustained rise in oil coupled with an equally unexpected and sustained decline in gold at some point later this year or early next as those that bought gold as an inflationary hedge realize that subsiding fear makes it an underperformer compared to oil.
Could I be wrong? Of course, and I'm willing to throw out my investment thesis if its hypotheses are proven wrong by unanticipated factors and realities. That's called falsifiablility, and I don't like to invest without it. There is no falsifiability in gold right now - Peter Schiff is perhaps the most recent poster child for the way this movement operates, and the inability of his gold-bug followers to profit from the financial system collapse is just as striking as his much-lauded accuracy about its root causes.
Am I telling you to short gold right now? No, for the simple reason that we would just as foolish to bet against more mass delusion right now. But what I am saying is that the set up for a huge fall is coming together nicely, and at some point the dam will break big and the smart money will be on the opposite side of that trade. I intend to prepare for that day with small offsetting positions both ways that let me stay close to the action for the volitility trade in the near term and some cash at the ready to jump in bigger soon after the gold bugs declare a premature victory.
Tuesday, January 13, 2009
After watching others exploit this effect backfire into short squeezes with DRYS and other shippers, I jumped in last Thursday with a $12.75 premarket buy that I expected to be nothing more than an entry position on a nice down move and was rewarded with a 20% single-day gain thanks to a rush to cover stupid shorts from the day before. I sold enough shares to pay for my entry costs and can now ride the rest out until another tempting drop comes along (short interest hasn't diminished enough to abandon this sector so the short temptation will be there again to exploit).
Meanwhile, I had noticed that institutional buying had driven ex-Nasdaq-100 telecom LVLT back up above $1 after a brutal stretch that included dropping nearly all institutional investors in the process. Back in early November, LVLT tried to stage a comeback above $1 only to fall back brutally a few days later under heavy short selling. Eventually, full capitulation happened near $0.60 on December 30 under heavy short interest, and with all short-term longs now out, the stock has nowhere to go but up.
A large institutional buy on January 5 was the spark, and the stock was over $1 the next day and hasn't closed below it since. More institutions followed then next day (last Thursday), and the short squeeze was on, reaching 1.42 before a wave of double-down shorting pushed the price back to a $1.32 close on 10x normal volume. The next day, the smart money jumped in at the $1.17 open and pushed it to 1.65 before falling back to a 1.49 close. If you double-down shorted there and covered within the first 2 hours, you could have gone back to even. Since then, 1.13 is the lowest it's gone and it's holding steady in the mid-twenties with 12% short interest and nearly 18 days to cover. Ouch.
Lesson to would-be repeat shorts: If you're going to short a stock, pay attention to the flow of liquidity. Unless you have good reason to see an imminent liquidation pressure that wasn't there before, you're more likely to set yourself up for a short squeeze than you are to ride it down to old levels--especially if the flow of liquidity is more likely to bet against you.
Saturday, January 10, 2009
- Latency is the notion that there is a measurable period of time between cause and effect. We humans like to pretend latency doesn't exist: we fail to account for reaction time both in the way we drive and the way we run our countries, corporations, and personal finances. Even the minuscule latencies measured in nanoseconds in our microprocessors matter in nontrivial ways as they are amplified by larger scale systems and software that we directly interact with, but in this case we're also dealing with events that have latencies measured in months, years, and in some cases decades or more. Think of the latency between the time a real estate developer decides to move forward with a project and it's final completion. There are many effects of The Great Disruption (my favorite name so far for this event) that won't be felt for many years while others seem to register instantaneously. Eventually, these will create significant investment opportunities (as well as unexpected risks).
- Novelty for our purposes is the degree to which any given idea, object, model, action, etc. has a loosely measurable sense of being new (or at least unconsidered). In 2008 much of the late sell-off could be in part attributed to panic induced by the novelty of the idea that we could see a repeat of the last century's Great Depression, and the day-to-day swings of the market are routinely attributed to their absorption of novelty in the form of recent news. As the novelty of an idea wanes we often say that the market has already "priced in" that notion, and sometimes there's truth to that idea.
- Scale in this case should be thought of as not only the measure of how "big" something is, but also the rough measure of how far its local effects propagate, from the micro and nano levels to the national, global, and universal. Measuring latency requires a known value for scale, since a given effect typically propagates more quickly at small scales.
So what do latency, novelty, and scale have to do with the recovery? Everything. We humans tend to (1) believe the latency between the cause of most events and their resulting effects is much, much smaller than it actually is (in other words, things take longer to play out than we think), (2) overreact to novelty in the short run but over the long term underestimate the effects of anything that is novel, and (3) consistently misjudge how effects will scale up or down as scales reach very large or very small values at which we lack native experience. Then we overcorrect once we realize we're off track. Eventually, like a lake that slowly returns to stillness when the wind dies down, our corrections become unconscious and continuous as we regain equilibrium.
Great fortunes are amassed (often unconsciously) by those who take advantage of this trio of human tendencies with the right investment vehicles. And we often find the seeds of this same trio at the root cause in the most spectacular (and banal) accidents and failures. The Great Correction is the mother lode of this dynamic in action. Here are a couple of quick examples:
- Financial institutions incorrectly assumed that (1) their proprietary risk models could be quickly adapted to reflect any fundamental changes in the global financial system and (2) widespread liquidity in many global financial markets would enable them to quickly dispose of hedging assets they no longer needed so they could acquire those they now lacked as their risk model changed. In fact, it took much longer than expected for them to realize what was happening and by the time they did a liquidity problem of historic proportions made trades that seemed trivial and quick a year ago expensively prohibitive and time-intensive today.
- Once it became apparent in 2007 that certain debt assets held by many large institutions had become worthless, a number of highly-leveraged institutions found themselves forced to raise cash to remain solvent. In many cases, illiquid markets elsewhere meant equities were the only asset a troubled institution could sell quickly to meet liquidity demands that weren't expected to become so big so quickly. This led to a powerful negative-feedback loop for the most troubled institutions where large equity sales over such a short period drove down equity values so much that further liquidity demands were created, forcing more sales by more and more players and leading to a vicious cycle that played out much more quickly than the process that built up those asset values in the first place. The Great Unwinding was upon us (and in fact, has not fully played out, as evidenced in part by the many hedge funds still imposing significant redemption restrictions).
Now that the novelty of the facts above is wearing out, we're seeing the market turn to the novelty of the Obama presidency for inspiration. When he talks about how dire the economic situation is, we no longer see the market swoon because the novelty there has been played out. But at the same time, for every piece of bad news that is already "priced in" to markets, there is a lot of kinetic energy still left from the crash (and subsequent response) that will result in delayed and unexpected effects at scales that range from the micro (me or my neighbor) to the macro (the US and world economies). In some cases, the delays are understood end expected by some investors but there are other cases where future effects will arrive with a great deal of novelty and little or no symmetry. And even widely expected effects will seem novel to certain investors even if they are "priced in" by others.
Add to this the fact that the sudden arrival of any effect will provoke different responses by each investor (some will freeze in fear, some will flee in panic, some will step in immediately to take advantage, while others will make future plans to acquire distressed assets as they reach maximum levels of discount), and it becomes immediately apparent that resulting pricing action will both (1) move predictably in response to those response instincts as they are identified but (2) be disguised by the fact that (a) each of these responses will happen over different timelines that often intersect with each other, and (b) cannot avoid producing echos that may have further positive or negative reinforcing effects.
Said another way: even though most effects are predictable, it is hard to know exactly which effect(s) are in play at any given time and and to what degree they have been played out. There's a variation on the Heisenberg uncertainty principle in play here where by the time that you know exactly what's going going on with pricing and scale for a given effect, there may be no more latency in which to take advantage. Subsequent gains and losses are then due to the reinforcing effects of echoes or the imposition of novel effects (which kick in because prior pricing action mis-judged the scale at which those effects apply). Fortunately for investors, these reinforcing effects usually become strong enough to justify our investment decisions over time.
Therein lies the problem for the recovery. There are lots of latent echos in play with negative reinforcing effects. Credit problems for financial institutions naturally beget credit problems downstream for businesses and consumers, and attempts to counteract those latent echoes with stimulus by even the most dedicated politicians and policymakers will only add novel sources of perturbation whose positive and negative reinforcing effects are even less understood and therefore much more likely increase the time required for an long-lasting economic equilibrium to be reached. Once it became clear that stimulus is coming, those who understand and contribute to their own local areas of economic activity have to consider the potential effect of such stimulus on their own activities, and may defer investment action until the effect is known or understood. The gradual accumulation of these deferred investments on a micro level will have negative impacts upstream as a result.
Think of the interference patterns that happen when a placid lake is perturbed: everyone across the lake can see them and immediately understand where they came from. Investors in calm times stay with their investments during small understandable perturbations because they can identify and understand the fluctuations they see. Even large perturbations from a single source are easy to identify and safely ride out. But as more perturbations are added, the complexity of the interference patterns that result becomes too difficult to understand and protect against. Rogue waves can develop and isolated areas of calm can appear momentarily but don't last long. The best thing a government can do in this situation is seek out and temporarily reduce the impact of the sources of perturbation they directly control:
- Streamline and simplify complex regulations and taxation that distorts investment decisions in unhelpful ways. In some cases, simplification can't happen without creating further perturbation - this can be mitigated by delaying the effective date of such simplification so that all those affected have sufficient time to react (an example would be removing the tax-deductability of mortgage interest, which could be removed only if the benefit was gradually reduced over time and did not take effect until the correction had run its course).
- Avoid the temptation to introduce new legislation where existing law could work if enforced. Seek out and prosecute those that flout any existing laws and regulations that are still valid and worthwhile so that uncertainty regarding the effect of new legislation is only introduced when no other option is available.
- Establish a culture of incorruptibility within government that fails to reward the bad behavior by private citizens and enterprises that is being poorly fought with Byzantine conflict-of-interest laws and rules that fail to rip out the soul of corruption
- Document and research all that is known and knowable about The Great Correction and its root causes (as well as similar crashes and downturns in the more distant past). This serves several purposes: (1) it helps citizens arrive more quickly to a common understanding of the problem, (2) it helps quell misguided anger and calls for reprisal that would fail to improve our conditions, and (3) it creates the justification for future pre-emptive actions to be taken by our children when such economic conditions return.
Washington has no intention whatsoever of undertaking any of these items in a serious way. Yes, you will see superficial treatments of each, but as much as I admire Obama and the way he used a combination of pragmatic leadership and Reaganesque embrace of optimism to gain the presidency (and our confidence), he would no more disown the established rules of Washington politics than he would his white grandmother. He is a politician's politician and in is in this way completely unlike Reagan who at a personal level hated politics and sacrificed his day-to-day reputation in order to get the most critical long term results that his successors were all too happy to own as their own. (Note that I'm not suggesting he isn't the best possible choice right now - no better alternative was electable. I still believe 8 years later that had McCain been successful in 2000 he would probably have been the right man for the job at that time; in 2008, not so much).
You've got to work with what you've got, however, so you will not find me bitching about Obama's approach. Even if I had his talent and experience, I could only hope to match his effectiveness and consistency. The man is smart enough not to start a two-front war on Washington and the economy simultaneously. So the best he can do is try to make the inevitable stimulus package as understandable as possible and respond with confidence when it inevitably fails to produce the desired effect of calm economic waters within the unrealistically short expectations we collectively cling to. And we'll love Obama for it just as we loved Roosevelt (albeit with two fewer terms).
Meanwhile, I'm doing my part by placing my bets on investments that have some upside potential to produce returns in these turbulent times, and avoiding treasuries and other "safe" vehicles that are going nowhere. Thanks to the emergence of inverse ETFs, I can make volitility my friend as well, taking a two part strategy that also has the side effect of encouraging less volatility in markets over time:
- After markets complete several days of large gains and sentiment feels euphoric, I begin buying small, cheap positions in inverse ETFs that move in the opposite direction of my holdings (like QID which has in objective of 2X the inverse daily performance of the NASDAQ 100 before fees - just keep in mind that compounding double daily performance over a year won't give give you double the yearly performance), and continue that accumulation gradually as prices rise (and their value shrinks) until the first large fall. At the same time, I trim holdings that are underperforming or overexposed. I wait to take profits on stronger positions until movement slows or starts to reverse but do not exit strong positions completely. And even when I leave weak positions, I often hold on to a few shares (enough that I wouldn't miss them if they were gone) on the premise that 20 years from now a handful of huge winners will emerge and I don't want to be tempted to touch the stock again in the interim. I also seek out stocks that may temporarily be moving in ways that are uncorrelated to the rest of the market and consider very small small entry positions in stocks that seem overpriced in some way but are worth more attention in the future.
- After a large fall or several consecutive days of smaller falls, I stop buying inverse ETFs altogether and begin accumulating new positions or expanding existing positions that are fundamentally strong but beaten down. I continue to seek out stocks that may temporarily be moving in uncorrelated ways and adjust positions of uncorrelated holdings. As a stable bottom forms (or the first signs of optimism return and I need to rebalance so I don't hold more than 33% of my total value in double inverse ETFs) I start selling my inverse ETFs but do not completely exit them since the worst that can happen is that a sudden move upward that doubles my long positions would only take out 75% chunk of my inverse ETF holdings even if I had equivalent amounts of each at the start (meaning that on the way down I had already doubled the value of my maximum starting position at the top of the euphoria which is having an amount equivalent to half of my long holdings in a 2x inverse ETF) still gives me a worst-case 25% gain on a violent and unexpected upturn, while a violent and unexpected downturn without any inverse ETF holdings could wipe out up to half my holdings in the worst case and I'm willing to give up about 10% of my slow-growth upside in stable markets for that kind of insurance. While markets are trending down, I tend to be aggressive in taking profits from uncorrelated investments. If a very short term rise is expected to be temporary, I may briefly take a 2X or 3X long index ETF position to ride upwards briefly but otherwise I try to avoid holding long leveraged ETF positions except when they have become so beaten down that a sector-oriented pop is inevitable. Those I buy along with other long-term holdings selling cheaply as I lighten up on my inverse ETF holdings
Eventually the level of volatility reach a point where the swings are less visible, the long-term trends are clear, and the transaction costs of this strategy make it unattractive to a retail investor. But in the mean time, I've helped the market reach an equilibrium and shaved more than a few points off for myself. And since I do this with my 401(k) account, I don't need to worry about tax consequences for my trades and I help ensure the financial stability of my 401(k) provider by passing lots of commissions to them. This is just one of millions of micro-recovery plans that have become possible thanks to the Internet and other technology advances, and I'll be writing more in the future about this micro-recovery concept and how it applies to other decisions we make because I think it holds the real key to our recovery.
In fact, we may well discover in 10 years that we didn't need much of these large financial institutions had to offer us because the most important infrastructure for microinvestment across a global scale was with us all along but had been hindered by regulatory and cultural roadblocks--but that's a topic for another day. In the mean time, I'd like to hear from you. What do you think will hasten the recovery? What is spurring you on to invest and what is causing you to slow down your own investment and savings decisions?
Sunday, January 4, 2009
- Stocks will rally briefly as Obama comes into office, but as quarterly reports come in for Q1, the reality of the challenge will re-test November lows
- Those who go long in the depths of the 2009 re-test will be rewarded handsomely as the massive short squeeze that follows will prove to be the best trading opportunity of the year
- Apart from that re-test and short squeeze, stocks remain sideways overall and by the end of the year we'll finally see widespread capitulation among long and short traders as the volatility (most visible through the VIX) will once again subside to the sub-20 levels by year's end.
- Gold and Oil, after enjoying a brief resurgence at the beginning of the year, will drop to surprisingly low prices as deflationary pressures prove stronger than expected for the rest of the year. Those who wait until the end of the year to buy will get the best prices in decades and will be well positioned for the inevitable turn towards inflation that will happen in the coming decade, but there will be trading opportunities throughout the year as oil-producing countries attempt to push prices upward but ultimately discover all such attempts are doomed to failure this year.
Next, let's talk technology:
- The hottest IT topic in 2009 will be Unified Communications but most organizations will struggle to understand UC in the same way they struggled with Web Services. Cisco, Microsoft, and Avaya will remain the top players as business issues force Nortel, Alcatel-Lucent, and Siemens to the sidelines but each will define UC in terms that play to their natural strengths. No winner will be crowned in 2009, but by the end of the year we'll know who is firmly in control of their own destiny after winning the battle for mindshare. After that, it will only be a question of execution and none of the contenders have consistent records in that department.
- The Intel-AMD wars will come to a sad final conclusion, not with a bang but a wimper. Intel will close the year with at least a 25% stock gain after it proves once again that during the hard times in tech, execution is the only thing that matters. Despite the value gap opened up by ATI, quality issues that can be traced back to the botched handling of the ATI-AMD acquisition will doom their attempt to stage a comeback against nVidia. ATI will become another poster child for what happens when you chase out high-priced talent after an acquisition in the short-sighted pursuit of cost savings as all the progress they made in 2008 disappears under the weight of a twice-bitten customer base.
- Gateway will disappear and some assets will be bought out by HP or Dell (likely on the cheap during bankruptcy proceedings) - nobody will attribute it to poor customer service except its customer base, another victim of the "twice-bitten" effect.
- The Information Security community will discover to its chagrin that blowback from irresponsible disclosures will cast the entire community under an uncomfortable spotlight and most organizations will re-think their security governance processes with an eye toward more tangible cost-benefit savings realizations. An immense industry consolidation among security startups will begin to cascade by the end of the year as VC firms begin pulling the plug on unprofitable investments.
- IT contract work will skyrocket as cost-saving investments are greenlighted while new hires are not.
- Patent and Intellectual Property disputes reach all-time highs as business conditions make out-of-court settlements less palatable to firms in desperate situations. The whole concept of software patents becomes hotly debated again after a series of irreconcilable judgements threatens to make a mockery of the patent system as a whole. Congress will be asked to step in to clear things up but they will not--at least this year.
- Google begins to consolidate gains and after further stock price erosion due to it's high P/E ratio finally declares a dividend and begins building a base that will eventually form a 10-year low. By the end of the year, it will be considered a legitimate blue chip but it won't return to its 2008 peak this year in spite of remarkably strong revenue.
Finally, some social and political predictions:
- Obama will allow the Bush tax cuts to expire on time but will propose middle-class tax cuts in the interim. Congress will not move quickly enough as the issues of "fairness" tie up both ends of the political spectrum, ensuring logjam.
- Despite putting millions of people to work on infrastructure projects in 2009, Obama won't be able to recapture the job loss of 2008. By the end of the year, it will become clear that apart from direct government contracts and a few minor tax breaks that will only be useful to employers with other reasons to hire, Obama's team isn't doing anything substantial to incentivize risk taking by potential employers.
- "Card Check" legislation becomes a political tar baby that ultimately fails to find a champion willing to push it through congress and on to the President. In the end Obama will be grateful he doesn't have to deal with it
- Splinters and divides within the Republican party will worsen as the lines between fiscal conservatives and social conservatives become more pronounced. The culture war meme is tried one too many times and begins to backfire.
- As some global warming trends fail to materialize during 2009, Al Gore will be famously quoted as being grateful the 2008 financial meltdown came when it did since it finally allowed mankind to reverse course. Later it will be determined that there had been no substantial decrease in carbon emissions over the past few years and the cause of the reversal had little or nothing to do with activities under the control of humans. The volume of Ice around Antarctica sets new records, even as the northern ice cap continues to recede.
- With George Bush finally out of office and Obama carrying out an inclusive centrist agenda, the radical left will call the honeymoon over by July. Be the end of the year, the few that remain will be more isolated and disempowered than ever before and become far more embittered with Obama than they were with George Bush. With Bush, the betrayal was expected and impersonal. With Obama, the blindside is personal and made that much the worse by his overwhelming popularity with the center-right. By the end of the year, they will accuse Obama of having hijacked the Democratic Party and rail at The New York Times in 2009 as if it were Fox News in 2008.
- California and Illinois will prove to be the tip of the iceberg when it comes to fiscal irresponsibility at the state and local level. New Jersey, Michigan, and Florida will soon follow. Obama will respond much like Ford did to New York City in 1975: after encountering initial resistance to a federal bailout, sobered leaders will do what it takes to cut back government, then Obama will deliver the goods with some significant strings attached. Colorado will become Obama's model for state fiscal responsibility and show strong signs of recovery by the end of 2009 but other states will have difficulty replicating its success.
- The trickle of migration out of the Northeast, Michigan, and California will grow to a flood. Primary beneficiaries will be the Northwest, Mountain West, and Texas. Growth in Denver will be the most unexpected upside surprise, as strong growth trends in cities like Portland and Dallas are not particularly new. Chicago, Phoenix, and the greater DC area will prove resilient as increases in outward migration are met with inflows that more than offset for a small net gain.
It's entirely possible that some of these predictions are a bit early and may take more than 2009 to realize. And next year the Jaded Apprentice will single out the most glaringly wrong prediction for special abuse and humiliation along with props for the reader who first calls it. Now it's your turn. What's on your list of predictions for 2009?
You may recall that Alan Greenspan admitted there was a "flaw in the model that I perceived is the critical functioning structure that defines how the world works" and went on to say that he wrongly believed market participants would behave rationally. Dan Ariely (who first glimpsed these disconnects as a patient recovering from severe burns to most of his body) tackles the myth of rational behavior head-on, and includes an impressive array of research to demonstrate the realities of human behavior. When viewed through the lens of the credit crisis, it's even more powerful today then when it first came out:
This second recommendation was published in the spring of 2007 and recently released in paperback. It should put to rest the myth that financial insiders and regulators could not have seen these systematic failures coming. Richard Bookstaber first grasped the problem in the 1987 crash when the "portfolio insurance" he helped pioneer created the same kinds of imbalances and liquidity traps that plagued the 2008 markets as the credit crisis took on the same dynamics. The conclusion, "Built to Crash" is particularly chilling as I found it to be far more accurate that what more famous doomsayers like Peter Schiff (whose suggestions in Crash Proof have been dead wrong in the near term but will eventually pan out when inflation returns (I predict that's at least a year out and Gold may not move much until then)). I couldn't make it through Peter's book - if you've seen him on CNBC over the years you won't find much new there. But Richard Bookstaber (who also spent a long time at Salomon Brothers) in many ways has written the sequel to Michael Lewis' Liar's Poker (which is just as entertaining and between the two books captures the essence of the last 30 years of Wall Street):
Saturday, January 3, 2009
First, let's review the patten. Initially, the first suggestions of weakness are met with derision and dismissed. Yet over time the reality becomes common knowledge as more people realize an imbalance is building that has not yet registered in the marketplace. Shortly thereafter, pundits arrive proclaiming that the latency, inertia, and distortions from regulations and other constraints that have kept the marketplace together is actually evidence that old rules no longer apply and prospective investors would be foolish to miss out on the gains that early speculators have amassed. A form of mass delusion ensues until the resulting bubble collides with reality when a critical mass of over-leveraged speculators is forced into a liquidity trap by an unforeseen event that even a few years prior could not have precipitated the crisis on its own. The near-instantaneous need for liquidity sends assets so quickly into the marketplace that it drives all asset values downward, forcing additional liquidation in a self-perpetuating cycle that if left unchecked can wreak enormous collateral damage in the process.
In the aftermath it is discovered that regulatory process in place from the last bubble not only failed to prevent this one, but in some cases was employed to legitimize those speculative excesses. Subsequent attempts to correct the effects of the burst bubble and protect against future excess have the perverse effect of chasing out the well-captialized risk-takers who could most quickly re-establish a growing economy, leaving the heavy lifting to undercapitalized visionaries who will come to dominate the next economy once the overall appetite for risk returns. In the mean time, the insatiable desire for risk reduction will drive social and economic policies that manage to preserve a few jobs in failing industries that quickly find themselves trapped by the very safety net meant for their rescue, unable to attract the talent an capital needed for the dramatic transformation they ultimately require.
It is tempting to suggest that regulation (or the lack thereof) is the root of the problem, I think both sides of that argument are missing the point. Even in a deeply regulated environment, an expanding appetite for risk-taking coupled with a reduced premium for risk taking will drive more and more capital toward higher-risk growth opportunities until unexpected systematic failures re-establish a meaningful risk premium by chasing out all but the most determined speculators. Regulation can be effective when it enables transparency for legitimate marketplace participants, but in practice that transparency proves elusive and is virtually impossible to maintain as the number of market participants mushrooms. The most effective government interventions are those that re-establish transparency as new bubbles form (an almost impossible task given the fact that (1) such moves will be unpopular with those who initially benefit from the opacity, which may include large segments of the public at large and (2) the government will be blamed for the market correction that follows, however mild it might be in comparison to a full-blown crash), and those that re-stimulate the public's appetite for risk following a crash (unfortunately history's best examples are either full-blown war such as WWII following the Great Depression or Reagan's dramatic military buildup and diplomatic confrontation that ended the Cold War, coupled with tax cuts that eventually resulted in the budget surpluses enjoyed during the Clinton era as America finally moved past the effects of all those failed 70s-era interventions).
Over the last 20 years, it's been widely accepted that actions of the Federal Reserve Bank system are most essential to the preservation of a sustainable American economy and I would be the first to agree that Alan Greenspan's actions following the tech bust helped maintain a healthy appetite for risk taking in the subsequent years. But apart from making the occasional speech regarding "irrational exuberance" on the part of investors, there is very little the Fed can do to when market imbalances will respond more effectively to transparency improvements than the blunt instrument of rate changes themselves. And constrained by the myriad charters of regulators with more direct responsibility for preservation of that transparency, any effort to drive fundamental market changes from the Fed would have been met with unbelievable opposition from all quarters.
Yet I believe strongly that sustainable approaches are possible going forward if we can get back to basics in a few areas where we've discovered systematic problems during 2008. Here's the model I have in mind:
- While direct representation of the interests of stakeholders like shareholders and bondholders are not be practical for all business decisions in publicly-held companies, we need to see more legitimate methods for representing their interests. The process that selects directors and drives board-level strategy is often so hostile to individual investors to such a degree that most shareholders make no attempt to participate and board members and senior officers do nothing to include them except when their approval is required. This not only wastes valuable input from shareholders as a group, but perpetuates the notion that shareholders have no real say on how a company is run apart from their veto power. There's an opportunity here for reform, but in many cases government regulations themselves are preventing meaningful innovation here by locking corporate governance structures into models that are a century old (or more) and require a bit of healthy adaptation to remain relevant. It will probably take a bit of experimentation to get this right, so it's more important initially to allow for legitimate innovation first than prescribe a single solution all at once.
- Quarterly financial reporting to shareholders in an era when management often has equivalent reporting tools that drill down to critical financial stats on a daily or hourly basis is an open invitation to creative financial engineering. In today's world, last quarters results typically arrive a month too late when the instantaneous flow of information from other sources has already driven a stock lower or higher. What's needed is a radical change to reporting frequency that applies to all publicly held companies equally and serves to discourage both speculation and insider trading by moving to much shorter reporting periods (perhaps as often as weekly or even daily) that immediately reward good sales and investment decisions while removing the incentives to game the system thru smoothing techniques that ultimately provide no lasting economic value. There will be legitimate smoothing techniques to employ, but the shorter reporting period will force these to be used only when they can be cost-justified over both short- and long-term views.
- Compensation alignment for both ordinary employees and senior executives to changes shareholder value over time is essential. Every attempt at government intervention to date has created further distortions that take us further from this goal, from limits on executive compensation to the process for calculation of stock options. Here's one suggestion on how to move in that direction: Rather than focusing on changes to corporate income tax laws and capital gains taxes, the government could encourage investment and improve productivity by providing tax-free employee compensation for convertible options or restricted shares that (a) must be granted to all employees (with reasonable ratio limits that ensure equitable distributions), and (b) require a holding period of at least 2 years from exercise (in place of a clawback provision which might discourage appropriate risk taking) to discourage management from undertaking short-term manipulations that undermine the long-term value of a stock. This has the additional benefit of increasing our savings rate at a time when an increase is sorely needed in a way that is neutral to existing compensation structures.
It's been more than 75 years since America had a comparable economic hangover brought on by historic levels of debt-driven finance that has turned corporate America and most of her consumers into Ponzi units, and like most problems that extend beyond our current generational memory this one won't respond well to our traditional economic thinking. The painful de-leveraging that should have started with the burst of the 2000 tech bubble was postponed by the easy-money Greenspan Era and finally forced out into the open by the collapse of toxic collateralized mortgage debt instruments that precipitated what will likely be remembered as the largest and most rapid stock market crash in history but just a prelude to the difficulties to come.
Getting through the next 10 years will put Americans in very unfamiliar territory. We are unprepared in every possible way for the end of rampant consumerism and the inevitable social upheaval to come. Even with a very pragmatic and popular Obama presidency, the anger, blame, and repercussions from the collapse will test social order in ways not seen since the 1930s. Our generations never realized that the 1929 stock market crash, ugly as it was, didn't immediately bring on the conditions we think of from the 1930s depression. In fact, it took a long time for unemployment to reach the unfathomable levels seen prior to WWII and America would not have become the Superpower it is today had FDR not deliberately pushed an unwilling and isolationist America into the war. The war effort finally set the stage for an aligned and expanding economy and it will take a similarly ambitious, uniting cause to exit the coming deflationary period.
Among the most difficult issues that will need to be addressed to exit this decade of upheaval, in no particular order:
- Governance and structural innovation for public and private enterprise. Information Technology could enable radical transparency and broad-based participation by shareholders and customers on a scale not previously fathomable -- yet we continue to build corporations in a command-and-control style with tone-deaf directors, overpaid executives and quarterly reporting that fails to provide a timely and responsive operational governance model for public shareholders. Alternative approaches are emerging from the Internet economy but these need to become legitimized, formalized, and scaled to the needs of the 21st century enterprise.
- The nature and structure of intellectual property and the legal and moral mechanisms that protect and enforce it. The current approaches to patent and copyright are unsustainable and breed uncertainty, open contempt, and abuses that subvert the original purposes for which they were established.
- An end to an ineffective and counterproductive War on Drugs in much the same way the end of Prohibition in 1933 marked an end to the corruption and influence of organized crime that had become much worse during the depression. Taxation, legalization, and government regulation will destroy the cash flow to organized crime and terrorism much more effectively.
- A push to enable community-centric health care, education, and welfare solutions that enable those who want to serve their communities to do so--instead of chasing them out. Today's overly-centralized, overly-bureaucratic and parochial systems are perhaps the most broken part of America's social framework--and the most disconnected from the middle class. This will require a frank acknowledgement of Great Society failures and a renewed and widespread determination for success at many levels and within many socio-economic subgroups, including those with conservative or religious leanings.
- Mechanisms to cripple the effectiveness of terrorist groups that don't rely on the use military or civilian police forces - if those who would be recruited by such groups can't be enticed to join because they have a legitimate stake in their society, the war on terror will be over and the seemingly endless cycle of blowback will finally play out.
Rebuilding functioning economic order that encourages both savings and risk-taking depends on clarity emerging in these 5 areas. I'm not going to hold my breath waiting for the answers -- but I do expect that as our situation deteriorates over the next decade we will finally gather the political will to legitimately tackle these issues. The next superpowers will be made up of those nations who successfully resolve these issues as leaders--and doesn't necessarily include the US unless we step up collectively in ways not seen since the decades following WWII.