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Speculators' Liquidity-Leverage Russian Roulette with Economy; Real Cap Gains Tax Scandal

(Econotech FHPN) -- "The point is that these innovations have externalities for the entire financial system that are hard to measure but dominate their apparent value. Rather than adding complexity and then trying to manage its consequences with regulation, we should rein in the sources of complexity at the outset. Linked to the need to reduce market complexity is the need to relax tight coupling ... A less disruptive course of action is to reduce the amount of leverage that comes as a result of liquidity, since this is ultimately the culprit that high liquidity and speed of execution breeds. The externalities to high leverage are greater than they appear, because on most days everything runs smoothly. But as we have seen time and again, in the instances where it really matters the liquidity that is supposed to justify the leverage will disappear with a resulting spiral into crisis. Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets." Richard Bookstaber, "A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation," 2007, Wiley, pg 260.

"Chuck Prince yesterday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, declaring that Citigroup was "still dancing". The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity at the moment it would not be disrupted by the turmoil in the US subprime mortgage market. He also denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back, in spite of problems with some financings. "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing" ... "The depth of the pools of liquidity is so much larger than it used to be that a disruptive event now needs to be much more disruptive than it used to be." ... "At some point, the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way. I don't think we're at that point."" FT, July 10, front page [bold emphasis added]

This article is mainly about whether to practically deal with an increasingly risky current investment environment, via hedging, as a follow-up on previous articles.

The Bookstaber quote above addresses the far larger issue of the safety of the current financial system, and what could be done to increase it. I strongly recommend the new one-hour interview with Bookstaber at financialsense.com link. Dr. Bookstaber's (MIT economics Ph.D.) practical knowledge of derivative and credit markets has been earned since the early 1980s as a "financial engineer" and "quant" at Morgan Stanley, Salomon Bros, and a hedge fund.

As for the above quote from Citigroup's CEO Prince, I will comment in the next to last section of this article on his "it's not my fault, the liquidity made me do it" rationalization for continuing the credit bubble. For now, I will just ask, is the almost adolescent yet high-stakes game of liquidity-leverage Russian roulette or chicken, or musical chairs to adapt Prince's dance metaphor, any way to finance a modern global economy, who do you think benefits from doing so, and who will lose if/when the music stops?

If you've seen this movie before, it might feel like watching a car wreck in seeming slow motion, you cringe, but can't stop it from happening. But you can, the current rules of finance are not the same as the immutable laws of physics. E.g., capital gains taxes which encourage the ongoing orgy of speculation can be changed, as I discuss in the third from last section. The last section talks about my web site's link new tag line, "FINANCE INNOVATORS, NOT SPECULATORS, For Just Global Development, To Restore America's Purpose and Values."

What to Do If/When the Liquidity-Leverage Music Winds Down

With a sell-off in U.S. stock markets July 24, I would like to give an update to my June 21 article, ""Goldilocks" 65 Basis Pts Higher" link, specifically the last section titled "If and When to Hedge?" where I wrote:

"As I've tried to imply earlier in this article and in recent previous ones, while I have consistently presented "the long-term uptrend is your friend" view on my web site since the middle of the sharp global sell-off May-June 2006 (starting with my June 2, 2006 article link), now might be one of those times to consider incurring the costs of hedging your bets, in some way to some extent, depending on your preferences. Again, in terms of timing a hedge strategy, July, like most first months of each quarter, tends to be seasonally stronger, after negative earnings news comes out in the previous month."

I have not given specific investment suggestions on my web site link, that is NOT its intent nor purpose. But by hedge, I meant exactly that, hedge, perhaps with puts, or however else one is most comfortable (including simply raising cash, using stop losses, buying precious metals, etc). Or, perhaps even easier, consider using calls (similar to going long both securities and puts), to limit downside risk and avoid the difficult task of trying to match-up hedges with longs (rising volatility is making the use of options more costly).

I tried to be a little more specific in a private e-mail distribution on June 30:

"To get right to the bottom line, I now feel that there is greater than a 50% chance of a significant correction in the stock market in the 3rd qtr. By significant, I mean at least 5-10%, but it could be much more ... for the very little that it's worth, my guess is that the stock market might be okay through around July 20, as money continues to flow into large cap and tech stocks during the upcoming 2nd qtr earnings season. Then I think the period of maximum risk begins, from around July 20 thru to about Oct 10."

Will July 20 mentioned above turn out to be a, or even "the," top? It simply doesn't matter, it was just a sheer guess. So far, July 19 has been the closing high in the S&P 500, and money did flow into tech and large cap stocks during the July earnings season, producing a rally stronger than I expected (I had previously written of this shift into large caps and tech a couple of times, e.g. on May 31 "Brief Update" link).

Regardless, do I still have the same concern about a significant market correction in the third quarter? Yes, I would again suggest that investors consider hedging to protect their gains. I discuss a couple of caveats in later sections.

Btw, I simply can NOT suggest such actions as going net short on my web site, so please don't read anything into my failure to do so, should the 2002-07 bull market look like it is sharply correcting.

How Far Will Credit Market Problems Go?

The basic investment problem that I've highlighted before remains that no one really knows how far the very obvious excesses that have been concentrated in the credit markets in the 2002-07 bull market are going to play out.

But so far all the news has been bad, and it keeps getting worse day after day, with the subprime woes spilling over into higher rated mortgage securities, and into the absurd economic misallocations of the lbo and m&a deals.

Under these circumstances, it is simply financially prudent to try to protect one's investments as best as possible.

However, until just the past few days, there has been a huge disconnect between what is going on in the credit and equity markets, with the latter seemingly almost willfully and deliberately ignorant of the problems in the former.

This is even more true of rising geopolitical risks, not only in Iraq, but especially in Pakistan and elsewhere, which global financial markets continue to almost completely ignore, other than through the price of oil and precious metals.

Unfortunately, as I've written several times already, e.g. on June 7 link and June 21 link, even most professional equity nvestors are woefully in the dark on the day-to-day working reality of credit and derivative markets, which are deliberately very non-transparent, even to government regulators, to their unease.

(Btw, I was tempted to post extensive quotes on these credit market issues, I have a 16,000 word file on them just from the past month alone, but I simply don't have the time to do news summaries on my web site. I would STRONGLY recommend that any equity investor interested in following credit market issues, which are particularly critical right now, regularly read Bloomberg at http://www.bloomberg.com/ and subscribe to the Financial Times, which are very good news sources on them.)

Precious Metals, Dollar, Oil Indicate Increasing Desperation to Contain Credit Market Damage

I do not have much to say here about gold, the dollar, and energy, especially oil, markets which are extensively covered by others more knowledgeable than myself on these issues, including on the sites that kindly repost my articles and I have listed in my links section, so I will defer to them on these topics for the moment, and not get into these issues.

But deferring does NOT mean minimizing their importance. Suffice to say, every investor should be very aware that precious metals, the dollar and oil are at critical levels, decisive breaking of which would reflect increasing major risks in the global economic/financial environment, so please continue to follow these markets very carefully.

The recent action of the dollar, precious metals and oil, along with the ongoing very rapid expansion of key monetary aggregates globally, seem to indicate that the financial powers that be are becoming increasingly desperate in their efforts to contain the damage in the credit markets.

Btw, Bernanke's talk about "anchoring" inflation expectations seems rather futile in a world in which the major reserve currency, the dollar, isn't anchored to anything real. One look at charts of the dollar index against major currencies from 1973 to the present (see below, courtesy of St. Louis Federal Reserve) and gold would seem to indicate that. Again, is this any way to run a global monetary system, for lack of a better term?

Equity Market's Suspect July Rally

In the equity markets, particularly suspect in the July rally was the seemingly manipulated short-covering strong gain, on relatively light volume, on Thurs, July 12, early in the day attributed to good same-store sales from Wal-Mart, and a large m&a deal, Rio Tinto's takeover of Alcan.

Needless to say, yet another mega-deal was hardly new news in a record-breaking year for m&a, nor is consumers' dealing with rising energy and food costs trying to stretch their budget by shopping at discount stores necessarily good news.

In fact, the very next day, Friday the 13th, came a report of very weak consumer spending in June, yet needless to say in the bull market media frenzy that did not reverse the previous day's gains. Lost in the mass media hype is that most of the increase in second-quarter GDP will be from a large inventory swing, secondarily from the external account, with consumer spending still expected to be below trend.

As for the other most common rationalization for the July rally, earnings so far have been coming in up about 8%, again better than the reduced expectations, again same old game. This seemed to be enough to spur a small tech-bubble redux, with lower but still nose-bleed p/e's in a few crowd favorites such as RIMM, AAPL, and AMZN that I've previously mentioned in another article.

It's Not Only About Your Father's S&P, Dow and Nasdaq Anymore

My first caveat regarding a significant market correction in the third quarter is that, while the S&P 500 is usually the benchmark index for American investors, it is far from the leading one in the 2002-07 bull market.

As I've said before, that prize goes to emerging markets, which are up 4 times as much as the S&P, and equities and commodities in energy, materials, precious metals, etc.

All these markets play off the same theme of strong global growth (with precious metals also reflecting other issues) that has been unprecedented in history, in terms of speed, scale and scope. As a result, U.S. financial markets are no longer as dominant as they once were.

So, in trying to determine the trends and risks of global financial markets, we need to look at other leading markets, not just the large cap U.S. S&P 500, Dow Industrials and Transports, Nasdaq 100, etc. (on which many more traditional technical analysts still seem fixated).

EEM, the emerging market etf, and OIH, the oil service etf, are still in strong long-term uptrends. But, as I've been writing for the past few months on my web site link , these uptrends are extremely over-extended at the current time, and thus susceptible to sharp declines.

E.g., here is a 4-year daily chart of EEM that I've shown before, courtesy of prophet.net (left click to enlarge), indicating that it has just started to pull back from being 2 standard deviations above its linear regression trendline, it is currently down nearly -6% today, while EFA, the developed markets ETF, is down -3.6% mid-day.

(I didn't use a log vertical scale since this greatly curves the regression lines, so EEM's current strength is somewhat visually exaggerated compared with earlier due to the linear scale, e.g., its recent 10 point move from 130 to 140 is far less in percent terms than the earlier 10 point move from 40 to 50 four years ago).

Let me be crystal clear that looking at these other leading markets is NOT meant to minimize the importance of developments in the U.S.--everything is connected nowadays, both in the real world and the financial one.

As I've indicated before link, up until the past few days, huge credit market risks have been counter-balanced to some extent by huge real global economic growth, though that balance is rapidly turning into global risk aversion. E.g., China grew 12% in the 2nd quarter in China (China's mainland stock markets have just come back to their previous highs, and are very highly valued and frothy). The world has never seen anything like this growth before, again in terms of speed, scale and scope, though it of course has seen many previous examples of excess speculation.

Why I Try to Stay Aligned with the Long-term Trends, Except When They Change :-)

As for my second caveat regarding the prospects of a significant market pullback in the third quarter, as my phrase "the long term uptrend is your friend" above clearly implies, I do not place too much faith in trying to forecast, or guess, critical turnings points in financial markets, for various reasons that I've described elsewhere on my web site.

Suffice to say here that the economic/financial environment has changed so much in the past decade that I have great difficulty extrapolating prior experience, statistical patterns, rules-of-thumbs, theories, hypotheses, sheer guesses, etc.

(The Bank for International Settlements says something similar in its recent "Annual Report": "the combination of developments is so extraordinary that it must raise questions about the source and, closely related, the sustainability of all this good fortune. A variety of hypotheses have been suggested to explain subsets of these phenomena, but each falls short of explaining them all.")

Given that, I am content with trying to merely recognize major trend changes early enough as they happen to matter. For most individual investors, that is more than good enough. Larger, slower institutions must invest on the basis of their forecast.

(Btw, on the efficacy of forecasting financial markets, I recommend the views of portfolio manager and economics Ph.D. John Hussman. I would especially note his July 16 "Weekly Market Comment," "A Who's Who of Awful Times to Invest," link which does an excellent job indicating the risks of this type of market environment.)

A Real Capital Gains Tax Scandal

Recently there has been a little political concern raised over very low taxation of the huge gains of private equity fund owners, though their lobbyists quickly squashed it. The issue raised was whether their gains should be taxed as capital gains or income.

Of course it should be the latter, but that misses the key point. The very low capital gains tax rate has not done what it was sold to do, i.e. increase investment in productive economic activity, that investment has been low by historical standards in this economic cycle.

Rather, low capital gains taxes, including real estate, have clearly done what they could be expected to do, produce enormous speculative financial capital gains, mainly for the benefit of the ultra-wealthy. That is what the tax system and U.S. economy is geared toward doing.

Obviously capital gains that reflect expected real future cash flows from expected real future economic activity should be strongly encouraged and very lightly taxed. The same is true for real income, probably even more so, because real income must come from the production of real goods and services.

Whereas, in contrast, capital gains can often be manufactured out of pure Wall Street financial fantasies and speculation, purely in fanciful spreadsheet projections and the click of an electronic trade in cyberspace.

Today, much capital gains, again most especially of the ultra-wealthy, are from mere paper shuffling of assets and virtually unlimited credit creation, with very little, if any, link to real productive economic activity.

(Btw, mainstream economists don't seem to be willing to look at these financial speculative capital gains as probably the main source of growing income and wealth inequality in the U.S., instead focusing on differences in education which doesn't explain the rising disparity in favor of those at the very, very top vs other very well-educated people.)

I think any honest person who has ever worked in a hedge or private equity fund or i-bank would know how completely economically absurd many of their deals really are, and the fact that they are driven by pure greed, plain and simple. This is not how markets' "invisible hand" is supposed to work. Most mainstream economists, especially academic ones who haven't worked in speculative markets, just don't seem to know this, much less the politicians.

Paul Krugman, an honest and extremely capable mainstream economist (e.g. a 1991 winner of the highly prestigious John Bates Clark Medal), came close to hitting the capital gains tax nail on the head in a recent NYT column on this issue:

"There's a larger question one could ask: should we even be giving preferential tax treatment to true capital gains? I'd say no, because there's very little evidence that taxing capital gains as ordinary income would actually hurt the economy. Meanwhile, the low tax rate on capital gains is one main reason the truly rich often pay lower tax rates than the middle class. A couple of weeks ago, Warren Buffett pointed out that he pays an average federal income tax rate of 17.7 percent, while his receptionist pays about 30 percent. But even those who disagree with me on the larger point, who think the special treatment of capital gains is justified, should be able to agree that treating the income of fund managers differently from the way we treat the income of everyone else who works for a living makes no sense. And that's why it's very disheartening to read that prominent Democratic senators are taking seriously the claims of fund managers that making them pay taxes like regular people would discourage risk-taking." NYT, July 13, Paul Krugman, op-ed, "An Unjustified Privilege" [bold emphasis added by econotech]

But even Dr. Krugman, who has been extremely outspoken in going after the U.S. political elite on Iraq and other issues, so far has been unwilling to do the same with its speculative financial elite. In general, most well-meaning and very capable economists still show great deference to the financial, as opposed to political, elite

What Citigroup's CEO Didn't Say

While Krugman at least honestly raises the critcal capital gains tax issue, compare this with the quote from Citigroup's CEO at the front of the article.

Citigroup's Prince failed to make two critical points, first that the global hyper-speculators are dancing to music of their own making, to use his metaphor, through their infinite credit creation schemes. I.e, liquidity is not some external, exogenous, force of nature, it's created by the global hyper-speculators' own daily decisions and actions.

The second, even more critical point, that Prince obviously won't say is that this liquidity-driven global financial system is mainly intended to benefit its mega players, and is a completely absurd way to allocate savings and capital in a global economy.

Again, what this monetary/financial regime, for lack of a better word, is very good at is creating capital gains out of thin air, which mainly accrue to the ultra-wealthy, hence the unending stream of absurd deals that do just that.

What it isn't very good right now is rationally allocating investments that actually produce real income, again which should have very little if any tax, by meeting the real needs of the vast majority of the world's population.

Sooner or later, this massive global misallocation of capital for the benefit of a comparatively small handful of global hyper-speculators will change, hopefully positively, but it not, then with negative consequences.

That has always been the case throughout history, when an entrenched elite doesn't do the right thing, bad things invariably follow in reaction, in terms of conflicts and ideologies, which the elite then use to rally people against.

Let's hope history doesn't sorrily repeat itself yet again.

The Meaning of My New Tag Line: "FINANCE INNOVATORS, NOT SPECULATORS, For Just Global Development, To Restore America's Purpose and Values"

I've shortened the tag line on my web site link, still keeping the capitalized main theme, it now reads, "FINANCE INNOVATORS, NOT SPECULATORS, For Just Global Development, To Restore America's Purpose and Values"

This reflects my belief that the leading front in global history is the amazing economic development going on in many parts of the globe, while the U.S. government is bogged down in a debilitating, in many ways, rear-guard battle in the war in Iraq. (I view global history in terms of the leading nations moving forward human progress and global development, or unfortunately not, in any given era.)

I believe it's very unfortunate that the U.S., and many Americans, seems so pre-occupied with other things, including a huge capital gains fueled consumption binge of unprecedented proportions among its elites, to truly understand and appreciate the march of global progress in many parts of the world right now, which the U.S. previously had led for much of the past century, resulting in its much higher former global standing.

I also believe that the current U.S. failure to provide such global leadership, especially the U.S. financial elite's focus on its own ill-gotten speculative gains, has greatly eroded America's historical purpose and values.

As for the U.S. tech elite, it's nice that Apple is selling a lot of iPods, iPhones, and Mac's, Amazon a lot of stuff, and Google a lot of ads. But Steve Jobs, the once hip computer revolutionary, and Silicon Valley, the once awesome center of American innovation, have increasingly gone the way of Madison Avenue and Hollywood (though Yahoo recently switching CEO's was a small step in the other direction).

Hopefully the U.S., and its tech elite (I have little hope for the financial elite, perhaps those around the Rubin/Summers wing of the Democratic Party in the Hamilton Project will belatedly surprise me) will once again rejoin the global march of progress. If so, the U.S. might begin by once again starting to pay its way, instead of sucking in the world's savings much needed for economic development elsewhere.

After more than three decades of becoming the world's credit junkie, to start to change would require difficult but nevertheless doable reforms in the world monetary and financial regime, again for want of a better word. It would be much easier to make the much-needed global economic adjustments while things are still going relatively well.

But with the speculative finance elite dominating the U.S. economy, and the leading candidates of both parties seemingly in their hip pockets (with Clinton and Obama particularly good at getting money from hedge and private equity funds and i-banks), I personally don't have much optimism about that occurring any time soon. I hope I'm wrong.


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