October 14, 2009

John Hussman - Zen and the Art of Market Analysis

Fund manager John Hussman makes some interesting, if a bit gimmicky, connections between the zen Buddhist teachings of Thich Nhat Hanh and financial decision making in his latest newsletter:
The best way of preparing for the future is to take good care of the present, because we know that if the present is made up of the past, then the future will be made up of the present. All we need to be responsible for is the present moment. Only the present is within our reach. To care for the present is to care for the future.

Thich Nhat Hanh

This week's comment is dedicated to my dear friend Thich Nhat Hanh, a Vietnamese Buddhist monk who was born on October 11, 1926, having been born previously in January of that same year, and twice again about 25 years earlier, not to mention countless other times through his ancestors, teachers, and other non-Thich Nhat Hanh elements. Thay (the Vietnamese word for “teacher”) would simplify this by saying that today is his eighty-third “continuation day,” because to say it is his birthday is not very accurate.


So here's another koan – “If a share of stock is sold in a forest, and nobody is around to buy it, does it still generate a fill?”

The immediate implication of interbeing is that we are forced to think about “general equilibrium” rather than imagining that one side of a trade can exist without the other. This immediately clarifies all sorts of misconceptions that we could fall victim to if we aren't careful.

For example, it immediately tells us that “cash on the sidelines” is not a useful concept, except as a measure of issuance. See, whatever “cash” is there on the sidelines exists because government has created paper money, or the Treasury has issued bills, or because companies have issued commercial paper. Until those securities are actually physically retired, they will and must remain “on the sidelines” because somebody will have to hold them.

If Mickey wants to sell his money market fund to buy stocks, the money market fund has to sell commercial paper to Nicky, whose cash goes to Mickey, who uses it to buy stocks from Ricky. In the end, the commercial paper Mickey used to have is now held by Nicky. The cash that Nicky used to have is now held by Ricky, and the stock that Ricky used to have is now held by Mickey. There is exactly the same amount of “cash on the sidelines” after this transaction as there was before it.


Here's another koan:

A novice monk approaches his teacher and asks “What is the price movement of one share being bought?”

The teacher holds out a cypress leaf in his palm and asks, “Did I catch the leaf as it fell from the tree, or did I raise it from the ground?”

We are used to thinking that the act of buying necessarily implies rising prices. But think about this for a second. In either case, the teacher gets the cypress leaf. What makes the difference so far as direction is concerned is where the pressure is coming from. If the cypress leaf is being offered down by gravity, it is caught on a decline. If the leaf is being lifted by the teacher, it is caught on an advance. Remember that. It is easy to get trapped in wrong thinking by people who talk about “cash on the sidelines” or talk about “investors” buying or selling in aggregate.

There was no excess of stock that was “sold” in March that has to be “bought” back now. Investors didn't “get out” of the market last year, and we shouldn't think that they have to “come into” the market now. Every share that was sold was bought. That has been true for every minute of every trading day since the beginning of the financial markets.
These insights, though perfectly understandable without esoteric zen Buddhist thinking, are spot on. There is no such thing as "cash on the sidelines".

Instead, one could try to evaluate the amount of potentially untapped credit. Reductions in credit lines all around have been taking this measure down lately. Both businesses and households have been shrinking their debt loads in the US somewhat. Unfortunately unemployment, lack of demand and shrinking collateral are eating the other side of the equation.

Thich Nhat Hanh writes well about zen in terms that are easily understandable by the average layperson. I liked his book "Peace is Every Step". He has lots of interesting advice for practicing zen in everyday situations, like driving a car or washing dishes. Unfortunately I have great problems in adhering to the principle of mindfulness. Absent-mindedness is my second nature. (Or is it the first?)

Financial Analyst Bias and Client Pressure

Bloomberg has published an interesting article by Edward Robinson about the influence that sales representatives of investment banks have had on the financial analysts working at the companies (hat tip to C K Michaelson of Some Assembly Required):
When Credit Suisse Group analyst Ivy Zelman refused to turn bullish on homebuilding stocks during a rally in the fourth quarter of 2006, the blowback was intense.

She says investors told her that some housing industry executives were ridiculing her analysis as a “jihad,” and several of the bank’s sales representatives pressed her to upgrade “hold” ratings to “buys” on companies to appease bullish institutional-investor clients. One sales manager even sent her an e-mail warning that analysts who stayed bearish too long often lost their jobs.
The article goes on to explain how very biased analysts in general are against handing out "sell" recommendations for stocks.

The pressure that is applied on analysts that make "sell" recommendations has been documented before. Start analyst Meredith Whitney even got death threats for giving out a pessimistic but accurate analysis of Citigroup in late 2007.

The reference to "appeasing insitutional-investor clients" is a dead giveaway of the cause of this pressure. These clients are not after sound advice. They have already made their minds. What they are after is a blanket of security in the form of advice that just happens to agree with their prior decisions.

If things go wrong, these institutional investors (read retirement fund managers) can just explain that they relied on the investment bank analyst's analysis. This partly relieves them from the responsibility for the bad investments.

Maybe it would not be a bad idea to prevent companies that handle client money or have proprietary trading desks from publishing any analysis or advice at all. At least fund managers shouldn't be able to hide behind advice from parties that are completely dependent on them as clients.

October 5, 2009

Bubbles, Unemployment and Fiscal Stimulus

Paul Krugman, is trying to fight for the usefulness of fiscal stimulus in mitigating unemployment.
Ryan Avent has some fairly harsh words for Arnold Kling’s recalculation theory of business cycles. Tyler Cowen, predictably, thinks Ryan is too snide.

But what none of the participants in the debate seem to realize is that Arnold is basically reinventing 1934 macroeconomics.


It’s all there: mass unemployment is necessary, because you have to shift resources away from sectors that got too big, stimulus is a bad thing because it slows the necessary adjustment. And now as then, the whole notion falls apart when you ask why, say, a housing boom — which requires shifting resources into housing — doesn’t produce the same kind of unemployment as a housing bust that shifts resources out of housing.
Both booms and busts involve shifting of resources between sectors. This much is self evident. It would be stupid to try to deny that. This doesn't mean that the unemployment should not be alleviated at all.

Krugman unfortunately makes a complete fool of himself in the last paragraph. Of course booms don't involve unemployment. In a boom, the driving force of inter-sectoral adjustment is a surge in demand. In a bust, the cause is a collapse of demand.

In a boom, the workforce moves behind the pull of opportunity. This was clearly visible in the flow of newly minted real estate brokers who were encouraged to leave their prior jobs in search of bubble-induced income. In a bust, the realignment is caused by a push-type phenomenon. (Or is it a kick?)

This is such an elementary thing that I can only wonder what Mr. Krugman has been smoking while writing that last paragraph.

To clarify, my own view is that increasing unemployment can hardly be completely avoided in a major bust of a bubble, but that government projects can (and should) be brought forward to mitigate it, if only to make use of the suddenly cheap labor and raw materials. Busts clearly have effects on people who were not directly involved in the bubble and an uncontrolled collapse is bad for everybody.

Equally, I believe that fiscal measures might even be appropriate in controlling the growth of a bubble. Additional small taxes on house-flippers (say for houses bought and sold within 12 months) could have helped slow down the development of the housing bubble. Additionally, it could have provided a larger cushion for the inevitable fiscal collapse.

In both ends of the boom-bust cycle, monetary policy should be the primary means ahead of fiscal measures. In this sense, the QE policies should go even further, as there is a lot of credit that is (and should be) paid down.

This collapsing credit can be replaced with base money even if the money multiplier has collapsed to unity. Instead of "mopping up the liquiduidity", central banks should bring back meaningful cash reserve requirements (to all bank-like entities) after the economy has recovered from the excess of credit. This would naturally will be fought against tooth and nail by the financial sector.