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DERIVATIVES WILL BITE U.S. AND U.S TAX PAYERS AGAIN

DERIVATIVES WILL BITE U.S. AND U.S TAX PAYERS AGAIN

U.S. ECONOMICS

The current U.S. economic depression (as measured by industrial production) is the longest since the Great Depression of the 1930’s.  And unemployment numbers are moving closer to depression levels each day.

Yet while the economic reality is clear, there is an unwritten convention not to call it a depression.  Perhaps this is to avoid unsettling people and creating fear.  But calling it by its proper name would at least be more truthful.  And in these times when truth is sorely lacking in pronouncements by public figures it would be just what the market ordered.

We estimate that the current decline has longer to run.  This is part of the reason we have focused our research away from the depressed parts of the world economy, such as the U.S., Europe and Japan.  We prefer to focus on the growing parts of the world economy.

THE NEW GLOBAL ECONOMIC REALITY

We understand that it is not easy for a country to hear that, after a long time of being on top, they are becoming less important, powerful, or significant in the global marketplace.  We sympathize with the plight of Americans, Europeans, and Japanese who are facing exactly this challenge.  But from an economic data point of view, there can be little doubt that a new global economic reality is dawning.  That reality is China, India and others are gaining influence and gradually the former big powers of Europe, Japan and U.S. are losing economic status.

Investors can deny this seismic shift in global economics and offer subjective one off examples of how this shift is not happening, they can dig in our heels and ignore the change, but none of these approaches will lead to investment success.  Success comes to those who admit that change is happening and will continue to happen and will make the adjustments necessary to profit from the new reality.

WORLDWIDE OIL DEMAND

India, China and other nations are demanding more oil.  Even though there is a decrease in demand from the U.S., Europe, and Japan, it is going to be hard for oil to fall much below $57 per barrel.  OPEC has not been cheating much on their quotas.  If oil gets back down below $60, it will be a bargain.  We expect oil prices to rise above $85 per barrel in the not too distant future.  At that time, we expect OPEC will raise production quotas for its members.

INDIA TO OPEN DOOR TO FOREIGN UNIVERSITIES

According to the Indian National Knowledge Commission, a group reporting to India’s Prime Minister, about 160,000 Indians leave India each year to study abroad.  Many great Indian minds have helped the technology revolution in the U.S. and Europe.  Indian CEO’s have risen to the highest levels in world businesses, Indian scholars are found throughout world’s universities, and Indian MD’s are ubiquitous in the world’s hospitals.  Yet little of this has helped India because when Indians go to school abroad they are likely to seek foreign citizenship.

The problem is that Indian universities do not educate nearly enough people, and the competition for a seat at a university is very political and unfair.  Historically, politicians have wanted all undergraduate universities within India to be controlled by the government of India…and its amazingly cluttered and inefficient bureaucracy.

Part of this confused strategy was intended to disallow the traditional intellectual families to benefit from free education.  Instead, the government focused many of the university acceptances on those students from non intellectual backgrounds.  This caused many of India’s best and brightest to leave India for a foreign education, which was often followed by foreign citizenship.

These students often stayed abroad creating a brain drain in India. Anything that India can do to reverse the brain drain will be good for the continued growth of the nation.  This new program looks like it could open university admission to a much larger percentage of the total population.  If this is the case, it’s a very positive, important, and far reaching change for India.  We expect India’s economic machine will greatly shine in the world markets.

COPENHAGEN CLIMATE TREATY IS DUE TO BE SIGNED AT THE END OF 2009

The article in the NY Times Science section on July 21, 2009 titled “Is the Sun Missing its Spots” points out that many solar meteorologists and astronomers believe that we will be undergoing a minimal sunspot activity over the next 11 year sunspot cycle, which could lead to colder temperatures worldwide.  This follows an eleven year cycle that just concluded where the world cooled from its high temperatures set in the mid 1990’s.

We would like to suggest to politicians and their staff who may read this letter, that they discourage the U.S. and other western governments from signing the Copenhagen treaty.  The signers may be decreasing their country’s ability to provide jobs for their populace and increase the cost of producing goods within their country.  These agreements and their costs could be a big mistake.  China, India and other highly carbon emitting countries will certainly not sign them, and the costs of complying may guarantee that China and India far outstrip the rest of the world in corporate profits over the next few decades.

Further, there is strong evidence that the world is cooling due to decreased sunspot activity and cooler temperatures lie ahead.  Could this be another situation where by the time the government gets around to fixing a perceived problem, it is no longer a problem…and the solution is far more debilitating than the problem?

SHORT SELLING-ILLEGAL AND LEGAL

The U.S. SEC is using only a patchwork attempt against illegal short sellers.  The crackdown against illegal short selling includes a few new regulations, but we don’t expect significant progress.  Illegal short selling is often sourced from Canada and Germany where financial services regulation is much more lax than in the U.S.  If financial forces want to manipulate stocks down, they can just set up clearing and trading operations in these two countries to launch their short selling attacks.  We believe the SEC’s latest rule changes are likely to send illegal short sellers overseas.

Legal short selling is fine, and it has a place in the marketplace.  Most observers agree that the “uptick rule” (where a stock being sold short must trade on an uptick in the price from the previous trade) should be reinstituted.  This former rule, which was removed during the G.W. Bush administration, helps keep legal short selling from becoming market manipulation.

In our opinion, not having the uptick rule accounted for at least 1,000 points of the decline in the Dow Jones Industrial average during the recent bear market.  In certain industries, the effect was far greater.  Our point is that the uptick rule works to stop the bullying of stocks down for pure profit.  This short selling is often done by trading desks at major banks and investment banks.  This sets the financial service industry at odds with most of its customers who hold long positions in stocks (often on margin).  This behavior will unfortunately be allowed to continue because the financial services industry provides much of the campaign financing for the US congress.

DERIVATIVES WILL BITE INVESTORS AND THE U.S. TAXPAYER AGAIN

The fact is the most powerful lobbying group in Washington a few years ago was real estate, especially real estate finance.  Just look at what happened with sub-prime and alt-A loans and the huge bill to the U.S. taxpayers as a result of the residential real estate lending industry getting too much power…and having too many politicians kowtowing to them.

Today, Wall Street is the most powerful lobbying force in the U.S.  If one was to look at what happened after a huge bailouts of derivatives, one would come to the conclusion that the government still dances to Wall Street’s tune.  We believe we are in for more crises involving derivatives, as they are continuing to be manufactured and will in the foreseeable future once again create huge problems for the world, especially U.S. taxpayers.

Another area of possible crisis has to do with high-speed stock trading, and the erosion of confidence that this type of unfair trading inspires.  The article below from The New York Times discusses this in more detail.

HURRYING INTO THE NEXT PANIC?

By Paul Wilmott

July 28, 2009

On vacation in Turkey, I am picked up at the airport by a minibus. It’s past midnight, pitch-black, the driver is speeding around corners. Only one headlight is working. And I have my doubts about the brakes. In my head I’m planning the letter of complaint to the tour company. And then the driver’s cellphone rings, he picks it up and answers it, he has only one hand on the steering wheel. Now I’m mentally compiling the list of songs to be played at my funeral.

That’s rather how I feel when people talk about the latest fashion among investment banks and hedge funds: high-frequency algorithmic trading. On top of an already dangerously influential and morally suspect financial minefield is now being added the unthinking power of the machine.

The idea is straightforward: Computers take information — primarily “real-time” share prices — and try to predict the next twitch in the stock market. Using an algorithmic formula, the computers can buy and sell stocks within fractions of seconds, with the bank or fund making a tiny profit on the blip of price change of each share.

There’s nothing new in using all publicly available information to help you trade; what’s novel is the quantity of data available, the lightning speed at which it is analyzed and the short time that positions are held.

You will hear people talking about “latency,” which means the delay between a trading signal being given and the trade being made. Low latency — high speed — is what banks and funds are looking for. Yes, we really are talking about shaving off the milliseconds that it takes light to travel along an optical cable.

So, is trading faster than any human can react truly worrisome? The answers that come back from high-frequency proponents, also rather too quickly, are “No, we are adding liquidity to the market” or “It’s perfectly safe and it speeds up price discovery.” In other words, the traders say, the practice makes it easier for stocks to be bought and sold quickly across exchanges, and it more efficiently sets the value of shares.

Those responses disturb me. Whenever the reply to a complex question is a stock and unconsidered one, it makes me worry all the more. Leaving aside the question of whether or not liquidity is necessarily a great idea (perhaps not being able to get out of a trade might make people think twice before entering it), or whether there is such a thing as a price that must be discovered (just watch the price of unpopular goods fall in your local supermarket — that’s plenty fast enough for me), l want to address the question of whether high-frequency algorithm trading will distort the underlying markets and perhaps the economy.

It has been said that the October 1987 stock market crash was caused in part by something called dynamic portfolio insurance, another approach based on algorithms. Dynamic portfolio insurance is a way of protecting your portfolio of shares so that if the market falls you can limit your losses to an amount you stipulate in advance. As the market falls, you sell some shares. By the time the market falls by a certain amount, you will have closed all your positions so that you can lose no more money.

It’s a nice idea, and to do it properly requires some knowledge of option theory as developed by the economists Fischer Black of Goldman Sachs, Myron S. Scholes of Stanford and Robert C. Merton of Harvard. You type into some formula the current stock price, and this tells you how many shares to hold. The market falls and you type the new price into the formula, which tells you how many to sell.

By 1987, however, the problem was the sheer number of people following the strategy and the market share that they collectively controlled. If a fall in the market leads to people selling according to some formula, and if there are enough of these people following the same algorithm, then it will lead to a further fall in the market, and a further wave of selling, and so on — until the Standard & Poor’s 500 index loses over 20 percent of its value in single day: Oct. 19, Black Monday. Dynamic portfolio insurance caused the very thing it was designed to protect against.

This is the sort of feedback that occurs between a popular strategy and the underlying market, with a long-lasting effect on the broader economy. A rise in price begets a rise. (Think bubbles.) And a fall begets a fall. (Think crashes.) Volatility rises and the market is destabilized. All that’s needed is for a large number of people to be following the same type of strategy. And if we’ve learned only one lesson from the recent financial crisis it is that people do like to copy each other when they see a profitable idea.

Such feedback is not necessarily dangerous. Take for example what happens with convertible bonds — bonds that can be converted into stocks at the option of the holder. Here a hedge fund buys the bond and then hedges some market risk by selling the stock itself short. As the price of the stock rises, the relevant formula tells the fund to sell. When the stock falls the formula tells it to buy — the exact opposite of what happens with portfolio insurance. To the outside world — if not necessarily to the hedge fund with the convertible bonds — this mix is usually seen as a good thing.

Thus the problem with the sudden popularity of high-frequency trading is that it may increasingly destabilize the market. Hedge funds won’t necessarily care whether the increased volatility causes stocks to rise or fall, as long as they can get in and out quickly with a profit. But the rest of the economy will care.

Buying stocks used to be about long-term value, doing your research and finding the company that you thought had good prospects. Maybe it had a product that you liked the look of, or perhaps a solid management team. Increasingly such real value is becoming irrelevant. The contest is now between the machines — and they’re playing games with real businesses and real people.

Summary

The Chinese market is getting a correction. This is what we have been hoping for. We will add to our China investment on this correction. We continue to like oil, especially below $60 dollars a barrel. In our opinion, gold, China, India, Hong Kong and Singapore are good to buy on corrections.


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