For a while, the term 'piracy' conjured up notions like 'use of unlicensed software' and 'intellectual property bootlegging' instead of images of Black Beard or Sir Francis Drake. This is no longer true. High seas piracy is in vogue again. Somali pirates are wreaking havoc with shipping lanes in one of the busiest routes in the world. Having he longest shores in Africa and located at the Horn of Africa, destitute Somalis, who populate a land with practically no government, discovered unto themselves a lucrative business. All ships traveling through the Suez Canal to Europe or USA have to pass through the Horn of Africa. Somali pirates have been increasingly targeting these ships. It was thought, however, that by avoiding that route and going Cape of Good Hope (southern tip of Africa) the piracy threat can be avoided albeit at some added cost. The capture of the Sirius Star last week changes the belief. By capturing the newest and largest Saudi owned oil tanker on its way to the USA with 2 million barrels of oil (1/4 of the Saudi daily production) Somali pirates now showed that the Cape of Good Hope is not off limits.
This strange development (namely, the return of piracy) has broader and a more disturbing significance than meets the eye. It is a telling symptom of the times. We are moving into a world that is undergoing a global power restructuring. Nations that for a few centuries dominated the world power scene and projected a revered image, no longer command the same respect. Others that are bound to take their place are not there yet. In the mean while, chaos ensues. More specifically, the economic troubles of the West is creating a power vacuum that is allowing rogues everywhere to expand their influence unimpeded. The disturbing truth is that the troubles of the West are not simply a fleeting hiccup. There is well-founded concern that as the pirates further hone their skills they (or others like them) might try hand at other locales; most notably the oil shipping highway, i.e. the Persian Gulf.
Economically, this is big news. First, the cost of insurance will rise significantly. Secondly, the market for armed guard and protection services will grow. Consequently, the global cost of goods and transportation will rise. The fact that the price of oil went down following this piracy incidence is scary!
If the piracy business model proves lucrative, others may be enticed to join in. Aided by cheap satellite imagery, GPS equipment, and fast boats, unscrupulous souls, with access to a safe haven, might try larger scale operations. Piracy which plagued the world for many centuries became virtually extinct in the last two due to the hegemonic control exercised by the western nations over most of the globe. Failed states and malfeasant safe havens were either eliminated or held accountable. The current financial meltdown in the West will be accomapanied by the return of failed states and corrupt safe havens of every stripe. Naval protection will be needed. You could buy the services of the US Navy or the Royal Navy, as in the days of old. Or, given the unsophisticated nature of the threat, you could recieve sufficient protection from the Indian,Chinese or Egyptian Navy, for a fraction of the cost.
More foreboding, is what we are currently witnessing a harbinger to the return of old times in a lot of other ways? Will crime rise everywhere, particularly in the west, as cities, states and municipalities falter towards bankruptcy? Will we travel in convoys surrounded by armed vehicles? Will physical security become a major concern? Will the caravan make a comeback?
Tuesday, November 25, 2008
Saturday, November 1, 2008
We Want Change
When Obama supporters shout 'We Want Change' they seem to be, at least on a subconscious level, actualizing what they feel is already happening about them. They tend to sense the presence of a strong undercurrent of ‘Change’. Change with an upper case 'C' represents a paradigm shift; a global power structure rearrangement. In a recent WSJ opinion piece, titled Obama And The Politics Of Crowds, Fouad Ajami discusses Obama's mastery of crowd politics. He argues that Obama, like all revolutionaries before him, is using the crowds, building up their hope, ultimately to disappoint them.
I spent years of my life studying the behavior of aggregate media. An aggregate medium is a large mass made up of a very large number of particles. Various types of aggregate media share similar dynamics. This is generally true, whether we are talking about a fluid medium, such as a large body of water, or a public medium, such as a large society or a nation. Masses, as such, are usually found in one of two states. The first state (scientifically called the ‘steady state’) is a state with a strong and discernible current or flow. In such a state, the current is too powerful for any one (or a few) human actor (actors) to alter. Thus it is hard for charismatic leaders to truly shine when the medium is in such a state.
The second state is a state of turbulence. The currents may be strong, yet the aggregate overall is directionless. This type of state is inherently unstable. The longer it lasts the more chaotic it gets. Such a state eventually results in the ushering in of a charismatic leader. In addition to being in command of crowd dynamics, this leader has to be well in tune with the most dominant of the prevailing undercurrents. The leader then acts as a crystallizing catalyst who helps the alignment of particulate direction. The charismatic leader ultimately helps the return to a steady state as chaos subsides. Observers tend to attribute the state change to the abilities and extreme skill of the charismatic leader. The truth, however, is that in a large pool of talents there is almost always such a leader. Unstable dynamic systems, almost invariably, ultimately reach a steady state stable configuration. The charismatic leader is more like a skilled surfer. When the right wave arrives there is usually a talented surfer around to ride it.
Socially, economically and demographically the world lives in a state of unclear direction. The currents have been building underneath the surface for a long time (see Greenspan's book The Age of Turbulence). It took the recent economical and financial crisis, however, to bring it all to the surface. Mohamed El-Erian, in his book When Markets Collide, analyzed certain of these currents and their impact on the field of investing.
As an example let us briefly examine one such undercurrent, namely the public view regarding the economic direction of America. It seems, at least on the face of it, that Obama supports a socialistic redistributive economy. McCain, on the other hand, seems to advocate the continuation of a regulation-free laissez-faire capitalist economy. The truth is: this is just a hoax. The country is already undergoing the most socialistic wealth redistribution since its inception. The amount of money randomly distributed by the US government in the last year is mind boggling. The sums of money involved in the current economic bailout by the Treasury Department, combined with the unrestrained liquidity offered by the Fed to curb or mitigate the failure of banks and other financial institutions (Bear Stearns, AIG, Fannie Mae, Freddie Mac, Lehman Brothers, WaMu, Wachovia, …), add up to trillions of dollars. By the time the current financial crisis is over, the government would have randomly injected more than $3 trillion into the system. This is in excess of the total IRS collection for the year 2006 of $2.5 trillion. Stated differently, the current government is effectively doubling the tax burden on every American taxpayer. This is happening without the taxpayer’s awareness, since it is done through money supply inflation. Taxpayers still think we live in a free market; and fear Sweden style socialism. When the citizens expect the government to bail them out, they have already voted for socialism. Even more foreboding, when the citizens act irresponsibly for years, turning their economy into a third order one, a form of socialism is almost a foregone conclusion.
I spent years of my life studying the behavior of aggregate media. An aggregate medium is a large mass made up of a very large number of particles. Various types of aggregate media share similar dynamics. This is generally true, whether we are talking about a fluid medium, such as a large body of water, or a public medium, such as a large society or a nation. Masses, as such, are usually found in one of two states. The first state (scientifically called the ‘steady state’) is a state with a strong and discernible current or flow. In such a state, the current is too powerful for any one (or a few) human actor (actors) to alter. Thus it is hard for charismatic leaders to truly shine when the medium is in such a state.
The second state is a state of turbulence. The currents may be strong, yet the aggregate overall is directionless. This type of state is inherently unstable. The longer it lasts the more chaotic it gets. Such a state eventually results in the ushering in of a charismatic leader. In addition to being in command of crowd dynamics, this leader has to be well in tune with the most dominant of the prevailing undercurrents. The leader then acts as a crystallizing catalyst who helps the alignment of particulate direction. The charismatic leader ultimately helps the return to a steady state as chaos subsides. Observers tend to attribute the state change to the abilities and extreme skill of the charismatic leader. The truth, however, is that in a large pool of talents there is almost always such a leader. Unstable dynamic systems, almost invariably, ultimately reach a steady state stable configuration. The charismatic leader is more like a skilled surfer. When the right wave arrives there is usually a talented surfer around to ride it.
Socially, economically and demographically the world lives in a state of unclear direction. The currents have been building underneath the surface for a long time (see Greenspan's book The Age of Turbulence). It took the recent economical and financial crisis, however, to bring it all to the surface. Mohamed El-Erian, in his book When Markets Collide, analyzed certain of these currents and their impact on the field of investing.
As an example let us briefly examine one such undercurrent, namely the public view regarding the economic direction of America. It seems, at least on the face of it, that Obama supports a socialistic redistributive economy. McCain, on the other hand, seems to advocate the continuation of a regulation-free laissez-faire capitalist economy. The truth is: this is just a hoax. The country is already undergoing the most socialistic wealth redistribution since its inception. The amount of money randomly distributed by the US government in the last year is mind boggling. The sums of money involved in the current economic bailout by the Treasury Department, combined with the unrestrained liquidity offered by the Fed to curb or mitigate the failure of banks and other financial institutions (Bear Stearns, AIG, Fannie Mae, Freddie Mac, Lehman Brothers, WaMu, Wachovia, …), add up to trillions of dollars. By the time the current financial crisis is over, the government would have randomly injected more than $3 trillion into the system. This is in excess of the total IRS collection for the year 2006 of $2.5 trillion. Stated differently, the current government is effectively doubling the tax burden on every American taxpayer. This is happening without the taxpayer’s awareness, since it is done through money supply inflation. Taxpayers still think we live in a free market; and fear Sweden style socialism. When the citizens expect the government to bail them out, they have already voted for socialism. Even more foreboding, when the citizens act irresponsibly for years, turning their economy into a third order one, a form of socialism is almost a foregone conclusion.
Tuesday, October 28, 2008
Third Order Economy
'So the last will be first, and the first last.' (Matthew 20:16)
In his highly insightful book 'When Markets Collide', Mohamed El-Erian attributes current financial woes to the rapidly changing economic realities in today's world. He points to several germane factors such as trade and account deficits, national debt levels and GDP growth. He makes the case that world economy is undergoing a reconfiguration phase. The new players are high productivity (in terms of real goods) nations such as China and India, and natural resource rich nations such as Gulf oil producers and Russia. Highly consuming nations such as the USA and the UK are bound to suffer significant standard of living readjustment until they return to savings and productivity.
Although GDP growth and net account and trade deficits are neat quantitative indicators, they may mask deeper indicators that are more qualitative in nature. Economies are dynamic systems whose basic components are human agents and transactions. As such, they tend to undergo anthropomorphic cycles. To a poor individual, activities pertaining to basic needs such as food, shelter, personal safety and procreation seem to occupy the majority of the individual's attention and most of his resources. These are, therefore, first order priorities. The economic activity of a poor nation focuses primarily on the provision of such first order needs. Agriculture, construction, and textile and garment production tend to represent the majority of economic activity of such economies. As the individual's financial standing improves, he starts to value second order priorities such as health, looks, wealth, and leisure. A nation, whose average citizen is in that category, tends to favor economic activities in medicine, pharmaceuticals, sports, cosmetics, architecture, transportation, banking, and time-saving gadgets. In this phase of the economy's cycle it is most productive and flourishing. It is also the most exportable phase, since the basic needs of the local population have already been fulfilled.
A second order economy is a maturing economy that tends to handsomely rewards its agents. Bank accounts start swelling. Standards of living rise. And a general sense of euphoria prevails. Near the end of this phase, with a lot of time to spare, the individual shifts to third order desires; desires that are neither palpable nor necessarily useful. Rather than participate in sports, in this phase individuals watch sports. Rather than work to increase wealth, individuals spend their time thinking up get-rich-quick schemes. A sense of entitlement and invincibility prevails. A third order economy is an aging economy. It is dominated by entertainment, marketing activities, financial bubbles, luxury products, and frenzied non-productive activities. In a second order economy, lawyers are agents of protection. In a third order economy, they are agents of extortion. In a third order economy, a class of extreme elite citizens is born. Its function is primarily organizational, and its compensation is stratospheric.
A prolonged third order economy is possible given it manages to maintain an outward appearance of health. As long as second order economies do exist, and are willing to deal with a third order economy, such economy can manage to stay in business. At the earliest signs of trouble, however, trust is lost as the 'Emperor's New Clothes' are fully exposed for what they really are.
China, India, Brazil and a host of other developing economies are second order economies. Germany, Japan, Switzerland and a host of other developed economies are borderline second/third order economies that can easily revert to a second order economy. The USA and the UK are full-fledged third order economies. Natural resource rich economies are economies whose nature is different from the nature of their individuals. More precisely, such economies may have individuals who live in a first, second or third order lifestyle, yet the economy itself is a first order economy by virtue of what it produces and exports.
Thus, the current tectonic realignment is more fundamental than can simply be explained away via deficit and debt figures. Tectonic shifts of this size and nature are usually painful to all involved. The final outcome is often hard to predict. One thing is certain, however. As a third order economy crumbles under its unsustainable appetite, it has to revert, depending on the skill set retained by its citizens, to either a first order or a second order economy. For us in the USA, let's hope it is the latter.
In his highly insightful book 'When Markets Collide', Mohamed El-Erian attributes current financial woes to the rapidly changing economic realities in today's world. He points to several germane factors such as trade and account deficits, national debt levels and GDP growth. He makes the case that world economy is undergoing a reconfiguration phase. The new players are high productivity (in terms of real goods) nations such as China and India, and natural resource rich nations such as Gulf oil producers and Russia. Highly consuming nations such as the USA and the UK are bound to suffer significant standard of living readjustment until they return to savings and productivity.
Although GDP growth and net account and trade deficits are neat quantitative indicators, they may mask deeper indicators that are more qualitative in nature. Economies are dynamic systems whose basic components are human agents and transactions. As such, they tend to undergo anthropomorphic cycles. To a poor individual, activities pertaining to basic needs such as food, shelter, personal safety and procreation seem to occupy the majority of the individual's attention and most of his resources. These are, therefore, first order priorities. The economic activity of a poor nation focuses primarily on the provision of such first order needs. Agriculture, construction, and textile and garment production tend to represent the majority of economic activity of such economies. As the individual's financial standing improves, he starts to value second order priorities such as health, looks, wealth, and leisure. A nation, whose average citizen is in that category, tends to favor economic activities in medicine, pharmaceuticals, sports, cosmetics, architecture, transportation, banking, and time-saving gadgets. In this phase of the economy's cycle it is most productive and flourishing. It is also the most exportable phase, since the basic needs of the local population have already been fulfilled.
A second order economy is a maturing economy that tends to handsomely rewards its agents. Bank accounts start swelling. Standards of living rise. And a general sense of euphoria prevails. Near the end of this phase, with a lot of time to spare, the individual shifts to third order desires; desires that are neither palpable nor necessarily useful. Rather than participate in sports, in this phase individuals watch sports. Rather than work to increase wealth, individuals spend their time thinking up get-rich-quick schemes. A sense of entitlement and invincibility prevails. A third order economy is an aging economy. It is dominated by entertainment, marketing activities, financial bubbles, luxury products, and frenzied non-productive activities. In a second order economy, lawyers are agents of protection. In a third order economy, they are agents of extortion. In a third order economy, a class of extreme elite citizens is born. Its function is primarily organizational, and its compensation is stratospheric.
A prolonged third order economy is possible given it manages to maintain an outward appearance of health. As long as second order economies do exist, and are willing to deal with a third order economy, such economy can manage to stay in business. At the earliest signs of trouble, however, trust is lost as the 'Emperor's New Clothes' are fully exposed for what they really are.
China, India, Brazil and a host of other developing economies are second order economies. Germany, Japan, Switzerland and a host of other developed economies are borderline second/third order economies that can easily revert to a second order economy. The USA and the UK are full-fledged third order economies. Natural resource rich economies are economies whose nature is different from the nature of their individuals. More precisely, such economies may have individuals who live in a first, second or third order lifestyle, yet the economy itself is a first order economy by virtue of what it produces and exports.
Thus, the current tectonic realignment is more fundamental than can simply be explained away via deficit and debt figures. Tectonic shifts of this size and nature are usually painful to all involved. The final outcome is often hard to predict. One thing is certain, however. As a third order economy crumbles under its unsustainable appetite, it has to revert, depending on the skill set retained by its citizens, to either a first order or a second order economy. For us in the USA, let's hope it is the latter.
Monday, October 27, 2008
Easier Said Than Done
George Soros is claimed to have once said, "Find a trend whose premise is wrong and bet against it." This exhortation has been repeatedly considered a most profound nugget of wisdom provided by a superstar hedge fund manager. Traders and portfolio managers have been forever trying to heed this morsel of financial truth in order to achieve the enviable feats of its author. In practice, however, things proved a little more complicated than originally thought. We think of at least four reasons why this piece of advice proves hard to successfully utilize.
First, one never knows how long a wrong trend can last. To the trader who bets against it, the trend might seem eternally persistent. Usually, the cost of a bet is directly proportional to its duration. For instance, shorting a stock incurs the cost of dividends. A bought option has an expensive time decay. Credit insurance in CDS or any other form requires the payment of a periodic spread. A more severe cost of delayed reckoning is the opportunity cost. The nature of the 'dot com' bubble was recognized by astute market participants well in advance of its bursting. Those that refused to join in the party, in the name of participating only in things correct, ended up waiting on the sidelines for over five years (1995-2000) while almost everyone else was having a jolly good time reveling in the three digit returns of their portfolios. Most investors shunned money managers whose returns did not live up to their bubbly peers'. Deprivation of the money management fees was a great cost to pay while waiting for the trend to correct.
Secondly, as the wrong trend persists it can inflict inordinate amount of pain on those who bet against it. Markets with strong fallacious trends never stay put. Instead they keep moving in the wrong direction for the duration of the trend. Imagine the pain incurred by a short seller as his losses keep mounting beyond his wildest nightmare.
Thirdly, and mostly ignored until the recent financial woes, one has to find someone to place the bet with. Converse to initial intuition, this may be the most severe of all the difficulties the astute trader faces. If the trend one is betting against is extremely wide spread, it is likely that all the parties interested in taking the other side of the bet are going to be in a precarious situation once the trend properly corrects. To gain the fruit of the painfully awaited bet, the counterparties have to remain in good financial health. This, however, is made less likely by the bet itself. In the end, whoever bets against the trend is usually left with serious credit exposure. Traders who realized the extreme overvaluation of the subprime market bought credit protection on the subprime bonds and CDO's from Bear Stearns and Lehman Brothers. Guess what! These financial giants failed, and to a good measure due to the protection they had provided. A smart trader would have bought some CDS protection against such counterparties. The protection would have, probably, been bought from the AAA rated AIG. And then AIG also nearly failed! Thus the smart trader ended up in the same, or even worse, predicament thant the gullible trader.
Fourthly, one has to be certain that no government agent, or a similar authority, will change the rules of the game while the game is still in play (i.e. the bet is still on). This type of risk (usually referred to as political risk) was thought to be only possible in third world non-free markets. History testifies, however, that governments tend to act in similar fashion when placed in similar situations. In 1933 FDR proscribed the holding of gold. Those who had cleverly understood the economic landscape about them, and predicted the collapse of the dollar and bet against it through the hoarding of gold, were stunned to see their actions ultimately criminalized. Similarly, the situation of the dollar in 1971 had encouraged many traders to accumulate it in the hope of exchanging it for gold. Their trade was shattered as president Nixon permanently suspended the gold backing of the dollar. Finally, and still fresh in the memory of many traders, short selling was suspended on 799 stocks in the summer of 2008 by the SEC at the urging of the US Treasury. Short selling had up to that point been considered a beneficial market practice performed by the long/short hedge fund community to weed out the least fit and insure market health by guaranteeing that only the fit survived. Now, a repulsive stench and an eerie stigma have been entrenched in the minds of the masses with respect to such practice.
Betting against a trend requires very careful risk management and a methodical appreciation of the exogenous forces that are always ready to change the rules of the game mid course.
A trader friend once told me, "A wrong trend will last longer than you think; then it will reverse faster and more violently than you can imagine."
First, one never knows how long a wrong trend can last. To the trader who bets against it, the trend might seem eternally persistent. Usually, the cost of a bet is directly proportional to its duration. For instance, shorting a stock incurs the cost of dividends. A bought option has an expensive time decay. Credit insurance in CDS or any other form requires the payment of a periodic spread. A more severe cost of delayed reckoning is the opportunity cost. The nature of the 'dot com' bubble was recognized by astute market participants well in advance of its bursting. Those that refused to join in the party, in the name of participating only in things correct, ended up waiting on the sidelines for over five years (1995-2000) while almost everyone else was having a jolly good time reveling in the three digit returns of their portfolios. Most investors shunned money managers whose returns did not live up to their bubbly peers'. Deprivation of the money management fees was a great cost to pay while waiting for the trend to correct.
Secondly, as the wrong trend persists it can inflict inordinate amount of pain on those who bet against it. Markets with strong fallacious trends never stay put. Instead they keep moving in the wrong direction for the duration of the trend. Imagine the pain incurred by a short seller as his losses keep mounting beyond his wildest nightmare.
Thirdly, and mostly ignored until the recent financial woes, one has to find someone to place the bet with. Converse to initial intuition, this may be the most severe of all the difficulties the astute trader faces. If the trend one is betting against is extremely wide spread, it is likely that all the parties interested in taking the other side of the bet are going to be in a precarious situation once the trend properly corrects. To gain the fruit of the painfully awaited bet, the counterparties have to remain in good financial health. This, however, is made less likely by the bet itself. In the end, whoever bets against the trend is usually left with serious credit exposure. Traders who realized the extreme overvaluation of the subprime market bought credit protection on the subprime bonds and CDO's from Bear Stearns and Lehman Brothers. Guess what! These financial giants failed, and to a good measure due to the protection they had provided. A smart trader would have bought some CDS protection against such counterparties. The protection would have, probably, been bought from the AAA rated AIG. And then AIG also nearly failed! Thus the smart trader ended up in the same, or even worse, predicament thant the gullible trader.
Fourthly, one has to be certain that no government agent, or a similar authority, will change the rules of the game while the game is still in play (i.e. the bet is still on). This type of risk (usually referred to as political risk) was thought to be only possible in third world non-free markets. History testifies, however, that governments tend to act in similar fashion when placed in similar situations. In 1933 FDR proscribed the holding of gold. Those who had cleverly understood the economic landscape about them, and predicted the collapse of the dollar and bet against it through the hoarding of gold, were stunned to see their actions ultimately criminalized. Similarly, the situation of the dollar in 1971 had encouraged many traders to accumulate it in the hope of exchanging it for gold. Their trade was shattered as president Nixon permanently suspended the gold backing of the dollar. Finally, and still fresh in the memory of many traders, short selling was suspended on 799 stocks in the summer of 2008 by the SEC at the urging of the US Treasury. Short selling had up to that point been considered a beneficial market practice performed by the long/short hedge fund community to weed out the least fit and insure market health by guaranteeing that only the fit survived. Now, a repulsive stench and an eerie stigma have been entrenched in the minds of the masses with respect to such practice.
Betting against a trend requires very careful risk management and a methodical appreciation of the exogenous forces that are always ready to change the rules of the game mid course.
A trader friend once told me, "A wrong trend will last longer than you think; then it will reverse faster and more violently than you can imagine."
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