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.

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."