Eugene Linden
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Latest Musing

The Supreme Court's Own Goal on Climate Change

[This article appeared in Lawfare. It's long for a musing, but I think it's important that the public see just how shoddy was the majority reasoning in West Virginia v EPA]

In 1970, Sen. Roman Hruska of Nebraska achieved a dubious immortality when he argued that mediocrity deser...

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Fire & Flood
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Deep Past
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Articles by Category
endangered animals
rapid climate change
global deforestation
fragging

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The Ragged Edge of the World



Winds of Change
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Afterword to the softbound edition.


The Octopus and the Orangutan
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The Future In Plain Sight
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The Parrot's Lament
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Silent Partners
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Affluence and Discontent
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The Alms Race
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Apes, Men, & Language
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THE CRISES THAT DARE NOT SPEAK THEIR NAMES


Thursday May 15, 2014

[I'm going to continue to bang this drum until I get it right! This appeared in The Daily Beast]

In the first quarter of 2014, the economic impact of extreme weather related to climate change, combined with the inherent weakness of an economy suffering through a depression, produced a preliminary estimate of nearly no economic growth. This stark portrayal is a far cry from how the 0.1% GDP growth of the quarter has been presented. Rather, the narrative has gone something like this: Weather-related disruptions weighed upon business investment and consumer spending as the weak recovery continued.

Thus we continue to endure the two most consequential events of the recent decade without acknowledging either for what they are.

In the case of climate change, this timidity is understandable as change comes as weather and there will never be one clear event that signals indisputably that we’ve entered the climate rapids. Fifty years from now, however, odds are that historians will mark the first decade of this new millennium as the point at which global warming became undeniable, particularly in its economic impacts.

Similarly, future economic historians will likely mark the financial crash of 2008 as the beginning of a depression (it would be nice if they would come back in time and told us when it will end). Here too, it is understandable because there is such a high noise-to-signal ratio amid an incessant drumbeat of often conflicting economic data and so many false starts that it is extremely difficult to define a depression except in retrospect.

Part of the problem is that definitions of depression abound (the concept is so nebulous that the National Bureau of Economic Research, which officially calls recessions, demurs on the question of calling depressions). The description of depression that fits the present situation is a sustained period in which economic output falls substantially below an economy’s potential. Now five years into our “recovery” the Congressional Budget Office estimates that the economy this year will still fall short of its potential output by $723 billion (and this gap comes against figures for potential output that have been steadily marked down by the CBO since 2008, essentially lowering the bar).

Recognizing that things have truly changed has always been difficult for those living through inflection points in history. Those deepest inside the U.S. government and the intelligence community in the late 1980s were among the last to acknowledge that the Cold War was really over as the Soviet Union unraveled. “The Great Depression” as a proper noun only came into popular use in the 1950s, long after the event was over. As the economy bounced around in the mid-1930s, there were many premature calls that the crisis had ended, including one by President Roosevelt in 1936, after three years of impressive recovery, but just before a vicious new recession hit, and unemployment rose to new highs.

This blindness is deeply embedded in human nature. Such is our commitment to the world view we forge during our formative years that often we can’t see what is literally staring us in the face. Jerome Brumer, father of gestalt psychology, demonstrated this in a celebrated experiment in which he showed people a deck of cards salted with the wrong colors for different suits such as a red ace of spades. When the cards were turned over, most people saw them as normal. Only when they could linger for long periods would they see that something was amiss, but even then some people could not put their finger on what was wrong.

Does it matter whether and when we put a label on an era? Yes, greatly. Our reticence to state the obvious but unproven may be understandable, and even prudent, but it is not helpful. Recognizing that the changing climate carries with it harsh economic consequences might spur action to limit the harm. The Obama administration just did its part releasing a draft assessment of climate change asserting that it is already hurting Americans. Still, our current posture that global warming is a nebulous, far-off problem largely explains our complacency about a threat that has in the past been a civilization-killer.

Similarly, while economists will argue over whether the present period of near zero growth and stretched household finances is a depression long after the economy really does recover, acknowledging that for all but a tiny group of Americans the economy is in depression would do a world of good. For one thing, there might be less push for deficit reduction and more pressure for programs that might improve the incomes of ordinary Americans. One school of thought holds that FDR’s false belief in 1936 that the depression was over led his administration to tighten credit, pushing the fragile economy back into recession.

So, let’s acknowledge the obvious. The upside is that we might muster the political will to develop policies that match reality. Do we want those yet unborn historians (who are going to be royally annoyed about the world we bequeath them anyway) wondering how it was that we ignored what was staring us in the face?

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Short Take

HOW THE OPTIONS TAIL HAS COME TO WAG THE MARKET DOG: A Simple English Language Explanation of How Structural Changes in the Stock Markets Contribute to Whipsaw Movements in Prices.

Lately a string of violent price movements and reversals in the equity markets make it look like the markets are having a nervous breakdown. The last day of trading in April 2022 saw a 939 point drop in the Dow. The day before that, the Dow rose about 625 points, and two days before that it fell over 800 points. The very next week, after two quiet days, the Dow rose over 900 points after the Fed announced its biggest rate hike in 22 years (ordinarily a big negative for the markets), and then, the next day, fell over 1000 points (more on this later).  There have been plenty of headlines – about the Ukraine Invasion, inflation, the threat of a Fed caused recession, supply chain disruptions – to justify increased uncertainty, but the amplitude of the moves (and the sudden reversals) suggest something more may be at work. Here follows an effort to explain in simple language the significant changes in the market that have contributed to this volatility.

 

“This time it’s different” is perhaps the most dangerous phrase in finance as usually it’s uttered by market cheerleaders just before a bubble bursts. That said, markets do change, and those changes have their impacts. One change in the markets has been the shift from intermediaries (such as brokers) to direct electronic trading, a shift that has made the markets somewhat frictionless, and allowed computer driven funds to do high speed trading. This shift began a couple of decades ago. Today’s markets can move faster than a human can react.

 

Another shift has been the degree to which passive investing through index funds and algorithmic trading through various quant funds have come to eclipse retail investing and dominate trading. A consequence of this is that to some degree it has mooted individual stock picking because when investors move in or out of index funds, the managers have to buy or sell the stocks held on a pro rata basis and not on individual merit. This change too has been developing over recent decades.

 

A more recent and consequential shift, however, has been the explosion in the sale of derivatives, particularly options (the right to buy or sell a stock or index at a specified price on or before a specific date). Between 2019 and the end of 2021, the volume of call options (the right to buy a stock at a specified price on or before a particular date) has roughly doubled. During times of volatility, more and more retail and institutional investors now buy calls or puts rather than the stocks. 

 

Today, trading in options has reached a scale that it affects market moves. A critical factor is the role of the dealers who write options and account for a significant percentage of the options issued. Dealers have been happy to accommodate the growth in option trading by selling calls or puts. This however, makes them essentially short what they have just sold. Normally, this doesn't matter as most options expire out of the money and worthless, leaving the happy dealer to book the premium. Being short options, however, does begin to matter more and more as an option both moves closer to being in the money and closer to expiration. 

 

This situation is more likely to occur when markets make large and fast moves, situations such as we have today given the pile of major uncertainties. Such moves force dealers to hedge their exposure. 

 

Here’s how it works. If, for instance, a dealer has sold puts on an index or a stock, as a put comes closer to being in the money (and closer to expiration), the dealer will hedge his short (writing the put) by selling the underlying stock. This has the combined effect of protecting the dealer -- he's hedged his potential losses – while accelerating the downward pressure on the price. In other words, this hedging is pro-cyclical, meaning that the hedging will accelerate a price move in a particular direction.

 

Traders look at crucial second derivatives of stock prices, referred to by the Greek letters delta and gamma to determine exposure to such squeezes. As an option moves closer to in the money it's delta -- it's price movement relative to the price movement of the underlying, and its gamma -- the rate of change of the delta relative to a one point move in the underlying, both rise. The closer to both the strike price and expiration date, the more the dealer is forced to hedge. The result is what’s called a gamma squeeze. Once the overhang of gamma exposure has been cleared, however, the selling or buying pressure abates, and gamma may flip, with new positioning and hedging done in the opposite direction. The result can be a whipsaw in the larger markets. This same phenomenon can happen with indexes and futures.

 

How do we know that the hedging of option positioning are contributing to violent price changes and reversals in the market? While not conclusive, perhaps the strongest evidence is that large lopsided agglomerations of options at or near the money have been coincident with surprising market moves as expiration dates approach. In fact, some market players use this data to reposition investments, in effect shifting investment strategy from individual companies to the technical structure of the markets. This is what Warren Buffett was referring to when, at his recent annual meeting, he decried the explosion of options and other Wall Street fads as reducing companies to “poker chips” in a casino.

 

The week of the May Fed meeting gave us a real-time example of how a market move that looks insane on the surface reflects the underlying positioning in various derivatives. To set the stage: ordinarily, given debt burdens and the threat of recession, the markets would be expected to react badly to a Fed tightening cycle that is accelerated by the biggest rate hike in 22 years. On Wednesday, however, market indices began to soar on Wednesday when Fed Chairman Powell, one half hour after the Fed announced it 50 basis point raise, suggested that the Fed was not considering larger 75 basis point hikes during this tightening cycle. Traders interpreted this as taking the most hawkish scenario off the table. Up to that point, institutions were extremely bearish in their positioning, heavily weighted to puts on indexes and stocks, and also positioned for future rises in volatility in the markets. Right after Powell made his comments, investors started hedging and unwinding this positioning, and all the pro-cyclical elements entailed in this repositioning kicked in. By the end of the day, the technical pressures producing the squeeze had largely abated, setting the stage for a renewed, procyclical push downward the next day, as the negative aspects of the tightening cycle (and other economic headwinds) came to the fore. 

 

What these violent moves in the market are telling us is that while in the broader sense, this time is not different --the overall sine wave of the market is still that bubbles build and burst -- how the present bubble is bursting may be following a different dynamic than previous episodes. The changes since the great financial crisis-- the rise to dominance of passive trading through indexes and algorithmic trading through various quant strategies – reduced the friction in the markets as well as the value of picking individual companies. Now, the more recent explosion of option issuance, further accelerates market moves, and leads to unpredictable reversals that have to do with option positioning rather than fundamentals such as earnings, politics, or the state of the economy. 

 

The tail (the options and other derivatives markets) now wags the dog (the equities markets).

 

 



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