Eugene Linden
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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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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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A Future We Don't Want


Thursday October 23, 2014

Since 1998, when The Future in Plain Sight was published, I’ve been watching the nine clues to future instability that I put forth in that book come into to the headlines one by one, and, unfortunately, way ahead of schedule. The basic argument in TFIPS is that the contours of the future might best be glimpsed through the filter of stability. While predicting whether we’d all have personal flying machines is a fool’s errand, we could know a lot if we could make an informed guess as to whether the future was likely to be more or less stable than the present.

With that in mind, I proposed nine, long wave-length trends/clues that strongly implied that the future would be less stable than the present. After exploring how different an unstable world is from a relatively stable one (less investment and innovation, religion/family/clan more important, etc), the book offered a series of scenarios set in the year 2050, which tried to put some flesh on what such a future might look like.

Alas, it looks like we won’t have to wait until 2050 to see this unstable future. We have had vivid, real world examples of the disruptions wrought by religious extremists (the chapter “The Rise of the True Believers” was written before the religious right gained ascendence here, and radical Islam began its bombings and wars); a disappearing Middle Class (“the Ubiquitous Wage Gap”); markets wrecking economic chaos (“Hot-Tempered Markets”); and so on.

And now, with the Ebola crisis, unless the world takes action real fast, we are going to witness the unholy synergy of three other clues offered in the book – “Infectious Disease Resurgent,” “A Biosphere in Disarray,” and the inherent instability of swollen, emerging nation cities. Wholesale ecological disruption very likely played a role in Ebola jumping from its animal host to humans, its emergence also signals that the “honeymoon” from infectious disease that started with sanitation in the late 19th century and the discovery of antibiotics in the 20th, is coming to an end, and the swollen cities of emerging nations are providing the springboards for the return of the microbes.

In the years since I wrote that book, I’ve looked back many times, wondering whether I was wrong about any of the clues, or whether I missed one that I should have added. One such candidate for inclusion is the rise of international criminal gangs. The drug cartels and their affiliates have made much of Mexico to dangerous to travel, and similar, large scale criminal enterprises destabilize scores of cities around the world.

As for a clue where I might have overstated the threat, there is one that bears directly on whether or not the world will contain the Ebola threat. That clue focused on the destabilizing aspects of the emergence of megacities. Given their size and importance to regional economies, it is easy to see how problems in a megacity could bring down an entire nation’s economy. What happens to Japan, for instance, if radiation from Fukushima continually worsens and makes Tokyo uninhabitable, or, what happens to Brazil if large parts of Sao Paolo really do run out of water, as is threatened now? On the other hand, these giant cities also create a critical mass of intelligence and the capital to deploy it. There's a ray of hope in the fact that an Ebola carrier made it to Lagos, the very poster child of a city always on the verge of collapse, and yet the city was able to respond and contain the disease. If the home of kleptocrats and email scams can deal with Ebola, maybe other African cities can too. Go Lagos!

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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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