Eugene Linden
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THE PROBLEM WITH MUSK'S BID FOR TWITTER IS NOT THAT HE'S A BILLIONAIRE

Matt Taibbi, a journalist whose writing I admire, has joined the throng decrying the hypocrisy of pundits who write on the pages of the Washington Post (owned by a billionaire) that if billionaire Elon Musk buys Twitter it will be a threat to democracy. This is too glib. The problem isn’t b...

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Fire & Flood
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Deep Past
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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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Everyone Saw This Coming


Friday May 22, 2015

Twenty-seven years ago, when the world briefly awoke to the threats of global warming and tropical deforestation, scientists could only speculate on what changes might come in the future. Now, one need only look and observe.

Nineteen years ago, I went to Antarctica to report for Time magazine on the ways in which global warming was affecting the frozen continent. One concern was the stability of the West Antarctic Ice Sheet (or WAIS).

In 1996, scientists had detected an increase in the velocity of the so-called “ice streams,” which transport ice from the interior of the immense glacier to the shore. The fear was that as WAIS diminished, salt water might intrude under the ice and eventually cause it to float, raising sea level around the world, and inundating large swaths of Florida, not to mention Bangladesh, Indonesia and other low lying areas that are home to hundreds of millions of people.

This year, Eric Rignot, a scientist with NASA’s Jet Propulsion Laboratory, published a study confirming these fears with the stark conclusion that the ice sheet is in a state of “irreversible decline,” and in early May, Princeton University researchers released a new study confirming the accelerating melting.

The great ice sheet won’t collapse any time soon, but it’s a chilling thought in a warming world that an ice sheet that has been stable through the entire time modern humans have existed has now begun to come apart.

More than 20 years ago, INPE, Brazil’s Space Agency published studies arguing that continued cutting of the Amazon was diminishing the vast forest’s ability to recycle moisture. Water – it used to be seven trillion tons each year – evaporated from the Amazon forest rises above the forest, bounces south along the Andes, and then is carried by prevailing winds, first across the dryer areas of southern Brazil and then, after traversing the Atlantic, to South Africa, where it nourishes the corn crop. Since then, the forest has shrunk by an area equivalent to the size of Texas, and now residents of Sao Paulo, the hemisphere’s largest city, desperately scrabble for water after multiple years of drought have desiccated the reservoirs.

And of course, at the same time, California is trying to cope with the worst drought in its modern history. This drought was predicted 18 years ago by Richard Seager of Columbia University, who in 1998 published a paper in Science arguing that a warming world shifted the global precipitation patterns pole ward leaving California and other mid-latitude regions in a rain shadow. Exacerbating California’s problems has been a diminished snowpack – this year at 6 percent of normal. Ordinarily, the snowpack stores water and then melting acts as a meter, delivering water during the dry summer months. Tim Barnett of Scripps Oceanographic Institute first predicted 15 years ago that the combination of drought and warming would have this result.

Are you seeing the pattern here? Time and again, the world’s best scientists have done their job and made predictions based on the best available evidence, only to watch in dismay as their predictions come true because an oblivious world fails to act.

Many other predictions made about the likely consequences of global warming have come to pass: more extreme weather events (a drumbeat of such studies the mid-1990s, with the most recent published in Nature Climate Change on April 27); the disappearance of arctic sea; the collapse of fish populations in the Pacific; and even the series of frigid winters in the Northeast, fueled by a slowdown of the ocean circulation pattern that distributes heat from the tropics to the North Atlantic (predicted by Wallace Broecker of Lamont-Doherty Earth Observatory in an article in Science in 1997, and now back in the news).

Can it be said unequivocally that the drought in California is related to climate change, or that Sao Paulo’s water crisis is tied to cutting of the Amazon, or that there is, in fact undeniable evidence of an increase in extreme weather events? Nope, weather might be the most complicated phenomenon on the planet, influenced at any given time by myriad cycles as well as by such disparate factors as air pollution, land, even the expansion of cities, as well as the difficulty of obtaining consistent measurements on a global scale.

As new predictions of past decades come to pass, however, it makes it harder to explain these changes as coincidence. And there are quite unequivocal signals of a warming planet. Sea level rise, resulting from increased melting of ice and the thermal expansion of the oceans, offers a mute, global signal of a warming planet. Moreover, sea level is rising much faster than predicted, possibly because ice sheets in Greenland and Antarctica are melting more rapidly than predicted.

Could any of these unfortunate events have been prevented? Of course! Fifty years ago, Rachel Carson published Silent Spring, which warned that unchecked use of DDT would lead to the collapse of bird populations. The United States and other developed nations banned the pesticide, and bird populations have recovered to the point where bald eagles visit New York City (China ignored the warnings about DDT, and has suffered the silent spring that Carson predicted). Dealing with greenhouse gas emissions is vastly more complicated, but it is highly likely that the world would be in a better position to fight the threat now had it begun to take action in 1988.

Now we’ve gone backwards. Thanks to a campaign to discredit the threat of climate change financed by the fossil fuel industry and vigorously promoted by Fox News and other right-leaning media, fewer Americans think global warming is human caused than they did eight years ago, according to a recent study conducted by Anthony Leiserowitz* of Yale University.

Think about that: even as predictions of past decades have become reality, the American attitude about global warming has shifted towards “prove it.” One thing is certain: we’ve forfeited the right to say, “Nobody saw this coming.”

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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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