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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OUR CONFEDERACY OF DUNCES


Saturday April 14, 2018

            The Darwin Award confers mock recognition on individuals killed by their own stupidity, thereby improving the gene pool by removing themselves from it. If there existed such an award at the national level, the U.S. of today would be a lock to win. Put aside ideology and step back from the drumbeat of constant crises that has characterized the Trump Presidency, and the sheer stupidity of our current posture on major issues comes into focus, along with a big question: How could a superpower with an incomparable network of universities, scientific institutions, and think tanks be so colossally dumb when it comes to government policy?  Simple answer; that’s the path we’ve chosen.

            Let’s look at a few of the particulars.

            Gun Violence:  We have roughly the same crime rate as other industrial countries, but we’re the most trigger-happy developed nation on earth with more than 10 times the rate of gun-related deaths as does Australia and Germany, 20 times the rate of gun deaths as Spain, 50 times that of the United Kingdom, and an infinitely greater rate than Japan and South Korea, which really don’t have statistically significant, gun-related deaths at all. Yet, the Trump’s first response to the Parkland slaughter is that we need more guns, with the current push being to arm teachers in schools. Consider the counterfactual: If more guns were the solution, wouldn’t all those other developed nations that have vastly fewer guns and strict gun control laws be collapsing amid rampant killings?   

            Climate Change: After 2017’s $307 billion dollars in losses from hurricanes, drought-related wildfires and other severe weather, one might think that the federal government would want to understand whether a warming world might increase the risk of more such events. One would be wrong. Instead, the administration has been stripping all mention of climate change from its publications and policies, and installing people who deny the threat in key positions. And given those losses, wouldn’t governments at all level want to update flood zone maps to take in the threat of rising sea levels and more intense storms? Apparently not; there’s active opposition to updating the maps at all levels of government, all but guaranteeing that future storms will produce even more losses for taxpayers (because private insurers will update their own loss projections and pull out of vulnerable areas). Dumb? As Trump often says, “you tell me.”

            Finance and the Economy: After 2008’s near death experience for the U.S. financial system, the Congress enacted Dodd-Frank, with rules limiting risk taking by large financial institutions. Before that, risk-taking in the opaque world of derivatives had been involved the collapse of Long Term Capital Management in 1998, as well as in the fall of the energy trading giant Enron. Now, Congress apparently feels that bankers will never again try to game the system, because there is a bi-partisan effort to roll back regulations on banks with under $250 billion in assets (up from the current $50 billion threshold), a move that would deregulate lenders as large as some of the worst actors in the housing bubble collapse. Not content to unleash the banks, Congress and administration are also dismantling the Consumer Protection Bureau, which was set up to protect people from the predatory practices rampant before the financial crisis.

            The Fourth Estate: Journalists in this country have already been marginalized by the rise of free digital news and the spread of social media. Now the Trump administration has been attacking the very concept of a free press with its dismissal of any reporting it doesn’t like as “fake news.”  At a time when politicians routinely lie, and big corporations have been freed by the Supreme Court’s Citizen’s United decision to devote massive efforts to influencing public opinion, access to independent, credible reporting becomes the last check on the abuse of power and corruption. The campaign to discredit this vital backstop may be the most short sighted Trump initiative of all -- just ask the citizens of North Korea, Iran, or Russia what are their checks on power in countries without a free press?

            Diplomacy: With ambassadorships in crucial posts such as Riyadh and Seoul still waiting to be filled and senior positions at the State Department left vacant, the Trump administration seems to believe that diplomacy does not require diplomats, particularly when we have a lot of nuclear weapons, and a President willing to use them. With a growing number of unstable nations trying to join the nuclear club, this approach to foreign policy seems like a promising fast track for the U.S. to win a collective Darwin Award, dragging the rest of the world to the podium along with us.

           And so it goes: Trump looks back to the days of Herbert Hoover in his trade policy; the Energy Department is busy trying to revitalize coal burning as the rest of the world pushes full throttle towards the transition away from fossil fuels. We’re looking back, while others look forward. It’s as though the loud, ignorant bully in the back of the classroom has come to the front, shoved aside the teacher and taken over the curriculum.

            We have only ourselves to blame. Long before Trump won in 2016, voter disengagement abetted the election of governors and state legislators who pandered to the more motivated extremes, and, once in power, who then gerrymandered districts to solidify their grip. We started down the path of stupid years ago. If we want to change direction, voters need to rouse from their apathy lest, as the Chinese proverb holds, we end up where we’re headed. If, however, the above policies represent who we truly are; we deserve what we reap.

           

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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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