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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A Nobel Prize in Economics a Climate Change Denier Might Love


Monday November 05, 2018

It has been a scary month in climate science. Hurricane Michael and a frightening report from the U.N. Intergovernmental Panel on Climate Change underlined the potential costs of human-caused global warming. Then to add insult to injury, William Nordhaus won the economics Nobel Prize.

Nordhaus was recognized for his work developing a model to guide policymakers on how best to address the costs and benefits of limiting greenhouse gases. That’s a noble goal, but Nordhaus’ work has no more helped to defuse the threat of global warming than Neville Chamberlain’s appeasement of Germany prevented World War II. Rather, Nordhaus’ low-ball estimates of the costs of future climate change and high-ball estimates of the costs of containing the threat contributed to a lost decade in the fight against climate change, lending intellectual legitimacy to denial and delay.

In Nordhaus’ 1993 paper, “Rolling the ‘Dice’: An Optimal Transition Path for Controlling Greenhouse Gases,” he wrote: “A growing body of evidence has pointed to the likelihood that greenhouse warming will have only a modest economic impact in industrial countries, while progress to cut [greenhouse gases] will impose substantial costs.” How modest? Nordhaus estimated that a 3 degrees Celsius warming would cost the U.S. economy a miniscule one-quarter percent of national income. He admitted that unmeasured and unquantifiable variables might affect that prediction, but in his view, they might only bring the cost up to about 1% of national income.

Given such a tepid assessment of the threat, it is little wonder that Nordhaus’ biggest cheerleaders have come from the “do nothing about it” crowd. In 1997, for instance, William Niskanen, then chairman of the ultra-conservative Cato Institute, seized on Nordhaus’ estimates to argue before Congress that it was premature to take action on climate change because “the costs of doing nothing appear to be quite small.” Yet four years before his testimony, scientists had discovered that, in the past, climate changed quite abruptly and dramatically, not slowly and moderately as Nordhaus’ model assumed.

The warming we’ve experienced so far allows us to put this in context. Global temperatures are now 1 degree Celsius above pre-industrial levels, but even this increment has accelerated the melting of the ice caps, spurred sea-level rise and increased the frequency and intensity of storms, droughts and floods. It has also spawned myriad derivative impacts: the spread of tree-killing bark beetles that provide fuel for record-setting wildfires in the West, as well as intolerable temperatures and droughts in the Middle East and Africa that have contributed to war in Syria and destablilizing migration.

The IPCC report, released the same day Nordhaus got his Nobel, heightens the award’s absurdity. Nordhaus in 1992 estimated the net economic damage of 3 degrees Celsius of global warming, under a business-as-usual scenario, at $5.6 trillion globally (about $10.2 trillion in today’s dollars). The climate change panel now estimates the damage from 2 degrees’ Celsius warming to be $69 trillion. Even this figure might prove radically conservative.

Four years after climate scientist James Hansen told Congress that global warming was already happening, Nordhaus suggested that the “thermal inertia of the oceans” meant climate change would have a “lag of several decades behind [greenhouse gas] concentrations. That year, 1992, scientists studying ice cores taken from the Greenland Ice Sheet, confirmed that, in the past, climate had undergone huge swings in as little as a few years.

In fairness, Nordhaus has always recognized global warming as a threat. He advocates a tax on carbon, which is a good idea. If the price is right, a carbon tax would push people and industries to cut emissions without cumbersome bureaucracy.

Nordhaus has also revised and updated the model he developed as the IPCC has revised its forecasts, and he and his colleagues have (in their view) gotten a better grip on the variables at work in the interplay of climate and an economy. His most recent work implies an optimum tax on carbon at $31 a ton, which, in real terms, is about three times his too-low 1992 estimate.

Nordhaus and his colleagues concede that even with a $31-a-ton carbon tax, the planet would be on a track for 3 degrees Celsius of warming, but they don’t appear to recognize that such an increase would render much of the world unrecognizable and vulnerable to mass starvation (a number of studies predict yield declines of up to 70% for vegetables if the world warms beyond 2 degrees Celsius). In any event, 26 years after his first publications, the U.S. still doesn’t have a carbon tax, in part because Nordhaus (and others who shared his views) underestimated the cost of doing nothing.

Most economists famously failed to predict the near-collapse of the banking system in 2008, and it may be asking too much that such a “science” ace the far more complicated problem of estimating the impact of climate change. Still, it’s jarring that the same organization that in 2007 gave its Peace Prize to Al Gore and the IPCC for their efforts to come to grips with climate change, would, 11 years later, honor an economist whose work more undermined efforts to deal with the threat than helped them.

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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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