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THE MATRIX MARKET


Thursday February 03, 2011

Eugene Linden

 

A well-trodden meme of TV and cinema has been the plot in which someone or something uses tantalizing illusions to sap humans of their will to resist while simultaneously pursing hostile ends. In The Martian Chronicles, the subtle race of Martians distracted the invading Americans with irresistible life-like illusions that spoke to their most intimate yearnings; in one episode of the X-Files, a fungus slowly digested an unlucky couple who lay in a field and were rendered completely passive by the fungus’ hallucinogenic properties. And then, most famously, the machines of the movie The Matrix ruled over a ruined wasteland and seduced people with a beguiling virtual reality in order to maintain their passivity while they tapped humanity’s body heat as an energy source.

Now, a lot of investors believe that life is imitating art in an alliance of the Federal Reserve and the big banks to create the illusion of healthy equity markets despite massive retail equity withdrawals in the years following the financial crisis. In this broadly-believed scenario the Fed’s motives are comparatively benign – to foster asset inflation that improves animal spirits, fosters a wealth effect, and restores access to the equity markets for financial institutions and other companies in need of capital.

The idea is that through its program of quantitative easing the Fed is buying treasuries from its primary dealers who then turn around some portion of the proceeds in the equity market. Data miners have discovered strong correlations between the Fed’s permanent open market operations (POMOs) and up days in the equity markets, with a statistically significant spike on such days during the final 45 minutes of trading. So strong is the perception that these operations pump the market that Bernanke’s announcement of a new quantitative easing program last August set off a rally that moved the market up over 14% before the program was scheduled to begin in November.

Whether or not there is a direct connection between QE and a bid for stocks, the mere fact that the link is so widely believed has played a non-trivial role in the equity markets. Which begs the question: if the markets have risen on this scenario, does it matter whether or not this connection exists? After all, millions of investors have been benefitting from the ride. The cynical answer is that it probably does not matter -- if such manipulations could continue in perpetuity.

There’s the rub: nothing continues in perpetuity. In fact, QE2 is scheduled to end around mid-year and if it is not extended, the markets will face a crunch whether or not there is a real connection between QE and the market. Thus, if the Fed will not (or cannot) extend QE past June, it behooves its officials to convince investors well beforehand that it has not provided the invisible hand supporting stocks. Regardless of the Fed’s role, there have been other, more disturbing bits of evidence that we are in a Matrix Market.

Exhibit One is the so-called “flash crash of May 2010 during which stocks fell by 600 points in five minutes before staging and equally vertiginous recovery. The crash offered evidence that something truly scary lay behind the reassuring façade of buoyant markets. Subsequent investigation revealed that High Frequency Trading, which relies on algorithms to execute superfast trades, exacerbated the collapse. Revelations about the extraordinary percentage (sometimes over 80%) of trading attributable to HFT programs in stocks such as Citi and AIG suggest that the metaphor of a Matrix Market may be literally as well as figuratively true, and also helped explain how a market suffering continuing retail withdrawals could still rise to a multi-year high during a very weak economic recovery.

Economist Michael Hudson of the University of Missouri calculated that the average time a stock was held during 2010 was 22 seconds, not exactly buy and hold. Of course it’s entirely possible that both HFT and the impact of the Fed’s easing program are overblown; that the market’s rise can be simply explained by solid corporate earnings and the perception of a real recovery. If that’s the case, the market will continue to plug higher so long as the recovery story remains credible to investors and earnings hold up. If, however, the rally is largely an artifact of the jet fuel supplied by the Fed and amplified by algorithmic trading, then watch out.

The recent example of the auction-rate securities market shows that fake markets can seduce and then trap the most sophisticated investors. Adapted for municipal finance in 1988 by Goldman Sachs, the market grew to about $300 bn before it collapsed amid a series of failed auctions when the main players – Citi, UBS, AG, MS, and ML – pulled back from their practice of being the bidders of last resort. What was revealed subsequently was that for several months before that, auctions had basically been a sham with the big underwriter banks supplying the majority of bids for the securities they helped issue. Given that the investors were institutions and high net worth individuals, it’s remarkable that this could carry on so long without being uncovered. The ARS market was doomed in March, 2007 when FASB announced that ARS should not be counted as cash on balance sheets and liquidity began to dry up. From that point on the auction rate securities market was a ghost.

Those who paid attention (which did not include me) saved themselves much grief. Others remained oblivious for eleven months before the axe fell, and when it fell, it fell suddenly – one week after the first cracks appeared in the market 80% of the auctions that priced the securities failed. In hindsight it’s obvious that during that “dead man walking” period it was in not in any underwriter or broker’s interest to say that the ground had fatally shifted under what had been a highly profitable market. This was not a grand conspiracy or racket, but, more likely, a series of individual crimes as like-minded players continued a game because they could see no alternative. I’m sure that many of the players were amazed that it continued as long as it did.

Something similar happened in the mortgage-backed securities market as firms such as Bear Stearns continued to package and push them on investors long after it became obvious that the underlying mortgages were going sour in unprecedented numbers (when the MBS market finally did collapse new issuance went from hundreds of billions annually to zero). Something very similar is going on right now in the commercial real estate market where lenders are extending maturities because no-one wants to face the consequences of setting off a cascade of defaults and subsequent massive write-downs in a weak market. Is something similar going on in the equity markets?

For sure, we’re gonna find out, probably by mid-year.

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Short Take

[Mild spoiler alert: the book is a fictionalized exploration of a girl who falls under the spell of a Manson-like cult. We all know how that story unfolded. In this Short Take I’ll be offering my reactions to the protagonist, Evie Boyd.]

 

The Girls offers as bleak a view of the amorality of American youth as I have ever encountered. In a review of my first book, I was called “Intolerably apocalyptic,” but I can’t hold a candle to Ms. Cline. The book is a novelistic attempt to try and understand how some of the privileged young women of the late 1960s could commit unspeakable acts while under the sway of a Manson-like psychopath. 

 Thus we meet Evie Boyd, a fourteen year-old growing up amid relative affluence in Petaluma California. She’s directionless, with no apparent passions, self-conscious about her looks, emotionally needy, alienated from her parents (who get divorced), but possessed of a tough inner core and a rebellious streak. She’s enthralled when she encounters Suzanne, a wild, charismatic 19 year-old who seems to be a composite of Patricia Krenwinkel and Leslie Van Houton, and Evie is honored when Suzanne pays her some attention. Events bring her to the cult’s squalid ranch, and for some weeks, Evie maintains a dual life, throwing herself into the life of the cult, while returning home enough not to galvanize her mother, who is pre-occupied with a rebound relationship with Frank, an entrepreneur who comes across as a hustler with a heart of gold.

Evie is so smitten by Suzanne that she doesn’t notice as the cult spirals down from talk of love and freedom to episodes of paranoia, back-biting and revenge. Along the way, Evie has her first sexual adventures, and enters sufficiently into the spirit of the cult that she brings them to the house of the family next door (which they descrate), even though she has known the family all her life and has no score to settle. Later, Evie talks her way into joining Suzanne as she and others set off to inflict mayhem on a Dennis Wilson-like figure, but Suzanne kicks her out of the car before they begin a horrific rampage.

Did Suzanne do this to protect Evie from what she knew was about to happen, or because she felt that Evie wasn’t a murderer and would become a liability? That’s left unanswered, but the bloodbath that Evie missed is so depraved – including the slashing apart of a toddler – that no human with a soul could find that earlier gesture redemptive … except for our Evie, who still feels the tug of Suzanne’s power, even after she learns every gory detail of Suzanne’s actions.

It’s several months between the time of the murders and when the cult is finally caught. During this time, Evie keeps her mouth shut about what happens and meekly allows herself to be shipped off to boarding school to resume her comfortable existence, though as a wreck, not a spirited teenager.

That’s when I decided Evie was a worthless human being. Sure, she was terrified that the cult would come after her, and there’s some honor on not squealing, but Evie had to know that the cult would likely kill again, and that made her an enabler of whatever they did subsequently.

The book interweaves the present and the past and so we learn how these events haunted Evie’s life. But there’s no redemptive moment, no act where she summons the courage to do the right thing, or rises above her own self-absorption. Even in the present, when the psychopath-in-the-making son of a friend and his underage, impressionable girlfriend crash at her digs, she can only summon a half-hearted (and failed) attempt to save the girl from following the path that so grievously sidetracked her own life.

All the men in the book are either pathetic or pigs of various shapes and forms – except for a premed student named Tom, who sees the cult for what it is, but who Evie rejects as a dork. Towards the end of the book, Evie ticks off a long list of subsequent experiences with awful men that could summon in her the hatred to commit horrendous crimes, seeming to imply that with the right mix of events, she too might have become a Suzanne, and, by implication, so could enormous numbers of other young women.

My first reaction was to call “Bullshit!” Were all young women potential Suzannes, we would have seen endless repeats of the Manson horrors in the nearly 50 years since the events. Instead, those murders still stand as a touchstone of horror because nothing since has eclipsed their mindless violence.

The Manson cult was at the far far end of the normal curve during truly abnormal times. In just the two years leading up to the murders, we had the huge escalation of a senseless war, the explosion of the anti-war movement and counter-culture, a breakdown of generational trust, my generation’s first experiences with powerful, mind-altering drugs, and a sexual revolution. In a country of more than 200 million people, that roiling stew of disruptive forces bubbled to the surface about 20 broken souls, deranged by drugs and in the thrall of a false prophet.

On reflection, however, maybe Ms. Clein was making a different point. All we have to think of are the teenage executioners of Pol Pot’s Cambodia or the child soldiers of Africa to recognize that the capacity for evil lies latent in the young. And, while in fiction we want our protagonists to find redemption or transcend their flaws perhaps Evie’s failure to rise to the occasion was making the point that a civilization that keeps our murderous impulses in check is not innate, but something external that has to be actively inculcated and supported. That’s something to keep in mind amid the current insanity of gun violence, and as more dark clouds gather on the horizon.



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