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Imagining a Post Pandemic World

How might a post-pandemic world look and feel? Let’s imagine a creative team at a New York City advertising agency pitching a campaign in 2050 for a new perfume (more than most products, perfumes are sold by attaching to the dreams and aspirations of their times).  The Big Apple, ...

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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

Relaxing COVID-19 Restrictions will Kill, not Save, the Economy


 

[This is a more developed version of the previous Short Take}

Those who want to relax mandates on self-isolation and social distancing to save the economy have got it exactly backwards. Reopen society too soon, and we risk destroying the economy as well as public order and our shaky democratic institutions. The reason comes down to two words: supply lines.

 Supply lines for necessities such as food are already under stress. Those going to grocery stories encounter random instances of empty shelves and vegetable bins. Smithfield Farms shut down a South Dakota plant that supplies roughly 4% of the pork in the nation after over 500 of its workers tested positive for the coronavirus. Other giant meat processors such as Tyson have also shut down plants for similar reasons. Farmers in the West are having trouble finding workers to harvest the crops now reaching maturity in the fields. And even if they manage to get the crops picked, farmers are out of luck if the truckers fail to show up, or the flow of packaging for their products get interrupted. 

Right now, these disruptions are episodic, but that should be concerning because we haven’t even seen the end of the first wave. What we have seen is that vital front-line workers such as nurses, doctors, EMT’s, and other first responders have had trouble finding protective equipment and maintaining morale. Some have staged walkouts over the dangerous conditions, and these are workers with a sense of mission.

By contrast, for most of the hourly-paid workers who keep supplies made, distributed, and sold, their work is a job that pays the bills. It would be appropriate if society recognized that they played a vital role, but mostly these workers encounter demanding bosses, monotony, and surly customers. If sick, they are not going to work – nor would we want them too. And they are not likely to risk their lives if going to work exposes them to contagion.

Disruption of one link, e.g. the trucker that delivers food the last mile, could halt a supply chain. COVID-19 is a threat to every link. Should a second wave hit before there is a readily available, cheap and effective treatment, it’s a very high probability that many supply lines will be disrupted and filling the gaps could easily overwhelm the nation’s businesses. 

Even today, on the evening news, we see images of vast caravans of cars lined up to get supplies from food banks. Imagine two weeks of empty shelves in the stores that feed our cities. How likely is it that civil order could be maintained in that situation? Will people suffer in silence if they realize that they can’t buy food for their kids because our leaders reopened the economy before a treatment was available because they wanted to prop up the stock market (which is how it will be portrayed)? If we want to look analogues for what life is like once supply chains break down, they’re readily available today in cities like Mogadishu, Kinshasa, and Port au Prince. 

 Thus far, the Trump administration’s response to the pandemic seems to be a mélange of Boss Tweed, Don Corleone and Inspector Clouseau. For the next act, the administration has a choice: Churchill, who bolstered British morale during the London Blitz, or Pol Pot, who sacrificed millions of his countrymen for a bad idea. Let’s hope those around Trump can convince him that the cure for the disease is the cure for the economy.
 



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