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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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IS OUR BRAND OF CAPITALISM MAKING US STUPID


Tuesday August 30, 2011

 

Eugene Linden


           How can a society that contains so much individual brilliance act so collectively dumb? Does it matter that we know that there is a cliff ahead if we still go racing off the edge?  The Wikileaks publication of State Department emails demonstrated that there is tremendous expertise at the ground level in foreign policy.  That didn’t stop us from charging into what has been called the “most feckless” war in American history. The key to our success as a species has been the development of communication and cognitive skills that enable us to leverage our collective intelligence so that a group is vastly smarter than an individual.  In recent years, that seems to have gone into reverse. While individual brilliance abounds, collective stupidity prevails.

Consider a few recent examples:

The Ongoing Financial Crisis:

            The most devastating financial crisis since the Great Depression followed the dismantling of reforms put in place during and after the 1930s to prevent institutions from bringing about the very financial collapse we just experienced. While there were many tributaries to the meltdown, a common element was a system of incentives that was optimized to reward those who made the biggest bets. Penalties for failure were gradually stripped away, and the costs dumped on taxpayers. Does anyone think that the Dodd-Frank package of financial regulation package signed into law by President Obama has eliminated these incentives, or that if it turns out that new regulations actually impede financial institution profits that they will stay in place?

Given that the crisis wiped out $13 trillion in national wealth and has brought much of the middle class to the brink of insolvency, one would think that voters, who vastly outnumber the rich, would insist on enacting a robust regulatory framework. One would be wrong.
     
And now, carrying forward its proud tradition of doing the wrong thing at precisely the wrong time, Congress just forced through, and the President signed into law, a series of spending cuts in return for allowing the US government to pay bills it had already incurred. This will shrink government spending even as the economy slows, removing any doubt that we will slip back into recession and unemployment will worsen. Congress and the president have thus exactly repeated the mistake of FDR, who agreed to cuts in 1937 that plunged the US back into the Great Depression.


The Deepwater Horizon oil spill:

            The Gulf of Mexico oil spill of 2010, the most catastrophic environmental event in American history, directly followed from the neutering of regulations, safety mechanisms, and procedures put in place after earlier spills such as the Ixtoc Spill of 1979, and the Exxon Valdez spill in Alaska in 1989.  Does anyone seriously believe that new regulations that arise from this disaster won’t also be neutered?  We need oil, and the easy-to-find oil is gone so we need to drill in the most inaccessible, politically hostile, and/or environmentally vulnerable places on the planet.

Climate Change:

            Now here’s a problem perfectly designed for a species with an abilitiy to anticipate and avoid disaster! The science of the greenhouse effect that underlies concerns that emissions of C02 are changing climate is uncontroversial. There is overwhelming agreement among climate scientists that human-sourced emissions, largely traced to the use of fossil fuels, are already warming the planet; climate historians have vividly documented how civilizations are vulnerable to climate change, and since the 1980s, policy-makers have been discussing ways to reduce emissions.
        
So what has the U.S. done to avert the threat? Nothing! Despite 30 years of verbiage and negotiations, the recession has done more to limit U.S. emissions than anything we have done legislatively. The pattern for species ranging from fruit flies to elephants, and, yes, humans, has been for numbers to explode when the climate is favorable and plummet when it turns hostile. Our numbers have exploded in the climatically benign years since the end of the last Ice Age. Will it be different this time if climate turns hostile?

A Global Pandemic of Willful Blindness

            America has no monopoly on collective dumbness – after all Japan, perhaps the most rational nation on the planet, saw fit to site nuclear power plants in areas vulnerable to both earthquakes and tsunamis, and Europe continues to pile blunder upon blunder as it tries and fails to contain its own financial crisis. Time and again the best and brightest have alerted society to looming problems, but a persistent pattern has been to ignore the warnings, ridicule the experts, and suffer the consequences.

The pathetic refrain of recent years  -- “nobody saw this coming” –is always a self-serving lie.  Something is making us stupid.  My candidate is the way we practice capitalism, specifically the skewed incentives that promote hyper-focus on short-term gains, while leaving us effectively blind to long-term threats.
      
In each case cited above, actions to head off a threat were perceived to impinge on present profits, and, in modern market economies, we consistently make the decision that we’d rather head off a cliff in the future than limit the gains of those with access to the levers of power. In all these cases, economic interests ultimately control the lawmakers.  We’ve created a system that leaves us constantly surprised by the obvious.
          
I’m certainly not arguing for central planning – the failed communist states constitute a monument to collective stupidity. But there is a middle ground. Consider Canada, the friendly giant to the north, which seems to be able to regulate without suffocating innovation. Can this be fixed in the U.S.? Sure! Will it be fixed? Probably not, at least, not without shock therapy far worse than what we have recently endured, and that’s exactly what we are rocketing towards right now.

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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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