The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Kate Welling of Weedon directs or attention to the following:

Kaufman’s Better Ideas On Market Structure (PDF)

August 5, 2010

The Honorable Mary L. Schapiro, Chairman
U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-1090

Re: Ongoing Market Structure Review

Dear Chairman Shapiro (Mary):

I am writing to you once again out of concern for the credibility of our equity markets. You have said on several occasions that the markets exist to serve two primary functions: (1) capital formation, so companies can raise capital to invest, create jobs and grow; and (2) attracting and serving long-term investors to help facilitate the capital formation process.

I wholeheartedly endorse this philosophy. The Securities and Exchange Commission’s review should assess every market structure and practice through this lens and determine, first and foremost, the degree to which each feature serves or detracts from those functions. Despite the enormous and important workload Congress has placed on the Commission by enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act, I hope you agree with me that it is critical for the Commission to continue its work in this area expeditiously and propose further needed changes.

The May 6 “flash crash,” during which liquidity dried up and the stock markets failed their essential price discovery function for a harrowing 20 minutes, exposed serious flaws in our market structure. In its aftermath, the commissioners and staff of the SEC and Commodity Futures Trading Commission (CFTC) worked heroically to try to understand the unusual trading activity of that day and draw needed lessons. While putting in place stock-specific circuit breakers was a useful first step, much work remains if we are to restore investor confidence and ensure our markets are strong and credible.

In particular, several areas of current market structure lead me to be concerned about the performance of the markets for investors and companies seeking to raise capital. The proliferation of exchanges and other market centers that has increased fragmentation, the substantial rise in volume executed internally by broker-dealers or in dark pools, excessive messaging traffic, the dissemination of proprietary market data catering to high frequency traders, and order-routing inducements all may be combining in ways that cast doubts on the depth of liquidity, stability, transparency and fairness of our equity markets. These areas deserve further review and possible rulemaking by the Commission. Repairing investor confidence and fixing a broken market structure cannot take a back seat to the Commission’s other statutorily imposed responsibilities.

For example, while speed and efficiency can produce certain benefits, they have also created a micro-arms race that is being waged in our public marketplace by high frequency traders and others. At least partially as a result, much of the deepest and most valuable order flew has retreated from the “lit” public markets to dark trading venues. Accordingly, some market participants argue that high frequency traders have certain advantages and, therefore, should be subjected to trading obligations and other regulations. High frequency traders, on the other hand, complain that the best liquidity to trade against (retail and large orders) is routed to dark markets. With that being the case, they question why they should be obligated to make markets on public venues, where they are trading against dark pool “exhaust” and competing with other sophisticated traders, leaving them with razor-thin per-trade profits.

The answer, in my view, lies in both directions: we must improve the quality of the public marketplace by harmonizing and reducing the fragmentation in ways that diminish those parts of the high frequency “arms race” that have no social utility. At the same time, however, we must reduce the amount of order flow executed internally by broker-dealers and in dark pools.

It may seem counterintuitive, but the Commission should even examine whether regulation should aim not to facilitate narrow spreads with little size or depth of orders, but instead promote deep order books -and if necessary -wider markets with large protected quote size. Wider spreads with a large protected quote size on both sides may facilitate certainty of execution with predictable transparent costs. Narrow fluctuating spreads, on the other hand, with small protected size and thin markets, can mean just the opposite -and actual trading costs can be high, hidden and uncertain. Deep stable markets will bring back confidence, facilitate the capital formation function of the markets and diminish the current dependence on the dark pool concept. At a minimum, the Commission must carefully scrutinize and empirically challenge the mantra that investors are best served by narrow spreads. In reality, narrow spreads of small order size may be an illusion that masks a very “thin crust” of liquidity (which leave markets vulnerable to another flash crash when markets fail their price discovery function only next time within the bounds of circuit breakers) and difficult-to-measure price impacts (that might be harmful to average investors and which diminish investor confidence), both of which the Commission must examine and possibly address.

As I wrote to you on August 21, 2009, the markets have changed dramatically in recent years. The Commission urgently needs to undertake (and complete) a comprehensive review of how these changes, both individually and in the aggregate, affect long-term investors. In the aftermath of the flash crash, this is an historic moment for the Commission, a moment when it must fulfill its obligation as steward for those investors who lack the clout of Wall Street’s largest financial players. I have proposed some problems and possible solutions that the Commission and its staff should consider; admittedly, there are no silver bullets or easy answers for complex markets.

Yet we can, and must, expect answers. The direction the Commission takes in its bid to fulfill its mission will say much about the type of country in which we live. As difficult as it might be, regulators must stand apart from the industries they regulate, listening and understanding industry’s point of view, but doing so at arm’s length, and with a clear conviction that on balance our capital markets exist for the greater good of all Americans. This is a test of whether the Commission is just a “regulator by consensus,” which only moves forward when it finds solutions favored by large constituencies on Wall Street, or if it indeed exists to serve a broader mission, and therefore will act decisively to ensure the markets perform their two primary functions of facilitating capital formation and serving the interests of long-term investors.

A consensus regulator may tinker here and there on the margins, adopt patches when the markets spring a leak, and reach for low-hanging fruit when Wall Street itself reaches a consensus about permissible changes. In these times, however, the Commission must be bold and move forward.

Please see the attached document where I have laid out some themes that elaborate on my views about the ongoing market structure review.

Sincerely,

Edward E. Kaufman

United States Senator

cc: The Honorable Kathleen L. Casey

The Honorable Elisse B. Walter

The Honorable Luis A. Aguilar

The Honorable Troy A. Paredes

*****

ATTACHMENT

POSSIBLE MARKET STRUCTURE SOLUTIONS

Read the rest of this entry »

Succinct summation of week’s events:

Positives
1)Refi’s rise 17% to highest since May ’09 on lower mortgage rates
2)July IP better than expected but auto seasonal distortion a caveat
3)Bundesbank raises German ’10 GDP est to 3% from 1.9%
4)German ZEW current conditions well above expected
5)UK retail sales higher than forecasted
6)US bank lending standards ease a touch
7)Ireland eases concerns with its finances after good bond auctions.
8)M&A activity

Negatives
1)Greek debt concerns flaring again
2)Japanese Q2 GDP up only .4%, Nikkei just shy of lowest since Nov ’09 also on strong yen
3)ZEW 6 mo outlook lowest since Apr ’09
4)Philly Fed mfr’g unexpectedly contracts
5)NY Fed mfr’g new orders negative for 1st time since June ’09
6)Initial Claims poor
7)Home builder sentiment lowest since Mar ’09
8)Purchase apps near lowest since ’97
9)Housing starts and permits weak.

With the cost of bank bailout fears flaring up again last week in Ireland combined with a weaker than expected drop in Q2 GDP in Greece, and general risk aversion seen in the rally in Treasuries and Bunds after the FOMC meeting and weak US economic data, Greek asset prices are again pointing to trouble. This week the Greek 2 yr yield at 10.71% has risen 60 bps, is higher by 120 bps over the past 2 weeks and is approaching the 10 yr yield of 10.77%. Greek 5 yr CDS is at 895bps, up 75bps on the week and 140bps in two weeks. It now exceeds Argentina again and is now only below Venezuela. What is most worrying about the action in their 2 yr is that the EU has in place a 3 yr 110b euro bailout package for Greece, fully covering all of their debt obligations during this time. The market clearly has worries still that a debt restructuring is the inevitable outcome. Greek stocks closed down on the day 3.5% to a 4 week low.

James Montier is a member of GMO’s asset allocation team. Prior to joining GMO in 2009, he was co-head of Global Strategy at Société Générale. Mr. Montier is the author of several books including Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance; as well as Value Investing: Tools and Techniques for Intelligent Investment; and The Little Book of Behavioural Investing.

In between longer think pieces for GMO, James publishes at Behavioral Investing, which he describes as the “application of psychology to finance and the home of an investing skeptic.”

Enjoy:

~~~

Note: This was originally written for the FT, but they seem to have gone the same way as so much media and are dumbed down these days – they said it was too technical (after sitting on it for more than a week).

>

Reports of the death of mean reversion are premature

In a recent article [1] Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.

I. Investing based on mean reversion will be less compelling

II. Risk on/risk off fluctuations in sentiment will continue

III. Tail hedging becomes more important

IV. Historical benchmarks and correlations will be challenged

V. Less credit will be available to sustain leverage and high valuations

Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.

However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.

As long as markets continue to follow the second implication (as they have done since time immemorial) and flip flop between irrational exuberance and the depths of despair, then mean reversion (at least in valuations) is likely to remain the best strategy for long-term investors. (This also highlights the apparently contradictory nature of the first two implications that the authors point out). We don’t require long periods of time at equilibrium for mean reversion strategies to work, rather (and considerably less onerously) we simply require markets to pass through the equilibrium periodically.

As always, investors need to be mindful of the context of their investment decisions. It is always possible that we are standing on the brink of a shift in the level to which asset valuations mean revert. But that has always been the case. Only careful thought and research can work to try to mitigate the dangers posed by this threat. After all, if investing were both simple and easy, everyone would be doing it.

The third implication that tail risk hedging will become more important is and always has been true (much like the second implication). The prudent investor should always pay attention to tail risk – the new normal doesn’t alter that.

Ever eager to please, the ‘engineers of innovation’ (or should that be the ‘architects of destruction’?) are happily creating products to serve the new bull market in tail risk. Deutsche Bank is launching a long equity volatility index, while Citi has come up with a tradeable crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Strangely enough, Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. Even the CBOE is planning a new index based on the skew in the S&P 500.

However, any consideration of the purchase of insurance should not be divorced from a discussion of the price of the insurance. Cheap insurance is wonderful, and clearly benefits portfolios in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand!

You should really only want insurance when it is cheap, as this is the time when no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset … a path to the permanent impairment of capital. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves your dry powder for times when you want to deploy capital, and limits the downside.

So buy insurance when it’s cheap. When it isn’t and you are worried about the downside, hold cash. As Buffett said, holding cash is painful, but not as painful as doing something stupid!

In summary, the new normal may pose some issues for investors who have never bothered to study history (which is, of course, littered with many, many ‘new normals’). However, for those with perspective, prudence, patience and process, many of the same ‘eternal’ rules are likely to govern the game as they always have, come rain or shine. In essence, many of the implications are less the new normal, and more the old always!

From Stratfor:

Le Grand Content examines the omnipresent Powerpoint-culture in search for its philosophical potential. Intersections and diagrams are assembled to form a grand ‘association-chain-massacre’. which challenges itself to answer all questions of the universe and some more. Of course, it totally fails this assignment, but in its failure it still manages to produce some magical nuance and shades between the great topics death, cable tv, emotions and hamsters.

Le Grand Content from Lucas Carlisle on Vimeo.

The film is a co-production with Karo Szmit. Narration is by Andre Tschinder. The diagrams are inspired by the site indexed.blogspot.com created by Jessica Hagy.
There is also an alternate version with music by Andre Tschinder instead of Aphex Twin.

Over the past few weeks, I have posted on an eclectic assortment of items. That is keeping with the blog’s sub-title: Macro Perspectives on Capital Markets, Economy, Technology, and Digital Media. A few of you have commented (here and here) or emailed about this recently.

I want to take a few moments to explain the thought process behind what appears to be a random collection of posts, but actually, is not. Instead, it is part of a broader process that ranges across a variety of disciplines, interests, methodologies.

The broader mission of what I try to do is seek the Truth.

I define “the Truth” as being in accord with objective reality. Philosophers have argued we can never achieve that degree of perfection, so to me it means getting as close as possible to the Truth as any slightly cleverer, pants-wearing monkey can.

I do this for three reasons: The first is that I am interested in it intellectually. I am aware that our individual universes are mere constructs of a sophisticated cognitive process, the evolutionary apex of this planet. I am also all too aware it is filled with flaws and biases and error. So few people seem to understand what objective reality is that it is a rarified space to even get near, much less inhabit.

This means venturing far and wide in search of “enlightenment.” No one discipline has a monopoly on the Truth, and very often a brilliant insight from one field can be applied in another. Hence, Behavioral economics, music, neurophysiology, methods of data-depiction (aka chart porn), market history, even automotive innovations all part of the cross-discipline process.

The second reason is professional: Fund managers whose universe deviate from reality eventually come to major losses, under-performance, and professional ruin. The most public version of this was Bill Miller: His failure to understand the derivative situation, creaky Housing edifice, and the artifice of the 2002-07 finance rally led his fund to load up on banks, GSEs, investment houses — and ruined an incredible record. There are many other examples, but this one is the most acute. Note there is a distinction between those who play probabilities that do not play out, and those whose world view is so flawed as to make losses all but inevitable.

I believe in Variant Perspective as an investment thesis: Identify where most of the investing public is objectively wrong; determine what the best approximation to reality is; factor in timing, and invest accordingly. Value investors do this when they buy undervalued stocks; they are saying the public is wrong (the variance) about the lack of worth of an issue; short sellers do this as well, explicitly stating the opposite — that the variance is the public overvaluing a stock, and making their bets.

One of the surprising things this blog has taught me is how long it takes Reality to go viral. There are entrenched interests opposed to the Truth; they release their grip on their subjective fantasies very, very slowly.

When people said that Housing never falls in price, that is an example of entrenched interests pushing their false view of the world. Some argued that sub-prime mortgages were such a small part of the economy, they could never have much of an impact. That was not an error, or a difference of opinion, mind you, but a cognitive failure on their part to hypothesize a probable or likely outcome. Years passed before the Truth became known.

The inverted Yield Curve as an omen of impending recession? Dismissed as different this time (inviting our criticism). Erroneous discussions of how cheap home builders were, how expensive tech stocks were, how low inflation was, and how high employment were all subjects of discussions here as alt.universe fantasies. It took years before the Truth became widely accepted — and even that required a massive global crisis.

There are 100s of such examples. Some people claim that nobody forecast a possible housing/derivative/market collapse (a blatant lie to obscure their own failures). When the CRA or Fannie/Freddie are blamed for the economic crisis, I recognize this as false, a blatant attempt to obscure, rather than reveal the Truth. Arguments talking up or down the economy usually have a specific agenda apart from the objective reality of the situation.

Which leads us to our headline: Seeking the Truth — Or Obscuring It?

I have explained my motivations as a truth seeker. It is intellectually stimulating, and it can be profitable. The major investment houses have, for the most part, abandoned it as part of their model. I should be thankful they left that market niche open to smaller, nimble firms (like mine).

But what motivates people to pursue a narrative that is blatantly false, misleading or intellectually dishonest? Typically, it meets a powerful group’s specific agenda. There is a embedded interest amongst the entrenched to preserve the status quo. The thought process seems to be “Hey, its working for us, let’s not mess up a good thing.”

Said another way, look at what it is they are selling.

We see this in a variety of areas: Politics are notorious for disregarding the Truth. Political objectives are to win votes, control public monies, amass power and influence. The Truth is an obvious casualty in this process.

Amongst corporate interests, the Truth can get in the way of sales, earnings reports, and profitability, impacting careers, stocks prices and of course bonuses. Regulation reduced profits. Impacting the debate to achieve a desired outcome is worth billions, even if the consequences to society costs trillions.

Even academia is suffers from this error prone tendency to obscure the Truth when it contradicts a long held theory or belief system. Look no further than the Efficient Market Hypothesis, and the way it was applied in real world discussions of policy, and self-regulation. Then consider the tortured route it took to go from the intellectual standard of academic capital market explanations to a partially discredited, somewhat outmoded belief system.

I initially mentioned three reasons. The third is simply that we live in a society where decision-making takes place with less and less reverence for the Truth, with terrible consequences. Those people who seek to obscure the Truth for personal gain do an enormous disservice to our nation. Public policy is made based on false pronouncements, monies are allocated based upon misleading arguments, laws are made, taxes levied, policy executed. The lives of 100s of millions of people is significantly impacted by our public policy.

When the entire edifice rests on falsehoods, mistruths, faulty assumptions, false premises, future  outcomes, as we have seen over the past few years, can be horrific. History teaches us that eventually, the Truth will reveal itself. When that happens, there can be terrible consequences: Economies collapse, wars occur, empires crumble, millions die.

Whenever I read a major policy piece, newspaper article, or OpEd, I ask the following question: Is this person a truth seeker, or a truth obscurer? When you see nasty posts that dissect/shred/fisk these, it is because I was not happy with the answer to that question.

Are you a truth seeker, or a truth obscurer?

With yesterday’s close in the SPX cash at 1075, dead smack in the middle of the trading range from early July, the daily quote on today’s Bloomberg terminal seemed very apropos in describing the market action, “If you don’t know where you are going, you might wind up someplace else,” said Yogi Berra. I’ll add another of his, “If you come to a fork in the road, take it.” Stocks are dealing with the tug of war of a clearly softening economy on one hand and the hopes that it’s just temporary in part due to the hopes for a political ‘time out’ in Nov. I do not want to get into a political/policy discussion at all but it’s clear a ‘time out’ is desired by the market. The ECB’s Weber said he prefers to wait until after year end in normalizing policy due to possible “end of year tensions” and the Euro quickly moved lower in response and European stocks followed. The European iTRAXX financial 5 yr CDS is wider by 9 bps to 137, the highest in a month. Also as a result, German bund yields went to new record lows. The Shanghai index lost 1.7% from a 3 month high and the Sensex index lost .3% from a 30 month high.

Dilbert looks at the issue of regulatory capture, with just a touch of sarcasm:

>

Wired has an odd little feature Web is Dead (Long Live the Internet) about their forecast from 1997 (Push!). They claimed way back then that the browser was dead, and push technologies would soon rule.

Um, wrong.

What really stands out, however, is the post YouTube, Hulu, Vimeo rise of video. According to the graphic below, video now accounts for 51% (WTF?!?) of total US web traffic. (Some of this reflects that video data  is so much denser than mere text and images).

Indeed, if you look at our video tab, most of the content I embed — WSJ, Yahoo Tech Ticker, TED, CNBC, Bloomberg, NYT,  Fora — simply was not available 2 years  ago.

>