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Submitted by Peter Schiff of Euro Pacific Capital,

Most economic observers are predicting that 2014 will be the year in which the United States finally shrugs off the persistent malaise of the Great Recession. As we embark on this sunny new chapter, we may ask what wisdom the five-year trauma has delivered. Some big thinkers have declared that the episode has forever tarnished freewheeling American capitalism and the myth of Wall Street invincibility. In contrast, I believe that the episode has, for the moment, established supreme confidence in the powers of monetary policy to keep the economy afloat and to keep a floor under asset prices, even in the worst of circumstances. This represents a dramatic change from where we were in the beginning of 2008, and unfortunately gives us the false confidence needed to sail blindly into the next crisis.

Although the media likes to forget, there was indeed a strong minority of bearish investors who did not drink the Goldilocks Kool-Aid of the pre-crisis era. As the Dow moved up in 2006 and 2007 so did gold, even though a rising gold price was supposed to be a sign of economic uncertainty. The counter intuitive gold surge in those years resulted from growing concern among a committed minority that an economic crisis was looming. In the immediate aftermath of the crisis in 2009 and 2010, gold shifted into an even higher gear when those investors became doubly convinced that the extraordinary monetary measures devised by the Fed to combat the recession would fail to stop the economic free fall and would instead kick off a new era of inflation and dollar weakness. This caused many who had been gold naysayers and economic cheerleaders to reluctantly jump on the gold band wagon as well. 

But three years later, after a period of monetary activism that went far beyond what most bears had predicted, the economy has apparently turned the corner. The Dow has surged to record levels, inflation (at least the way it is currently being measured) and interest rates have stayed relatively low, and the dollar has largely maintained its value.  Ironically, many of those former Nervous Nellies, who correctly identified the problems in advance, have thrown in the towel and concluded that their fears of out of control monetary policy were misplaced. While many of those who had always placed their faith in the Fed (but who had failed – as did Fed leadership – from seeing the crisis in advance) are more confident than ever that the Central Bank can save us from the worst.

A primary element of this new faith is that the Fed can sustain any number of asset bubbles if it simply supplies enough air in the form of freshly minted QE cash and zero percent interest.  It’s as if the concept of “too big to fail” has evolved into the belief that some bubbles are too big to pop. The warnings delivered by those of us who still understand the negative consequences of such policy have been silenced by the triumphant Dow.

The proof of this shift in sentiment can be seen in the current gold market. If the conditions of 2013 (in which the Federal Government serially failed to control a runaway debt problem, while the Federal Reserve persisted with an $85 billion per month bond buying program and signaled zero interest rates for the foreseeable future) could have been described to a 2007 investor, their conclusions would have most likely been obvious: back up the truck and buy gold. Instead, gold tumbled more than 27% over the course of the year. And despite the fact that 2013 was the first down year for gold in 13 years, one would be hard pressed now to find any mainstream analyst who describes the current three year lows as a buying opportunity. Instead, gold is the redheaded stepchild of the investment world.

This change can only be explained by the growing acceptance of monetary policy as the magic elixir that Keynesians have always claimed it to be. This blind faith has prevented investors from seeing the obvious economic crises that may lay ahead. Over the past five years the economy has become increasingly addicted to low interest rates, which underlies the recent surge in stock prices. Low borrowing costs have inflated corporate profits and have made possible the wave of record stock buybacks. The same is true of the real estate market, which has been buoyed by record low interest rates and a wave of institutional investors using historically easy financing to buy single-family houses in order to rent to average Americans who can no longer afford to buy.

But somehow investors have failed to grasp that the low interest rates are the direct result of the Fed’s Quantitative Easing program, which most assume will be wound down in this year. In order to maintain the current optimism, one must assume that the Fed can exit the bond buying business (where it is currently the largest player) without pushing up rates to the point that these markets are severely impacted. This ascribes almost superhuman powers to the Fed. But that type of faith is now the norm.

Market observers have taken the December Fed statement, in which it announced its long-awaited intention to begin tapering (by $10 billion per month), as proof that the dangers are behind us, rather than ahead. They argue that the QE has now gone away without causing turmoil in the markets or a spike in rates. But this ignores the fact that the taper itself has not even begun, and that the Fed has only committed to a $10 billion reduction later this month.  In fact, it is arguable that monetary policy is looser now than it was before the announcement.

Based on nothing but pure optimism, the market believes that the Fed can somehow contract its $4 trillion balance sheet without pushing up rates to the point where asset prices are threatened, or where debt service costs become too big a burden for debtors to bear.  Such faith would have been impossible to achieve in the time before the crash, when most assumed that the laws of supply and demand functioned in the market for mortgage and government debt. Now we “know” that the demand is endless. This mistakes temporary geo-political paralysis and financial sleepwalking for a fundamental suspension of reality.

The more likely truth is that this widespread mistake will allow us to drift into the next crisis. Now that the European Union has survived its monetary challenge, (the surging euro was one of the surprise stories of 2013), and the developing Asian economies have no immediate plans to stop their currencies from rising against the dollar, there is little reason to expect that the dollar will rally in the coming years. In fact, there has been little notice taken of the 5% decline in the dollar index since a high in July. Similarly, few have sounded alarm bells about the surge in yields of Treasury debt, with 10-year rates flirting with 3% for the first time in two years.

If interest rates rise much further, to perhaps 4% or 5%, the stock and real estate markets will be placed under pressure, and the Fed and the other “Too Big to Fail” banks will see considerable losses on their portfolios of Treasury and mortgage-backed bonds. Such developments could trigger widespread economic turmoil, forcing the Fed to expand its QE purchases. Such an embarrassing reversal would add to selling pressure on the dollar, and might potentially trigger an exodus of foreign investment and an increase in import prices. I believe that nothing can prevent these trends from continuing to the point where a crisis will be reached. It’s extremely difficult to construct a logical argument that avoids this outcome, but that hasn’t stopped our best and brightest forecasters from doing just that.

So while the hallelujah chorus is ringing in the New Year with a full-throated crescendo, don’t be surprised by sour notes that will bubble to the top with increasing frequency. Ultimately the power of monetary policy to engineer a real economy will be proven to be just as ridiculous as the claims that housing prices must always go up.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/azIq7I6g33k/story01.htm Tyler Durden

As we reported previously, currently the biggest problem facing Obamacare is the sudden “realization” by as many as half of any given state’s enrollees, that in addition to signing up for Obamacare, one also has to make a payment which is rapidly becoming a dealbreaker for many, and leading to total confusion at the doctor’s office. However, even if one were to assume that payment is not a major hurdle (after all funding for a subsidized ponzi scheme can always be… further subsidized), there are various other key issues that still remain. Such as the administration’s repeatedly stated target of 7 million enrollees by the end of March. Actually wait, it may have been 7 million once upon a time, as in the days before the Healthcare.gov rollout became an unmitigated disaster, but suddenly that bogey no longer exists.

Enter revisionist history:

“That was never our target number. That was a target that came from the Congressional Budget Office, and it has become an accepted number. There’s no magic to the 7 million. What there is magic to is that in the month of December a million Americans signed up for insurance.”

     – White House aide Phil Schiliro, interview on MSNBC, Dec. 31, 2013

Guiding lower? Happens all the time on Wall Street so it was only a matter of time before D.C. started as well. Watch:

The key points from the Jay Carney:

“We’re not backing away from a number that we didn’t put out originally…. “I think that others noted that 7 million is a fine target, but that that will not determine whether the marketplaces function effectively…. It’s important to understand that it is not — that there’s not some magic number: 6,999,999 and the system collapses; one more than that and it functions perfectly.”

At this point it is worth remembering just how fudged the very definition of “enrolled” is: The White House counts “an enrollee” as anyone who has selected a qualified health plan. “Once someone clicks “enroll” and selects a plan, we consider them enrolled,” a senior White House official said. “We don’t know if they have paid or when they pay the company because it’s a private transaction between the company and the consumer.” And as we explained before, up to 50% of “enrollees” haven’t actually enrolled by making any payments.

So to summarize: the White House crowed about the 2.1 million Americans who have signed up for insurance either through the federal health-care exchange or state-run exchanges (even if the payment status is unclear). At the same time, Obama’s henchmen backed away from the idea that they had suggested a “target” of 7 million enrollees when the enrollment period for 2014 ends in March. As Schiliro put it, “that was never our target number”… even though it was consistently framed, implied and suggested as precisely that.

The question then is: did someone lie? For the answer, we go to the authoritarian source on massaging spin when it comes to the administration: The Bezos Washington Post. Here is what D.C. favorite newspaper had to say:

The 7 million figure did originate as an estimate (not a target) by the CBO. Before HealthCare.gov launched, senior administration officials certainly embraced the number.

 

Here’s Health and Human Services Secretary Kathleen Sebelius speaking to reporters last June: “We’re hopeful that 7 million is a realistic target.”

 

And here she is on Sept. 30, in an interview with NBC News: “I think success looks like at least 7 million people having signed up by the end of March 2014.”

 

Moreover, on Sept. 5, 2013, Marilyn Tavenner, administrator of the Centers for Medicare and Medicaid Services, sent Sebelius a memo titled, “Projected Monthly Enrollment Targets for Health Insurance Marketplaces in 2014.”

 

The memo offered an estimate of 7,066,000, drawing both on CBO’s estimate and the experience of the universal health plan in Massachusetts, Medicare Part D “and conversations with employers, issuers and states.” It projected that enrollment would be 3.3 million by the end of December.

 

The 7 million figure, apparently, became less relevant as “a target” or a measure of success when it became clear that the Web site’s problems were making it difficult for people to sign up.

 

Instead, officials have argued that a more relevant figure is the mix of young and old people. That’s because younger people tend to be healthier and thus have lower medical expenses; if only older people sign up, premiums would soar.

WaPo’s conclusion:

Whether or not the administration originally came up with the 7 million figure, officials certainly embraced it as a target in the months leading up to the implementation of the Affordable Care Act. We agree that the mix of young and old enrollees is perhaps the more relevant number, but it’s a bit odd at this point for the administration to minimize the 7 million figure.

Ok, so they lied. But if the mix of enrollees, however one defines them, is skewed toward the younger population, all should be forgiven right? Sure. However, there is a tiny problem: the administration refuses to give away the demographic split data! From The Hill:

The White House said Monday that it was still unable to provide the demographic data is describes as a “key element” to evaluating the overall success of ObamaCare.

 

White House press secretary Jay Carney insisted on Monday that “at this point” the administration did not have information about the makeup of early enrollees in the president’s signature legislative program.

 

But the White House spokesman also pledged to make the data “available as soon as possible.”

 

“If you look at how we’ve dealt with data as it’s become available over the past several months, both good data and bad data, we’ve done our best to provide it to you when we are confident about the accuracy of it,” Carney said.

 

Healthcare experts have warned of a “death spiral” if not enough young, healthy adults buy into the ObamaCare marketplace to offset the cost of insuring older and sick Americans. A study report by the Kaiser Family Foundation showed that 4 of 10 enrollees would need to be between 18 and 34 years old to prevent a rise in premiums in subsequent years.

So: first the lies about the definition of enrollment, then the lies about how many actually have insurance, i.e., have paid and are officially enrolled, then the realization that the schedule is hopeless off track and and the need to guide down, but only after misdirection pointing at “good data”…  which just so happens does not exist.

Oh, and something about a “death spiral” if not enough young, healthy… oh wait, look over there: the market is at all time highs (or just below them).

We truly wonder: how much longer will this patented and indefinitely repeated distraction scheme, aimed at the absolutely lowest common denominator, continue to work without a glitch?

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/OdObirXH5KY/story01.htm Tyler Durden

Submitted by James H. Kunstler of Kunstler.com,

Many of us in the Long Emergency crowd and like-minded brother-and-sisterhoods remain perplexed by the amazing stasis in our national life, despite the gathering tsunami of forces arrayed to rock our economy, our culture, and our politics. Nothing has yielded to these forces already in motion, so far. Nothing changes, nothing gives, yet. It’s like being buried alive in Jell-O. It’s embarrassing to appear so out-of-tune with the consensus, but we persevere like good soldiers in a just war.

Paper and digital markets levitate, central banks pull out all the stops of their magical reality-tweaking machine to manipulate everything, accounting fraud pervades public and private enterprise, everything is mis-priced, all official statistics are lies of one kind or another, the regulating authorities sit on their hands, lost in raptures of online pornography (or dreams of future employment at Goldman Sachs), the news media sprinkles wishful-thinking propaganda about a mythical “recovery” and the “shale gas miracle” on a credulous public desperate to believe, the routine swindles of medicine get more cruel and blatant each month, a tiny cohort of financial vampire squids suck in all the nominal wealth of society, and everybody else is left whirling down the drain of posterity in a vortex of diminishing returns and scuttled expectations.

Life in the USA is like living in a broken-down, cob-jobbed, vermin-infested house that needs to be gutted, disinfected, and rebuilt — with the hope that it might come out of the restoration process retaining the better qualities of our heritage. Some of us are anxious to get on with the job, to expel all the rats, bats, bedbugs, roaches, and lice, tear out the stinking shag carpet and the moldy sheet-rock, rip off the crappy plastic siding, and start rebuilding along lines that are consistent with the demands of the future — namely, the reality of capital and material resource scarcity. But it has been apparent for a while that the current owners of the house would prefer to let it fall down, or burn down rather than renovate.

Some of us now take that outcome for granted and are left to speculate on how it will play out. These issues were the subjects of my recent non-fiction books, The Long Emergency and Too Much Magic (as well as excellent similar books by Richard Heinberg, John Michael Greer, Dmitry Orlov, and others). They describe the conditions at the end of the cheap energy techno-industrial phase of history and they laid out a conjectural sequence of outcomes that might be stated in shorthand as collapse and re-set. I think the delay in the onset of epochal change can be explained pretty simply. As the peak oil story gained traction around 2005, and was followed (as predicted) by a financial crisis, the established order fought back for its survival, utilizing its remaining dwindling capital and the tremendous inertia of its own gigantic scale, to give the appearance of vitality at all costs.

At the heart of the matter was (and continues to be) the relationship between energy and economic growth. Without increasing supplies of cheap energy, economic growth — as we have known it for a couple of centuries — does not happen anymore. At the center of the economic growth question is credit. Without continued growth, credit can’t be repaid, and new credit cannot be issued honestly — that is, with reasonable assurance of repayment — making it worthless. So, old debt goes bad and the new debt is generated knowing that it is worthless. To complicate matters, the new worthless debt is issued to pay the interest on the old debt, to maintain the pretense that it is not going bad. And then all kinds of dishonest side rackets are run around this central credit racket — shadow banking, “innovative” securities (i.e. new kinds of frauds and swindles, CDOs CDSs, etc.), flash trading, insider flimflams, pump-and-dumps, naked shorts, etc. These games give the impression of an economy that seems to work. But the reported “growth” is phony, a concoction of overcooked statistics and wishful thinking. And the net effect moves the society as a whole in the direction of more destructive ultimate failure.

Now, a number of stories have been employed lately to keep all these rackets going — or, at least, keep up the morale of the swindled masses. They issue from the corporations, government agencies, and a lazy, wishful media. Their purpose is to prop up the lie that the dying economy of yesteryear is alive and well, and can continue “normal” operation indefinitely. Here are the favorites of the past year:

• Shale oil and gas amount to an “energy renaissance” that will keep supplies of affordable fossil fuels flowing indefinitely, will make us “energy independent,” and will make us “a bigger producer than Saudi Arabia.” This is all mendacious bullshit with a wishful thinking cherry on top. Here’s how shale oil is different from conventional oil:

• A “manufacturing renaissance” is underway in the US, especially in the “central corridor” running from Texas north to Minnesota. That hoopla is all about a few chemical plants and fertilizer factories that have reopened to take advantage of cheaper natural gas. Note, the shale gas story is much like the shale oil story in terms of drilling and production. The depletion rates are quick and epic. In a very few years, shale gas won’t be cheap anymore. Otherwise, current talk of new manufacturing for hard goods is all about robots. How many Americans will be employed in these factories? And what about the existing manufacturing over-capacity everywhere else in the world? Are we making enough sneakers and Justin Beiber dolls? File under complete fucking nonsense.

• The USA is “the cleanest shirt in the laundry basket,” “the best house in a bad neighborhood,” the safest harbor for international “liquidity,” making it a sure bet that both the equity and bond markets will continue to ratchet up as money seeking lower risk floods in to the Dow and S & P from other countries with dodgier economies and sicker banks. In a currency war, with all nations competitively depreciating their currencies, gaming interest rates, manipulating markets, falsely reporting numbers, hiding liabilities, backs
  topping bad banks, and failing to regulate banking crime, there are no safe harbors. The USA can pretend to be for a while and then that illusion will pop, along with the “asset” bubbles that inspire it.

• The USA is enjoying huge gains from fantastic new “efficiencies of technological innovation.” The truth is not so dazzling. Computer technology, produces diminishing returns and unanticipated consequences. The server farms are huge energy sinks. Online shopping corrodes the resilience of commercial networks when only a few giant companies remain standing; and so on. Problems like these recall the central collapse theory of Joseph Tainter which states that heaping additional complexity on dysfunctional hyper-complex societies tends to induce their collapse. Hence, my insistence that downscaling, simplifying, re-localizing and re-setting the systems we depend on are imperative to keep the project of civilization going. That is, if you prefer civilization to its known alternatives.

Notice that all of these stories want to put over the general impression that the status quo is alive and well. They’re based on the dumb idea that the stock markets are a proxy for the economy, so if the Standard & Poor’s 500 keeps on going up, it’s all good. The master wish running through the American zeitgeist these days is that we might be able to keep driving to Wal-Mart forever.

The truth is that we still have a huge, deadly energy problem. Shale oil is not cheap oil, and it will stop seeming abundant soon. If the price of oil goes much above $100 a barrel, which you’d think would be great for the oil companies, it will crash demand for oil. If it crashes demand, the price will go down, hurting the profitability of the shale oil companies. It’s quite a predicament. Right now, in the $90-100-a-barrel range, it’s just slowly bleeding the economy while barely allowing the shale oil producers to keep up all the drilling. Two-thirds of all the dollars invested (more than $120 billion a year) goes just to keep production levels flat. Blogger Mark Anthony summarized it nicely:

…the shale oil and gas developers tend to use unreliable production models to project unrealistically high EURs (Estimated Ultimate Recovery) of their shale wells. They then use the over-estimated EURs to under-calculate the amortization costs of the capital spending, in order to report “profits”, despite of the fact that they have to keep borrowing more money to keep drilling new wells, and that capital spending routinely out paces revenue stream by several times… shale oil and gas producers tend to over-exaggerate productivity of their wells, under-estimate the well declines…in order to pitch their investment case to banks and investors, so they can keep borrowing more money to keep drilling shale wells.

As stated in the intro, these perversities reverberate in the investment sector. Non-cheap oil upsets the mechanisms of capital formation — financial growth is stymied — in a way that ultimately affects the financing of oil production itself. Old credit cannot be repaid, scaring off new credit (because it is even more unlikely to be repaid). At ZIRP interest, nobody saves. The capital pools dry up. So the Federal Reserve has to issue ersatz credit dollars on its computers. That credit will remain stillborn and mummified in depository institutions afraid of lending it to the likes of sharpies and hypesters in the shale gas industry.

But real, functioning capital (credit that can be paid back) is vanishing, and the coming scarcity of real capital makes it much more difficult to keep the stupendous number of rigs busy drilling and fracking new shale oil wells, which you have to do incessantly to keep production up, and as the investment in new drilling declines, and the “sweet spots” yield to the less-sweet spots or the not-sweet-at-all spots… then the Ponzis of shale oil and shale gas, too will be unmasked as the jive endeavors they are. And when people stop believing these cockamamie stories, the truth will dawn on them that we are in a predicament where further growth and wealth cannot be generated and the economy is actually in the early stages of a permanent contraction, and that will trigger an unholy host of nasty consequences proceeding from the loss of faith in these fairy tales, going so far as the meltdown of the banking system, social turmoil, and political upheaval.

The bottom line is that the “shale revolution” will be short-lived. 2014 may be the peak production year in the Bakken play of North Dakota. Eagle Ford in Texas is a little younger and may lag Bakken by a couple of years. If Federal Reserve policies create more disorder in the banking system this year, investment for shale will dry up, new drilling will nosedive, and shale oil production will go down substantially. Meanwhile. conventional oil production in the USA continues to decline remorselessly.

The End of Fed Cred

It must be scary to be a Federal Reserve governor. You have to pretend that you know what you’re doing when, in fact, Fed policy appears completely divorced from any sense of consequence, or cause-and-effect, or reality — and if it turns out you’re not so smart, and your policies and interventions undermine true economic resilience, then the scuttling of the most powerful civilization in the history of the world might be your fault — even if you went to Andover and wear tortoise-shell glasses that make you appear to be smart.

The Fed painted itself into a corner the last few years by making Quantitative Easing a permanent feature of the financial landscape. QE backstops everything now. Tragically, additional backdoor backstopping extends beyond the QE official figures (as of December 2013) of $85 billion a month. American money (or credit) is being shoveled into anything and everything, including foreign banks and probably foreign treasuries. It’s just another facet of the prevailing pervasive dishonesty infecting the system that we have no idea, really, how much money is being shoveled and sprinkled around. Anything goes and nothing matters. However, since there is an official consensus that you can’t keep QE money-pumping up forever, the Fed officially made a big show of seeking to begin ending it. So in the Spring of 2013 they announced their intention to “taper” their purchases of US Treasury paper and mortgage paper, possibly in the fall.

Well, it turned out they didn’t or couldn’t taper. As the fall equinox approached, with everyone keenly anticipating the first dose of taper, the equity markets wobbled and the interest rate on the 10-year treasury — the index for mortgage loans and car loans — climbed to 3.00 percent from its May low of 1.63 — well over 100 basis points — and the Fed chickened out. No September taper. Fake out. So, the markets relaxed, the i
nterest rate on the 10-year went back down, and the equity markets resumed their grand ramp into the Christmas climax. However, the Fed’s credibility took a hit, especially after all their confabulating bullshit “forward guidance” in the spring and summer when they couldn’t get their taper story straight. And in the meantime, the Larry-Summers-for-Fed-Chair float unfloated, and Janet Yellen was officially picked to succeed Ben Bernanke, with her reputation as an extreme easy money softie (more QE, more ZIRP), and a bunch of hearings were staged to make the Bernanke-Yellen transition look more reassuring.

And then on December 18, outgoing chair Bernanke announced, with much fanfare, that the taper would happen after all, early in the first quarter of 2014 ­— after he is safely out of his office in the Eccles building and back in his bomb shelter on the Princeton campus. The Fed meant it this time, the public was given to understand.

The only catch here, as I write, after the latest taper announcement, is that interest on the 10-year treasury note has crept stealthily back up over 3 percent. Wuh-oh. Not a good sign, since it means more expensive mortgages and car loans, which happen to represent the two things that the current economy relies on to appear “normal.” (House sales and car sales = normal in a suburban sprawl economy.)

I think the truth is the Fed just did too darn much QE and ZIRP and they waited way too long to cut it out, and now they can’t end it without scuttling both the stock and bond markets. But they can’t really go forward with the taper, either. A rock and a hard place. So, my guess is that they’ll pretend to taper in March, and then they’ll just as quickly un-taper. Note the curious report out of the American Enterprise Institute ten days ago by John H. Makin saying that the Fed’s actual purchase of debt paper amounted to an average $94 billion a month through the year 2013, not $85 billion. Which would pretty much negate the proposed taper of $5 billion + $5 billion (Treasury paper + Mortgage paper).

And in so faking and so doing they may succeed in completely destroying the credibility of the Federal Reserve. When that happens, capital will be disappearing so efficiently that the USA will find itself in a compressive deflationary spiral — because that’s what happens when faith in the authority behind credit is destroyed, and new loans to cover the interest on old loans are no longer offered in the non-government banking system, and old loans can’t be serviced. At which point the Federal Reserve freaks out and announces new extra-special QE way above the former 2013 level of $85 billion a month, and the government chips in with currency controls. And that sets in motion the awful prospect of the dreaded “crack-up boom” into extraordinary inflation, when dollars turn into hot potatoes and people can’t get rid of them fast enough. Well, is that going to happen this year? It depends on how spooked the Fed gets. In any case, there is a difference between high inflation and hyper-inflation. High inflation is bad enough to provoke socio-political convulsion. I don’t really see how the Fed gets around this March taper bid without falling into the trap I’ve just outlined. It wouldn’t be a pretty situation for poor Ms. Janet Yellen, but nobody forced her to take the job, and she’s had the look all along of a chump, the perfect sucker to be left holding a big honking bag of flop.

We’re long overdue for a return to realistic pricing in all markets. The Government and its handmaiden, the Fed, have tweaked the machinery so strenuously for so long that these efforts have entered the wilderness of diminishing returns. Instead of propping up the markets, all they can accomplish now is further erosion of the credibility of the equity markets and the Fed itself — and that bodes darkly for a money system that is essentially run on faith. I think the indexes have topped. The “margin” (money borrowed to buy stock) in the system is at dangerous, historically unprecedented highs. There may be one final reach upward in the first quarter. Then the equities crater, if not sooner. I still think the Dow and S &P could oversell by 90 percent of their value if the falsehoods of the post-2008  interventions stopped working their hoodoo on the collective wishful consciousness.

The worldwide rise in interest rates holds every possibility for igniting a shitstorm in interest rate swaps and upsetting the whole apple-cart of shadow banking and derivatives. That would be a bullet in the head to the TBTF banks, and would therefore lead to a worldwide crisis. In that event, the eventual winners would be the largest holders of gold, who could claim to offer the world a trustworthy gold-backed currency, especially for transactions in vital resources like oil. That would, of course, be China. The process would be awfully disorderly and fraught with political animus. Given the fact that China’s own balance sheet is hopelessly non-transparent and part-and-parcel of a dishonest crony banking system, China would have to use some powerful smoke-and-mirrors to assume that kind of dominant authority. But in the end, it comes down to who has the real goods, and who screwed up (the USA, Europe, Japan) and China, for all its faults and perversities, has the gold.

The wholesale transfer of gold tonnage from the West to the East was one of the salient events of 2013. There were lots of conspiracy theories as to what drove the price of gold down by 28 percent. I do think the painful move was partly a cyclical correction following the decade-long run up to $1900 an ounce. Within that cyclical correction, there was a lot of room for the so-called “bullion banks” to pound the gold and silver prices down with their shorting orgy. Numerous times the past year, somebody had laid a fat finger on the “sell” key, like, at four o’clock in the morning New York time when no traders were in their offices, and the record of those weird transactions is plain to see in the daily charts. My own theory is that an effort was made — in effect, a policy — to suppress the gold price via collusion between the Fed, the US Treasury, the bullion banks, and China, as a way to allow China to accumulate gold to offset the anticipated loss of value in the US Treasury paper held by them, throwing China a big golden bone, so to speak — in other words, to keep China from getting hugely pissed off. The gold crash had the happy effect for the US Treasury of making the dollar appear strong at a time when many other nations were getting sick of US dollar domination, especially in the oil markets, and were threatening to instigate a new currency regime by hook or by crook. Throwing China the golden bone is also consistent with the USA’s official position that gold is a meaningless barbaric relic where national currencies are concerned, and therefore nobody but the barbaric yellow hordes of Asia would care about it.

Other nations don’t feel that way. Russia and Switzerland have been accumulating gold like crazy at bargain prices this year. Last year, Germany requested its sovereign gold cache (300
tons) to be returned from the vaults in America, where it was stored through all the decades of the cold war, safe from the reach of the Soviets. But American officials told the Germans it would take seven years to accomplish the return. Seven years ! ! ! WTF? Is there a shortage of banana boats? The sentiment in goldville is that the USA long ago “leased” or sold off or rehypothecated or lost that gold. Anyway, Germany’s 300 tons was a small fraction of the 6,700 tons supposedly held in the Fed’s vaults. Who knows? No auditors have been allowed into the Fed vaults to actually see what’s up with the collateral. This in and of itself ought to make the prudent nervous.

I think we’re near the end of these reindeer games with gold, largely because so many vaults in the West have been emptied. That places constraints on further shenanigans in the paper gold (and silver) markets. In an environment where both the destructive forces of deflation and inflation can be unleashed in sequence, uncertainty is the greatest motivator, trumping the usual greed and fear seen in markets that can be fairly measured against stable currencies. In 2014, the public has become aware of the bank “bail-in” phenomenon which, along with rehypothication schemes, just amounts to the seizure of customer and client accounts — a really new wrinkle in contemporary banking relations. Nobody knows if it’s safe to park cash money anywhere except inside the mattress. The precedent set in Cyprus, and the MF Global affair, and other confiscation events, would tend to support an interest in precious metals held outside the institutional framework. Uncertainty rules.

Miscellany

I get a lot of email on the subject of Bitcoin. Here’s how I feel about it.
It’s an even more abstract form of “money” than fiat currencies or securities based on fiat currencies. Do we need more abstraction in our economic lives? I don’t think so. I believe the trend will be toward what is real. For the moment, Bitcoin seems to be enjoying some success as it beats back successive crashes. I’m not very comfortable with the idea of investing in an algorithm. I don’t see how it is impervious to government hacking. In fact, I’d bet that somewhere in the DOD or the NSA or the CIA right now some nerd is working on that. Bitcoin is provoking imitators, other new computer “currencies.” Why would Bitcoin necessarily enjoy dominance? And how many competing algorithmic currencies can the world stand? Wouldn’t that defeat the whole purpose of an alternative “go to” currency? All I can say is that I’m not buying Bitcoins.

Will ObamaCare crash and burn. It’s not doing very well so far. In fact, it’s a poster-child for Murphy’s Law (Anything that can go wrong, will go wrong). I suppose the primary question is whether they can enroll enough healthy young people to correct the actuarial nightmare that health insurance has become. That’s not looking so good either now. But really, how can anyone trust a law that was written by the insurance companies and the pharmaceutical industry? And how can it be repealed when so many individuals, groups, companies, have already lost their pre-ObamaCare policies? What is there to go back to? Therefore, I’d have to predict turmoil in the health care system for 2014. The failure to resolve the inadequacies of ObamaCare also may be a prime symptom of the increasing impotence of the federal government to accomplish anything. That failure would prompt an even faster downscaling of governance as states, counties, communities, and individuals realize that they are on their own.

Sorry to skip around, but a few stray words about the state of American culture. Outside the capitals of the “one percent” — Manhattan, San Francisco, Boston, Washington, etc. — American material culture is in spectacular disrepair. Car culture and chain store tyranny have destroyed the physical fabric of our communities and wrecked social relations. These days, a successful Main Street is one that has a wig shop and a check-cashing office. It is sickening to see what we have become. Our popular entertainments are just what you would design to produce a programmed population of criminals and sex offenders. The spectacle of the way our people look —overfed, tattooed, pierced, clothed in the raiment of clowns — suggests an end-of-empire zeitgeist more disturbing than a Fellini movie. The fact is, it simply mirrors the way we act, our gross, barbaric collective demeanor. A walk down any airport concourse makes the Barnum & Bailey freak shows of yore look quaint. In short, the rot throughout our national life is so conspicuous that a fair assessment would be that we are a wicked people who deserve to be punished.

Elsewhere in the World

Globalism, in the Tom Friedman euphoric sense, is unwinding. Currency wars are wearing down the players, conflicts and tensions are breaking out where before there were only Wal-Mart share price triumphs and Foxconn profits. Both American and European middle-classes are too exhausted financially to continue the consumer orgy of the early millennium. The trade imbalances are horrific. Unpayable debt saturates everything. Sick economies will weigh down commodity prices except for food-related things. The planet Earth has probably reached peak food production, including peak fertilizer. Supplies of grain will be inadequate in 2014 to feed the still-expanding masses of the poor places in the world.

The nervous calm in finance and economies since 2008 has its mirror in the relative calm of the political scene. Uprisings and skirmishes have broken out, but nothing that so far threatens the peace between great powers. There have been the now-historic revolts in Egypt, Libya, Syria, and other Middle East and North African (MENA) states. Iraq is once again disintegrating after a decade of American “nation-building.” Greece is falling apart. Spain and Italy should be falling apart but haven’t yet. France is sinking into bankruptcy. The UK is in on the grift with the USA and insulated from the Euro, but the British Isles are way over-populated with a volatile multi-ethnic mix and not much of an economy outside the financial district of London. There were riots in — of all places — Sweden this year. Turkey entered crisis just a few weeks ago along with Ukraine.

I predict more colorful political strife in Europe this year, boots in the street, barricades, gunfire, and bombs. The populations of these countries will want relief measures from their national governments, but the sad news is that these governments are broke, so austerity seems to be the order of the day no matter what. I think this will prod incipient revolts in a rightward nationalist direction. If it was up to Marine LePen’s rising National Front party, they would solve the employment problem by expelling all the recent immigrants — though the mere attempt would probably provoke widespread race war in France.

The quarrel between China and Japan over the Senkaku Islands is a diversion from the real action in the South China Sea, said to hold large underwater petroleum reserves. China is the wo
rld’s second greatest oil importer. Their economy and the credibility of its non-elected government depends on keeping the oil supply up. They are a long way from other places in the world where oil comes from, hence their eagerness to secure and dominate the South China Sea. The idea is that China would make a fuss over the Senkaku group, get Japan and the US to the negotiating table, and cede the dispute over them to Japan in exchange for Japan and the US supporting China’s claims in the South China Sea against the other neighbors there: Vietnam, Indonesia, Malaysia, and the Philippines.

The catch is that Japan may be going politically insane just now between the rigors of (Shinzo) Abenomics and the mystical horrors of Fukushima. Japan’s distress appears to be provoking a new mood of nationalist militarism of a kind not seen there since the 1940s. They’re talking about arming up, rewriting the pacifist articles in their constitution. Scary, if you have a memory of the mid-20^th century. China should know something about national psychotic breaks, having not so long ago endured the insanity of Mao Zedong’s Cultural Revolution (1966-71). So they might want to handle Japan with care. On the other hand, China surely nurtures a deep, deadly grudge over the crimes perpetrated by Japan in the Second World War, and now has a disciplined, world-class military, and so maybe they would like to kick Japan’s ass. It’s a hard one to call. I suspect that in 2014, the ball is in Japan’s court. What will they do? If the US doesn’t stay out of the way of that action, then we are insane, too.

That said, I stick by my story from last year’s forecast: Japan’s ultimate destination is to “go medieval.” They’re never going to recover from Fukushima, their economy is unraveling, they have no fossil fuels of their own and have to import everything, and their balance of payments is completely out of whack. The best course for them will be to just throw in the towel on modernity. Everybody else is headed that way, too, eventually, so Japan might as well get there first and set a good example.

By “go medieval” I mean re-set to a pre-industrial World Made By Hand level of operation. I’m sure that outcome seems laughably implausible to most readers, but I maintain that both the human race and the planet Earth need a “time out” from the ravages of “progress,” and circumstances are going to force the issue anyway, so we might as well kick back and get with the program: go local, downscale, learn useful skills, cultivate our gardens, get to know our neighbors, learn how to play a musical instrument, work, dine, and dance with our friends.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/88WpqDUbbiE/story01.htm Tyler Durden

Submitted by James H. Kunstler of Kunstler.com,

Many of us in the Long Emergency crowd and like-minded brother-and-sisterhoods remain perplexed by the amazing stasis in our national life, despite the gathering tsunami of forces arrayed to rock our economy, our culture, and our politics. Nothing has yielded to these forces already in motion, so far. Nothing changes, nothing gives, yet. It’s like being buried alive in Jell-O. It’s embarrassing to appear so out-of-tune with the consensus, but we persevere like good soldiers in a just war.

Paper and digital markets levitate, central banks pull out all the stops of their magical reality-tweaking machine to manipulate everything, accounting fraud pervades public and private enterprise, everything is mis-priced, all official statistics are lies of one kind or another, the regulating authorities sit on their hands, lost in raptures of online pornography (or dreams of future employment at Goldman Sachs), the news media sprinkles wishful-thinking propaganda about a mythical “recovery” and the “shale gas miracle” on a credulous public desperate to believe, the routine swindles of medicine get more cruel and blatant each month, a tiny cohort of financial vampire squids suck in all the nominal wealth of society, and everybody else is left whirling down the drain of posterity in a vortex of diminishing returns and scuttled expectations.

Life in the USA is like living in a broken-down, cob-jobbed, vermin-infested house that needs to be gutted, disinfected, and rebuilt — with the hope that it might come out of the restoration process retaining the better qualities of our heritage. Some of us are anxious to get on with the job, to expel all the rats, bats, bedbugs, roaches, and lice, tear out the stinking shag carpet and the moldy sheet-rock, rip off the crappy plastic siding, and start rebuilding along lines that are consistent with the demands of the future — namely, the reality of capital and material resource scarcity. But it has been apparent for a while that the current owners of the house would prefer to let it fall down, or burn down rather than renovate.

Some of us now take that outcome for granted and are left to speculate on how it will play out. These issues were the subjects of my recent non-fiction books, The Long Emergency and Too Much Magic (as well as excellent similar books by Richard Heinberg, John Michael Greer, Dmitry Orlov, and others). They describe the conditions at the end of the cheap energy techno-industrial phase of history and they laid out a conjectural sequence of outcomes that might be stated in shorthand as collapse and re-set. I think the delay in the onset of epochal change can be explained pretty simply. As the peak oil story gained traction around 2005, and was followed (as predicted) by a financial crisis, the established order fought back for its survival, utilizing its remaining dwindling capital and the tremendous inertia of its own gigantic scale, to give the appearance of vitality at all costs.

At the heart of the matter was (and continues to be) the relationship between energy and economic growth. Without increasing supplies of cheap energy, economic growth — as we have known it for a couple of centuries — does not happen anymore. At the center of the economic growth question is credit. Without continued growth, credit can’t be repaid, and new credit cannot be issued honestly — that is, with reasonable assurance of repayment — making it worthless. So, old debt goes bad and the new debt is generated knowing that it is worthless. To complicate matters, the new worthless debt is issued to pay the interest on the old debt, to maintain the pretense that it is not going bad. And then all kinds of dishonest side rackets are run around this central credit racket — shadow banking, “innovative” securities (i.e. new kinds of frauds and swindles, CDOs CDSs, etc.), flash trading, insider flimflams, pump-and-dumps, naked shorts, etc. These games give the impression of an economy that seems to work. But the reported “growth” is phony, a concoction of overcooked statistics and wishful thinking. And the net effect moves the society as a whole in the direction of more destructive ultimate failure.

Now, a number of stories have been employed lately to keep all these rackets going — or, at least, keep up the morale of the swindled masses. They issue from the corporations, government agencies, and a lazy, wishful media. Their purpose is to prop up the lie that the dying economy of yesteryear is alive and well, and can continue “normal” operation indefinitely. Here are the favorites of the past year:

• Shale oil and gas amount to an “energy renaissance” that will keep supplies of affordable fossil fuels flowing indefinitely, will make us “energy independent,” and will make us “a bigger producer than Saudi Arabia.” This is all mendacious bullshit with a wishful thinking cherry on top. Here’s how shale oil is different from conventional oil:

• A “manufacturing renaissance” is underway in the US, especially in the “central corridor” running from Texas north to Minnesota. That hoopla is all about a few chemical plants and fertilizer factories that have reopened to take advantage of cheaper natural gas. Note, the shale gas story is much like the shale oil story in terms of drilling and production. The depletion rates are quick and epic. In a very few years, shale gas won’t be cheap anymore. Otherwise, current talk of new manufacturing for hard goods is all about robots. How many Americans will be employed in these factories? And what about the existing manufacturing over-capacity everywhere else in the world? Are we making enough sneakers and Justin Beiber dolls? File under complete fucking nonsense.

• The USA is “the cleanest shirt in the laundry basket,” “the best house in a bad neighborhood,” the safest harbor for international “liquidity,” making it a sure bet that both the equity and bond markets will continue to ratchet up as money seeking lower risk floods in to the Dow and S & P from other countries with dodgier economies and sicker banks. In a currency war, with all nations competitively depreciating their currencies, gaming interest rates, manipulating markets, falsely reporting numbers, hiding liabilities, backstopping bad banks, and failing to regulate banking crime, there are no safe harbors. The USA can pretend to be for a while and then that illusion will pop, along with the “asset” bubbles that inspire it.

• The USA is enjoying huge gains from fantastic new “efficiencies of technological innovation.” The truth is not so dazzling. Computer technology, produces diminishing returns and unanticipated consequences. The server farms are huge energy sinks. Online shopping corrodes the resilience of commercial networks when only a few giant companies remain standing; and so on. Problems like these recall the central collapse theory of Joseph Tainter which states that heaping additional complexity on dysfunctional hyper-complex societies tends to induce their collapse. Hence, my insistence that downscaling, simplifying, re-localizing and re-setting the systems we depend on are imperative to keep the project of civilization going. That is, if you prefer civilization to its known alternatives.

Notice that all of these stories want to put over the general impression that the status quo is alive and well. They’re based on the dumb idea that the stock markets are a proxy for the economy, so if the Standard & Poor’s 500 keeps on going up, it’s all good. The master wish running through the American zeitgeist these days is that we might be able to keep driving to Wal-Mart forever.

The truth is that we still have a huge, deadly energy problem. Shale oil is not cheap oil, and it will stop seeming abundant soon. If the price of oil goes much above $100 a barrel, which you’d think would be great for the oil companies, it will crash demand for oil. If it crashes demand, the price will go down, hurting the profitability of the shale oil companies. It’s quite a predicament. Right now, in the $90-100-a-barrel range, it’s just slowly bleeding the economy while barely allowing the shale oil producers to keep up all the drilling. Two-thirds of all the dollars invested (more than $120 billion a year) goes just to keep production levels flat. Blogger Mark Anthony summarized it nicely:

…the shale oil and gas developers tend to use unreliable production models to project unrealistically high EURs (Estimated Ultimate Recovery) of their shale wells. They then use the over-estimated EURs to under-calculate the amortization costs of the capital spending, in order to report “profits”, despite of the fact that they have to keep borrowing more money to keep drilling new wells, and that capital spending routinely out paces revenue stream by several times… shale oil and gas producers tend to over-exaggerate productivity of their wells, under-estimate the well declines…in order to pitch their investment case to banks and investors, so they can keep borrowing more money to keep drilling shale wells.

As stated in the intro, these perversities reverberate in the investment sector. Non-cheap oil upsets the mechanisms of capital formation — financial growth is stymied — in a way that ultimately affects the financing of oil production itself. Old credit cannot be repaid, scaring off new credit (because it is even more unlikely to be repaid). At ZIRP interest, nobody saves. The capital pools dry up. So the Federal Reserve has to issue ersatz credit dollars on its computers. That credit will remain stillborn and mummified in depository institutions afraid of lending it to the likes of sharpies and hypesters in the shale gas industry.

But real, functioning capital (credit that can be paid back) is vanishing, and the coming scarcity of real capital makes it much more difficult to keep the stupendous number of rigs busy drilling and fracking new shale oil wells, which you have to do incessantly to keep production up, and as the investment in new drilling declines, and the “sweet spots” yield to the less-sweet spots or the not-sweet-at-all spots… then the Ponzis of shale oil and shale gas, too will be unmasked as the jive endeavors they are. And when people stop believing these cockamamie stories, the truth will dawn on them that we are in a predicament where further growth and wealth cannot be generated and the economy is actually in the early stages of a permanent contraction, and that will trigger an unholy host of nasty consequences proceeding from the loss of faith in these fairy tales, going so far as the meltdown of the banking system, social turmoil, and political upheaval.

The bottom line is that the “shale revolution” will be short-lived. 2014 may be the peak production year in the Bakken play of North Dakota. Eagle Ford in Texas is a little younger and may lag Bakken by a couple of years. If Federal Reserve policies create more disorder in the banking system this year, investment for shale will dry up, new drilling will nosedive, and shale oil production will go down substantially. Meanwhile. conventional oil production in the USA continues to decline remorselessly.

The End of Fed Cred

It must be scary to be a Federal Reserve governor. You have to pretend that you know what you’re doing when, in fact, Fed policy appears completely divorced from any sense of consequence, or cause-and-effect, or reality — and if it turns out you’re not so smart, and your policies and interventions undermine true economic resilience, then the scuttling of the most powerful civilization in the history of the world might be your fault — even if you went to Andover and wear tortoise-shell glasses that make you appear to be smart.

The Fed painted itself into a corner the last few years by making Quantitative Easing a permanent feature of the financial landscape. QE backstops everything now. Tragically, additional backdoor backstopping extends beyond the QE official figures (as of December 2013) of $85 billion a month. American money (or credit) is being shoveled into anything and everything, including foreign banks and probably foreign treasuries. It’s just another facet of the prevailing pervasive dishonesty infecting the system that we have no idea, really, how much money is being shoveled and sprinkled around. Anything goes and nothing matters. However, since there is an official consensus that you can’t keep QE money-pumping up forever, the Fed officially made a big show of seeking to begin ending it. So in the Spring of 2013 they announced their intention to “taper” their purchases of US Treasury paper and mortgage paper, possibly in the fall.

Well, it turned out they didn’t or couldn’t taper. As the fall equinox approached, with everyone keenly anticipating the first dose of taper, the equity markets wobbled and the interest rate on the 10-year treasury — the index for mortgage loans and car loans — climbed to 3.00 percent from its May low of 1.63 — well over 100 basis points — and the Fed chickened out. No September taper. Fake out. So, the markets relaxed, the interest rate on the 10-year went back down, and the equity markets resumed their grand ramp into the Christmas climax. However, the Fed’s credibility took a hit, especially after all their confabulating bullshit “forward guidance” in the spring and summer when they couldn’t get their taper story straight. And in the meantime, the Larry-Summers-for-Fed-Chair float unfloated, and Janet Yellen was officially picked to succeed Ben Bernanke, with her reputation as an extreme easy money softie (more QE, more ZIRP), and a bunch of hearings were staged to make the Bernanke-Yellen transition look more reassuring.

And then on December 18, outgoing chair Bernanke announced, with much fanfare, that the taper would happen after all, early in the first quarter of 2014 ­— after he is safely out of his office in the Eccles building and back in his bomb shelter on the Princeton campus. The Fed meant it this time, the public was given to understand.

The only catch here, as I write, after the latest taper announcement, is that interest on the 10-year treasury note has crept stealthily back up over 3 percent. Wuh-oh. Not a good sign, since it means more expensive mortgages and car loans, which happen to represent the two things that the current economy relies on to appear “normal.” (House sales and car sales = normal in a suburban sprawl economy.)

I think the truth is the Fed just did too darn much QE and ZIRP and they waited way too long to cut it out, and now they can’t end it without scuttling both the stock and bond markets. But they can’t really go forward with the taper, either. A rock and a hard place. So, my guess is that they’ll pretend to taper in March, and then they’ll just as quickly un-taper. Note the curious report out of the American Enterprise Institute ten days ago by John H. Makin saying that the Fed’s actual purchase of debt paper amounted to an average $94 billion a month through the year 2013, not $85 billion. Which would pretty much negate the proposed taper of $5 billion + $5 billion (Treasury paper + Mortgage paper).

And in so faking and so doing they may succeed in completely destroying the credibility of the Federal Reserve. When that happens, capital will be disappearing so efficiently that the USA will find itself in a compressive deflationary spiral — because that’s what happens when faith in the authority behind credit is destroyed, and new loans to cover the interest on old loans are no longer offered in the non-government banking system, and old loans can’t be serviced. At which point the Federal Reserve freaks out and announces new extra-special QE way above the former 2013 level of $85 billion a month, and the government chips in with currency controls. And that sets in motion the awful prospect of the dreaded “crack-up boom” into extraordinary inflation, when dollars turn into hot potatoes and people can’t get rid of them fast enough. Well, is that going to happen this year? It depends on how spooked the Fed gets. In any case, there is a difference between high inflation and hyper-inflation. High inflation is bad enough to provoke socio-political convulsion. I don’t really see how the Fed gets around this March taper bid without falling into the trap I’ve just outlined. It wouldn’t be a pretty situation for poor Ms. Janet Yellen, but nobody forced her to take the job, and she’s had the look all along of a chump, the perfect sucker to be left holding a big honking bag of flop.

We’re long overdue for a return to realistic pricing in all markets. The Government and its handmaiden, the Fed, have tweaked the machinery so strenuously for so long that these efforts have entered the wilderness of diminishing returns. Instead of propping up the markets, all they can accomplish now is further erosion of the credibility of the equity markets and the Fed itself — and that bodes darkly for a money system that is essentially run on faith. I think the indexes have topped. The “margin” (money borrowed to buy stock) in the system is at dangerous, historically unprecedented highs. There may be one final reach upward in the first quarter. Then the equities crater, if not sooner. I still think the Dow and S &P could oversell by 90 percent of their value if the falsehoods of the post-2008  interventions stopped working their hoodoo on the collective wishful consciousness.

The worldwide rise in interest rates holds every possibility for igniting a shitstorm in interest rate swaps and upsetting the whole apple-cart of shadow banking and derivatives. That would be a bullet in the head to the TBTF banks, and would therefore lead to a worldwide crisis. In that event, the eventual winners would be the largest holders of gold, who could claim to offer the world a trustworthy gold-backed currency, especially for transactions in vital resources like oil. That would, of course, be China. The process would be awfully disorderly and fraught with political animus. Given the fact that China’s own balance sheet is hopelessly non-transparent and part-and-parcel of a dishonest crony banking system, China would have to use some powerful smoke-and-mirrors to assume that kind of dominant authority. But in the end, it comes down to who has the real goods, and who screwed up (the USA, Europe, Japan) and China, for all its faults and perversities, has the gold.

The wholesale transfer of gold tonnage from the West to the East was one of the salient events of 2013. There were lots of conspiracy theories as to what drove the price of gold down by 28 percent. I do think the painful move was partly a cyclical correction following the decade-long run up to $1900 an ounce. Within that cyclical correction, there was a lot of room for the so-called “bullion banks” to pound the gold and silver prices down with their shorting orgy. Numerous times the past year, somebody had laid a fat finger on the “sell” key, like, at four o’clock in the morning New York time when no traders were in their offices, and the record of those weird transactions is plain to see in the daily charts. My own theory is that an effort was made — in effect, a policy — to suppress the gold price via collusion between the Fed, the US Treasury, the bullion banks, and China, as a way to allow China to accumulate gold to offset the anticipated loss of value in the US Treasury paper held by them, throwing China a big golden bone, so to speak — in other words, to keep China from getting hugely pissed off. The gold crash had the happy effect for the US Treasury of making the dollar appear strong at a time when many other nations were getting sick of US dollar domination, especially in the oil markets, and were threatening to instigate a new currency regime by hook or by crook. Throwing China the golden bone is also consistent with the USA’s official position that gold is a meaningless barbaric relic where national currencies are concerned, and therefore nobody but the barbaric yellow hordes of Asia would care about it.

Other nations don’t feel that way. Russia and Switzerland have been accumulating gold like crazy at bargain prices this year. Last year, Germany requested its sovereign gold cache (300 tons) to be returned from the vaults in America, where it was stored through all the decades of the cold war, safe from the reach of the Soviets. But American officials told the Germans it would take seven years to accomplish the return. Seven years ! ! ! WTF? Is there a shortage of banana boats? The sentiment in goldville is that the USA long ago “leased” or sold off or rehypothecated or lost that gold. Anyway, Germany’s 300 tons was a small fraction of the 6,700 tons supposedly held in the Fed’s vaults. Who knows? No auditors have been allowed into the Fed vaults to actually see what’s up with the collateral. This in and of itself ought to make the prudent nervous.

I think we’re near the end of these reindeer games with gold, largely because so many vaults in the West have been emptied. That places constraints on further shenanigans in the paper gold (and silver) markets. In an environment where both the destructive forces of deflation and inflation can be unleashed in sequence, uncertainty is the greatest motivator, trumping the usual greed and fear seen in markets that can be fairly measured against stable currencies. In 2014, the public has become aware of the bank “bail-in” phenomenon which, along with rehypothication schemes, just amounts to the seizure of customer and client accounts — a really new wrinkle in contemporary banking relations. Nobody knows if it’s safe to park cash money anywhere except inside the mattress. The precedent set in Cyprus, and the MF Global affair, and other confiscation events, would tend to support an interest in precious metals held outside the institutional framework. Uncertainty rules.

Miscellany

I get a lot of email on the subject of Bitcoin. Here’s how I feel about it.
It’s an even more abstract form of “money” than fiat currencies or securities based on fiat currencies. Do we need more abstraction in our economic lives? I don’t think so. I believe the trend will be toward what is real. For the moment, Bitcoin seems to be enjoying some success as it beats back successive crashes. I’m not very comfortable with the idea of investing in an algorithm. I don’t see how it is impervious to government hacking. In fact, I’d bet that somewhere in the DOD or the NSA or the CIA right now some nerd is working on that. Bitcoin is provoking imitators, other new computer “currencies.” Why would Bitcoin necessarily enjoy dominance? And how many competing algorithmic currencies can the world stand? Wouldn’t that defeat the whole purpose of an alternative “go to” currency? All I can say is that I’m not buying Bitcoins.

Will ObamaCare crash and burn. It’s not doing very well so far. In fact, it’s a poster-child for Murphy’s Law (Anything that can go wrong, will go wrong). I suppose the primary question is whether they can enroll enough healthy young people to correct the actuarial nightmare that health insurance has become. That’s not looking so good either now. But really, how can anyone trust a law that was written by the insurance companies and the pharmaceutical industry? And how can it be repealed when so many individuals, groups, companies, have already lost their pre-ObamaCare policies? What is there to go back to? Therefore, I’d have to predict turmoil in the health care system for 2014. The failure to resolve the inadequacies of ObamaCare also may be a prime symptom of the increasing impotence of the federal government to accomplish anything. That failure would prompt an even faster downscaling of governance as states, counties, communities, and individuals realize that they are on their own.

Sorry to skip around, but a few stray words about the state of American culture. Outside the capitals of the “one percent” — Manhattan, San Francisco, Boston, Washington, etc. — American material culture is in spectacular disrepair. Car culture and chain store tyranny have destroyed the physical fabric of our communities and wrecked social relations. These days, a successful Main Street is one that has a wig shop and a check-cashing office. It is sickening to see what we have become. Our popular entertainments are just what you would design to produce a programmed population of criminals and sex offenders. The spectacle of the way our people look —overfed, tattooed, pierced, clothed in the raiment of clowns — suggests an end-of-empire zeitgeist more disturbing than a Fellini movie. The fact is, it simply mirrors the way we act, our gross, barbaric collective demeanor. A walk down any airport concourse makes the Barnum & Bailey freak shows of yore look quaint. In short, the rot throughout our national life is so conspicuous that a fair assessment would be that we are a wicked people who deserve to be punished.

Elsewhere in the World

Globalism, in the Tom Friedman euphoric sense, is unwinding. Currency wars are wearing down the players, conflicts and tensions are breaking out where before there were only Wal-Mart share price triumphs and Foxconn profits. Both American and European middle-classes are too exhausted financially to continue the consumer orgy of the early millennium. The trade imbalances are horrific. Unpayable debt saturates everything. Sick economies will weigh down commodity prices except for food-related things. The planet Earth has probably reached peak food production, including peak fertilizer. Supplies of grain will be inadequate in 2014 to feed the still-expanding masses of the poor places in the world.

The nervous calm in finance and economies since 2008 has its mirror in the relative calm of the political scene. Uprisings and skirmishes have broken out, but nothing that so far threatens the peace between great powers. There have been the now-historic revolts in Egypt, Libya, Syria, and other Middle East and North African (MENA) states. Iraq is once again disintegrating after a decade of American “nation-building.” Greece is falling apart. Spain and Italy should be falling apart but haven’t yet. France is sinking into bankruptcy. The UK is in on the grift with the USA and insulated from the Euro, but the British Isles are way over-populated with a volatile multi-ethnic mix and not much of an economy outside the financial district of London. There were riots in — of all places — Sweden this year. Turkey entered crisis just a few weeks ago along with Ukraine.

I predict more colorful political strife in Europe this year, boots in the street, barricades, gunfire, and bombs. The populations of these countries will want relief measures from their national governments, but the sad news is that these governments are broke, so austerity seems to be the order of the day no matter what. I think this will prod incipient revolts in a rightward nationalist direction. If it was up to Marine LePen’s rising National Front party, they would solve the employment problem by expelling all the recent immigrants — though the mere attempt would probably provoke widespread race war in France.

The quarrel between China and Japan over the Senkaku Islands is a diversion from the real action in the South China Sea, said to hold large underwater petroleum reserves. China is the world’s second greatest oil importer. Their economy and the credibility of its non-elected government depends on keeping the oil supply up. They are a long way from other places in the world where oil comes from, hence their eagerness to secure and dominate the South China Sea. The idea is that China would make a fuss over the Senkaku group, get Japan and the US to the negotiating table, and cede the dispute over them to Japan in exchange for Japan and the US supporting China’s claims in the South China Sea against the other neighbors there: Vietnam, Indonesia, Malaysia, and the Philippines.

The catch is that Japan may be going politically insane just now between the rigors of (Shinzo) Abenomics and the mystical horrors of Fukushima. Japan’s distress appears to be provoking a new mood of nationalist militarism of a kind not seen there since the 1940s. They’re talking about arming up, rewriting the pacifist articles in their constitution. Scary, if you have a memory of the mid-20^th century. China should know something about national psychotic breaks, having not so long ago endured the insanity of Mao Zedong’s Cultural Revolution (1966-71). So they might want to handle Japan with care. On the other hand, China surely nurtures a deep, deadly grudge over the crimes perpetrated by Japan in the Second World War, and now has a disciplined, world-class military, and so maybe they would like to kick Japan’s ass. It’s a hard one to call. I suspect that in 2014, the ball is in Japan’s court. What will they do? If the US doesn’t stay out of the way of that action, then we are insane, too.

That said, I stick by my story from last year’s forecast: Japan’s ultimate destination is to “go medieval.” They’re never going to recover from Fukushima, their economy is unraveling, they have no fossil fuels of their own and have to import everything, and their balance of payments is completely out of whack. The best course for them will be to just throw in the towel on modernity. Everybody else is headed that way, too, eventually, so Japan might as well get there first and set a good example.

By “go medieval” I mean re-set to a pre-industrial World Made By Hand level of operation. I’m sure that outcome seems laughably implausible to most readers, but I maintain that both the human race and the planet Earth need a “time out” from the ravages of “progress,” and circumstances are going to force the issue anyway, so we might as well kick back and get with the program: go local, downscale, learn useful skills, cultivate our gardens, get to know our neighbors, learn how to play a musical instrument, work, dine, and dance with our friends.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/88WpqDUbbiE/story01.htm Tyler Durden

While banks have been shown to manipulate every asset class (except of course stocks where HFT is merely a liquidity provider), it has largely been left to the Chinese to be blamed for ‘plan‘ what data is released to the world and ‘manage‘ expectations. With conspiracy ‘theories’ in market and macro data manipulations being proved ‘fact’; we thought it intriguing that the US Macro data cycle has rapidly diminished since the financial crisis. This, of course, makes perfect sense in a world where fundamentals no longer matter; nevertheless, compared to the pre-crisis swings, things are different this time.

On a side-note, US macro data has collapsed in the last few days to a one-month low from a five-month high.

Chart: Bloomberg

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/vVra8qyxcXE/story01.htm Tyler Durden

Submitted by W. Ben Hunt via Epsilon Theory blog,

The illustration at the top of this note is taken from Charles Darwin’s so-called “B” notebook, where in mid-summer 1837 on page 36 he wrote the words “I think” followed by the first depiction of an evolutionary tree. The rest, as they say, is history, first with the publication of “The Voyage of the Beagle” in 1839, which made Darwin famous, and then with “On the Origin of Species” in 1859, which made him immortal. I think it’s fair to say that the theory of evolution is the most influential pillar of science since the development of Newtonian physics, topping even the theory of relativity developed by Einstein et al., and has done more to shape the modern human belief system around the Narrative of Science than anything since Galileo’s introduction of the idea of empirical tests and the scientific method in the 17th century.

I want to use evolutionary theory as a perspective for understanding human behavior within capital markets for a couple of reasons. First, I think it’s a more useful perspective than what economic theory has become … a cloistered, brittle theology that day after day becomes more abstract in its formation and more narrow in its application. I’m not saying that modern economic theory is wrong. I’m saying that it’s a beautiful, elegant mental construct – much like the medieval Christian construct of Heaven’s hierarchy with Seraphim, Cherubim, Ophanim, Thrones, etc. all in their proper sphere and convoluted yet logical relationship with each other. Both constructs are marvels of inspiration and genius, for sure, and yet they are useful to my life … how, exactly?

Gustave Doré, “Rosa Celeste, The Divine Comedy Canto XXXI”

Second, I want to use evolutionary theory because it is a Narrative with a great deal of power and meaning for anyone reading this note, enough power and meaning (I hope) to make a new vantage point on markets possible. The hardest thing in the world is to break free from the perspective imposed by an entrenched social construction while you’re immersed in it, and so much of history seems ludicrous to our modern eye in this respect. What do you mean the Italian State put Galileo on trial for saying the Earth goes around the sun, all evidence to the contrary? Boy, those guys must have been really stupid. Well … no, they were just as smart as we are. But they were immersed in an entrenched Biblical Narrative that defined their reality more than any amount of empirical evidence from astronomical observations ever could. Rather than argue against a mental construct of markets derived from the entrenched Narrative of Modern Economic Science, I’d rather argue for a mental construct of markets derived from the equally entrenched Narrative of Modern Evolutionary Science. Galileo didn’t have that option, as he was just getting the Narrative of Science off the ground. Fortunately, I do.¹

But as is often the case, the Scientific Narrative of our imagination and popular belief is somewhat at odds with the usefulness of the actual scientific toolkit. If you look again at Darwin’s drawing, it doesn’t look much like a tree in the botanical sense, or even what we tend to think of as an evolutionary tree, with a “primitive” species forming the trunk and “advanced” species forming the branches, such that the higher you go in the tree the more advanced the life-form must be. The truth, as Darwin wrote, is that “it is absurd to talk of one animal being higher than another”, and the popular conception of evolution-as- hierarchy is just plain wrong. No, what Darwin meant by an evolutionary tree is more like a map. There’s an element of time embedded in the map, with ancestors at the trunk and descendants as you move away from that trunk (hence the title of Darwin’s second-most famous book, “The Descent of Man”), but descendant species are not more advanced in nature, they are simply more suited to survival in their particular environment.

This, I think, is the first and most basic lesson of an evolutionary perspective properly applied: we are well served as investors to jettison the superiority complex that comes with living in the present and looking back on what naturally seems a benighted past. The notions of liberal progress and evolution-as-hierarchy are so deeply ingrained that we assume that whatever behaviors are new or modern, including modern investment management practices or modern investment strategies (or modern monetary policy), must be part and parcel of some advancement over what existed in the past. In truth there is no up-and-to-the-right arrow associated with evolution; there is no intelligent design pushing us “forward”. Modern behavioral adaptations are probably more complex than historical behaviors (adaptation tends towards specialization and complexity), but that’s a far cry from being inherently superior on some absolutist scale. All you can say about a successful behavioral adaptation is that it has made its adopters more suitable for their current environment, where suitability and success are defined in terms of the prevalence of the population of behavioral adopters, not the individual achievement of whatever goal the behavior is ostensibly supposed to address.

Using concepts like “suitability” and “population” and “adaptation” and “habitat” to describe human behaviors in market settings may seem like a trivial (or weird) distinction from the dominant mental constructs we use to understand The Market (itself a mental construct of a particular sort), but I hope to make the case over the next few months that it can make all the difference in the world.

Here’s a small example of what I mean. A fad diet that gains millions of converts is almost certainly a successful behavioral adaptation even if no one actually keeps off a single pound. If you want a more incendiary phrasing, replace “fad diet” with “routine mammograms” or “daily multivitamins” or, for you risk managers out there, “portfolio stress scenarios”. There’s a long list of modern behavioral adaptations that provide little or no direct benefit to their adopters, but are nevertheless useful in advancing the strength and numbers of the population of adopters through a dynamic based on biological or social signaling. I take a multivitamin every day, even though I think we can all agree that I am unlikely to develop a case of scurvy in its absence and that taking 30x the recommended daily allowance of thiamin is just silly. Why? Because I can say to my wife and my kids that I do. It makes them feel better about me. To them it’s shorthand for “I’m taking care of myself” and they treat me as more fit and powerful than if they think that I’m “not taking care of myself.” I am a slightly more successful husband and father because I take a multivitamin every day, as is every middle-aged American male who shares this behavioral trait with me. As a group, we do a little bit better in our family lives than the population of middle-aged American males who don’t. So if you’re a risk manager and you run a daily suite of portfolio stress scenarios, go right ahead. It is a perfectly rational thing to do even if you don’t think there is any direct benefit. But you’ll understand your own behavior better (and thus choose to embrace or reject that behavior with awareness) if you recognize portfolio stress scenarios for what they are … the equivalent of a bird species evolving an elaborate but functionally rather useless dance to demonstrate relative fitness to other members of the species.

Darwin’s evolutionary tree encapsulates these concepts of suitability, population, adaptation, and habitat. It is a depiction of adaptive radiation, one of the core principles of evolutionary theory and the source of a valuable toolkit for understanding markets. Adaptive radiation describes the creation of new species through the opportunistic spread of an old species into new habitats. Over time, adaptations that make the species more suitable for the new habitat are naturally selected, and as those adaptations grow in number and scope the population of the original species in the new habitat becomes increasingly differentiated from the population of the original species in another new habitat or the old habitat. Ultimately the populations are unrecognizable to each other from a breeding perspective (which is the only perspective that matters in natural selection terms), and you have new species in the various new habitats … but still sharing an ancestral genetic makeup and some sort of morphology or physical instantiation of that shared ancestral DNA.

Adaptive radiation is at the core of Darwin’s eureka moment on the Galapagos Islands, where he identified multiple species of finches, each inhabiting a different ecological or geographical niche.

Adaptive radiation of Galapagos finches (evolutionproject.wikispaces.com)

Darwin’s insight was to recognize that each separate species must have descended from a common ancestral finch, and that natural selection over hundreds of thousands of generations would drive preferential survival for those sub-populations that developed habitat-specific adaptations and eventually “create” the separate species.

This evolutionary process of adaptive radiation occurs everywhere life and habitat change meet, from a minor island chain to a small African lake to Earth itself. Here, for example, is the adaptive radiation pattern of forelimbs in mammals around the world.

Adaptive radiation of the mammalian forelimb (Jerry Crimson Mann)

How is the concept of adaptive radiation useful to our understanding of markets? Let’s start by taking seriously the notion that there are distinct populations of market participants, call them investor “species” if you like, developed over long periods of time through the adaptation of ancestral market attributes to provide improved suitability for specific market “habitats”. Obviously the morphology or physical instantiation of these attributes isn’t going to be a skeletal system as it was with the mammalian forelimb. It has to be something much more specific to the human animal, a creature with characteristics that throw traditional evolutionary theory for a loop.

First, we have a unique physical combination of enormous brains and non-specialized, grasping hands within an overall body size that is large enough to manipulate the environment and control fire (living on land in an oxygen-rich atmosphere helps quite a bit, too … sorry, dolphins). As a result we have the ability to create both physical constructs (inventions) and mental constructs (ideas) that accelerate our adaptation process exponentially beyond what is possible through natural biologic
al selection alone. Homo sapiens broke out of Africa only 60,000 years ago! This is less than the blink of an eye in evolutionary terms, an almost comically short period of time for a species to not only spread globally, but to transform the entire world into a habitat of its own choosing. Science fiction authors are fond of the “terra-forming” trope, where an alien planet is made Earth-like through some application of massive, futuristic technologies. What they really mean is human-forming, and our own species history proves that it requires remarkably little time and remarkably little technology to accomplish that feat when you can take adaptation out of the realm of biological reproduction and place it into the realms of inventions and ideas.

Second, we are almost unique among mammals (it’s just us and naked mole rats … funny, but true) in that we are social animals. I mean this in the sense of what’s called “eusociality”, where populations of a species are organized by nests or colonies in which you find cooperative brood care, overlapping generations, and a division of labor between groups of individuals. Eusociality is the common thread between the most successful insect species on earth – the ants, the bees, and the termites – which is to say it is the common thread between the most successful life forms on Earth, period. But despite its sheer potency as an adaptation, eusociality is extremely rare outside of the insect world, as it requires a tremendously lucky deal of the DNA cards in terms of genetic pre- adaptations. The human animal was dealt just such a lucky hand, a straight flush in poker terms, and by combining the adaptive robustness and potency of eusociality with our individual inventiveness we are truly a uniquely powerful life-form. Basically we are huge mammalian termites with self-awareness and fire. The rest of the world never had a chance.

It’s this termite aspect of the human animal that is most at odds with our popular conception of who we are, as well as the aspect that is most relevant for an evolutionary perspective on markets. I don’t want to overplay the termite angle, because most of the time our big brains give us enough self-awareness to act as individuals rather than as drones to some hive dictat … as Jon Haidt writes, “humans are 90 percent chimp and 10 percent bee.” But that 10% is enough to confound modern economic theory and account for otherwise inexplicable behavior in markets.

To understand how this 10% bee-ness is relevant for markets, we need to focus on the way in which information pervades and flows through eusocial colonies. I believe that eusocial species are more successful than non-eusocial species because they are more information-rich, particularly in the information embedded within the colony hierarchy … its biologically-based collective norms and regimes. Various eusocial insect species have invented assembly lines, domesticated animals, irrigated farms, and built air-conditioned cities with millions of inhabitants. They all have complex caste systems with extraordinarily effective divisions of labor. There’s an enormous amount of information in these behaviors, all carried within the individual insect DNA but only expressed within the collective insect group.

Each individual ant or bee or termite may “know” what to do as an individual piece of the puzzle, but the only way to create the group expression of all this information is to act in a coordinated fashion, not as individuals. Acting as a coordinated group requires two things beyond the behavioral instruction book that every eusocial insect is born with – a language to transfer informational signals and a sensory/neural system that is constantly looking for and responding to these signals. Ants and bees and termites all have a complex language with a discernible grammar, and they are biologically evolved to respond to these language signals. But it’s the constancy of both the communication and the behavioral response that is the hallmark of every eusocial species and sets them apart from other group-oriented but non-eusocial species like a pack of wild dogs or a troop of chimps. Ants talk to each other all the time. They live in an atmosphere that is literally swimming with pheromone molecules conveying instructions and signals from other ants, and they can’t help themselves but to respond behaviorally to those signals. Sound familiar? How many human-generated or human-mediated signals hit you every day? For me it’s easily 4,000 to 5,000 and it’s probably a lot more than that once you start breaking down media and complex messages into their component signals. In fact, most days I don’t think I am ever separated from some sort of human-mediated signal for more than a few minutes. How many times did you check your email or Twitter feed today? Do you feel uncomfortable if you don’t respond to your spouse or child’s text message right away, even if it’s something trivial? Welcome to the world of the ant.

This is the eusocial aspect of the human animal, the 10% bee-ness that we are evolved to possess: we can no more ignore a speech by Ben Bernanke than a worker bee can ignore a pheromone from her queen. We are evolved not only to live in groups, but also to seek out and immerse ourselves in signals from other humans in our groups and, crucially, to respond to those signals in predictable, group-oriented ways. A Bernanke speech is a more complex signal than a queen bee pheromone, and our specific response to the Bernanke signal is not biologically hard-wired, but our hunger for human-mediated signals and our interpretation of those signals in the context of group dynamics IS biologically hard-wired. Language and communication are everything to the eusocial piece of the human animal, not just what is said, but who is saying it and how it is said. Thus language and communication are the human attributes we must examine to track adaptive radiation in the human context.

Iranian language family tree (Araz)

Actually, I don’t think that’s a terribly contentious statement, as even a cursory look at the human diaspora out of Africa and the subsequent behavioral adaptations of the human animal to their new geographies demonstrates both a classic adaptive radiation pattern and a tit-for-tat marriage with language development and evolution. Here, for example, is the Iranian language family tree, which I chose just for its obvious resemblance to Darwin’s notebook doodle and its explicit linkage of geographic habitat to language adaptation.

But here’s a more contentious statement: I think that there are meaningfully distinct market languages that are just as powerful in reflecting market participant populations undergoing adaptive radiation as “real” languages have been in reflecting global human populations undergoing adaptive radiation. If I’m right, the entire toolbox of linguistics and evolutionary biology opens up to us. If I’m wrong, we’re left with lots of nice metaphors but not much in the way of practical applications.

What are these languages? I think the granddaddy of them all is the language of Value, together with its grammar, Reversion to the Mean. To have an instituti
onal market you must have market makers, so I would guess that the language of Liquidity was not far behind in development, as was the language of Growth, together with its grammar, Extrapolation. These are the three great proto- languages of the market (although the language of Liquidity is rapidly becoming a non-human tongue), and all market participants think and converse predominantly in one of them.

Can you think in more than one proto-language? I don’t believe so, any more than you can be both a dyed-in-the-wool Republican and Democrat at the same time. Can you speak more than one proto-language? Sure, in the same way that a lot of animals can both walk and swim. But if I had to bet on the winner of a 100-meter freestyle swim I’d put my money on the dolphin.

Aren’t there really dozens of distinct market languages out there? Absolutely, but I’d characterize them as genetic offshoots of the proto-languages, as the reflection of the adaptive radiation that has occurred as these ancestral investor “species” moved into new “habitats” and took on behavioral adaptations that made them more suitable for that environment. A value-oriented stock-picker today speaks an almost entirely different investment language than a value-oriented macro investor, and if you looked at them from a distance you might be fooled by the morphology, by the equivalent physical distinction between a big black ground finch and a tiny gray warbler finch. But if you pay attention to the grammar of their language, you’d see that they both interpret the world through a reversion-to-the-mean prism. This is their ancestral genetic code, and I believe that there are useful and practical applications that stem from making this connection, by observing that the population of value-oriented macro investors has more in common (from this perspective) with a population of stock-pickers than with growth-oriented macro investors.

Essentially I’m saying that every investor has a “market DNA” … not a genetic code that you’re born with, but a distinct collection of behavioral attributes that can be measured and summed up by the language you speak and think with to express your market behaviors. How did you come by this market DNA? The same way you absorb every other collection of behavioral attributes that makes you a member of whatever human tribes you belong to … your relatives’ attitudes towards money and risk when you were a child, your friends, your first job in financial services, a mentor, a successful friend or colleague, the books you’ve read and the TV shows that you watch … there’s no mystery to this, and no shortcut to creating or changing this identity, either. There’s a huge body of empirical work in political science about what’s called Party Identification, the way we identify with a political party at an early age and then tend to stick with that association through thick and thin for the rest of our lives. We create this stable political association out of lot fewer stimuli than we receive on money and investing. Why would the result be any different?

I included this quote by E.O. Wilson at the outset, but it’s so important for the concept of Adaptive Investing that it bears repeating:

As market participants we are acting as both individuals and, whether we realize it or not, as members of a distinct group with a distinct language and a distinct set of behavioral adaptations to our particular market habitat. Our group is, in a very real sense, in competition with other groups for all the good things that a market can provide. Our market interactions are almost always with fellow members of our group. They are who we talk with, they are who we listen to, they are who we transact with. That last bit means that we are indeed competing with other individuals in our groups … there’s no denying that. But in meaningful ways we are also cooperating with other individuals within our investor “species”. As human animals we are biologically hard-wired to live through and for our groups as well as ourselves, and our market lives are no exception.

If your view of capital markets is solely through the lens of individual decision-making, of a buyer and a seller agreeing to a transaction regarding some security based on their individual utility functions, then you are only seeing a piece of the puzzle. Unfortunately, all of modern microeconomic theory – ALL of it – is based on assumptions of individual decision-making and optimization. Until we take context and populations seriously, until we recognize that economic behaviors are not simply optimization exercises against some exogenously assumed set of environmental constraints, until we understand that individual behavioral outcomes and decisions are, in part, driven by group dynamics and individual traits that only make sense in a group context … we are looking through a glass, darkly.

Whew! Okay, Ben, that’s a lot of words and imagery, but what’s the pay-off?

Here are a few brief examples of what it means to bring linguistic and evolutionary biology toolboxes – where the most advanced game theory and information theory of the past 20 years has been developed – to bear on market puzzles. I’ll unpack each in a future note, and there’s a lot more where this came from.

One of Jim Cramer’s favorite lines is “there’s always a bull market somewhere,” and this always used to annoy me as just another hucksterism. Now I think it’s a pretty good point. If your collection of investment behavioral adaptations is no longer working so well because your investment environment has changed … and here I’m looking at you, Mr. Value Investor … you can either change your collection of behaviors or you can move to a habitat that is more conducive to your attributes. The former is absolutely impossible for any non-self aware animal, and darn near impossible for even the most self-aware investor. A tiger can’t change his stripes, a seed-cracking finch can’t start eating insects, and a value investor can’t become a momentum day-trader. The latter – changing your habitat – is similarly impossible if you don’t have the means to get from one habitat to another. If you’re a snake on a tropical island and disaster wipes out your habitat … you will soon be a dead snake. If you’re a bird, on the other hand, hope is on the next island over. Will it be a struggle to find your way on what is probably a crowded new island? Sure, but that’s better than being a dead snake. I think that market participants often overestimate the value of their factual knowledge and personal experience within a particular market “habitat”, whether that’s an industry sector or asset class, when what’s really of importance is the fit between personal attributes and whatever habitat you’re in. A value investor can always learn new facts, but h
e can’t “learn” how to be a growth investor. The liquidity of capital gives you wings, and it’s probably a good idea to use them when you have to.

Still … it sure would be nice to know if the island you’re flying to is a new Eden where your investment attributes are highly suitable or if you’re flying into a new Hell, and this is where the linguistics toolbox can help. What we’re interested in measuring is HOW other market participants are talking about this new habitat, not WHAT they are saying. If you’re a value investor, you want to hear other value investors using value language and reversion-to-the-mean grammar in their description of the habitat, not growth investors using growth language and extrapolation grammar. It doesn’t really matter what your same-species investors are saying about the habitat (in fact, if they’re all saying wonderful things about the new habitat in your language, you’ve probably already missed the low-hanging fruit, whatever that means to your species). All you should care about is whether you’ve got a critical mass of fellow species members to interact with, and this is what an evolutionary perspective can reveal.

The same principle applies for single security analysis, particularly if you’re thinking about going short. I say this because shorts don’t work as the mirror image of longs. Longs tend to grind their way higher, as good news and story-supporting news is dribbled out more or less intentionally bit by bit. Shorts, on the other hand, work in punctuated fashion, as bad news comes out in an unanticipated rush. (Steve Strongin at Goldman Sachs wrote a tremendous article on this in April 2009, titled “Why Shorts Aren’t Longs: Stockpicker’s Reality Part IV”; it’s a great read for anyone interested in information flow and investing.) Put simply, shorts only work when the bull story breaks. Even so, if the story is not being told in the language that fits your market DNA, you’re going to have no idea whether to press the short or cover on the break. Moreover, you’re far more likely to have a sense of the catalyst that actually breaks the bull story if you’re in sync with the language of the prevalent conversation, which gives you a fighting chance to establish a position ahead of the break without getting killed by poor timing.

For example, let’s say that you shorted Twitter right after the IPO because you’re a value investor and you believe that the stock is just crazily priced on a value basis. The stock has gone against you significantly in recent weeks, but over the past few days it’s declined about 15%. Okay … what now? Do you press the short because you think maybe the story is broken, or do you thank your lucky stars for the brief reprieve in the onslaught and cover? You have no insight on this whatsoever because the bull story on Twitter has nothing to do with value and the recent price decline has nothing to do with value. Everything about the stock is being spoken with the grammar of extrapolation, which you don’t understand, and the dominant population around the stock is not your tribe. I know what I’d do with the position if I were you, but then I wouldn’t have put it on in the first place.

One last example, something using the biology toolkit … let’s say that you’re an allocator trying to evaluate several different strategies. Some present themselves as alpha-generating strategies, where the goal is uncorrelated absolute returns; others are smart (i.e. inexpensive) strategies for capturing broad market returns; others are some mix of the two. You can calculate Sharpe ratios, look at volatility and drawdowns, all the usual stuff, but you can’t shake the feeling that you are comparing apples and oranges here. Which of course, you are.

One new perspective on this age-old question is to look less at the external characteristics or morphology of the strategies and pay more attention to their market DNA, in particular to the grammar of the strategy language in theory and practice. This is a crucial aspect of diversification and risk management in portfolio construction that I think is often overlooked.

Or expressed in a more formal way – how suitable are the embedded utility functions in these investment strategies for the market environments they inhabit? What I mean by this is that adaptation means different things to a species at different stages in its relationship with its habitat. In the adaptive radiation stage, where the new species is just being “created”, the trick is keeping the sub-population together long enough for natural selection to do its work and the adaptations to “take”. There is no substitute for a high growth rate in this opportunistic phase. On the other hand, once you have a well-established species the adaptive focus shifts from high growth to maintaining its established position in the face of unknown shocks to its habitat. Suitability in this core phase of a species lifecycle is a function of adaptations that confer robustness on the population.

I believe that there are strong corollaries between an alpha-generation investment strategy and an opportunistic phase sub-population moving into a new habitat, as well as between a broad market return strategy and a core phase population maintaining its position within an existing habitat. The former lend themselves to behaviors that prioritize growth rates; the latter to behaviors that prioritize robustness. There’s a large body of work on both types of behaviors in biology and economics, and I’m pretty giddy about the opportunity to synthesize this with a game theoretic toolkit. Ultimately, I think, a biological perspective holds the key for constructing an exciting new way of understanding risk and reward in portfolio construction, a perspective that avoids the one-size-fits-all utility model that pervades politics and the treat-utility-as-exogenous assumption that pervades economics. Constructing that new perspective on investment risk and reward is the ultimate goal of the Adaptive Investing project, and I’ll be building this in plain sight and in real time at Epsilon Theory. Like evolution itself I’m sure there will be false starts and dead ends aplenty, but with your participation I’m confident we can come up with a set of behavioral adaptations that will make the Epsilon Theory sub-population more suitable for our unstable markets and our unstable world.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/VQjvcB1sq-w/story01.htm Tyler Durden

Submitted by W. Ben Hunt via Epsilon Theory blog,

The illustration at the top of this note is taken from Charles Darwin’s so-called “B” notebook, where in mid-summer 1837 on page 36 he wrote the words “I think” followed by the first depiction of an evolutionary tree. The rest, as they say, is history, first with the publication of “The Voyage of the Beagle” in 1839, which made Darwin famous, and then with “On the Origin of Species” in 1859, which made him immortal. I think it’s fair to say that the theory of evolution is the most influential pillar of science since the development of Newtonian physics, topping even the theory of relativity developed by Einstein et al., and has done more to shape the modern human belief system around the Narrative of Science than anything since Galileo’s introduction of the idea of empirical tests and the scientific method in the 17th century.

I want to use evolutionary theory as a perspective for understanding human behavior within capital markets for a couple of reasons. First, I think it’s a more useful perspective than what economic theory has become … a cloistered, brittle theology that day after day becomes more abstract in its formation and more narrow in its application. I’m not saying that modern economic theory is wrong. I’m saying that it’s a beautiful, elegant mental construct – much like the medieval Christian construct of Heaven’s hierarchy with Seraphim, Cherubim, Ophanim, Thrones, etc. all in their proper sphere and convoluted yet logical relationship with each other. Both constructs are marvels of inspiration and genius, for sure, and yet they are useful to my life … how, exactly?

Gustave Doré, “Rosa Celeste, The Divine Comedy Canto XXXI”

Second, I want to use evolutionary theory because it is a Narrative with a great deal of power and meaning for anyone reading this note, enough power and meaning (I hope) to make a new vantage point on markets possible. The hardest thing in the world is to break free from the perspective imposed by an entrenched social construction while you’re immersed in it, and so much of history seems ludicrous to our modern eye in this respect. What do you mean the Italian State put Galileo on trial for saying the Earth goes around the sun, all evidence to the contrary? Boy, those guys must have been really stupid. Well … no, they were just as smart as we are. But they were immersed in an entrenched Biblical Narrative that defined their reality more than any amount of empirical evidence from astronomical observations ever could. Rather than argue against a mental construct of markets derived from the entrenched Narrative of Modern Economic Science, I’d rather argue for a mental construct of markets derived from the equally entrenched Narrative of Modern Evolutionary Science. Galileo didn’t have that option, as he was just getting the Narrative of Science off the ground. Fortunately, I do.¹

But as is often the case, the Scientific Narrative of our imagination and popular belief is somewhat at odds with the usefulness of the actual scientific toolkit. If you look again at Darwin’s drawing, it doesn’t look much like a tree in the botanical sense, or even what we tend to think of as an evolutionary tree, with a “primitive” species forming the trunk and “advanced” species forming the branches, such that the higher you go in the tree the more advanced the life-form must be. The truth, as Darwin wrote, is that “it is absurd to talk of one animal being higher than another”, and the popular conception of evolution-as- hierarchy is just plain wrong. No, what Darwin meant by an evolutionary tree is more like a map. There’s an element of time embedded in the map, with ancestors at the trunk and descendants as you move away from that trunk (hence the title of Darwin’s second-most famous book, “The Descent of Man”), but descendant species are not more advanced in nature, they are simply more suited to survival in their particular environment.

This, I think, is the first and most basic lesson of an evolutionary perspective properly applied: we are well served as investors to jettison the superiority complex that comes with living in the present and looking back on what naturally seems a benighted past. The notions of liberal progress and evolution-as-hierarchy are so deeply ingrained that we assume that whatever behaviors are new or modern, including modern investment management practices or modern investment strategies (or modern monetary policy), must be part and parcel of some advancement over what existed in the past. In truth there is no up-and-to-the-right arrow associated with evolution; there is no intelligent design pushing us “forward”. Modern behavioral adaptations are probably more complex than historical behaviors (adaptation tends towards specialization and complexity), but that’s a far cry from being inherently superior on some absolutist scale. All you can say about a successful behavioral adaptation is that it has made its adopters more suitable for their current environment, where suitability and success are defined in terms of the prevalence of the population of behavioral adopters, not the individual achievement of whatever goal the behavior is ostensibly supposed to address.

Using concepts like “suitability” and “population” and “adaptation” and “habitat” to describe human behaviors in market settings may seem like a trivial (or weird) distinction from the dominant mental constructs we use to understand The Market (itself a mental construct of a particular sort), but I hope to make the case over the next few months that it can make all the difference in the world.

Here’s a small example of what I mean. A fad diet that gains millions of converts is almost certainly a successful behavioral adaptation even if no one actually keeps off a single pound. If you want a more incendiary phrasing, replace “fad diet” with “routine mammograms” or “daily multivitamins” or, for you risk managers out there, “portfolio stress scenarios”. There’s a long list of modern behavioral adaptations that provide little or no direct benefit to their adopters, but are nevertheless useful in advancing the strength and numbers of the population of adopters through a dynamic based on biological or social signaling. I take a multivitamin every day, even though I think we can all agree that I am unlikely to develop a case of scurvy in its absence and that taking 30x the recommended daily allowance of thiamin is just silly. Why? Because I can say to my wife and my kids that I do. It makes them feel better about me. To them it’s shorthand for “I’m taking care of myself” and they treat me as more fit and powerful than if they think that I’m “not taking care of myself.” I am a slightly more successful husband and father because I take a multivitamin every day, as is every middle-aged American male who shares this behavioral trait with me. As a group, we do a little bit better in our family lives than the population of middle-aged American males who don’t. So if you’re a risk manager and you run a daily suite of portfolio stress scenarios, go right ahead. It is a perfectly rational thing to do even if you don’t think there is any direct benefit. But you’ll understand your own behavior better (and thus choose to embrace or reject that behavior with awareness) if you recognize portfolio stress scenarios for what they are … the equivalent of a bird species evolving an elaborate but functionally rather useless dance to demonstrate relative fitness to other members of the species.

Darwin’s evolutionary tree encapsulates these concepts of suitability, population, adaptation, and habitat. It is a depiction of adaptive radiation, one of the core principles of evolutionary theory and the source of a valuable toolkit for understanding markets. Adaptive radiation describes the creation of new species through the opportunistic spread of an old species into new habitats. Over time, adaptations that make the species more suitable for the new habitat are naturally selected, and as those adaptations grow in number and scope the population of the original species in the new habitat becomes increasingly differentiated from the population of the original species in another new habitat or the old habitat. Ultimately the populations are unrecognizable to each other from a breeding perspective (which is the only perspective that matters in natural selection terms), and you have new species in the various new habitats … but still sharing an ancestral genetic makeup and some sort of morphology or physical instantiation of that shared ancestral DNA.

Adaptive radiation is at the core of Darwin’s eureka moment on the Galapagos Islands, where he identified multiple species of finches, each inhabiting a different ecological or geographical niche.

Adaptive radiation of Galapagos finches (evolutionproject.wikispaces.com)

Darwin’s insight was to recognize that each separate species must have descended from a common ancestral finch, and that natural selection over hundreds of thousands of generations would drive preferential survival for those sub-populations that developed habitat-specific adaptations and eventually “create” the separate species.

This evolutionary process of adaptive radiation occurs everywhere life and habitat change meet, from a minor island chain to a small African lake to Earth itself. Here, for example, is the adaptive radiation pattern of forelimbs in mammals around the world.

Adaptive radiation of the mammalian forelimb (Jerry Crimson Mann)

How is the concept of adaptive radiation useful to our understanding of markets? Let’s start by taking seriously the notion that there are distinct populations of market participants, call them investor “species” if you like, developed over long periods of time through the adaptation of ancestral market attributes to provide improved suitability for specific market “habitats”. Obviously the morphology or physical instantiation of these attributes isn’t going to be a skeletal system as it was with the mammalian forelimb. It has to be something much more specific to the human animal, a creature with characteristics that throw traditional evolutionary theory for a loop.

First, we have a unique physical combination of enormous brains and non-specialized, grasping hands within an overall body size that is large enough to manipulate the environment and control fire (living on land in an oxygen-rich atmosphere helps quite a bit, too … sorry, dolphins). As a result we have the ability to create both physical constructs (inventions) and mental constructs (ideas) that accelerate our adaptation process exponentially beyond what is possible through natural biological selection alone. Homo sapiens broke out of Africa only 60,000 years ago! This is less than the blink of an eye in evolutionary terms, an almost comically short period of time for a species to not only spread globally, but to transform the entire world into a habitat of its own choosing. Science fiction authors are fond of the “terra-forming” trope, where an alien planet is made Earth-like through some application of massive, futuristic technologies. What they really mean is human-forming, and our own species history proves that it requires remarkably little time and remarkably little technology to accomplish that feat when you can take adaptation out of the realm of biological reproduction and place it into the realms of inventions and ideas.

Second, we are almost unique among mammals (it’s just us and naked mole rats … funny, but true) in that we are social animals. I mean this in the sense of what’s called “eusociality”, where populations of a species are organized by nests or colonies in which you find cooperative brood care, overlapping generations, and a division of labor between groups of individuals. Eusociality is the common thread between the most successful insect species on earth – the ants, the bees, and the termites – which is to say it is the common thread between the most successful life forms on Earth, period. But despite its sheer potency as an adaptation, eusociality is extremely rare outside of the insect world, as it requires a tremendously lucky deal of the DNA cards in terms of genetic pre- adaptations. The human animal was dealt just such a lucky hand, a straight flush in poker terms, and by combining the adaptive robustness and potency of eusociality with our individual inventiveness we are truly a uniquely powerful life-form. Basically we are huge mammalian termites with self-awareness and fire. The rest of the world never had a chance.

It’s this termite aspect of the human animal that is most at odds with our popular conception of who we are, as well as the aspect that is most relevant for an evolutionary perspective on markets. I don’t want to overplay the termite angle, because most of the time our big brains give us enough self-awareness to act as individuals rather than as drones to some hive dictat … as Jon Haidt writes, “humans are 90 percent chimp and 10 percent bee.” But that 10% is enough to confound modern economic theory and account for otherwise inexplicable behavior in markets.

To understand how this 10% bee-ness is relevant for markets, we need to focus on the way in which information pervades and flows through eusocial colonies. I believe that eusocial species are more successful than non-eusocial species because they are more information-rich, particularly in the information embedded within the colony hierarchy … its biologically-based collective norms and regimes. Various eusocial insect species have invented assembly lines, domesticated animals, irrigated farms, and built air-conditioned cities with millions of inhabitants. They all have complex caste systems with extraordinarily effective divisions of labor. There’s an enormous amount of information in these behaviors, all carried within the individual insect DNA but only expressed within the collective insect group.

Each individual ant or bee or termite may “know” what to do as an individual piece of the puzzle, but the only way to create the group expression of all this information is to act in a coordinated fashion, not as individuals. Acting as a coordinated group requires two things beyond the behavioral instruction book that every eusocial insect is born with – a language to transfer informational signals and a sensory/neural system that is constantly looking for and responding to these signals. Ants and bees and termites all have a complex language with a discernible grammar, and they are biologically evolved to respond to these language signals. But it’s the constancy of both the communication and the behavioral response that is the hallmark of every eusocial species and sets them apart from other group-oriented but non-eusocial species like a pack of wild dogs or a troop of chimps. Ants talk to each other all the time. They live in an atmosphere that is literally swimming with pheromone molecules conveying instructions and signals from other ants, and they can’t help themselves but to respond behaviorally to those signals. Sound familiar? How many human-generated or human-mediated signals hit you every day? For me it’s easily 4,000 to 5,000 and it’s probably a lot more than that once you start breaking down media and complex messages into their component signals. In fact, most days I don’t think I am ever separated from some sort of human-mediated signal for more than a few minutes. How many times did you check your email or Twitter feed today? Do you feel uncomfortable if you don’t respond to your spouse or child’s text message right away, even if it’s something trivial? Welcome to the world of the ant.

This is the eusocial aspect of the human animal, the 10% bee-ness that we are evolved to possess: we can no more ignore a speech by Ben Bernanke than a worker bee can ignore a pheromone from her queen. We are evolved not only to live in groups, but also to seek out and immerse ourselves in signals from other humans in our groups and, crucially, to respond to those signals in predictable, group-oriented ways. A Bernanke speech is a more complex signal than a queen bee pheromone, and our specific response to the Bernanke signal is not biologically hard-wired, but our hunger for human-mediated signals and our interpretation of those signals in the context of group dynamics IS biologically hard-wired. Language and communication are everything to the eusocial piece of the human animal, not just what is said, but who is saying it and how it is said. Thus language and communication are the human attributes we must examine to track adaptive radiation in the human context.

Iranian language family tree (Araz)

Actually, I don’t think that’s a terribly contentious statement, as even a cursory look at the human diaspora out of Africa and the subsequent behavioral adaptations of the human animal to their new geographies demonstrates both a classic adaptive radiation pattern and a tit-for-tat marriage with language development and evolution. Here, for example, is the Iranian language family tree, which I chose just for its obvious resemblance to Darwin’s notebook doodle and its explicit linkage of geographic habitat to language adaptation.

But here’s a more contentious statement: I think that there are meaningfully distinct market languages that are just as powerful in reflecting market participant populations undergoing adaptive radiation as “real” languages have been in reflecting global human populations undergoing adaptive radiation. If I’m right, the entire toolbox of linguistics and evolutionary biology opens up to us. If I’m wrong, we’re left with lots of nice metaphors but not much in the way of practical applications.

What are these languages? I think the granddaddy of them all is the language of Value, together with its grammar, Reversion to the Mean. To have an institutional market you must have market makers, so I would guess that the language of Liquidity was not far behind in development, as was the language of Growth, together with its grammar, Extrapolation. These are the three great proto- languages of the market (although the language of Liquidity is rapidly becoming a non-human tongue), and all market participants think and converse predominantly in one of them.

Can you think in more than one proto-language? I don’t believe so, any more than you can be both a dyed-in-the-wool Republican and Democrat at the same time. Can you speak more than one proto-language? Sure, in the same way that a lot of animals can both walk and swim. But if I had to bet on the winner of a 100-meter freestyle swim I’d put my money on the dolphin.

Aren’t there really dozens of distinct market languages out there? Absolutely, but I’d characterize them as genetic offshoots of the proto-languages, as the reflection of the adaptive radiation that has occurred as these ancestral investor “species” moved into new “habitats” and took on behavioral adaptations that made them more suitable for that environment. A value-oriented stock-picker today speaks an almost entirely different investment language than a value-oriented macro investor, and if you looked at them from a distance you might be fooled by the morphology, by the equivalent physical distinction between a big black ground finch and a tiny gray warbler finch. But if you pay attention to the grammar of their language, you’d see that they both interpret the world through a reversion-to-the-mean prism. This is their ancestral genetic code, and I believe that there are useful and practical applications that stem from making this connection, by observing that the population of value-oriented macro investors has more in common (from this perspective) with a population of stock-pickers than with growth-oriented macro investors.

Essentially I’m saying that every investor has a “market DNA” … not a genetic code that you’re born with, but a distinct collection of behavioral attributes that can be measured and summed up by the language you speak and think with to express your market behaviors. How did you come by this market DNA? The same way you absorb every other collection of behavioral attributes that makes you a member of whatever human tribes you belong to … your relatives’ attitudes towards money and risk when you were a child, your friends, your first job in financial services, a mentor, a successful friend or colleague, the books you’ve read and the TV shows that you watch … there’s no mystery to this, and no shortcut to creating or changing this identity, either. There’s a huge body of empirical work in political science about what’s called Party Identification, the way we identify with a political party at an early age and then tend to stick with that association through thick and thin for the rest of our lives. We create this stable political association out of lot fewer stimuli than we receive on money and investing. Why would the result be any different?

I included this quote by E.O. Wilson at the outset, but it’s so important for the concept of Adaptive Investing that it bears repeating:

As market participants we are acting as both individuals and, whether we realize it or not, as members of a distinct group with a distinct language and a distinct set of behavioral adaptations to our particular market habitat. Our group is, in a very real sense, in competition with other groups for all the good things that a market can provide. Our market interactions are almost always with fellow members of our group. They are who we talk with, they are who we listen to, they are who we transact with. That last bit means that we are indeed competing with other individuals in our groups … there’s no denying that. But in meaningful ways we are also cooperating with other individuals within our investor “species”. As human animals we are biologically hard-wired to live through and for our groups as well as ourselves, and our market lives are no exception.

If your view of capital markets is solely through the lens of individual decision-making, of a buyer and a seller agreeing to a transaction regarding some security based on their individual utility functions, then you are only seeing a piece of the puzzle. Unfortunately, all of modern microeconomic theory – ALL of it – is based on assumptions of individual decision-making and optimization. Until we take context and populations seriously, until we recognize that economic behaviors are not simply optimization exercises against some exogenously assumed set of environmental constraints, until we understand that individual behavioral outcomes and decisions are, in part, driven by group dynamics and individual traits that only make sense in a group context … we are looking through a glass, darkly.

Whew! Okay, Ben, that’s a lot of words and imagery, but what’s the pay-off?

Here are a few brief examples of what it means to bring linguistic and evolutionary biology toolboxes – where the most advanced game theory and information theory of the past 20 years has been developed – to bear on market puzzles. I’ll unpack each in a future note, and there’s a lot more where this came from.

One of Jim Cramer’s favorite lines is “there’s always a bull market somewhere,” and this always used to annoy me as just another hucksterism. Now I think it’s a pretty good point. If your collection of investment behavioral adaptations is no longer working so well because your investment environment has changed … and here I’m looking at you, Mr. Value Investor … you can either change your collection of behaviors or you can move to a habitat that is more conducive to your attributes. The former is absolutely impossible for any non-self aware animal, and darn near impossible for even the most self-aware investor. A tiger can’t change his stripes, a seed-cracking finch can’t start eating insects, and a value investor can’t become a momentum day-trader. The latter – changing your habitat – is similarly impossible if you don’t have the means to get from one habitat to another. If you’re a snake on a tropical island and disaster wipes out your habitat … you will soon be a dead snake. If you’re a bird, on the other hand, hope is on the next island over. Will it be a struggle to find your way on what is probably a crowded new island? Sure, but that’s better than being a dead snake. I think that market participants often overestimate the value of their factual knowledge and personal experience within a particular market “habitat”, whether that’s an industry sector or asset class, when what’s really of importance is the fit between personal attributes and whatever habitat you’re in. A value investor can always learn new facts, but he can’t “learn” how to be a growth investor. The liquidity of capital gives you wings, and it’s probably a good idea to use them when you have to.

Still … it sure would be nice to know if the island you’re flying to is a new Eden where your investment attributes are highly suitable or if you’re flying into a new Hell, and this is where the linguistics toolbox can help. What we’re interested in measuring is HOW other market participants are talking about this new habitat, not WHAT they are saying. If you’re a value investor, you want to hear other value investors using value language and reversion-to-the-mean grammar in their description of the habitat, not growth investors using growth language and extrapolation grammar. It doesn’t really matter what your same-species investors are saying about the habitat (in fact, if they’re all saying wonderful things about the new habitat in your language, you’ve probably already missed the low-hanging fruit, whatever that means to your species). All you should care about is whether you’ve got a critical mass of fellow species members to interact with, and this is what an evolutionary perspective can reveal.

The same principle applies for single security analysis, particularly if you’re thinking about going short. I say this because shorts don’t work as the mirror image of longs. Longs tend to grind their way higher, as good news and story-supporting news is dribbled out more or less intentionally bit by bit. Shorts, on the other hand, work in punctuated fashion, as bad news comes out in an unanticipated rush. (Steve Strongin at Goldman Sachs wrote a tremendous article on this in April 2009, titled “Why Shorts Aren’t Longs: Stockpicker’s Reality Part IV”; it’s a great read for anyone interested in information flow and investing.) Put simply, shorts only work when the bull story breaks. Even so, if the story is not being told in the language that fits your market DNA, you’re going to have no idea whether to press the short or cover on the break. Moreover, you’re far more likely to have a sense of the catalyst that actually breaks the bull story if you’re in sync with the language of the prevalent conversation, which gives you a fighting chance to establish a position ahead of the break without getting killed by poor timing.

For example, let’s say that you shorted Twitter right after the IPO because you’re a value investor and you believe that the stock is just crazily priced on a value basis. The stock has gone against you significantly in recent weeks, but over the past few days it’s declined about 15%. Okay … what now? Do you press the short because you think maybe the story is broken, or do you thank your lucky stars for the brief reprieve in the onslaught and cover? You have no insight on this whatsoever because the bull story on Twitter has nothing to do with value and the recent price decline has nothing to do with value. Everything about the stock is being spoken with the grammar of extrapolation, which you don’t understand, and the dominant population around the stock is not your tribe. I know what I’d do with the position if I were you, but then I wouldn’t have put it on in the first place.

One last example, something using the biology toolkit … let’s say that you’re an allocator trying to evaluate several different strategies. Some present themselves as alpha-generating strategies, where the goal is uncorrelated absolute returns; others are smart (i.e. inexpensive) strategies for capturing broad market returns; others are some mix of the two. You can calculate Sharpe ratios, look at volatility and drawdowns, all the usual stuff, but you can’t shake the feeling that you are comparing apples and oranges here. Which of course, you are.

One new perspective on this age-old question is to look less at the external characteristics or morphology of the strategies and pay more attention to their market DNA, in particular to the grammar of the strategy language in theory and practice. This is a crucial aspect of diversification and risk management in portfolio construction that I think is often overlooked.

Or expressed in a more formal way – how suitable are the embedded utility functions in these investment strategies for the market environments they inhabit? What I mean by this is that adaptation means different things to a species at different stages in its relationship with its habitat. In the adaptive radiation stage, where the new species is just being “created”, the trick is keeping the sub-population together long enough for natural selection to do its work and the adaptations to “take”. There is no substitute for a high growth rate in this opportunistic phase. On the other hand, once you have a well-established species the adaptive focus shifts from high growth to maintaining its established position in the face of unknown shocks to its habitat. Suitability in this core phase of a species lifecycle is a function of adaptations that confer robustness on the population.

I believe that there are strong corollaries between an alpha-generation investment strategy and an opportunistic phase sub-population moving into a new habitat, as well as between a broad market return strategy and a core phase population maintaining its position within an existing habitat. The former lend themselves to behaviors that prioritize growth rates; the latter to behaviors that prioritize robustness. There’s a large body of work on both types of behaviors in biology and economics, and I’m pretty giddy about the opportunity to synthesize this with a game theoretic toolkit. Ultimately, I think, a biological perspective holds the key for constructing an exciting new way of understanding risk and reward in portfolio construction, a perspective that avoids the one-size-fits-all utility model that pervades politics and the treat-utility-as-exogenous assumption that pervades economics. Constructing that new perspective on investment risk and reward is the ultimate goal of the Adaptive Investing project, and I’ll be building this in plain sight and in real time at Epsilon Theory. Like evolution itself I’m sure there will be false starts and dead ends aplenty, but with your participation I’m confident we can come up with a set of behavioral adaptations that will make the Epsilon Theory sub-population more suitable for our unstable markets and our unstable world.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/VQjvcB1sq-w/story01.htm Tyler Durden

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/V0UkzMzZySM/story01.htm williambanzai7

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/V0UkzMzZySM/story01.htm williambanzai7